Scott Olsson – Equity Analyst, Macquarie Investment Management
Tuesday 30 May 2017
Should Australian insurance companies be trading at a "Premium"?
Scott Olsson – Equity Analyst, Macquarie Investment Management
Rising insurance premiums appear to be driving Australian insurance company stock prices to lofty heights. The two largest domestic insurers, IAG and SUN, are currently trading 10-25% above their long-term average Price to Earnings ratios.
Typically when insurance premiums are rising, gaining exposure to General Insurance is a sound investment decision. However, our research indicates that rising prices are being offset by rising claims (or claims inflation).
The purpose of this month’s research insight is to de-mystify investing in insurance stocks and outline why we are sitting on the sidelines despite market hype that the insurance cycle is ‘turning’.
"What Matters" for Australian Insurance companies
As with all of our research we focus on the 2-3 things that drive company earnings and performance. For insurance companies this is:
- Margins (pricing vs claims)
- Capital strength
The cyclicality of pricing, claims and profitability in this industry over time is often referred to as the "insurance cycle".
What is the insurance cycle?
The insurance cycle is typically characterised by a number of years of steadily declining prices, followed by a period (tends to be ~1-2 years) of increasing prices. A number of distinct cycles can be observed in the data for the Australian insurance industry over the past 20 years, with each one lasting anywhere from three to seven years.
What stage of the cycle are we at in Australia?
Through 2014/15, pricing was generally reducing across most lines of business, with modest declines in Personal Lines (Motor, Home) but more substantial reductions in Commercial (Workers' Compensation, Liability). Pricing started improving across both segments over the course of 2016, and this appears to have continued so far 2017.
This has been driven by a range of factors, but two in particular stand out:
- Increased willingness of insurers to address declining profitability, despite the potential negative impact on volume growth and market share.
- Rising claims inflation in a number of classes.
All else being equal, price increases should improve insurer profitability. However, we believe the market may be under-estimating the extent to which the 2nd factor above, claims inflation, is diluting the benefit that ultimately flows to the bottom line.
Are price rises enough to counter claims inflation?
Most industry data available on claims inflation for insurance is either (i) distorted by large catastrophe events; (ii) lagged by more than six months, or (iii) both distorted and lagged. As such, we rely on consistent contact with companies and various industry contacts to help form our opinion on underlying trends in the industry.
The chart below lines up changes in average premiums against average claim size movements for one of the insurers' biggest and most important classes – Motor. Note that claims data is only available up to Sep-16.
Motor average premium vs average claims size growth
Source: APRA, Insurance Statistics Australia, Macquarie
There are some distortions in claims figures caused by natural disasters, however given relatively few events in 2016 we regard the recent data as reasonably representative. This shows that while premiums are increasing, claims appear to have been rising at a faster rate up until Sep 2016. Our channel checks indicate that this trend has not improved in 2017 – if anything inflation may have increased.
This is putting substantial pressure on the Motor claims line for most insurers. Given Motor insurance makes up ~30% of total insurance premium for both IAG and SUN, fortunes in this class will have a significant bearing on margins across the group.
Feedback on inflation in Home and Commercial classes is more mixed, but in general it appears that price increases are at least in some part also being eroded by rising claims inflation.
Impact on consumers
With prices rising across Motor, Home, and Commercial classes, the impact on household and business budgets from insurance costs looks set to increase. However there are some positives for consumers, including NSW CTP, where scheme reforms should lead to price reductions from December 2017.
Every company has a price – insurance stocks are factoring in material margin expansion
While improving pricing, and as a result increasing revenue, in General Insurance is a differentiating characteristic relative to many other sectors in the ASX200, we believe share prices are factoring in future outcomes that may prove optimistic.
The two large domestic insurers, IAG and SUN, are trading 10-25% above 3-year and long-term average Price to Earnings ratios, with earnings already factoring in some margin expansion in future years. Given the risks posed by inflation and a lack of conviction in prices moving well ahead of this, we do not currently have exposure to insurance within the Macquarie High Conviction Fund.
For financial advisers only – not for distribution to retail investors
This information has been prepared by Macquarie Investment Management Australia Limited ABN 55 092 552 611 AFSL238321, the issuer of units in the Macquarie High Conviction Fund for general information purposes and does not take into account the objectives, financial situation or needs of any person. Before making any financial investment decision or a decision about whether to acquire, or continue to hold an investment in the Fund, a person should obtain and review the Product Disclosure Statement for the Fund and also seek independent financial, legal and taxation advice.
Future results are impossible to predict. This report includes opinions, estimates and other forward-looking statements, which are, by their very nature, subject to various risks and uncertainties. Actual events or results may differ materially, positively or negatively, from those reflected or contemplated in such forward-looking statements. Forward-looking statements constitute our judgement as at the date of preparation of this report and are subject to change without notice. This information is not a recommendation to buy, sell or hold any financial product, security or other instrument.
No representation or warranty, express or implied, is made as to the suitability, accuracy, currency or completeness of the information, opinions and conclusions contained in this document. In preparing this document, reliance has been placed, without independent verification, on the accuracy and completeness of information available from external sources. To the maximum extent permitted by law, no member of the Macquarie Group nor its directors, employees or agents accept any liability for any loss arising from the use of this document, its contents or otherwise arising in connection with it.
Other than Macquarie Bank Limited (MBL), none of the entities noted above are authorised deposit-taking institutions for the purposes of the Banking Act 1959 (Commonwealth of Australia). The obligations of these entities do not represent deposits or other liabilities of MBL. MBL does not guarantee or otherwise provide assurance in respect of the obligations of these entities, unless noted otherwise.