2017 is set to be the worst year on record for insured catastrophe losses. With some three months to go, 2017 insured losses of around US$150 billion are set to exceed the $120 billion of 2005 and $134 billion in 2011. Hurricanes Harvey, Irma, Maria and the Mexican earthquakes will add around $128 billion to $22 billion of losses from the June half.
What does this mean for QBE Insurance Group, the ASX’s only global insurer? The company has increased its own allowance for 2017 large individual risk and catastrophe claims to $1.75 billion, forecast a $600 million detraction from 2017 pretax earnings and downgraded its 2017 combined ratio guidance from 94.5-96.0 per cent to 100-102 per cent (a ratio above 100 per cent means an underwriting loss). This will mean QBE cannot fund an unchanged final dividend of 33 cents and investors should expect something more like 12 cents.
QBE is now the worst-performing ASX 200 non-bank financial stock of the financial year to date after the earlier 21 June downgrade to earnings guidance due to inadequate risk management in certain emerging markets. This makes the stock interesting, as underperforming large-cap stocks tend to revert higher given the pressure on boards and management to restore positive returns. Underperformance by a large company is never tolerated for long and backing ASX large company turnarounds is a consistently reliable investment strategy.
At the time of writing, 6 October, the stock was trading marginally above levels before the hurricanes and earthquakes downgrade on 3 October. This correctly reflects the suddenly better outlook for QBE’s 2019 earnings since the hurricanes and earthquakes. The low returns world of recent years has encouraged the inflow of globally mobile capital to markets with low barriers to entry, like commercial property catastrophe insurance. Bond yields and borrowing costs have been so low that expectations of returns on this capital have been only mid-single digit in some markets like the US. The destruction of some US$150 billion of insurance industry capital this year, due to the hurricane and earthquake losses, and the need for insurers to rebuild earnings and returns mean premiums and returns on capital will rise for the few insurers with 2018 reinsurance costs mostly already locked in – like QBE. A 10 per cent increase in property insurance rates in North America and non-Asian emerging markets would boost QBE’s 2019 earnings by around eight per cent. Meanwhile QBE is leveraged to higher US bond yields and a lower Australian dollar, both of which we expect.
The optimism in QBE’s share price above $10.40 this week could however be premature. Investors should expect new CEO Pat Regan, who starts on 1 January, to top up 2018 provisions and announce the board has slashed the 2017 final dividend. The US$1bn on-market buyback continues but our valuation includes a 6% discount to this total for conservatism – and now the extra capital will be needed to support more aggressive underwriting by QBE after the catastrophes. We expect the stock will consolidate around our $10.31 valuation until there is more certainty about the extent of the upturn in the upturn in commercial premiums and the changes the new CEO will make. The standard playbook is to provision and restructure heavily to reduce the base for subsequent growth. QBE has made good progress over the five years of the current CEO’s term at reducing operating costs and derisking but the poor risk management in the emerging markets business this year proves there is more work to do – and this is achievable in our view. The emerging markets debacle was an incredible oversight and entirely avoidable. QBE can be run better than it has been and this could yet drive valuation upgrades over time. We’ll hold for now.