We continue sticking to the insurance thematic this week by looking at the other giant in the Australian market: IAG. We will continue using the same template as last week in assessing this business and its reports. The simple/straightforward equation: Profit = Earned Premium + Investment Income – Incurred Loss – Underwriting Expense.

We’ve previously written about IAG and how it seems to have a parallel story to its competitor Suncorp. For one, this business also saw a transition in senior management with the retirement of its long-standing CEO Peter Hammer, who was replaced by the group’s CFO yet again. There is a common thread where margins are tight, CFOs tend to get preference. Nevertheless, let’s look at the results for the year, top-line growth again being our biggest issue previously.

On this front, the business has performed reasonably well, with gross written premium (GWP) for Home growing 13% while motor performed at a reasonable 8%. NZ added another 9% to growth on local currency terms. These numbers align with its counterpart Suncorp which saw higher numbers across motor and NZ. What was interesting for us was not this top-line number but how much of this accounted for premium increases vs. underlying customer growth. On this count, IAG does not compare particularly well with Suncorp, with the higher amount of its GWP growth driven primarily by rate inflation instead of member growth. However, the group has indicated quite ambitious targets for the coming year.

So on the first part of the equation, the business gets a manageable pass.

Again this is one aspect where the tailwind has been apparent for the business. The business now has an AUD $12 billion investment portfolio with a gain of AUD $80 million in technical reserves driven by higher yields and narrowing credit spreads. With the Fed and RBA likely to continue on their trajectory, we will probably see this increasingly grow. The yield on these funds is circa. 3.7%. Regarding shareholder funds, around 23% of the portfolio is weighted toward growth though there has been substantial derisking following exits from hedge funds.

On this front, as compared to Suncorp, the firm’s investment mix leaves much to be said, given that the total yield remains lower by 140 bps (though a like-for-like comparison is a little on the creative side, given the substantial differences in the underlying business). Again, assuming the status quo in central bank policy, we should continue to see the increase in yields.
We rate the company as a pass on the second part of the equation.

Just a refresher, the definition of incurred loss is the total benefits paid to policyholders during the current year plus changes to loss reserves from the previous year. Here it is perhaps appropriate to break this definition down into two components. The first is the benefits paid, which, more often than not, has a lot more to do with external events outside of the firm’s control and the loss of reserves (which indicates the extent or certainty to which the firm forecast future loss).

Like Suncorp, the business continues to battle the weather, with NZ floods taking away and putting pressure on margins. 1H ’23 perils have come in around AUD $70 million above estimate, and inflation is significantly impacting claims, especially in the motor segment. While IAG has a broader geographic segmentation than Suncorp, the La Nina weather cycle has still significantly impacted overall losses.

This brings us to the second part of the definition, which is the firm’s ability to adequately forecast and manage its risk profile (hence reserves). Despite the lack of geographic concentration in the same manner as Suncorp, the firm’s actuaries still have much to answer for, given the lacklustre performance in forecasting the increasing frequency of climate-induced perils. This is not the exception to the rule but rather becoming more habitual. On this front, the firm could certainly have done a better job.

We still give the firm a moderately good rating on the third part of the equation, not for any reason to do with its risk management practices but purely based on its greater geographic diversification. Also, its lack of legacy issues makes it a pure-play insurance provider (Suncorp has been operating the bank in addition).

This brings us to the final part of the equation, and similar to Suncorp, with an Ex-CFO in charge, we should expect some reasonable performance. We were however disappointed that while expenses have declined by about 9.9%, additional outlays were required in what was categorised as the cost to transform expenditure, increasing 41.9%. For those unfamiliar, IAG has been (in)famous for legacy issues, including failed IT systems, provisions hits and charges. We would still have liked to see a greater decrease in the absolute number. We become rather cynical when businesses use words or synonyms like ‘transformation’, ‘strategic’ or words of that nature, especially when the business is being run by an accountant (i.e. new categories are not a particularly good look).

On the insurance trading ratio (standing at 10.7%), the business also fails in comparison to Suncorp, though again, it may not be fair given its quota-sharing agreement with Berkshire, to whom it will give away the lion’s share. That is, the firm effectively gives away close to AUD $3 Billion of its AUD $3.5 Billion in premium income for a 32.5% quota share. This does significantly derisks the firm as a tradeoff.

​Still, overall, we give the business a fail.

The business stands to benefit from the broader tailwinds associated with a rising interest rate environment and premium escalation. That said, we think the business could do a lot better when it comes to a like-for-like comparison with its competitor Suncorp. As a pure-play insurer that had significantly derisked (especially in quota sharing), one could understand why it may have struggled. We don’t recognise preventable issues such as prudent allocation of reserves, a more conservative allocation of its investment portfolio and, quite simply put, a basic understanding of modern IT systems.

Would we still buy it?

From a pure valuation perspective, we still think it’s a reasonable allocation especially given that the insurance market remains a duopoly and the fact that it has a good geographic diversification. An average business at a great price is the best way to put it. We see the possibility of a price target or significant upside of 20% from where it is trading today ($5.80).

Disclaimer: ASX.IAG is currently held in TAMIM portfolios.