The insurance cycle works in the following way:
- A period of few natural disasters and low claims leads to improved profitability.
- This attracts new competitors, forcing down premium prices and eroding margins.
- At some point natural disasters occur, causing major losses to insurers.
- Insurers suffering the greatest losses go out of business and premiums rise.
Looking at the last six years of profit figures for Insurance Australia Group Ltd (ASX: IAG), it is clear that we are approaching a peak in the insurance cycle in Australia. Net profits have grown rapidly in recent years, from $207 million in 2012 to $1.2 billion in 2014. This improvement was largely due to a benign claims environment and therefore it is unlikely to be sustained.
The share price history of rival Suncorp Group Ltd (ASX: SUN) further supports the view that conditions are favourable. It has risen 90% since May 2012 after two years of little movement.
It is important to focus on average earnings across the cycle rather than recent results when valuing insurers. Earnings of IAG averaged just $511 million during the past five years compared to $1.2 billion last year. Its price-to-earnings (P/E) ratio using average figures is 30 indicating the company may be too expensive at current prices.
Of course there are other factors to consider when estimating normalised earnings. For example, IAG acquired the underwriting division of Wesfarmers in 2014 and divested its poorly performing UK business in 2013. Moreover, it has established businesses in China and India where the insurance industry is expected to grow strongly for decades. However, these make up only 7% of total premium revenues and there is no guarantee they will be successful.
IAG's attractive 6% fully franked dividend yield is supported by a robust balance sheet, with net cash of $3.7 billion after allowing for regulatory capital requirements. Despite this, management would cut dividends should profits fall because it targets a dividend payout ratio of less than 70%.
I believe current normalised earnings are roughly $750 million per year, giving a P/E ratio of 20. This is too high for a company with limited growth prospects, and I wouldn't consider buying shares unless they fell to below $4.30.
A better insurance opportunity?
QBE Insurance Group Ltd (ASX: QBE) differs from Suncorp and IAG because of its more extensive international operations and it may be emerging from the bottom of its cycle. The company incurred heavy losses when Hurricane Sandy devastated the east coast of the United States in 2012. Profits declined from $1.5 billion in 2009 to a loss of $254 million in 2013 and shares are trading at around 10-year lows.
Obviously, it is important to consider the quality of the company as well as the state of the industry before making an investment decision. This, along with purchase price, will dictate the success of any investment over the long term.
Cyclical industries are a great hunting ground for contrarian investors. Buying at the bottom when conditions are at their worst can provide excellent returns. For example, purchasing either Suncorp or IAG in May 2012 would have delivered share price appreciation of over 90%.
Conversely, it is dangerous to buy these businesses after they have enjoyed years of favourable conditions because a drop in performance may be just around the corner. Short-sighted market participants cause prices to closely follow industry cycles, and this provides opportunities for wily investors.
