Insurance Australia Group Ltd (ASX: IAG) enjoyed its biggest jump in over three years this morning on news that Warren Buffett's Berkshire Hathaway is buying a $500 million stake in the company.
Shares in IAG surged 5.9% to $5.90 at the open as management announced a 10-year strategic partnership that will see the iconic US specialty insurance giant receive 20% of IAG's consolidated gross written premiums and pay 20% of claims.
Berkshire will buy a 3.7% stake in IAG via a zero-discount placement priced at yesterday's closing price of $5.57 a share.
The tie-up is a big confidence booster for IAG as this will increase its capital flexibility and reduce earnings volatility as it will lower the Australian's exposure to reinsurance rates and increase its commission income.
The partnership with Berkshire will not only bolster IAG's cash balance by $500 million but it will also free up $700 million in capital requirements as Berkshire will shoulder some of the risks from potential claims.
Berkshire is a reinsurance provider – meaning it sells insurance to insurance companies to limit the amount an insurer has to pay out for a catastrophic claim – and both companies have been working together since 2000.
But don't hope that the deal will ultimately herald a takeover bid for IAG even though management can sell a further 5% of the company to Berkshire within the next two years.
Berkshire is promising not to buy more than 14.9% of the insurer over the 10-year period that covers the partnership and is committed to holding on to its initial 3.7% stake in IAG for at least that long.
I think IAG looks attractive in light of this deal with management forecasting insurance margins to increase to between 14% and 16% in 2015-16 from this year's forecast of 10.5-12.5%.
However, growth in premiums for the current financial year is expected to come in at the bottom end of management's 17% to 20% guidance and the growth is expected to be fairly flat at 0-3% for the next financial year.
The stock is trading on a 2014-15 price-earnings multiple of around 13x, which is a discount to peers like QBE Insurance Group Ltd (ASX: QBE) and Suncorp Group Ltd (ASX: SUN).
What's more, the stock is on a forecast yield that's close to 8% once franking credits are included and I think IAG is in a good position to generate a total return of around 20% in the next 12 months.
This makes the stock a "buy" in my book.
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