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Why QBE Insurance is down 30% in 2 days

QBE Insurance’s (ASX: QBE) shock downgrade to earnings has been met with a severe and negative reaction by investors that has seen its share price plunge 30% from $15.45 to $10.82 in two days.

The downgrade stated that management now expects QBE to report a net loss of US$250 million for the full year after reporting an interim profit of US$477 million. (The company has a December financial year end.)

The dramatic decline in earnings is largely due to increases in claims provisioning and intangibles and goodwill write-downs in North America. The goodwill impairment of $600 million is an acknowledgement that shareholder value has been destroyed by recent acquisitions, as is the further $330 million write-down of the specialist lender placed property insurer QBE FPS, which will also take a ‘one-time restructuring charge’ of $150 million.

Excluding these non-cash or non-recurring items the downgrade to earnings is not as dire, with management stating that they expect a cash profit of around US$850 million.

While many investors will indeed look past the ‘non-cash’ items, there are at least two major obstacles stopping investors from being comfortable with QBE.

Firstly, this is not the first time QBE has disappointed the market and when coupled with the complex nature of the accounts, investors are wary that there could be more bad news out to come.

Secondly, the downgrade also showed deterioration in parts of QBE’s business. The company will take a charge of US$650 million for prior year claims development (US$300 million in the North American division); higher than expected US crop claims have pushed the combined operating ratio to 99%, and a strengthening of risk margins will have a US$200 million affect.

The combined result of this deterioration and declining profitability in the North American division is a forecast combined operating ratio of 111%.

It’s a huge blow for shareholders who prior to the downgrade had been enjoying significant outperformance from their QBE stock. Last week before the company entered a trading halt, QBE’s share price had rallied 47% over the past 12 months compared with the S&P/ASX 200 Index (Index: ^AXJO) (ASX: XJO), which had increased by 14%. Now after the shocking last two days shareholders are up just 3%, compared with a 13% return from the Index.

Foolish takeaway

QBE’s downgrade is a good reminder for all investors of the complexities of understanding the accounts of both insurers and banks. Due to the complexity and limited outside knowledge an investor can obtain, a larger margin of safety should be demanded when investing in these types of businesses.

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Motley Fool contributor Tim McArthur owns shares in QBE Insurance.

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