Should you buy Insurance Australia Group Limited?

When Insurance Australia Group Limited (ASX: IAG) reported better than expected results in FY 2013, Morningstar equities analyst Ravi Reddy said thatthe strong result reflected double-digit gross written premium (GWP) growth, lower-than-expected natural peril claims, higher-than-expected reserve releases and a positive credit spread impact.” The international research firm now has an “accumulate” recommendation on IAG and has a fair value estimate of $6.50. Excluding the proposed Wesfarmers Ltd  (ASX: WES) insurance acquisition.

IAG has recently announced an intention to buy WFI and Lumley Insurance from Wesfarmers, and as a result, the company will sell shares to raise $1.4 billion in new capital. $1.2 billion worth of shares have already been allocated to institutions at the price of $5.47, and another $200 million worth of shares will be available to retail investors, at the same price. Morningstar recommends that shareholders take up their allocation.

However, it’s not clear what allocation retail investors will receive, as there is almost certain to be a scale back. As I wrote in this article on the IAG share purchase plan (SPP). “For small shareholders (with less than $4000 worth of shares), I think it’s highly unlikely participation in the SPP would be worth the effort.” This is because I don’t think a small holder will receive anywhere near the minimum application of $1000. However, it might simply be worth buying shares on the market.

In his 2004 Letter to Investors, Warren Buffett says:

“The source of our insurance funds is “float”, which is money that doesn’t belong to us but that we temporarily hold… Float is wonderful – if it doesn’t come at a high price. Its cost is determined by underwriting results, meaning how the expenses and losses we will ultimately pay compare with the premiums we have received. When an underwriting profit is achieved – as has been the case at Berkshire in about half of the 38 years we have been in the insurance business – float is better than free. In such years, we are actually paid for holding other people’s money”

Below is the underwriting profit or (loss) recorded by IAG over the last 10 years:

Foolish takeaway

As you can see, Insurance Australia Group has achieved an underwriting profit in seven of the last 10 years. That’s a fairly strong result, so I certainly think the company deserves a spot on your watch list. However, there is some concern that climate change will make the insurance business less profitable, with the insurance companies themselves warning that: “The industry is at great financial peril if it does not understand global and regional climate impacts.” I believe that IAG is reasonably attractively priced, but I would only buy shares when the market is responding to a bad year, rather than a good year.

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Motley Fool contributor Claude Walker (@claudedwalker) does not own shares in any of the companies mentioned in this article.

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