Insurance Australia Group Ltd & Berkshire Hathaway: The unanswered question

Existing shareholders could suffer from Insurance Australia Group Ltd's (ASX:IAG) $500m issue!

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Yesterday was potentially a landmark day for the Australian share market. It represented the first investment in an Australian company by the legendary Warren Buffett and his Berkshire Hathaway investment conglomerate.

Berkshire purchased a 3.7% stake in Australia and New-Zealand focussed Insurance Australia Group Ltd (ASX: IAG) via a $500 million placement of new shares. The placement was accompanied by the announcement of a strategic partnership between the two companies in which Berkshire will receive 20% of IAG's consolidated gross written premiums and pay 20% of claims.

Hold on a minute!

As some questioned in the conference call "is Berkshire getting 20 per cent of IAG for 3.7 per cent of the capital?"

The answer from IAG's chief executive Mike Wilkins and chief financial officer Nick Hawkins? Well, yes, but the most important thing is that the company will be able to lift margins by 200 basis points (0.2%) and cut the group's capital requirements by $700 million over the next five years.

So, acquisitions are on the cards?

The next logical question was what IAG planned do with the savings and placement proceeds. The answer is that in the short term, IAG will not change its dividend policy and wouldn't aggressively target purchases, instead the agreement was struck purely from a beneficial relationship perspective.

The real trade off

IAG says that the deal will lower its earnings volatility (actually quite a big benefit for shareholders), lower its exposure to variable reinsurance rates, and increase commission income. This is brought about by another part of the agreement where IAG has agreed to buy Berkshire's personal and small business lines, while Berkshire will acquire the renewal rights to IAG's large-corporate and property-and-liability insurance business in Australia. This change will increase IAG's fee-based income while lowering its risk to large catastrophe claims by making Berkshire accountable for 20% of them.

Impact to Earnings and Dividend per Share

Analysts on the call yesterday were less than convinced that the deal made sense for shareholders with a number noting that it could result in earnings per share dilution. Mr Hawkins denied in the question and answer session that the agreement itself was dilutive to earnings but agreed that the capital raising would be "modestly dilutive".

Motley Fool contributor Andrew Mudie has no position in any stocks mentioned. You can find Andrew on Twitter @andrewmudie The Motley Fool Australia has no position in any of the stocks mentioned. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. This article contains general investment advice only (under AFSL 400691). Authorised by Bruce Jackson.

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