Queensland-based bank and general insurer Suncorp Group Ltd (ASX: SUN) shocked the market on Monday by announcing a profit downgrade for the 2016 full year. The stock has fallen 13% as a result, providing a good opportunity to pick up this growing business at a cheap price.
The announcement
New chief executive Michael Cameron announced a fall in the Group's insurance trading ratio (ITR) — which is seen as a key measure of profitability — to 10% for the half year to 31 December 2015. This compares to an ITR of 14.7% for its full year ended 30 June 2015, indicating pressure on insurance margins.
The bad news was compounded with Suncorp revealing larger-than-anticipated losses in its Commercial Insurance division and a $75 million increase to its natural hazards allowance due to increased climate volatility (i.e. bad weather). Suncorp also expects earnings to be hit by a spate of higher claims and higher costs due to a lower Australian dollar.
Accordingly, the shock announcement has seen Suncorp shares fall 13% over two days. I believe this pullback makes them a buy today.
The company
Suncorp Group operates in three key markets comprising general insurance, life insurance and banking. The group derives almost 60% of earnings through general insurance, leveraging its household brand names AAMI, GIO and Australian Pensioners Insurance Agency (APIA) to fiercely compete against fellow insurer Insurance Australia Group Ltd (ASX: IAG).
Suncorp generates 30% of group earnings through its namesake Suncorp Bank. In this regard, Suncorp competes against regional banks such as Bank of Queensland Limited (ASX: BOQ) and Bendigo and Adelaide Bank Limited (ASX: BEN) to provide a genuine alternative to the big four.
Finally, Suncorp's life insurance business provides a steady annuity stream which accounts for around 10% of group earnings, making for a well-diversified earnings base amidst ongoing market volatility.
Accordingly, the recent pull-back in price appears overdone given the underlying strength of earnings and Suncorp's strong capital position.
The industry
Anyone will tell you that investing in insurance companies can be volatile, given the uncertain nature of insurance operations. As long-term shareholders of QBE Insurance Group Ltd (ASX: QBE) will attest, a few natural disasters in a given year can cause significant destruction of shareholder value, with earnings plummeting as a result of unforeseen circumstances.
The market appears to perceive Suncorp's profit warning as the first of many, sparking the steep sell-off. Although risks remain around investing in insurance companies, I view Suncorp's announcement as a positive for the company.
The group has come clean with its problems instead of waiting to announce full-year results and has provided a step plan of its strategy to remediate margins through an increase to premiums. This is sound risk management, which is what an insurance company should be good at. As such, investing in an insurance company which actively practices this is a good start.
Foolish takeaway
With Suncorp targeting an ITR target of 12% per annum, the group remains determined to manage downside risks and use its levers to increase earnings.
Although significant risks remain around investing in the volatile insurance industry, Suncorp's strong capital position has seen it return excess capital in prior years with an indication that it will continue to do so. As such, an investment in Suncorp at current prices is likely to provide a solid income stream in a conservatively managed insurance company. You can't get much better than that.
