Insurance Australia Group Ltd enters into Warren Buffett style insurance deals

Insurance Australia Group Ltd (ASX: IAG) has announced that it has entered into agreements with reinsurers Munich Re, Swiss Re and Hannover Re to share its premiums.

The agreements will take effect from 1 January 2018 with the reinsurers set to receive a combined 12.5% of IAG’s consolidated gross earned premium and pay 12.5% of its claims and expenses.

IAG will receive an exchange commission for providing access to its strong core franchise which will mostly consist of a fixed fee (as a % of premium). A profit share arrangement is also part of the exchange commission and will be based on IAG’s future profitability.

The reinsurance agreements are expected to reduce IAG’s earnings volatility with 12.5% of insurance risk effectively transferred for an income stream with more stability. The deal will lower IAG’s requirement for catastrophe reinsurance reducing its exposure to volatile premium swings.

The insurer’s regulatory capital requirement will also decrease by approximately $435 million over a 3-year period. The agreements are expected to have a broadly neutral effect on earnings per share and return on equity.

Today’s deal is very similar to the one the company struck with Warren Buffett’s Berkshire Hathaway in June 2015, except the Buffett deal involved a 20% quota share.

The Buffett deal has worked out well for long term shareholders with the stock up approximately 29% since June 2015.  Reinsurance deals effectively remove downside earnings risk from part of the business whilst also maintaining exposure to earnings upside from the profit share arrangements.

FY18 guidance

Management has guided for gross written premium to grow in the low-single digits for FY18 and its reported insurance margin guidance will rise by 125 basis points to 13.75%-15.75% following the quota share agreements.

The new quota share agreements will also reduce the company’s FY18 natural perils allowance from $680 million to $627 million.

The stock currently trades at an above average market multiple of 19 times forward earnings which does seem a little expensive given its earnings growth outlook. Today’s tepid rise is in stark contrast to the 4% jump the stock enjoyed when the Buffett deal was announced and suggests that a lot of optimism is already priced into the stock.

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Motley Fool Contributor Tim Katavic has no financial interest in any company mentioned. The Motley Fool Australia owns shares of Insurance Australia Group Limited. 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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