4 reasons IAG stock could see 'material earnings upside'

Here's what could drive IAG stock in the next two years, according to this fundie.

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The Insurance Australia Group Ltd (ASX: IAG) stock price could see further gains if it can benefit from a number of positives, according to a leading funder manager. The business has had an excellent 2024 to date.

Australia's insurance sector has already benefited from a number of positives in recent times, including inflation of insurance premiums, which has helped increase overall profit. The higher interest rates have enabled insurance businesses to generate higher earnings from their float/investment portfolios (namely bonds).

Looking at the chart below, we can see the IAG stock price has climbed by more than 50% since early 2023.

Despite that strong rise, the investment manager Firetrail believes there's still a positive outlook for the insurance business.

Bullish outlook for IAG stock

Firetrail said in its recent monthly update that during September, IAG received notice that a class action related to business interruption claims from COVID had been "declassified".

Due to that declassification, the fund manager is expecting the majority of the $380 million provision IAG is holding against this risk "to be returned to shareholders". Despite that, the IAG share price performance was disappointing (down 2.5%) in September following a rotation from ASX financial shares to ASX mining shares.   

There are three more reasons why the fund manager likes IAG stock, which I'll cover below.

Price increases helping higher margins

The fund manager noted that claims inflation across motor insurance and home insurance increased, boosting profitability. All insurance players increased prices "materially", with IAG's motor and home premiums growing by double-digits in FY23 and FY24.

Due to those price rises, IAG's underlying margin rose by almost 2% in FY24 and is expected to increase again in FY25 as inflation continues moderating. Firetrail is expecting IAG to be "modestly above" its through-the-cycle margin target of around 15% in both FY25 and FY26.

Reinsurance

The fund manager pointed out that another reason to like the insurance giant is the "degree of downside earnings protection it now has" after two reinsurance deals announced in late June 2024. This includes protection against claims costs from catastrophe events above a certain level.

If this arrangement had been in place for the last eight years, in total, the reinsurers would have contributed more than $1 billion of claims protection, limiting IAG's downside in particularly bad years.

Firetrail estimated that IAG's earnings per share (EPS) would have been 10% higher on average, with less variability and lower capital intensity.

The fund manager is excited about the insurer's earnings potential to keep rising, which could further support IAG stock.

IAG stock price valuation

Firetrail is positive on the insurance giant's current valuation.  

Due to the positive industry backdrop, reduced earnings volatility, and substantial surplus capital, the company believes that IAG deserves to "trade at a premium to its historic range and its closest peer", Suncorp Group Ltd (ASX: SUN).

The fund manager thinks the IAG business should be more predictable and capital-light than a typical insurance underwriter.

Firetrail concluded:            

In summary, IAG's pricing strategy, coupled with its strengthened reinsurance structure, positions the company for sustained earnings growth and reduced volatility. Given these factors, we believe IAG is undervalued relative to peers and deserves to trade at a premium, with consensus upgrades likely to follow in FY 2025 and FY 2026.

Motley Fool contributor Tristan Harrison has no position in any of the stocks mentioned. The Motley Fool Australia's parent company Motley Fool Holdings Inc. has no position in any of the stocks mentioned. The Motley Fool Australia has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy. This article contains general investment advice only (under AFSL 400691). Authorised by Scott Phillips.

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