Why we’re backing IAG as a top investment pick

Insurance Australia Group (IAG) was a new addition to the Firetrail Australian High Conviction Fund  during the quarter. We forecast earnings upside versus current market expectations, driven by pricing power, margin improvement, and robust reinsurance protection. Below, we outline the key drivers behind this outlook.

Price increases now translating into higher margins

The second half of 2022 was a meaningful period for IAG and the wider Australian insurance industry. As seen in Figure 1, claims inflation in motor insurance spiked to above 10%. Home insurance also experienced elevated claims inflation during this period which pressured profitability. In response, all players increased pricing materially. IAG’s motor and home premiums grew by double-digits in both FY 2023 and FY 2024.

Figure 1: Claims inflation in motor insurance spiked

Source: IAG, September 2024.

Figure 2: IAG’s motor and home premiums grew by double-digits in both FY 2023 and FY 2024

Source: IAG, Firetrail, September 2024.

As a result of these sustained price increases, IAG’s “underlying” margin increased by almost 2% in FY 2024 and should improve again in FY 2025 as inflation continues to moderate. We expect IAG will be modestly above it’s through-cycle margin target of ~15% in both FY 2025 and FY 2026.

Figure 3: IAG’s underlying margin is on an upwards trajectory

Source: IAG, Firetrail, September 2024.

Reinsurance provides point of difference versus peers

A further underpin to the IAG investment thesis is the degree of downside earnings protection it now has, following two reinsurance deals announced in late June 2024. The new covers announced were:

• Protection against negative moves in claims reserves held against various portfolios up to $680m.
• Protection against claims costs from catastrophe events above a certain level for five years.

While we had seen reinsurance structures like this in the past, none had provided protection of the same quantum or duration that IAG was able to negotiate.

For illustrative purposes, Figure 4 shows what proportion of catastrophe claim costs would have been passed on to the reinsurer if this arrangement had been in place for the past eight years. In aggregate, the reinsurers would have contributed more than $1 billion of claims protection, limiting IAG’s downside in particularly bad years.

Figure 4: IAG’s new reinsurance would have significantly limited losses if it was in place for the past 8 years¹

Source: IAG, Firetrail Estimates, September 2024. Notes (1) For illustrative purposes we have assumed the retrospective reinsurance would have applied above IAG’s stated natural perils allowance for each specific financial year.

Extending this to earnings per share (EPS), we estimate IAG’s earnings would have been 10% higher on average under this scenario, with less variability and lower capital intensity.

Figure 5: We estimate IAG’s earnings would have been 10% higher if the new reinsurance policies had been in place for the past 8 years

Source: IAG, Firetrail Estimates, September 2024.

Valuation

Given a positive industry backdrop, reduced earnings volatility and substantial surplus capital, we believe IAG deserves to trade at a premium to its historic range and its closest peer, Suncorp. Indeed, due to the reinsurance coverage now in place, IAG’s business should be more predictable and capital-light than a typical insurance underwriter. We believe consensus EPS is likely to be upgraded over the course of FY 2025/26, which will highlight the resilience of IAG’s earnings profile.

Figure 6: We believe IAG deserves to trade at a premium to its historic range

Source: FactSet, Firetrail, September 2024.

Conclusion

In summary, IAG is well positioned to capitalise on the current tailwinds in the Australian insurance sector, with adequate structures in place to limit downside volatility. We believe there is scope for the market to place a higher multiple on the stock as IAG delivers what we believe will be strong earnings over the next few years.

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All prices and analysis at 22 October 2024.  This document was originally published in Livewire on 22 October 2024. This information has been prepared by Firetrail Investments Pty Limited (‘Firetrail’) (ABN 98 622 377 913, AFSL 516821). The content is distributed by WealthHub Securities Limited (WSL) (ABN 83 089 718 249)(AFSL No. 230704). WSL is a Market Participant under the ASIC Market Integrity Rules and a wholly owned subsidiary of National Australia Bank Limited (ABN 12 004 044 937)(AFSL No. 230686) (NAB). NAB doesn’t guarantee its subsidiaries’ obligations or performance, or the products or services its subsidiaries offer.  This material is intended to provide general advice only. It has been prepared without having regard to or taking into account any particular investor’s objectives, financial situation and/or needs. All investors should therefore consider the appropriateness of the advice, in light of their own objectives, financial situation and/or needs, before acting on the advice.  Past performance is not a reliable indicator of future performance.  Any comments, suggestions or views presented do not reflect the views of WSL and/or NAB.  Subject to any terms implied by law and which cannot be excluded, neither WSL nor NAB shall be liable for any errors, omissions, defects or misrepresentations in the information or general advice including any third party sourced data (including by reasons of negligence, negligent misstatement or otherwise) or for any loss or damage (whether direct or indirect) suffered by persons who use or rely on the general advice or information. If any law prohibits the exclusion of such liability, WSL and NAB limit its liability to the re-supply of the information, provided that such limitation is permitted by law and is fair and reasonable. For more information, please click here.