its just quality, page-71

The analysis comments should convince us to hold on doom day .. . This is just a quality stock.

Event Analysis
Given the negative commentary surrounding QBE’s 2008 results one would have thought it had reported a massive loss and was in need of a bail out. The reported profit – yes profit – of $1.859bn was generally in line with expectation – we were looking for $1.88bn. There were items of significance relating to the global financial crisis. That is what has overwhelmed the world over the past 18 months and naturally impacted a global insurance company with an investment portfolio of some $27bn. The US giant insurance group AIG reported a loss of US$62bn for the December and a massive US$99bn loss for 2008. It also was affected by the global financial crisis but notice the slight difference in results!

Analysts are concerned QBE’s capital adequacy declined from 2.4 times APRA’s stringent risk based minimum capital requirement in 2007 to 1.7 times in 2008. The fact is the capital adequacy ratio was too high at 2.4 times in 2007. Were QBE management ahead of the curve readying the balance sheet for a tumultuous 2008? Wonder what AIG’s capital adequacy is? - or Munich Re’s, or Swiss Re’s or Suncorp’s, or IAG’s. There was no impairment in the investment portfolio. Net investment income was slightly higher at $1.18bn with realised and unrealised equity losses of $554m offset by foreign exchange gains of $409m and a $303m profit on the repurchase of $1.003bn of perpetual debt at a discount. These are one-off benefits but clearly indicate how management conservatism and low risk strategy is at work across all aspects of the global business.

We quote from the 2008 Berkshire Hathaway Annual Report – “As predicted in last year’s report, the exceptional underwriting profits that our insurance business realized in 2007 were not repeated in 2008. Nevertheless, the insurance group delivered an underwriting gain for the sixth consecutive year. This means that our $58.5 billion of insurance “float” – money that doesn’t belong to us but that we hold and invest for our own benefit – cost us less than zero. In fact, we were paid $2.8bn to hold our float during 2008. Charlie and I find this enjoyable.”

Similarly QBE’s exceptional underwriting profits of 2007 were not repeated in 2008 but they were still a handsome $1.275bn. QBE achieved an underwriting gain for the seventh consecutive year and was paid $908 million to hold the float during 2008. Chairman John Cloney and CEO Frank O’Halloran find this enjoyable. So do we!

QBE is first and foremost an underwriting company. It underwrites insurance risk and makes money from that activity – an underwriting profit. It does this by understanding the risk taken and adequately pricing for it. It may decide to take all the risk or lay some off – reinsure and pay a premium to the reinsurance company. The difference between Gross Written Premium (GWP) and Net Earned Premium (NEP) is reinsurance expense.

QBE is run by insurers – conservative insurers. Insurance has enough embedded risk that does not need to be increased by an over zealous investment strategy. An underwriting profit coupled with a low risk approach to investment – being paid to hold the insurance float – results in significant profitability and QBE out performing most peers in all markets. The insurance “float” is the pool of premium income – policyholders’ funds – from which claims are paid. In good years claims reserves are built up and when the cycle turns these reserves are drawn upon. Call them hollow logs. QBE has hollow logs that are still quite full. We suspect Suncorp’s are empty and IAG’s near depletion. Analysts are slow to reward when reserves are built but immediately criticise their use. Give us a break!

Large catastrophe claims in isolation do not generally cause concern. It is the frequency of large claims that stretch reserves and deplete hollow logs. Instance the impact on Suncorp and IAG of significant storms, floods and bush fires in one year. In 2008 QBE’s net claims ratio increased from 54.3% to 57.6% reflecting 29 natural peril catastrophe claims with a net cost to QBE of $424m compared with 21 in 2007 at a net cost of $317m. Net claims ratio from large individual risk and catastrophe claims greater than $2.5m increased from 6.6% of NEP in 2007 to 10.2% in 2008. Claims did include provisions of $200m for reported and potential claims from financial and credit related policies exposed to the global financial crisis. Insurance is a somewhat like bookmaking at the races. If one favourite wins on an eight race program the bookmaker usually has a winning day. If all eight favourites win the bookmaker probably loses. Frequency of claims!

Looking forward we see QBE in a different light to many analysts and commentators. We see a profitable business, extremely well managed by a team of conservative insurance professionals. We see a solid balance sheet with capacity to capitalise on the many opportunities the global financial crisis presents. Debt to equity ratio at 32.9% is the lowest in many years with room for future funding when debt markets return to normal levels. In 2008 QBE made 11 acquisitions with the initial cost of $2.7bn expected to generate around $900m of new GWP and pre tax profit of $565m in 2009. QBE will almost assuredly make several acquisitions in 2009 and if necessary raise new equity.

The combination of past acquisitions, high customer retention and an average 4% increase in premium rates as the market hardens will drive GWP and NEP growth in 2009. Management guidance is for growth over 20% - excluding new acquisitions – in both GWP and NEP using budgeted foreign exchange rates (US$/A$ 0.68¢ and A$/£Stg 0.45 pence). The combined operating ratio to be less than 88.0% (88.5% in 2008) indicating an increase of 30% in underwriting profit from $1.275bn in 2008 to $1.65bn in 2009. The swing factor will be investment income on policyholders’ funds. Management will maintain a low risk strategy that had no impairment in the $27bn portfolio in 2008. Investment yields will therefore be lower in 2009 than the $908m of 2008 particularly as the foreign exchange gains and repurchase profit will not recur. Lower investment income impacts insurance profit and the much watched insurance margin. In 2008 the margin was 19.7% with 1H08 at 21.8% and 2H 17.7%. Guidance for 2009 is 16% to 18%.

We reduce our FY09 NPAT estimate from $2.35bn to $1.95bn with EPS down from 234.5¢ to 194.0¢. We anticipate a useful improvement in FY10 with continued solid growth in GWP and NEP and a recovery in investment income with NPAT forecast of $2.2bn. Fair value falls from $34.00 to $28.15. Price triggers adjust accordingly. We retain our Buy recommendation.