qbe buys pmi, page-7

Intersuisse update just out:

QBE Insurance Group Limited QBE Monday 18 August 2008

Bottom of the cycle acquisition of the leading Australian mortgage insurer

Recommendation: Buy

Investment Rationale
QBE is one of the best managed insurance groups in the global general
insurance and reinsurance industry. An enviable track record of strong
earnings growth is testament to a first class business model and conservatism.
Extensive risk management is in place to protect all stakeholders. Throughout
QBE diversification is used to reduce the overall risk profile by spreading
exposures by product and geography. Overlaying fundamental procedures and
strategies is a level of prudence providing significant comfort. A growth
strategy of organic growth and insightful acquisitions should continue to deliver
well above average growth in earnings and dividends. PMI adds to diversity on
good terms. QBE is an excellent stock for long term growth portfolios.
Event
 QBE is to acquire PMI Mortgage Insurance Ltd in Australia and New
Zealand (PMI Australia) and PMI Mortgage Insurance Asia Limited (PMI
Asia). The purchase price is $1.027bn based on NTA using US GAAP
including the investment portfolio at fair value.
 PMI Australia has for over 40 years been a mortgage insurer for lenders
and writes around 40% of the residential mortgage insurance market in
Australia, with an expected 2008 gross written premium of around $200m,
including around A$5m through its New Zealand branch. PMI Asia has
gross written premium of around A$12m in Hong Kong.
Impact
 Mortgage insurance is a new line for QBE but this management team has
repeatedly shown it knows how to take risk and more importantly price for
that risk. That cannot be said for many competitors or banks.
 The acquisition, struck at a time when US mortgage insurers are under
great pressure, is clearly attractive and will be EPS accretive in year one.
 The acquisition is expected to be completed in September 2008
suggesting very willing vendors. The price of $1.027bn will be paid 80% in
cash and the balance by a QBE promissory note payable in three years.
The note plus interest will only be paid if the claims ratio on policies in
force is less than 50% of the US GAAP unearned premium liability of
A$525m at June 30, 2008 and reduces by $1 for each $1 the claims ratio
exceeds 50%. The vendor will contribute $50m toward the cost of
reinsurance protections above the unearned liability.
 QBE will fund the transaction using $522m excess capital and borrowings
of $300m. It will provide support to PMI Australia and PMI Asia to maintain
S&P’s AA- insurer financial strength ratings.
 In 2007 PMI Australia achieved NPAT of $109m US GAAP with a
combined operating ratio (COR) of 71.8%. The ROE was 11.2% due to
PMI’s high capital requirements.
 Prior to settlement QBE will have appropriate reinsurance covers in place
which address an economic scenario three times worse than that
previously experienced by Australian residential mortgage insurers in the
past 40 years. This worst case scenario assumes a significant rise in
unemployment, much higher interest rates and a major downturn in
property markets.
 This is a minor acquisition compared to the $7bn+ approach to IAG but it
opportunely breaks new ground. QBE CEO Frank O’Halloran noted that in
the 15 years to June 2008, including two significant downturns in the
Australian housing market, PMI’s gross incurred claims were $345m
against gross earned premium of $1.68bn. A distinct whiff of profitability!
Recommendation Impact
We have not raised our estimates at this stage but the impact will be positive.
We retain our Buy recommendation, enhanced by this deal.