Avoiding traps in jumpy times

In terms of reported margins, the major banks’ downward trend could still eventuate.
Although recent mortgage repricing initiatives should provide some short term stability
in the next 6-12 months, the low rate environment is expected to persist for some time
and would continue to dampen margin expectations. Insurer underwriting and
insurance margins in contrast have been trending upwards since 2012 and would have
been higher if not for lower investment yields on the float. Insurer cost ratios are
largely unchanged since 2003 and cost initiatives should be positive for margins.

The average loss ratio for the major banks over the last 12 years is around 25-30bp
and is also in line with their “through-the-cycle” views, although there appears to be
further catching up to do in the next 6-12 months. On the other hand, general insurer
losses have reached the 12-year average although we believe this is due to prior year
adjustments. Current benign conditions in addition to the end of the cyclone season
lead us to believe there will be stability in this space until summer. Underpinning
earnings stability and predictability in the general insurance space would also be ever
increasing loss buffers that are in stark contrast to the banks’ decreasing provisions.

We also reimagine the major banks and general insurers on a level playing field.
Using margin income as a percentage of earning assets, we derive notional margins
for the insurers in the 6.1-9.4% range vs. 2.0% for the banks. While the insurers
appear disadvantaged on the cost front, we see this as a huge opportunity in
streamlining and eliminating legacy costs. The more important item is that the
insurers’ ROA remains ahead of those at the banks while the banks’ higher ROE is
only due to higher leverage. More resilient in any crisis, the general insurers are also
better placed than the banks in terms of earnings quality and value upside. The
reimagined general insurers are wholly funded by interest-free debt and invested
mainly in low risk assets. They would also not be subject to the usual constraints
given their superior capital, leverage and liquidity positions, much lower reliance on
expensive offshore wholesale funding and minimal balance sheet mismatch.

It may seem like “Chalk and Cheese” but the general insurance sector remains
fundamentally sound and we favour them over the major banks in the next 6-12
months based on fewer operational distractions and regulatory constraints. Our
ratings, forecasts and price targets for IAG, QBE and SUN are unchanged.

[Avoiding Traps in Jumpy times - Insurance notes.pdf]