28 May 2019
Reach Markets publish the notes from our analyst meetings with company management. They should be read in conjunction with the research we’ve completed. Reach Markets endeavour to provide self-directed investors a seat at our investment meetings. We publish these notes in a conversational format to get these out as quickly as possible for your consumption.
We recently had a one-on-one meeting with Tony Jackson from QBE Insurance Group Ltd (QBE). The meeting was used as a refresher on the QBE story as well as to reassess our investment thoughts on the Company. Below are the key points from our discussion.
Overview – QBE is undertaking a process of improving underperforming ‘cells’ and making its leaders more accountable around three pillars: 1. risk selection; 2. pricing; and 3. claims management; to target 12% ROE and ~75% claims ratio (and appropriate expense ratio for that insurance category)
Mr. Jackson started the conversation by providing an overview of QBE Insurance group and some key numbers, noting in the words to the effect of, “when we do our cell reviews its exactly what we are doing, we are looking at breaking the business down into individual cells and a cell for example at group level would be Australian CTP (compulsory third party insurance), Australian business will drill down further and will have a sub cell which could be NSW CTP or SA CTP and when Patrick (Pat) Regan (Group CEO) and I go around the world on a quarterly basis to review the 100 global cells we look at say CTP, and the actuaries would say based on some of cash flow characteristics and based on the current investment return that we get and based on the allocated expenses and allocated capital, we would need and we target a 12% return on capital and we would need a claims ratio of 75% and obviously different classes have different expense ratios (e.g. home insurance has a higher expense ratio than motor insurance because settling home claims is more complicated, whereas motor could have a higher claims ratio) so when you allocate your expenses and you know your expense ratio is, you can work out what exactly is the claims ratio that you need and what happens in the cell reviews is that the person who owns the cell has to present to the group CEO his historical quarterly performances and what he had agreed to do to improve performance, his actual performance and the future trends…what Pat is trying to achieve with this is making sure that the individual accountability at the cell level improve performance on cell level to achieve the target return on equity…it’s also about identifying problems early and rectifying them early.”
We think QBE’s cell review process is quite efficient and would actually lift the performance and help rectify the problems at an early stage. It is hard to think that the company would not face any problems or make any mistakes but if the company could identify them early and take rectifying actions, it would materially help improve the performance at a group level. We think the new CEO has taken good steps to improve the culture of the company by incorporating the cell reviews on a quarterly basis and establishing minimum standards and a consistent approach across the three pillars of the insurance business; risk selection, pricing and claims management. Mr. Jackson also noted (in the words to the effect of), “today we look at a chart of whole cells and find their individual return on capital, earlier 3 or 4 were making a lot of money, a big pile made nothing and a big pile was losing money, but the ones that made no money earlier have now improved and the number of cells that were loss making have reduced.”
Reinsurance treaty with Berkshire Hathaway won’t be renewed as QBE looks to capitalise on their efforts in underwriting improvements and move to a more ‘traditional’ reinsurance program
According to Mr. Jackson, the issue with the current program is that it does not allow QBE to benefit from “crediting” its underwriting success in a particular year. QBE has an aggregate reinsurance treaty with Berkshire Hathaway, which Mr. Jackson described as “unusual”, according to which once the total cost of cumulative claims over $2.5m (individual claims or catastrophe) reaches $1.2bn, QBE has $900m of protection.
Mr. Jackson noted in the words to the effect of, “we have $900m of protection above $1.2bn which protects us in 19 out of 20 years scenario…the total cost of claims out of $2.5m is $1.2bn, which is 10% of net earned premium and it would be extraordinary for us to go out of top of that this year because this year has actually been very benign…the problem with that treaty is that in a really benign year it is in the money put…the reason for that to be in the money is that Berkshire wanted a very large premium, so you pay $200m for $200m in the money element and you pay $200m for the cover above that, so it’s like a $400m premium for the treaty…the problem with it is that in a really benign year it’s still $1.2bn, so let’s say $1.4bn drops to $1.25bn in a benign year, but it’s still $1.2bn, so you don’t see the upside especially outside of extreme years and you don’t see any upside outside of extremely benign years…so if we do this all over the group successfully it would lead to reduction in large risk losses of individual claims over $2.5m…if we renew that treaty next year and the year after it would be silly in some aspects because we think we can lower the frequency of large risk losses and we are starting to see that already and that would be to the benefit of reinsurer and not shareholder…it’s an unusual treaty and no other company in the world has that kind of treaty…we will move to a more traditional reinsurance structure next year, we will lower the exposure to a single catastrophe and buy more cover at the top which will get us a capital credit.”
We think QBE is moving to a more traditional reinsurance structure would decrease its total reinsurance spend (because they will not be buying this very expensive total volatility reinsurance program) on which Mr. Jackson noted, “we will be better protected for catastrophes going forward but we will be more exposed to frequency of individual claims over $2.5m…the reinsurance spend should be lower than what it is now but we will have to allow for a higher cumulative cost of risk and cat losses the net of those two will be a slight headwind initially but over the time as the risk losses come down that will actually end up being a tail wind.”
We think if QBE can improve its risk selection, frequency of large losses would fall and if they can improve pricing, their overall loss ratio should improve.
Disposals are largely completed in our view
QBE plans no further disposal of businesses once it has completed the disposal of personal loans business in the U.S. ($375m business), by a renewal rights deal that starts on 1st of January and the sale of another personal loan business (worth $125m), on which Mr. Jackson noted, “once that’s done that’s basically it…we are where we want to be so you shouldn’t expect any further top line shrinkage”.
Upcoming reinvestment and growth opportunities are unlikely in our view except CBA’s insurance business
Mr. Jackson said that the company is comfortable in making acquisitions for growth only when all the existing operations are running efficiently, noting in the words to the effect of, “we have the basics in place across the entire group and we are confident that everywhere we do business and every class we do business in, we are actually doing it appropriately then we are happy to grow…so if you think about that therefore probably you could say categorically that we have very little interest in aggressive growth in North America and Asia Pacific, because they have got work to do on their own business and so equally from an acquisition perspective if there was some fantastic acquisition that presented itself to our European or Australian business that could be a possibility but it’s not on the agenda…we will look at Commonwealth Bank’s insurance business which it is considering to sell eventually but it will come down to price…acquisitions elsewhere in the world, even in Europe might still be a hard swallow for the shareholders at the moment and there is a lot of upside in what we have in front of us…”.
Interestingly, Mr. Jackson noted potential minor investments that may be disruptive technologies to the insurance industry, noting “the board and the tech team based in the U.S. regularly meet to look at tech opportunities around the world and we have made 3 investments in tech companies and we have $50m dedicated for that…we invested in a company called Cytora, which is run by a bunch of rocket science mathematicians from Cambridge University who use unstructured data to risk select for property underwriting…at the moment we are not looking for techy things that are going to totally revolutionise insurance, where we are trying to invest in things that could improve the 3 basics; pricing, risk selection and claims management.”
Potential cost outs to come but yet to be stipulated
Mr. Jackson noted “we are going to come out in next quarter with some comments on cost out and it will be a gross cost target and a net cost target and the difference between the two would be reinvestment…a lot that’s happening at the moment is looking at where we spend and if we are actually getting value for that…”.
Sensitivity of movements in interest rates
Mr. Jackson said that the company writes policies in multiple different currencies around the world but invest in the same currency, so the balance sheet is primarily hedged, noting, “when I give you the sensitivity of movement in interest rates it is across the curve and it assumes that all the curves by currency move by the same amount…as of 31st December 2017 it was $430m reduction pre-tax profit, reduction in claims liability for 1% parallel shift in all yield curves and it was about $370m unrealised asset loss…our asset duration on 31st December was 1.5 years and the liability duration was 3 years…the reason why that sensitivity is not more positive is because we have more dollars of assets than we do liabilities and if you look at sensitivity of insurance profit, excluding the assets backing the shareholder’s funds, it would be a bigger mismatch…since then the duration of the liability has been pushed out a little bit and is 3.2 years now and our asset duration today is about 1.7 years and we are slowly moving the asset duration out and we will be very sensitive about which currencies we do it in, primarily in US$…the right place to be would be around 2.2-2.5 years but the good news is that between now and then as yield curves steepen and shift up we are in a very beneficial position because the liability impacts will more than offset the asset impact and we can pick up term premium overtime by moving up whereas our peers are already out on the curves so they will have big unrealised losses on fixed income whereas we won’t…we will gradually move out which will lead to narrowing of that positive gap.” We think QBE will fall short of around its investment guidance this year because of unrealised losses in fixed income.
Thoughts on share buyback
Mr. Jackson said that because the company is not focussed on growth right now, it’s not using capital and so they can basically pay 100% of returns out, noting in the words to the effect of, “if we had 100% franking we would probably be more inclined to pay specials on top of normal dividends but because we don’t have 100% franking and given where the share price has been and given what we think we can deliver in the future it is sensible to buy stock back so we are basically doing 65% payout ratio and the other 35% covers the A$333m share buyback for which we have already done A$200m… that’s another A$133m between now and year end…it’s all about improving capital efficiency as well as driving for better returns.”
Mr. Jackson concluded our talk by noting in words to the effect of, “we will come out sometime in between now and year end with certain commentary around what we think our cost out target would be, how are we going to get it and we will also come out with more detail on what we are doing with reinsurance and what the net impact of that would be…what we are ultimately driving for is at the moment we are doing a 7%-8% ROE which I think is not good enough and if we don’t improve that we might as well shut it down and invest somewhere else…we have got a 3 year path to a double digit ROE…another thing we are trying to do is improving the culture in the company.”