Attack At The Bounce

The Age

Saturday May 11, 2002

Leon Gettler

Q The company says the worst is behind it, and it has forecast strong earnings growth for 2002. What's the evidence of progress in the first months of 2002?

A The only stated evidence thus far is comment at the AGM, when QBE indicated it was on track to deliver its targeted net earned premium revenue of $5.5 billion and insurance margin of between 6 per cent and 6.5 per cent. However, if you look more broadly, we can learn a little from companies like ACE and XL - insurers based in Bermuda - which, in some areas, have similar operations to QBE. Both reported substantial improvements in their FIrst-quarter 2002 underwriting results.

Q Other Australian insurers that have entered the global reinsurance market have come a cropper. Does QBE have any sustainable advantage taking on the global players? Is it too small to be a player in the changing reinsurance market?

A We think it is utterly inappropriate to group QBE in the same category as the likes of New Cap Re, Reinsurance Australia or GIO Re. These companies underwrote very different risk-proFIle business at arm's length with substandard retrocession covers and depended on a few individuals for a high proportion of their business. Secondly, we are not sure that scale is the relevant metric. For insurers we think it is credit rating, a better measure of their capacity to meet obligations. That said, larger players do tend to have a higher credit rating. QBE has scale in its Lloyd's operations where it has around 8 per cent market share, with Lloyd's premiums accounting for around 32 per cent of group premium income in 2001. It also has scale in Australia, which accounted for 20 per cent of 2001 group premium income, and it has scale in some countries in the PaciFIc region. Further, it is ranked in the top 20 reinsurers globally by premium income. There are, of course, other regions and risk classes where we are sure QBE would prefer to have more scale.

Q There is still an overhang of risk associated with September 11. How much share-price upside is there if the risks recede?

A We think valuations will really depend on the longevity of the insurance cycle and QBE's performance through the cycle. Most in the insurance market believe the insurance cycle will be strong through 2003. The upside in the share price from the current point really depends on QBE delivering on its promises.

Q The bulk of growth was expected to come from hikes in premium rates across all classes. Chief executive officer Frank O'Halloran says these won't boost profit until 2003. What effect will these have on earnings, and your valuation?

A There are several factors driving timing of the earnings momentum that QBE expects from the current rate increases. These range from when the premium income written is actually earned, to reserving practices, to the adequacy of past accident year reserves. QBE has stated it will keep adding to prudential margins in 2002, which is one of the reasons why it expects earnings momentum will be more apparent and margins will be stronger in 2003. As for valuation, we tend to look through the cycle and value the group on sustainable, longer-term trends, so short-term positive or negative fluctuations don't tend to materially change our view of fair value.

Q Are you confident that QBE is completely across its exposure to the aftermath of September 11?

A The issues to consider are the adequacy of gross claims reserves and prospect of receipt of all expected reinsurance recoveries. On gross claims estimates, QBE stated that it had reserved to the full amount on exposures with FInite risk - which constitutes the majority of its exposures - and had taken conservative estimates on other exposures. QBE has minimal exposure to the actual WTC buildings. The majority of its exposures lay elsewhere, including aviation risk. It reported at its annual general meeting that claims trends on WTC were tracking as expected, with the level of reported claims increasing and the incurred but not reported claims decreasing, but with no net change in estimated liability. In terms of its own reinsurance, QBE has stated it expects 40-45 reinsurers to contribute to its reinsurance recoveries on WTC, with the average recovery from each insurer relatively small. Given this, the low risk of systemic failure from WTC, and the fact that a high proportion of QBE's reinsurers have a high credit rating, we are relatively comfortable. Nonetheless, also remember that the WTC event has more or less rewritten insurance rule books, and that it is likely to take many years for the true cost of WTC to emerge. To that extent, claims development costs and cashflows will be something to monitor for some time.

VERDICT

Macquarie - outperform

J.P. Morgan - buy

Deutsche - market perform

Merrill Lynch - buy

BNP Paribas - outperform

ABN Amro - add

Salomon Smith Barney - outperform

JB Were - buy

CSFB - buy

© 2002 The Age

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