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Here are some reasons to consider buying QBE

Nicholas Grove  |  07 Dec 2016Text size  Decrease  Increase  |  

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Globally focused general insurer QBE Insurance (ASX: QBE) is currently trading at a modest discount to Morningstar's fair value on the stock, and despite the company carrying a high fair value uncertainty rating, there are several reasons why investors may want to consider adding the stock to their portfolios.

Firstly, as Morningstar head of Australian banking research David Ellis points out, the company is set to benefit from the recent surge in long-term bond yields.

"Longer-term bond rates have been edging up over the previous two months and we are particularly pleased with the sharp increase in bond rates since the US presidential election and see it as a catalyst for better times ahead for QBE," Ellis says in a recent research note.

"Recent international developments add weight to our positive long-term view and our unchanged $14 fair value estimate."

Ellis explains there are two main ways in which QBE will benefit from higher long-term government bond rates: First, a higher discount rate will be used to value future claims liabilities, thereby reducing the value of these liabilities, while QBE should also record higher earnings from its US$25.7-billion investment portfolio.

"To the extent higher interest rates signify stronger economic conditions in the US, QBE should be able to grow new business and increase premiums," he says.

In addition to the positive earnings impact of higher interest rates, Ellis believes cost control and improved operational efficiency will remain a key driver of future earnings growth for QBE.

UBS analyst James Coghill also believes now is a good time to take stock of QBE, noting that the insurer has so far avoided the second half-year "hoodoo" of recent years by issuing profit warnings-- as it has done for four second halves in the past five.

"While surprises can't be ruled out, benign catastrophe losses, reportedly good US crop conditions, rising bond yields ... should provide sufficient shock absorption for the tough backdrop faced by insurers," Coghill says in a recent note.

He also examines the potential for capital management initiatives from QBE, pointing out the insurer holds around $2 billion of surplus capital above the level required for its current credit rating.

And while QBE's "chequered" track record for consistency leaves UBS hesitant to factor capital returns into its estimates, Coghill acknowledges this "latent positive could evolve into a bankable proposition".

In a similar vein to Ellis, Coghill also feels that cost reduction should be a "key source of margin widening for QBE over the next couple of years".

Superior, moat-worthy profitability

Morningstar's Ellis believes QBE possesses a narrow economic moat rating, despite property-casualty insurers not generally benefiting from favourable competitive positions due to fierce industry competition and their commodity-like products.

"Insurance companies can create durable competitive advantages through underwriting profitability, but not from investment returns," he explains.

"We argue the narrow moat is derived from superior underwriting profitability because of disciplined risk assessment and pricing across an extended period.

"The competitive advantage leads to a lower combined operating ratio, driving profitable underwriting."

... But not without risks

However, Ellis is quick to point out that underwriting profitability depends on strong risk management.

And while QBE may have a solid risk-management track record, write-downs in 2013 and increased provisioning in 2014 tested his view.

"It will take some time for investors to regain confidence in management. We were impressed with the 2015 result, but were disappointed again with the first-half 2016 performance," Ellis says.

"Obviously, our confidence in management and the remedial action undertaken between 2013 and 2015 needs to be supported by a string of improving results."

Ellis says the risks posed to QBE's earnings include the possibility of an extended period of major catastrophes, higher reinsurance costs, increasing insurance lapse rates, higher claim numbers, and sustained weak investment performance.

"Other operational risks are incorrect forecasts of insurance claims liabilities, weak economic conditions depressing new business, and increased competitive pressures reducing premium rates," he says.

And while Morningstar takes a long-term investment view on QBE, the high uncertainty rating on the stock "makes sense due to the increased volatility in the company's earnings".

However, Ellis is confident the CEO and revamped management team have resolved QBE's recent risk-management and restructuring issues, and that underlying profits should therefore be much more consistent going forward.

All up, while there is plenty to like about the stock, there are also plenty of other factors to consider before investing in QBE.

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Nicholas Grove is a Morningstar journalist.

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