First fires, then floods: How listed insurers are weathering extreme events

Emma Rapaport: Hello, and welcome to Morningstar. I'm Emma Rapoport. Here today with me is Nathan Zaia. He is our banking and insurance analyst.

Nathan, thank you very much for joining us.

Nathan Zaia: Thanks, Emma.

Rapaport: So, Nathan, I think a lot of our viewers would understand that these big natural disasters would be huge events for insurers like IAG and Suncorp that have huge costs and huge repairs. But in your recent note you've talked about how the financial damage will be limited for both of these insurers due to reinsurance. Can you just explain why they are somewhat protected from these major costs?

Zaia: Yeah, sure. So, basically, how it works, the insurer is taking on a lot of risk when they write their insurance policies. And to try to mitigate the potential impact that has on their profitability, both when you have a really large event or when you have a number of medium-sized events over the course of year, they take out reinsurance. So, how that basically works is a few different programs they can buy. But one of the big ones is, if there's a major event, they might only incur the first $250 million of claims, then the reinsurer will step in and pay the rest, and that can be up to – for some, it's $5 billion, $6 billion. And then, when you have a second event in the year, what that insurer is on the line for falls again and again. So, in this case, if this is, say, the third big event they've had in the year, they only have to pay $50 million, for example, for Suncorp and then, the reinsurer will pay the rest. So, that's why the cost of this recent event has been relatively small, like despite it being over a $2 billion claims event and these insurers having, like, decent market share.

Rapaport: So, if these insurers increase the amount of reinsurance that they take on every year due to these floods, yes, but two years ago, we had the bushfires as well. So, are they upping the amount of insurance that they're getting?

Zaia: So, last year, Suncorp didn't, but over time, yes, they have been and it's getting a little bit more expensive to take out these reinsurance programs as well. So, they have to balance, is it worth it for us, because at the end of the day, the insurer is making an estimate of what they think the claims will be, and it's always the reinsurer. So, they're both trying to make a decent return on that exposure they have. So, over time, the allowances that the insurers are making for these natural hazard events have gone up materially, I think, in the last five years, maybe 40%, 45%. So, the reinsurance has had to step up to absorb that as well.

Rapaport: Yeah. So, I think the obvious question for a lot of investors, a lot of shareholders is, if we continue to see these natural disasters and we continue to see more and more and more on a more frequent basis, then insurance will have to take on bigger and bigger reinsurance. Does that ultimately – the reinsurance is getting more expensive, does that ultimately create too big of a cost for these insurers and is that something that you think shareholders should be worried about?

Zaia: Yeah, I think the bad news is for the policyholders, like you and I, insuring our car and our home, because ultimately the insurer is only going to offer that policy if they think they can make a decent return for their shareholders. So, if those claim costs just keep going up, be it what they're paying to repair things, what they've to pay for reinsurance, the frequency of events, then the premiums have to go up so that they can make a profit. So, I think that's what will ultimately drive the profitability of the insurers.

Rapaport: Yeah. So, do you think at this point that the insurers in the market have enough capacity to increase the premiums that they're charging for members? Or are they at risk of losing members at this point if they bring the charges to the individuals, or really to the degree that they might have to?

Zaia: Yeah, that's interesting. I think we don't really know where they need to bring them yet, right? Like, we know what happened last year and what happened the year before, they've been really bad events. So, does the reinsurer just set a premium assuming that that is the new base and it's just going up from there, because then you might have a competitor that says, well, things might be a bit better, so we'll price below you and take share. So, it is a bit of a balancing act. But yeah, ultimately, like, there will be examples where it's a region that's prone to these, like, large events where it might get too expensive and it's already happened in the past that people don't renew. But insurance is one of those things where people tend to try and hold onto it for as long as they can. But I don't think we're at that point where home and motor for most people has got too expensive where they're going to up their insurance. Where that tipping point is, it's hard to say.

Rapaport: Yeah. And at this point, you – and you discussed how you are seeing some level of margin pressure for both IAG and for Suncorp. Is that something that you expect to see over the next few years?

Zaia: Yeah, I think some of it will probably unwind. I think we've spoken a lot in the past around is this the new norm or not. So, we're basically seeing that insurers put up rate to recover some of these claims inflation that we're seeing. And on the other hand, the investment income they earn on their policyholder funds and their own shareholder funds, that's been under a lot of pressure. The insurers haven't tried to reprice for all these headwinds at once. So, hopefully, as their investment income picks up, then that should help their margins improve. And they also are doing good things which keep getting overshadowed around their own operating efficiencies, so doing more digitally. So, less people in the call centers makes it faster to process the claim. Those things help reduce their operating costs. And as they should trying to manage the actual claims costs, getting groups of builders together that they can set rates to do repairs, more of their own repair networks that again they have set prices for set repairs, and they can try to keep a lid on inflation that way as well.

Rapaport: Well, that was – you've just sort of steamrolled into my next question, which was, investors seeing a lot of inflation in the market, especially around some of the prices of these goods that needs to go into repair, you know, lumber and petrol costs, et cetera. Is this something that you think the insurers are having to worry about right now as they're about to do these big repairs and could it cost them more to do it?

Zaia: Yeah, I think it definitely is a risk to short-term earnings. As we've discussed, I think, longer term, those inflationary pressures will get priced into the premiums. But there is a risk short term that they haven't adequately allowed for that. Suncorp did state that with their repair work post these floods they've agreed to pay a surcharge or a premium on those repairs to their builders. But it only applies to those repairs. So, everything else they had agreed to in November is retained. So, they're trying to keep that inflation just to that region. But I mean, I'm sure it will spill over. The labor construction and shortages is going to be an issue, I think.

Rapaport: So, just to close out, we're talking about all these difficulties going on with both of these businesses, especially coming up to the floods. But you say that both are undervalued in your view. Why do you think the market is discounting these large insurers?

Zaia: Yeah, I think it is these large events that keep – they do dent their short-term earnings. Like, even though, like we talk about the hit to their earnings being small in the context of how big the event was, it is still hitting their bottom line quite materially. So, I think there's – it's, I guess, hard to have confidence that that might ease in the short term. I think that's one of the market's issues. I think probably overlooking some of the good work they're doing on underlying inflation and the operating efficiencies that I spoke of, and also the uplift from investment income. Like, it's been sometime coming before that eventual cash rate starts to come through. But yeah, I think we're trying to look a couple years out and we think that investment income will be a nice uplift to earnings. And eventually, these insurers make a return at least close to their cost of capital again.

Rapaport: Thank you very much for joining us today.

Zaia: Thanks, Emma.