QBE

A$12.00 - SELL
Jan van der Schalk
jan.vanderschalk@clsa.com +61 2 8571 4245

When the tide goes out...

Insurance underpins OECD economies: in the modern world we dont float, fly, tunnel or build without insurance. Insurance provides a safety net, thus, it sets us free. It allows us to unleash our imagination, to actualise our flights of fancy. Thats a weighty responsibility, which requires a disciplined and rigorous approach to pricing the future. QBE is part of an industry which forms an integral lever for society to move forward, to improve. However, QBEs focus on returns saw it putting profit before purpose which, as with everything, means you will fail. Fail they have and now its being compounded for the job is only half done. Today was about putting out fires, not preventing them. Sad. SELL. Is John Neal still the right man for the job? When insurers sell a policy they dont know the cost. When competition is fierce it is, therefore, easy to discount prices, for claims develop over a long time period and its relatively easy to rob todays Peter to pay yesterdays Paul: this equation is only in equilibrium for so long. John Neal knows this, but got it horribly wrong. It happens (ask Mike Wilkins). We believe it wont happen again, but we need convincing on Europe: proper disclosure is key. If this is the kitchen sink, why not Europe? Today saw QBE deal with their USA exposures. We have no idea whether the latest round of reserve strengthening is good enough, but lets assume it is. But structurally, the European business suffers from the same long-tail issues as the USA, it just lags. Remember Italian medical malpractice issues 6mos ago? We would like to see a USA have-the-drains-up process on Europe. Risk is still being under-priced According to QBE every single risk is priced to a return hurdle of 14-15% ROE and this produces a 13-14% margin (it should be 17.5%): what does that tell us about rate adequacy for FY14? Its clear, QBE remain more concerned at losing income rather than upping margins, hence theyre under-pricing their risks. Keep doing that and you wont solve your problems. Theres no reward in this risk 10% margin FY14 really doesnt see investors being rewarded for taking on poorly explained, opaque risk. This is a complex, global, operation still digesting a rash of acquisitions effected only to pimp-the-top-line-ride. When there is no trust, there is no adequate reward, and the managements mindset towards investors has to change. We cant see it. Target price $9.89 SELL. Financials
Year to 31 December Gross premiums (US$m) Combined ratio (%) Net profit (US$m) NP forecast change (%) EPS (US) CL/consensus (15) (EPS%) EPS growth (% YoY) ROE (%) PE (x) PB (x) Dividend yield (%)
Source: CLSA

Company update

Swati Reddy
+61 2 8571 4256

9 December 2013

Australia
Insurance
Reuters Bloomberg QBE.AX QBE AU

Priced on 9 December 2013 ASX200 @ 5,144.4

12M hi/lo

A$17.49/10.30 A$9.89 -18% 1,199.0m 100.0% US$17,249m

(US$83.6m)

12M price target % potential Shares in issue Free float (est.) Market cap

3M average daily volume

A$89.3m

Major shareholders

Aberdeen Asset Management 11.9%

Stock performance (%)

1M Absolute Relative Abs (US$)
20.0 18.0 16.0

3M (23.7) (23.2) (24.4)

(% )

12M 14.3 1.1 (0.8)

150

(19.7) (15.7) (22.2)

(A $ )

100

14.0 12.0 10.0 Dec-11 Jun-12 Dec-12 Jun-13

QBE (LH S) Rel to ASX200 (RH S)

50

Source: Bloomberg

11A 18,291 96.8 704 73.0 (43.0) 6.8 16.9 1.3 7.3

12A 18,434 97.1 761 88.1 20.6 7.0 14.1 1.3 4.2

13CL 17,963 97.1 (252) (122.8) 71.9 74 (18.4) (2.3) 15.2 1.3 3.2

14CL 17,013 94.2 886 (28.0) 78.9 67 9.8 8.4 12.9 1.1 3.8

15CL 17,648 93.8 1,037 (19.8) 90.2 66 14.3 9.2 11.3 1.1 4.4

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When the tide goes out...

QBE - SELL

How to manufacture a result

Reserves exist to provide a buffer against the uncertainty inherent in the pricing of an insurance policy. However, the temptation to use these reserves to bolster under-priced risk and to manufacture a result is tempting: especially when investors reward you for this sleight-of-hand.
Figure 1

Guidance misses

Insurance margin Guidance vs. Reported 35% 30% 25% 20% 15%
10% 14% 13% 11% 8% 7% 8% 6% 17% 18% 20% 17% 15% 12% 11% 10%

Guidance Ins Margin % Reported Ins margin %

22%

22% 20% 17% 17% 17%

17%

10% 5% 0%

7%

6%

FY02 Source: CLSA

Figure 2

FY04

FY06

FY08

FY10

FY12

FY14CL

Series of reserve deterioration

Reserving Trend (+ve numbers indicate reserve strengthening, -ve numbers indicate reserve releases) 10.0%
1.5 1.5 1.4 2.8% 0.7% 1.5 1.4 1.4 1.3 1.2 1.3% 0.8% 2.9% 6.5% 4.3%

1.50

5.0%

0.0%
-2.3%

0.0% 1.2

1.30

-3.0% -2.7% -4.2%

1.1 1.1 1.0

-5.0%

1.10

Reserve movement as % of NEP -10.0% FY02

Source: CLSA

Total Reserves to NEP (RHS) FY04 FY06 FY08 FY10 FY12 FY14CL

0.90

Whilst we might be tempted to delve into the arcane world of insurance accounting and to baffle investors with weird terminology, at its simplest QBE have consistently not charged enough for the risk they have run. Why? Because investors have rewarded the company for growing the top-line rather than for carefully husbanding their margin. Insurance stands or falls solely on pricing risk to the best of your ability and, in the event theres any uncertainty to that, declining to underwrite the risk. It is clear that QBE have tried to circumvent this simple rule by means of an acquisitions strategy.

9 December 2013

jan.vanderschalk@clsa.com

2
Prepared for: Bloomberg

This document is being provided for the exclusive use of VIRAJ MEHTA at ANTIPODEAN ADVISORS

When the tide goes out...

QBE - SELL

Figure 3

QBE Performance $50.0

26% 24% 26%

30% 25%
22% 22% 20% 20% 18% 17% 14% 15% 13% 8% 7% 7% 7% 6% 5%

$40.0
18%

22%

$30.0

17%

20% 15% 10% 5%

$20.0
9% 7%

10%

QBE Shareprice A$ QBE Ins margin % QBE ROE %

$10.0

$0.0 Dec 01
Source: CLSA, Iress
Figure 4

Dec 03

Dec 05

Dec 07

Dec 09

Dec 11

0% Dec 13

Last 5 Earnings Downgrades Event 1) 2) 3) 4) 5) Date 12-Jan 12 17-Aug 12 12-Nov 12 20-Aug-13 9-Dec 13 Description FY11 earnings downgrade 1H12 result announcement FY12 earnings downgrade 1H13 result announcement FY13 earnings downgrade movement in stock price (12.70%) (4.50%) (8.30%) (5.50%) (20.00%) incremental reserve deterioration $m 0 117 263 178 500 reserve det. as % of NEP 0.00% 1.60% 3.10% * 2.40% 3.30%

* this was later increased (in Feb 2013) to $341m, representing 4.0% of 2H12 NEP; Source: CLSA
Figure 5

Last 5 Earnings Downgrades 150 140 130 120 110 100 90 80 70 60 Dec 11
Source: CLSA, Iress AUD devaluation and rising US 10yr bond yield

ASX200 QBE

Last 5 earnings downgrades (FY11, 1H12, FY12, 1H13, FY13)

Event 2 Event 1 Event 3 Apr 12 Aug 12 Dec 12 Apr 13 Event 4 Aug 13 Event 5

Dec 13

9 December 2013

jan.vanderschalk@clsa.com

3
Prepared for: Bloomberg

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When the tide goes out...

QBE - SELL

A job half done.

What we believe is still required to do the job properly: 1. Forensic examination of the European reserves 2. Greater transparency and disclosure by the company (after raising this point with QBE we are putting a proposal to them) in order to establish the veracity of some of their remedial efforts 3. A commitment to producing an insurance margin of greater than 15% where, we realise, this will impact the top line negatively. To put it starkly: a commitment to pricing risk to stated hurdle rates which will recompense investors for the complex risks being run within QBE.

Figure 6

Figure 7

QBE North America

10,000 GWP U$m NEP U$m Ins margin %

QBE Europe

QBE N.America

40%

7,000
6,000

GWP (GBP m)

QBE Europe
26% 25%

40% 32%
24%

NEP (GBP m)
Ins margin %
22%

7,500

25%

30%

5,000
4,000 3,000
15%

5,000
14%

2,500
3%

8%

10%

14% 15% 14%

12%

20%

16%

15% 9% 10%

16% 8%
4%

10%
4%

2,000 1,000 0

8% 10%

11%

7%

0
-5%

0%

5%

0% -8%

-2,500
FY02 FY04 FY06 FY08 FY10 FY12

-10%

-10%

-1,000

FY14CL

FY02

FY04

FY06

FY08

FY10

FY12

FY14CL

Source: CLSA

Source: CLSA

Figure 8

Figure 9

Group GWP growth %

45% 35%
29%

Group COR %
Australia Group
34%

Europe

110%

N.America Australia Group

98% 94%

Europe Equator Re
97%

33%

100%

97%

98%

25%
20% 21%

90%

91% 89% 86%

89%

90% 90%

94%

15% 5% -5% FY02

11% 9% 6% 2% 1%

85%

80%

-3%

FY04

FY06

FY08

FY10

FY12

FY14CL

70% FY02

FY04

FY06

FY08

FY10

FY12

FY14CL

Source: CLSA

Source: CLSA

9 December 2013

jan.vanderschalk@clsa.com

4
Prepared for: Bloomberg

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When the tide goes out...

QBE - SELL

This was disastrous

Figure 10

FY13 Guidance At 1H13 Catastrophe losses Attritional losses Reserve strengethening Other Net Loss Ratio Expense ratio COR Insurance margin
Source: CLSA
Figure 11

Today 8.5% 50.0% 4.5% 1.0% 64.0% 33.50% 97.5% 6.0%

10.5% 47.0% 1.0% 1.0% 59.5% 32.50% 92.0% 11.0%

FY13 Increase in Attrional Losses Cost (U$m) FPS restructuring charge Crop 11% increase to COR Est. GOT program TOTAL
Source: CLSA

One off impacts? 1.0% 0.5% 0.9% 2.4%

150 76 135 361

There was a lot in this profit warning to digest: if it hadnt been for favourable tailwinds on natural perils the result would have been worse still. We wonder if this might not lead to a downgrade by S&P (as we set out in our note QBE SELL (QBE BBB+?)). We are, however, not clever enough to work this all out in a hurry, and will revert on these issues. In the meantime, our target price moves from $10.36 to $9.89 (as weve increased our PE multiple, for the business is moving forward if only part of the way). We end with our oft published chart comparing this stock to AIGs calamitous decline many investors have dismissed this as a piece of sensationalism; we think theres a remarkable similarity between the drivers of both stocks (growth) and that, in the event tough decisions arent taken soon by QBE, theres lessons to be learned from history yet. SELL.
Figure 12

AIG Peak Dec 2000 QBE Peak Sep 2007

AIG and QBE

1800.0 1600.0 1400.0 1200.0 1000.0 20.0 800.0 600.0 400.0 200.0 15.0 10.0 5.0

AIG vs QBE (high points interspersed)

40.0

35.0

AIG Shareprice
QBE Shareprice

30.0 25.0

0.0 Nov82

0.0
Nov86 Nov90 Nov94 Nov98 Nov02 Nov06 Nov10

Source: CLSA, Bloomberg

9 December 2013

jan.vanderschalk@clsa.com

5
Prepared for: Bloomberg

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When the tide goes out...

QBE - SELL

Companies mentioned
QBE (QBE AU - A$12.00 - SELL)

Recommendation history of QBE Insurance Group Ltd QBE AU

Stock price (A$)

Jan van der Schalk Other analysts No coverage 20

BUY U-PF N-R

O-PF SELL

15

10 Jan 11 May 11 Sep 11 Date 20 Aug 2013 04 Jun 2013 22 Apr 2013 26 Feb 2013 05 Dec 2012 11 Oct 2012 20 Aug 2012 28 Feb 2012
Source: CLSA

Jan 12 May 12 Sep 12 Target 10.36 13.67 11.73 12.77 9.43 11.19 11.00 9.02

Jan 13 May 13 Sep 13 Rec Target U-PF 11.62 O-PF 15.71 Dropped Coverage BUY 21.30 U-PF 18.60 U-PF 18.05 U-PF 20.00 U-PF 18.05

Rec SELL SELL SELL U-PF SELL SELL SELL SELL

Date 13 Jan 2012 06 Dec 2011 09 May 2011 28 Feb 2011 07 Feb 2011 05 Feb 2011 04 Feb 2011 18 Jan 2011

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9 December 2013

jan.vanderschalk@clsa.com

6
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