By Adele Ferguson
IT'S no surprise that QBE Insurance Group's share price tanked after its chief, Frank O'Halloran, issued a chilling 52 per cent profit downgrade, confessing that its all-important insurance margins would continue to collapse.
The downgrade was all the more disappointing so soon after the company had walked investors through its financial expectations on June 16. That update said insurance margins would be between 16 and 18 per cent. Yesterday he downgraded them to 15.7 per cent.
While O'Halloran blamed the crunch in insurance margins on the volatility of discount rate movements, the explanation does little for the insurance company's credibility.
Insurance groups live and die on their estimations and forecasts. By stuffing up so badly, O'Halloran does little for confidence in a company that has been battered on the sharemarket - down 32 per cent in the past six months - and massively underperforming the overall market and its listed peers, Suncorp, IAG Australia and AMP.
It also raises the question: why did it take so long to make the downgrade? A July 5 report by Axiome Equities noted that the average three-year government bond rate for the major countries in which QBE operates had fallen about 25 basis points. It estimated that this would lead to a $100 million reduction in insurance profit, based on QBE's sensitivities. "QBE reported that its first-half insurance margin will be at the low end of its 16 per cent target when it updated the market on June 16. Had the investor update been on July 1, it may have reported the first-half insurance margin would be below this target," the Axiome report said.
QBE also said yesterday it had decided to change to US dollar reporting, effective immediately. That reduces the profit downgrade from 52 per cent in Australian dollars to 40 per cent in US dollars.
If that wasn't enough, QBE will use a dividend reinvestment plan, using a 2.5 per cent discount on the share price, to replenish capital so it can pay a dividend of 62¢ when it has earnings per share of about 50¢.
It all points to a company under pressure. O'Halloran, 64, has been chief executive for 12 years and his mantra has been to grow the business through acquisitions.
He has made more than 100 acquisitions since he took the helm in 1998.
The group's interim results will be released on August 19 and the fear is that the skinny risk margins will provide another disappointment.
In yesterday's announcement, O'Halloran mentioned that the risk-free interest rates used to discount the group's outstanding claims had fallen since its presentation in London on June 16. This has adversely affected not only the insurance profit margins by 0.6 per cent, or about $US30 million ($A33.5 million), but also risk margins in insurance liabilities.
In simple terms, it looks like the results will show that insurance profit and risk margins are going to fall. Farewell to the hollow logs.
In Australia, all listed insurers release their results in the next few weeks, with investors now interested in how they will deal with lacklustre equity markets and softening premiums. This means the industry will again cut prices for growth on rates, many of which are already below technical pricing.
For O'Halloran, times will only get tougher in the second half, with premiums softening in most insurance lines due to overcapacity, and the US on high alert for another season of above-average hurricane activity.
The reason is simple: more hurricanes mean more expensive claims and that translates into lower insurance profits and a squeeze on insurance margins.
The experts in predicting hurricanes in the US, Philip Klotzbach and Bill Gray at the department of atmospheric science at Colorado State University, have just put out their latest US forecast and they believe the hurricane season will be much more active than average.
They estimate that this year will have about 10 hurricanes (the average is 5.9), 18 named storms (9.6), 90 named storm days (49.1), 40 hurricane days (24.5), five major hurricanes (2.3) and 13 major hurricane days (5).
''The probability of US major hurricane landfall and Caribbean major hurricane activity is estimated to be well above its long-period average,'' they say. ''We expect Atlantic basin net tropical cyclone activity in 2010 to be approximately 195 per cent of the long-term average. We have increased our seasonal forecast from early April."
What makes Klotzbach and Gray's predictions so frightening is that their calculations have correctly predicted either an above-average or below-average season in five of seven years since 1999.
Because QBE is more exposed than any other insurance company in Australia, it stands to lose the most if the US suffers from yet another destructive hurricane.
QBE's deteriorating capital position, its use of captive insurance to reduce the cost of reinsurance - which is adding to the group's overall risk - an opaque balance sheet, currency risk, low growth and declining return on equity are making investors increasingly wary.
As QBE's share price continues its retreat, O'Halloran's once-held ambition to end his reign with the acquisition of IAG looks a pipedream.