Earlier today Insurance Australia Group Ltd (ASX: IAG) dropped a bombshell that caused an instant drop in the share price of QBE Insurance Group Ltd (ASX: QBE). IAG announced that it had formed a strategic relationship with Warren Buffett's Berkshire Hathaway.
The story was reviewed by my colleagues earlier today but the gist of the deal is that IAG will be issuing $500 million worth of shares to Berkshire Hathaway in exchange for Berkshire Hathaway receiving 20% of IAG's gross written premiums and paying for 20% of claims.
Moving the furniture in
Berkshire Hathaway stated that the deal would help fast-track the company's entry into the Asia-Pacific region following its entry into the local market last year under the stewardship of former QBE head of reinsurance, Blair Nicholls. Berkshire expanded its presence in Australia in April when Berkshire Hathaway Specialty Insurance (BHSI) opened its doors in the country.
BHSI offers more exotic commercial and complex insurance needs including property, casualty, financial lines and marine cargo insurance, while Berkshire Hathaway Insurance targets the retail insurance segment, including home and motor cover, similar to IAG and QBE.
The Threat to QBE
Berkshire Hathaway is threatening the local operations of all major providers. To QBE, Berkshire is now coming for the company's home, motor, and marine insurance, and will no doubt expand its offering in time to include healthcare, surety, home owners' insurance and travel insurance like it does in the US.
At the end of 2014, QBE generated Gross Written Premiums (GWP) of over $US16 billion. About 33 per cent of this was generated in North America, with Australia and New Zealand, and Europe both providing close to 28 per cent.
The Australia and New Zealand division was by far the most profitable of QBE's reporting segments, generating an insurance margin of 17.7%, compared to just 0.2% in North America, 9.7% in Europe and negative 6.4% in emerging markets!
Big Risk
The biggest risk is that QBE's local margins will plunge with Berkshire entering the market, threatening the group's combined operating ratio target of 94% to 95% in the 2015 financial year. I believe investors are now starting to take into account a slight drop in QBE's margins going forward. Analysts' forecasts have pulled back ever so slightly and the share price has dropped from a 12-month high of $14.82 to below $14.
