IAG and Buffett: ‘The first step in the dance’
Warren Buffett’s first big investment in an Australian company – IAG – has both the insurance industry and the equity market agog: just what is the old campaigner up to?
The deal with IAG is anything but straightforward. The operative word is “deal”. Mr Buffett’s Berkshire Hathaway investment powerhouse hasn’t simply paid $500 million for a 3.7% stake in IAG. There’s much more to this alliance – and much more than is immediately obvious.
IAG Chairman Brian Schwartz says Berkshire Hathaway is a “strategic partner” as well as a shareholder, and he hopes for a “long and mutually beneficial relationship”.
Under a 10-year, 20% quota share arrangement, Berkshire Hathaway will receive 20% of IAG’s consolidated gross written premium (GWP) and pay 20% of claims.
Berkshire Hathaway will pay an undisclosed percentage-based fee in return for access to IAG’s insurance income.
The fact the fee is undisclosed has caused some disquiet in the analyst community. As one analyst complains: “The fee is surely material.”
The fee ostensibly offsets the impact of IAG ceding 20% of its premium income to Berkshire Hathaway, but analysts argue that without knowing the actual fee it’s difficult to assess who has the better part of the deal.
Not surprisingly, the money is on the wily Mr Buffett.
The deal also involves a swapping of business lines between the two companies. IAG will acquire Berkshire Hathaway’s local personal and SME lines, and Berkshire Hathaway will acquire the renewal rights to IAG’s large-corporate property and liability insurance business in Australia.
The rights to be transferred by IAG represent less than 1% of its annual GWP.
The companies know each other well. They’ve had a successful reinsurance relationship since 2000, which might explain how such a complex, multi-layered deal was struck. Mr Buffett speaks warmly of his relationship with IAG MD and CEO Mike Wilkins and his management team.
“We have worked with IAG for more than 15 years and over that time we’ve developed a good understanding and respect for its people, what they offer and the way they do business,” Mr Buffett said. “For us, it is a natural partner.”
Given that he is not one to offer idle compliments, particularly when it comes to investment decisions, the signs are good for a harmonious – and prosperous – partnership.
Mr Buffett has let it be known that he wanted a bigger slice of IAG – a 3.7% cupcake is not his style – but was rebuffed.
“We would have liked to have committed more money actually, but they’d only take $500 million,” he said in a media teleconference. “Maybe we can correct that later on.”
IAG has an option to place up to a further 5% of its capital within the next two years.
Investors around the world will be watching Mr Buffett’s Australian play with interest, as they do all his moves. Why Australia, why insurance and why now?
The short answer is Asia.
“Our strategic partnership with IAG will help fast-track our entry into this region,” Mr Buffett said.
Australia provides Berkshire Hathaway with a gateway to the region, and IAG’s knowledge of the region will also come in handy.
In 2013 Mr Buffett launched Berkshire Hathaway Specialty Insurance (BHSI) as part of a plan to create a global commercial insurance operation, and Asia looms large in that ambition.
Earlier this year BHSI set up its Australian operation under the leadership of Chris Colahan, who is President for Australia and New Zealand.
He has recruited a formidable leadership team, including former IAG Direct CFO Frank Costigan, who is now BHSI’s COO and CFO.
The longer answer to the analysts’ question also includes Australia.
Mr Buffett’s investment in IAG is just the beginning of a long-term presence in the Australian equities market.
He has foreshadowed stakes in “four or five” Australian Securities Exchange-listed companies in the next two to five years, including at least one bank. (One wonders if banking and insurance group Suncorp is on his investment horizon.)
The deal with IAG provides him with more than $2 billion a year to invest in Australian equities. On last year’s insurance revenue of $11 billion it comes to $2.2 billion a year.
IAG is already involved in some Asian businesses which have considerable potential, and Mr Wilkins has been outspoken in urging Australian business leaders to engage with the region.
As reported in insuranceNEWS.com.au in May, he told an American Chamber of Commerce audience in Melbourne that Australian businesses “can’t afford not to be in the region”.
IAG has six target markets in Asia: India, Thailand, Malaysia, Vietnam, Indonesia and China.
“Asia continues to represent an important plank of IAG’s strategy, given the relatively low penetration of insurance in our target markets,” Mr Wilkins said at the media briefing.
“This, along with the rising affluence and consumption of the emerging middle classes, presents an opportunity we believe all forward-thinking Australian companies should pursue.”
Mr Wilkins is particularly bullish on China, describing it as a “source of enormous potential growth” for IAG. He has bold plans to compete in that market on a “national scale”.
The deal with Berkshire Hathaway provides IAG with the capital to pursue those opportunities confidently and aggressively.
But has it given too much away?
At the announcement of the deal last week, Commonwealth Bank analyst Ross Curran set the tone with this question: “Forgive me for sounding flippant, because I don’t intend to be, but is Berkshire getting 20% of IAG for 3.7% of the capital?”
Mr Wilkins, naturally enough, rejected this: the quota share arrangement will free up $700 million in capital over the next five years and will enhance IAG’s insurance margin by 200 basis points.
By the time Mr Curran issued his client advisory, he was obviously feeling a little more sanguine about the deal.
“We expect this deal will be broadly neutral for IAG’s insurance profit,” he said. “However, it provides significant capital relief to IAG.”
Domestically, the teaming of IAG with Berkshire Hathaway may serve to deter new entrants to the Australian insurance market.
“Importantly, we see the threat of a significant new entrant moving into the Australian market is somewhat abated by this arrangement,” Mr Curran said.
About 6.4% of IAG’s GWP is sourced from Asia, according to Standard & Poor’s (S&P), and IAG has previously reported a target of 10%.
The extra capital IAG has secured would seem to exceed its requirements – even if it has designs on Asia.
If IAG is indeed looking to boost its presence in Asia – including in non-life insurance markets in Thailand, Malaysia and China, plus a distribution partnership in Indonesia – S&P does not expect any major announcements in the short term.
“We expect any expansion activity IAG undertakes in Asia will remain modest relative to the size of its Pacific operations,” the ratings agency said in a bulletin released the day the deal was announced.
“We also consider IAG’s Asian operations are largely capable of funding their own underwriting and development costs, at least in the medium term.”
When all is said and done, most of the excitement surrounding last week’s shock announcement was focused the arrival of Mr Buffett onto the Australian equities scene. But as the dust settles, it is somehow less clear precisely why the deal was done – certainly from IAG’s perspective.
Centric Wealth Portfolio Manager Mark Cox says the “great irony” is that a deal intended to create certainty is creating uncertainty – or at least confusion.
“While IAG has indeed reduced the uncertainty of its core Australian and New Zealand franchise, it has perhaps introduced greater uncertainty with regards to how and when the company deploys what will be a significant excess capital position,” he told insuranceNEWS.com.au.
“While a capital return is a possibility, it would amount to little more than taking money out of Buffett’s pocket and putting it the stockholders’.
“What may concern the market is a significant acquisition in Asia where, fundamentally, the existing strategy has yet to vindicate the capital employed.
“A substantial ramp-up could heighten investor anxiety, particularly given the track record of Australian insurers expanding overseas is mixed at very best.”
Morningstar insurance analyst David Ellis says there remain some gaps to be explained.
“It’s a complex and multi-layered deal, which makes it difficult to make a complete assessment of the deal, but I’m relatively comfortable and positive about the deal,” he told insuranceNEWS.com.au.
“It’s the first step in the dance. Who knows how active or how large Berkshire Hathaway is going to be within IAG?”
Mr Ellis says it is unclear what IAG’s plans are in Asia, but the market will be watching closely.
“Mike Wilkins sees growth opportunities in Asia, but the risk is that he blows some of this capital in pursuing those opportunities,” he said.
In the short term, Mr Ellis does not believe the IAG-Berkshire Hathaway alliance will have much impact on the local insurance landscape.
For now, the spotlight remains on Mr Buffett and his plans for the region.
“I got the view from the analysts’ briefing that [Mr Buffett] sees this investment in IAG as a back door, an indirect way, into taking advantage of growth opportunities throughout Asia,” Mr Ellis said.
He also expects Berkshire Hathaway to be a presence on the IAG register for the long term.
“Looking at Berkshire Hathaway’s history in the US, it seems to take large holdings in companies that it favours. For Berkshire Hathaway, $500 million is nothing. As long as IAG continues to perform strongly it wouldn’t surprise me to see Berkshire Hathaway increase that investment.”
In the meantime, Mr Ellis says Mr Buffett’s stake in IAG is not just a vote of confidence in the Australian insurance market, but in the Australian economy generally.
“Big American firms may become more interested in investing in Australia, and not just in insurance. There are probably other big international investors looking at the Australian market with much greater interest as a result of this deal.”
BHSI’s man in Australia, Mr Colahan, can shed little light on what comes next.
“We’re excited about the deal,” he insuranceNEWS.com.au. “It further accelerates our move into the commercial market in Australia and we’re excited about working closely with IAG. It’s a fairly significant acceleration of our expansion plans [in the region], but in line with what we’re doing.”
Beyond saying there will be no change to the structure, strategy or size of BHSI in Australia and New Zealand as a result of the deal, Mr Colahan can add nothing on its likely ramifications.
“This is more IAG’s deal than ours,” he said.
Mr Buffett, at the age of 84, shows no sign of slowing down, nor that he is any less astute than when he acquired struggling textiles company Berkshire Hathaway in 1962 and turned it into a $US355 billion ($456.32 billion) investment conglomerate.
For now, we can only wait to see what the Omaha Oracle has in mind for IAG and the Australian investment market.