In an industry based on calculating risk, the blue chip’s luck has finally run out, writes Michael West.

Halo slips … investors have lost faith in chief executive Frank O’Halloran. Photo: Jim Rice

On January 12 disaster struck. Just as the market bigwigs were kicking back in Palm Beach and Portsea, the most azure of insurance sector blue chips, QBE, unveiled a horrendous profit shock.

This was no regulation downgrade. It was a Category 5 widow-maker; earnings would fall short of estimates by up to 50 per cent. The stock tanked and now, one month later, it is clear QBE – the ”market darling” of the insurance sector since it was laid low by the September 11 attacks in 2001 – has finally broken trust with investors.

The stock looks cheap – having fallen from $20 to $12 in a year – though it stands to gain from rising yields on its $20 billion bond book, not to mention hardening insurance premiums worldwide.

But the big bargain hunters are sidelined. A capital raising is on the cards, capital ratios are stretched, and people are speculating as to the next bit of bad news.

More broadly, the moral of the QBE story is, if something looks too good to be true, it probably is.

Look no further than its corporate advisor Macquarie, which foreshadowed ramshackle results from its now dilapidated model earlier this week. Such is the fate of the corporate Pacman. There is always a comeuppance.

For its part, QBE has racked up a mind-numbing 112 acquisitions since 1983. The playbook was to buy insurers in the US and Europe on cheaper multiples then revel in the valuation uplift.

You see, insurers in other parts of the world tend to trade on price-earnings multiples of six times, as QBE once did. Yet its superlative run of profits and seemingly never-ending penchant for striking successful acquisitions, while apparently never getting whacked by a catastrophe, put it on a valuation twice as rich as its peers.

Its chief executive, Frank O’Halloran, was a veritable market hero until two years ago when things began to come unstuck. For the market, it was a case of ”trust Frank”. And for Frank, it was a case of buy on a price-earnings ratio of six times, consolidate and parade the massive increase in capital value through the profit and loss account.

Here was the ultimate black box. There were so many acquisitions, it was hard to keep track. And besides, for the analyst, insurance companies with all their assumptions, variables, jurisdictions and reinsurance side deals, are the hardest of any company to evaluate.

It was about trust. That was the premium in the stock price. It is something easier lost than won back.

Some QBE watchers believe the recent downgrade was brought on by directors wanting to protect themselves in case things got really ugly.

This bad news was not just about investment markets – where insurers derive half their income – but also about elevated catastrophe costs, spread movements, discount rates. A host of things. It had the aroma of a house-cleaning about it.

The rub is, capital adequacy levels are tight, especially in light of impending Basel changes on how much capital insurance companies and banks need to hold as a buffer against big claims.

It was always a thing for suspicion among insurance types that QBE had such a golden run averting cyclones and other natural disasters. Now, in this latest downgrade, it has taken one (Thailand floods) right between the eyes with seemingly not enough risk hedged.

O’Halloran and his trusty numbers man Neil Drabsch had always seemed so well provisioned in the past. Perhaps they are no longer the only people in the picture.

QBE shares are yet to bounce in line with the six-week equity rally and the hardening premium cycle. After the worst year for catastrophes in many years, premiums are rising, certainly in property classes.

Rate increases of up to 15 per cent have been reported in some areas. If the group managed to get increases of just 5 per cent across its $15 billion insurance business – and holding everything else constant – that would be about $750 million flowing straight to the pre-tax profit line.

Its catastrophe claims in 2011 were $US1.2 billion ($1.1 billion) higher than in 2010. That gives you a sense of how much the bottom line could be improved if 2012 turns out to be a more normal year for catastrophes.

And with a bond book of more than $20 billion, every 1 per cent by which bond yields increase is worth about $200 million a year. The question remains though, what lurks beneath?