ECONOMIC

IAG operates its economic policy according to five key risk levers: underwritten insurance policies; reinsurance; capital; asset allocation; and a risk management framework and control environment. Risk appetite is the way in which these risk levers are adjusted to produce acceptable economic outcomes for all shareholders, policyholders and the workforce. These five levers are strongly interrelated meaning that a change to any is likely to impact several, if not all, of the other levers.

Capital represents a response to the residual risk faced by IAG that has been absorbed by underwriting activity and investment of assets but offset by reinsurance and operational risk management. The challenge of capitalisation is getting the balance right. Too little capital poses an unacceptably high insolvency risk for both shareholders and policyholders whereas too much capital requires high profit margins from policyholders that would fail to meet shareholder return expectations. The Board has established a target level of capital that balances competing objectives and is synchronised with the other risk levers.

The long term level of capital, termed risk based capital, is assigned to each insurance portfolio and fee producing business within IAG. Return on risk based capital targets, tailored to each insurance portfolio or fee business are also assigned. This process promotes accountability throughout the organisation with each portfolio manager focusing on economic sustainability from their controllable perspective.

During the year, a number of capital initiatives have been implemented. These included raising $84.4million under our Share Purchase Plan and repurchasing a further £36million of our sterling denominated subordinated debt. Such initiatives have reduced the extent of our debt gearing, promoted a strong capital position to regulators and rating agencies and helped us to strategically move above our long term capital target in response to current economic conditions.

Reinsurance is where an insurance company buys insurance to cover the risks it takes on, so it's 'insurance for insurers'. Like buying insurance for one car, we buy insurance (called reinsurance) for many. Reinsurance becomes particularly important for us in the event of large disasters like the Victorian bushfire and Sydney hail storms.

There are two ways that we purchase reinsurance. Firstly there is treaty reinsurance: this is where a group (portfolio) of similar risks is insured by an insurer. For example, just as when a customer insures their single car valued at $20,000, IAG may insure 100,000 similar cars. If each of these cars was worth $20,000 (so together $2billion), we purchase car insurance at a value of $2billion. Just like our customers, we worry about events that might damage cars (such as a hail storm) and so we buy insurance to cover that risk.

Secondly, there is facultative reinsurance. This is where we buy insurance for an individual very large risk. For example, we might insure a million dollar Vintage Ferrari, and so we will buy reinsurance specifically for this vehicle.

Within these categories of insurance there are further types; these include proportional and excess of loss. With proportional reinsurance we pay the reinsurer a premium for them to cover an agreed portion of a loss that occurs. Excess of loss reinsurance operates on exactly the same basis as a car insurance policy; continuing the example above, a customer’s car may be worth $20,000, with an agreement to pay an excess of $500 in the event of a claim. Our reinsurance value may be $2 billion, but we agree with the reinsurer to pay an excess of $50 million. The principal is the same, it’s just that the size of the cover is larger. One of our biggest individual reinsurance purchases is our catastrophe excess of loss policy which covers disasters like the Victorian Bushfire and Sydney hail storms.

Insurance premiums are calculated to take account of the losses or claims that we can expect our customers to be making over a period of time. We may expect three thefts a year and five break-ins, so we charge a premium to cover this. Additionally, we may expect to get one severe hail storm every eight years however it is a little harder for us to know what amount of premium to charge and how significant loss could be. To help us manage this we buy reinsurance, for these kinds of large random events.

Our customers insure their cars so as not to sustain a large financial loss in any given year. They may not have the funds to replace a vehicle or borrowing could place a strain on their income. These are the same reasons as to why IAG buys reinsurance. Reinsurance protects us against larger than normal losses, unexpected losses or infrequent losses and in doing so we protect IAG’s capital, our profit and our cash flow.

In line with IAG's strategy to concentrate on its profitable specialist motor underwriting business in the United Kingdom (UK) market, IAG announced in December 2008 that it had agreed to sell its non core UK mass market distribution businesses for a total value of £73.5 million (approximately A$165 million).

The divestment was completed in early 2009 and involved two separate transactions:
• IAG's UK insurance branch network was sold to Swinton Group for £50 million (approximately A$112 million); and
• IAG's Hastings and Advantage businesses was sold via a management buy out for £23.5 million (approximately A$53 million).

The transaction allows IAG's UK business to focus on its profitable specialist motor underwriter, Equity Red Star, and is expected to improve IAG's sustainability in the UK market.

The Asia division generated a total profit before tax of $15 million for the 2009 financial year, which was a significant improvement over the result recorded the previous year. This net profit contribution reflects the continuing investment both in our current operating businesses and in developing new opportunities in selected markets.

The historically high growth markets of Thailand and Malaysia have been affected by the current global economic crisis; significant falls in car sales and consumer confidence have occurred in both regions. However, despite the difficult economic conditions, our Thailand operations increased gross written premium by 2% in local currency terms during the year, predominantly through selective branch expansion outside the competitive Bangkok region. The gross written premium of our Malaysian operations increased by 2.6% in local currency terms during the 2009 financial year. These businesses also achieved improved insurance profits in the 2009 financial year over the previous year; Thailand reported an insurance profit of $9 million, while Malaysia reported an insurance profit of $8 million.

2009 has been a significant year for the Asian division, with major developments in both Malaysia and India.

We signed a joint venture agreement in November 2008 to establish a general insurance business in India with the State Bank of India for which the first of three regulatory approvals has been received. We increased our interest in the general insurance business in Malaysia, and now own 49% of renamed AmG insurance.

We believe the outlook for our Asia division remains positive. The strong operational performance of our existing businesses in Thailand and Malaysia, along with the opportunities presented by the new joint venture in India and increased interest in Malaysia means we are well positioned to take advantage of the growing Asian market.

Within this strategy, IAG's Asset Management function continues to grow our Sustainable Investment Fund that was established in 2008. The objective of the fund is to invest in a diverse suite of assets that generate attractive long term wealth for IAG's shareholders, while aligning shareholder value with the values of the communities and the environments in which we operate.

The funds aims to:
• provide opportunities for strong and consistent investment returns through investing in emerging growth industries. This will contribute to ensuring we are well placed to continue to pay claims and generate long term shareholder wealth;
• contribute to the community by supporting more sustainable business outcomes. This will contribute to IAG reducing the long term risks to its business;
• source investment opportunities that may lead to new product innovation in other parts of our business. This could potentially provide development opportunities for our workforce and ultimately better solutions for our customers; and
• enhance brand value through enhanced community trust and improved reputation.

The cornerstone of this Fund is IAG's investment in Generation Investment Management's (Generation) Global Equities strategy. Generation is a privately owned, London based investment management firm of which the former US Vice President Al Gore is both cofounding partner and Chairman. Generation's global equities strategy was one of the first to integrate sustainability research within a rigorous fundamental equity analysis framework. IAG was a foundation investor in this strategy and has followed this up with a further investment in Generation's Climate Solutions Fund in 2008.  The Climate Solutions Fund invests in both listed and unlisted companies that contribute to the transition to a low carbon economy.

Other investments in the Fund include a green property investment with Climate Change Capital, an equity stake in a rooftop wind turbine manufacturer and an investment in the Arkx Carbon Fund. All of these investment aim to deliver long term returns for investors by investing in assets that enable the transition to a low carbon economy.

We also continue to be a signatory to the UN Principles for Responsible Investment. The UNPRI encourages signatories to advocate that companies and countries in which they are investing integrate Environmental, Social and Governance (ESG) factors into their investment processes and practices, thus contributing to better long term financial performance.

When an individual customer or business takes out an insurance policy, they are doing so to protect themselves against unexpected events, for example if they experience an accident in their car or their property is damaged. On taking out a policy, each customer or business pays an insurance premium, which we put into a pool with premiums that other customers and businesses pay us. If an individual or business ever needs to make a claim on their insurance, we use funds from this pool to pay for the losses covered by their policy.

However in Australia, it is not just the premium charged by IAG that the customer or business pays for when they purchase a premium. There are other insurance taxes and charges that IAG collects on behalf of the government that are also included, for example GST, insurance transaction taxes and in some states insurance companies are required to contribute directly to the funding of fire services. The following table illustrates the level of premium taxes and fire services levies on household insurance premiums in Australia compared to other countries.

What this shows is that relative to other countries, the level of additional taxes applied to household insurance premiums is significant, particularly in New South Wales and Victoria. The implications of this are clear. The interaction of these taxes increases the cost of premiums relative to other products, which can influence individuals and businesses to take up less insurance than they otherwise might.

IAG believes that this level of taxation provides a clear economic case for reducing insurance taxes and charges ahead of many other taxes in order to reduce the taxation burden on businesses and households. These taxation regimes contribute to underinsurance and non insurance, with consequential negative fiscal impacts when the public purse is called upon in times of climate related disasters.

In addition, as a general insurer, IAG is also subject to an insurance protection tax (IPT). The IPT arose subsequent to the collapse of HIH Insurance when significant liabilities were incurred by New South Wales through the operation of state guarantees to claimants. To assist in funding these liabilities, the New South Wales government imposed an IPT which, unlike any other jurisdiction faced with similar liabilities, effectively levied insurance company shareholders rather than policy holders through a prohibition on passing on tax as a cost of business. To provide some context, IAG's total of the New South Wales IPT remained at $20m for FY2009.

What this means is that we are being taxed to cover the costs to that State that may arise from the failure of a competitor.

These examples illustrate the impacts on customers and communities, as well as insurance company shareholders. Insurance plays a critical role in the economy and community however the current taxation system is penalising insurance relative to other more discretionary purchases.

IAG continues to respond to this issue and work with government. Our submissions to government on this topic can be found in the government submissions section of this website.