IAG will radically realign its UK business and push further rate increases after a shock third profit downgrade this year.

The insurer is now expecting a 2010 fiscal year insurance margin of 6-7% after its UK business took a $365 million hit through raising reserve levels, including a new $60 million reinsurance arrangement to stem further losses.

The downgrade continues a horror start to the year for IAG, which has slashed its insurance margin by six percentage points from the high end of 13% following the March Melbourne and Perth hailstorms which caused industry-wide losses of nearly $2 billion.

IAG opened at $3.61 on the Australian Securities Exchange on Wednesday morning before falling to its lowest point since July 2009, down more than 6% to open at $3.37 this morning.

The group’s UK business has taken a pummelling from rising bodily injury claims in the Equity Red Star vehicle specialist business, where cost per accident has risen by 10%.

This has been driven largely by the rise of “no win no pay” legal actions in the UK, where litigation lawyers have aggressively engaged in so-called “claim farming” against insurers. The ailing UK economy is also contributing to a rise in fraudulent claims activity.

CEO Mike Wilkins told a market briefing in Sydney last week the company will also write down $86 million in goodwill and intangibles to get the business back on a profitable footing.

“This is a challenging time for the UK motor insurance industry as a whole,” he says. “We remain confident that Equity Red Star retains a strong niche position in UK motor classes and is capable of delivering attractive returns for IAG over the longer term.”

Mr Wilkins says he stands behind the business and its management, led by UK CEO Neil Utley. He also ruled out the need for raising additional capital.

Beginning with aggressive rate hikes of 10-20% across different classes of business, IAG will shed 5% of its UK brokers while recruiting several “experienced individuals” in underwriting and actuarial roles.

Perhaps most surprising is IAG’s planned withdrawal from all external aggregator-sourced business of a “non-bike nature”. More than 40% of all personal lines insurance in the UK is sourced through online comparison websites, and IAG’s decision to extract itself represents a tacit admission of defeat in the cut-throat UK vehicle insurance market.

About 60% of IAG’s UK portfolio is tied up in aggregator websites.

Analysts are now asking questions about the wisdom of IAG persisting in an already saturated market. In 2006 the group purchased Equity Insurance Group, the UK’s fifth-largest motor insurer, for $1.4 billion. However, the aggressive expansion has so far failed to live up to expectations.

The business accounts for 10% of IAG’s total gross written premium, and is driven by Equity Red Star, which is the largest vehicle syndicate at Lloyd’s. The UK vehicle sector has squeezed the profitability out of Equity in recent years. Its insurance margin fell to 6.6% this year after reaching 20.2% in the first half of last year.

Mr Wilkins says the UK business will go into the red this fiscal year before returning to “small digit” profitability in 2011.

IAG will also pass on small rate increases across its Australian business. Mr Wilkins says local insurance margins will bounce back to between 10.5%-12.5% in 2011 with gross written premium rising by 3.5-5%.

He says IAG usually delivers dividends on 50-70% on cash earnings, but that has “been adjusted” in the past. “The directors will make that decision in August.”