What it does is to take any postcode entered as a continuous string and format it correctly - not what you wanted - try this instead

=IF(OR(MID(A1,2,1)="1",MID(A1,2,1)="2",MID(A1,2,1)="3",MID(A1,2,1)="4",MID(A1,2,1)="5",MID(A1,2,1)="6",MID(A1,2,1)="7",MID(A1,2,1)="8",MID(A1,2,1)="9"),LEFT(A1,1),LEFT(A1,2))