When Royal Bank of Scotland floated 35 per cent of shares in insurer Direct Line (DLG) in October, demand was high. The offer was quickly oversubscribed and retail investors eventually snapped up shares worth £125m. But the success of the flotation shouldn't obscure Direct Line's weak trading prospects. The worry is that these are poor enough to wipe off the share price gains to date.
- Decent dividend prospects
- Significant cost-cutting potential
- Motor premium rates falling fast
- Uncertainty from competition probe
- Barely makes underwriting profits
- Share price boosted by technical factor
Direct Line's biggest business is motor cover, which generates 43 per cent of its gross premiums. But the UK motor market has been lossmaking for years. Accountancy firm Deloitte reckons that in 2010 in aggregate UK motor insurers generated a combined ratio of 120 per cent. In other words, they lost money - for every £100 of premium income they brought in, they paid £120 in claims. Insurers have been trying to rectify that lossmaking situation by boosting motor premium rates. According to the Office of Fair Trading (OFT), these rose 12 per cent in 2010 and 9 per cent in 2011. Such rate increases, says Deloitte, meant the sector's combined ratio had improved to a less painful 106 per cent in 2011. But fierce competition among insurers means that rates have slid since then. Price comparison site Moneysupermarket.com revealed that average UK motor rates slumped 10.6 per cent in the year to spring 2012, and that pressure looks set to persist.
Matters won't be helped by the OFT's decision in September to refer UK motor insurance pricing to the Competition Commission. The OFT reckons that "competition appears not to be working in the private motor insurance market. The insurers of at-fault drivers appear to have little control over the bills they must pay, and this may be leading to higher costs for them and ultimately higher premiums for motorists". That probe may take up to two years and could result in lower premiums - bad news for the motor insurers' long-term profitability.
DIRECT LINE (DLG) | ||||
|---|---|---|---|---|
| ORD PRICE: | 198p | MARKET VALUE: | £2.97bn | |
| TOUCH: | 198-199p | 12-MONTH HIGH: | 206p | LOW: 175p |
| DIVIDEND YIELD: | 6.3% | PE RATIO: | 7 | |
| NET ASSET VALUE: | 187p | COMBINED RATIO: | 99.7% | |
| Year to 31 Dec | Gross premiums (£bn) | Pre-tax profit (£m) | Earnings per share (p) | Dividend per share (p) |
|---|---|---|---|---|
| 2009 | 5.33 | 132 | 8.9 | nil |
| 2010 | 5.15 | -378 | -18.1 | nil |
| 2011 | 4.52 | 343 | 16.6 | nil |
| 2012* | 4.17 | 253 | 27.9 | 7.6 |
| 2013* | 4.67 | 345 | 27.9 | 12.4 |
| % change | +12 | +36 | nil | +63 |
Normal market size: 5,000 Matched bargain trading *Investec Securities estimates (earnings not comparable to historic figures) | ||||
Direct Line doesn't seem to be coping as well as its rivals. It barely broke even at the underwriting level in the nine months to end-September with a combined ratio of 99.7 per cent. Yet Admiral reported a decently profitable 95.2 per cent combined ratio for the first half of 2012 and RSA, which has a significant UK motor book, reported a 96 per cent ratio with its third-quarter figures. Analysts at investment bank JPMorgan Cazenove don't expect Direct Line to generate a similar combined ratio until after 2015.
That said, management is targeting £100m of gross annual cost savings by end-2014, which should help to support profits, and the group's investment portfolio, which is focused on safe-looking bonds and cash, yielded a 3.1 per cent return for the nine months to end September. That’s in line with the returns generated by most insurers. Dividend prospects look good, too, with analysts at broker Investec Securities expecting 2013's payout to generate a 6.3 per cent yield on the current share price; although shares in other underwriters yield something similar right now.
