Bank a 30% return as this insurer goes 'back to basics'

The group has fallen on hard times recently with a combination of operational missteps and regulatory changes forcing both the exit of its chief executive and a thorough re-evaluation of its purpose in life. The attrition of the share price under such circumstances has been predictable, with Direct Line losing more than a quarter of its value over the past 12 months at a time when the FTSE All-Share index has risen.

Yet there is no point in being contrarian for the sake of it – what Direct Line offers for investors is an opportunity to test the theory that individual corporate actions can have a positive effect on a company that had lost its way in the basic management of its affairs. In the process, Direct Line can restore both investors' confidence and one of the best dividend payouts on the market. However, it will take the right combination of internal action and external factors for the shares to regain some of their lustre.

The first area that can be quickly improved is Direct Line’s basic underwriting function. One of the criticisms of the previous top management was that it seemed more concerned with nebulous concepts, such as “AI in customer experience”, than with the basics of insurance underwriting. This criticism seems to have been borne out by the instability in the sub-board level of management, where most of the key operational decisions were made.

However, the main cause of Direct Line’s downfall over the past two years was that it underestimated the cost of inflation in its car supply chain once the dampening effect on insurance claims had subsided, and tried to keep insurance premiums low to hold on to market share in face of fierce competition. It also didn’t help that a surprisingly early and widespread cold snap last winter added £90mn of costs to the income statement due to burst pipes and the sort of mishaps that often occur in the winter.

This approach left Direct Line with low-yielding policies that tied up regulatory capital and contributed to the stretching of the balance sheet. Luckily, reversing this approach and writing policies with a better margin against inflation is straightforward enough when the underwriting goal is clear.

There are signs this year that the industry has turned a corner with its pricing policies. For instance, comparison website Gocompare reports that average car insurance renewal rates are up by 20 per cent this year across the board. This suggests that insurers are not taking any chances when it comes to keeping on top of inflation.

For Direct Line, the underwriting result is also forecast to turn into profit next year and the year after, according to estimates from broker Berenberg. This is doubly important as the company has warned that car claims' inflation will still be a problem this year. In Direct Line’s case, the company’s recent trading update described trading as stable, rather than getting either better or worse. Where that leaves the return of the dividend is uncertain, although that will depend on how much capital the balance sheet produces after the company has rebuilt its financial position. It is unlikely that the dividend will be fully restored before the start of the 2024 financial year.

One reason why Direct Line could benefit from optimism around premium volumes is that the new car market seems to be on a rapidly rising upwards trend, with the effect on sales of the pandemic and supply chain shortages finally working itself out of the system. According to figures from the Society for Motor Manufacturers and Traders, the most recent figures for April showed another double-digit percentage rise in new car registrations – up 11 per cent to 132,990, compared with 2022. In total, so far this year around 627,000 cars have been registered, which is a 16 per cent increase on the same period last year. For the insurers, these numbers are a positive sign that volume growth is returning to the market and should, by extension, lift total policy numbers simply by default. By some measures, the total number of new cars registered in the first four months of 2023 matches the entire newly registered stock for 2021.

The other factor that investors must consider is that, for all its problems, Direct Line still has a sizeable share of the UK car insurance market. According to Statista, the company sits second behind the market leader, Admiral (ADM), with 10.8 per cent of the UK insurance market, with Aviva (AV.) following close behind in third place with 10.5 per cent. In a business as competitive and cut-throat as car insurance, size matters – which is why smaller players have started to fall to the wayside. SAGA (SAG) recently announced it was selling off its underwriting business after disappointing results.

In addition, the exit, or consolidation, of smaller players is an ongoing feature of motor insurance. In other words, having brand appeal and deep underwriting counts hugely in a market where the easy money generated by ‘price walking’ – charging renewing policyholders higher rates than newcomers – has been banned by regulatory decree. Overall, insurance companies have less scope to offer the unsustainable teaser rates that were unwittingly financed by loyal customers – and that may be for the better in the long run for well-established operations such as Direct Line.  

Unlike the more diversified Admiral, which has an extensive US business, plus a personal loans sideline, Direct Line is a highly geared play on the health of the UK insurance market. Without a dividend, investors will have to be reliant in the meantime on new management proving its worth and sorting out its underwriting so that the share price returns to its longer-run average. As the chart indicates, by comparing Direct Line’s one-year share price performance with Admiral's, that alone would mean a useful uplift. 

Meanwhile, broker Berenberg forecasts a price/earnings ratio of just 7.3 for 2024 at a point when returns on net tangible assets are expected to be back to 20 per cent. This implies a re-rating of approximately 30 per cent on the current share price, which would represent an acceptable return for the short-term risk. Like all insurance companies with asset-based balance sheets, Direct Line will see better returns from its consolidated risk capital as interest rates rise.

In summary, Direct Line is a case of corporate actions returning the company to its average performance over the past few years, with a measurable return for investors who are prepared to sit out the lack of a dividend. It is fair to say that buying at barely seven times forward earnings for 2024 will help to lock in a decent income yield once the company has the means to resume its payments. Buy.