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Direct Line - premiums and profits down

Nicholas Hyett, Equity Analyst | 3 March 2020 | A A A
Direct Line - premiums and profits down

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Direct Line Insurance Group plc Ordinary

Sell: 270.10 | Buy: 270.40 | Change 0.20 (0.07%)
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Full year gross written premiums declined marginally to £3.2bn and underlying operating profits fell 9.8% to £546.9m. The fall was primarily due to substantially lower prior year reserve releases.

The board announced a 2.9% increase in the final dividend to 14.4p, bringing the full year dividend to 21.6p. Direct Line is not paying a special dividend, but will buy back up to £150m of shares by the end of July 2020.

The shares rose 4.5% in early trading.

View the latest Direct Line share price and how to deal

Our view

Personal insurance can be a tough industry.

It's highly competitive, and with rivals offering pretty generic products, few companies can maintain any semblance of pricing power. That tends to have negative consequences for combined operating ratios (the percentage of premiums that are paid out as claims or expenses) as companies are forced to cut prices to attract customers. Price comparison websites have only exacerbated the problem.

Nor is that the only headwind. The industry at large has struggled with technical changes to the way personal injury claims are valued, increasing the reserves insurers need to hold.

Against this backdrop, new CEO Penny James has updated the market with a strategy firmly focused on cutting costs and leveraging recent investments in technology. The goal is to bring the group's operating costs down to 20% of premiums by the end of 2023, compared to 23.2% last year. While the cost of the IT upgrade will weigh on profits, James reckons lower capital spending going forward and £50m of cost cutting can generate an extra £100m of capital each year.

In recent years profits have been flattered by the release of prior years' reserves. That's unsustainable, and James wants more profit to come from current year underwriting, driven by lower costs, better underwriting and some growth. That could prove easier said than done though, as better underwriting often means higher prices, which would make growth a challenge.

Direct Line does have a few key advantages. The first is the brand, which has helped it price more aggressively than competitors. The second is scale, because the new, leaner cost base can be spread across more policies. The new technology infrastructure should also help the group compete on price comparison sites, and may improve underwriting accuracy for the direct brands.

The other big news is that the group looks set to favour share buybacks over special dividends going forwards. That will significantly reduce the prospective yield and potentially makes it easier for management to flex total shareholder returns. Although, on the bright side it could provide some support to the share price over time. The shares currently offer a prospective yield of 7.5%.

Overall we think the new targets are ambitious but not unachievable - although a lot's riding on the group's new technology investments living up to their billing. The PE ratio of 11.8 prior to the announcement is slightly above the long run average.

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Full Year Results

Direct Line's total number of in-force policies fell 1.9% to 14.8m, although own brand policies rose 1.4% to 7.3m. Net earned premiums shrank 3.4% to £3bn.

Net earned premiums in Motor, the group's largest division, were down 2.2% to £1.5bn. The current year loss ratio was broadly flat at 81.2%, but prior year reserve releases fell 34.7% to £180.5m. In total the division's combined operating ratio rose from 88.6% to 94.8%.

Home's combined operating ratio improved from 93.5% to 80.3%, primarily because of more benign weather in 2019. Normalised for weather the combined operating ratio improved 4.7 percentage points. Net earned premiums fell 14% to £573.6m.

Rescue and other personal lines and Commercial saw their combined ratios deteriorate marginally to 95.4% and 95.7% respectively, although net earned premiums increased slightly too.

In total, Direct Line's combined operating ratio worsened from 91.6% to 92.2%. The current year combined ratio improved from 104.7% to 102.1%, but the reduction in prior year reserve releases from £404.4m to £294.5m more than offset the improvement. Underlying operating costs fell £24.5m to £693.7m.

Instalment and other operating income fell 6.1% to £180.2m, while investment returns shrank 12.9% to £134.6m.

The group finished the year with a Solvency II ratio (a key measure of insurers capitalisation) of 165% (2018:170%).

Direct Line is targeting a combined ratio of 93% to 95% for 2020, adjusted for the weather. CEO Penny James said the group remains on track to achieve the targets set out at the recent Capital Markets Day.

Find out more about Direct Line shares including how to invest

Unless otherwise stated estimates, including prospective yields, are a consensus of analyst forecasts provided by Thomson Reuters. These estimates are not a reliable indicator of future performance. Yields are variable and not guaranteed. Investments rise and fall in value so investors could make a loss.

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