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Direct Line - Dividend suspended alongside buybacks

Sophie Lund-Yates, Equity Analyst | 8 April 2020 | A A A
Direct Line - Dividend suspended alongside buybacks

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Direct Line Insurance Group plc Ordinary

Sell: 274.90 | Buy: 275.60 | Change 4.90 (1.81%)
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After prompting from the regulator, Direct line has suspended its dividend. The board will review this decision on an ongoing basis.

This follows the suspension of the group's share buyback program, of which £29m of a planned £150m had been completed.

The shares fell 8.4% in early trading.

View the latest Direct Line share price and how to deal

Our view

Given the importance of the insurance industry in absorbing shocks to society and to the financial system, the regulator seems very keen that insurers remains well capitalised throughout the crisis. The regulator has prompted the sector to suspend dividend payments for the time being, and Direct Line has complied. Even if it had paid the dividend, Direct Line would still have had a Solvency II coverage ratio of 161%, which is plenty for normal operations.

Investors should remember that the dividend hasn't necessarily gone - if all goes to plan it should just be delayed. There's always the possibility that conditions get substantially worse though, so nothing's guaranteed.

In the longer term nothing has changed for the group. Personal insurance remains 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, CEO Penny James has firmly focused on cutting costs and leveraging recent investments in technology. COVID-19 may have upset the timing slightly, but we expect the same basic ideas to stick.

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 in profits, James reckons lower capital spending going forward and £50m of cost cutting could generate an extra £100m of capital each year.

In recent years profits have been flattered by the release of prior years' reserves. Insurers must set aside a portion of the premiums they receive to meet future claims, called reserves. But, if claims turn out to be lower than expected or the rules around how much must be set aside change, the excess can be released as profit.

That's unsustainable in the long run, 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.

Overall we think Direct Line's targets are ambitious but not unachievable - although a lot's riding on the new technology investments living up to their billing. Of course, this relies on James navigating the ongoing pandemic successfully. The PE ratio of 11.1 prior to the announcement is slightly below the long run average. We would caution investors that the next year's earnings may be more volatile than usual, so metrics like PE ratios should be handled with care.

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Operating update

Direct Line's Solvency II coverage ratio stood at 176% on 31 March, towards the top of the target 140% to 180% range. As of 31 March gross travel insurance claims were £22m before reinsurance cover of around £18.5m. Motor claims have fallen as fewer people drive due to government restrictions.

The majority of the group's employees now work from home on full pay, and all job roles will be protected until at least autumn. The 24/7 road rescue service and Accident Repair Centres are still operating, albeit on a reduced service. Direct Line is donating £3.5m to charity to support vulnerable people during the pandemic.

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