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Direct Line - lower weather costs boost profits

William Ryder (Equity Analyst) | 3 August 2021 | A A A
Direct Line - lower weather costs boost profits

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Direct Line Insurance Group plc Ordinary

Sell: 216.60 | Buy: 216.90 | Change 0.50 (0.23%)
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Direct line's first half gross written premiums fell 1.5% year-on-year to £1.6bn. Of this, £1.1bn was for own-brand policies, down 2.4%. In force policies fell 1.1% to 14.5m, and own-brand policies rose 1.3% to 7.5m.

Direct Line's underlying operating profit rose from £264.9m to £369.9m and headline profit rose after tax rose from £192.6m to £203.8m. The difference largely reflects the purchase of the lease at the group's Bromley offices, higher taxes and higher interest costs.

The board has declared an interim dividend of 7.6p per share, up 2.7% year-on-year.

The shares rose 2.6% in early trading.

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Our view

The impact of coronavirus has been felt unevenly across Direct Line's business, as reduced motor claims have partially offset higher costs and claims in areas like travel. The dividend was temporarily suspended, but is now back and the group has launched a share buyback programme to return excess capital to investors.

In the longer term very little has really changed for Direct Line. Personal insurance remains highly competitive, and with rivals offering pretty generic products, few companies can maintain any semblance of pricing power. That has tended 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.

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. In recent years profits have been flattered by the release of prior years' reserves.

That's unsustainable in the long run, so CEO Penny James has firmly focused on cutting costs, capitalising on recent investments in technology and increasing the contribution of current year underwriting. That could prove easier said than done though, as better underwriting often means higher prices, which would make growth a challenge. COVID-19 may have upset the timing slightly, but we expect the same basic ideas to stick.

Direct Line does have a few key advantages. The first is the brand, which has helped it price more aggressively than competitors and also secure a relatively high proportion of direct sales (without selling though price comparison sites). The second is scale, because the new, leaner cost base can be spread across more policies. In time the new technology infrastructure should help the group compete on price comparison sites, and may improve underwriting accuracy for the direct brands.

Direct Line's dividend yield is now at the point where we need to talk about it. In this market, an 8+% prospective dividend yield should ring alarm bells rather than get your mouth watering. We'd usually want profits to be at least 1.5 times the dividend, and Direct Line is some way off at the moment. The group needs to recover to 2019's level of profitability, and then surpass it, for the dividend to become more sustainable. That's reflected in the relatively low valuation and high dividend yield and as always there are no guarantees.

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. If the group can't recover and return to growth quickly, the dividend could come under pressure.

Direct Line Group key facts

  • 12m forward Price/Earnings ratio: 11.4
  • Average 12m forward Price/Earnings ratio since listing (2012): 11.2
  • PProspective yield: 8.4%

All ratios are sourced from Refinitiv. Please remember yields are variable and not a reliable indicator of future income. Keep in mind key figures shouldn't be looked at on their own - it's important to understand the big picture.

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Half Year Results

The group's combined operating ratio improved by 6.1 percentage points to 84.2%, largely reflecting lower losses due to bad weather, increased prior year reserve releases and the impact of Covid on the travel division last year. Direct Line expects to report a full year combined ratio of 90-92%.

The group made an underwriting profit of £229.3m (up from £143.6m), instalment and other income of £72.2m (down from £80.0m) and an investment return of £68.4m (up from £41.3m).

Motor premiums fell 6.2% to £755.6m, reflecting the decision to prioritise underwriting discipline instead of price competitiveness in a deflationary pricing environment. This trend was weighted towards the first quarter, and premiums were down just 1.5% in the second quarter. Motor's current year loss ratio deteriorated by 1.4 percentage points to 66.9%, as trends normalised throughout the half. Motor's combined ratio improved very slightly to 81.8%.

Home premiums rose 0.8% to £278.3m, reflecting stable retention rates and growth from price comparison websites and direct sales. The division's current year loss ratio, before weather event claims, improved by 0.7 percentage points to 52.3%. Home's combined ratio improved by 13.4 percentage points to 79.0% thanks to higher prior year reserve releases and lower major weather event costs.

Green Flag Rescue and Other Personal Lines premiums fell from £210.1m to £186.5m. This mostly reflects falling premiums in all Other Lines except Pet, especially in Travel which was down 33.2%. The combined ratio for the division improved from 111.3% to 93.0%, reflecting the impact of travel costs last year and improvements in Rescue.

Commercial premiums rose from £289.3m to £336.1m, reflecting growth in all areas of the division. The current year loss ratio rose 0.9 percentage points to 61.1% and the combined ratio improved by 4.7 percentage points to 90.2%, largely reflecting lower weather claims.

Direct Line's Solvency Capital Ratio, a key measure of financial strength for insurers, rose 4 percentage points to 195% after the interim dividend payment.

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This article is original Hargreaves Lansdown content, published by Hargreaves Lansdown. Unless otherwise stated estimates, including prospective yields, are a consensus of analyst forecasts provided by Refinitiv. 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.

This article is not advice or a recommendation to buy, sell or hold any investment. No view is given on the present or future value or price of any investment, and investors should form their own view on any proposed investment. This article has not been prepared in accordance with legal requirements designed to promote the independence of investment research and is considered a marketing communication. Non-independent research is not subject to FCA rules prohibiting dealing ahead of research, however HL has put controls in place (including dealing restrictions, physical and information barriers) to manage potential conflicts of interest presented by such dealing. Please see our full non-independent research for more information.