Introduction

For public equities investors, the U.K. motor insurance sector consists of Admiral (OTCPK:AMIGF), Direct Line (OTC:DIISF), Sabre Insurance (OTC:SBIGY), and (soon-to-be-acquired) Hastings (OTC:HNGGF), with market capitalizations ranging from Admiral’s £7.67bn ($10bn) to niche player Sabre’s £650m ($850m).

Year-to-date, Hastings’ share price is up nearly 40% due to the takeover, Admiral is up 17%, but Direct Line and Sabre remain substantially down. The three still-public motor insurers’ shares currently offer Dividend Yields of between 5.5% and 8% approximately.

In this article, we explain why they can be attractive to dividend investors.

Long-Term Structural Growth

U.K. motor insurance premiums have long-term structural growth driven by growth in both the number of vehicles and claim costs.

The number of registered cars and other vehicles in the U.K. has increased every year since the 1990s until H1 2020 (which saw a decline due to COVID-19), with annual growth mostly in the 1-2% range and averaging 1.7%:

Claim costs have also been growing over the long term, driven by structural factors such as more expensive and complex vehicles (which increase repair costs) and medical advances (which increase bodily injury costs).

In the 20 years to 2016, total direct motor Gross Written Premiums have doubled, implying a long-term CAGR of approx. 4%:

Profitability Pressures in Recent Years

Except Sabre, all of the insurers mentioned above have other business lines (especially home insurance), but motor insurance continues to drive the bulk of their profits – and this has been under pressure in recent years.

The 2019 underwriting margins for the different companies’ motor businesses are shown below. The range is diverse – while Sabre and Admiral each had an underwriting margin exceeding 20%, Direct Line had one of only 5%, Hastings barely broke even and esure (OTC:ESXRY) (listed until 2018) made an underwriting loss:

U.K. Motor Underwriting Ratios by Provider (2019)

Source: Company filings.

The overall underwriting margin is driven by many factors. For example, while Hastings did have the lowest Expense Ratio (15.4%, better than even Admiral’s 19.1%), it is not the most profitable. However, Sabre, with its leading Loss Ratio of 51.5%, does have the best underwriting margin overall.

The sector’s profitability has been under pressure in recent years due to an acceleration in claim costs inflation and below-inflation price increases. From a long-term historic average of 3-5%, claim costs inflation has accelerated since 2017, to 5% in 2017, 6% in 2018, and 7-8% in 2019:

Price increases have not kept pace with claim costs. Premiums went through a period of deflation from 2018, on the expectation that “whiplash” reforms that year would reduce claim costs substantially. Premium pricing started increasing in 2019, but, on average, remained below claim costs inflation. The cycle appeared to start turning from late-2019, but COVID-19 reduced claims and drove pricing into reverse in Q2 2020:

U.K. Average Motor Premiums Y/Y Change (2014-H1 2020)

NB. ABI figures capture the entire market; Confused figures capture new business on its site only. Source: Admiral results presentation (H1 2020).

However, we believe the motor insurance pricing cycle will turn, and premiums will start rising more than claim costs, sometime in the next 1-2 years.

Cycle to Turn with Smaller Players Exiting

The turning of the motor insurance pricing cycle will be driven by smaller, unprofitable players exiting the market. Poor sector pricing has been due to a long tail of smaller, unlisted players – the 5 main players mentioned above together only insure fewer than 35% of total vehicles. As shown in the chart below, many of the smaller players have been writing motor insurance at Combined Ratios of above 100% (i.e. a loss). (Note that premiums are shown net of reinsurance and so understate the size of listed players which use reinsurance – e.g. Admiral gross U.K. motor premiums were £2.2bn in 2019):

U.K. Motor Net Earned Premium & Combined Ratio (2019)

NB. Includes Sabre management estimates (before actual results). Annotations are by Librarian Capital. Source: Sabre results presentation (H1 2020).

During this period of unattractive premium pricing, many of the larger insurers have slowed down their growth, as shown below – Admiral’s number of motor policies has decelerated markedly since 2018, while Sabre has been getting smaller. By contrast, when premium increases accelerate, they motivate customers to shop around and the larger players tend to gain share, as shown below during 2015-17 “up” cycle:

U.K. Motor Insurance Policy Numbers by Provider (Since 2012)

NB. Direct Line figures include both own-brands and partnerships. Hastings’ motor numbers not disclosed; we assume motor is always 87% of the total policy count. esure H1 2020 figure is assumed to be flat from 2019, based on management comments.

Source: Company filings.

In fact, before the COVID-19 outbreak, the cycle already seemed to be turning, with both Admiral and Sabre expecting market prices to move up in 2020; COVID-19 has provided a respite in profitability to the weaker players, but the effect will likely prove temporary:

With market price increases apparent in the most recent months there is a possibility that growth opportunities may arise later in 2020 or early in 2021. Whilst it is now likely that COVID‐19 will drive a significant, temporary, reduction in claims frequency it is anticipated that other claims pressures will emerge as social distancing continues and then ultimately winds down.”

Sabre results release (2019) (April 7, 2020)

In the past couple of months … we have continued putting prices up, but we believe that the market has put prices up slightly more … we believe we are going to continue to see prices going up in the market, at least in the first half of the year. What is going to happen in the second half will be also very much influenced by the FCA market study and the whiplash reform.

Cristina Nestares, Admiral Head of U.K. Insurance (2019 earnings call, March 5, 2020)

In addition, some smaller insurers rely on reinsurers for their underwriting capacity, and they appear to be raising prices substantially during H1 2020:

Reinsurers have been seeking to reprice their U.K. motor portfolios to reflect several years of underwhelming performance and Ogden impacts leading to substantial double-digit increases”

Sabre results release (2019) (April 7, 2020)

On the earnings call, Sabre management further stated that they were seeing price increases of 10-30% in the market, while their own reinsurance was renewed somewhere near the middle of this range.

Several small insurers involved in U.K. motor insurance have already failed since late 2018, including Octagon (December 2018), Qudos (December 2018), and Elite (December 2019).

Upcoming increases in the levies charged by the Motor Insurers’ Bureau (as an after-effect of the finalisation of the Ogden rate in July 2019) and the Financial Services Compensation Scheme (after the failure of several insurers, including ones mentioned above) will also drive up costs for motor insurers.

COVID-19 Impact

The net impact of COVID-19 has so far been positive for motor insurers, as lower claims volumes more than offset lower premiums. For example, Admiral saw its U.K. motor Net Earned Premiums fell 7.5% (£16.9m) year-on-year in H1 2020, but the business’ Profit Before Tax rose 23.3% (£58.7m). Admiral was alone in providing rebates (worth £110m) to customers for their lower driving frequency, though other insurers also reduced their pricing during Q2.

Since the trough in April, U.K. car transport usage has continued to recover, and so has motor quote volumes:

Upcoming Regulatory Changes

Upcoming regulatory changes in U.K. motor insurance are likely to be neutral or positive for incumbents.

“Whiplash” reforms are a further set of changes under the Civil Liabilities Bill designed to reduce bogus small Bodily Injury claims. Originally scheduled for implementation in April 2020, they have been postponed twice due to COVID-19 and are now due to be implemented in April 2021. As more details on the changes have become known, some insurers are increasingly sceptical of their efficacy. Sabre management predicted their benefit would be “modest (at best)”, while Admiral has stated it would not be changing prices in response. The effect for motor insurance incumbents will likely be neutral.

“Loyalty Penalty” reforms are proposals announced by the Financial Conduct Authority in September 2020, in a consultation that would last until January 2021. The main proposal is that customers who renew motor or home insurance will get the same pricing as if they are new customers. In recent years, many insurers have been pricing policies to new customers at lower margins (or even at a loss) on the expectation they can raise prices later, which contributed to weak pricing in the sector. The proposal would make such aggressive sales efforts impossible without destroying the profitability of an insurer’s existing customer base. The most likely consequence is thus lower churn (and better Expense Ratios) for motor insurers, or perhaps even an increase in overall premium prices and will be positive for incumbents.

Admiral and Sabre are particularly well-placed to benefit, as Admiral already has 80% of its customers shopping around each year before renewing, while Sabre already gives the same pricing to new and renewing customers.

Private Equity & Strategic Interest

In the past few years, private equity and strategic buyers have acquired two of the top-5 U.K. motor insurers.

esure agreed to a £1.21bn Leveraged Buy-Out by Bain Capital in August 2018, at a 29% premium to its last-3-months average share price.

Hastings agreed to be acquired by Finnish insurer Sampo (SAXPF) for £1.66bn in August 2020, at a 28% premium to its last 3 months average share price.

We believe these transactions imply there is significant value in the sector, may also lead to more focus on profitability under new owners and are thus a positive for the remaining listed players.

Valuation

Sabre and Direct Line currently trade at just over 14x P/E (on 2019 EPS) while Admiral is at 17.6x; their Dividend Yields range from 5.7% to 7.9%:

U.K. Motor Insurers’ P/E and Dividend Yields

Source: Company filings.

P/E multiples may depend on the point in the insurance cycle. esure’s 14.6x P/E was based on its EPS in 2017, when premium pricing was strong, while Hastings’s 23.6x was based on its EPS in 2019, when pricing had been weak.

When the motor insurance cycle turns, we expect the stronger insurers will gain faster growth and a step change in profitability, and a potential upwards re-rating as well.

Conclusion

U.K. motor insurance is a target-rich sector for dividend investors, with the 3 listed players offering Dividend Yields of between 5.5% and 8%.

Motor premiums have long-term structural growth, driven by the number of vehicles growing 1-2% and claim costs rising 3-5% annually.

Sector profits have been pressured by accelerated cost inflation and weak pricing in recent years, but the cycle will turn when smaller players exit.

Upcoming reforms are neutral to positive; when the pricing cycle turns, stronger players will gain faster growth and a step change in profitability.

Admiral, Sabre, and Direct Line are all potentially attractive targets, on which we plan to conduct further research in the coming weeks.

Note: A track record of my past recommendations can be found here.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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