It would be easy to dismiss the general or non-life insurance sector as an obscure and rather boring segment of the market. But this collection of companies are involved in exciting themes like cyber and offer some generous dividend yields to boot.

THE SECTOR AT A GLANCE

The UK FTSE 350 non-life insurance sector is comprised of five stocks whose market capitalisations range from relative sector minnow Lancashire (LRE) at £1.3 billion, up to Admiral (ADM) at £8.9 billion.

The sector has a combined valuation of £19.2 billion and covers a diverse array of insurance categories including motor, travel, property, home, pet and marine insurance. The sector also provides exposure to the reinsurance sector, and the rapidly growing market for cyber insurance.

The relatively high yield offered by stocks in the sector has resulted in considerable interest from income investors. We recommend Direct Line (DLG), as one of the few UK personal line focused insurers to have successfully diversified away from motor insurance. We also believe Lloyds of London insurer Beazley (BEZ) could be a high reward investment, albeit with commensurate levels of risk.

General insurance is predominantly a short-term business. The insurer collects a premium (the payment a customer makes to an insurance company in exchange for their insurance policy), and for the following 12 months is at risk of paying out.

Four key factors drive returns:

– Premiums earned;

– Claims paid out;

– Operating expenses;

– Investment returns from premiums paid in advance.

General insurance companies have a significant exposure to the bond markets. In order to preserve the value of the premiums they receive, continue to pay for claims when required and offset inflation, insurers invest the premiums they receive from customers. Bonds are a lower risk place for them to put this money.

In the case of Beazley, for example, bonds account for a considerable 81% of its portfolio. The low interest rate environment has negatively impacted returns from bonds.

This makes it increasingly important for insurers to focus on segments of the market where rates are improving.

KEY METRICS

• The claims ratio is the percentage of claim costs incurred in relation to the premiums earned.

• The expenses ratio is calculated by dividing the expenses associated with acquiring, underwriting and serving premiums by the net premiums earned by the insurance company

• The combined ratio is the total of claims paid plus operating expenses, divided by premium income.

If the combined ratio is below 100% then the insurer is earning in premiums more than it is paying out in claims and costs, and so is making an operating profit. But it can still be profitable if the combined ratio is over 100%, as investment income makes a further contribution to the bottom line

RATES SET TO MOTOR

Claims inflation running at 7% to 8% coupled with a 15% reduction in motor insurance premiums has created a toxic backdrop for the motor insurance segment. However new research by Peel Hunt suggests rates for motor insurance could be set to rise.

Lower levels of traffic on the roads as a result of Covid-19 have resulted in premium deflation for motor insurance. UK motor insurance premiums have declined by 15% since March 2020 according to CPI data provided by the Office for National Statistics (ONS).

According to Peel Hunt analyst Andreas von Embden ‘the motor pricing cycle is bound to turn after a number of soft years in which insurers underfunded claims inflation’. Embden believes that claims frequencies will jump back, which combined with new FCA pricing rules due to be implemented next year should force underwriters to increase new business rates.

PROPERTY, MARINE AND REINSURANCE

The strength of the reinsurance market has been reflected in recent comments made by the CEO of the historic insurance market Lloyd’s of London John Neal. He noted that the Lloyd’s market has ‘achieved rate increases for five years, something I haven’t seen during my time in the market’.

Global catastrophe losses have been unusually high since the second half of 2017, linked to everything from Asian typhoons to US hurricanes and widespread wildfires. These losses have been compounded by the impact of Covid 19.

This environment of sustained losses has provided a conducive environment for a rise in rates. Property, marine and reinsurance lines are experiencing the most favourable pricing conditions since 2008.

CYBER GROWTH OPPORTUNITY

The cyber insurance market present an exciting new growth market. Between 2015 and 2019 gross written premiums (the general insurance premium underwritten before any deductions for reinsurance), increased at a compound annual growth rate of 28%.

This growth is likely to continue driven by regulatory change coupled with an increasing awareness of cyber risks amongst management. A surge in ransomware claims in recent years has resulted in a hardening in the cyber insurance rate environment.

Rate increases of 44% in the first half of 2021 have been recorded, and this positive trend is expected to continue into the second half.

Stock picks

Direct Line  (DLG) 281p

The company offers motor, home, rescue, travel, credit and pet insurance under a number of brands most notably, Direct Line, Churchill, Green Flag and NIG.

Direct Line’s repair garage network (DLG Auto Services) gives it a truly differentiated competitive advantage. This division has enabled it to maintain underlying claims inflation at approximately 3% to 5% in recent years.

This is considerably lower than that of its peer group. Owning its own network allows it to offer very quick repair times due to its large and bespoke repair centres. Its operation in Birmingham is a good example of this. Currently 55% of claims go through DLG Auto Services. The longer term ambition is for 70% to go through these centres.

Direct Line is reaping the benefits from investment in technology. A new underwriting platform is facilitating cost reductions, Jefferies expect the business to beat its 20% expense ratio target by 2023. Jefferies forecast operating expenses of £697 million in 2021 (equivalent to a 23.6% operating expense ratio), with further reductions by 2023 resulting in a 19.5% expense ratio.

It will also enable the company to be more agile with its pricing. This is critical given that the motor industry is characterised by a high degree of price elasticity.

According to research by Nordic insurance company Sampo Group, new business volumes change by 5% for every 1% change in price. Historically Direct Line has been slower than competitors to respond to price changes in the market, which has constrained growth. It now has the capability to implement more rapid price changes for a specific cohort of drivers, which is likely to result in market share gains.

Recent high levels of capital expenditure due to investment in technology have resulted in cash earnings being below IFRS earnings. As the technology transformation nears completion
this situation will be reversed, and higher cash earnings will support an 8% dividend yield, and £100 million of potential share buy-backs between 2021 and 2023.

Beazley (BEZ) 372p

This Lloyd’s of London insurer writes traditional property, marine, and reinsurance lines through its Lloyd’s syndicate. The group recently merged its Political Risk and Accident & Health lines into Political Risk, Accident and Contingency (PAC). The most valuable components are the group’s Specialty (Casualty) lines and Cyber & Executive Risk (CyEx) businesses.

According to research from advisory firm Willis Towers Watson all but one major line of business in the London Market are expected to benefit from rate increases (see chart).

Beazley’s exposure means that it is particularly well positioned to benefit from an improving pricing environment. Research by Jefferies, estimates that from 2015 to the end of 2021 Beazley has benefited from over 44% compound rate increases.

However the nature of insurance accounting means that the benefits of rate increases can take several years to be recognised. Consensus earnings estimates may significantly underestimate the impact of the earnings accretive impact of these rises. This view underpins Jefferies 2022-2023 earnings forecast which is 20% ahead of consensus.

Another appealing facet of Beazley’s business model is its exposure to the most exciting growth opportunity in global insurance cyber. Cyber attacks are becoming an increasing concern amongst corporates with management becoming increasingly cognisant that insurance cover is inadequate. Beazley has the greatest exposure to cyber insurance amongst global listed insurers accounting for 15% of gross written premiums.

Beazley Breach Response which is the group’s signature product and protects clients from malware, ransomware and other cyber threats. It has provided Beazley with a first mover advantage in the sector which has been strengthened by its ability to also offer risk management services.

The growth dynamics for the cyber insurance market are encouraging. According to Aon approximately 65% of organisations in 2020 expect cyber exposure to increase from 58% in 2015.

The same survey shows 32% of organisations now believe their cyber insurance cover is insufficient, compared to 19% in 2015. This shift in attitudes surrounding the need for greater cyber insurance is likely to drive future demand and earnings growth for Beazley.

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