Investment View: Insurance woes make Direct Line wrong destination

Direct Line: Our view: Avoid

James Moore

There are good reasons to be very careful before buying into Direct Line today, which is the deadline for retail shareholders with at least £1,000 handy to register their interest with a participating stockbroker.

Direct Line is primarily a personal lines insurer with its core business (just over 40 per cent of its premiums) in motor. In fact it insures one in every five cars in the UK. It owns several high-profile brands, such as Churchill, the breakdown company Green Flag, and businesses in German and Italy.

The problem for investors is that motor insurance is not a happy place to be. The Office of Fair Trading has referred the industry to the Competition Commission on the basis that the market is "dysfunctional" and that consumers are getting soaked as a result.

On the other hand, analysts will tell you car insurers are barely profitable. Direct Line made an underwriting loss when it reported its interim results. Its combined ratio of 101.1 means that for every pound taken in just over £1.01 was paid out in costs and claims (anything over 100 equals an underwriting loss). It's an improvement over the 102.5 of the previous year, but it's not good. Rivals such as Royal & SunAlliance (RSA) and even troubled Admiral made underwriting profits, but Direct Line is only making money because of the returns it makes on investing the premiums it brings in. And investment returns are pretty poor right now.

How does one square the circle of what the OFT (and the consumer) is saying and what the analysts and the industry argue? Answer: this is an industry that has been managed poorly and has structural problems as a result.

Claims are processed with an incompetence that beggars belief. The OFT argues that excess profits are made through insurers of drivers who are not "at fault" having sweetheart deals with, for example, the providers of courtesy cars and the garages that handle repairs. The insurer of the "at fault" driver therefore has little control over costs, pays too much out, and passes the excess costs on.

The Competition Commission is likely to take a couple of years to sort it all out. So there's no imminent threat. What its inquiry will do, however, is cast a pall over the industry because of the uncertainty that it creates. That will weigh on the shares of all involved.

Even were everything rosy, the UK is a mature market which doesn't offer great growth prospects for insurers, while Direct Line's international businesses don't yet make money. They are both potentially bigger insurance markets than the UK and there is growth potential: the Italians and Germans as a rule have less insurance than comparable Britons. But both are in the eurozone, so don't get too excited.

Is there anything going for the company at all?

Here's the bull case. The shares are cheap. The price range of 160p-195p is much lower than had been expected, and suggests a market value of somewhere around £2.5bn when the company reaches the market. That is about the value of the company's "net tangible assets", a number produced by adding up all the insurer's businesses and assets. It's not much of a valuation for a business that Royal Bank of Scotland, which is having to float the company to keep EU regulators happy as a result of its bailout, tried to sell for £7bn back in 2008. RSA, by comparison, trades at about 1.7 times (although it is a far more diverse business).

Then there's the yield. Direct Line has committed to handing between 50 and 60 per cent of its profits to its investors. The prospective yield could be 7.5 per cent, depending on the price at which the shares make their market debut. With £100m of costs due to come out of the business, the dividend ought to be more or less stable (but customers be warned).

That yield is certainly worth having, but it is worth noting that RSA yields 8.5 per cent, Admiral 8 per cent and Aviva (primarily a life insurer, but with a big general insurance business) 8 per cent. RSA and Aviva arguably offer better prospects for investors.

Long-term, I'd be a sceptic about Direct Line unless its new management team can prove itself to be truly inspired and have the ability to shake the company out of the insurance industry's traditional torpor (I'll believe it when I see it).

With a regulatory cloud hanging over the industry and limited growth prospects, Direct Line is basically reliant on those cost cuts to make the numbers add up. Oh dear.

If you want income, there are better options. The shares might enjoy a brief uptick when they join the market. After all, Royal Bank of Scotland is a forced seller and forced sellers have to sell cheap. So they might just be worth a short-term gamble.

But if you do take the plunge and the shares rise, get out quickly.

I'd advise a watching brief. RBS is only selling a maximum of 33 per cent of the shares. There will be other opportunities to get involved if Direct Line proves doubters like me wrong. Avoid.

Life and Style
Child's play: letting young people roam outdoors directly contradicts the current climate
lifeHow much independence should children have?
Arts and Entertainment
Tycoons' text: Warren Buffett and Bill Gates both cite John Brookes' 'Business Adventures' as their favourite book
booksFind out why America's richest men are reading John Brookes
Arts and Entertainment
<p>Troubled actor Robert Downey Jr cements his comeback from drug problems by bagging the lead role in Iron Man. Two further films follow</p>
filmRobert Downey Jr named Hollywood's highest paid actor for second year running
Life and Style
Dale Bolinger arranged to meet the girl via a fetish website
Sign here, please: Magna Carta Island
propertyYours for a cool £4m
Life and Style
ebookA unique anthology of reporting and analysis of a crucial period of history
The Commonwealth flag flies outside Westminster Abbey in central London
Arts and Entertainment
Struggling actors who scrape a living working in repertory theatres should get paid a 'living wage', Sir Ian McKellen has claimed
Skye McCole Bartusiak's mother said she didn't use drink or drugs
peopleActress was known for role in Mel Gibson film The Patriot
Arts and Entertainment
tvWebsite will allow you to watch all 522 shows on-demand
Latest stories from i100
Have you tried new the Independent Digital Edition apps?
Independent Dating

By clicking 'Search' you
are agreeing to our
Terms of Use.

iJobs Job Widget
iJobs Money & Business

Training Programme Manager (Learning and Development)-London

£28000 - £32000 per annum + benefits: Ashdown Group: Training Programme Manage...

Training/Learning and Development Coordinator -London

£28000 - £32000 per annum: Ashdown Group: Training/Learning and Development Co...

Business Anaylst

£60000 - £75000 per annum + BONUS + BENEFITS: Harrington Starr: Business Anal...

Project Manager - ETRM/CTRM

£70000 - £90000 per annum + Job Satisfaction: Harrington Starr: Project Manage...

Day In a Page

Some are reformed drug addicts. Some are single mums. All are on benefits. But now these so-called 'scroungers’ are fighting back

The 'scroungers’ fight back

The welfare claimants battling to alter stereotypes
Amazing video shows Nasa 'flame extinguishment experiment' in action

Fireballs in space

Amazing video shows Nasa's 'flame extinguishment experiment' in action
A Bible for billionaires

A Bible for billionaires

Find out why America's richest men are reading John Brookes
Paranoid parenting is on the rise - and our children are suffering because of it

Paranoid parenting is on the rise

And our children are suffering because of it
For sale: Island where the Magna Carta was sealed

Magna Carta Island goes on sale

Yours for a cool £4m
Phone hacking scandal special report: The slide into crime at the 'News of the World'

The hacker's tale: the slide into crime at the 'News of the World'

Glenn Mulcaire was jailed for six months for intercepting phone messages. James Hanning tells his story in a new book. This is an extract
We flinch, but there are degrees of paedophilia

We flinch, but there are degrees of paedophilia

Child abusers are not all the same, yet the idea of treating them differently in relation to the severity of their crimes has somehow become controversial
The truth about conspiracy theories is that some require considering

The truth about conspiracy theories is that some require considering

For instance, did Isis kill the Israeli teenagers to trigger a war, asks Patrick Cockburn
Alistair Carmichael: 'The UK as a whole is greater than the sum of its parts'

Alistair Carmichael: 'The UK as a whole is greater than the sum of its parts'

Meet the man who doesn't want to go down in history as the country's last Scottish Secretary
Legoland Windsor's master model-makers reveal the tricks of their trade (including how to stop the kids wrecking your Eiffel Tower)

Meet the people who play with Lego for a living

They are the master builders: Lego's crack team of model-makers, who have just glued down the last of 650,000 bricks as they recreate Paris in Windsor. Susie Mesure goes behind the scenes
The 20 best days out for the summer holidays: From Spitfires to summer ferry sailings

20 best days out for the summer holidays

From summer ferry sailings in Tyne and Wear and adventure days at Bear Grylls Survival Academy to Spitfires at the Imperial War Museum Duxford and bog-snorkelling at the World Alternative Games...
Open-air theatres: If all the world is a stage, then everyone gets in on the act

All the wood’s a stage

Open-air productions are the cue for better box-office receipts, new audiences, more interesting artistic challenges – and a picnic
Rand Paul is a Republican with an eye on the world

Rupert Cornwell: A Republican with an eye on the world

Rand Paul is laying out his presidential stall by taking on his party's disastrous record on foreign policy
Self-preservation society: Pickles are moving from the side of your plate to become the star dish

Self-preservation society

Pickles are moving from the side of your plate to become the star dish
Generation gap opens a career sinkhole

Britons live ever longer, but still society persists in glorifying youth

We are living longer but considered 'past it' younger, the reshuffle suggests. There may be trouble ahead, says DJ Taylor