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.