Deciding what to do next won’t be easy for Direct Line

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Once might be considered an accident, but thrice is hard to forgive. Direct Line faces an uphill battle to regain credibility with investors after a trio of profit warnings and a decision to scrap the final dividend, despite assurances that shareholder returns were safe.

The mess culminated in Penny James stepping down as the insurer’s boss last week, replaced in the interim by Jon Greenwood, the former chief commercial officer, but any hope that a permanent successor can engineer a quick fix in the FTSE 250 group’s fortunes is remote.

The December cold snap broke the insurer’s back. Homes flooded by burst water pipes and other large claims caused by the big freeze cost the home and commercial insurance business £90 million, pushing the bill for weather-related claims for last year up to £140 million, almost double the amount expected. Being caught off-guard by claims inflation in its motor business is a more persistent problem.

The upshot? The insurer expects to report a combined operating ratio — a measure of profitability where anything above 100 per cent indicates a loss — of between 102 per cent and 103 per cent for last year. That is worse than its medium-term target of 93 per cent to 95 per cent and the guidance for a ratio of 98 per cent issued with November’s profit warning. The final dividend for last year has been scrapped and the prospective payment for this year is hugely uncertain.

Inflation is hardly a burden that Direct Line alone has faced, but rivals have borne it much better. Aviva said last week that it expected a combined ratio of just under 95 per cent for last year.

James’ successor will need to more firmly balance premium prices and volume growth. Increasing prices by a greater magnitude than it has put through would be likely to weigh on new business. And Direct Line has long had a growth problem, undershooting rivals such as Admiral in an ultra-competitive motor market. Yet shrinking the volume of business written and improving prices could help to restore profitability, build capital levels and fund a more sustainable dividend.

As for business already written, the insurer has warned that higher motor claims inflation will add two to three percentage points to the combined operating ratio this year. Even if inflation does start to ease, there is every chance the loss ratio will be elevated this year, too, as the impact of previous underwriting decisions unwinds. Weak earnings prospects are reflected in a forward price/earnings ratio of just under nine — a discount to a ten-year average, but not a compelling one.

What about more aggressive cost-cutting? The insurer has already given up on cutting its expense ratio, a measure of operating expenses as a proportion of net earned premiums, to 20 per cent this year from 24.3 per cent at the half-year in the face of rampant inflation.

Strengthening capital levels is something that might not wait until a permanent boss is found and, given that the impact of claims inflation is likely to linger, more work is needed on repairing the balance sheet. Issuing more debt could be one option, but what coupon would woo investors aware of higher risk? A fundraising at the present share price would be “difficult to swallow”, analysts at Panmure Gordon reckon. The insurer might have little choice.

Original article here:

Author: Emma Powell, Tempus Editor, The Times

Abid Hussain

Director, Research Analyst, Insurance

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