HSBC (LSE: HSBA) (NYSE: HSBC.US) is one of the FTSE 100‘s dividend champions, supporting a dividend yield of 4.8% at present levels. However, the bank is facing numerous headwinds and there has been some speculation that management could be forced to slash the dividend payout to save cash.
With this in mind, I’ve swapped my HSBC holding for insurer, Lancashire Holdings (LSE: LRE).
Uncertain future
HSBC’s dividend yield may seem attractive at first glance but as the bank’s earning start to fall, the payout may come under pressure. For example, the bank’s earnings per share fell by around 8% during the first half and as a result, dividend cover fell from 1.9 times to 1.7 times.
Then there’s the issue of fines from regulators, which could dig into HSBC’s capital reserves. HSBC was slapped with a $500m mortgage mis-selling fine earlier this year and regulatory compliance costs are now rising at a rate of $200m per year.
Slow and steady
Insurance may not be the world’s most exciting industry but it can be highly lucrative. Lancashire is no ordinary insurer, the company only insures risks, which produce a high return. For example, you won’t catch the company entering the UK motor insurance market, there’s just too much competition.
Instead, the company operates within the property, aerospace, space and offshore insurance market, amongst others. What’s more, Lancashire uses excess of loss contracts meaning that each policy has a defined limit of liability arising from one event, when the limit is reached, no additional payouts are required.
Historically, Lancashire’s underwriters have been extremely conservative and, since inception, the company’s combined ratio has averaged 59%. The industry’s combined ratio for 2014 is expected to come in at 98%. So, it’s easy to see how Lancashire is beating its peers.
Industry trends
Right now the insurance industry is being flooded with cheap capital, as investors hunt for yield in this low-yield environment. Unfortunately, this influx of capital is pushing down profitability within the industry but Lancashire is not worried.
You see, the company has buckled down and remains true to its roots, only writing risks when the risk/reward is attractive. And right now, the insurance market is not providing the returns that Lancashire is used to so the company is reducing its exposure.
For investors, this is great news. Management has stated that if Lancashire cannot find any opportunities within the insurance market, any excess capital will be returned to investors.
Indeed, this policy has results in special dividend payouts every year since Lancashire came to market. When you factor in these special dividends as well as regular payouts, an investment in Lancashire has risen four-fold since 2007. City analysts currently expect the company to support a yield of 8.6% this year and 8.7% the year after.
