High dividend yields are often popular with investors looking for a second income. But I think anyone looking at Legal & General (LSE:LGEN) shares should take a second look – and a third one after that.
Insurance companies aren’t straightforward, but investors need to know what they’re getting themselves into. So let’s take a look at what’s going on with the company.
First look: dividend yield
Like a lot of insurance companies – especially life insurers – Legal & General shares come with a huge dividend yield. At 8.25%, it’s the second-highest in the FTSE 100 right now.
The only stock with a higher yield is Admiral (another insurance firm) and that organisation is set to lower its dividend. So there’s an obvious reason for income investors to look at Legal & General.
There’s also more to the stock than just a big dividend yield. The company has an impressive record of returning cash to shareholders over the last 10 years, including during the Covid-19 pandemic.
That’s a sign of a firm with a responsible culture. So at first sight, there’s a lot for income investors to feel positive about with Legal & General shares.
Second look: coverage ratio
A closer look, though, reveals something that typically ought to alarm income investors. Over the last few years, Legal & General has been paying out more in dividends than it’s made in earnings.
That’s normally a big warning sign. Most companies can – if they want to – find ways to maintain their shareholder distributions through profit dips, but they can’t do this indefinitely.
But with Legal & General, the situation is slightly different. The firm’s official net income is affected by a lot of accounting adjustments that make it somewhat unreliable.
For example, stock and bond prices moving following the ‘Liberation Day’ tariffs cause the value of Legal & General’s assets to fall. This weighs on net income, but doesn’t threaten the dividend.
Third look: cash generation
Ultimately, what matters for Legal & General’s ability to pay its dividend is the cash it brings in. The metric the firm focuses on is its Solvency II Capital Generation.
The company’s Solvency II ratio is the cash it has on hand relative to what it needs to meet its requirements. And this is what management uses to decide dividends and share buybacks.
Legal & General’s dividend cover is much better from this perspective. In 2024, the firm generated £1.8bn – more than enough to cover a £1.2bn dividend and a £200m share buyback.
Investors therefore need to look beyond the net income line to assess the viability of the company’s dividend. And it looks much more secure from this perspective.
Long-term investing
The details of Legal & General’s business are complicated, but the basic structure is simple. It collects cash upfront and pays out later, hoping to make money by investing it along the way.
This inevitably involves risk. If costs turn out to be higher than expected – for example, as a result of people continuing to live longer – the company can’t reprice its policies to make up for it.
That uncertainty is enough to make me think I can find more obvious opportunities elsewhere. But I can see the attraction for investors aggressively targeting an 8.25% dividend yield.
