The 2 Big Weaknesses That Make Direct Line Group plc, RSA Insurance Group plc and Admiral Group plc Bad Buys

When I think of insurers Direct Line Insurance Group (LSE: DLG ), RSA Insurance Group (LSE: RSA) and Admiral Group (LSE: ADM) two factors jump out as those firm’s greatest weaknesses and top the list of what makes the companies less attractive as an investment proposition.

1. Fierce competition

Direct Line reckons the UK motor and home insurance markets were highly competitive during 2013 and 2014, and the industry saw significant premium deflation. RSA thinks that insurance market conditions in its recent third quarter remained competitive across all its operating territories, and Admiral says it anticipates that the decline in premiums experienced across the market in recent years coupled with a return to higher claims inflation will affect future earnings.  

Whichever way we look at the insurance market, 2015 seems set to shape up to be highly competitive and some market participants will no doubt be reducing prices. Insurance is something of a commodity-type product with little differentiation between suppliers. Competing on price has always been part of the game.

To counter the problem of competition, and to minimise risk from low pricing, Direct Line, for example, reduces prices selectively in line with claims trends. The result shows falling figures for gross written premiums, at least until (and if) industry prices firm up again. All three firms watch costs with vigour to try to gain a competitive edge.

It’s worth noting that we are arguably moving through benign macro-economic conditions at the moment and still it’s tough being an insurer. Imagine what it must be like trading through the depths of a recession.

I reckon the cyclicality of the insurance industry is the first consideration we should make before investing in these three firms — before considering the level of the dividend yield, before looking at valuation multiples such as the P/E ratio, and before looking at forward guidance on profits. Cyclicality can turn all those things on their heads, and the next cyclical share-price plunge will always be lurking ahead — we just don’t know where!

 2. Regulatory change

The UK motor insurance market  seems to be experiencing a dynamic and evolving regulatory landscape where, over the past few years, a number of reviews and initiatives have been announced by the UK Government, the Ministry of Justice (MoJ), the Financial Conduct Authority (FCA) and the Competition Commission (CC).

Firms such as Direct Line, RSA and Admiral tend to embrace the regulatory changes, being proactive in implementing them, as required. However, dealing with ever-changing red tape is a time-consuming and expensive pursuit. There’s also the risk that regulation might go too far and make it impossible for firms like Direct Line, RSA and Admiral to turn a profit.

What now?

The insurance industry sector, with its low margins, fierce competition, regularity scrutiny, and high cyclicality, seems a fragile base upon which to build an investment. I certainly wouldn’t buy and forget any holding in the sector.

Instead, these five shares make good candidates for further research. They are strong, well placed in their markets, and exhibit far less cyclicality than the insurers.

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Kevin Godbold has no position in any shares mentioned. The Motley Fool UK has no position in any of the shares mentioned. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors.