Should You Buy Admiral Group plc, Direct Line Insurance Group plc, Aviva plc & RSA Insurance Group plc As Motor Insurance Premiums Rise?

UK motor insurers have seen their profitability squeezed in recent years, as intense competition led to falling insurance premiums. Over the past 20 years, the industry as a whole made an underwriting loss in every year except 2013 and 2014.

But there are early signs that motor insurance premiums, which have been falling for three consecutive years, are beginning to rise again. Accounting firm Ernst & Young said motor insurance rates had risen by 2% on the previous year in the first quarter of 2015. Claims inflation also appears to be slowing slightly, having dropped 0.1 percentage points to 4.3% in 2015.

It also appears that the rise in insurance premiums is being sustained, as and consultancy firm Towers Watson found average premiums rose 1.5% in the second quarter of 2015. Thus, premiums have been steadily increasing over the past year.

Last week’s budget saw Chancellor George Osborne raise Insurance Premium Tax (IPT) from 6% to 9.5%, starting from 1 November 2015. Although insurers are likely to pass on much of the added cost to policyholders, it could lead to more aggressive price competition in the industry and lead to more people choosing not to take out insurance. In a soft insurance market, insurers may not be prepared to raise premiums for fear of losing customers; which could lead to premiums falling again.

On a brighter note, the chancellor also announced tighter regulation on claims management companies, and in particular tackle organised insurance fraud. Whilst the overall effect of the budget on the insurance industry is uncertain; motor insurance premiums should continue to rise as unprofitable insurers withdraw capacity from the market, and higher premiums are being passed onto consumers.

Admiral Group (LSE: ADM), Direct Line (LSE: DLG), Aviva (LSE: AV) and RSA Insurance Group (LSE: RSA) are some of the UK’s largest motor insurers. The introduction of higher solvency requirements and increased regulation on the industry have depressed the valuation of these shares. But, with signs that motor insurance premiums are sustaining rate increases, profitability should improve from here.

Admiral Group, which most resembles a car insurance pure play, should gain the most from higher premiums. Its industry leading combined ratios of 78.5% for UK car insurance gives it a strong competitive advantage. The company also has a growing price comparison websites business, which is expanding in France, Spain and the US. After seeing EPS fall 2% to 103 pence in 2014, analysts expect earnings will fall by another 10% in 2015 to 92.3 pence, which gives its shares a forward P/E of 15.5. But, these estimates may seem a little pessimistic, given the sustained rise in premium rates.

Valuations for Aviva and RSA are much cheaper, with their shares trading at forward P/E ratios of 10.8 and 14.3, respectively. But, their diversification will mean they will have less to benefit from higher premium rates.

Direct Line, which is the UK’s largest private motor insurer, is especially attractive on expectations of greater shareholder returns. The company pays a regular dividend of 13.2 pence per share, which equates to a 4.0% yield; but analysts expect it to pay special dividends of around 33.5 pence, which boosts its total dividend yield to 13.8%. On top of this, analysts expect underlying EPS will rise 12% to 28.8 pence in 2015, which gives it a forward P/E of 12.5.

Too much uncertainty?

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Jack Tang 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.