Top Insurance Stocks For 2016: Admiral Group plc, RSA Insurance Group plc & Lancashire Holdings Limited

The outlook for insurance stocks in 2016 is looking very promising. Such stocks are trading at low valuation multiples, despite having some very attractive income and growth prospects. Robust economic growth in the UK and US is expected to lead to steady volumes growth, while strong balance sheets should mean dividend payouts in 2016 are set to grow.

With this in mind, I’ll take a look at three of the strongest picks from the sector.

Industry-leading combined ratios

Admiral Group (LSE: ADM) is one of the most promising insurance companies, despite the fact that it operates in the highly competitive UK motor insurance market. This is because while many of its competitors are barely profitable on an underwriting basis, Admiral has a combined ratio of 82.7%. A combined ratio of less than 100% indicates the company is making underwriting profits.

Admiral also continues to grow faster than many of its competitors, with customer numbers rising 6% to 4.19 million in the first half of 2015. The combination of Admiral’s industry-leading combined ratio and its strong volume growth demonstrates the insurer’s competitive advantage.

With shares trading at a 16.1 multiple on its 2015 estimated earnings per share of 98.9p, Admiral is more expensive than its peers. But, as the company is highly cash generative, it can afford to pay a prospective dividend of 96.2p per share this year, which equates to an attractive dividend yield of 5.9%.

Turnaround play

RSA Insurance Group (LSE: RSA), which has been embroiled in a major accounting scandal at its Irish division, is a potentially undervalued turnaround play. The insurer, which is the second largest in the UK general insurance market, is in the midst of a three-year restructuring drive. Its strategy is to focus on core markets in the UK, Scandinavia and Canada, cut costs, shore up its balance sheet and improve the operational side of the business.

The insurer is already showing the green shoots of recovery, and the improvement in performance is exceeding market expectations. Operating profits increased 84% to £259m in the first half of 2015, and its combined ratio fell to 96.9%, from 100.3% last year. Analysts expect RSA will deliver underlying EPS of 32.7p per share for the full year, which gives its shares a very reasonable forward P/E of 13.8.

Potential takeover target

Specialist insurer Lancashire Holdings (LSE: LRE) is a potential takeover target because of its strong underlying profitability, low valuation multiples and its presence in the Lloyds of London market. Two of its rivals, Catlin and Amlin, have already been acquired by larger foreign insurance groups this year. And, further industry consolidation of Lloyds insurers is likely as the sector is cash-rich and low interest rates have made financing deals cheap.

Recent weakness in its share price could make a potential deal much more likely. Lancashire’s shares have fallen 8% since the start of December on news that CEO Peter Scales and CFO John Lynch of Cathedral, its Lloyds of London subsidiary, would be leaving the company on 31 March 2016. Both directors are founding partners of Cathedral and have been in their positions since 2000.

With shares trading at a forward P/E of 12.5, or 1.5 times tangible book value, Lancashire is cheap. By contrast, Mitsui’s £3.5bn bid valued rival Amlin at 2.4 times tangible book value, with a forward P/E of 17.0.

And even if a takeover bid doesn’t come along, shareholders will likely be well rewarded by its dividend prospects. Analysts expect Lancashire to pay shareholders a dividend of 64.6p per share this year, which equates to a prospective dividend yield of 9.9%.

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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.