Should you lock in this 8% dividend yield before it’s too late?

Shares of specialist insurer Lancashire Holdings Limited (LSE: LRE) rose by more than 8% this morning after the company announced a special dividend of $0.75 per share. That’s about 61p at current exchange rates.

The special payout is in line with broker dividend forecasts, which have been set at $0.75 for some time. But confirmation of the payout has helped lift the shares to a three-year high of more than 760p.

Ultra-high dividend yields, such as this, are often a warning that problems may lie ahead. But today’s trading statement suggests that Lancashire can comfortably afford this payout. In this article I’ll explain why this is and what it could mean for the future. I’ll also take a look at a second insurance firm with a track record of generous special dividends.

Returning surplus cash

Lancashire specialises in providing insurance for valuable assets such as buildings, ships, planes and oil rigs. The firm also provides cover against terrorism, political risk and catastrophes, such as earthquakes.

The market for Lancashire’s services has been relatively soft in recent years, with very few major claims. This has put pressure on insurance rates. Rather than reduce its rates and accept lower profit margins, the group has opted to maintain a core book of business and to limit expansion, instead returning surplus capital to shareholders.

Today’s trading statement suggests that this situation remains unchanged. Gross premiums fell by 10.1% during the third quarter, compared to 2015. Lancashire’s book value per share fell to $6.55 (532p), from $6.78 one year ago.

Earnings per share fell to $0.51 for the first nine months of the year, down from $0.64 per share last year. But limited losses meant that return on equity rose to 3.1% for Q3, compared to 2.6% for the same period last year.

What happens next?

What’s likely to happen eventually is that the sector will be hit by some very large claims. This will probably cause short-term operating losses, but should also enable insurers like Lancashire to increase their rates, and start expanding once more.

I see this stock as a long-term holding. Dividend returns are likely to be lumpy over time and could fall sharply in a bad year. I’d rather invest when the shares are trading closer to their book value, so in my view Lancashire is a hold.

How about this 6.4% yield?

Home and motor insurer Admiral Group (LSE: ADM) is an easier business to understand. The group’s policy is to pay 65% of post-tax profits as an ordinary dividend each year, with a further special dividend paid out of earnings not required for regulatory purposes.

Admiral reduces the amount of cash it needs to hold by purchasing reinsurance for many of its policies. This approach has helped Admiral become a popular income growth stock in recent years.

However, earnings growth has slowed significantly since 2014. Admiral also warned after the referendum that ultra-low interest rates had reduced its level of surplus capital. If this situation persists, future special dividend payments could be lower.

The latest consensus forecasts suggest that Admiral will deliver adjusted earnings of 109.6p per share this year, and pay a total dividend of 122.1p per share. This puts the firm’s stock on a forecast P/E of 17, with a prospective yield of 6.4%. I’d hold.

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Roland Head 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.