Over the last few years, the stock market has richly rewarded the few insurance companies that have taken advanced steps to get to an efficient solvency level, to remit excess cash up to the holding company, to return this to shareholders and to improve disclosure as to the sustainability of those cash flows. We believe that shareholders have not only appreciated the higher dividend returns, but also the implications for potential M&A (increased discipline).
An active capital management policy (including capital allocation, capital discipline and capital return) has recently become a more widespread practice within the insurance sector. Over the second half of 2014, insurers’ stock market performance has been supported by encouraging messages from management teams on the return of capital to shareholders.
We believe that the “capital management” theme in its broadest sense (capital allocation, capital discipline and capital return) will continue to play an important role in sustaining sector performance. Counter-intuitively, the low interest rate environment has increased the attractiveness of the sector. It is putting the sector’s attractive and sustainable dividend in the spotlight, while earnings are at the same time proving to be resilient to the low interest rate environment.
An attractive dividend yield…
The insurance sector pays an attractive dividend yield (4.6% for 2015e). This yield is even more appealing when put into context with the current low interest rates. Today, the sector yields 350bp more than a basket of investment grade corporate bonds (an all-time high) and provides a 420bp spread on German Bunds. The sector yield also looks attractive when compared to the 3.6% average dividend yield for the equity market. Insurance is the third highest yielding sector after the Oil & Gas and Utilities sectors.
… supported by a moderate pay-out ratio…
The pay-out ratio of the sector is not excessive, at 51% vs. a 52% average for the equity market. This compares to 60% and 70% pay-out ratios respectively for the other high-yielding sectors, Oil & Gas and Utilities.
There is room for the industry’s pay-out ratio to increase.
… and that is sustainable
Investors should find comfort in the sustainability of the dividends from the companies’ strong and recurring cash generating capacity and their strong capital base.
Good visibility on FCF generation
Over the last few years, the sector’s cash generation has improved significantly as actors have deliberately moved their business mix towards capital light products and as organic growth prospects within the industry are limited. Insurers therefore need little capital to write new business. Additionally, the amount of required capital falls over time as the older, more capital-intensive business runs off the books. Insurers have also worked hard to increase cash generation through cost cutting and have improved visibility on how cash is generated in the business.
The sustainability of cash flow generation is also driven by the resilience of insurers’ earnings. On that topic, the picture looks good, especially when comparing with the rest of the stock market. Analysts have on average not really revised insurers’ earnings downwards over the 2012-2015 period. This compares very favourably to negative earnings revisions of 11% for the market on average.
A strong capital base
Over the last few years, insurance companies have become more disciplined in terms of capital usage, through risk reduction, selective capital allocation and a sensible approach to M&A. Through de-risking and capital discipline, insurers have rebuilt their balance sheets and reduced the volatility of their solvency ratios.
When looking at the investment portfolios for example, insurers have reduced their equity holdings (to around 5% today from 19% in 2006) and increased their fixed-income holdings (to around 82% from 59%). Within fixed-income, the industry has reduced the exposure to corporate bonds (to 33% of fixed income today, from 44% in 2006) and structured assets (now at 5%, from 12%), while increasing the exposure to sovereign bonds (42%, from 38%) and covered bonds (10%, from 0%).
Capital discipline has been partially driven by the preparations for Solvency 2, which is to be finally implemented in January 2016.
Overall, we believe that the direction in which Solvency 2 is headed will not put at risk the sustainability of the insurers’ dividend payments or capital return policies. Over the last few years, the original Solvency 2 rules have been watered down resulting in a much diluted framework, reducing the risk of any sort of capital shortfall for the listed European insurance sector. Any surprises from the final clarity on Solvency 2, expected in Q3 2015, are likely to be skewed to the positive side. Final calibration of Solvency 2 might lead to room for some insurers to return more capital to shareholders. Another potential positive impact from the implementation of Solvency 2 is the expected homogeneity and therefore comparability of published economic solvency ratios, which would lead investors to feel more comfortable with insurers’ solvency positions.
The sector yields today 350bp more than a basket of investment grade corporate bonds and provides a 420bp spread on German bunds