Motor insurance stocks took a knock last week, as investors priced-in the impact of an increase in compensation payout levels on existing policies.
Admiral Group (LSE: ADM) stoked concerns by delaying its final results by a week. It wanted extra time to calculate the impact of reducing the Ogden rate, the interest rate used by insurers when calculating compensation payments. The government has cut this rate from 2.5% to -0.75%, pushing up payouts.
Investors were concerned that the group’s generous dividends could come under pressure. But Admiral’s results are now out. And they suggest to me that the cut to the Ogden discount rate will soon seem like a storm in a teacup. Indeed, I believe there’s a good chance that investors may end up profiting from this change.
Short-term pain, long-term gain?
The cut to the Ogden rate caused Admiral’s pre-tax profit to fall by 25% to £284.3m last year. Earnings per share fell by 27% to 78.7p. However, the group’s total dividend was left unchanged at 114.4p, giving a yield of more than 6%.
This generous payout looks stretched following the Ogden hit to earnings, but Admiral says that the group’s high levels of surplus capital mean that it’s still affordable. Admiral ended last year with a solvency ratio of 212%, which is significantly higher than most peers.
In its results, Admiral warned that the Ogden rate cut will mean “lower reserve releases and profit commission”. This suggests that dividend growth could come under pressure. However, management has made clear that it expects insurers to increase premium rates to reflect the extra cost of the Ogden cut. So dividends may be protected after all.
The near-term outlook is uncertain, but I believe there’s a good chance that the rate cut will be partially reversed by a planned government review. This could actually boost profits at some point during the next few years.
Admiral stock currently trades on a 2017 forecast P/E of 17 with a prospective yield of 6.3%. I think the risks are acceptable. I’d hold.
This stalwart could be hard to beat
Utility stocks such as SSE (LSE: SSE) generally benefit from predictable long-term revenues and offer high yields. But a recent round of price increases by SSE and its peers have triggered yet another warning that the government is “prepared to act” on prices if necessary.
Personally, I’m not sure there’s much evidence to support claims of profiteering. SSE has reported an operating profit of just 3% over the last 18 months. That doesn’t seem excessive to me.
However, what does seem clear is that SSE’s fundamentals are improving. The group’s adjusted earnings are expected to rise modestly to 121.5p this year, while dividend forecasts suggest the payout will be increased by 2% to 91.4p. The improved level of dividend cover seen last year should be maintained, giving investors greater confidence that SSE’s policy of inflation-linked dividend growth is sustainable.
SSE shares have underperformed the FTSE 100 over the last year, rising by just 5%. But the group’s 6% dividend yield is tempting and I believe the stock remains a high quality choice for income investors.
