Direct Line dividend cut + December 2022 portfolio update

I got that one wrong. Back in March, I thought that the 9% dividend yield being offered by portfolio stock Direct Line Insurance Group (LON: DLG) was probably safe.

It wasn't. Last week Direct Line cancelled its final dividend, blaming December's freezing weather and higher than expected motor claims inflation.

In this catch-up update, I'll review the Direct Line news and explain what I'm going to do now. I'll also review the recent full-year results from a small-cap company in my model portfolio that's now clocked up 34 years of unbroken dividends.

Direct Line Insurance

For the avoidance of doubt, I hold Direct Line shares personally and in my model dividend portfolio at the time of publication.

Description: A FTSE 250 company that's one of the UK's largest motor, home and commercial insurers. Click here for an archive of past posts.

I haven't include my quality dividend score or a forecast yield estimate in the table above. I don't consider my system's current score for DLG to be representative of the current situation, until the next accounts are published. In my view, the likely size of the 2023 dividend payout is also uncertain.

RNS release: Trading update

"... the Board no longer expects to declare a final dividend for 2022."

Direct Line shares fell by around 25% on Wednesday, after the company warned of increased losses this year and cancelled its dividend.

Trading update: Chief executive Penny James says that Direct Line was hit by three unexpected financial issues during the fourth quarter. The combined effect of these is such that the company no longer has enough surplus capital to pay a final dividend this year.

December freeze: the cold weather in December caused a sudden surge of home and business insurance claims relating to burst pipes and other such issues. The company says it's handling three thousand claims, at an expected cost of around £90m (average c.£30,000 per claim).

When combined with the impact of January's cold weather and summer subsidence claims, weather-related claims are now expected to be "in the region of £140m for 2022". That's double the original budgeted amount of £73m.

Motor claims inflation: to recap, Direct Line issued a profit warning in July, warning that motor claims costs had risen much faster than expected. At the time, Admiral, Saga, and Sabre Insurance all issued similar warnings, so I wasn't too concerned.

By November, management claimed to have increased motor prices to "restore margins". The firm said that motor claims inflation was "tracking closely to our expectations".

Or not.

Last week's update revealed that while Direct Line's in-house claims costs were broadly as expected during the fourth quarter, third-party claims continued to rise more quickly than expected.

It seems that the company still hadn't increased its prices sufficiently during the final part of the year. Management are presumably trying to protect market share, but there's not much value in writing loss-making insurance.

Commercial property portfolio: the company's investment portfolio includes some commercial property. According to the firm, the value of this property has fallen by 15%, or around £45m.

Once again, management say that this reduction "is greater than we had initially expected", although it's in line with commerical property price indices.

Occupancy (and presumably rent) are said to remain stable, but the valuation loss will affect Direct Line's capital surplus.

Outlook: Direct Line now expects to report a combined operating ratio of 102%-103% this year. A figure over 100% indicates an underwriting loss.

In other words, the company expects that its claims costs and operating expenses will be greater than the insurance premiums it collected for the year.

The shortfall will be absorbed by investment returns and surplus capital on the balance sheet, derived from cash and investment assets. But this result means that the group's solvency capital ratio (a regulatory measure) will now be "at the lower end" of its targeted range of 140%-180%. Paying dividends reduces this ratio, hence no final dividend.

2023: looking ahead, management have also downgraded their estimate of underwriting profitability for next year. In a weasel-worded statement, they say that motor claims inflation on policies already written mean that the group's combined operating ratio (COR) will rise by 2%-3%, relative to the target of 95%.

In plain English, Direct Line appears to be forecasting a COR of 97%-98% for next year. That should mean profitable underwriting, just. But this guidance doesn't leave much room for any further nasty surprises.

There was no comment on the 2023 dividend and broker forecasts have been left unchanged.

I'm no expert on insurance accounting, but I've taken a look at the half-year accounts to see how bad things might be.

My sums suggest it will be difficult for the firm to improve its capital coverage next year without a sizeable dividend cut – unless the group's investment portfolio performs much more strongly. That's possible, in an era of rising interest rates, but far from certain.

My view: Bad weather losses are a fact of life for non-life insurers that provide home and motor cover.

I could (possibly) accept the December freeze as an exceptional event, although I'm not really convinced. But I think it's very disappointing that the company is still getting motor claims assumptions wrong, more than six months after this issue triggered a profit warning.

I can't help feeling that Direct Line has consistently been too optimistic about likely claims levels. Alternatively, I'd suggest that a planned dividend cut should have taken place earlier this year, in order to increase the capital buffer available to handle unexpected spikes in claims.

Direct Line has now delivered a profit warning followed by a dividend cut – two of the events on my stock-selling checklist.

I may wait until the company's full-year results are published on 7 March to make a final decision, but I am increasingly minded to replace Direct Line in my portfolios.

I'll confirm my decision and the identity of any replacement in in my March portfolio update, if not sooner.

The remainder of this review covers a small-cap stock in the portfolio that's available to subscribers only.