A Sector for Yield

We all know what the ideal investment is like: A solid business, perpetually unloved by mainstream investors, that pays a reliable >5% yield, while its share price rises at least by inflation year after year, as does the dividend. Such companies are rare because, sooner or later, above average yields are normalised either by a dividend reduction or a market rerating. As investors, we hope for the the latter but so often we get the former. Mr. Market is not always right, but he sure knows a thing or two.

Of course, I have no magic formula for distinguishing between the two possible outcomes, but I thought I'd share with you a sector of companies that are mostly high yielders, some of which, for better or worse, I have incorporated into my portfolio over the past year or two. The sector is the somewhat unloved one of insurance. It breaks down roughly into three categories: general, life and specialist, but some companies span more than one category and many have idiosyncrasies which differentiate them from rivals. Insurance now constitutes 14% of my holdings and I plan to add more in the course of the year. Not all of them are high yielders, but many are, and so they are at least worth a look for those seeking income.

If we restrict our attention to the FTSE350, there is only one comprehensive pure player in the general insurance category. This is RSA (RSA), formerly known as Royal and Sun Alliance. The company offers all types of general insurance (retail and commercial) around the world but a current problem is the small dividend cover. Admiral (ADM) specialises in motor insurance, but rapid growth over the past three years has made it less desirable for income seekers and it too has a fairly low cover ratio. Another large company, Aviva (AV.), which was formed by the merger of Norwich Union and CGU, is fairly evenly split between general and life insurance, but concentrates its business in Europe and the UK. A smaller, but still large, mixed enterprise is  Legal & General (LGEN) which offers a somewhat lower yield.

There are a few companies which offer just life insurance. Prudential (PRU) is the biggest, but more growth oriented and hence less attractive for income seekers than Standard Life (SL.). The South African based Old Mutual (OML) is also a sizeable player in this subsector. All of these have big asset management arms and so tend to be geared somewhat to worldwide markets. As well as companiy specific risks, a general risk hanging over all insurance companies is the EU Solvency II regime which is due to take effect in 2013. This will compel companies to be more conservative financially by holding more capital and may, therefore, impede profit growth. However, the extent of the changes is subject of discussion and lobbying, and no one knows what the outcome will be. Bad news is to some extent priced in already and any relaxation in the likely framework should give many companies a boost.

Aside from these companies which are known to the general public, there are specialist insurers that operate on the London Lloyds insurance market (and elsewhere). These grew out of the Lloyds syndicates that used to operate until the "recruit to dilute" scandals of the 80s/90s. New members of Lloyds must now be limited liability companies, although some old syndicates remain. For the investor, putting your money into a specialist insurance company is safe in the sense that, just like any other listed company, you can only lose your initial stake, unlike the syndicate investors who, as "names", were faced with unlimited liability to punitive abestosis claims.

Several such companies are listed in the FTSE 350 and many of them offer enticing yields. Aha, you will say, these companies are risky. Yes, they are, for the obvious reason that they handle natural disasters, like the earthquakes, tsunamis, storms, oil spills and radiation leaks that have become so familiar recently. But, a well diversified operation with good underwriting should not be hit for claims any more than any other, which means that it will be in a strong position to raise premiums with the rest. This feature is what makes catastrophe insurance such good business in the long term. Disasters, in fact, are what drive the sector forward. Of course, an individual company can get it wrong and be more exposed than its peers. It's very difficult to tell how much a company will be exposed to specific disasters, although the amount of reinsurance they handle can be a rough guide. Even the companies themselves don't usually know until several months later. Generally, bigger is safer.

Anyone considering buying into any of these companies might like to look at the free 2010 report "Cliff edge or knife edge" from Edison Investment Research, which gives a comprehensive overview of the subsector. You will need to register, though.. An interesting feature of these companies (and, in fact, most insurers) is that they tend to hold a lot of money in liquid cash and bonds in order to meet claims. Currently, just like you and me, they don't get much of a return. However, as rates rise, so will their investment income and this should help to support yields in the future. What matters most, however, is premium income and that is going to be determined by how lucky/skillful the underwriters are.

The table below gives the basics of the companies considered. I have excluded some oddballs like CPP, Phoenix and Resolution. As always, do your own research, since insurance company accounts have a tendency to opacity.