Why Novae Group plc shares got slashed by 20% today

Shares in Lloyd's of London insurer Novae(LSE: NVA) have plunged by more than a fifth in early deals today after the company announced that increased losses in the second half mean its underwriting profit is likely to be lower than previous expectations for the full year.

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The "continued prevalence of larger individual risk and catastrophe losses" has hammered the company's expected earnings and these losses mean underwriting contribution for the year is likely to be "lower than...prior expectations". Management is now forecasting an overall combined ratio, a key measure of profit for underwriters, to be within the range of 98% and 100% for 2016 as a whole. A ratio of less than 100% means the insurer is generating a profit from its underwriting activities.

The higher loss ratio also includes a writedown of the firm's deferred acquisition costs by approximately £17m, and an increased charge for 2016 of approximately £5m.

No surprise

In many ways, it's not surprising that shares in Novae have plunged following today's announcement. Insurance is an inherently risky business with insurance losses sometimes pushing insurers to the brink of bankruptcy. However, despite this risk the market seems to have ignored Novae's past, pushing the shares up to a high of the back of better than average profitability forecasts.

The City was expecting the company to report earnings per share of 111.3p this year, up 37% year-on-year. Nonetheless, earnings were expected to fall back to 80.5p next year. Such earnings volatility isn't unusual for insurer although, Admiral(LSE:ADM) seems to have bucked the trend.

Cracking the code

Unlike Novae, which ensures against large one-off risks, Admiral writes motor insurance. Motor insurance isn't as profitable as the Lloyd's business Novae takes on, but it is somewhat predictable. Admiral has been able to capitalise on this trend by achieving economies of scale, pushing costs down and profits up. This, in turn, has made the group more attractive to customers.

Over the past five years, Novae's pre-tax income has moved from a loss of £6.3m to a profit of £55.4m reported last year. Over the same period, revenue has grown by 30%.

In comparison, Admiral's revenue is expected to hit £2.1bn this year, up from £960m in 2011, and earnings per share are slated to come in at 109p this year, up from 82p in 2011. Further, as Admiral's business is more predictable, with smaller regular losses, the firm can afford to return more capital to investors than Novae, which has to keep a significant amount of capital on its books to protect against one-off shocks.

As a result, Admiral is a FTSE 100 dividend champion. This year the shares of support a dividend yield of 6.3% and next year analysts have pencilled-in a yield of 6.5%. The company has returned almost 100% of its net income over the past five years to investors.

The bottom line

So overall, today's profit warning from Novae highlights why insurers are risky investments but not all insurance companies are created equal. Admiral has cracked the insurance code and as a result, the company looks to be a much better investment than its smaller peer.

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Rupert Hargreaves 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.