Insurance stocks crash on Government cut to Ogden discount rate

Direct Line red phones

Shares of motor insurance firms fell sharply when markets opened on Monday morning, after the Lord Chancellor released details of a proposed change to the way that compensation payments are calculated.

The discount -- or interest -- rate used to calculate compensation payouts will be cut from 2.5% to -0.75%, to reflect the fall in inflation-linked government bond yields since 2001, when it was last revised.

The effect of the change will be to increase the amount insurers have to pay claimants to reflect today's lower interest rates. But the cut is bigger than most insurers expected.

As far as I know, there aren't any retail savings products offering negative interest rates. So insurers were hoping that the cut would be more reflective of conditions in the retail savings market, rather than the government bond market.

The government has now promised a review of the way that this rate is calculated. I suspect further changes are likely.

In the meantime, investors in firms such as Direct Line Insurance Group (LSE: DLG) could see dividend growth come under pressure. Should you buy, sell or hold after today's news?

Profit down by a third

Direct Line is today's biggest faller in the insurance sector, down by 7.6% to 336p at the time of writing. The group said that the impact of the -0.75% rate on its 2016 results would be to reduce pre-tax profit by between £215m and £230m.

Pre-profit during the first half of the year was £298m, so assuming a similar performance during the second half this means pre-tax profit will be down by about one third.

The group's Solvency II capital coverage ratio, a key regulatory measure, would also fall "towards the higher end of the Group's target range of 140-180%" before dividends. So dividend growth might slow.

Direct Line looks heavily exposed following today's news, but the bad news is probably in the price. I'd hold.

Results on hold

Admiral Group (LSE: ADM) will postpone its full-year results until 8 March in order to fully calculate the impact of today's change.

The firm says that the impact of existing claims settling at the new rate is expected to be between £140m and £175m. Admiral's 2016 reported profit will be £70m-£100m lower than expected.

However, the group is confident that the insurance market will adjust its pricing so that premium rates reflect this higher level of payout. Admiral believes "there will be no significant impact on future business and its profitability".

The group's shares are only down by 2.7% today, so the market seems confident in Admiral's judgement. I'd hold until we know more.

This stock has risen today

Insurance peer Esure Group (LSE: ESUR) is one of today's winners. The firm's shares rose by 2.8% after the group reminded investors that it had already budgeted for a cut to 0%.

Esure's management say that today's changes will only reduce the firm's reserve margin by £1m. The group is still confident that 2016 profits will be "ahead of market expectations" thanks to strong investment returns last year.

The firm's shares trade on a forecast P/E of about 13.5, with a prospective yield of 4.7%. I'm encouraged by Esure's prudent approach to this change and attracted to its modest valuation. I'd be happy to buy at current levels.

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Roland Head 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.

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