Stockwatch: All about the dividend

What further upside is there for this FTSE 100-listed insurer RSA Insurance? I initially drew attention at 480p in May 2016 as a turnaround able to re-rate given its "best in class" operating targets and the chief executive buying half a million pounds worth of equity.

The chart has shown solid progress with scant volatility, as if investors are satisfied by the progress and potential. I reiterated a 'buy' case last August at 507p after interims beat expectations, and the stock has continued to edge up, currently at about 627p.

That was after a first-quarter 2017 trading update cited operating profit ahead of management expectations due to strong underwriting results and ongoing improvement in operating ratios.

This builds on the 2016 results (promptly released in February) with operating profit up 25% to £655 million and underwriting profit by 73% to £380 million; the combined ratio (losses/expenses divided by insurance premiums written) improving from 96.9% to 94.2%.

Significantly, the UK business achieved its first material underwriting profit - £123 million – in a decade, despite flood claims after Christmas 2015. On the investment side, income slipped 8% to £369 million after a Latin American disposal and low bond yields, partly offset by foreign exchange benefits of translating returns into weaker sterling.

In terms of what management can control, they are doing well, although it's fair to consider if perception will in due course shift from out-performance from restructuring, to what kind of results might be more reflective of the industry?

There's precedent by way of a restructuring at Direct Line which saw its stock double from 2013 to 2016 (maybe enhanced by QE early in this period). However, it has run into consolidation, with the market exacting a yield over 6%. In a sense, insurance is too competitive to offer long-term growth; the stock being re-appraised for income.

On the other hand, latest analysis suggests that staying loyal to an insurer can cost a household up to £1,000 a year, with firms overcharging by up to three times to fund cut-price deals for new customers.

CEO entertains 'organic outperformance'

Sometimes "recovery-to-growth" stocks do evolve from turnarounds; the message RSA is trying to get across. All areas are growing except Ireland, with overseas interests recently benefiting from sterling's devaluation (when like-for-like revenues are adjusted or translated back). UK premiums are up 10% to £629 million or 7% at constant foreign exchange, with new business up on a year ago and strong retention levels across the group.

In Scandinavia, RSA's largest region, premiums rose 14% to £664 million albeit a modest 2% at constant forex, while Canada rose a better 28% to £267 million or 6% at constant forex. In smaller businesses the Middle East rose 7% to £59 million or 7% at constant forex, while in Ireland premiums were flat at £62 million or down 10% at constant forex.

Altogether net written premiums rose 14% or 4% at constant exchange rates, possibly "as good as it gets" in insurance, with overall volume growth of 2% and rate increases adding a further 2%. As consumers become resigned to the return of inflation, it may be possible to continue raising prices without much attrition. For example my own car insurance is with RSA's More Than and each year they push through increases, but online searches still don't locate a better-price.

In terms of policy value, I've had only one claim – a cracked windscreen – which was resolved promptly with flexibility to use a local garage (who were better on price) obtaining my car manufacturer's glass than be restricted to a mobile servicer with OEM glass. So altogether I stay with RSA after many years despite it pushing through price increases. From direct experience and published figures, RSA appears a strong insurer to be with, which augurs well for its equity.

Efficiency gains can only extend so far

Prelims quantified core business "controllable costs" as down 6% year-on-year, with 8% cost reductions offset by 2% inflation, the programme achieving £290 million gross annualised savings versus £180 million targeted originally. This is a third upgrade from £350 million to £400 million as the overall target to be achieved by 2018.

Moreover, February's disposal of £834 million UK Legacy liabilities means RSA's return on tangible equity can increase to a 13-17% range (on net tangible assets of 282p per share as of end-March), with management targeting the upper range. An improving corporate risk profile is shown also by the Solvency II coverage ratio rising from 158% to 166%.

Such a cornucopia of costs applying to a FTSE 100 insurer has offered good opportunities for restructuring, although they have a limit and in due course attention will shift to premiums' growth. My sense is that the board rapidly restoring dividend payouts such that when this perception shift happens, yield prospects will satisfy the key institutional holders.

Special dividends

The medium-term ordinary dividend policy is 40-50% of earnings, enhanced by special dividend payments – where Direct Line has regularly done so its yield is over 6%, thereby attracting income funds. RSA's £834 million proceeds from the disposal don't look marked for a distribution, however.

Instead, it will cut £592 million high-interest debt and slash interest costs from £99 million in 2016 to £54 million this year and just over £40 million in 2018. The end-2016 balance sheet showed net cash up from £816 million to £985 million: note 15 does not clarify what extent of this might need retaining to meet regulatory needs.

However, on the face of it, RSA's capital base supports enhanced dividends, although it is tricky to speculate what extent until management shows action on special payouts. This is significant in terms of projecting what RSA's genuine yield might be, beyond a notional 3-4%, also in terms of limiting downside risk.

Relatively insulated from Brexit

Some 70% of profit is non-sterling based and management contends the group has separate, locally-regulated European subsidiaries, so should not be in the EU firing line as negotiations get underway.

As I've mentioned before with JD Sports Fashion it remains to be seen how British companies with EU subsidiaries end up treated, as their substance is not dissimilar to exporting despite their form of local EU operations.

The brokers' consensus now projects £720 million pre-tax profit for 2018, implying a forward price/earnings (PE) reducing to 11.6 times, which looks fair enough on a medium-term view.

If the board is serious about special dividends, then the stock remains of buying interest, if increasingly for income investors. Those sitting on gains might wait to see how such payouts re-define RSA's risk/reward profile, as potentially they can underpin it.