2 UK Insurance Stocks to Diversify Your Portfolio

Insurance is one of Warren Buffett's favorite business models

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Jan 23, 2023
Summary
  • An insurance business model offers float that can be invested for extra income. 
  • Legal & General is a leading UK life insurance company with a vast portfolio of real estate bonds. 
  • Aviva is a diversified insurer which is expanding its wealth management business. 
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The insurance industry operates with an interesting business model based on the risks, odds and result of various incidents and loans. In simplified terms, the insurance industry enables the transfer of risk. The job of an insurance company is to calculate the risks of certain happenings accurately so it can price its premium for customers to pay. This includes the risk of a car crash (car insurance), the risk of passing away prematurely (life insurance), etc. Predicting and forecasting risks can be difficult, and an insurer's portfolio is often prone to “Black Swan” or “long tail” events.

Warren Buffett (Trades, Portfolio) has historically invested in a variety of insurance companies such as Geico, National Indemnity, etc. In the past, Buffett has expressed the challenges of running an insurance business, but he also is quite fond of the business model. He has generously praised Berkshire's (BRK.A)(BRK.B) Ajit Jain for his ability to turn around Berkshire's reinsurance group.

The unique thing about insurance companies is that they hold a float, which is a pool of cash from policyholders' premiums ready to deploy if policyholders make a valid claim. Many insurance companies invest this float to generate extra income. This is the ultimate business model from the perspective of someone like Buffett, as it effectively enables a dual engine of growth. In addition,policyholders are usually paying to mitigate the risk of an even that will never occur. For companies that can master the insurance business, stable cash flows await as premiums received will ideally be less than claims payouts. As the insurance industry is regulated, it also has built in barriers to entry, which slows down the competition.

Given the Russia-Ukraine war and tough economic environment in Europe, many insurers have had their stocks beaten down. Thus, in this article, we will take a look at my two favorite UK-based insurance stocks; let’s dive in.

1. Legal & General

Legal & General (LSE:LGEN, Financial)(LGGNF, Financial) is a UK-based financial services company that specializes in life insurance, pensions and investment management. Life insurance is an interesting business that uses marketing to effectively play on the fear of not being able to look after dependents if one passes away. Therefore a policyholder will pay premiums for many years and then the individual's family or partner will receive a payout after the person passes away. Of course, many insurers tend to be strict on who they insure and the premiums charged. For example, if a person has underlying health conditions and is 80 years old, most companies will be less likely to offer insurance. It's all about mathematical odds and risk.

Given the rapid advancements in disease prevention, hygiene and education regading diet and exercise, life expectancy has increased substantially. In the 1800s, the average life expectancy of a person was just 40 years old. Today, the average life expectancy in the U.S. is 77 years, and in the UK it's 80 years.

For life insurance companies, this is a positive as the longer people live the more insurance premiums are paid over time. This also means insurance companies can hold the float of funds longer in investments.

Therefore, it should be no surprise that Legal & General also runs an investment management business that invests in areas such as real estate. For example, in the UK, I have seen many new apartment buildings and modular homes that were funded by Legal & General.

Legal & General now has ~$1.3 trillion in assets under management, which makes it a substantial player in the industry.

Growing financials

Legal & General reports its financial results on a biannual basis, as opposed to quarterly. For the first half of 2022, the company reported operating profit of 1.16 billion British pounds ($1.42 billion), up 8% year-over-year from the ÂŁ1.07 billion reported in the prior-year period.

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Its earnings per share (EPS) was 19.28 pence, which increased by 8% year-over-year from 17.78 pence.

Legal & General has generated strong returns on its past investments, with a return on equity of 21.3%. Legendary investor Peter Lynch has stated in the past that if a stock has a constant valuation than an investor's annual return can be approximated as the return on equity or return on capital.

The company's ÂŁ72 billion annuity bond portfolio means it has strong and consistent cash flows, which is great for managing tough economic times. Legal & General aims to grow its dividend at 3% to 6% each year, and the current dividend yield is 7.34%.

In addition, the company has a strong balance sheet with an AA- rating by Fitch and an Aa3 rating by Moody’s. Its solvency coverage ratio of 212% is up from 182% a year ago.

Valuation

Valuing Legal & General is fairly challenging as the company runs quite a complex business. The stock trades at a price-earnings ratio of 7.7, which is just 3% cheaper than its five-year average.

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The GF Value chart indicates a fair value of $4.22 per share for its American depository receipt listing and rates the stock as modestly undervalued at the time of writing.

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2. Aviva

Aviva (LSE:AV., Financial)(AVVIY, Financial) is the largest general insurer in the UK and also has operations in Canada. The business provides a wide array of insurance products which include life insurance, health insurance, property and casualty insurance, car insurance and even travel insurance.

Its scale with a ÂŁ12 billion market capitalization (big for the UK) gives it a competitive advantage in the market, as it better able to manage its cost structure and specific risks.

Growing financials

Aviva reported solid financial results for the trailing nine months. Its life insurance revenue was ÂŁ466 million, which increased by a rapid 46% year-over-year. This was at a solid 1.9% margin, which increased from 1.3% in the prior year.

Its wealth management business has also continued to grow with 6% inflows in assets under management (AUM). The business also acquired Succession Wealth, which gives Aviva access to a range of financial advisors and connects them with its multi-asset investment funds.

The general insurance segment reported a staggering ÂŁ7.2 billion in gross written premiums (GWP), which increased by 10% year-over-year.

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Aviva has focused on cost reduction, and reduced its overall costs by 2% year-over-year, which is a great sign for efficiency.

The company has a strong balance sheet with $16.7 billion in cash and cash equivalents vs. total debt of $8.4 billion, which is manageable as the majority of this is long term debt.

Valuation

Aviva trades at a price-earnings ratio of 7, which is cheaper than historic levels.

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AVVIY Data by GuruFocus

Final thoughts

Both Legal & General and Aviva are large and highly regarded UK insurers. Aviva offers a great way to gain exposure to a diverse range of insurance offerings in the UK and Canada. However, I personally prefer Legal & General, as most as its real estate portfolio offers consistent cash flow from a range of apartment buildings. In addition, its valuation looks to be cheaper than Aviva's.

Disclosures

I/we have no positions in any stocks mentioned, and have no plans to buy any new positions in the stocks mentioned within the next 72 hours. Click for the complete disclosure