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In-depth: are insurance companies the best high yield shares for my ISA?

Sale agent deal to car loan contract with customer.

One of the attractions of holding high yielders in my ISA is that they can help me earn passive income for years to come. Certain industries tend to have a number of high yield shares for various reasons. These include tobacco, mining, and insurance.

Here I want to look at some examples of insurance shares I would consider for my ISA. I will discuss whether they are the best high yield shares for my objectives.

Insurance names among UK high yield shares

Looking across the yields offered by various UK shares, a number of insurance companies are notable for the size of their dividends. For example, Direct Line is yielding 8.2%, Legal and General 6.1%, Aviva 5.0%, and Admiral 4.9%.

All four of those shares are members of the FTSE 100 index, but their yields are above the average offered by FTSE 100 shares. Nor is that a recent phenomenon: it’s often been the case that insurance companies offer higher yields than the market average. Why is that?

The economics of insurance

I see a couple of main reasons.

First, insurance can be a very lucrative business. Insurers are able to collect premiums and invest them to generate returns for themselves. They can also profit through careful underwriting – charging customers more in total than they expect to end up paying out. There’s a reason so many customers think insurance companies are greedy.

On top of that, insurance companies often don’t have the same reinvestment needs in their own business as other companies do. They don’t need to build factories or spend money on costly research and development. Of course, insurers do incur some costs in the course of their business. But overall the business model often throws off significant cash flows, which can be paid out to shareholders in the form of dividends.

Income or share price growth?

Sometimes when a share offers attractive dividends, it can come at the cost of capital growth. If a company is paying out surplus funds as dividends, that means it is not investing much to grow its business for the future.

If we look at the share price performance of the four insurers mentioned above over the past five years, some possible evidence for this can be seen. Aviva has fallen 15% and Direct Line has dropped 24%. On the other hand, Legal & General is up 21% and the Admiral share price has grown by 75%. So it may be that, rather than insurance companies offering limited capital growth opportunities, the story is similar to many other business sectors. Over the long run, within a sector some companies will see their share prices grow while others will drop.

That said, I do think it’s worth thinking about capital growth prospects when considering whether to add insurers to my ISA. If a company pays out juicy dividends but the share price drops, I could end up losing money. Looking at dividend yields in isolation therefore isn’t enough when deciding whether insurers are the right high yield shares for me to own. Instead, I ought to do what I would do when considering potential share purchases from any other sector. That involves me looking at a company’s finances, assets, and business strategy to decide whether I think it can produce substantial free cash flows over the long term. Such free cash flows could help support dividends. But they could also boost the case for the insurer’s business model. Over time hopefully that might translate into share price growth.

Insurers and risk

If any sector ought to be good at assessing and managing risk, one might think that it ought to be insurers. After all, that’s how they earn a living.

In reality, just like any other business, insurers face risks. These include increasing competition from fintechs, which threatens to reduce profit margins across the industry as a whole. Another risk for specific insurers is bad underwriting decisions. In a bid to boost revenues, an insurer might be tempted to lower their underwriting criteria. But such criteria are there for a reason. Offering policies to riskier customers can hurt the financial returns on an insurance book.

One thing I like about companies such as Direct Line and Admiral is that they tend to focus on fairly straightforward lines of business, such as home and car policies. Those areas of business can move about somewhat – Direct Line has warned that increasing second hand car prices could hurt its profit margins this year, for example. But broadly speaking, they tend to be fairly consistent businesses. Insurers and actuaries can use a lot of data to estimate the percentage of drivers who might be involved in an accident in any given year, for example.

That is why I like so-called general insurers more than specialist underwriters such as Beazley. Those types of insurers underwrite events which are rare but can be very costly, such as environmental liability. The nature of such business means that it can be hard for me as an investor to assess how a firm is doing. It may take in large premiums for decades without having to pay out. But that can come to a sudden end. So while these can be great businesses, they don’t offer the relative predictability I would look for when choosing high yield shares for my ISA.

Insurers as an ISA pick

Insurers spread their risk by writing policies for large numbers of customers. While some will be costly, hopefully that will be more than covered by other customers who do not make any claims.

I apply the same risk management principle to my ISA. By diversifying across different sectors and companies, I spread my risk. So I would only ever have insurance as one of the sectors in which I invest. I do think some of the sector’s high yield shares offer me attractive passive income potential and would happily own them in my ISA.

They might not be the best high yield shares in terms of absolute return, as higher yields are available in other sectors such as tobacco and the capital price growth opportunities offered by insurers seem to be mixed. But as part of a balanced portfolio, I see a role for them in my portfolio. 

The post In-depth: are insurance companies the best high yield shares for my ISA? appeared first on The Motley Fool UK.

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Christopher Ruane has no position in any of the shares mentioned. The Motley Fool UK has recommended Admiral Group. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.