Investors stall as Admiral hits a dead-end

What kind of motor insurer can report a 29% increase in first-half net profit, yet be rewarded with a crushing 12% drop in share price on the same day?

The answer is of course Admiral, which is no stranger to defying logic and expectations with its results. The company’s share price has continued to suffer today – it was down another 5.8% at the time of writing.

So why have investors dumped Admiral stock so unceremoniously? While referral fees are part of the answer, they’re not the full story. Admiral revealed yesterday that the controversial fees only made up 5.6% of first-half profits. The loss of this would be disappointing, but hardly catastrophic, and Admiral could plug the gap with something else if it became clear the fees would be banned.

The real issue

The drop in underwriting profitability is the bigger issue here for shareholders. Admiral’s UK motor combined ratio jumped 7.5 points to 90.4% and underwriting profit dropped 7% to £21.7m.

Admiral points out that this was largely because its reserve releases dropped to £4m from £17m. However, investors are unlikely to take much comfort from the fact that underwriting results are so dependent on the excess in prior year reserves.

The reason for the lower releases is also troubling. Admiral said the cut was prompted by “increases in the projections of ultimate loss ratios on earlier underwriting years, in turn resulting from worse development in average claim costs on those years than was previously projected” – in short, worse than expected bodily injury claims inflation.

Until now, Admiral had appeared reasonably immune to the bad side of bodily injury claims inflation, instead reaping the rewards of higher rates without having to suffer the attendant pain. In last year’s first-half results, for example, Admiral said that while bodily injury claims were making up a growing proportion of total claims, it had not detected any unusual trends, implying that it had a firm grasp of the rate of claims inflation.

In the wrong gear

The first-half 2011 results announcement shows Admiral, just like the rest of its peers, got its sums wrong. In fairness it got them far less wrong than others – its combined ratio is still way below the industry average, and it is still releasing reserves from old years rather than adding to them. Nonetheless it is further proof of the company’s fallibility.

Then there is the context: most insurers’ personal lines motor underwriting is getting better, not worse. Recent examples include Ageas, with a 12.1 percentage point improvement in UK motor combined ratio, and Aviva, with a 10 point improvement.

It is also difficult to discount the persistent mystery surrounding ‘ancillary income’ as a source of investor concern. Investors know what’s in the pot, and now know how much of it is referral fees, but the proportions of the rest of the elements are still unclear. Investors and analysts dislike anything they cannot measure or quantify. For Admiral, the opaque element in question now accounts for 54% of its main operating unit’s pre-tax profit.

Admiral is clearly not struggling or in any danger – it is still an extremely profitable company by any measure. Nor are its results propped up by large slugs of lawyers’ money, as evidenced by its referral fee disclosures. However, it is now far more clear to investors than before that Admiral does not possess magical powers that make it impervious to industry trends and troubles.