I’ve been staying well clear of shares in both Aviva (LSE:AV) and Direct Line (LSE:DLG). But I think the FTSE 100 company’s move to acquire its smaller competitor is a smart one.
As I see it, the deal could generate real value for Aviva’s shareholders. So should I reconsider my previous aversion to the stock?
A quick insurance overview
Insurance firms make money in two ways. One is keeping the claims they pay out below the premiums they collect and the other is by investing those premiums to earn a return before paying them out.
Different insurers take different strategies. Admiral, for example, focuses on underwriting profit and Berkshire Hathaway leans more on its investments.
Intrinsically, neither is better than the other. But a good insurance business needs to have a strong competence in at least one of these areas.
Prioritising both is hard – a strong investment firm should want to bring in as much cash from policies as possible, even at lower underwriting margins. With that in mind, let’s turn to Direct Line and Aviva.
Joining forces
The reason I’ve stayed well away from Direct Line over the past couple of years is its underwriting (its main profit engine) has been disappointing. It made a loss in 2023 before scraping back to profit in 2024.
There are two ways for this to improve. The first is pricing its policies more efficiently and the second is cutting back on its costs – and it’s been making moves towards doing both.
Joining forces with Aviva should help with both parts of this. Most obviously, the combined business won’t need two sets of staff doing the same job, so there should be additional cost savings available.
Aviva has also fared much better with underwriting over the last couple of years. So there’s reason to think there could be improvements on this front as well.
Why I’ve never bought Aviva shares
Aviva shares have a 7.5% dividend yield, which is very attractive. But there are two reasons I’ve never bought the stock in the past.
One is slightly ironic – I think the firm’s risks are extremely difficult to assess. Insurers in general find out at the start of a policy what its maximum profit is and only later what its liabilities might be.
This is especially true of life insurance, which makes up a significant part of Aviva’s revenues. But this isn’t the only source of uncertainty I have.
Aviva’s profits have fluctuated depending on things like inflation and interest rates. While this isn’t unusual, there have been years when these have been below the dividend and this creates a risk.
Foolish takeaway
I’ve never had any interest in buying Direct Line shares, but I think I can see why Aviva has. The insurance giant has far more capacity to improve the business than I do.
Acquiring Direct Line at a 22% discount to where the stock was five years ago looks like a smart move. But it doesn’t put me any closer to wanting to buy Aviva shares.
This post was originally published on Motley Fool
