Zurich Insurance Group (OTCQX:ZURVY) is one of the largest European insurance companies and has a relatively good dividend history, making it a clear income investment within the sector due to its high-dividend yield of 7%. However, its business fundamentals have deteriorated recently and its dividend sustainability is now being increasingly questioned by investors. Its dividend sustainability seems to rely on its restructuring capacity, something that may take some time to show its effect. Therefore, its yield seems to be a trap and better value can be found somewhere else within the European insurance sector.
Zurich Insurance Group is one of the largest composite insurance companies in Europe, which means it operates on life and non-life insurance businesses. It was founded in 1872 and is based in Switzerland. Its main competitors are other large composite insurance companies based in Europe, namely Axa (OTCQX:AXAHY), Allianz (OTCQX:AZSEY) and Generali (OTCPK:ARZGY). Zurich operates globally, offering insurance products and services in more than 170 countries and has about 55,000 employees.
Zurich has a conservative business culture which is reflected on its strong credit rating of AA- by Standard & Poor's, showing also its good financial strength. Zurich has a market capitalization of about $36 billion and trades in the U.S. on the over-the-counter market through its ADR program.
Regarding its investment portfolio, it has a conservative approach with about 85% of its asset allocation on fixed income, mortgages and cash. More than half of its fixed-income portfolio is allocated to AAA and AA credit ratings. Equities, hedge funds and private equity only represent 8% of its asset portfolio, which is acceptable within a conservative investment portfolio.
Geographically, Zurich has a good diversification with Europe being its largest market, generating almost half of its revenues. It also has significant exposure to the North American markets, where it offers commercial insurance and also has indirect exposure to the U.S. personal lines market, via its management of the Farmers Exchange. These markets represented close to one third of its revenues in the past year, while Latin America was responsible for 10% of revenues and Asia-Pacific generated 7%.
Zurich operates under three business divisions, namely General Insurance, Global Life e and Farmers Insurance. In Non-Life, the company is a diversified global player, and is within the top three global commercial insurers. It has a multinational life business with operations in a number of key markets. During the past year, Farmers were Zurich's largest division measured by operating profit with a weight of about 40%, followed by Global Life (36%) and General Insurance (24%).
Financial Overview & Dividends
Zurich's financial results have been impacted negatively over the past few years by a challenging operating environment on several fronts. In the U.S. commercial, non-life insurance market the competitive landscape has been fierce and interest rate increases are needed to offset the impact of a low yield environment, while in Europe insurance pricing has been weak across several markets. In Switzerland, insurers have come under pressure since the Swiss National Bank's removal of the currency peg versus the Euro impacting negatively companies with large business abroad like Zurich. Additionally, the low interest rate environment in Europe is also negative for its investment income and specifically negative on its life business which has relatively high rate guarantees.
Given this backdrop, it's no surprise that Zurich's earnings have dropped considerably in 2015 with net income, decreasing by more than half from the previous year to $1.8 billion. The company has faced several issues, including higher losses on natural catastrophes, but also reserve issues in the U.S. that led to adverse reserve development. As the company does not write directly any personal business line in the U.S. this issue seems to be structural rather than cyclical and further reserve issues can't be ruled out in the future.
Due to lower profits, its return on equity declined markedly in 2015 to only 6.4%. This was way below its previous year at 13% and nowhere near its ROE target of 12-14%. Historically, Zurich has had a relatively stable profitability level above its cost of equity, and over the medium-term should return to levels more in line with its target.
Reflecting its issues within its General Insurance segment, Zurich's combined ratio of this unit increased to 103.6% in the past year from less than 97% in the previous year. This means that it had underwriting losses in this unit at close to $2 billion in the year, justifying to a large extent the steep earnings drop at the group level. One of its top priorities in the short-term is to turn around this business and Zurich given that this is its main tool to recover group earnings in the next few years.
Zurich has made several initiatives to address key issues, namely exited some businesses, reviewed internal procedures and is accelerating its cost-cutting program. However, this may take some time to materialize and be reflected in improving operating earnings. Indeed, in the first quarter of 2016, its General Insurance operating profit continued to drop and at the group level, it declined by 16% to $1.08 billion, thus its restructuring program is not showing a fast improvement yet.
Despite its recent weak earnings, Zurich's capital position remains strong with a solvency ratio under Swiss rules of 110% at the end of March 2016. This is comfortably within its desired target range of 100-120%, thus Zurich does not need to retain much profits to enhance its capitalization. Indeed, its goal is to return some of all of its excess capital, but considering the challenges it faces this may be postponed to the future. Compared to other European insurance companies, its capitalization looks good given that it is not under Solvency II regime but its Swiss Solvency regime is usually more conservative.
Due to its excess capital position, Zurich announced that it was looking to deploy $3 billion by the end of 2016 in mergers and acquisitions (M&A). A few months ago, the company was looking to acquire its British peer RSA Insurance (OTCPK:RSNAY), but the acquisition was aborted due to Zurich's own problems within General Insurance. Therefore, other M&A opportunities don't seem to be Zurich's priority in the short-term and most likely it will deploy its excess capital to enhance its shareholder remuneration strategy.
Regarding its shareholder remuneration, Zurich has a long history of dividend payments and this is one of its main positive factors, being Zurich mainly an income investment. Its goal is to maintain a sustainable and attractive dividend over the long-term. Indeed, Zurich has historically offered an above-average dividend yield, a very important feature within the insurance sector.
At its current share price, Zurich offers an attractive dividend yield above 7% based on its annual dividend of CHF 17 per share ($17.68). However, this dividend is unchanged since 2010, not a good sign for future dividend growth. Additionally, investors should note that the Swiss dividend withholding tax is high at 35%, making its high-yield less attractive for U.S. investors.
Zurich has historically paid a large part of its earnings to investors, with a dividend payout ratio on average of about 70% since 2010. However, in 2015 its dividend per share was flat, even though its earnings collapsed by half. This led to a dividend payout ratio of 140%, clearly not sustainable over the long-term. This means that as an income investment the dividend sustainability has been put in jeopardy and its 7% yield may be a trap despite being very attractive for income investors in the current low interest rate environment.
Zurich is a relatively defensive company with a good capitalization and stable dividend history, making it a clear income investment story. Due to this profile it has historically traded at a premium valuation compared to its peers, but its recent business performance has been quite weak and its fundamentals have deteriorated considerably, making its dividend sustainability a key issue. Zurich so far has maintained its dividend unchanged, but the risk of a dividend cut seems to be relatively high, thus despite its 7% yield this appears to be a trap.
Given this backdrop and the potential of losing a large part of its income appeal if the dividend is cut over the next few quarters, there seems to be better income investments elsewhere. Within the European insurance sector, Axa seems to offer better value even though its dividend yield is lower at 5.2%, but it is clearly more sustainable over the long-term. Its dividend payout ratio was below 50% in the past year and has good growth prospects in the future while its valuation is also cheaper than Zurich, making it a better income investment for long-term investors.
Disclosure: I am/we are long AXAHY.
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