Direct Line: Review by FCA a Big Negative; We Lower Fair Value Estimate; Shares Remain Undervalued

After Direct Line DLG announced the appointment of new CEO Adam Winslow a few days ago, it revealed on Sept. 1 that the Financial Conduct Authority is undertaking a review of its past business. This news is highly disappointing and highlights two things. The primary reason for the review by the authority is to investigate an error in Direct Line’s implementation of the new general insurance business pricing rules, effective Jan. 1, 2022. First, this error has meant that for some customers Direct Line has not calculated equivalent new business prices in line with these rules. This could mean that either new customers have been offered and sold insurance at prices that are lower than the prices being charged to existing customers with the same risk profile or existing customers have been offered renewal prices that are higher than the prices they would be offered if the same customers were new. The FCA’s review is being undertaken across home and motor insurance, Direct Line’s primary lines of business. Second, we believe it highlights that under the old regulatory regime, Direct Line more than likely used the practice of price walking as we concluded in our April 30, 2022 special report “In General, Admiral Is One of Our Favourite Businesses in Insurance.”

As a result, we’ve revised our estimates for Direct Line’s motor policyholder growth down from negative 2.5% to negative 10% for full-year 2023 and stretched the recovery back to positive growth over a longer period. We have also revised our estimates for home policyholder growth from negative 4.7% to negative 6.5% for full-year 2023. We haven’t made adjustments to our estimates for pricing because currently, our pricing estimates are a little low. However, prices are likely to be hit by this review of past business. We lower our fair value estimate to GBP 2.20 per share and maintain our no moat rating.