Today’s reports that the Financial Conduct Authority (FCA) is expected to open an investigation into 30 million pension and investment policies, sold by Aviva (LSE: AV) (NYSE: AV.US) and its UK peers between 1970 and 2000, have left Aviva shares down by nearly 7% on last night’s closing price.
These older products typically have much higher charges than today’s equivalents, and the FCA’s suspicion is that older customers are being locked into uncompetitive products in order to subsidise the lower costs charged to new customers.
I suspect that this could end up being the insurance industry’s version of the PPI mis-selling scandal. This could put huge pressure on Aviva’s profits and cash flow, so I’ve been taking a closer look to gauge how the firm might cope.
1. Operating profit/ interest
What we’re looking for here is a ratio of at least 1.5, preferably more than 2, to show that Aviva’s operating earnings cover its interest payments with room to spare:
Operating profit / finance costs
£2,049m / £609m = 3.4 times cover
Aviva’s operating profits covered its finance costs 3.4 times in 2013. While this is adequate, many FTSE 100 firms have much higher levels of cover.
If Aviva faces a reduction in profit margins and a round of compensation payments, following an FCA investigation, the dividend could come under threat — again.
2. Debt/equity ratio & cash generation
Commonly referred to as gearing, this is simply the ratio of debt to shareholder equity, or book value (total assets – total liabilities).
Aviva’s total debt of £7.8bn is offset by £25bn in cash, but the firm isn’t free to spend all of this. Similarly, although Aviva generated impressive cash remittances of £1.2bn last year, this cash generation could tail off if annuity sales fall, and the FCA decides to take action against Aviva.
3. IGD capital surplus
The Insurance Groups Directive (IGD) capital surplus sounds a bit of a mouthful but is actually a very simple — and important — figure.
Insurance firms have to hold a certain amount of capital to ensure they can cope with unexpected events and financial problems. The IGD surplus is a measure of how much capital they hold on top of the minimum required.
Aviva’s IGD surplus was about £3.6bn at the end of 2013, giving a coverage ratio of 1.7 times, which is acceptable.