The Case for Insurance: Finding Value in an Outdated Industry

The insurance industry, despite its massive size and critical role in the global economy, operates with outdated practices.

Legacy systems, slow technology adoption, and complex product offerings make it one of the frontiers for disruption, and an intriguing opportunity for investors like me.

This interest was first sparked by Warren Buffett's resounding success with GEICO. If the Oracle of Omaha’s most famous investment came from insurance, could there be another hidden gem waiting to be uncovered today?

But what truly draws me to insurance is its inefficiency. A sector long overdue for innovation offers opportunities for forward-looking companies and the investors who spot them early.

Why Insurance Appeals to Me

Insurance companies tend to have unique financial characteristics that set them apart from high-growth sectors like technology. Mature market dynamics and regulatory constraints often limit growth, while profitability is tied closely to macroeconomic factors like bond yields.

However, the sector's outdated nature presents an opportunity for companies willing to innovate. As an investor, I believe that identifying these disruptors can yield significant returns, despite the challenges posed by traditional valuation metrics.

The Challenges with Aviva

Among the companies I examined, Aviva caught my attention. As one of the UK’s leading providers of insurance, wealth, and retirement products, it seemed promising at first glance. With a price-to-earnings (P/E) ratio of 9, it appeared undervalued compared to the lofty multiples common in tech.

But further analysis revealed a different story.

The Flaws of the P/E Ratio

The P/E ratio is often used to gauge whether a stock is undervalued, comparing its price to earnings per share (EPS). However, in sectors like insurance, where earnings can be volatile, this metric can be misleading.

In Aviva’s case, its current P/E of 9 isn’t historically low for the company. Over the past five years, its P/E ratio dipped below 8 in 2019 and 2020. This indicates that such valuations may reflect persistent challenges rather than hidden value.

More importantly, insurance companies’ earnings are influenced by factors like bond yields and claims cycles, making metrics like book value per share or the combined ratio more useful in evaluating their performance.

Revenue and Free Cash Flow Instability

One major concern with Aviva is its inconsistency in revenue and free cash flow over the past three years. Steady cash flow is critical in the insurance sector, as it supports dividends, debt reduction, and potential expansion. Unfortunately, Aviva’s free cash flow has been negative, signalling struggles in generating sufficient operational cash.

Earnings Per Share (EPS) Volatility

Unsurprisingly, this revenue and cash flow instability has led to volatile earnings per share (EPS). Over the last three years, Aviva’s EPS has fluctuated significantly, making it harder to assess its true profitability or determine whether the stock is undervalued.

Stock Price Variability

These financial challenges have also introduced considerable volatility in Aviva’s stock price. While the low P/E ratio might initially suggest undervaluation, it likely reflects broader uncertainties about the company’s future rather than a clear buying opportunity.

The Lessons from Aviva

As an investor, I prioritize companies with consistent revenue growth, a reliable profit track record, and strong free cash flow generation. Unfortunately, Aviva doesn’t meet these criteria.

However, this analysis of Aviva reinforced an important lesson: surface-level metrics like the P/E ratio often fail to capture the full picture, especially in sectors with unique dynamics like insurance. Investors must dig deeper, analysing cash flow trends, competitive positioning, and macroeconomic dependencies to identify true value.

Conclusion: The Search Continues

While Aviva’s challenges make it an unlikely candidate for my portfolio, the broader insurance sector remains a fertile ground for investment opportunities. The inefficiencies of legacy systems and the sector’s overdue need for disruption leave room for innovative companies to thrive.

For now, my search for a company poised to disrupt the insurance industry, and deliver consistent growth, continues.