Insurance Australia Group Ltd (ASX: IAG) yields 4.7%. That’s 50 basis points higher than the ASX’s yield, although it is behind popular dividend stocks such as Westpac Banking Corp (ASX: WBC) and Suncorp Group Ltd (ASX: SUN). They have yields of 6.3% and 5.4% respectively. However, it is IAG’s dividend growth prospects which make me optimistic about its long-term income return.

Payout ratio

IAG increased its payout ratio to 60%-80% of cash earnings in financial year 2016. This was up from a previous range of 50%-70%. The payout ratio in financial year 2016 was 72.9% and this indicates that there is scope for a higher dividend as a proportion of earnings over the medium term. In fact, in financial year 2017 IAG’s dividend payout ratio is forecast to rise to 75.6%.

Beyond that, I believe there is potential for a further increase in the payout ratio owing to IAG’s financial position. As at the end of June 2016 IAG’s capital position was 1.72 times the Prescribed Capital Amount. This is also above its target range of 1.4-1.6. Its Common Equity Tier 1 (CET1) ratio of 1.06 times was at the upper end of its target range of 0.9-1.1. This means that IAG may not need to retain the vast majority of profit each year in order to stay within its targeted capital ratios.

Further, the 20% whole-of-account quota share arrangement with Berkshire Hathaway has reduced IAG’s earnings volatility. It has also lowered IAG’s regulatory capital requirement by $400 million. This could lead to increased dividends and additional share buybacks above and beyond the $300 million which will be completed by mid-October 2016.

Profit growth

I believe that IAG’s dividend will increase over the long run due to the strategy it has adopted to boost earnings. IAG will become more streamlined and efficient through a technology simplification programme. This will reduce 32 policy and claims platforms down to two and consolidate IAG’s insurance licenses from nine to two. In my view, IAG’s partnering with offshore-based global service suppliers provides scope for further margin enhancement. It has already made improvements in this area, since underlying margins increased by 90 basis points in financial year 2016.

IAG has also invested in new technology through its IAG Labs and IAG Garage divisions. They will experiment with new technologies such as the connected home, drones and the latest collision avoidance technology. This could lead to greater product differentiation versus peers. I believe this could result in a competitive advantage for IAG and the potential for higher margins.

Outlook

IAG has growth potential outside of Australia. Its operations in Malaysia and Thailand delivered proportional gross written premium growth of 7% in financial year 2016. Their combined profitability increased by 16% versus the prior year. Further growth in India, Vietnam and Indonesia could boost profitability and dividends over the long term in my view. For this reason as well as IAG’s scope to increase its payout ratio and its current strategy, I’m bullish on its income potential.

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Motley Fool contributor Robert Stephens has no position in any stocks mentioned. The Motley Fool Australia has no position in any of the stocks mentioned. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. This article contains general investment advice only (under AFSL 400691). Authorised by Bruce Jackson.