Warren Buffett is famous for using the earnings from his insurance businesses to fund his investments in other companies. This strategy is also commonly used by ASX investors, who use dividends to contribute to their savings or pay down debt.
However, such a strategy depends on the ability of your chosen company to fund its obligations to shareholders. With Insurance Australia Group Ltd (ASX: IAG) offering a 5.2%, fully franked dividend (7.5% when grossed-up to include the effect of franking credits), investors must surely wonder if the company can continue making such a high payment for the long term:
| Cash flows | 2015 ($m) | 2014 ($m) |
| Premiums, interest, + reinsurance received | 14919 | 12746 |
| Claim + finance costs, reinsurance expense | (14221) | (11669) |
| Net cash flows from operating activities | 698 | 1077 |
| Proceeds from disposal of investments | 11315 | 14543 |
| Outlays for investments | (13007) | (14838) |
| Net cash flows from investing activities | (1692) | (295) |
| Proceeds from issue + redemption of shares, trust units | 630 | 1935 |
| Dividends paid + borrowings repaid | (1202) | (1462) |
| Net cash flows from financing activities | (572) | 473 |
| Total net movement in cash held | (1566) | 1255 |
| Cash held at end of the financial year | 1433 | 3010 |
The above figures are all taken from IAG's 2015 annual report. I have condensed all the cash inflows into one item and all the cash outflows into another item for simplicity.
As readers can see from the condensed statement, IAG can't afford another year like 2015, which admittedly featured an unusually high number of claims.
While the cash flow statement does look rough, it's not the full story. IAG has a sound balance sheet, with $7 billion in net assets (assets minus liabilities) and just $1.7 billion in 'interest bearing liabilities' (i.e., debts).
This means the company has plenty of cushioning to absorb further shocks, and I consider it highly likely IAG will pay a similar dividend again this year, especially if trading conditions normalise.
However, I find it difficult to characterise IAG's $900m annual dividend as 'sustainable' since the business and many other insurers are forced to adjust their dividend up and down in accordance with the number of claims they receive. Readers can see a 10-year history of IAG's dividends per share in this article.
Instead, I would say that IAG is extremely likely to continue paying a dividend, although that dividend will fluctuate in line with business performance and the number of claims. This unfortunately also means that investors can expect a sell-down every time we have a cyclone.
