Travelers (NYSE:TRV) had a stellar first quarter, beating on both lines and raising the dividend by 12%. Shares rallied 3.75% on the announcement and closed at $61.70. Pricing has been an important issue for the industry, which is arguably in the process of exiting a year-long soft market in commercial lines. The conference call featured an in depth discussion of retention, a key issue when assessing the effectiveness of price increases.
Insurance is a competitive business. Companies frequently underprice in order to win new accounts and regularly jack up prices on renewal. Retention, the percentage of accounts that accept renewal, is an important metric in this environment.
Word counts can be informative. Checking the transcript of the Q1 2012 earnings conference call, the word "retention" is used 15 times in the presentation, and 33 times in the Q&A.
Travelers' Approach to Pricing
It's easy to say, but hard to implement: Premiums should be commensurate with risk. Access to information can provide a critical advantage. Travelers has paid a great deal of attention to this area, a factor that management believes can improve profitability long-term.
CEO Jay Fishman, from the conference call:
In Business Insurance, we continued to achieve improved pricing. Renewal rate change in the quarter was a positive 8%, up from 6% in the fourth quarter of 2012, while retention remains stable. Importantly we believe that we differentiate ourselves from many in the marketplace by not taking a one-size fits all approach to pricing in our individual underwriting businesses. Each customer's needs, characteristics, geographies, and risk and loss profile is different, and as such each transaction is analyzed and priced separately. In select accounts, analyzing the returns we earn from our insurance industry segment in conjunction with the individual insured characteristics is critical to success.
We continue to leverage what we believe is industry leading data and analytics to help us optimize rate and retention, that is achieving higher retentions on our best customer relationships, while simultaneously identifying the walk-away point for our least profitable relationships. This differentiation is best evidenced by an analysis of rate and retention by historical loss ratio performance that Brian will share with you later. We are very pleased how we're executing in the field, and this analysis summarize and demonstrates the effectiveness of our analytics, and the thoughtful way we're approaching business pricing.
Obviously the company has committed substantial thought and resources to handling these issues in a systematic and quantifiable way.
During the Q&A, Fishman gets down to the real nitty-gritty of the balance between rate and retention:
Yeah, actually it's a very good question, and it really gets to the core of how we execute in the marketplace. First, in its most simplistic form, and you all are knowledgeable enough about our industry to understand it, if you get a point of rate, 85% of that, I'm taking 15 points of commissions and taxes, the direct cost, if you will, fall right to the pre-tax line. So a point of rate is really quite powerful from a profitability standpoint. Now a point of retention has dramatically lower impact on profitability because you have all the loss costs associated with it. So you have the variable costs that goes out, but you also have the direct loss costs that goes with it. So it's quite easy to say that a point of rate is worth a multiple (emphasis mine), five times, and I'm guessing at that number sitting here this morning but five times a point of retention (emphasis mine). Now that theory is good until your last account (emphasis mine). At some point it breaks down, but as we sit here looking at it, a point of rate on the margin versus a point of retention, that's a really easy call, as long as we're being thoughtful about how it's executed.
The point is, Travelers is doing a good job managing the issue, communicating it to agents and employees, and bringing resources in the form of accurate information to the table.
Insurance is a cyclical business. Travelers has done a lot of buybacks, reducing share counts 9.9% per year for the past five years. As a way of getting at normalized earnings, five-year average EPS, adjusted for buybacks, may provide some insight. Here's a snippet from my spreadsheet:
Based on this analysis, normalized earnings are about $8 per share. Applying a multiple of 9, a fair value and target price of $72 emerges. The low multiple is justified by the fact that much of the value creation process has relied on buying back shares at a discount, an opportunity that is unlikely to continue indefinitely.
Strategy and Tactics
At today's prices, an investor has a realistic expectation of receiving the dividend, currently yielding 2.98%, and eventual share price appreciation. Investors who have opinions on the short-term direction of either the market or this individual stock will want to gauge their entry points accordingly.
The stock is optionable, to include LEAPS, and I've had good results with a diagonal call spread strategy, long distant expiration deep in the money calls, and short out of the money calls with shorter durations. My current position is long vertical call spreads: April 45/55, July 50/60, October 60/65, and January 2013 45/60.