Admiral is renowned for paying modestly. Both senior executives were paid less than £400,000 last year – low for a FTSE 100 company worth £4bn. And that was almost all salary, for each declined to be paid a bonus and neither take part in any share plan. For its other executives, Admiral has recently introduced two new performance conditions, based on total shareholder return (TSR) and return on equity, in addition to the existing one based on earnings per share. A third of their long-term performance-based-pay is now linked to each.
The investors performance condition
TSR is the investor’s performance condition because it mimics what shareholders do. It seems simple because everyone can understand it. TSR assumes you buy a company’s shares and reinvest the dividends until you sell the lot in, say, three years time. Your total shareholder return is calculated by dividing what you get for the shares by what you initially paid for them (ignoring any extra costs like broker fees).
TSR becomes a performance condition when a share award is attached to it; the proportion that participants receive depends on how the TSR fares. And it’s at this point that life gets a bit more involved. Since share prices tend to fluctuate with the whole market, TSR is normally made relative to others. Assuming that you want to invest in the best performing insurance company, you could buy shares in Admiral and nine competitors all on the same day. Three years later, you can see who’s made the highest return. One way of linking pay to this would be to pay out 100 per cent of the award if Admiral is in top place, 80 per cent if it’s second, 60 per cent if third and so on. If it’s in the bottom half (below median), participants receive nothing. This sort of TSR is simple and transparent but there are good reasons why Admiral is not ranking its TSR like this.
Ranking is volatile - a few pence on or off a share price could push the company up or down the league table and so cut or boost the share award undeservedly, turning the whole thing into a bit of a lottery. Rather than having 20 per cent chunks, some companies have tried smoothing them by using formulae to take into account near misses. Others have abandoned ranking and adopted indexation. The payout is now determined by how much the company’s TSR outperforms that of an index. It’s feasible to tailor an index from selected competitors by using Exchange Traded Funds. But that’s at the cost of transparency – the index TSR would have to be taken on trust since it couldn’t be readily be checked by outsiders.
It’s not difficult to find Admiral’s motor insurance competitors. Its website, confused.com, lists 132 brands, such as Churchill (Direct Line); More Than (RSA); Aviva, AXA and a host of others. But as investments, they’re only part of the picture. Some rival companies have a wider range of general insurance products; some cover life assurance and investments; some are multinational, others more domestic. In fact, choosing peer companies that closely resemble Admiral is a challenge in itself. Throw in risk and life gets even harder: after all, Admiral started off insuring the riskier drivers that others hesitated to cover. Unless you weight companies according to risk (and how do you do that?), there will be cyclical distortions – companies with riskier business models might be more likely to outperform but will also have bouts of underperformance.
Admiral, though, would claim that it’s less risky than others. That’s because unlike them, it reinsures most of its risk. As a result, Admiral doesn’t need the capital that others do. Its rivals’ return on equity is typically less than 15 per cent; Admiral’s is over 50 per cent. (And hence its third performance condition, though some might quibble why return on capital employed wasn’t chosen.)
Some consider this disruptive business model as a sort of moat because it’s counter-intuitive for most insurance executives: reinsuring would give away most of their profits. (Admiral makes its money from add-ons, such as breakdown cover or car hire and by charging people more if they pay monthly rather than annually.) It operates somewhere between an insurance company and a Lloyd’s syndicate and as such it’s unique. For its performance condition, it sidesteps the need to identify its closest rivals by comparing its TSR not with named competitors but with the broader FTSE350 after stripping out investment companies. (Frustratingly, it won’t say what its targets are in advance, but presumably dividends paid by the FTSE350 constituents will be factored in.)
In general, there are other details of TSR that need to be agreed in advance: since stock markets can blip, should the start price and/or end price be based on a single day or averaged over several days? Since the UK taxes dividends in a different way to other countries, how are foreign dividends to be treated? What if there’s a corporate action among the peer group, like a takeover or rights issue? What about foreign exchange distortions?
As with so much with pay, simplicity breeds complexity.
Not so plain sailing
Admiral too is going through changes. Competition is fierce, it’s bedding down a new IT system and its international operations are still in their infancy. The highly-regarded Mr Engelhardt will be standing down next year, and Mr Stevens will replace him, so they’ll need a new chief operating officer. Pay is still likely to be modest – it helps being based in Cardiff.
But it also helps being paid in shares. Geraint Jones, who took over as chief financial officer a year ago, will earn £0.5m this year for an on-target performance. His maximum could be £1.5m, on the low side for a FTSE 100 company. But in addition, he owns about £1m of Admiral shares, built up over years working for the company, and he has more that are subject to performance conditions. All these receive dividends or their equivalent, which paid Mr Jones a further £125,000 last year.
Admiral’s policy of paying out its surplus capital as dividends would also have produced incomes for Mr Engelhardt and Mr Stevens that more than dwarfed their conventional pay. (This assumes that they did not sacrifice their dividends. The 2014 total dividend was 98p a share.)
But at some point, skin in the game has to be shed. No doubt, Mr Engelhardt will say at some point whether or not he’ll be selling down his 34m shares (which is 12 per cent of the company) and if so, how many and when. Shareholders and employees might want to know. Uncertainty over a stake this large could overhang the share price – and dampen Admiral’s TSR performance.
