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PGR Investment Analysis

PGR Investment Analysis

Progressive is an attractive opportunity, and I expect the company to generate 12-15% IRR's for investors over the next 5 years. Progressive is a leading property and casualty insurer who has generated industry leading ROE’s over the past two decades driven by its excellent underwriting performance. PGR’s superior underwriting is driven by both a lower loss ratio and a lower expense ratio. Specifically, PGR prices policies on a much more segmented and granular basis than its peers, by utilizing telematics such as Snapshot for personal auto and Smart Haul for commercial auto. Additionally, PGR’s direct to consumer (DTC) marketing strategy and lower commission rates paid to agents have led to lower customer acquisition costs.

Through differentiated pricing and substantial advertising investments, PGR has rapidly expanded its personal auto market share from 7.7% in 2010 to 12.2% in 2019, and its commercial auto market share from 6.6% to 12.2% over that same time frame. PGR is now the 3rd largest personal auto insurer and the largest commercial auto insurer in the U.S. Additionally, PGR has an opportunity to expand its market share in homeowner’s insurance, where PGR is a relatively small player, by bundling homeowner’s and personal auto insurance leading to higher customer retention. This strategy also has PGR focused on less price sensitive consumers and provides ample runway for future growth. While personal auto rates had been strong for a decade through 2018, personal auto rates were weak in 2019 and turned negative in 2020 due to impacts from COVID-19. However, I expect pricing will remain only a near term challenge, as PGR has successfully navigated prior soft insurance cycles over the past 20 years. The low interest rate environment has also hurt earnings over time, although less so for Progressive than its peers, given PGR’s strong underwriting performance and lower reliance on investment income. The largest risk facing PGR is the threat that autonomous vehicle (AV) adoption substantially reducing the need for auto insurance. However, I believe concerns are overblown as there are numerous technological and political roadblocks limiting widescale AV adoption through the next 10 years.

PGR Key stats

Description: Progressive was formed in 1937 and became an insurance holding company in 1965. PGR is the third largest P&C insurer in the U.S., generating annual revenue of roughly $40 billion and annual normalized net income of over $3 billion. Additionally, PGR generates 100% of its premiums domestically. Progressive is largely focused on auto insurance with 85% of its premiums from personal auto, 9% from commercial auto, 4% from homeowners, and 1% from specialty, which includes marine and motorcycle insurance. In its personal lines of business, roughly 50% of premiums are generated through the agency channel, and 50% through direct to consumer. In the commercial segment, roughly 85% of policies are sold through the agency channel, with the remaining 15% sold on a direct basis.

Industry leading returns on equity driven by excellent underwriting

PGR has generated ROE’s well above the industry average over the past 5, 10, and 20 years as shown below. Over the 20-year time frame, PGR’s average ROE of 18% is nearly twice the industry average of 10%! PGR’s excellent ROE’s are driven by the company’s superior underwriting described below.

PGR Roe

 

In personal auto, which makes up roughly 85% of PGR’s premiums, PGR averaged a 93.8% combined ratio from 2007-2019 compared to the industry average of 100.9%. PGR’s 714bps annual benefit was driven by a 350bps advantage in loss ratios, and a 364bps advantage in expense ratios.

Personal auto CR

 PGR’s underwriting advantage is even more pronounced in commercial auto (9% of premiums), where PGR averaged a 90.4% combined ratio from 2007-2019, compared to the industry average of 105.3%. PGR’s impressive 1490bps advantage was driven by a 590bps improvement in loss ratios and a 900bps improvement in expense ratio.

Commercial auto CR

So what accounts for PGR’s combined ratio advantage over its peers? For one, PGR’s use of telematics such as the Snapshot program for personal auto and Smart Haul for commercial auto customers. These usage-based programs incentivize better customer behavior by reducing customer premiums based on the customer’s driving record. Customers with riskier driving behavior typically see their premiums increase at renewal, allowing PGR to eliminate exposure to higher risk drivers or be compensated through higher premiums. Additionally, PGR has collected substantially more customer data than their peers using these programs, leading to greater pricing segmentation. As a result, PGR can offer discounts to safe drivers, helping PGR retain less risky drivers. By reducing exposure to riskier drivers and retaining safer drivers, PGR has reported lower loss ratios than its peers. 

PGR’s other key advantage is their lower customer acquisition costs. This is driven by PGR's direct to consumer (DTC) marketing strategy with 50% of PGR’s personal auto policies and 15% of commercial auto policies sold through the direct channel. Incredibly, PGR has a much lower expense ratio than peers despite its large advertising budget. PGR has ramped up its advertising spend recently as advertising costs increased $750mn in 2015 and 2016, to $1bn in 2017, $1.4bn in 2018 and $1.8bn in 2019. This has been an effective investment as shown by PGR’s substantial growth in policies and market share over the past few years. Additionally, PGR pays a lower commission rate to independent agents than its peers, further reducing PGR’s expense ratio. Finally, PGR has trimmed roughly 300bps off its non-acquisition expense ratio over time in Personal auto through a focus on running an efficiency claims organization.

Dominant market position in auto insurance with continued growth ahead

Over the past decade, PGR has successfully grown its market share of personal auto from 7.7% in 2010 to 12.2% in 2019, and is now the 3rd largest personal auto insurer in the U.S. Similarly, in commercial auto, PGR has expanded its market share from 6.6% in 2010 to 12.2% in 2019 and is now the largest commercial auto insurer in the U.S. PGR’s market share growth has been driven by more granular pricing as mentioned above in addition to the company’s focus on a direct to consumer (DTC) marketing strategy.

progressive flo

Specifically, direct channels now represent over 50% of PGR’s personal auto premiums. PGR has utilized its large advertising budget and built a recognizable consumer brand, which is a necessity given the highly commoditized nature of auto insurance. PGR’s increase in market share has driven impressive financial results over the past decade, and especially strong in the past few years when PGR ramped up its advertising budget. While personal auto remains somewhat concentrated as the top 10 insurers have a 72% market share, commercial auto is more fragmented as the top 10 insurers have a 47% market share. PGR continues to take market share, with policies in force up 11% y/y through 3Q20, and I expect PGR to continue driving market share given PGR’s enviable track record. Given how large the personal and commercial auto insurance business is ($287bn of premiums in 2019), small increases in market share can lead to meaningful earnings growth for PGR.

policy growth

Opportunities to expand homeowner’s insurance through bundling

PGR expanded into homeowner’s insurance by acquiring a 62% stake in ARX holdings in 2015 and spent $242mn to acquire the remaining shares of ARX in early 2020. PGR has expanded its homeowners’ line of business from FL and TX initially, to 29 states today but is still a relatively small player with only a 1.6% market share. PGR’s strategy to expand its penetration in homeowners involves bundling homeowners and auto insurance to increase retention and selling through the independent agency channel. PGR has recently expanded its Platinum program to incentivize independent agents to sell PGR policies. The program includes higher commissions for home/auto bundles and performance bonus opportunities. So far, this program has been successful, as management noted that $750mn of auto premiums generated from the agency channel would not have existed with the company’s bundling capabilities. This equates to $5bn of lifetime earned premiums.

PGR is focused on a customer segment it has named “The Robinsons” who represent customers who purchase both homeowners and auto insurance and are viewed as less price sensitive relative to the other customer segments. PGR only has 2% penetration in this $59 billion market compared to an average of 13% across all customer types.

personal line customer segments

While homeowners represent a growth opportunity for Progressive, it has also been a much less profitable line of business for PGR with a 101.7% combined ratio in 2019 and a 106.9% combined ratio for that business in 2018 driven primarily by natural disasters such as hurricanes, and wind and hail. Management is highly focused on turning around profitability in homeowners by raising premiums in states that have been impacted by natural catastrophes as well as utilizing new tools to better model natural catastrophes. PGR also utilizes reinsurance to reduce losses in its homeowner’s business. Management continues to focus on writing business with a target of a 96% combined ratio across all business segments. While PGR may be able to improve its underwriting results over time in homeowner’s, I expect auto will remain much more profitable over time, given PGR’s substantial experience in that line of business.

Risks

Low interest rate environment negatively impacting net investment income

The low interest rate environment remains a challenge for the Insurance industry. PGR’s pre-tax investment yield has declined by roughly 50% since 2007, from 4.9% in 2007 to an estimated 2.6% for 2020. And each 10bps change in PGR’s investment yield has a roughly 1% impact on its earnings. Like its P&C peers, PGR runs a conservative portfolio comprised of 84% fixed income, 8% equities (mostly invested in the Russell 1000 index), 5% cash and 3% preferred stock. The investment portfolio has an average AA credit rating and a 3-year average duration given the short-tailed nature of PGR’s liabilities. I don’t expect PGR to extend duration or take on additional credit risk to boost their investment yield. While it’s a fool’s errand to try and predict interest rates, the market currently expects interest rates to remain lower for longer. As a result, I don’t expect PGR’s pre-tax investment yield to increase from its current level. However, any sustained increase in rates would be a clear positive for earnings.

PGR investment yield

Pricing turns from a tailwind to a headwind

From 2008-2018, personal auto rates increased well above the rate of overall inflation in the U.S. This trend was driven by increased accident frequency, from more miles driven and distracted driving, and higher severity due to the increased level of technology that embedded in cars. This technology includes safety features related to advanced driver assistance systems (ADAS) including front crash warning, lane departure warning, blind spot warning, park assist, and automatic emergency braking. This higher level of losses prompted insurers to raise prices in the personal auto line of business. As a result, by 2019, rates had risen at a high level for many years causing consumers to become much more price conscious and shop around more aggressively. Additionally, loss ratios declined industry wide in 2018 and 2019, allowing insurers to reduce rates in 2019 without sacrificing margins.

auto insurance CPI

As shown above, auto insurers have cut rates in 2020 for the first time in well over a decade because of fewer accidents as miles driven declined substantially due to COVID-19. In April, PGR’s auto property and auto injury claims were down 40%! The National Highway Traffic Safety Administration (NHTSA) forecasts car crashes will drop 9% y/y in 2020 before increasing by 6% in 2021.

Auto claims frequency

PGR is not immune to these industry headwinds and the company lowered its rates by 3% in 37 states from April to September, and by December will have lowered rates in 42 states, representing 84% of total premiums. I expect rates to remain weak heading into 2021 as vehicle miles will stay low due as many workers continue working remotely. But ultimately, I expect claims frequency to rise and pricing increases to return to more normalized levels by 2022. As auto insurance reprices on an annual basis, insurers can quickly adjust to changes in accident frequency and severity.

Importantly, PGR has successfully navigated prior soft markets, and I expect this soft market to be no different. PGR has consistently grown market share over time while remaining disciplined on its underwriting, given management’s 96% combined ratio target. And in fact, this market environment should allow PGR to continue taking market share as evidenced by PGR’s 11% y/y growth in policies through 3Q20.

Long-term concerns related to AV’s

Over the very long-term auto insurance faces the existential risk that widespread adoption of autonomous vehicles (AV’s) dramatically reduces demand for auto insurance. AV’s have been a major topic in the industry for years, and there are numerous OEM’s investing heavily in the space. However, there are several reasons why I don’t expect demand for auto insurance demand to decline in the next 10-15 years. First, from a technological standpoint we are still at least a decade away from any significant AV penetration, as shown in the below chart. Additionally, the average car on the road is roughly 12 years old, implying it would take a long time to turn over the existing fleet of cars even if autonomous features were introduced sooner than expected. Furthermore, it has taken more than a decade for prior safety features such as front and side air bags, to be fully implemented in all new models. It’s also important to note that auto insurance is required by state laws, as a result, numerous state laws would need to be changed to substantially reduce demand for auto insurance. Finally, there will likely be a role for auto insurance in a world of AV’s, with insurance covering cyber-attacks, algorithm errors, and other liabilities.

McKinsey AV chart
Source: https://www.mckinsey.com/industries/financial-services/our-insights/state-of-property-and-casualty-insurance-2020

Financials:

PGR Financials

 

Valuation:

PGR currently trades at attractive valuations with a forward P/E of 15.9x and EV/EBITDA of 7.7x. I expect PGR to deliver 12-15% IRR's over time driven by a 3% dividend yield and 9-12% EPS growth over the next five years. I believe PGR has the opportunity to continue gaining market share across personal auto, commercial auto, and a substantial opportunity in homeowners’ given PGR’s current market share of 1.6%.

Disclaimer
This article is not to be taken as financial advice and is not recommending the purchase or sale of any particular securities. This information is meant merely for informational and discussion purposes only. Please do your own research or seek out a licensed financial professional for help with personal finance and investment decisions.

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