By Drew Woodbury
Progressive (PGR) is among the highest-quality property-casualty insurers, in our view, and consistently generates some of the best returns of the insurance companies we cover. The company's culture of forward thinking and looking for innovative ways to segment risks, combined with its scale advantages, has allowed it to increase profitability for a number of years. We expect these competitive advantages will be durable and allow the company to post strong underwriting margins and high returns for many years to come. That said, we think growth will continue to be slower than it was during the past decade as the company's share of the direct market normalizes as the channel matures. After accounting for the company's strong competitive position and more muted growth prospects, we believe the shares are fairly valued.
In general, property-casualty insurers do not benefit from favorable competitive positions. Industry competition is fierce, and the products are essentially commodities. Furthermore, participants do not know their cost of goods sold for a number of years, allowing them to underprice policies without knowing it. Companies have an incentive to chase growth without regard for profitability, a cycle that repeats itself as competitors are forced to match artificially low prices or risk losing business. We focus on insurance profitability in determining P&C insurers' economic moats.
Insurance is unique in that customers pay premiums up front to cover losses that may or may not occur in the future. Insurers get to hold the premium money, which is commonly referred to as float, and benefit from the investment income. Therefore, insurers have two potential sources of income: float and insurance profitability. This might seem like a recipe for high profitability, but competitive dynamics typically drive insurance profitability to zero or into the red.
The level of investment income for insurers depends on hard-to-predict capital market movements and is largely out of the company's control, and higher investment returns typically reflect higher risk-taking as opposed to investing acumen. We think insurance companies that can consistently achieve positive insurance profitability are investors' best bets because strong insurance profitability, in most cases, is more sustainable than relatively strong investment income.
Scale and Underwriting Prowess Set Progressive Apart
Progressive has set itself apart from the industry primarily by its scale in the direct market, in our opinion, but also through its underwriting prowess. Given a high level of variable costs, achieving scale is more difficult for insurance companies. Personal line insurers like Progressive are better able to spread fixed costs over a wider base, as their business model does not require as many specialized underwriters and human capital. Therefore, some back-office processes and company administration can be scaled.
Through its scale advantages, Progressive is able to offer policies for similar costs as competitors but earn a higher profit margin. Also, Progressive historically has had an edge on competitors in its underwriting expertise. The company is constantly creating new ways to more precisely assess the risk of each individual customer. For example, it was the first to offer online policy quotes and comparisons and 24-hour claims service, and it was the first to use advanced factors in premium pricing such as consumer credit scores.
If the company is able to more appropriately price policies, it can retain low-risk drivers through discounted pricing while charging more or declining the highest-risk policies. Through continuous innovations - first using credit scoring and other advanced metrics as an indication of driver behavior, and more recently through Snapshot Discount, the company's pay-as-you-drive program - the company has built a data edge over competitors, although some firms are closing the gap as they develop similar capabilities. The scale Progressive has built in the direct channel, along with these core values and the execution of them, has allowed the company to grow profitably and gives it a narrow moat, in our opinion. These advantages manifest themselves in the company's consistently superb combined ratio.
Growth Has Been Increasingly Difficult to Come By
Progressive, which was known for much of the late 1990s and early 2000s as a growth company because of its prominence in the direct-sold auto insurance market, has seen its premium growth slow dramatically in recent years. In fact, premiums had shrunk for a few years around the time of the recession. To counteract these challenges, the firm shifted from an explicit profitability target to a growth target in 2007, when management announced that it would look to grow as much as possible while maintaining a 4% underwriting margin. While premium growth has resumed, we do not expect that it will achieve rates anywhere near previous levels.
In our opinion, the growth of the direct channel was due to a bifurcation in the auto insurance market rather than indicative of the new way in which all insurance would be purchased. Younger drivers who often only require monoline auto insurance policies and nonstandard insureds are more likely to shop for the lowest price at each renewal, a group to which online sales cater. This demographic has always existed and was previously served through select independent agents. With the advent of the Internet and direct-sold policies, these customers are finding this is the most convenient way to buy their policies and compare prices.
On the other hand, people with multiple policy needs and complex insurance demands will continue to value the service an agent can provide, in our opinion. Furthermore, by bundling policies with the same company, policyholders can pay less for their insurance. What's more, these multiline insurers do not need to sacrifice underwriting margins in order to offer lower prices, as the multipolicy customers have been actuarially proven to carry lower risks. We still expect direct-channel sales to continue to take share from the agency channel in the near term as the market evolves. However, we believe that eventually the relative shares will reach an equilibrium, as we do not think the agency channel is going away, given the value it provides for certain customers.
Management is increasingly trying to attack the agency channels head on by turning its focus toward the customers the agency channel has historically served the best: preferred customers and bundlers. Progressive believes these policyholders are more sticky to the company they choose to insure with and therefore have "higher lifetime value." To try and secure these customers, Progressive announced a couple of years ago that it would bend on its 4% underwriting margin requirement slightly and tolerate near-term combined ratios above 96% for certain types of insureds so long as the lifetime profitability of these policyholders met the company's threshold. In theory, this strategy makes sense if Progressive is able to, in fact, acquire these sticky customers.
It is still early in the process and the data and results so far are insufficient to measure the success of this initiative, but agents (both captive and independent) have a strong hold on this type of customer. Giving preferred policyholders the opportunity to bundle their auto policies with a third party that provides umbrella and homeowners insurance is a good strategy to try to match the savings and offerings of agents, but this strategy relies on Progressive finding partners willing to write monoline homeowners polices, which has been an unprofitable product type. Ultimately, we think it will be a challenge for the company to succeed in this initiative, but we also believe Progressive is forward-looking enough that it is likely to retreat from its plans before sacrificing too much in terms of underwriting profitability.
Snapshot Could Provide Growth Opportunities, but Ultimate Impact Remains to Be Seen
Progressive has long been a pioneer in the segmenting and accurate pricing of risks, a key attribute underlying its long-term competitive advantages. Its newest imitative is Snapshot, which measures driving behavior for more accurate pricing of policy risks. Usage-based insurance has the potential to be a game changer in the industry as it is the first product that allows a company to observe drivers' behavior directly. Until now, insurance companies measured tangential variables that helped predict the risk profile of policyholders, such as their age, sex, or credit score. However, none of these existing variables predict eventual losses as well as a direct measurement of driving behavior, which is what Snapshot achieves. Despite these theoretical advantages, hurdles remain that could block this measurement style from becoming widely used.
First, consumer acceptance is still a challenge. While there are some drivers who would volunteer to place a monitoring device in their cars in order to reduce their premiums, there are others who fear that the company will use the information to increase their rate (even though Progressive has explicitly promised not to do this) or are generally against the idea of their insurance company knowing their driving behaviors. To different extents, regulators have similar fears and could prevent implementation. While Snapshot is approved in most states, a number of larger states, including California and Illinois, have not yet approved the device. Both of these states have historically had regulators that have prioritized consumer protection (for example, California does not allow insurers to use credit scores in their pricing algorithms) and may deem Snapshot to be too invasive. Furthermore, even though it is allowed in most states, that does not prevent consumer opposition or special interest groups from pressuring regulators to disallow the device in the future (as happened in California for credit scoring).
Even if pay-as-you-go or usage-based insurance never becomes widely adopted, it could serve as an incremental positive in that it allows the company to lower prices and effectively generate higher retention rates for select lower-risk drivers. On the other hand, if it becomes broadly accepted, Progressive's first-mover advantage should give it a leg up on the competition.
The company has been the first to collect data on driving behavior, which it can use in its pricing algorithms, and if competitors implement similar products they will be at a significant handicap to Progressive's more robust data. This will allow the company to interpret the patterns and risks better, giving it a short-term pricing advantage for low-risk policyholders while adequately pricing, or--more likely, given its advantages--avoiding higher-risk drivers. In this case, when usage-based insurance builds a critical mass, even if the device is not used by everyone, the drivers who do not opt into the program will have essentially self-selected themselves as higher-risk drivers, which will allow insurers to avoid them or price their risks accordingly.
Despite what's possible in a best-case scenario for Snapshot, we do not believe that underwriting innovations like this can provide the company with a sustainable competitive advantage or an economic moat by themselves since competitors can quickly replicate the products. Even if usage-based insurance becomes more mainstream, we do not necessarily think the first-mover advantage that Progressive will initially enjoy will prove to be insurmountable. We agree that it would give the company a near-term pricing advantage, allowing it to segment and more effectively acquire lower-risk drivers, but competitors would soon be able to match with similar datasets and rating algorithms. As it stands now, Snapshot is somewhat of a call option for the company. If usage-based insurance becomes the trend of the future or Progressive's first-mover advantage is more significant than we anticipate, there would be upside to our fair value estimate.
Shares Look About Fairly Valued
Our fair value estimate of $22 per share is equivalent to approximately 2.3 times book value. After strong growth for many years, Progressive is finding it increasingly difficult to increase earned premiums. The recession compounded this problem as consumers cut back on coverage and new-car sales declined. Since then, growth has resumed in both agency and direct-sold business, but at a slower pace. We expect premium growth will accelerate as conditions improve, but growth will not return to historical levels. During our five-year forecast horizon, we assume earned premiums will grow at a 6% compound annual rate.
Despite growth difficulties, Progressive's impressive profitability has continued. We believe the company will maintain its industry-leading profitability, although we also expect increased competition to act as a slight headwind. During the next five years, we forecast the combined ratio will average 93%, which is equal to the average combined ratio the company has generated over the most recent five years. While Progressive has stated that it will write policies up to a 96% combined ratio, this is the upper limit, and more profitable policies should push the overall combined ratio below the 96% threshold.
Progressive is among the highest-quality insurers we cover, and over the past 10 years, it has often generated returns on equity that exceeded 20%. As a consequence, the stock often trades at a premium multiple relative to book. Our valuation is more in line with recent multiples than where the stock traded in the past, during its highest-growth years. This is largely due to our projections for lower growth compared with what the company had experienced in the past. As the direct market has matured, Progressive's growth has subdued and is now closer to industry averages, though it still outpaces them slightly. The multiple relative to book value implied in our valuation is still high for an insurance company, given the negative dynamics of the industry as a whole. We think this premium is justified for Progressive, however, as we expect the firm to generate high returns for the foreseeable future.
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