Progressive is a well-positioned and well-managed company that is a leader in the United States auto insurance industry with approximately 8% market share. The company’s stock has declined more than 25% over the past 15 months, primarily as a result of stalled growth, which will likely prove to be temporary. Progressive’s lack of growth, along with the widespread negative view on the current auto insurance environment with respect to declining rates and profitability erosion, have driven the company’s stock price to a level where an investment in Progressive represents a compelling long term risk/reward.         

 

Progressive is an excellent company with a number of attractive investment characteristics:

 

·     Progressive has long been a superior underwriter of auto insurance, exhibiting the ability to segment and price risk better than its competitors. The company has achieved this underwriting superiority through enhanced systems as well as superb business strategy and execution.

·     Progressive has historically enjoyed high returns on equity (20-25%+), highlighting the company’s top-tier franchise characteristics. This outstanding ROE is even more impressive when factoring in the relatively low risk nature of the business.  Auto insurance is low risk because the business has a short tail and is highly predictable through a cycle.

·     The company’s usage of the direct model is fundamentally superior to the industry standard agency model, whether the agent is captive or independent. Progressive’s direct model lowers costs and eliminates the need for an agent, which cuts into the insurance provider’s profit. Currently, the company’s direct business represents 31% of total premiums written with the remaining 69% coming from its agency channel. Note that approximately 13% of premiums written are generated from commercial lines (remainder from personal lines), and Progressive’s commercial business is executed entirely through its agency channel.

·     Progressive’s premier computer systems developed over years of IT enhancements, along with innovative cost saving service initiatives (such as concierge services and roaming on-call representatives), have allowed the company to achieve an industry low expense ratio. Combining the company’s superior underwriting, claims processing and overall cost management, Progressive has achieved a 10 year average combined ratio of approximately 900 basis points better than the industry average over the same time period. This advantaged cost structure allows the company to offer among the lowest rates in the industry.

·     The U.S. auto insurance industry is a fragmented, cyclical industry, providing the company with opportunities to take market share and excel, especially during times of market dislocation. Over time, Progressive will continue to take meaningful share given its advantaged business model.

·     Progressive has a smart, innovative and focused management team with respect to operations, strategy and capital allocation.  The quality of management, coupled with Progressive’s strong brand and top-tier customer service has driven prolific customer acquisition rates over time.

·     Progressive’s stock currently trades at a price significantly below its intrinsic value.

 

Progressive will likely increase premium growth in the current environment, aggressively increase growth if the market hardens, and continue to earn a return on equity in the high teens or low to mid-twenties. However, Progressive’s share price does not reflect such growth and ROE characteristics and does not account for the quality of the company’s competitive position or management. At 2.1X Price / 2007E Book Value, 12.3X 2007E P/E and an LTM ROE of 23%, an investment in Progressive’s stock at current prices represents a compelling risk/reward and is likely to generate attractive returns over a 5 year time period with minimal risk of capital loss.

 

 

Progressive is the third largest writer of private passenger auto insurance in the U.S. with approximately 8% market share, trailing only State Farm (18% share) and Allstate (11% share). GEICO is a close 4^th with 7% share. The company’s history dates back to March 1937, when Progressive Mutual Insurance Company was formed. In 1956, the company formed Progressive Casualty Company to write non-standard auto insurance, or insurance for high-risk drivers whose accounts were rejected or canceled by other companies. Nonstandard auto had historically represented the majority of Progressive’s business, but in the early 1990s, the size of the nonstandard market was shrinking, and the company saw the opportunity to use its strength in segmenting, underwriting and pricing risks to enter the standard and preferred market. Currently, Progressive writes auto insurance for all drivers and its business mix is much more balanced between standard or preferred and nonstandard business. (The company no longer provides a breakout between these segments.) The company is headquartered near Columbus, Ohio. Progressive went public in 1971 and is rated “A+” by A.M. Best, the worldwide insurance-rating agency.

 

Progressive’s main business is personal auto insurance, though it also has a leading commercial auto underwriting business. Progressive's personal lines segment represented 87% of total premium earned in 2006 and includes insurance for private passenger automobiles, motorcycles, recreational vehicles, mobile homes, watercraft and snowmobiles. Personal lines products are sold through Progressive's network of approximately 30,000 independent agencies, brokers and strategic business relationships (56% of total 2006 net premium written) or directly to consumers via the phone or Internet (31%). Progressive’s commercial auto segment represented 13% of total premium written in 2006 and writes primary liability and physical damage insurance for automobiles and trucks owned by small businesses. The company writes insurance in 49 states and the District of Columbia, avoiding the difficult state of Massachusetts, where most insurers have found it challenging to operate profitably. In 2005, Progressive entered New Jersey, where it previously had chosen not to operate because of a difficult regulatory environment.

 

It is important to note that unlike many of its competitors, Progressive does not underwrite homeowners insurance, finding it difficult to underwrite profitably. The company briefly experimented with homeowners insurance in the late 1990s but cancelled the effort after mixed results. However, Progressive is expected to begin offering stand-alone homeowners coverage as part of its agency program in Arizona, Minnesota, and Ohio through an agreement with Homesite Insurance Group. Homesite is a national provider of homeowners, rental and condo insurance which writes most of its $200 million in premiums in New Jersey, Michigan and California. Importantly, Progressive will not take any underwriting risk. The risk is retained by Homesite.

 

Progressive’s stalled growth over the past couple of years is largely attributable to two issues: i) the company has lost potential volume as a result of not lowering rates, and ii) the company has not increased its advertising spending as much as its competitors. Regarding rates, Progressive’s management team has held rates reasonably firm, despite decreasing loss cost trends. The decline in loss costs since 2000 is primarily attributable to a decrease in frequency, which the company believed was not entirely explainable and therefore should not be extrapolated into the future. However, management recently acknowledged that it believes the decline in frequency is indeed a structural shift in the auto industry, attributing the decline primarily to safer automobiles. In response, Progressive plans to cut rates more aggressively than it has over the past several years. While this will likely erode the company’s extremely high underwriting margins (combined ratios in the mid-to-high 80%s over the last few years), it will also likely reignite the company’s growth. Furthermore, if there is a spike in either frequency or severity, Progressive will be in a wonderful position to aggressively write high-return business in a hardening market. Such market dislocation allows the most skilled underwriters to take advantage of the uncertainty in the market, which would provide Progressive with excellent opportunities to grow profitably. With its premiums written-to-surplus ratio at 2.5X (below its target of 3.0X), Progressive is holding extra ready-to-deploy capital in the event of a dislocation.

 

With respect to advertising, Progressive has been hesitant to increase advertising during the current soft market. It is typical in soft markets, when insurers enjoy above average profitability but lack robust growth opportunities, for insurers to significantly increase advertisement spending in hopes of driving growth.  A quirk of the auto insurance industry is that since many state regulators make it hard to raise rates again after they are lowered, insurers are more likely to compete in an advertising arms race than lower prices. Progressive has largely remained on the sidelines while other auto insurers have taken part in this current advertising binge. Most significantly, GEICO has aggressively ramped up spending, which has been immensely successful (especially because of the iconic GEICO Gecko and Cavemen) in driving strong growth. GEICO has increased market share and captured over 100% of the industry’s growth in 2006. Progressive has acknowledged that it has thus far failed in competing well in advertising. The company embarked on a new advertising campaign in October 2006, exhibiting a new focus after its previous lackluster advertising efforts. Over time GEICO’s lead in advertising will likely diminish while Progressive will continue to improve, albeit perhaps over a several year period.

 

Progressive has several long-term opportunities to grow and gain market share. It is important to note that Progressive is currently only the largest auto insurer in three states: Maine, Rhode Island, and Vermont. Furthermore, it ranks fifth or higher in only 20 of the states in which it operates. Within these 20 states and, more significantly, in the remaining jurisdictions where the company underwrites business, Progressive has ample room to grow through market share gains. Along with lowering rates and increasing advertising, the company has additional initiatives that will drive growth. First, Progressive remains continually focused on improving segmentation and data gathering, including its pilot program TripSense, whereby Progressive installs a device into customers’ cars to record their driving habits. Progressive is then able to charge a more accurate, competitive rate based on the driver’s characteristics and insurance needs. Second, Progressive has successfully undertaken several customer service initiatives in order to differentiate Progressive’s brand, including its concierge program, enhancement of its roaming-service program and overall smoothing of the claims process for the customer. Progressive’s roaming-service program has claims adjusters driving around in a car prominently displaying Progressive as an advertisement. The insurance adjusters go to the crash site, home or office of the customer when they have been in an accident, analyze the damage, make recommendations for body shops and settle the claim. In a change of claims management strategy, Progressive has begun a concierge program. Instead of Progressive going to the driver, the driver drives to the claims center located approximately a half-hour outside a metropolitan area. There, the driver is interviewed by the staff and given a rental car. The staff of the service center assesses the damage and sends the job out to a body shop. The driver returns to pick up the car at a later date, and Progressive has handled the entirety of the service process.  The company has built 54 concierge-level claims centers and has plans to expand that to over 70 nationwide by 2008. Improving customer service drives growth from increased customer acquisitions as well as from increased retention of current policyholders. Third, in the past Progressive has not adequately focused on renewal business, which is a higher margin business due to the lower commissions required. Management has emphasized that they are now focused on improving renewal trends, which would improve profitability. And fourth, the continued shift in the buying patterns of consumers to purchase auto insurance online (particularly from younger generations that are more comfortable with the internet) will likely serve as a nice tailwind for Progressive’s direct business.

 

Progressive’s excellent competitive position and superior pricing and claims management systems have allowed it to enjoy a 20-25%+ return on equity over decades. During times when there is not ample room to underwrite good business, management has chosen to return cash to shareholders through dividends and share buybacks. Given the company’s superior underwriting and cost management, and excellent overall competitive position, Progressive is well-positioned to significantly increase value for shareholders over the next 5 years.

Management: 

Progressive’s management team is experienced, smart and focused. Peter Lewis, current Chairman of the Board, was the architect of Progressive’s success from 1965-2000. In 1965, Peter inherited his father's company, becoming CEO after joining as an underwriting trainee in 1955. At that time, Progressive had 100 employees and $6 million in revenues. From 1965 to the present, Progressive has grown to approximately 28,000 employees with revenues of over $14 billion and become the third largest auto insurance company in the U.S. The main reason for such growth is that Progressive hired the best and brightest and focused on rigorous segmentation of rates based on factor analysis that was much more complex than what other companies were using. In 2001, Peter retired as CEO of Progressive, although he continues to be non-executive Chairman of the Board. Peter currently owns approximately 6.6% of Progressive’s outstanding stock.

 

Peter's approach to business is unorthodox. For instance, Progressive's headquarters includes a health club and travel agency in addition to the ubiquitous contemporary art. Peter credits these and other unconventional factors for helping create an environment in which creative thinking thrives. This creative and innovative culture persists throughout the company, fostering Progressive’s innovation and successful track record of trying new ideas in order to drive profitable growth, such as its roaming on-call claims representatives, concierge service and gainshare programs. The company’s gainshare program aims to align incentives amongst employees, senior management and shareholders. The program consists of having an employee’s bonus portion of their total compensation multiplied by a “gainshare” factor, ranging from 0-2X. The gainshare factor is determined by growth and profitability objectives approved by the board.

 

Glenn Renwick is the current CEO and took over after Peter stepped down in January 2001. Glenn joined Progressive in 1986 as an auto product manager for Florida. Glenn learned early on in his career that the easier a company makes it to buy a policy, the more likely a customer is to purchase the insurance. Thus, Glenn helped develop a strategy to assist customers in shopping for insurance. His idea was to focus Progressive's marketing campaign on the specific services that helped customers in their search for the best insurance carrier. These services included competitively priced auto insurance rates, excellent customer service and a practice of giving customers quotes from other competitive insurance companies as well as their own. Glenn’s contributions to the company have no doubt aided in its substantial increase in market share over the last decade, from approximately 3% in 1995 to 8% in 2006.

 

Glenn was forced to make tough decisions as soon as he was named CEO of Insurance Operations in 2000, and they have proven to be the right decisions. With the spike in loss costs during 1999-2000 because of severity trends, Glenn decided to raise insurance rates because it was the only way that Progressive could keep rates accurately reflecting current costs. At the same time, Glenn changed the duration of the insurance policies from 12 months to 6 months. Although a survey of customers found that most people prefer a longer-duration policy, Glenn felt that a shorter policy would allow the company to enhance the accuracy of their insurance rates. Investors, analysts and other industry leaders immediately criticized Glenn for this rate hike, and in 2000 Progressive only grew net premiums by 1%. However, the company soon gained more new business when its major competitors, such as State Farm and Allstate, had to start aggressively raising their rates after their artificially low rates resulted in large financial losses. By 2002, Progressive's new net business was thriving, and the company had a 30% increase in new premiums written. From 2000-2004, Progressive grew net premiums written by a 21% CAGR.

 

Excluding Glenn, Progressive’s senior management has experienced a reasonable amount of turnover within the last 15 months. Note that all of the departing executives were replaced internally, in keeping with the company’s culture. The changes included a new CFO and new presidents of both the agency and direct personal insurance lines.  Glenn and current management have indicated that the recent changes provide renewed energy in the management team and demonstrate the company’s deep bench. From discussions with management, it is clear that the company indeed has a deep bench, and these changes were likely a response to Progressive’s poor recent performance, especially in comparison to GEICO.

 

By managing its business in a centralized fashion, Progressive’s executive management team sets policy and makes key strategic decisions. This centralization eliminates group managers from unilaterally taking on undesirable risks, and the underwriting process is centrally controlled through the company’s extensive computer systems. Nevertheless, the group presidents are challenged to develop and manage product offerings and customer service processes. This combination of centralization and division autonomy creates an efficient, controllable yet innovative managerial atmosphere, which has served Progressive extremely well over its history.

 

Progressive’s management team members are not only sound operators but also good capital allocators. Historically, the company has invested in the business when market conditions warrant while restricting premium growth and buying back stock at other, more opportune times.

 

Industry: 

The U.S. auto insurance industry is comprised of personal and commercial lines, with the majority of the industry comprised of personal lines. In 2006, the estimated industry net premiums written for personal auto insurance in the U.S. was $161.1 billion, with Progressive being the 3^rd largest insurer with 8% share. The personal auto insurance industry is a cyclical, steady long-term growth industry, exhibiting fluctuations in combined ratios and growth through soft and hard markets. Importantly, people have to buy auto insurance, so unit demand is about as predictable as it gets in insurance.

 

From 1980-2005, net premiums written grew at approximately a 6.5% CAGR. However, this growth rate fluctuates somewhat. For example, growth has slowed over the last several years. The 2004-06 CAGR is 1.2%, while the growth from 2000-04 was 7.1%. The growth in the number of policies remains relatively stable year-over-year so the fluctuation in premiums written is due to changes in pricing. The slow growth in premiums in the late 1990s came in a soft market when insurers were aggressively lowering rates, while the hard market in the early 2000s was driven by large price increases. In the most recent trough-to-peak cycle, combined ratios hit a trough in the mid-to-late 1990s and peaked in the early 2000s. Currently, with combined ratios near historic lows and premium growth stalled near 1%, the auto insurance market is experiencing a soft market with many providers cutting rates. Most industry professionals believe that combined ratios are not sustainable at current levels, and I tend to agree. Over the next several years, industry combined ratios will likely move closer to the historical average around 100 as opposed to staying in the mid 90s.

 

The personal auto insurance industry continues to be reasonably fragmented, with approximately 280 insurance companies/groups that each write over $5 million of private passenger auto insurance premiums annually in the U.S. The top 10 and top 15 private passenger auto insurers comprised approximately 65% and 75% of this market, respectively. A table showing the respective market shares of the leading U.S. personal auto underwriters is below:

 

 

 

While the top 15 providers garner 75% market share, the remaining 265 providers comprise the fragmented other 25% of the market, so there is a significant pool from which superior operators can take share. Moreover, the largest provider, State Farm, has proven to be a mediocre underwriter at best, run by a lethargic management team and not narrowly focused on auto insurance but instead having its balance sheet complicated with largely unprofitable homeowners insurance.

 

As compared to other property and casualty insurance industries, the auto insurance industry is relatively low risk due to its short tail and reasonable predictability of results. The tail on the claims reserve, or the average length of time until the claim is actually reported and then paid, depends on the line of insurance. In a short tail insurance business, such as auto, the amount of the claim can be determined and paid fairly quickly. In contrast, for longer tail lines of business in which a relatively low percentage of incurred losses are actually paid in the first year, the accident year incurred losses largely reflect loss reserves established to pay the claims in the future. Claims in long tail lines of business, such as general liability or medical malpractice, can take up to 10 years or more to actually pay off. Simply getting through the civil court system can add years to the claims process. In such lines, a company’s incurred losses in the year a policy is written are largely an estimate of future claims payments, so there is potential for them to be drastically incorrect. It is important to note that Progressive has historically had high quality reserves due to reasonable conservatism, and reserve quality is unlikely to diminish in the future.

 

In auto insurance, loss costs are driven by two factors: severity and frequency.  Severity, average costs per claim, has been rising over the past several years. This is primarily due to: i) health care costs that are rising at a pace above overall inflation; and ii) auto repair costs that have been rising as well. Although severity has been rising, frequency has been declining. While there has been a long-term trend of lower frequency, the drop has been most noticeable during the past several years. Insurers do not have a definitive explanation for the drop in frequency, but most have acknowledged a structural shift in frequency trends, and there is no prevailing theory that explains why frequency would increase materially in the future. Several potential drivers for the recent greater-than-expected decline in frequency are:

·     Vehicles are becoming safer, reducing the overall number of accidents.

·     The number of cars has grown faster than the number of drivers. The resulting higher cars/drivers ratio means that there are simply more cars sitting in driveways and garages at any given point in time.

·     Higher fuel prices have an impact on miles driven. Historically, there has not been a strong correlation between fuel costs and claims frequency, although given the significant increase in the price of gasoline, gas price inflation could be playing a role.

·     After seeing rate increases since 2000 until recently, insured drivers may be holding back on filing claims for fear of seeing their insurance rates moving even higher.

 

Lastly, auto insurance is reasonably, but not entirely, commoditized. Auto insurers generally compete on the basis of price, coverages offered, financial stability, consumer recognition, claims handling and customer service. The latter three are indeed differentiating factors amongst insurers, allowing for some competition outside of price and terms and conditions. However, price will continue to be an extremely competitive factor for insurers.  In an industry in which historical average combined ratios are approximately 100, the provider who can offer the lowest priced policies while remaining profitable will be best positioned to win. This reality is a somewhat unavoidable force that will likely drive growth for Progressive and GEICO given their low cost structures. Progressive’s average combined ratios over the last 5 and 10 years are 90 and 93, respectively, well below the industry average.

 

Progressive will not win this long run race alone given the strong success GEICO has had in the past. However, it is essentially a two horse race. Comparing the two, GEICO has lower costs to acquire new customers because its entire market share is in the direct-only model, while Progressive is better at handling claims (from a cost perspective and a customer service perspective). Thus, the two have a roughly equal cost structure (although full details are not available as GEICO is not a stand-alone public company and is fully owned by Berkshire Hathaway). Furthermore, GEICO remains less innovative and more dependent on the direct business model as compared to Progressive.

 

Given the capital requirements and complex segmentation and pricing systems involved in auto insurance, there are significant barriers to entry. Therefore, the emergence of a strong new competitor is very unlikely.

 

Competitive Position: 

Progressive’s competitive position is excellent. Progressive is the third largest underwriter of U.S. personal auto insurance, and over the past decade, Progressive has increased its market share by approximately 450 basis points through almost entirely organic growth. Progressive’s commercial auto business was also ranked third in market share on a national basis in 2005. Although the margin by which Progressive is superior to its competitors has diminished somewhat over time, the advantage remains significant and will likely remain so for the foreseeable future. Progressive’s segmentation systems are extremely sophisticated since they are based on decades of data and experience and not easily replicable. The company begins segmenting potential customers at the exact time they place their first call or login to Progressive’s website. Progressive continually looks to innovate and enhance ways to better price risk, notably with its pilot program TripSense. While many industry experts, investors and analysts have criticized Progressive for its recent hesitancy to adjust rates for lower frequency trends, this was the most prudent course of action given the situation and timeframe. Management has indicated that they are now pricing for the current environment while giving themselves flexibility to adapt to changing market conditions. Moreover, Progressive will likely thrive in a time of market dislocation.

 

Along with having the best segmentation and pricing systems, Progressive also has the industry’s lowest claims management costs. Progressive’s innovative cost saving service initiatives such as its concierge service and roaming on-call representatives, along with its complex and sophisticated computer systems, have allowed the company to achieve industry-low claims management costs. Combining the company’s superior underwriting, claims processing and overall cost management, Progressive has achieved a 10 year average combined ratio of approximately 900 basis points better than the industry average. This superior cost structure allows the company to be one of the lowest cost providers in the auto insurance industry, a significant competitive advantage. 

 

While claims management initiatives have served to lower overall claims costs, these initiatives have also improved customer service. Currently, Progressive is ranked amongst the highest in customer service surveys. Progressive is structured to minimize the hassle and stress for customers involved with an auto insurance claim. If a claim is not handled quickly and accurately, a customer is more likely to change carriers, which would lead to lost business and potentially brand erosion. Progressive’s claims operations focus on immediate response by having representatives available 24 hours per day, 7 days per week to report a claim. In addition, most claims are handled on a “face-to-face” basis with customers. Claims are handled internally by Progressive’s 13,000 employees (located in 450 offices throughout the country) and are not outsourced like most of its competitors. By doing so, Progressive’s adjusters are able to more accurately estimate the losses compared to independent repair shops that want to maximize their own revenue.

 

As previously discussed, Progressive also has a sustainable competitive advantage with its direct model, which is a lower cost model as compared to an agency model. Progressive’s direct model lowers costs partially by eliminating the need for an agent. Approximately 30% of Progressive’s net premiums written are generated from its direct business, and it has offered a direct option to customers since the early 1990s. Additionally, many customers prefer to buy auto insurance through the internet, without the hassles of an agent, driving high customer service ratings. Given the cost and customer service advantages of a direct model, Progressive and GEICO are best positioned to garner a significant portion of the industry’s growth going forward, as well as take share from competitors.  There was a major question when Progressive first started its direct business of whether its independent agents would revolt.  It turned out that the direct business was not harmful to its agency business and arguably even helped it by advancing the Progressive brand. 

 

While Progressive’s gem of a business is indeed its direct business, its agent business has performed very well over time and benefits from strong relationships with independent agents. Progressive often offers the best price with the least amount of work for the agent both in selling the policy and also in servicing claims. While Progressive pays among the lowest commissions in the industry (only 10%), these other features allow it to maintain very good relationships with its agents.  The ease of use and reliability of the systems is a testament to the value of the enormous amount of investment Progressive has made in technology over the years.

 

It is also important to note that among the top four auto insurance providers essentially only Progressive utilizes independent agents. GEICO uses a direct model, while State Farm and Allstate primarily use captive agents. Thus, Progressive is not usually competing against the other dominant industry players in the independent agent channel.

 

Through superior underwriting and cost management systems, Progressive has built a superb operating model with strong brand equity and high barriers to entry. It would take competitors many years and enormous amounts of capital to replicate Progressive’s complex and sophisticated systems. Given the company’s sustainable competitive advantages, it is very well positioned to continue to take market share, profitably, going forward.

 

Price: 

Progressive’s shares currently trade at 2.1X Price / 2007E Book Value and 12.3X 2007E P/E, reflecting concerns around future premium growth and profitability erosion. Profitability will likely decline as Progressive reduces rates and management aims to write business to a 96 combined ratio. While the current level of profitability will likely decrease going forward, Progressive should be able to maintain an attractive ROE in the high teens to twenties over the next several years.  To the extent management cannot put capital to use at such high rates, they will return the excess through dividends and share buybacks.

 

In sum, although Progressive will likely increase premium growth in the current environment and continue to earn a return on equity in the high teens to twenties, its share price does not reflect such growth and ROE characteristics and does not account for the quality of the company’s competitive position or management team.  The market is pricing Progressive as if it has lost its edge, despite Progressive still very much maintaining, if not expanding, its advantaged position.  It is more the case that the advantages have been masked by its decision not to reduce rates as soon as others and its decision not to participate in advertising escalation.

 

An investment in Progressive’s stock at current prices is a compelling risk/reward and is likely to generate annual returns in the high teens to low twenties over a 5 year time period with minimal risk of capital loss. It is important to note that in a downside scenario (assuming low premium growth and rapid margin erosion), compounded annual returns over a 5 year holding period remain at 5-8%. This is an investment where risk/reward is excellent because of both the high likely return and also the low risk.

 

Growth Continues to Stall: 

During 2006, net premiums written grew only 1%, exemplifying Progressive’s current difficulty in growing its business. As discussed in detail above, this lack of growth is largely due to other competitors dropping rates faster than Progressive and spending more dollars on advertising in a soft market. Given Progressive’s strategy to further lower rates, improve marketing and enhance customer service through initiatives such as its concierge program, Progressive will likely reignite growth in the future. Moreover, if the market hardens, Progressive will be in an excellent position to underwrite very good business.

 

GEICO: 

GEICO is a well-positioned and very well-managed company that has been a solid grower over the last several years. There is a risk that GEICO continues to take all of the market growth, as well as taking the lion’s share of market share gains from competitors, and significantly outperforms Progressive. For reasons explained in detail above, including top-tier underwriting systems, efficient cost management and a talented management team, this outcome is unlikely. That said, GEICO’s business model is terrific and GEICO will continue to be a fierce competitor going forward.  Also, Buffett seems inclined to spend enormous amounts on advertising if it continues to reap the same reward he has achieved over the past few years.  There is some concern that Progressive is disadvantaged because Buffett can underwrite to a higher combined ratio than Progressive and still make a high return on equity because Lou Simpson is investing the float. However, this should not be a major risk because it is not the way Buffett has ever run his insurance companies; rather, he has wanted to make excess returns on both the insurance side and the investment side.

 

Loss Costs Increase:

Largely due to a greater-than-anticipated decline in frequency since 2000, loss costs for Progressive and other auto insurers have remained lower than expected. If frequency or severity spikes, Progressive’s financial results will be adversely impacted. That said, Progressive will likely thrive in a time of market dislocation, as it has in the past (most recently in the early 2000s), due to its superior underwriting ability and will likely grow profitably in the years that follow such a dislocation. 

 

Leverage:

While Progressive does not take on much financial leverage, the company does take on operating leverage. Management maintains that it aims to write to a net premiums written to surplus ratio of 3.0X, and the ratio stood at 2.5X at April 30, 2007. While the current level of premiums to surplus is somewhat conservative from a business optimization perspective, it remains higher than the industry average of approximately 1.5-2.0X. Management intends to increase operating leverage slowly through a higher rate of net premiums to surplus where permitted by law. It is important to note that substituting operating leverage for financial leverage reduces the company’s risk profile. In the event of profitability problems, Progressive could raise rates to slow growth, which would reduce the operating leverage, but would have little or no effect on the company’s debt service obligations.

 

Another important point is that auto insurance is more processing than true insurance.  Unlike traditional property and casualty insurance in which losses are unknown and may fall within a very wide band, the variance on auto insurance is small.  Therefore, it is arguable that very little capital needs to be held for economic (as opposed to regulatory) reasons.

 

 

An investment in Progressive is a very compelling risk/reward. Progressive has an excellent competitive position in a stable, albeit cyclical, low risk industry; is run by a focused and smart management team; and is currently trading at a price that represents a significant discount to intrinsic value.