Driverless Cars and Progressive’s Durability
Value and Opportunity linked to a Bank of England blog I never would have found on my own. The Bank of England blog did a post on how driverless cars could hurt the future of auto insurers. Last year, we did a Singular Diligence issue on U.S. car insurer Progressive (PGR). A big part of the durability section of that issue was about driverless cars.
So, here is the Bank of England blog post on driverless cars.
And here is Singular Diligence’s discussion of Progressive’s durability…
Originally Published: December 2014
DURABILITY: Progressive’s Focus on a Combined Ratio of 96 or Lower Makes it Durable
Auto insurance is a durable industry. The only risk of obsolescence is driverless cars. Car accidents are caused by human error. If all cars on the road were driven by computers – there would be virtually no car accidents. This would eliminate the need for auto insurance. The technical difficulties of developing driverless cars are not the biggest obstacle to their adoption. Even much simpler safety technologies like front air bags, side air bags, electronic stability control, and forward collision avoidance generally took 10 years from the time they were ﬁrst introduced on a car sold to the public till the majority of new models sold in a given year included these features. So, the “tipping point” of safety feature adoption by manufacturers is usually around a decade. Complete adoption takes about 15 years. The average car in the U.S. is about 11 years old. This number has increased over time. Cars are more durable now than they were in the past. Based on these ﬁgures, it is likely that once the ﬁrst driverless car is introduced by a major auto maker on a popular model it will take another 15 to 20 years before half of all cars are driverless.
Auto insurance is required by state law. States will certainly not eliminate this requirement while the majority of cars are still driven by humans. Total adoption of the technology could take up to 30 years. If enough car owners prefer to drive themselves instead of letting a computer drive their car for them, there could be resistance to any laws limiting human drivers. Without such laws, highways would include a mix of human and computer driven cars. Under such conditions, laws might still equally “fault” driverless cars for accidents involving human drivers. These legal complications mean that auto insurance would probably persist into the early stages of a mostly driverless car society.
Today, there are no commercially available driverless cars. So, the end of car insurance would likely be some point 15 to 30 years after the successful introduction of driverless cars. The vast majority of net present value in a stock comes from returns generated within the ﬁrst 30 years. Even if driverless cars are successfully introduced in the U.S. soon – and that is a completely speculative assumption – it is very likely that auto insurance will persist as a legal requirement for car owners for at least the next 15 to 30 years. So, even if the eventual adoption of driverless cars is a certainty – the durability of car insurers as a long-term investment is still sufficient to generate good returns for today’s investors. The shift to a driverless society is far enough in the future to justify an investment in Progressive right now.
The greatest risk to Progressive’s durability is underwriting error. Progressive writes more insurance – assumes the risk of more losses – relative to its surplus (the capital buffer available to absorb losses) than other auto insurers. One way of judging the underwriting leverage of an insurer is to look at its premiums relative to its equity plus debt (its capital). Progressive writes 2 times its capital in premiums. First Acceptance writes at 1.7 times. Inﬁnity at 1.4 times, Mercury at 1.3 times, Safety at just 1 times, while other insurers – with large non-auto businesses – like Travelers and Chubb write at well below their capital. Underwriting leverage is only a problem when an insurer’s combined ratio – its losses and expenses divided by its premiums – exceeds 100. Companies with underwriting losses in a normal year must be very careful not to write too much insurance relative to the capital that can absorb those losses.
To understand the risk in Progressive, it is critical to understand the concept of a combined ratio. Insurers generate a “return on sales” (sales are called premiums in the insurance industry) in two ways. One: the policyholder pays more to the insurer than the insurer pays out in corporate expenses, commissions, advertising, and losses. Two: the insurer makes money by investing the premiums paid upfront by its policyholders in securities like common stocks, preferred stock, corporate bonds, municipal bonds, and federal government debt. Different insurers try to make their money in different ways.
Historically, Progressive has generated more than half of its return on sales from its underwriting. This is unusual. In a normal year, the average insurer loses money on its underwriting. But it more than makes up for that by investing its ﬂoat. Progressive earns a lot from underwriting relative to other insurers. It earns little from investing. And Progressive takes much less investment risk than other insurers. In 2013, Progressive was 75% in bonds and these bonds were actually short-term government debt due in 2 years or less. In the last 20 years, Progressive’s only major investment loss – when the company had more losses than gains on investments for the year – was during the 2008 ﬁnancial crisis. Progressive held preferred stock in big banks. The company marked these securities to market. Progressive did not realize actual losses on the preferred stock. After the banks were bailed out, they continued to make payments on their preferred stock and these securities rebounded fully in value in the years since. Given today’s conservative investment policy, the investing side of Progressive’s business does not present any risks to the company’s survival even under crisis conditions worse than 2008.
All of the long-term risk in Progressive comes from the underwriting side. Because Progressive takes in double its capital base in premiums each year, any underwriting loss would lead to a hit double that magnitude relative to capital. For example, in 1991 and 2000 Progressive had a combined ratio of about 105. This means the company had an underwriting loss equal to 5% of its sales. Because sales are twice capital, the company lost about 10% of its capital in each of those years. Obviously, investment gains offset some of this loss. Progressive maintains a ratio of debt to total capital of about 25% to 30%. When debt is 30% of total capital, a 10% destruction of capital causes a 14% destruction of equity. This is because debt only absorbs losses after all of a company’s equity has been impaired.
Shareholders should focus on the amount of underwriting losses relative to equity that Progressive can cause in any one year. Assuming premiums are double capital and equity is 70% of capital, it would take a combined ratio of 112 to destroy a third of Progressive’s equity (12% * 2 = 24%; 24%/0.7 = 34%). Theoretically, it is not difficult to imagine a scenario where Progressive’s underwriting loss forced the company to raise capital by issuing stock and diluting its shareholders. In practice, Progressive’s culture minimizes the risk of large underwriting losses relative to the company’s capital cushion.
Progressive has a 96% combined ratio target. It has been remarkably consistent in averaging a combined ratio below this target. Since 1991, the company’s average combined ratio was 92.6%. In the last 20 years, the average was 92.3%. In the last 15: 92.6%. In the last 10 years: 92.5%. And over the last 5 years: 93%. Since 1991, Progressive has failed to hit its 96 combined ratio 4 times. The company’s combined ratio was 103.6 in 1991, 96.5 in 1992, 98.3 in 1999, and 104.4 in 2000. Progressive has yet to miss its 96 combined ratio since the turn of the millennium. Some of this consistency in underwriting may be due to pricing data. Progressive updates its prices faster than any other auto insurer. It is usually the ﬁrst company to raise prices.
The most important element in Progressive’s combined ratio is not competence. It is culture. The company never changes its stated goal of growing as fast as possible while keeping a combined ratio of 96. It has always said that any growth above a combined ratio of 96 must be avoided.
Here is what Progressive’s CFO said about the 96 combined ratio target in 2013: “(We) often get asked the question, ‘Would you consider changing your 96 combined ratio target?’ Certainly, in the most recent environment with lower interest rates, would we consider changing the combined ratio target? The simple answer to that is no. We feel that it served us well in a number of cycles, with economic cycles, (and) underwriting cycles. And for us it creates a good balance between attractive margins and competitive rates for customers. It’s important that we meet those proﬁtability targets because we are more leveraged to underwriting results…At the end of last year, our premium to equity was close to 2.7 to 1. A peer set of other…companies…were closer to 1 to 1….This combination of disciplined underwriting, ensuring we meet our proﬁt targets, and leverage the underwriting results is how we create good returns for shareholders.”