Progressive

Progressive has benefited from strong positioning and favorable industry conditions over the past couple of years. While second-quarter results remained strong, we see signs that tailwinds are starting to ebb.

Why it matters: Progressive's trailing 12-month return on equity of 35% is well above its historical average, highlighting the strength of the tailwinds Progressive has been enjoying. Insurance is a highly competitive, cyclical industry, and we are skeptical that returns at this level can be maintained. Pricing is typically the lever to move returns back in line with historical averages, and we continued to see signs in the quarter that pricing is getting weaker. The combined ratio for personal auto was 87.1% in the quarter, compared with 86.3% in the previous quarter and 85.9% in the previous year. Weaker pricing appears to be working its way into underwriting results, although underwriting margins remain quite attractive.

The bottom line: We will maintain our $191-per-share fair value estimate for the narrow-moat company and view the shares as modestly overvalued. We think the market is extrapolating favorable conditions too far. Year-over-year policies-in-force growth in personal auto remained healthy at 9%, with growth modestly tilted toward the direct channel. However, growth continued to moderate, suggesting Progressive's ability to take share is weakening as competitors regain their stride and the personal auto insurance market grows more competitive. Investment income in the quarter increased 12% year over year, but this was driven almost entirely by higher investment balances.

We are increasing our fair value estimate to $198 from $191 per share, due to time value since our last update and some modest adjustments to our assumptions. Our fair value estimate is equivalent to 3.7 times Progressive's 2025 year-end book value, or 3.7 times book value when excluding goodwill and accumulated other comprehensive income.

Progressive still benefits from the market share shift toward the direct channel, and the move over the past decade toward bundling homeowners policies ignited growth in the company's historically stagnant agent channel. Progressive's top line has been strong in recent years, as increasing penetration in the agent channel helped to maintain this growth. More recently, the company has benefited from pricing increases, and we think it has had significant opportunities to take share as competitors struggle. Going forward, though, we expect growth to moderate as pricing increases dissipate and industry conditions stabilize. During our five-year forecast horizon, we assume net earned premiums will grow at a 7% compound annual rate, with growth tapering over time.

We believe the company will maintain its industry-leading profitability. After suffering a hiccup in 2016, the combined ratio improved significantly due to price increases. The 2018 level was Progressive's best result in over a decade, and results in 2019 held basically steady. The impact of the coronavirus led to a major improvement on these already strong results in 2020.

However, we expected mean reversion at the industry level, and that arrived in 2021. Underwriting margins from 2021-23 were weak relative to the company's historical levels. However, pricing increases set the stage for major improvement starting in 2024. We expect underwriting margins in the near term to hold at a level significantly better than the company's historical average. In the second half of our projection period, we expect underwriting margins to start compressing as improved investment income reduces the need for underwriting profits. Over the next five years, we forecast that the combined ratio will average 92%, in line with the company's average over the past decade.

Our projections yield an average adjusted return on equity of 25% over the next five years. We think the company is positioned to outperform its historical averages over the next few years. However, by the end of our projection, we forecast ROE to return to a level roughly in line with historical averages.

We use a cost of equity of 8.9% in our valuation.

In general, property-casualty insurers do not benefit from favorable competitive positions. Industry competition is fierce, and the products are essentially commodities. Furthermore, most participants do not know their cost of goods sold for a number of years, allowing them to underprice policies without knowing it. Firms have a large 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.

Progressive is the second-largest underwriter of personal auto insurance, with about 15% market share, and has set itself apart from the industry by its scale in the direct channel and efficiency in the agent channel. Given a high level of variable costs, scaling is difficult for most insurance companies. Personal lines insurers, such as 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. We think scale is particular important in the direct channel, which accounts for almost half of Progressive's personal lines premiums. This shows clearly in the company's expense ratio, which has averaged 20% over the past 10 years, well below industry averages.

Progressive has historically been an innovator when it comes to underwriting. Through continuous innovations, the company has built a data edge that has at times given it a leg up on other competitors. While this has helped results, we think an edge from underwriting innovations is usually difficult to maintain, as they can be fairly easily replicated. Competitors have caught up to most of Progressive's innovations in the past, and almost all major carriers now have telematics programs similar to Snapshot. We think in the case of telematics this edge could be a bit more durable, as Progressive should be able to identify its safest drivers and retain them through discounts. However, results to date suggest any relative gains for Progressive have been modest.

Progressive has consistently outperformed peers in terms of underwriting margins.

Progressive's management has proved itself adroit at managing the pricing cycle.

Catastophe losses are typically minor for auto insurance, making Progressive's results relatively predictable compared with other insurers.

Progressive operates in an industry that competes almost entirely on price.

State Farm, a mutual company, is the largest auto insurer. Mutual companies are not driven by the same profit motives as public companies and could undercut Progressive on price.

Autonomous cars could eliminate, or at least dramatically reduce, the need for auto insurance over time.