Since writing up PGR last year, the stock underperformed the S&P 500, generating a total return of 11.4% compared to 32.6% for the S&P 500. In this update I’ll address the challenges PGR faced this year, and whether those challenges are transitory or point to longer term concerns. Additionally, I’ll discuss key takeaways from PGR’s recent Commercial Lines presentation, update my estimates for the next few years, and provide thoughts on PGR’s valuation.
Weak 3Q21 Earnings
PGR had a challenging 3Q21, with Operating Earnings down 92% y/y to $82mn. This large decrease was driven by a 1,260bps increase in its Combined Ratio (CR) to 100.4%. By segment, Personal lines reported a CR of 100.2% (+1,360bps y/y), Commercial Lines 89.5% (+230bps y/y), and Property 142.3% (+3,050bps y/y). For context, Personal lines make up 80% of PGR’s premiums, followed by 15% for Commercial, and 5% for Property. The one positive was the continued increase in policies in force, which increased 9% y/y, with Personal Lines +8%, Commercial Lines +19% (reflects Protective acquisition), and Property +13%. You can see below that PGR’s results were strong from 1Q20-1Q21 but deteriorated over the last couple of quarters.
Several headwinds have driven PGR’s higher CR in 3Q21, including increased accident frequency and severity, higher catastrophe losses, and weaker rates. These challenges are not unique to PGR, as Geico reported a 3Q21 CR of 103% (+620bps y/y) and ALL reported a 3Q21 CR of 105.3% (+1370bps y/y). The key questions are to what extent are these trends transitory and how will management respond?
In 3Q21, accident severity increased 12% y/y, and was one of the main drivers of PGR’s higher CR during the quarter. Higher personal auto severity was driven by higher repair costs reflecting higher used vehicle prices, and higher medical expenses due to more severe accidents. Used car prices are up 37% y/y in October and are up more than 50% from pre-COVID levels, due to supply chain issues which have reduced new car availability. Management noted on the 3Q21 earnings call that other key costs such as labor and parts have experienced more modest inflation in-line with overall CPI. Given that used car prices were the key driver of higher severity, I believe higher severity is largely transitory in nature and will be less of a drag going forward, as supply chain issues are worked out.
PGR also experienced higher catastrophe losses in 3Q21 compared to Q3 of prior years. Catastrophe losses increased PGR’s CR by 635bps for the quarter, compared to an average of 311bps for its Q3 from 2015-2020. Overall, 2021 was a challenging year from a catastrophe perspective, with the U.S experiencing 18 weather and climate disasters with losses over $1bn. Additionally, the U.S. has incurred total catastrophe losses of $104.8 billion so far in 2021, eclipsing $100.2 billion incurred last year (adjusted for 2021 inflation).
PGR’s property segment was hit particularly hard, with catastrophe losses adding 54.9 points to the segment’s 142.3% CR for the quarter. To address these losses, management plans to reduce its exposure to FL/TX/LA from 50% of premiums to 35-40%, over time by expanding its footprint in other states. Other corrective actions include increased reinsurance utilization, the non-renewal of certain policies in high cat states and increasing rates where possible. While PGR’s catastrophe losses will experience yearly fluctuations, I expect management’s action to positively impact Property’s CR going forward.
Higher accident frequency
PGR experienced a 10% y/y increase in personal auto accident frequency in 3Q21 as vehicle miles traveled (VMT’s) increased relative to 2020 with the U.S. economy reopening. Per the U.S. Department of Transportation, VMT’s increased 12.2% through August, compared to the same period last year.
However, PGR’s personal lines mileage is still down 6-8% relative to a 2017-2019 baseline, and VMT’s will likely normalize to pre-COVID levels in the near term. While increased levels of remote work could reduce VMT’s over time, it is too early to tell at this point. Longer-term I expect the proliferation of advanced driver assistance systems (ADAS) such as front crash warning and lane departure warning, to significantly reduce accident rates. Longer-term collision avoidance technologies could reduce accident frequency by 20-30% over the next few decades.
Finally, pricing turned negative as P&C insurers largely reduced auto rates in 2020 due to reduced driving from COVID-19 and are just starting to file for rate increases. Ultimately, it will take some time for PGR to be able to pass on higher prices to customers.
PGR began filing for personal and commercial auto rate increases earlier this year, and year to date rate increase in personal auto were roughly 5%, and 3% in commercial auto. In Q3, rate increases were already effective in 20 states, with an average increase of roughly 6%.
Commercial auto policies typically renew annually, while personal auto policies usually renew every 6-12 months, allowing PGR to pass through rate increases in a timely manner once they are approved by regulators. Here as well, I expect PGR to succeed in increasing rates in the near-term. Importantly, PGR earned goodwill with regulators and customers in 2020 by rebating personal auto customers $1.1bn because of fewer claims, and this should help PGR in getting rate hike approvals from regulators.
Commercial Lines Update
PGR recently updated investors on the large opportunity within its commercial lines business and provided an overview of the key drivers for that segment’s success over time. Over the past decade PGR’s commercial lines premiums grew at a much faster rate than the industry while generating superior margins. This combination of faster growth and higher margins is rare, and management’s presentation shed light on the key drivers.
The U.S. P&C market generates $730bn of annual premiums, with personal lines accounting for $366bn of premiums, and commercial lines accounting for $364bn of premiums. Despite being one of the largest P&C insurers in the U.S., PGR only has a 5.7% market share as the industry is highly fragmented.
PGR has a 9.6% market share in personal lines, with personal auto at 12.9% and homeowners at 1.7%. For commercial lines, PGR only has a 1.8% market share with 12.1% in commercial auto, and 0.3% of the $318bn other commercial market. Management considers its TAM of the $364bn of commercial lines premiums to be $78bn, of which I expect PGR to achieve a ~8% penetration in 2021, implying a large opportunity for continued growth.
Within commercial lines, PGR is targeting worker’s comp ($10.4bn TAM) and medium and large fleet commercial auto ($9.1bn TAM) as new business lines following its recent acquisition of Protective Insurance. Other key areas for growth include small business General Liability (GL)/Business Owners Policy (BOP), a $22.3bn opportunity, and Commercial Auto bundled with GL/BOP, a $12.2bn opportunity. For context Business Owner Policy combines business property and business liability into one policy and can be customized across industries and business size.
The majority of PGR’s commercial lines business is focused on commercial auto, and PGR has grown its commercial auto business at a much faster rate than the overall industry, while generating superior underwriting results. From 2000-2020, PGR increased its commercial auto market share from 2% to 13%, becoming the largest commercial auto writer in the U.S. in 2015.
From a profitability standpoint, PGR’s commercial auto business averaged a 90% combined ratio from 2000-2020, roughly 10% lower than the industry over that time frame.
So how has PGR achieved both better growth and better profitability?
PGR outlined the key drivers as greater customer segmentation, a sustained cost advantage through scale and better use of technology, more accurate loss reserving, and the use of telematics. PGR did not quantify all these advantages, but in aggregate they have added up to lower expense and loss ratios relative to peers. Because PGR can price policies more aggressively, the company has been able to drive much stronger growth than the industry.
A key differentiator for PGR is its customer segmentation. PGR introduced commercial auto business market targets (BMT’s) in 2014, which drive more granular pricing and underwriting. These target markets are tied into every aspect of running its commercial auto business, and management has observed key differences across its BMT’s.
Compared to personal auto, commercial auto is much less homogenous across a variety of factors. Each BMT has unique characteristics in terms of driving utilization rates which lead to significant differences in accident frequency and severity trends. Management also noted that BMT’s differ in terms of attorney representation rates and litigation outcomes. Additionally, BMT’s respond differently to changes in pricing, with some BMT’s being much more price sensitive than others. In combination these factors lead to more accurate rates for each BMT to optimize for growth and margins. As a reminder, PGR’s goal is to grow as fast as possible while achieving a 96% or lower Combined Ratio.
Sustained cost advantage
PGR’s expense ratio has consistently been 700-800bps lower than its peers over the past decade, driven by operating leverage, a focus on automation, and claims efficiency and accuracy.
PGR has realized meaningful operating leverage over time. From 2011-2020 PGR’s commercial auto premiums increased 220%, outpacing the 80% increase in real estate costs, and 180% increase in employee costs. Within employee costs, non-volume driven employees increased by ~50%, while volume-driven employees grew by ~221%, roughly in line with overall premium growth. As the largest commercial auto insurer, PGR should continue to benefit from its scale advantage going forward.
Part of the reduction in real estate costs is driven by the fact that PGR implemented a home-based consultant model for its customer and agent services organization several years ago. This model has led to efficiency gains and a broader access to talent and has provided additional flexibility for employees. In 2019 almost 40% of Commercial Lines agents and customer service consultants worked from home, and PGR expects that number to grow over time, allowing PGR to better manage its real estate footprint.
Another key driver has been PGR’s investments in technology to increase operational efficiencies. One example is a new policy administration system which enables faster delivery of products and enhancements and has led to an 80% improvement in online sales yield, translating to a more than 20% increase in direct auto sales. PGR has also increased automation for several manual processes such as archiving the millions of documents PGR receives every year rather than manually reviewing them.
Management also noted that PGR’s claims advantage is another differentiator. PGR has leveraged its scale on the personal lines sides to effectively manage commercial lines claims. Additionally, PGR has leveraged technology to increase productivity and accuracy. Specifically, management highlighted a tool built in house to provide real-time alerts to improve the handling of at-risk files. Frontline employees are notified about claims that could be at risk, prompting more expedient action, and leading to improved claims accuracy and lower costs over time.
More accurate loss reserving
Another key factor in PGR’s higher margins, is its more accurate loss reserving, with a tighter variance than the industry overall. More accurate loss reserving allows PGR to understand its true costs more quickly, leading to more responsive pricing and product adjustments. PGR’s advantage here is driven by its highly segment customer approach, and better utilization of technology and data analytics to improve the timeliness and accuracy of claims handling.
Finally, PGR’s telematics program, is a key driver of PGR’s lower cost structure. PGR has $500mn of commercial auto premiums (~8% of total) utilizing its telematics programs, providing PGR with more than 10 billion miles of data to analyze. Management noted that they see a sizeable loss advantage averaging $1500/policy, even after applying steep discounts, and telematics is by far PGR’s most predictive rating variable. Additionally, telematics data helps PGR better segment customers even within the same industry. For example, different restaurants will have unique vehicle utilization rates, as well as differences in time of use, which can impact accident frequency and severity trends.
Commercial Lines growth areas
Key growth areas within commercial lines include expanding commercial auto coverage to larger fleets, expanding into worker’s comp, and growing its small business coverage. PGR historically focused on fleets of fewer than 10 vehicles but is currently targeting businesses with 10 to 40 vehicles, which represents $7bn in annual premiums. PGR has low penetration in this market but has expanded its underwriting teams and has improved its quote turnaround time to drive additional sales. Beyond 10 to 40 vehicles, the acquisition of Protective helps PGR provide insurance for businesses with greater than 40 vehicles, with the underwriting expertise in that area, and a $9bn premium opportunity.
Workers' comp also represents a large opportunity for PGR, as the largest statutory commercial coverage at $45-$50bn/yr. of premiums, and highly profitable with this line of business generating an 85-90% CR across all carriers from 2016-2020. PGR believes its worker’s comp opportunity is around $10bn of annual premiums. Additionally, offering worker’s comp. will allow PGR to better compete across the small, medium, and large fleet sizes.
Finally, PGR is focused on growing its Business Owner Policy and General Liability product across various BMT’s including contractors, offices, restaurants, retail & services, and wholesale distributors. These BMT’s represent roughly 14mn businesses with fewer than 20 employees, accounting for almost half of the 31 million small businesses in the U.S. To expand into this market, PGR is offering its own products in addition to distributing products for other carriers through its in-house agency. PGR launched its product in 2019 and expects to be in states representing 67% of the market by YE21. Finally, cross-selling is a key part of PGR’s initiative as management noted that businesses with additional PGR products has increased the policy life expectancy. As noted, BOP/GL represents a $22bn opportunity, and bundled with commercial auto, a roughly $12bn opportunity.
Here are my assumptions going forward:
Premium Growth: I expect PGR to grow premiums by ~8%/yr. through 2026, driven by a 6% annual increase in policies in force, and a 2% annual increase in rates. This represents a slightly lower growth rate than PGR has achieved from 2015-2020 (10% PIF CAGR, and 14% Premium CAGR), and my estimates may prove to be conservative if PGR can take meaningful Commercial Lines market share as described above.
Combined Ratio: In terms of PGR’s combined ratio, I expect a 2021 CR of 96.3%, and a 2022 CR of 94.7%, with PGR getting back to a more normalized 93.5% CR in 2023. PGR averaged a 93% CR over the past 10 and 20 years, with stronger results from 2018-2020 driven by the pricing environment, and reduced accident frequency in 2020 due to COVID-19. PGR’s business mix will impact its CR going forward as Personal Lines and Commercial Lines have generated much stronger underwriting margins than Property over time. From 2015-2020, Personal Lines averaged a 91.6% CR, Commercial Lines an 88.9% CR, and Property a 101.1% CR. I expect stronger growth in Commercial Lines and Property than Personal Lines going forward due to a smaller baseline, but ultimately, continued strength in Commercial Lines should offset weak Property results. Additionally, I expect PGR to eventually drive its Property CR down to 100% by 2026, and there is potential upside to PGR’s CR if it can make headway in its Property business.
EPS growth: I have forecasted 19% annual EPS growth from 2021-2026, and 14% EPS growth from 2022-2026, driven by strong premium growth and an improved CR.
My base case scenario is for PGR to generate 17% IRR’s through 2025 driven by 14% EPS growth and a 3% dividend yield, assuming no change to the multiple. While PGR faced numerous challenges in 2021, some of which may persist in 2022, I expect underwriting to return to more normalized levels in the next couple years driven by rate hikes, lower severity, and a smaller impact from catastrophe losses. Additionally, PGR has a massive opportunity to continue expanding within Commercial Lines of business, including new lines such as worker’s comp and medium-large fleet coverage through its recent acquisition of Protective Insurance, as well as focus on small business coverage. In conclusion, I continue to believe that PGR represents an attractive investment opportunity, especially given PGR’s commanding underwriting lead over its peers, impressive market share gains over time, and attractive growth avenues.
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. You can follow Enlightened Capital on twitter here!