Progressive Corp (PGR) — Q3 2018 Earnings Call Transcript

Thank you, and good afternoon to all. Today we will begin with a presentation on industry-leading segmentation. After that presentation, we will have Q&A with our CEO, Tricia Griffith; our CFO, John Sauerland; our guest speakers today, Pat Callahan and Sanjay Vyas. And Bill Cody, our Chief Investment Officer, will join us by phone for Q&A. This event is scheduled to last 90 minutes. As always, discussions in this event may include forward-looking statements. These statements are based on management's current expectations and are subject to many risks and uncertainties that could cause actual events to differ materially from those discussed during the event today. Additional information concerning those risks and uncertainties is available on our 2017 annual report on Form 10-K where you will find discussions of the risk factors affecting our businesses, safe harbor statements related to forward-looking statements and other discussions of the challenges we face. These documents can be found via the Investors page on our website, progressive.com. It is now my pleasure to introduce our CEO, Tricia Griffith.

Good afternoon and welcome to Progressive's third quarter webcast. We have a terrific session for you today. Before we go into the topic on segmentation, I did want to reiterate a couple of the milestones I talked about in my letter. First and foremost, we surpassed $30 billion in net written premium on a trailing 12-month period. That is phenomenal for us. What's more phenomenal is the fact that less than three years ago, Glenn Renwick, John Sauerland, and I toured the country celebrating $20 billion in net written premium. So to put it into perspective, it took us nearly 80 years to get to $20 billion and less than three to get to another $10 billion, celebrating $30 billion. Phenomenal job for everyone at Progressive, and we couldn't be happier with those results. In addition, we just surpassed 20 million in overall policies in force and 13 million in auto policies in force. Why that's significant is that we are growing at a very rapid pace in both our agency and direct channels. And part of that is you want an influx of future customers. So those auto policies support that growth, and it's really important because they are our future customers. Having that two-pronged point of reference to be able to grow is necessary, and that's why our policy growth is important. We always talk about unit growth being a very important measure. And lastly, we had an internal goal of getting to 1 million customers, and we surpassed that as well. So a couple more milestones I won't go into, but a lot of excitement around the momentum we've had over this past couple of years. And we are ready to kind of wrap up 2018 and have great plans for 2019. Let's start with our four cornerstones: who we are, why we're here, where we're headed and how we're going to get there. Our core values are really the underpinnings of everything we do. We have five core values, and all of them work together to ensure we have a successful company. Our goal is to win, but we want to win the right way, and our core values guide us there. Why we're here: Our purpose statement is, true to our name, Progressive. And when I think about that, I think of the first eight letters, Progress, always thinking differently, always questioning what we've done yesterday, asking if we should do it the same way tomorrow, listening to our customers, listening to our employees and our shareholders, and understanding how to always be forward-thinking. Our vision, where we're headed: We want to become consumers' number one choice and destination for auto and other coverage. For us, this is just a great goal to achieve. We've got a little bit closer this year, but we know there's a lot of room we need to cover to get there, and we are ready for it. Our strategy is how we're going to be able to achieve our vision. Our strategy is based on four different pillars. You've seen all of these, and what we've spent time doing is dissecting each of these pillars so you can understand our business model and how we're going to achieve our vision. In fact, in the next quarter, we'll have our Chief Human Resource Officer, Lori Niederst, talk about our people and our culture, which is key to everything we do. Today, we're going to take a little deeper dive into the pillar you see with the blue background. In the first quarter, we had Kiara Berglund and Mike Esposito discuss the balance of operational efficiency and claims accuracy, always trying to achieve that near-perfect balance of cost and quality. Today, our guests are going to be discussing offering competitive prices driven by industry-leading segmentation. Let's start with our overarching goal, our operational goal for the company. This is something we've had in place for as long as I can remember, and it's been written about in our annual reports since we went public in 1971. Our goal is to grow as fast as we can at or below a 96 combined ratio. The only caveat is we won't grow if we don't think we can service our customers in the way they expect. The great news is that with our tremendous growth in these last three years, we have been able to hire in advance of needs, specifically in the CRM and claims organization. And I can tell you, the talent coming through the doors of Progressive is phenomenal; I'm excited about our future. For us, a 96 isn't just a variable to solve for; it's a constant. It sets the direction for the entire company and everything we do. It reflects a great balance of consumer competitiveness and attractive margins. As an example, in the third quarter of 2016, right after I took over as CEO, we went over 96. We had more claims than we've had the year before in our commercial lines business. We had put some rates in, but hadn't earned them yet because it's an annual policy. We were spending more on advertising, probably spending a little bit more across the board. And that zero ambiguity helped the entire organization because it forced us to come together and ask, what levers are we going to pull to ensure we get under that 96? And when we discussed expenses, it led us all to question everything we do regarding expenses, and we've changed ever since. That exercise was a valuable one when we went over 96. Again, as you know, the end of the story is that we got under 96 by the end of the year. The most important part of 96 is that it's truly ingrained in our culture. This slide shows a couple of results from 2015, '16, and '17, followed by five-year and ten-year results. We have outpaced the industry substantially in every single time period regarding growth and profitability. In fact, if you look at our ten-year results, we average 6.5 points better than our four-point margin goal. Conversely, the industry hasn't made money in every single time frame. Profit is one of our core values. We aim to make at least $0.04 and do everything we can to achieve that in every opportunity and every timeframe. We've grown our net written premium and outpaced the industry twofold across all these timeframes. We've also increased our policies in force. As I said last time, we are firing on all cylinders, and this is truly an exciting time. What these results lead to is a double-digit comprehensive return on equity for our shareholders, achieving a great balance for everyone. We've been able to grow the company for our employees, service our customers, and grow the entire company for our equity holders. Today, I want to have a deep dive into segmentation. Why? Because it is critical to all of these measures. We have two guests. Sanjay Vyas has been with us for 15 years. He has been a product manager for eight of those years in various states. For the last seven years, he's been a general manager overseeing product managers. He's going to provide a front-row view of how essential that product role is at Progressive, managing each state's P&L and understanding the overall fit of the business. And he recently took over as claims controller, which I'm very excited about. But before then, I will ask Pat Callahan to come up. Pat Callahan, as you know, is the Personal Lines President, and he'll give you an overview of the product strategy, specifically segmentation pricing and how we match rate to risk.

Thanks, Tricia. Let's start by looking at the last slide from Tricia's presentation. If you focus on the upper right-hand corner comparing Progressive versus the industry, you'll notice we are growing twice as fast while simultaneously delivering profit margins 8 to 10 percentage points wider. These results are not accidental; they stem from our deliberate investment in segmentation and matching rate to risk. I'm thrilled to share with you the investments we are making to advance segmentation and widen the moat around our Personal Lines franchise. Our vision is to grow Progressive in pursuit of becoming consumers' number one choice and destination for auto and other insurance. Growing an insurance company isn't difficult if you don't care about making money, and making money is not hard if you don't worry about growth. We are laser-focused on both, so it's critical we maintain high operating efficiency, great claims accuracy, and industry-leading segmentation. I'll share a breakdown of the U.S. auto and home market by distribution channel and Progressive segment. For decades, we've focused on growing our share within the simpler needs auto insurance marketplace, represented by the $90 billion tier comprising basic insurance needs. While these simpler needs customers honed our segmentation skills due to shorter policy life expectancy requiring accurate pricing, our shift toward the broader $230 billion-plus opportunity in home and auto is employing this pricing discipline well. It secures understanding of lifetime cost to serve these new customers and guards against subsidization as we expand market focus, enabling us to disrupt the property insurance market much like we did with auto insurance over several decades. We support this product expansion with five key tactics. First, we continuously invest to improve our matching of rate to risk. Second, we build and deploy competitive and stable products to meet the needs of these preferred customers. Third, we leverage verification to ensure the accuracy of rating models. Fourth, we continuously improve segmentation using third-party data, including our Snapshot usage-based insurance data. Finally, we ensure that while we enhance the accuracy of our rating models, we maintain ease of use to deliver simple products for our agents and all consumers. These five tactics are the foundation of what we call the virtuous cycle of risk selection. The U.S. auto insurance market is highly competitive, with many players, similar products, high transparency, and low switching costs. Given these dynamics, it's crucial to have a finely segmented and accurate product model. I'll walk you through this cycle that starts with step one: designing and deploying segmented models and leveraging pricing discipline to have competitive rates. Step two is beneficial rates driving up conversion and retention for preferred segments. Step three sees less well-segmented competitors face adverse selection as their better customers find more competitive offers from Progressive. This results in their book increasing in loss costs, leading them rationally to raise base rates, causing increased shopping rates among their entire book. This brings us to step four, with higher base rates leading customers to find better offers with Progressive, increasing our premium and enabling us to lower overall costs while enhancing our segmentation and pricing accuracy. The cycle of adverse selection occurs between steps three and four, where competitors raise base rates due to a lack of segmentation. Today, we will focus on implementing our highly segmented product models. Our product models aim to match rate to risk better than other carriers while delivering competitive rates for core customers and stable rates for preferred customers. We build highly complex product solutions to achieve these objectives, layering our indemnity models to predict future loss costs while incorporating acquisition expenses, operations expenses, billing, and bad debt into our segmentation. We also layer in our optional usage-based insurance program, known as Snapshot, which is highly predictive of future loss costs. The best segmentation and predictive models require accurate data inputs, so we focus on ensuring the accuracy of information from customers at inception. Think of our customer onboarding process like joining an interstate toll road, where most customers continue on to their destinations. However, about 10% have mismatched data at inception, leading us to confirm their information. This verification largely occurs among new customers where we find discrepancies. I want to share a bit about our most recent development: product version 8.5. The insurance marketplace is highly competitive, with the ability to offer competitive pricing hinging on low operational costs, high claims accuracy, and industry-leading segmentation. Nothing is standing still, and thus it’s vital to improve segmentation consistently. We do this through multiple sources: new external data, analyzing internal data, or learning from Insuretech and incumbent carriers. For instance, as we designed 8.5, one goal was to enhance the accuracy of the rating model without increasing complexity. We uncovered granular information in prior insurance data that let us segment the market effectively, leading us to adjust pricing on various segments to improve competitiveness and deliver target profit margins. With the growing digitization of customer interactions, we analyze billions of customer interactions to uncover predictive segments regarding future cost to serve potential. Today, about 10% of new customers previously had Progressive policies. We use this historical understanding to price more accurately, ensuring we build a fair pricing structure. Lastly, in usage-based insurance, we've pioneered this segmentation for nearly two decades, and we plan to keep investing in it to drive accuracy and adoption within our product suites. To date, we've been rolling out our 8.5 product into 16 states representing around 40% of Progressive's premium and expect to be in 23 states by year-end. We've monitored performance and are thrilled with how 8.4 performed, and 8.5 is outperforming across all key performance indicators. This significantly enhances the value of our product model, notably our preferred customer conversion rates, driving long policy life expectancy, greater propensity to bundle with Progressive, and fueling our virtuous cycle of risk selection. The key now is to get this segmentation market-ready as quickly as possible. While I am impatient for progress, I've discussed our pace initiative that cut our delivery time for model upgrades nearly in half. For 8.5, we reduced our model build cycle and significantly increased deployment capacity. But I’m excited that we can simultaneously develop and deploy product models. As 8.5 rolls out, we're already testing 8.6 and building requirements for 8.7, assuring us of a robust pipeline for future segmentation. Let's evaluate how our product models perform in the market. When we look at our loss ratio compared to the industry, we are out-segmenting the competition. Our investment in product development and risk selection has widened that gap over the past four years. While the industry has experienced a decrease in losses due to high rates and benign trends, our competitive edge persists. We can also analyze how current pricing interactions impact our growth. Observations of a 15-year trajectory show that we have doubled our business from about 6 million to more than 13 million policies. In the recent rollout of 8.3, 8.4, and 8.5, we've accelerated growth. We took 30 months to grow from 9 million to 10 million policies, but we halved that to 15 months for subsequent milestones. Ultimately, we can demonstrate that investing in segmentation and timely product upgrades stimulates both growth and profitability. Competitive auto and property insurance are crucial for meeting consumer needs. After acquiring a significant stake in ASI, or Progressive Home, we've ensured we leverage the property insurance expertise alongside our pricing and segmentation expertise honed over 80 years. This partnership enables us to deploy innovative solutions and achieve accuracy for both property and auto products, enhancing our growth potential moving forward.

Thank you, Pat. My name is Sanjay Vyas. As Tricia mentioned, I have a long experience in product management and recently transitioned to claims. I want to highlight three points. First, state deployment is complex due to legislative and regulatory diversity across the U.S. One personal experience illustrates this: recently, my wife was parked in Whole Foods when a pickup truck backed into our vehicle. In most states, the other driver’s insurance would pay for the repairs. However, in Michigan, my insurance would cover the repairs due to first-party liability laws. This shows how important state-specific data is for segmentation. In Michigan, the jurisdiction would impact outcomes significantly. Second, product managers’ decisions vary significantly across the 51 jurisdictions. During my time as a product manager responsible for multiple states, I had to navigate complex state regulations. When I first joined Progressive, we had issues in Mississippi and were generating losses. Thus, I had to assess our pricing, consult actuarial data, and file for potential rate increases. The state initially required approval before implementing changes to our rates, ensuring compliance with regional standards. I spent months monitoring these shifts. In terms of segmentation, it's critical for the product management role. Pat discussed our countrywide support, and as a PM, I must adapt that product to the local market. For example, I enhanced our 8.0 product offering in Florida, modifying it to comply with local laws that prohibit adding speeding points to in-force policies. Understanding territory models and local market considerations are necessary for tailored product adjustments. The complexity of state-level regulations shapes my product strategies. I now oversee two states, and each state has unique rules impacting my strategy. Scaling this process can be challenging but essential for effective segmentation. At Progressive, we collect data intelligently, empowering local PMs to identify trends that feed back into our R&D. We focus on recruiting talent who are entrepreneurial and possess a passion for winning. Summarizing, focus on state-level details allows product managers to tailor nuances affecting their profitability effectively. For our product models to succeed in the marketplace, a diligent blend of data and localized insight is necessary. We emphasize hiring business-minded individuals rather than solely focusing on actuarial skills to navigate these complexities, as seen in our unique approach to segmentation.

Thanks, Sanjay. Having spent much of my Progressive career in product management, I can vouch for the two-fold benefits of combining local market knowledge with countrywide segmentation. We discussed building and deploying our complex product models, and Sanjay shared how we customize those for our targeted opportunities. The integration of our countrywide product models with localized customizations, accelerated speed to market, drives our virtuous cycle of risk selection, fostering healthy growth within Progressive. Ultimately, our ongoing investments further cement our vision of being consumers' number one destination for auto and other insurance.

We talked about developing and implementing our intricate product models, and Sanjay explained how we tailor them for specific opportunities. The combination of our national product models with local customizations enhances our market entry speed, supports effective risk selection, and promotes strong growth at Progressive. In the end, our continued investments reinforce our goal of becoming the top choice for consumers seeking auto and other insurance.

My first question is regarding your competitive advantages relative to peers. I'm curious if you feel they're materially stronger today versus a couple of years ago? If yes, can you summarize one or two reasons for this impact?

Absolutely, we are continually aiming to create a greater gap with our peers, particularly through segmentation and matching rate to risk. Our cost structure is also vitally important, allowing for competitive pricing, along with service, local footprint, and brand. All these elements, taken together, position us favorably against competitors.

Thanks for that context. My follow-up is about your in-house marketing agency, 96 Octane, in relation to managing your digital ad spend effectively. Is this a major contributor to Progressive's unexpected growth?

From an advertising perspective, we aim to be visible in the places where customers want to shop. We established 96 Octane to manage in-house tasks that we had previously outsourced at a premium. Our understanding of ad spend efficiency, coupled with a focus on demographic trends, gives us an edge in purchasing ads. This approach is indeed a competitive advantage.

Further to that, the digital space is measurable, facilitating our understanding of advertising attribution. We're continually able to buy time slots and accurately measure costs, which creates negotiation advantages. This efficiency underpins our successful strategies.

Regarding the slowing growth in the agency and direct channels this quarter, can you discuss the underlying factors driving that reduction? Is it due to competitors taking less rate in pushing for growth?

We remain positive on growth, emphasizing trailing 12-month metrics rather than just the preceding quarter. We noticed less aggressive rate taking lately, which has led to some strain in PLE metrics. We also prioritize customer satisfaction, which sometimes involves decisions that might initially detract from PLE.

Thanks. My second question pertains to the severity trends, which you noted have increased. As you consider pricing adjustments, how do you reconcile those trends against frequency metrics?

Frequency is now aligned with industry benchmarks. The recent severity surge stems from collision and PIP costs. Should we observe consistent upward trends, we will adjust pricing accordingly, focusing on state-specific assessments.

Regarding the rising severity issue flagged by Allstate, are you surprised by this trend, given the increasing adoption of ADAS technologies?

We focus on data analysis rather than getting surprised. The total loss frequency and severity are significant metrics, and while ADAS technology has become widespread, there are still older vehicles lacking these systems. Our focus aligns with data, rather than emotional responses.

Our average premium has been in alignment with overall loss costs trends, thus indicating we are proactively engaging with these changes, ensuring sound pricing processes.

We must ensure we’re incrementally adjusting without overreacting to short-term data, maintaining a long-term perspective.

In examining the price versus loss cost trends, if frequency remains down, but loss costs are slightly rising, how will you react regarding pricing adjustments to maintain margins?

Our rate response can be swift; we are adept at adjusting quicker than others. Continuous monitoring is key and we're aware of current loss trends, pricing accordingly to ensure sustainability without loss of business.

The local product management structure allows for nimble responses. Product managers can decide where to adjust rates, ensuring sufficient flexibility for growth while maintaining our 96 combined ratio.

Given your focus on the 96 combined ratio, how will you approach future product segmentations like 9.6? Are diminishing marginal returns a concern?

Our focus lies in the vast opportunities with home and auto data consolidation. We expect significant improvements from the merging of these insights, fostering growth and segmentation efficiency.

As product upgrades evolve, they consistently introduce more opportunities. Our R&D division is actively developing, ensuring we face no diminishing returns at this stage.

What changes have you seen regarding the types of companies providing insurance and how has that shifted over the last year?

The competitive landscape remains dominated by larger players. Recent shifts in rate strategy will compel customers to leave for others. The ease of shopping for auto insurance rewards those with competitive and recognized brands.

What about distribution conversion trends? Have customers shifted from agency to direct channels?

While the perception is that everyone will migrate to direct, our agency business remains strong, with growth within both channels reflecting consumer preference.

Direct channels have gained share, primarily from captive agent firms, while independent agents have maintained consistency in their market share. We analyze prior insurance data broader than just recent providers, incorporating the context of their carrier history.

Can you elaborate on the balance between your variable dividend and growth pressures, particularly with your recent $30 billion premium milestone? How does that impact your annual decision process?

We aim to grow rapidly, even though this industry is capital-intensive. We strive to manage our regulatory compliance while ensuring rapid growth. This year’s variable dividend formula rates at 33.5%. The calculated dividend is derived from our after-tax underwriting profits, subject to board discretion.

Capital needs stem from growth, with premium projections this year expected to hit $6 billion. We maintain surplus requirements around 2.8 to 2.9 compliance ratio. We will continue pursuing capital market assistance when required to support operations and growth.

Please share your ambitions regarding the commercial lines and your market positioning in that sector.

We recently initiated our small business insurance solution, which serves as our gateway into the commercial lines sector. Our acquisition of ASI allows us to position well within this multi-faceted market. We're excited about future growth but prefer to pace our long-term ambitions prudently.

The commercial lines space is significantly larger than our traditional market. While we currently lead in commercial auto, our market expansion within commercial lines is on the horizon, fostering strategic collaborations.

Does your pricing sophistication mitigate the influence of variables like gas prices on results?

External factors like gas prices impact frequency, but our pricing strategy focuses on severity. Thus, we closely monitor these metrics, but fluctuations do not inherently transform our pricing strategies.

While pricing sophistication introduces nuanced competitiveness, economic changes will necessitate strategic responses, influenced by shifting consumer behaviors.

Can you compare the elasticity of pricing in homeowners insurance versus auto products?

Indeed, we recognize that shopping dynamics differ, with homeowners likely being less elastic than auto insurance due to premiums being bundled in mortgage payments.

Auto insurance tends to bear higher elasticity due to heightened shopping capabilities, while homeowners’ insurance typically features a more stable consumer base.

Could you update us on UBI's role in segmentation and whether it might eventually replace other variables in your rating plan?

UBI is certainly a powerful tool and potentially valuable in our rating plans. Although currently, it serves as one of many variables, we aim for further integration in future models, pending technology advancements.

While the most effective utilization of UBI may not be immediate, our ambition remains to incorporate these insights into holistic rating frameworks over time.

Regarding IoT technologies, how functional is data collection, and how is that influencing homeowners' segmentation?

We are investing in this area and collaborating with key individuals to probe IoT's influence on home insurance viability. While still early in our exploration, we are optimistic about untapped potential.

In terms of homeowner perils, we have established discount structures based on IoT adoption, paving the way for proactive cost mitigation practices we can build upon as trends evolve.

How crucial is segmentation life cycle update frequency for maintaining competitive advantage?

Maintaining an updated segmentation life cycle is imperative for us. The industry's competitive nature mandates that we stay ahead of the modeling evolution continuously.

Our priority remains expedited segmentation updates as a means to adapt and respond swiftly, reinforcing our competitive momentum in the marketplace.

We will conclude the caller questions at this juncture, as we approach the scheduled closing time.