PROGRESSIVE CORP quarterly report, Q3 FY2015

Business Context and Reporting Period

The Progressive Corporation filed an unaudited Form 10-Q for the quarter and nine months ended September 30, 2015. Progressive primarily writes personal auto, commercial auto, and property insurance, with additional service and run-off businesses. Beginning April 1, 2015, Progressive consolidated ARX Holding Corp., including American Strategic Insurance Corp. (ASI), and owned 69.1% of ARX at quarter-end.

Key Financial Metrics

Metric	Three Months 2015	Three Months 2014	Nine Months 2015	Nine Months 2014
Net premiums earned	$5,070.6 million	$4,540.1 million	$14,732.7 million	$13,455.9 million
Total revenues	$5,273.8 million	$4,766.1 million	$15,452.4 million	$14,215.2 million
Income before income taxes	$429.0 million	$441.8 million	$1,397.5 million	$1,361.0 million
Net income attributable to Progressive	$278.3 million	$296.1 million	$937.2 million	$910.8 million
Diluted earnings per share	$0.47	$0.50	$1.59	$1.53
Operating cash flow	Not separately provided	Not separately provided	$2,159.5 million	$1,657.5 million

Underwriting profit was $364.9 million for the quarter and $1,080.3 million for the nine months, compared with $339.8 million and $961.9 million, respectively, in the comparable periods. The total underwriting combined ratio was 92.8% for the quarter and 92.7% year to date, compared with 92.5% and 92.9% in 2014.

Personal Lines net premiums earned increased 7% in the quarter and 6% year to date; the combined ratio was 93.8% and 93.6%, respectively.
Commercial Lines net premiums earned increased 12% in the quarter and 9% year to date; the combined ratio was 84.8% and 83.7%, respectively.
The newly consolidated Property segment generated $205.2 million of quarterly earned premiums and had a 91.6% combined ratio, including catastrophe losses and acquisition-related amortization.
Investment income increased 16% to $117.5 million in the quarter and 10% to $335.9 million year to date.
Net realized investment gains and losses changed to a $15.8 million loss in the quarter and a $93.2 million gain year to date, compared with gains of $38.2 million and $198.0 million in 2014.
Other comprehensive income attributable to Progressive was $145.5 million for the quarter and $683.3 million year to date, down 37% and 27%, respectively, primarily because of declines in investment valuations.

Financial Position, Debt, and Liquidity

Total assets were $29.9 billion at September 30, 2015, versus $25.8 billion at December 31, 2014.
Total investments were $21.0 billion, including $15.6 billion of fixed maturities and $2.5 billion of common equities.
Cash was $194.5 million, compared with $108.4 million at December 31, 2014.
Debt was $2.7 billion on a carrying-value basis, compared with $2.2 billion at both September 30, 2014 and December 31, 2014. Debt-to-total-capital was 26.7%, versus 23.8% at both prior comparable dates.
Shareholders’ equity was $7.5 billion, and redeemable noncontrolling interest was $442.9 million.
Progressive maintained a $100 million discretionary line of credit, with no borrowings during the first nine months of 2015. Management stated that available capital, operating cash flows, and borrowing capacity were sufficient for expected business needs, debt service, dividends, and other capital requirements.
Cash used in investing was $1,859.2 million, including $752.7 million for the ARX acquisition and $12.6 million to acquire additional ARX shares. Cash used in financing was $213.5 million.

Material Changes Versus Prior Comparable Period

Progressive acquired a controlling interest in ARX for approximately $890 million, funded with available cash. ARX contributed $215.5 million of revenue and $26.8 million of net income in the third quarter, and $423.7 million of revenue and $43.5 million of net income for the post-acquisition period included in the nine-month results.
The acquisition added approximately $470 million of goodwill and $520 million of other intangible assets. A third-quarter purchase-accounting adjustment reduced goodwill by $26.5 million after updating acquired loss reserves and deferred taxes.
Net premiums written increased 14% in the quarter and 12% year to date. Excluding Property, management reported 10% quarterly growth in net premiums written.
Policies in force increased 11% companywide year over year, including approximately 1.1 million Property policies. Excluding Property, policies in force increased 3%.
Quarterly net income attributable to Progressive declined 6% despite revenue and underwriting growth, primarily because 2015 included net realized investment losses rather than the prior-year realized gains and included income attributable to ARX’s minority shareholders.
Interest expense increased 12% in the quarter and 17% year to date, reflecting additional debt issued in 2015 and 2014.
Net unrealized gains on securities declined to $777.4 million after tax at September 30, 2015, from $1,021.9 million at December 31, 2014, due to equity-market declines and wider credit spreads.

Guidance, Outlook, Commentary, Risks, and Unusual Items

Management stated that underwriting margins exceeded its long-term target of at least 4% in both the quarter and nine-month period.
Management highlighted continued growth initiatives in Direct auto, Commercial Lines, usage-based Snapshot, mobile distribution, and bundled auto-property products, including the Platinum offering powered by ASI and Progressive.
The 2015 annual variable dividend target was 33⅓% of after-tax underwriting income, with a year-to-date Gainshare factor of 1.53. However, comprehensive income of $683.3 million was below after-tax underwriting income of $702.2 million for the nine months. If this relationship persisted through year-end, the conditions for a variable dividend would not be met; any dividend remained subject to Board discretion.
Catastrophe losses were $37.7 million in the quarter and $201.7 million year to date. The Property segment was particularly exposed to hail losses in Texas, Colorado, and Minnesota.
Auto accident frequency increased approximately 5% to 6% in the quarter and 2% to 3% year to date. Management stated that the direction and magnitude of near-term frequency trends could not be predicted with certainty.
Favorable prior-year reserve development was $92.3 million in the quarter and $279.0 million year to date. Reserve estimates remain subject to future changes in claim frequency, severity, and payment experience.
The investment portfolio had a 0.4% negative FTE total return in the quarter and a 0.6% positive return year to date. Common-stock returns were particularly weak, at negative 6.9% and negative 5.3%, respectively.
Progressive reported $127.8 million of gross unrealized investment losses at quarter-end and recognized $23.2 million of other-than-temporary impairment losses year to date, primarily on common equities. Management concluded that the remaining unrealized losses were not other-than-temporary.
ARX’s term loans required specified leverage, coverage, capital, and ratings covenants; ARX was in compliance at September 30, 2015. ARX had $25.0 million of term-loan principal and $2.2 million of surplus-note principal due within 12 months.
ASI had $63.6 million of remaining deposits to be paid on catastrophe excess-of-loss reinsurance contracts. The filing identifies potential exposure from catastrophe losses, reinsurance recoverability, investment valuation, interest rates, litigation, regulation, competition, technology, and changing claim frequency and severity.
Pending litigation included ordinary-course insurance claims and lawsuits involving claims practices, policy documents, repair-shop labor rates, wage and hour issues, and other operations. The filing states that material outcomes generally could not be estimated and that a substantial judgment or settlement could adversely affect results.
Progressive was still incorporating ARX into its internal-control evaluation and expected full incorporation by June 30, 2016.

Important Facts for Investors to Verify

Whether ARX integration, property catastrophe exposure, and acquisition-related amortization support or dilute future underwriting margins.
Whether rising auto claim frequency and changing severity trends lead to future rate increases, reserve strengthening, or deterioration in combined ratios.
Whether equity-market declines and wider credit spreads produce additional realized or other-than-temporary investment losses.
Whether year-end comprehensive income exceeds after-tax underwriting income and permits payment of a 2015 variable dividend.
The future cash requirements associated with ARX’s redeemable noncontrolling interest, including Progressive’s call rights and minority shareholders’ put rights exercisable by the end of the second quarter of 2021.
The adequacy and collectability of catastrophe and other reinsurance, particularly for ASI’s Florida, Texas, and other catastrophe-exposed property business.
The effect of the higher debt balance, variable-rate ARX obligations, and future principal repayments on capital deployment and liquidity.