Business Context and Reporting Period
The Progressive Corporation, an insurance holding company, filed an unaudited Form 10-Q for the quarter and six months ended June 30, 2014. Its principal businesses are Personal Lines insurance, Commercial Lines insurance, run-off indemnity operations, and insurance-related services.
Key Financial Metrics
| Metric | Three Months Ended June 30 | Six Months Ended June 30 |
|---|---|---|
| Net premiums earned | $4,513.5 million, up 6% | $8,915.8 million, up 5% |
| Total revenues | $4,741.5 million, up 3% | $9,449.1 million, up 5% |
| Income before taxes | $437.4 million, down 10% | $919.2 million, down 3% |
| Net income | $293.4 million, down 10% | $614.7 million, down 3% |
| Diluted EPS | $0.49, down 8% | $1.03, down 2% |
| Underwriting profit | $332.3 million, up 16% | $622.1 million, up 3% |
| Total underwriting combined ratio | 92.6%, versus 93.3% | 93.0%, versus 92.9% |
| Operating cash flow | Not separately provided | $1,041.2 million, versus $1,137.2 million |
Net realized gains on securities were $40.4 million in the quarter and $159.8 million year to date, compared with $132.9 million and $213.5 million, respectively, in the prior-year periods. This decline was the primary reason net income decreased despite stronger underwriting results. Net investment income, after investment expenses, was $93.2 million in the quarter and $192.4 million year to date, down from $97.8 million and $193.4 million.
Comprehensive income increased to $381.0 million in the quarter and $701.9 million year to date, reflecting substantial increases in unrealized investment gains. Net unrealized securities gains included in accumulated other comprehensive income were $1,035.3 million at June 30, 2014.
Underwriting and Operating Performance
- Net premiums written increased 5% in both the quarter and first six months. Personal Lines premiums written increased 6% in both periods, while Commercial Lines increased 5% in the quarter and 3% year to date.
- Policies in force increased 3% year over year for Personal Lines to 13.36 million. Direct auto policies increased 7%, Agency auto was approximately flat, and Commercial Lines policies decreased 2%.
- Personal Lines underwriting profit was $258.6 million in the quarter and $508.2 million year to date. Its combined ratio was 93.6% and 93.7%, compared with 93.3% and 92.6%.
- Commercial Lines underwriting profit improved to $78.4 million in the quarter and $119.3 million year to date. The combined ratio improved to 82.5% and 86.5%, from 92.7% and 94.6%, primarily due to rate increases, lower frequency, and favorable reserve development.
- Catastrophe losses were $129.8 million in the quarter and $139.0 million year to date, compared with $83.4 million and $129.6 million in the prior-year periods.
- Personal auto severity increased approximately 2% to 4% year over year, while accident frequency was flat in the quarter and increased approximately 4% year to date.
Balance Sheet, Debt, and Liquidity
| Balance Sheet Item | June 30, 2014 | December 31, 2013 |
|---|---|---|
| Total assets | $25,452.7 million | $24,408.2 million |
| Investment portfolio at fair value | $18,759.2 million | $18,054.7 million |
| Cash | $126.1 million | $75.1 million |
| Loss and LAE reserves | $8,639.9 million | $8,479.7 million |
| Debt carrying value | $2,208.0 million | $1,860.9 million |
| Shareholders’ equity | $6,789.2 million | $6,189.5 million |
Progressive issued $350 million of 4.35% Senior Notes due 2044 in April 2014, receiving approximately $345.6 million of net proceeds. Total capital, defined as debt plus equity, was approximately $9.0 billion at June 30, 2014, versus $8.1 billion at December 31, 2013. Debt-to-total-capital was 24.5%, compared with 23.1% at year-end 2013.
Operating activities generated $1.0 billion of cash in the first half. Investing activities used $314.2 million, and financing activities used $677.2 million, including $892.6 million of dividends and $140.0 million of share repurchases. Cash increased by $51.0 million from year-end. The company had no borrowings under its $100 million discretionary line of credit and stated that available capital, operating cash flow, and borrowing capacity were sufficient for expected needs.
Material Changes Versus Prior Comparable Period
- Revenue and premiums grew, but net income declined because investment realized gains were substantially lower.
- Underwriting profit increased, led by a significant improvement in Commercial Lines, while Personal Lines profitability weakened year to date, particularly in the Direct channel.
- The total portfolio grew to $18.8 billion, with common equity fair value increasing from $2.2 billion at June 30, 2013 to $2.4 billion. Short-term investments also increased materially, while fixed maturities decreased.
- Gross unrealized investment losses declined to $30.6 million from $146.7 million at June 30, 2013. No OTTI losses were recorded in 2014 periods presented, compared with $1.6 million in the quarter and $1.8 million year to date in 2013.
- Operating cash flow declined year over year, while dividends paid increased substantially because the company paid both the annual variable dividend and a $1.00 per share special dividend in February 2014.
- Share repurchases totaled $140.0 million for the first half, covering 5.7 million shares. Approximately 25.3 million shares remained under the repurchase authorization at June 30.
Guidance, Outlook, Risks, and Unusual Items
- The filing does not provide formal earnings guidance. Management states a long-term objective of achieving an underwriting combined ratio of 96 or better; reported combined ratios were below that target in the quarter and first half.
- For 2014, the Board established a target annual variable dividend equal to 33⅓% of after-tax underwriting income, subject to a Gainshare factor and other limitations. The year-to-date Gainshare factor was 1.35, but the final factor and dividend remain subject to full-year results and Board discretion.
- Management expects to construct 5 to 10 new Service Centers over the next four years, at an estimated cost of $4 million to $6 million per center excluding land, funded through operating cash flow.
- Progressive identified risks from catastrophe losses, inflation, claim frequency and severity, medical and repair costs, reserve estimation, rate approvals, competition, investment-market and interest-rate movements, credit deterioration, litigation, regulation, technology and data-security failures, and reliance on third-party systems.
- Pending lawsuits include matters involving medical and injury claims, policy documents, auto repair labor rates, wage-and-hour issues, and other claims and marketing practices. Accruals for non-policy-claim litigation were not material, but management stated that an adverse outcome or inadequate accruals could materially affect results.
- The investment portfolio included $4.3 billion of asset-backed securities, including home-equity and Alt-A exposures, and $750 million notional of open interest-rate swaps. The portfolio’s duration was 1.6 years and its weighted-average fixed-income credit quality was AA-.
- Two properties held for future Service Centers were classified as held for sale, with a recorded value of $13.4 million at June 30, 2014.
Important Facts for Investors to Verify
- Whether premium and policy growth can continue while new applications and Commercial Lines policy counts are declining in some channels.
- Whether Personal Lines loss severity, frequency, catastrophe losses, and unfavorable prior-year reserve development improve or worsen.
- Whether Commercial Lines’ unusually strong 2014 margin is sustainable after favorable reserve development and recent rate actions.
- The sensitivity of earnings and shareholders’ equity to changes in interest rates, equity markets, credit spreads, and valuation of structured securities.
- The final 2014 Gainshare factor and annual variable dividend, which were not determinable at the reporting date.
- Future realized investment gains and losses, which materially affected the difference between underwriting performance and reported net income.