The Rational Walk
Intelligent Investing is not a "Random Walk"

What Does Buffett’s Valuation of GEICO Imply for Progressive? March 6, 2011

Note to Readers:  On March 1, 2011, The Rational Walk published a comprehensive report, Berkshire Hathaway: In Search of the Buffett Premium, which examines the intrinsic value of Berkshire in great detail.  Order the report for immediate electronic delivery, or download our free 22 page sample (pdf) — there is no registration required for the sample.

Warren Buffett provided an unusual level of insight into his views regarding Berkshire Hathaway’s intrinsic value in his latest letter to shareholders which we discussed in more detail when it was released last week.  While Mr. Buffett gave us his views of Berkshire’s normalized earnings power along with several other guideposts to his thinking on Berkshire’s intrinsic value, he did not present a specific estimate.  However, he came extremely close to doing so in the case of GEICO.  In this article, we will take a look at Mr. Buffett’s comments on GEICO and potential implications for the intrinsic value of Progressive, GEICO’s most fierce competitor.

Examining GEICO’s Economic Goodwill

Mr. Buffett’s letter describes his personal experience with GEICO over the past sixty years as well as the terms of Berkshire’s investments in the company.  In 1996, Berkshire purchased the 50 percent of GEICO that it did not already own for $2.3 billion implying a value of $4.6 billion for 100 percent of GEICO.  At that time, GEICO had tangible net worth of $1.9 billion which means that Berkshire valued GEICO’s goodwill at $2.7 billion.  Berkshire effectively paid 2.4 times tangible book value which was considered a high valuation at the time.

In the letter, Mr. Buffett elaborates on how he thought about the $2.7 billion of goodwill at GEICO in 1996 and how he views GEICO’s goodwill today:

The excess over tangible net worth of the implied value – $2.7 billion – was what we estimated GEICO’s “goodwill” to be worth at that time. That goodwill represented the economic value of the policyholders who were then doing business with GEICO. In 1995, those customers had paid the company $2.8 billion in premiums. Consequently, we were valuing GEICO’s customers at about 97% (2.7/2.8) of what they were annually paying the company. By industry standards, that was a very high price. But GEICO was no ordinary insurer: Because of the company’s low costs, its policyholders were consistently profitable and unusually loyal.

Today, premium volume is $14.3 billion and growing. Yet we carry the goodwill of GEICO on our books at only $1.4 billion, an amount that will remain unchanged no matter how much the value of GEICO increases. (Under accounting rules, you write down the carrying value of goodwill if its economic value decreases, but leave it unchanged if economic value increases.) Using the 97%-of-premium-volume yardstick we applied to our 1996 purchase, the real value today of GEICO’s economic goodwill is about $14 billion. And this value is likely to be much higher ten and twenty years from now. GEICO – off to a strong start in 2011 – is the gift that keeps giving.

Although a careful parsing of the statement shows that Mr. Buffett does not explicitly state that GEICO’s economic goodwill is $14 billion, it is strongly implied that using the “97%-of-premium-volume yardstick” is just as appropriate today as it was in 1996 when Berkshire acquired full control of GEICO.  Some analysts may question whether this is the case given that GEICO today has a much higher market share than it had in 1996 and presumably growth prospects from today’s levels might be slower.

Implied Value of GEICO:  $20.5 Billion

We do not have individual balance sheets for all of Berkshire’s insurance subsidiaries but GEICO publishes selected financial information based on statutory accounting rules, which generally presents a more conservative picture of a company’s net worth when compared to GAAP accounting.  According to data on GEICO’s website, policyholders’ surplus was approximately $6.5 billion as of December 31, 2010.  The policyholders’ surplus figure should be free of intangibles at this point (see this report for some information on statutory accounting and goodwill).  Therefore, if GEICO’s goodwill is worth $14 billion, it follows that the company as a whole is worth approximately $20.5 billion based on Mr. Buffett’s valuation methodology.

Implications for Progressive

We have periodically followed Progressive on The Rational Walk mainly because of the fierce competition between GEICO and Progressive but also because the companies are so similar in terms of performance over the years.  If Mr. Buffett loves GEICO, it is quite likely that he also admires Progressive’s performance.  In The Rational Walk’s recent report on Berkshire, In Search of the Buffett Premium, we include an appendix comparing GEICO and Progressive.  The following exhibit is taken from the report:

The similarities between the companies are striking particularly when viewed from the perspective of very consistent underwriting profits over the past decade.  Over the 1999 to 2010 period, GEICO grew premiums earned at a 10.5 percent rate while Progressive grew premiums at a 8.8 percent rate.  The average combined ratio was 93.6 for GEICO and 92.3 for Progressive.  In general, GEICO posted lower expense ratios while Progressive posted lower loss ratios in most years.  In 2010, earned premiums were very similar for GEICO and Progressive and underwriting results were almost identical.

We have not performed a thorough valuation of Progressive, but it does not seem too far of a stretch to consider the implications of Mr. Buffett’s views on GEICO’s intrinsic value on Progressive given the similarities between the two companies.

As of December 31, 2010, Progressive had tangible equity (based on GAAP) of $6,049 million.  If we use the “97%-of-premium-volume yardstick” to estimate Progressive’s economic goodwill, this results in a goodwill estimate of $13,886 million.  The total intrinsic value estimate would be $19.9 billion, or slightly over $30 per share.  Progressive’s market capitalization as of Friday, March 4 was $13.78 billion, or $20.88 per share.

Jumping to Conclusions?

Are we safe in assuming that Mr. Buffett would value Progressive in the same manner as he values GEICO?  Possibly not since he could believe that GEICO has important advantages over Progressive that will result in a higher level of growth going forward.  Past history would suggest that GEICO appears to be able to grow at a somewhat higher rate than Progressive while also maintaining excellent combined ratios.  Perhaps this is due to important competitive advantages emanating from a higher level of goodwill at GEICO compared to Progressive.

However, we can also look at Progressive’s valuation from another perspective.  Using the market value of $13.78 billion, implied economic goodwill assigned by the market is currently $7.73 billion.  As a percentage of last year’s earned premiums, economic goodwill is currently at a “54%-of-premium-volume yardstick” as compared to the “97%-of-premium-volume yardstick” that Mr. Buffett used in 1996 to value GEICO and appeared  to endorse as being equally relevant today.  It would appear that Progressive’s  track record is strong enough to justify a higher valuation if we use Mr. Buffett’s methodology even if Progressive’s position is not quite as strong as GEICO’s.

We should stress that a $19.9 billion valuation for Progressive would be quite aggressive at nearly 3.3 times tangible book value.  In addition, we are not stating that Progressive is worth $19.9 billion at this time, having not performed sufficient due diligence on the company to make such an assertion.  Instead, we are simply making the observation that Warren Buffett’s valuation of GEICO seems to imply that he would regard Progressive as undervalued if he views Progressive and GEICO as having similar economic characteristics.  Of course, he never made any such statement.  But the inference is, at the very least, interesting and warrants further study of Progressive.

Disclosure:  Long Berkshire, No Position in Progressive.

J.D. Power Releases Auto Insurance Customer Satisfaction Survey August 3, 2010

The criteria for selecting an auto insurer involves some of the same factors one must consider when selecting a dentist.  It may be very tempting to go with the low bid when selecting a dentist to clean your teeth, but that may not be the best decision when facing a root canal.  Similarly, buying auto insurance is normally a decision based entirely on the premium cost until an accident makes it necessary to file a claim.  Only then will a policyholder know if a discounted insurance policy was a wise decision.

J.D. Power released its 2010 U.S. National Auto Insurance Study (pdf) today and found that overall consumer satisfaction with insurance companies declined in 2010 after peaking in 2009.  Overall satisfaction averages 777 on a 1,000 point scale which represents a decrease of ten points from 2009.  The study measures consumer satisfaction across five factors:  interaction, policy offerings, billing and payment, price, and claims.  The main factor that led to the 2010 decline in satisfaction was due to price increases, which were reported by 22 percent of customers.

According to the survey, Berkshire Hathaway’s GEICO subsidiary ranked #6 with a score of 793.  Progressive, GEICO’s most aggressive rival, ranked #13 at 775, just slightly below the average ranking.  J.D. Power provides a sortable table that shows which insurers rank the highest for each of the five factors considered in the survey.  The highest ranked insurer was Amica Mutual with a score of 849.

Auto insurance is a non-discretionary purchase that all drivers are legally required to make and price is always going to be a key factor.  However, the survey also revealed that service and the ability to talk to an agent can be important considerations for baby boomers.  Older drivers may prefer the traditional agent relationship offered by insurers such as State Farm while younger drivers tend to be more comfortable with insurers emphasizing a heavy internet presence and a direct sales model such as GEICO and Progressive. Of course, the key test for policyholders who end up in an accident is the quality of the claims process – the equivalent of a botched root canal for drivers who select the wrong insurer.

Disclosure:  The author of this article owns shares of Berkshire Hathaway.

Progressive Offers Discount Based on Driver Monitoring July 26, 2010

Progressive has introduced a new discount program designed to offer lower auto insurance premiums to drivers who have favorable risk profiles.  The idea of offering discounts to drivers who do not use their cars for commuting or drive very rarely is nothing new.  Auto insurers have been surveying customers for years regarding such habits.  However, Progressive’s new program is not based on subjective self reporting by policyholders.  The company will monitor driver behavior using an electronic device.

Progressive’s new program, named “Snapshot Discount”, is voluntary and involves installing an electronic device in the policyholder’s car.  This device connects to the car’s computer system and stores information regarding how the vehicle is operated.  Factors such as overall mileage, time of operation, and driver habits are stored in the device.  After thirty days, the customer will be informed whether a discount will be offered.  The device does not have GPS capabilities in order to address privacy concerns.

The company has stated that the program will not cause a customer’s rate to increase, but it is unclear whether customers are going to be willing to take that risk.  Presumably, the device will be capable of detecting dangerous driving, or even driving that is perceived to be dangerous but might not be.  For example, traffic conditions sometimes legitimately require evasive maneuvers that could be interpreted as dangerous driving.  Progressive may have measures in place to only detect habitual patterns of dangerous driving, but the methodology is not transparent.

Insurance companies attempt to achieve underwriting profitability by setting premiums at a level that can cover underwriting losses as well as overhead expenses.  At the same time, insurers are interested in expanding market share.  These goals can often conflict since aggressively growing market share requires lower premium pricing which can lead to higher loss ratios.  To the extent that Progressive can identify the safe drivers and set premium levels aggressively for only those drivers, market share gains may be possible without compromising underwriting profitability.

Progressive’s latest discount program makes a great deal of sense but whether customers are willing to overcome the “big brother” aspect of plugging in a monitoring device remains to be seen.

Disclosure:  The author does not own shares of Progressive.

A Look at Progressive’s Loss Estimation Accuracy March 8, 2010

Progressive

Last week, we took a brief look at Berkshire Hathaway’s loss estimation accuracy over the past ten years.  As we noted in the article, the process of estimating the ultimate losses resulting from an insurance company’s business is one of the most important tasks facing management.  In the case of Berkshire Hathaway, many types of policies expose the company to liabilities that will develop over a very long period of time.  Therefore, the ultimate payout to policyholders can vary significantly from management’s original estimate and may not be known for decades.

Auto Insurance and Short Tails

One of Berkshire Hathaway’s insurance subsidiaries is GEICO, a company engaged primarily in providing private automobile insurance in the United States.  Auto insurance losses generally have a “short tail” which means that losses tend to be reported quickly and paid out to policyholders.  Berkshire Hathaway only reports loss estimate development for all of its insurance subsidiaries in aggregate.  Since many Berkshire reinsurance operations write policies with “long tails”, estimation error is more likely to be seen in a consolidated summary of loss development than if we were to look only at a company such as GEICO in isolation.

Progressive’s Loss Estimates:  1999 to 2009

It may be interesting to take a brief look at a “pure play” auto insurer to see how the loss triangle table would look for an insurance company focusing on “short tail” coverage.  In theory, the accuracy of initial estimates should be fairly high and could be expected to develop fully within a couple of years in contrast to the experience of a typical reinsurer.

Progressive’s 2009 annual report was filed last week and contains data on loss estimation accuracy for 1999 to 2009.  The table shown below provides a summary (figures in millions, click on the image for a larger view):

One interesting aspect of the earlier years is that even when we see that the variance between the original loss estimate and the ultimate figure is large, the amount of the error is mostly known within a few years.  For example, in 2004 the original loss estimate of $4,949 million turned out to be higher than necessary.  However, the discrepancy was recognized very quickly.  By the second year after the original estimate was made, the revised estimate was very close to the current estimate.

While we cannot see GEICO’s results presented in such a granular format within Berkshire Hathaway’s annual report, it is very likely than loss development follows a similar pattern.  Management may still make relatively large errors when the initial loss estimates are calculated, but any errors are likely to be corrected within a short period of time.  In contrast, management estimates for reinsurance covering claims associated with asbestos health damage may only develop over many decades.  In such cases, any estimation problems may remain undetected for very long periods of time.

The lesson to be drawn may be obvious for insurance industry veterans, but is nonetheless worth pointing out:  Loss estimates for very long tail insurance is inherently less accurate than for short tail insurance.  Furthermore, it may be years or even decades before you know whether a mistake has been made.  It is useful to keep this in mind when analyzing insurance companies.

Disclosure:  The author has no position in Progressive. The author owns shares of Berkshire Hathaway and is the author of The Rational Walk’s Berkshire Hathaway 2010 Briefing Book which provides a detailed analysis of the company along with estimates of intrinsic value.

GEICO May Soon Surpass Progressive’s Market Share January 23, 2010

Flo and the Gecko

It’s war on the television screen.  On one side you have GEICO’s Gecko and the famously maligned Caveman.  On the other side is Flo, the hyper enthusiastic Progressive sales clerk.  It’s hard to escape these characters during sporting events or prime time as they try to win market share through a combination of amusing brand building characters and claims of lower prices.

Which company is gaining the upper hand?

GEICO is a subsidiary of Berkshire Hathaway and investors can monitor the company’s progress through Berkshire’s quarterly financial statements.  Progressive is a publicly traded company where one can gain greater insights into financial results through monthly financial releases.

Last year, we presented a ten year comparison between GEICO and Progressive to see if any trends could be identified regarding underwriting results or market share.  (Note:  Since underwriting results and investment results should be evaluated separately, we focused only on underwriting results.)

From this study, we could see that over the ten year period GEICO generally had a slightly higher growth rate in premiums earned, a higher loss ratio, and a significantly lower expense ratio.  This led to the observation that GEICO has been able to gain market share in recent years by offering lower premiums (leading to higher loss ratios) while maintaining higher underwriting profitability over the past few years due to tight controls on expenses, as reflected in the lower expense ratio.

2009 Results

GEICO

Since Berkshire Hathaway’s annual report has not been released yet, we only have GEICO’s results through the first nine months of the year based on Berkshire’s Q3 report. GEICO had $10,103 million in net premiums earned, which is up 9% from the first nine months of 2008.  The loss ratio was 77.2 and the expense ratio was 18.3 which results in a combined ratio of 95.5.  Pre-tax underwriting profits for the first nine months of 2009 came in at $459 million.

Progressive

Progressive recently published financial results for December which also includes figures for the full year.  The company reported $14,012.8 million in net premiums earned, which is up almost 3% from 2008.  The loss ratio for the year was 70.7 and the expense ratio was 20.9 for a combined ratio of 91.6.  Pre-tax underwriting profits came in at $1,175.6 million for the year.

For comparative purposes, for the first nine months of the year we can examine Progressive’s results for September.  The company reported $10,293.4 million in net premiums earned, a loss ratio of 70.5, an expense ratio of 21.1, and a combined ratio of 91.6 for the first nine months of 2009.  Pre-tax underwriting profits for the first nine months of 2009 came in at $859.6 million.

GEICO Aims for Market Share

From looking at the data presented above, it would appear that GEICO has made a decision to take a more aggressive stance on pricing which has resulted in increasing market share but at the expense of a higher loss ratio.  For the first three quarters of 2009, GEICO nearly matched Progressive in terms of premiums earned and was growing premiums at a much faster rate than Progressive.

The higher loss ratio would suggest that GEICO is competing on price.  In addition, GEICO’s expense ratio for the first nine months of 2009 was 18.3 compared to 17.9 for 2008 which could indicate a more aggressive advertising strategy.

While we will not know for certain until Berkshire Hathaway publishes the 2009 annual report next month, it looks likely that GEICO may surpass Progressive in terms of net premiums earned for 2009 if the trends established during the first nine months of the year persisted into the fourth quarter.

The price of gaining this market share is a lower level of profitability compared to Progressive, at least in the short run.  However, since insurance is a product that has high switching costs given the hassle involved in changing insurance companies, GEICO may be able to retain the gains in market share even if they become slightly less aggressive on pricing going forward.  Generally, consumers are not going to be motivated to change auto insurance companies unless the savings is more than trivial.

Most Effective Ad Campaign?

So who is more effective:  Flo or the Gecko?  Take our poll and register your opinion.

Disclosure: The author owns shares of Berkshire Hathaway. No position in Progressive.