Executive Summary
In this assignment we looked the accounts of Progressive insurance, a US P&C insurance company. We then continued to estimate the weighted average cost of capital getting to the figure of 6.97%.
Company profile
Industry
Property and casualty insurance is a type of insurance which covers risks related to loss or damage of property. This type of insurance has two major areas: protection of physical objects and protection against legal liability. The first area offers protection for physical objects, such as houses, cars or valuable personal belongings. Protection against legal liability covers damage caused to someone else’s property or to compensate a third party due to a legal liability. Property insurance is referred as “first-party” coverage, considering that it is related to the policyholder’s property, while casualty insurance can be defined as “third-party” coverage.
In total, the value of gross premiums written by the U.S. property and casualty insurance sector amounted to approximately 564.14 billion U.S. dollars in 2013. In 2014, 36% of the U.S. P&C premiums were written by private passenger auto insurance companies.
The regulatory system in the use is a state-based insurance regulation system, each state operates independently to regulate their own insurance markets, typically through a state department of insurance. The state regulatory system has been described as cumbersome, redundant, confusing and costly
Main financial results and lines of business
Progressive trades in personal lines coverage only, mainly auto and vehicle insurance. They provide property and liability motor insurance. Progressive does not offer commercial lines insurance but acts as a broker for life and home insurance. One of Progressive’s flag ship products is snapshot, snapshot is a usage based insurance program which prices insurance differently and personalizes insurance rate based on your actual driving unlike typical car insurance rates that are based on a variety of factors related to driving history or the histories of drivers who are similar.
These are Progressive’s main current financial results:
- Premiums $22.69B
- Profit - $1.2B
- EPS $1.67
- Dividend yield - 2%
- Loss Ratio - 89%
Main competitors
Progressive’s main competitors in the american P&C insurance industry are:
- GEICO.
- Allstate.
- Travelers.
- Liberty mutual.
Comparables
Criterias for comparable companies
Main criteria for comparable in my opinion are companies selling similar products and of similar size and market share. In this case I can also find companies who are in the same market geographically as well. The competitors written above can be used as comparable companies.
Since GEICO is a subsidiary of Berkshire Hathaway we can only have their consolidated reports. Also, Liberty Mutual is a mutual (owned by policy holders) so we will only use Allstate and State Farm as comparable.
We can use the comparable to evaluate the value of a company (or of it’s debt) using the metrics of other businesses of similar size in the same industry. This analysis operates under the assumption that similar companies will have similar valuation multiples. For this reason we compiled the table of financial metrics below.
Since our company is publicly traded we have all the relevant financial information we need, we can estimate it’s weighted average cost of capital based on it’s current data.
Financial comparison
| Progressive |
22.69B |
1.26B |
1.67 |
0.1225 |
36.97 |
21.06B |
0.93 |
36.35 |
| Travelers |
27.09B |
3.49B |
10.39 |
0.1212 |
26.33 |
33.5B |
1.27 |
117.80 |
| Allstate |
35.95B |
2.17B |
3.69 |
0.0736 |
24.41 |
27.32B |
1.00 |
74.12 |
It can be seen that Allstate has the largest market share and that Travelers showed the highest profitability. They all have fairly similar gearing ratios and much higher than Israeli insurance companies that we saw in assignment 2.
Capital Structure
Equity
The market cap of a company is the market value of a the share (36.54) times the number of shares (583,600,000) resulting in the market cap of $21.32B.
Debt
We will take the book value from the balance as a proxy for the value of the debt. Progressive’s long term debt is $2,707,900,000. There is no Short/Current long term debt at the moment.
Estimating the systemic risk coefficient
We will estimate Progressive’s \(\beta\) using the following relationship: \[R_{i}=\alpha+\beta R_{m}\]
# Loading Necessary libraries
library(quantmod)
library(zoo)
library(tseries)
library(dplyr)
library(dygraphs)
library(knitr)
library(formattable)
library(ggplot2)
library(plotly)
library(readxl)
# Function to calculate monthly returns on a stock
monthly_stock_returns <- function(ticker, start_year) {
# Download the data from Yahoo finance
start_year <- paste(start_year,"-01-01",collapse = "",sep="")
symbol <- getSymbols(ticker, src = 'yahoo', from = start_year,
auto.assign = FALSE, warnings = FALSE)
# Tranform it to monthly returns using the periodReturn function from quantmod
data <- periodReturn(symbol, period = 'monthly', type = 'log')
# Let's rename the column of returns to something intuitive because the column
# name is what will eventually be displayed on the time series graph
colnames(data) <- as.character(ticker)
return(data)
}
Data is downloaded at a daily price rate. The log of the ratio of the adjusted closed price of each month is then used to calculate the monthly returns. This function builds upon the quantmod R package. I used the same function as in assignment 1.
It is a question what time period to select for estimating the systemic risk coefficient. P&C is a seasonal business due to the underwriting cycle. The underwriting cycle is the tendency of property and casualty insurance premiums, profits, and availability of coverage to rise and fall with some regularity over time.
A cycle begins when insurers tighten their underwriting standards and sharply raise premiums after a period of severe underwriting losses or negative stocks to capital (e.g., investment losses). Stricter standards and higher premium rates lead to an increase in profits and accumulation of capital. The increase in underwriting capacity increases competition, which in turn drives premium rates down and relaxes underwriting standards, thereby causing underwriting losses and setting the stage for the cycle to begin again.
P&C insurance companies stock returns are linked to the cycle but the S&P 500 isn’t. I chose the period of 2011 until now with a hope the it is long enough time period to even out the effect of the cycle.
# get data
prog <- monthly_stock_returns("PGR","2011")
sp500 <- monthly_stock_returns("^GSPC","2011")
# running regression
capm_prog <- lm(prog~sp500)
# results
betas <- coef(capm_prog)
names(betas) <- c("alpha","beta")
\[\alpha_{prog}=0.001\] \[\beta_{prog}=0.79\]
During the selected period, Progressive didn’t show any excess returns over the S&P 500 index. We can see that \(\beta_{prog}\) is not far from 1 as we could have guessed from assignment 2.
Estimating the required rate of return on equity
We will use the following relationship in order to get our company specific cost of capital: \[r_{i}=r_{f}+\beta_{i}(r_{m}-r_{f})\]
For the market return we will use the 5 year average return on the S&P 500.
For the risk free rate I will use the yield from Jan 19th on a 20 year US treasury bond.
rm <- (1+mean(monthly_stock_returns("^GSPC","2011")))^12 - 1
# Calculating the Cost of Equity
rf <- 0.0277
cost_equity <- rf+0.79*(rm-rf)
\[cost \ of \ equity=8.66\%\]
prog <- (1+mean(monthly_stock_returns("PGR","2011")))^12 -1
The 5 year average yearly return of progressive was 10%.
Comparing with gordon model:
\[P=\frac{D}{r-g}\] The Gordon model is a method of valuing a company’s stock price based on the theory that its stock is worth the sum of all of its future dividend payments, discounted back to their present value. We will use the share holders required return on equity as the discount rate.
The variables are:
- \({\displaystyle P}\) is the current stock price - will use this to try to verify our cost of equity.
- \({\displaystyle g}\) is the constant growth rate in perpetuity expected for the dividends - will use 4%. Since the past average yield rate was 2% and the expected rate is 2.44% which gives a 4% growth per year.
- \({\displaystyle r}\) is the constant cost of equity capital for that company - from our model.
- \({\displaystyle D}\) is the value of the next year’s dividends - expect to be 0.89 per share.
\[P=\frac{D}{r-g}=\frac{$0.89}{8.56\%-4\%}=$19.38\] Actual price is currently at $36.38 …..
Estimating the required rate of return on debt
In order to find the cost of debt for Progressive I extracted from Bloomberg all the data regarding bonds that it issued. We will calculate the cost of debt as the Bond issue amount weighted average of the yield to maturity. Since the $614.4M series has a floating coupon rate will exclude it from our analysis. Under the assumption that the characteristics of different debt insturments issued by the same company are similar, the effect of a bias to the estimated cost of debt will be minor.
Listing of all bonds issues by Progressive:
| Progressive Corp Ohio |
6/15/2067 |
50 |
614.4 |
99.1 |
6.700 |
FRN |
No |
— |
| Progressive Corp Ohio 3.75% |
8/23/2021 |
4 |
500.0 |
105.8 |
3.750 |
Fixed |
No |
2.42 |
| Progressive Corp Ohio 2.45% |
1/15/2027 |
10 |
500.0 |
93.1 |
2.450 |
Fixed |
No |
3.27 |
| Progressive Corp Ohio 6.25% |
1/12/2032 |
15 |
400.0 |
122.5 |
6.250 |
Fixed |
No |
4.28 |
| Progressive Corp Ohio 3.7% |
1/26/2045 |
28 |
400.0 |
95.3 |
3.700 |
Fixed |
No |
3.98 |
| Progressive Corp Ohio 4.35% |
4/25/2044 |
27 |
350.0 |
102.4 |
4.350 |
Fixed |
No |
4.2 |
| Progressive Corp Ohio 6.625% |
1/3/2029 |
12 |
300.0 |
127.4 |
6.625 |
Fixed |
No |
3.78 |
| Progressive Corp Oh 8.75% |
1/3/2017 |
0 |
0.0 |
— |
8.750 |
— |
No |
— |
The estimated cost of debt calculated as the Bond issue amount weighted average of the yield to maturity is 3.58%.
WACC
Effective tax rate
Since Progressive trades in many different states and due to the fact that each state might have a different tax rate we need to calculate the effective tax rate. We will define the effective tax rate as Income Tax Expense divide by Income before tax. In our case it will be \[\frac{611,100}{1,911,600}=32\%\]
WACC Calculation
We will use the following equation in order to calculate the WACC for progressive: \[WACC=\frac{D}{D+E}\cdot r_{d}\cdot(1-_{tc})+\frac{E}{D+E}\cdot r_{e}\]
In our case it will be: \[\frac{2,707,900}{2,707,900+7,289,400}\cdot3.58\%\cdot(1-0.32)+\frac{7,289,400}{2,707,900+7,289,400}\cdot8.66\%=\fbox{6.97%}\]