What Makes This Insurer Special?
Ted is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.
The best way to beat the market is to wait for great businesses to get cheap and then go all in. But in order to execute this strategy, you first have to identify great businesses. Great businesses are special; there's something unique about them that sets them apart from would-be competitors. In this article, I'm going to talk about what makes Progressive (NYSE: PGR) a special business.
Superior Business Model
In most states, motorists are required by law to have liability insurance for their automobiles. Many motorists go above the requirement by purchasing additional auto insurance. This is a nice feature of the insurance industry, but it doesn't set Progressive apart from the others.
What makes Progressive special is its direct-to-consumer marketing model. Most insurers do not have TV commercials with "Flo" or the GEICO gecko. Most insurers sell their products through agents, which sell to the consumers in their respective markets. Agents are an expensive middleman that serve as a significant drag on margins.
Since 2002, Progressive's cost of acquiring policyholders and other expenses have averaged 16.1% of premiums written. Meanwhile, Travelers (NYSE: TRV) averaged 17.9% and Mercury General (NYSE: MCY) averaged 21.3%. So, while Traveler's and Mercury General have much lower advertising costs than Progressive, the fees they pay to agents far exceed the cost to simply market directly to consumers.
This cost advantage is important in an industry that sells a commodity product -- and therefore competes on price. Because it sells directly to consumers, Progressive can underprice its competitors and still earn a profit.
In addition, Progressive is on the leading edge when it comes to policy underwriting. The company has earned an underwriting profit in each of the last 10 years. In fact, it consistently earns a much higher underwriting margin than most of its peers. This is made possible by Progressive's innovative risk segmentation -- a fancy way of saying the company is good at finding new ways to identify and price risk factors.
So, Progressive acquires policies for less and earns a higher profit on its policies than its competitors. This sounds like a special business to me.
Travelers is a large property and casualty insurer. It not only sells auto insurance, but also homeowners and specialized insurance. But they key difference is that it sells its products through a large network of brokers and agents. This makes it more expensive to sell its products despite its enormous size. Travelers is starting to market directly to consumers, which should help boost margins. However, the agent model is so ingrained in the company that it will be hard to match Progressive any time soon.
Mercury General specializes in low-cost auto insurance primarily in California. It sells bare-bones policies: policies that include just enough insurance to make motorists compliant with state law. The company markets its products exclusively through its agent network, with which it has a long and close relationship. This makes it unlikely that the company will ever change its model to the less expensive direct-to-consumer model that Progressive uses. In addition, Mercury's expansion into markets outside of California has been abysmal. Needless to say, Progressive does not have to worry about competition from Mercury any time soon.
It's important to remember that great businesses selling at high prices make terrible investments. Progressive is not selling for a really high price, but it's not selling for a really low price either. If you are patient and wait for great businesses to sell at great prices, you will almost certainly outperform the vast majority of professional money managers.
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