Progressive Corp

NYSE:PGR

Earnings Call Transcript 2019-Q1

[Operator]

Welcome to The Progressive Corporation's First Quarter Investor Event. The company will not make detailed comments related to quarterly results in addition to those provided in its Annual Report on Form 10-Q and the letter to shareholders, which have been posted to the company's Web site and will use this event to respond to questions after a prepared presentation by the company. This event is available via a moderated conference call line and a live webcast with a brief delay. Webcast participants will be able to view the presentation slides live or download them from the webcast slide.

Participants on the phone can access the slides from the Events pages at investors.progressive.com. In the event, we encounter any technical difficulty with the webcast transmission, webcast participants can connect through the conference call line. The dial-in information and passcode are available on the Events page at investors.progressive.com. Acting as a moderator for the event will be Julia Hornack.

At this time, I will turn the event over to Ms. Hornack.

[Julia Hornack, Investor Relations]

Thank you, Joel, and good afternoon to all. Today, we will begin with a presentation by two senior portfolio managers, Richard Madigan and Jonathan Bauer. That presentation will be followed by a Q&A with our CEO, Tricia Griffith; and our CFO, John Sauerland. Our Chief Investment Officer, Bill Cody will also join us by phone for Q&A. This event is scheduled to last 90 minutes.

As always, discussions in this event may include forward-looking statements. These statements are based on management's current expectations and are subject to many risks and uncertainties that could cause actual events and results to differ materially from those discussed during the event. Additional information concerning those risks and uncertainties is available on our 2018 annual report on Form 10-K, where you will find discussions of the risk factors affecting our businesses, Safe Harbor statements related to forward-looking statements and other discussions of the challenges we face. These documents can be found via the Investors page of our Web site at progressive.com.

It's now my pleasure to introduce our CEO, Tricia Griffith.

[Tricia Griffith, President and Chief Executive Officer]

Good afternoon and welcome to Progressive's first quarter webcast. We are delighted with our first quarter results growing net written premium 16% at 88.8 combined ratio, really great start to 2019 especially after several years of profitable growth.

Today's webcast is going to be a little bit different than what we have done in the past. We have focused the recent webcast on our operational strategies and how they help us make investments to ultimately achieve our vision.

Today, we're going to talk about the investments side of the house. Before we get into that I want to step back a little bit and just make sure we are all clear on our overall objective function and now it's for both the operating side of the business and the investment side of the business. We want to grow as fast as we can at or below at 96 combined ratio as long as we can service our customers.

The great news is, we have been achieving that goal many times over the last several years, 2016, we grew 2.8 and net written premium 2017 another 3.8, last year 5.4 and comparing quarter one of 2019 with quarter one of 2018, we've already grown nearly 1.3 billion. What that has made us a huge asset under management for our investment firm to invest of about $35 billion and of course premium flow is one of the input to our investment strategy.

Progressive Capital Management or PCM as you look here called today is based in Norwalk, Connecticut. It's a 13-member strong a small but mighty team.

It's first talk about overarching risk. We want to balance our operating risk with the risk of financing and investment activities to have sufficient capital to support all of the insurance we can possibly underwrite and service. Within that the PCM organization has three mandates, Jonathan will talk about this; Jonathan and Richard will both talk about this a little bit later in more detail.

The first one, protect the balance sheet. The second, achieve a strong risk-adjusted total return. And the third one, support the operating business as we think about future endeavors. I think about Horizon 3 that I shared with you before. We tend to be more conservative on the investment side because we have chosen to lever the operating franchise because we see it as our most durable means for a really strong ROE. Our comprehensive ROE is measured by a business profitability and capital efficiency.

This Slide gives you a sense of how we look at comprehensive income. This is the pre-tax basis and it is the past five years plus the first quarter of 2019. And each of the bars you will see several colors, the blue is underwriting profit, the orange is investment returns and the small sliver of gray are interest expenses.

As you can see, the investment part of our company is very important and that's why I thought it was important to share with you a little bit more about our philosophy today. As you can see for 2019, it's actually over 50% of our comprehensive income.

We don't have an exquisite comprehensive return on equity goal rather, it's the natural outcome of our operating goals, our investment mandate and our financial policy. So again, operating goal, grow as fast as we can into 96, investment mandate, have a strong total return on our investment; and our financial policies that we shared with you before and that is maintain a 3:1 premium to surplus and then have a contingency layer of capital for unforeseen things that could happen and then have no more than 30% of our total capital comprised of debt. When we have those three working together which we have for many, many years, we are able to earn an attractive comprehensive return on equity in excess of our capital structure.

So now I'm going to get to the heart of the matter and that is to introduce you to Richard and Jonathan. So, they both started out many years ago at PCM. They started out as analysts and quickly moved into the portfolio roles. They both report to Bill Cody who you've met before, so we thought it would be nice for you to meet two members of his strong bench.

Richard Madigan has his BA in Accounting from Boston College and his MBA from University of Chicago. He currently leads our structured product portfolio and he served on the strategy Council that we developed several years ago, and so works closely with Andrew as think about the future.

But first, I'm going to introduce to you Jonathan Bauer. He has his BA in Economics and Political Science from what we Ohioans call the school of North in Ann Arbor and he has his MBA from Columbia. He leads our corporate bond portfolio and he takes the initiative to think about technology strategies to make sure that PCM organization is efficient and effective.

[Jonathan Bauer, Portfolio Manager, Corporate Bonds]

Thanks Tricia.

Richard and I appreciate the opportunity to give you a more detailed understanding of who Progressive Capital Management is, what our strategy is and how do we fit into the larger organization. To start with, it's important to mention that we only manage the money of Progressive. We do not take in any outside funds as we believe it could distract from our core mission. As of March 31, 2019, we have 13 investment professionals who manage just under $35 billion in assets. That $35 billion is composed of $32 billion in fixed income and $3 billion of equities. We manage the fixed income portfolio on an active basis, while almost the entire equity portfolio is passively indexed to the Russell 1000 Index.

If you look back over the last 10 years, you can see a sharp increase in our assets under management, especially over the last three years. One of the benefits of investment management is the scalability of the business. As you can see, we have only added three members to the team even though our assets have more than doubled. However, that scalability does have limits, and as Progressive grows further, we will continue to make sure we have adequate resources.

Before we go any further, we thought it might be useful to review what the sources of our investment funds are. Starting at the bottom of Progressive's capital stack is our shareholders' equity which comes from the company's retained earnings. Next up is our preferred stock. Progressive issued $500 million of preferred stock in March of 2018 to support our operating growth. Above that, you can see our deck. Some of you on the call may have participated in our two issuances in 2018 as we came to market in both March and October.

Finally, the last two contributors to our investment portfolio, first is the float we make on premiums, next is the reserves we have in place in our insurance business. All of these funds flow up to our fixed income and equities portfolios. I would just point out that the size of these boxes on these slides are for illustrative purposes and are not the actual size of the category.

Now that we've talked about the sources and growth of our portfolio, let's talk about our investment returns and where you can find the components of our returns in our financial statements. We manage our portfolio on a total return basis. So, what encompasses that total return? First is recurring income. This flows through our operating income and comes from the interest income that we earn on our fixed income portfolio and the dividend income earned in our equity portfolio. This is one component of our total return.

Second on our slide is realized gains or losses on both portfolios as well as holding period gains and losses on equities. Now what does it mean for a gain to be realized or unrealized? We realize a gain when we sell a security at a price above where it was purchased. A gain is unrealized when a security is trading above the purchase price, but we have not sold again. As you can see, these gains and losses flow through our net income. I do want to point out that it was only last year in which holding period equity gains and losses started flowing through our income statement due to changes in accounting standards.

Moving on to the last component which is unrealized gains and losses on fixed income. This is not something that you would see on our income statement, but instead flows through our comprehensive income. As stated earlier, we measure ourselves by our total return, which encompasses income realized and unrealized gains on the fixed income portfolio.

I have mentioned earlier that we have 13 investment professionals. On this slide, you can see how we've structured the team. We have four individuals including Richard and myself who report up to Bill Cody, our Chief Investment Officer. The four individuals are broken up by corporate bonds, structured products, treasuries and short-term, and economics and financials. Beneath these four people, we have a team of portfolio managers and analysts who help to drive our strong performance. It's important to note that this is the current structure of the team. But as I will speak to you later in the presentation, rotation through different sectors is a core tenant of our investment philosophy.

While our team is small, that has not prevented us from achieving outperformance versus the overall market. While our compensation is not driven by outperformance of a benchmark, we thought it would be useful for demonstration purposes to compare us to the index that most closely matches our investment constraints. As you can see, there has been consistent outperformance on a three, five and 10-year basis. And on the following slides, I'll provide you some of the broad hallmarks of our group that we think have helped drive that outperformance.

We think there are certain aspects of our investment team that are unique compared with other fixed income investment managers. The first one, I would want to point out is our flexible mandate. As mentioned earlier, we measure our performance based on our total return. Therefore, our purchase and sale decisions are in no way influenced by the book yield of the security. We have the ability to purchase both high-grade and high-yield securities as long as we ensure that our overall portfolio rating does not drop below A plus. While we showed our performance versus an index on the previous slide, that was purely for illustrative purposes. Our security selection and asset class allocation are in no ways meant to match an index. Further, the size of our different portfolios whether they be corporates or mortgages are in no way fixed. So, we can adjust them based on the best opportunities that the market provides us.

As I mentioned earlier, a core tenant of our team is the rotation of analysts and portfolio managers through different sectors. So why do we do that; don't we give up a lot in terms of specialization? We think the rotation adds a significant amount of value to the organization. And in fact, this rotation is something similar to what occurs on the operating side of the business.

To begin with, it offers each individual a fresh look at the risk-return potential of different portfolios. Through this rotation, individuals get a better sense of relative value across different asset classes. While it's a daunting task to get up to speed on a new portfolio every few years, we think it actually helps with both recruiting and retention as it offers a continually challenging position to highly motivated individuals. We feel this rotation not only benefits the entire organization through improved performance, but also creates a deep bench of future leaders for Progressive Capital Management. As Lori mentioned on the last call, part of our culture is to promote from within and this rotation allows individuals to prepare for greater responsibility in the future.

The final component to our unique structure is our incentive system. To begin with, one portion of the incentive compensation is based on Progressive's overall gain share score. As I mentioned earlier, our first goal is always protect the balance sheet and we are incented to do so with such a significant component of our incentive compensation coming from Progressive's annual performance. The other important piece of our incentive compensation comes from the group's fixed income total return on a one and three-year basis versus a group of other fixed income money managers with generally similar constraints.

We point this out for two reasons; one, to show that the team is encouraged to be long-term focused in their thinking and investing; and two, that all members of the PCM team are incented by the group's total return not based on their portfolio size or their individual portfolio's return. Therefore, no one is incented to purchase assets that do not benefit the overall performance and everyone is encouraged to assist other team members because it will end up benefiting them in the end.

We feel like we have created an integrated path within the organization. Our unique strategy helps to drive outperformance which generates more capital for the operating business. This increased capital provides a base for further operating company growth and increases our assets under management and then the whole cycle begins again.

Now, we mentioned on the previous slide the flexibility in our mandate. However, that is not to say we don't have strict constraints in order to manage risk in our portfolio. On this slide, I will talk about some of our more important guidelines. We have a limit of 25% of Group 1 assets in our portfolio at any time. So, what does that mean? Group 1 assets include equities, non-investment grade bonds and preferred stock. The total amount of these three types of securities cannot equal more than 25% of our entire portfolio. Why did these securities get put into Group 1? We view these as our most volatile assets and also the ones most likely to incur a permanent loss of capital. Therefore, it makes sense to have a limit in terms of how much they represent within our portfolio.

We mentioned earlier that we have the ability to buy both high-grade and high-yield securities within our portfolio. That flexibility has benefited our performance over the longer term. However, that capacity to invest in lower-rated securities is not infinite as the weighted average portfolio rating must be at least A plus across the portfolio.

The constraints also extend to our interest rate risk. Our duration is an indicator of how much interest rate risk we're taking in our portfolio. The allowable range for the portfolio is 1.5 to 5 years. However, for individual securities, we will invest out to 10 years. At the end of the first quarter, we had a duration of 2.6 years as we believe there was a higher probability of rates increasing rather than decreasing over the intervening 12 months.

Finally, we feel it's important to have limits on how big any individual position can be in proportion to our shareholders' equity. The limit is 6% for municipal state obligation bonds, for investment-grade bonds the limit is 2.5% and 1.25% for non-investment grade bonds and preferred stock. We believe it is imperative to prevent one idiosyncratic investment from impairing Progressive's capital.

We've gotten the question from investors like yourself many times regarding yields that we're seeing in the market. So, we thought this chart showing yield opportunities in the U.S. fixed income market might be useful. The Y axis of the chart shows market yields on offer, while the X axis shows the total market size of these different asset classes, where you see the blue numbers is the post-crisis median yield for that individual asset class. As you can see, for many sectors that they are at or above their post-crisis median yield, a big driver of that increase has been the increase in treasury rates across the curve over the last few years.

We thought it would be useful to highlight a few of the market yields available on sectors where we have exposure, starting with high-yield corporate bonds, investment-grade corporate bonds, commercial mortgage-backed securities, asset-backed securities and treasuries and municipal bonds. We mentioned earlier in the presentation that our flexible mandate allows us to invest up and down the credit curve. So, when we make the decision to invest in high-yield corporate bonds, what are the characteristics of those types of investments? We look to invest in companies that are high-grade quality. The reason that they may be high-yield is that they have more financial leverage than the rating agencies: Moody's, Standard & Poor's and Fitch might be comfortable with. This provides us with an opportunity to purchase these investments at attractive levels and many times when the companies improve their balance sheets down the road and get upgraded, we see a strong incremental return.

Many times, we also find interesting opportunities within the industries that are penalized for previous issues which no longer exist. The most recent examples in the post-crisis period have been the automotive and housing sectors. Most importantly, what we want to get across is as you look at that table at the right, we only focus on the blue boxes. We're focused on avoiding investments in businesses that we view as weak even if the financial leverage seems relatively low.

Taking it one step further, let's look at a couple of examples of high-yield investments. First up is a BB rated non-cyclical business. The reason why this company will be high-yield is because they have high financial leverage that won't conform to rating agency high-grade standards. However, we view the leverage as sustainable. We could earn 275 basis points, or 2.75% more than treasuries. This would be about 125 basis points of incremental pickup over an investment-grade company. Potential outcomes for this type of bond is an upgrade to investment-grade. We would see about an 8% increase in the price of the bond. There's the potential for no change in price, but we would still get to earn the incremental compensation. And third, would be the potential for company underperformance driving a 4% depreciation in the bonds upon a downgrade. While possible, for the companies that we tend to invest in, we do not see a high probability of that downside outcome.

Now let's look at one more example. Instead of a non-cyclical BB rated name, let's assume we buy a more cyclical B rated issue. In this case, the financial leverage might look optically high because the industry has just recently bottomed. Therefore, the company's EBITDA or cash flow is at a cycle low. On this type of investment, we would expect to in the current environment to earn about 400 basis points or 4% over treasuries. That would be 250 basis points, or 2.5% over a similar maturity investment-grade bond.

In terms of potential outcomes, we could see an upgrade in ratings to BB. This could occur just by the EBITDA, or cash flow normalizing as the industry recovers. In this case, we would see both price appreciation and 400 basis points of incremental coupon. If we see no change in the business, we would still earn an incremental 4%. And in a downside scenario, we'd see an increase in financial risk because of depreciation in both ratings and price. I should mention that an investment like this one tends to occur earlier in the economic cycle as opposed to where we are now 10 years into the cycle.

And with that, I have the pleasure of passing it over to my teammate and partner Richard Madigan.

[Richard Madigan, Portfolio Manager, Structured Products]

Thanks Jonathan.

So, Jonathan walked you through how we're set up as a group, how we think about value, our performance over time, and how we think about opportunities in corporates. Now I'm going to spend a bit of time going into more depth about how we approach portfolio construction and securities selection including one example in commercial mortgage-backed securities before wrapping up and moving to Q& A.

Most basic question that we ask ourselves on a regular basis at PCM is, do we want to take more interest rate risk or credit risk? And as is the case with most questions, the answer is typically, it depends. In general, we look for asymmetric risk-reward relationships in which we believe the upside is greater than the downside.

As fixed income investors, we are particularly sensitive to downside scenarios and will generally look to stay away from low probability with high severity downside situations. We'd like to say that the upside takes care of itself if you're focused on protecting the downside.

This chart plots the path of the 5-year treasury note against Progressive's duration positioning over the last 10 years. As a reminder, duration is a proxy for how much interest rate volatility we are willing to take on. As Jonathan mentioned earlier, we have a guideline of 1.5 to 5 years on our duration, 1.5 would be taking the least amount of rate risk possible and 5 would be the most rate risk, mathematically putting our midpoint somewhere in the 3.25 range. As you can see in the chart, we've been lower than our midpoint and in fact very close to our lower bound of 1.5 on taking interest rate risk for quite some time, for the very similar reason that U.S. interest rates have been historically low coming out of the financial crisis.

You can also see that our duration positioning has come up more recently as the Fed has increased rates and moved toward a more neutral policy position. While we are closer to our own duration midpoint of 3.25, we're still short of that mark. Key indicators that we watch closely to inform our duration positioning include inflation, a multitude of economic indicators, rate movements themselves and Fed commentary. As always, we will be watching these indicators closely in 2019 and beyond to inform how we position our duration for rates going forward.

In addition to interest rate risk, the other major question we ask ourselves constantly as a group is, how much credit risk should we be taking on? And the answer once again is, it depends. It depends on where we are in the economic cycle, where valuation, also known as credit spreads are and it depends on the capital needs of the company.

This slide shows our Group 1 assets as a percentage of the portfolio over the last 10 years which is roughly the length of the current economic recovery. As a reminder, our Group 1 assets are a rough proxy for our general risk appetite because Group 1 contains our most risky assets, high-yield bonds, preferred stock and common equities. Coming out of the financial crisis, valuations were quite attractive.

As you can see from the chart, we maintained a Group 1 exposure very close to our 25% constraint for a number of years. There are some wiggles in there which were mostly related to intra-year capital planning activities like share buybacks and our dividend payment, but for the most part, we saw it as a good time to take risk from the standpoint of both valuations and the economic recovery. As the economic recovery is continued, risk assets have performed well as expected and valuations are no longer as compelling as they once were.

Additionally, there's the risk of a downturn at some point during which fundamentals and valuations will both likely take a hit. We don't know exactly when that will occur, so we've taken some chips off the table in advance. Our Group 1 assets have steadily come down over the last several years and we're currently running at 14.3% of the portfolio as of March 31. We're defensively positioned right now. And we hope to capitalize on more attractive valuations when markets get cheap. And they always get cheap at some point often very fast and without warning. We want to be ready for those type of opportunities.

Turning now toward our portfolio in aggregate, we thought it would be helpful to show our portfolio composition against the widely followed index, the Bloomberg Barclays Intermediate U.S. Government Credit Index. There are few differences that I would point out between our portfolio and the index. The first of course is that our portfolio is really the output of bottom-up security selection, not the result of top-down asset allocation. While we do discuss relative valuations across asset classes frequently to inform where we should put our resources in the short-term, our portfolio remains a bottom-up fundamental portfolio.

Turning now to a few examples of how our portfolio differs from an index. I will first point out the allocation to U.S. treasuries. In the index, treasuries make up 60% of the portfolio whereas cash and treasuries made up 39% of our fixed income portfolio at March 31. Second, you can see in the highlighted orange box that we have a significant exposure at 26% of our portfolio to securitized products. Securitized products, also called structured products, are bonds that are backed by common loans such as car loans, home mortgages, credit cards or commercial real estate mortgages. I am personally biased because I oversee securitized products for Progressive, but I believe that we have great domain knowledge in this space and it will likely continue to be an important asset class for us over time.

Finally, I'd like to point out the duration differences. The index currently has a duration of 3.9. That would be at the longer end of our duration range of 1.5 to 5 and we would be taking on higher than average interest rate risk if we were to map to the index. As you can see in our portfolio, our current duration is 2.6 resulting in lower than the index interest rate risk. You can see the contrast between our portfolio and an index even more starkly in our corporate portfolio. The left pie chart shows the Bloomberg Barclays U.S. Intermediate Corporate Investment-Grade Index and the right pie chart shows our corporate portfolio as of March 31.

The first major difference you can see is the difference in allocations to financials. The index has 40% financials exposure while our corporate exposure is 23%. We do broadly see value in financials and we take targeted risk to financial institutions through both our corporate portfolio in the 23% you see here and our preferred stock portfolio where we think there are number of attractive securities.

The second difference I would point out is our exposure to consumer non-cyclicals. Consumer non-cyclicals are a broad category containing things like healthcare and consumer packaged goods. We have spent considerable time researching both of those industries and we feel great about our 30% portfolio weighting versus the index weighting of 15%, particularly as we get closer to the end of a long economic expansion.

The last difference I would point out is our smaller than the index exposure to the energy industry. We have approximately 3% in energy versus 8% for the index. The rationale for our smaller exposure is that we're very mindful of the volatility of commodity price movements and our inability to predict those movements. As a result, within energy, we skew toward stable subsectors like pipeline assets. While our positioning limits our upside during commodity price spikes or risk-on markets, it substantially helped us during the big high-yield and energy sell-off in 2015 and '16. As mentioned previously, we are focused on protecting our downside and we worry less about giving up a bit of upside in euphoric markets. I haven't shown duration on this chart, but our duration is lower than the generic index. As a reminder, we manage our duration at the aggregate portfolio level the rather than at the individual asset class level.

I thought I would spend some time describing how we think about security selection in two of our major portfolios, corporate bonds, which Jon overseas and structured products, which I oversee. They include things like asset-backed securities and commercial mortgage-backed securities.

If I were to summarize our corporate bond strategy, I would say that we're looking for great businesses with great management teams and stable industries. So how do we do that in a bit more detail, first, we look at the industry structure. All else equal, we prefer more mature industries with some level of consolidation, stable pricing power and no major threats from emerging technologies. When we look at management, we look for a strong track record of doing what they say they are going to do. We will not invest in companies with known questionable ethical track records. We have in fact sold securities after attending meetings or conferences with management teams that left us uncomfortable.

Management compensation is a powerful tool that directly drives behavior. We look to ensure that management compensation is aligned with stability and conservative debt management and not with a specific accounting metric that might encourage lender unfriendly behavior. EPS and sales growth, those are examples of broad compensation metrics that could encourage things like large M&A activity which is generally a negative for bondholders. Cash flow. cash flow is where the rubber hits the road for the credit investors. We either look for stability over an economic cycle or strong tailwinds in the cyclical recovery. Cash is king. We love the Benjamins.

Predictable capital allocation policies. Management has a number of choices in capital allocation. They can invest in the business, pay down debt, pay dividends, pursue share buybacks or pursue M&A. We prefer debt paydowns or business investment first and we look for predictability and stability in dividends, buybacks and M&A.

Performance during the financial crisis. We have a great built-in stress test for how companies perform in a sharp downturn. If it's available, we always look at performance during the financial crisis even if the business has changed since then. It's a great data point.

Finally, as Jonathan mentioned earlier, we look for catalysts that could drive credit performance. One key catalyst that comes to mind is whether the company is a potential acquisition target. If they are a strategic target for well-capitalized competitors, that's great. That could cause their bond prices to rise potentially significantly. If they are target for a debt fueled type private transaction, that would generally be a negative.

Another asset class that's very important to our portfolio is structured products which I rotated on to and have overseen since 2016. Again, structured products sometimes referred to as securitized products are bonds that are backed by cash flows from everyday assets, things like car loans, home mortgages, commercial mortgages or credit cards, everyday stuff in the real economy. Because not everyone on this webcast may have the same level of background in structured products, I thought I would use a simple example of car loans to help visualize how these securities work and how we think about them.

Structured products typically start with a product we're all familiar with in our daily lives such as auto loans. In the case of this example, the process starts with a consumer purchasing a car and taking auto loan. Millions of buyers purchase cars every month making this an important market. Auto loans are typically extended by a bank or a consumer finance company such as Ford Motor Credit. The banks and finance companies have a choice. Do they hold these loans, or do they sell them to free up capacity to make more loans? When they sell them, that's where structured products come into play.

When enough loans are made, the bank or finance company sells those loans into a trust. The trust receives the cash flows and security on those loans and then the finance company working with an investment bank creates and sells bonds to institutions such as ourselves. These bonds are typically enhanced by various forms of what is known as credit protection to shield them against defaults and losses in the loan portfolio. It sounds complicated, but these products have long track records and work well through the ups and downs of the economy.

So, what do we look for when we evaluate a deal? First, we look at the reputation and track record of the issuer. How long have they been in business; how have their assets performed; do they do what they say they will do? Next, we look at the underlying asset class. Car loans to prime buyers had been a very dependable asset class. But contrast to autos might be something more esoteric like aircraft finance or shipping containers which are considerably more difficult to analyze and predict. Next, we look at the underlying borrowers. We look for quality and reliability and statistics such as FICO score, income levels and geographic diversity.

And finally, we look at the structure of the bonds themselves. Structured products are typically issued with built-in credit protection. The most simple example is the bond ABC example, I have highlighted here. In the case of a typical deal, bond A would be senior to bonds B and C, in case the trust started to incur losses from defaulted car loans. If you make bonds B and C large enough, bond A can survive even the harshest stress test which is what we look for.

Last point I'd like to make about structured products can be summarized through a simple example. Unlike corporate bonds in which we are analyzing one company, structured products often contain hundreds or even thousands of underlying loans and mortgages. As a result, we have to rely more in statistical testing to underwrite the credit quality. And as Mark Twain was rumored to have once said facts are stubborn things, but statistics are pliable. We couldn't agree more and we reflect that in our analysis.

This chart shows two-illustrative normally distributed borrower pools that might exist in a typical securitized deal. Both of them have a seemingly identical creditworthiness as shown by an average FICO score of 740. If you knew nothing else, you would think these are both high-quality borrower pools. However, it's not the average that we are after, but rather the dispersion of the FICO scores and the size of the left tail which represents the lower FICO score borrowers with higher default risk. As you get below the roughly 660 or so FICO scores subprime cut-off, that default risk rises exponentially. So that's were you're exposed as a lender. In the left chart, FICO scores have a wide range from 580 which is considered deep subprime to 900 which is pristine. You might think that having pristine borrowers in your pool is a positive, but that merely helps the average of the pool without improving the loss potential of the lower quality borrowers. Mark Twain would probably furrow his substantial brow here. The right chart has a much more narrow dispersion. In other words, all FICO scores are closer to the average than the left chart. The pool ranges from just under 660 that rough subprime cut-off, to just under 860. While this pool doesn't have any 900 FICO score borrowers, statistically speaking, a 900 FICO score borrower isn't much different from an 800 FICO score borrower in terms of probability of default. So, we would strongly prefer to invest in case 2 which contains a significantly smaller left tail and probability of sustaining material credit losses.

Now, I'm going to run you through a quick example in commercial mortgage-backed securities which I will refer to as CMBS going forward. There's a lot going on in this chart, so I'll try to break it down for you. Before I describe this slide, the punchline is that we like to deal on the left and we chose not to purchase the deal on the right. CMBS is really a tale of two markets. The depiction on the left is an example of the single asset single borrower market which is a fancy way of saying each deal contains only one property and that property is often a very high quality such as Trophy New York City office building on Park Avenue. Loans are typically also backed by large sponsors such as publicly traded REITs or other large well-known real estate investors.

That depiction on the right is an example of a conduit. Conduits are deals that contain multiple loans usually more in the small to medium size range. Properties and conduits can range from things like regional malls, to suburban offices, to self-storage facilities. Sponsors can range from high-quality sponsors, to small local real estate investors.

If we were to stop there, it would seem to be enough to convince us that the single asset single borrower market is of much higher quality and it typically is. However, it gets a bit even better from there. The single asset market is also known for its lower leverage which results in more protection against losses. By way of comparison, if you look at the skinny blue bar on each chart known as the single A rated tranche, you can see they are protected from losses from all of the bonds and the equity beneath them. In the case of the single asset deal, the property's value would have to go down by a stunning 68% before the single-A tranche lost money. In the case of the conduit deal, the bonds are protected from a loss of value of 47%. Now both are substantial cushions, but think back to the quality and resiliency of the underlying assets. On the left, you have that Trophy New York City office building backed by a deep-pocketed sponsor. On the right, you have a set of lower quality properties with lesser-known financial backers and therefore more volatility and more downside.

So, is this all too good to be true? Why not? Always just buy the quality single asset deal. Well, if you look at the numbers circled on the track, these show credit spreads that you receive as investors and you do get paid more to hold the conduits bonds, higher compensation for high risk. In the case of the single asset deal, you would receive a spread of 100 basis points or 1% over LIBOR. In the case of the conduit, you would receive treasuries plus 215 basis points or 2.15%. While you're certainly getting paid more to own the conduit, we believe the better risk-adjusted return through both economic ups and downs is in the higher quality asset. You can either eat well by getting paid more to own the conduit bonds or sleep well by owning a single asset deal. We prefer to sleep well at this point in the economic cycle.

So, how are we positioned now? As mentioned in an earlier slide, our Group 1 risk assets are at 14.3% of the portfolio relative to our 25% constraint. That's on the low side for us as you saw from our 10-year chart. Cash and treasuries make up 36% of the total portfolio and 39% of our fixed income portfolio. And our interest rate exposure is lower than the midpoint of our duration range.

In short, we feel that we're conservatively positioned and ready to take advantage of market opportunities as they present themselves. What will we be thinking about going forward? First and foremost, we will continue to support the company and its mission to grow as fast as possible at 96 or better combined ratio. Second, we're watching the risks out there, things like unexpected inflation, or signs of an economic downturn. And we're always mindful about what we're focused on, it's unlikely to be the actual problem. Black swans absolutely do exist in our experience.

And finally, valuations are fair at best right now. These things can change suddenly as they did in 2015, '16, and December of 2018. We will focus on staying nimble with the goal of going on offense and buying cheap securities when others are playing defense.

So, in summary, we believe our team is rock solid. We have significant investment experience through economic ups and downs, we have a great culture, and we're tightly integrated with operating business. Our mandate is clear, support the business. We do this by focusing on protecting our balance sheet first while pursuing the best risk-adjusted returns we see in the financial markets. Our model is flexible. We can shift the portfolio rapidly when we see opportunity and we're focused on generating total returns without having to worry about accounting or other metrics.

And finally, our compensation plan is simple, company gain share and our performance against our peers. We'll work toward the same common goal of generating one aggregate portfolio return.

Thank you very much for your time. And now we will pause and transition to Q&A.

[Julia Hornack, Investor Relations]

[Instructions] Joel, can you please introduce our first participant from the conference call line please?

[Operator]

The question comes from the line of Yaron Kinar of Goldman Sachs. Mr. Kinar, your line is now open.

[Yaron Kinar, Goldman Sachs]

Thank you very much. Good afternoon, everybody. My first question is around severity and then I have a follow-up. So, with regards to severity, I clearly saw an up tick in the BI severity in the first quarter. And physical damage severity is also continuing its creep up. I guess, do you have any thoughts as to what's leading these increases now of all times as opposed to say the last I don't know a year or two years, three years? And what actions could you take in order to offset some of that other than raising price?

[Tricia Griffith, President and Chief Executive Officer]

Yes. on the physical damage the portion of it, we are still seeing the component parts are more expensive. So, that continues to be pretty clear as cars get -- as the technology gets more advanced. So, we can price that pretty quickly. On the BI side, what we did is we took kind of a deep dive into that trend. Mike Sieger, who is our Claims President has a group of people and they did a deep dive and have narrowed down the BI severity to seven specific states and specifically we look at segmentation and claims like we do in product, specifically soft tissue, attorney rep claims that aren't litigated.

And we're actually seeing the special damages increase, not the general damages. So, think of general damages as pain and suffering, the specials as medicals. So, what Mike and his team are doing is they're taking another deep dive right now into those seven states to understand and have hypotheses to prove or disprove so they can take action, are the specials, is it more frequency of bills or more severity; is it the fact that we've grown a lot, so newer people? So, more to come on that. But Mike is all over it and literally we've gone through a lot of data to understand that BI severity so that we can correct any actions from our process improvement perspective.

[Yaron Kinar, Goldman Sachs]

Got it. Okay, we'll keep track of that I guess as we've. Then my second question is around PLE. So, I think in the 10-Q you mentioned that you've made some targeted underwriting changes in the new product model and that's what's some of the PLE erosion. Can you maybe explain what you're trying to achieve by these changes? And I don't know if you'd be able to quantify what portion of the PLE decline came from those changes specifically?

[Tricia Griffith, President and Chief Executive Officer]

I touched about this at a little bit in the last call. A big portion of some of the decline in PLE was the process change that we made. And the reason we did it was for our lifetime underwriting profit goals. So, we had process in place. It was basically a timeframe that you could renew without a lapse. And when we looked at that timeframe, one, we thought it was too long because we were able to tell that those customers were not profitable. And when we narrowed it down, one, we're more consistent with the industry; and two, we make money on those customers. So, we knew we would lose those customers and that would decline in PLE. And I think two, and I can't necessarily quantify specifically, but we have our usage-based insurance and as we continue to evolve that model and we have people that are surcharged, they tend to leave as well. So, a couple of different components. But the process change was the biggest component. We should see that diminish a little bit after the second quarter after it's gone through the book.

[Yaron Kinar, Goldman Sachs]

Thanks so much.

[Tricia Griffith, President and Chief Executive Officer]

Thank you.

[Julia Hornack, Investor Relations]

Joel, if you could take --

[Operator]

Our next question comes from the line of Mike Phillips with Morgan Stanley. Mr. Phillips, your line is now open.

[Mike Phillips, Morgan Stanley]

Thank you. Good morning. I want to hit on I guess my first question on the other side of the loss side and frequency. And this is not a new topic obviously, but you said in the past that that you don't price for the frequency changes, the favorable frequency. I guess I want to understand that a little bit better, if that's what you said and kind of why not if long-term trends and short-term trends are still very favorable, kind of talk about why you're choosing not to price the latter, it's what you meant by that?

[Tricia Griffith, President and Chief Executive Officer]

What we don't do is we can't -- there are so many macroeconomic trends that go into frequency. So, severity we can pretty much pinpoint what we think is happening, where frequency, it could be vehicle miles driven, it could be our mix of business on the book, it could be gas prices. So there are so many things that go into it. It's hard to have the specific input. So what we do is, we watch that trend to see what's happening, but it's much more difficult than severity. Do you want to add anything?

[John Sauerland, Chief Financial Officer]

Sure. Yes. We absolutely price the frequency. We have a frequency assumption that's forward looking to some degree driven obviously by the past. I think our previous statements have been that the frequency assumptions we made for forward-looking pricing weren't as big of a decrease as we've seen. So, we didn't price for the level of decrease in frequency that we've seen, we have been assuming smaller frequency declines in our pricing. But not again as much as we've seen recently.

[Mike Phillips, Morgan Stanley]

Okay. Thank you. That's helpful. Second question on the commercial side, commercial auto, can you talk about what you see in terms of different loss experiences for I guess your core commercial versus kind of the ride-sharing business?

[Tricia Griffith, President and Chief Executive Officer]

Yes. I mean commercial also has five different what we call BMTs. So, it is across the board from a tow truck to a sand and gravel hauler. So, they are very different across the board. And TNC is a higher frequency I think because they are in more of an urban areas. So, I can't give you specifics on that. We're look at that specifically with each of the BMTs, the TNC will look at state, we look at especially in the bigger states where there's a lot of construction going on. So, it varies dramatically. It would take me quite a while to go over it. I am going to have John Barbagallo who runs our commercial business attend the next webcast because I think he can go into a deeper dive on how we look at that product from a profitability perspective and a growth perspective.

[Julia Hornack, Investor Relations]

Thanks Mike. Joel, can we get the next question from the conference call line please?

[Operator]

The next question comes from the line of Elyse Greenspan with Wells Fargo. Ms. Greenspan, your line is now open.

[Elyse Greenspan, Wells Fargo]

Thank you. My first question, Tricia, in your Shareholder Letter, you mentioned that there are some signals of a softening personal auto market. I was just hoping that you could just give us a little bit more color on what you are seeing and how you guys are kind of trying to combat that and just kind of policy growth thoughts given expectations that the market could be a little bit softer?

[Tricia Griffith, President and Chief Executive Officer]

Sure Elyse. So, let me give you sort of a little bit of the punchline. But, let me walk back and walk you through how we have been thinking about for the last couple of years because we have a lot of tenure at Progressive and we've seen hard and soft markets come and go. So we're just seeing less price movements, so whether it's less rate take or actually many companies are taking slight decreases, so there's just less shopping. So, people are satisfied with their rate, less shopping.

But let me walk you back a couple of years ago because as we have this robust or have continued to have this robust growth in profit, what we wanted to do is we wanted to take a look and say, okay, during times where there was a soft market, what are the things that we did or didn't do that we would want to do differently in this next market. And of course, things always change, so it's never the specific point in time. But a couple of years ago, we did -- about 1.5 year ago we did a deep dive into saying, okay, what would we do differently and sort of kind of gauged that around our operational strategies to continue on this growth. Because we really enjoy this great growth and profitability and we wanted to continue and we want to set ourselves up to continue that. So just recently as we've seen less rate take in the market, less shopping in the market, prospects are a little bit more challenging to get where we have great conversion now., so that's what has enabled us to continue to grow. We got together our group of people, Pat Callahan, our Personal Lines President, got together just to have a summit to say, okay, what -- how are we going to get out on front of this while we're in this really great position to continue this? So clearly, we continue to increase our marketing. And we're having a lot of unique marketing where actually you'll see something new next week from us with our specialized lines of motorcycles in particular product that a new campaign we are excited about. And we're looking at different ways to market in different areas to get the customers that we desire.

On the agency side and I wrote about this a lot in my letter, we've done a lot of investments for the agents and we are really trying to focus on agencies that we believe can continue to help us grow that may be haven't grown as much as other ones and work with them on our product and our systems to have them sell more Progressive, making Progressive number one or two in their firm.

And the overall, I think when we think about combating the soft market, I think about what we talked about for years. And that's the whole destination era strategy. Obviously, we invested in homeowner's company and we have many other unaffiliated partners that we work with, so making it easy for our customers. So HQX we have a Progressive home buy button in eight states now and we have other unaffiliated partners we work with to make it really easy to buy that home and connect it with the auto.

We also have and we talked about this a lot. When we talked about the destination era, a lot of people that are going to graduate ultimately they have an auto and may be a renter's policy now they are going to graduate. So how do we market to them? We have metrics that we look at in the destination era that we look at auto plus another product. And when customers have more products and they are able to have our service and on the claims side and the CRM side and they like it, likely they're going to have more products. And if you compare the auto plus one metric from March of this year to March of 2018, we're up about 8.5%. So that's actually just kind of scratching the surface. Pat's team and actually teams around the company are working on, okay, what do we do? And we're just seeing slightly softening, so we want to really get out in front of that to continue to set ourselves up to ensure a profitable growth for some time to come.

[Elyse Greenspan, Wells Fargo]

Okay. That's very helpful. My follow-up which is I want to go back to the severity conversation from earlier when you had mentioned there are seven states that have really kind of been a red flag for you guys. Are those states that you've grown -- that the growth was greater in over the past few years than other states that would may make you think that maybe it was greater growth?

[Tricia Griffith, President and Chief Executive Officer]

I would say about half of them are. So, yes, we have grown so much in every state. But yes, there are couple of larger states where we have grown tremendously and that's where we are really taking the deep dive to understand and create hypotheses to get our arms around it.

[Elyse Greenspan, Wells Fargo]

Okay. Thank you very much.

[Tricia Griffith, President and Chief Executive Officer]

Thanks Elyse.

[Julia Hornack, Investor Relations]

Thanks. Joel, can you take the next call from the conference call line please?

[Operator]

The next question comes from the line of Mike Zaremski with Credit Suisse. Mr. Zaremski, your line is now open.

[Mike Zaremski, Credit Suisse]

Hey, thanks. Follow-up to one of the previous questions about the targeted underwriting changes that will continue through the second quarter. Are those changes behind some of the underlying loss ratio improvement and I think the last quarter on the call I asked you guys about that. You said it was due to business mix changes. And I'm curious if this is a major component to that?

[Tricia Griffith, President and Chief Executive Officer]

These are really more process changes. Our underwriting is a little bit different. It would be a portion of it, I don't think it would be a huge amount. A lot of it is our ability to make sure that we care about expenses deeply. Our mix of business continues to change. I didn't mention this when Elyse asked the question, but we are seeing our agents more and more floating us the preferred business that we are starting to come to enjoy. So, it's a portion of it, I wouldn't say it's a major portion of it.

[John Sauerland, Chief Financial Officer]

And most of our underwriting activities are focused on incoming customers. The process change that Tricia mentioned was the renewals, so obviously in force customers with us, but the predominance of our underwriting efforts when we talk about them over the past I don't know five years or so have ensured that we are getting accurate information from people coming in the door and risks whose intent is truly to ensure.

[Mike Zaremski, Credit Suisse]

Okay, great. And my last question is regarding your ambitions to grow into small business, commercial, and BOP. In terms of the playbook, I'd be curious, is the majority of your current commercial auto book, is that sourced through brokers? And two, in terms of the BOP business you are selling today, are you privy to the underwriting and loss ratio data that is ultimately going on to the third-party paper that you're using? Thanks.

[Tricia Griffith, President and Chief Executive Officer]

So, the majority of the BOP already now is from unaffiliated third parties. So, we just rolled out our -- and sold our first policy on Good Friday for our BOP coverage. And we're going slow as we want to understand the system implications et cetera. So, we have it in Ohio handful of agents, we're going to add on more agents in May and then continue the roll. So, it would be slow and methodical just to make sure that it's a good process for the agents, a great product for the customer et cetera. So, slow and steady. What we're happy about is that we invested in this a couple of years ago because we think -- as we think about Horizon 2 initiatives, this is an important piece of it. And again, John Barbagallo will go into detail in the next webcast on what we're doing and commercial. We don't use the data from the other companies those who inform us of what we do. We bifurcate that data.

[Mike Zaremski, Credit Suisse]

And your commercial auto book today -- it's commercial auto, is that sourced mostly through brokers?

[Tricia Griffith, President and Chief Executive Officer]

Commercial auto -- I get what you're saying. Through our independent agents, yeah, the majority of our commercial auto business is -- does go through commercial agents. We rolled out there BQX, the soft launch of BQX a couple of months ago, which is BusinessQuote Explorer. So, we'll continue to have more direct and online, but right now I'd say about 95% of ours goes through independent agents.

[John Sauerland, Chief Financial Officer]

In terms of premium for first quarter was about 84% of premium went through independent agents. So, a slight majority.

[Mike Zaremski, Credit Suisse]

Thanks so much.

[Tricia Griffith, President and Chief Executive Officer]

Thanks.

[Julia Hornack, Investor Relations]

Thank you. So, I'm actually going to take question from the webcast right now. So, this question is from a current shareholder and their question is, what is Progressive's view on investing in alternative asset classes, specifically private equity?

[Tricia Griffith, President and Chief Executive Officer]

Do you want to take that Jonathan? Okay, we'll have Jonathan Bauer answer that.

[Jonathan Bauer, Portfolio Manager, Corporate Bonds]

Sure. Thanks very much for the question. We take a very thoughtful approach to all of our investing, at the moment, how we've currently decided to split it out is public equities that we index as I mentioned before, actively managing fixed income. Within that fixed income portfolio, we focused on having more liquid securities as we mentioned in terms of mortgages, treasuries and corporate bonds. We always stay open to looking at other opportunities in terms of alternative asset classes. But, at this point in time, we felt that we'd prefer to stay in more liquid asset classes and have chosen not to invest in private equity.

[Julia Hornack, Investor Relations]

Great. Thanks Jonathan.

[Tricia Griffith, President and Chief Executive Officer]

Thanks Jonathan.

[Julia Hornack, Investor Relations]

Joel, can we take the next caller from the conference call line please?

[Operator]

The next question comes from the line of Jeff Schmitt with William Blair. Mr. Schmitt, your line is now open.

[Jeff Schmitt, William Blair]

Hi, good afternoon. Question on severity, it was 7.8% in the quarter, looks to be above the industry or at least at the high-end of the industry, and I think it had been running below for you guys fairly recently. Do you have any sense on what may have driven that shift?

[Tricia Griffith, President and Chief Executive Officer]

Well, we don't have the industry quarter results yet, so we'll compare after that. But there is the three components that we talked about, the BI severity specifically soft tissue in several states, the physical damage or severity in terms of components and car parts. And then PIP severity went up a little bit based on, I talked about this on the last call on a Supreme Court case with the industry lost in Florida. And that's the main piece. We'll continue to watch it and watch what happens in the industry.

[John Sauerland, Chief Financial Officer]

To that I'd add, we are looking at a quarter and maybe you've seen a couple of other reads from other companies for the quarter. If you look over the long-term, I mean decades or even years, generally you see our severity trends track fairly well with the industry. We are also the subject to the same inflation trends for parts, for medical services et cetera. Where you see our trend diverge from the industry is on frequency. So, our frequency trends have been going up less than the industry over the longer term, or more recently going down more. And we think there's a lot of things that go into that, but certainly we think our pricing, segmentation goes into that, the underwriting efforts that I mentioned previously as well as our shift to a more preferred end of the customer spectrum. So, over the longer term, I think you'll generally see our severity trends similar to the industry, we think if you look over the longer term, again, frequency is where we find the advantage.

[Jeff Schmitt, William Blair]

Okay. That's helpful. And just one more on the Robinson's segment. Could you discuss how growth looks there versus the year ago and what your outlook is?

[Tricia Griffith, President and Chief Executive Officer]

Yes. Growth continues to be strong. We're growing the fastest in Robinson's I think in both direct and agency by a lot. We only have about 2.5% of the home market with our PHA and our Platinum agents. So, we believe that there is a lot of runway there. And we have our agency and team working with our agents to make sure they think about us when they are thinking about auto and home bundle, but that's a place where we continue to be really bullish on our ability to grow and grow substantially which of course the more we have that preferred segment relates to frequency. So, we're really excited about that.

[John Sauerland, Chief Financial Officer]

And on the direct side, obviously we've been putting a lot of new products in place or new methods of coding, our HomeQuote Explorer is a great example where we're making it easier for Robinson's to either graduate to Robinson's with us or come to us as new customers, our advertising mix has shifted toward messages that are geared toward that segment of the population. So, that's helping drive business there. And as Tricia mentioned, getting agents to change behavior around whom they think are Progressive best serving, it takes a while. And we've seen that shift she mentioned earlier in agents coding us we think their most preferred households. Within the independent agent channel, we actually find a lot more potential for Robinson's growth than the direct channel. So, we're really excited about that.

[Julia Hornack, Investor Relations]

Thanks Jeff. Joel, can we take the next caller from the conference call line please?

[Operator]

The next question comes from the line of Meyer Shields with KBW. Mr. Shields, your line is now open.

[Meyer Shields, KBW]

Great. Thanks very much. Tricia, I was hoping you could comment on whether the growth that you're seeing in Robinson's sector implies that all else equal Progressive is less vulnerable to market competition than five years ago or some prior period?

[Tricia Griffith, President and Chief Executive Officer]

Yes. I mean it's hard to quantify, but I would say that's one of the reasons why we chose to invest in ASI and invest in relationships with other unaffiliated partners. We know from data when customers have more than one product, their likelihood to stay is longer, their stickiness is better. And we wanted to be -- as part of our strategy, we wanted to make sure that -- and I think you said this in a webcast, I think John Sauerland said, we want to be able to say, yes, we got that, we can get that for you. And so whether it's on our paper or not, yes, I do believe you are less vulnerable if you have more and more products and services that can take care of as many consumers as possible.

[Meyer Shields, KBW]

Okay. Thanks. That's helpful. Second question, unrelated. Is the shift to the Robinson's having any impact on the average claim settlement in the legacy non-standard book, in other words, is it changing the mindset of claims adjusters?

[Tricia Griffith, President and Chief Executive Officer]

No. I mean I would say our claims adjusters and this is I think a little -- couldn't be different than what I've heard from adjusters who are coming from other companies. We focus on every customer whether they are Sam, Diane, Wright or Robinson and make sure we give them the best service ever. So, I don't believe that Robinson's affect the Sam's. Of course, a lot of the Robinson's have higher limits, so that could be a dependent factor as well, but I don't think that has an effect.

[Meyer Shields, KBW]

Great. Thank you very much.

[Tricia Griffith, President and Chief Executive Officer]

Thanks Meyer.

[Julia Hornack, Investor Relations]

Well, that actually appears to be the last question in the queue. So, Joel, I'm going to hand the -- I'm going to hand it back over to you for the closing scripts.

[Operator]

That concludes the Progressive Corporation's first quarter Investor event. Information about a replay of the event will be available on the Investor Relations section of Progressive's Web site for the next year. You may now disconnect.