Making Financial Goals and Reporting Policies Serve : Corporate Strategy: The Case of Progressive Insurance

VOLUME 16 | NUMBER 4 | FALL 2004

In This Issue: Disclosure

Beyond Financial Reporting—An Integrated Approach to Corporate Disclosure

Amy Hutton, Dartmouth College

Making Financial Goals and Reporting Policies Serve Corporate Strategy: The Case of Progressive Insurance

An Interview with Tom King, Progressive Insurance

Identifying and Attracting the “Right” Investors: Evidence on the Behaviorof Institutional Investors

Brian Bushee, University of Pennsylvania

Roundtable on Corporate Disclosure Panelists: John Graham, Duke University; Trevor Harris,

Morgan Stanley; Amy Hutton, Dartmouth College; Charles

Kantor, Neuberger Berman; Tom King, Progressive

Insurance; Rick Passov, Pfizer; Erik Sirri, Babson College;

and Joe Willett, (formerly) Merrill Lynch.

Moderated by Don Chew.

Where M&A Pays and Where It Strays: A Survey of the Research Robert Bruner, University of Virginia

Pathways to Success in M&A Mahmoud Mamdani and David Noah, Morgan Stanley

In Defense of Incentive Compensation: Its Effect on Corporate Acquisition Policy

Sudip Datta and Mai Iskandar-Datta, Wayne State

University, and Kartik Raman, Bentley College

Reappearing Dividends Brandon Julio and David Ikenberry, University of Illinois

Making Capitalism Work for Everyone Raghuram Rajan and Luigi Zingales, University of Chicago

Where M&A Pays and Where It Strays: A Survey of the ResearcAPPLIED CORPORATE FINANCE

Journal of

A M O R G A N S T A N L E Y P U B L I C A T I O N

Making Financial Goals and Reporting Policies Serve Corporate Strategy: The Case of Progressive Insurance

Journal of Applied Corporate Finance A Morgan Stanley Publication / Volume 16 Number 4 • Fall 2004 17

Bennett Stewart: I am Bennett Stewart, Senior Partner of Stern Stewart & Co., and I have the privilege today of interviewing Tom King, Vice President and Treasurer of Progressive Insurance. Tom, can you start out by giving us a thumbnail sketch of Progressive Insurance and telling us a bit about its history?

Tom King: Progressive is the third largest writer of private passenger auto insurance in the United States. Although the company was formed in 1937, the watershed event took place in 1965, when Peter Lewis, then the 31-year-old son of one of the founders and now our chairman, bought out the other partners and took over. Peter was a maverick CEO whose strength lay even more in his busi-ness sense than in his technical insurance knowledge. What distinguished Peter is that he tried harder than anyone else in the industry to have very clear goals, to articulate those goals both internally and to the investment commu-nity, and to hire the best people he could fi nd to achieve those goals.

Stewart: Do you think that’s unusual?

King: I do. Few companies do a good job of explaining their goals to their most important constituencies: their employ-ees and their stockholders. Most top managements, instead of focusing on things that matter, seem to be preoccupied with reporting continuous increases in earnings per share. At the same time, their line managers and employees are urged to pay attention to a number of different, often mutually

An Interview with Tom King, Vice President and Treasurer

inconsistent, variables. And the net result of all this is confu-sion about the corporate mission.

Stewart: If Progressive’s fi nancial goal is not to grow EPS, then what is it?

King: Our fi nancial objective is simple: to grow as fast as we can while keeping our combined ratio no higher than 96.

Stewart: What’s a combined ratio?

King: It’s a measure of return on sales for the insurance industry. A combined ratio of 96 means that for every $100 of premium revenue we take in, we expect to pay out no more than $96 in losses and expenses. It’s the same as a 4% underwriting profi t margin.

Stewart: At Stern Stewart, we tell people that what matters is your return on capital, and that the goal is to create economic value added, or EVA, by earning a higher return on capital than your cost of capital. Now, in your case, isn’t your total return on capital a function of not just your combined ratio, but also of the returns you earn on the “fl oat,” on the premi-ums you’ve taken in and not yet paid out?

King: You’re right. But we think it makes things much simpler to keep investment returns out of the picture. Our analysis shows that if we maintain a 96 combined ratio, along with three other company fi nancial policies—a sales-to-capital (or “premium-to-surplus”) ratio of 3-to-1, a

If you were to ask a group of our line managers, “What are your goals?,”

I can guarantee you that the uniform response would be “96 and grow.”

I am also confi dent that if you were to put the same question to the managers

of any of our competitors, their answers would not have nearly the same

degree of clarity and consistency. —Tom King

18 Journal of Applied Corporate Finance A Morgan Stanley Publication / Volume 16 Number 4 • Fall 2004

debt-to-capital ratio of 25%, and an investment portfolio allocation of 85% bonds and 15% equities—we will earn a return on equity that is higher than our cost of equity. We use the 96 combined ratio because it makes things clear for all 25,000 employees. It has been our main corporate goal since the 1960s.

And the fact that we keep our investment returns out of the picture is completely consistent with our strategy in the following sense: Our comparative advantage at Progressive is underwriting auto insurance, not managing investments. The investment markets, as you tell your clients, are very effi cient; and we would be foolish to predicate our success on our ability to add value in managing money. We expect to add value in underwriting and administering insurance—and the combined ratio provides us with a simple, but very useful, metric for evaluating the profi tability of those activities.

Stewart: So I guess people at Progressive have a pretty good idea of what they’re supposed to accomplish?

King: That’s right. If you were to ask a group of our line managers, “What are your goals?,” I can guarantee you that the uniform response would be “96 and grow.” I am also confi dent that if you were to put the same question to the managers of any of our competitors, their answers would not have nearly the same degree of clarity and consistency. Both profi tability and growth would likely be mentioned; but the tradeoff would not be spelled out clearly, and most managers would probably say that the emphasis shifts during differ-ent phases of the insurance cycle, with most fi rms pushing growth at the top of the cycle and profi tability only after the losses resulting from the last growth spurt come home to roost.

Stewart: There’s a business bestseller called From Good to Great that argues that the great corporate successes in recent years can be attributed to maintaining an intense focus on a few simple principles. Companies add value by identifying their competitive advantages and then doing everything they can to build and maintain those advantages. What you seem to be saying is that your organization is another example of the power of clarity and focus.

King: That’s exactly right. We reject the idea that underlies the strategy of the many fi nancial services fi rms that have decided to become highly diversifi ed “one-stop shops” for fi nancial products. We have chosen to focus just on auto insurance, and to be very clear about our goals in that industry.

Stewart: But does that strategy give you enough room to grow? Aren’t you concerned that at some point you may need to go beyond those boundaries?

King: Perhaps. But keep in mind that the U.S. auto insur-ance industry is a $140 billion market, and we have only a 7% share. In fact, we could triple our current size today and still be smaller than State Farm, one of our major competi-tors. So, we feel there is plenty of room for us to grow in our business. And the last time we checked, there was still lots to learn about the business that could help us achieve that growth—while insisting on our 96 combined ratio.

Decentralization as StrategyStewart: Having that kind of focus and then hiring the best people to execute your strategy has also probably caused your company to become more decentralized than most. In other words, I would guess that your clarity about what you want to accomplish has given you the ability to delegate greater decision-making responsibility than most of your competi-tors. Am I right?

King: Decentralization is a critical part of our strategy and our success. And since Stern Stewart is the former publisher of the Journal of Applied Corporate Finance, you’ll probably be happy to hear that we think about decentralization in much the same way as Michael Jensen, one of your regu-lar contributors. That is, we think in terms of the optimal assignment of “decision rights.” We try hard to give those rights to the people in the organization who have the specifi c knowledge—the knowledge of local markets and condi-tions—necessary to make the best decisions.

To illustrate my point, our most important decision makers at Progressive are the 100 product managers who decide within each of our markets how much to charge for car insurance. Auto insurance is pretty much a commodity business. If we charge too much we won’t sell much; but if we charge too little, we’ll do lots of business at a loss and never make it up on volume.

Stewart: So, in contrast to the practice of most fi nancial institutions and insurance companies, you have found that it makes sense to decentralize some important decisions. But does headquarters offer any guidance to managers when making these pricing decisions?

King: Our product managers can get as much help as they want—and with no transfer charges—from headquarters and colleagues. But the responsibility for those pricing deci-sions rests fi nally with the product manager. So, if you run our Indiana business, you get to set prices in Indiana—and then you’re held accountable for the results.

When you delegate that kind of decision-making author-ity, it’s important to do a good job of measuring and evaluating performance. We have spent a lot of time developing a cost accounting system that measures the results of our Indiana auto insurance business to a pretty fi ne level of granularity.


Stewart: How many different profi t and loss centers do you measure inside the company? Does your measurement system drill down well below the level of your 100 product managers?

King: Yes, it does. There are thousands of individual income statements that we can look at to evaluate the contribution of specifi c activities. We keep slicing the data up to the point where we stop getting useful information.

Stewart: How do you know what that level is?

King: That’s a judgment call. At some point, you’re refi n-ing powdered sugar. But we would rather give the product manager too much information than too little; it’s up to the product manager to determine at what point to stop disag-gregating the data.

Stewart: So you take great pains with your measurement system in order to give your product managers as clear a picture as you can of the revenue and cost drivers in their businesses. And your premise is that better measurement can help managers make better decisions.

King: Exactly. Bad pricing decisions result in something economists call “adverse selection,” which is the kiss of death in the insurance business. Adverse selection is what happens to your business when a competitor’s rates refl ect better infor-mation about individual risks than your own rates. In that case, you are either going to pass up a lot of good business or incur losses selling underpriced policies. For example, if you offer average prices to all comers, knowing nothing about their individual risks, and if your competitor has a more sophisticated pricing model, you will be stuck with all the underpriced business and more than your share of underwrit-ing losses.

Stewart: So it’s really a question of how many variables you put in the regression equation, how many separate discriminating factors you can identify with any degree of confi dence.

King: We are looking for reliable predictors of customer acquisition expenses and loss costs from auto accidents. If we are not careful, we can end up with a model that either underestimates or overestimates expected costs and losses. Signifi cant error on either side is going to end up destroy-ing value, either in the form of excessive losses or forgone growth in premium revenue.

Stewart: And you’ve created this central statistical bureau whose aim is to help your product managers create their own pricing models that are customized for each of your markets. That sounds like quite an undertaking.

King: It is. We invest heavily in information technology, about $500 million a year. One important responsibil-ity of our product managers is to make sure they follow consistent data coding guidelines so that premium loss and expense information coming from Oregon and Virginia are comparable. We aggregate this information into a central warehouse and then have a team of corporate statisticians mine the data looking for relationships. These fi ndings are then challenged by our product managers, and there is a sort of an ongoing give-and-take. But at the end of the day, it’s the product manager on the line who decides the form of the model and what the pricing is going to be in his or her jurisdiction.

Corporate PerformanceStewart: Let’s talk a little about how the company has performed over the past 20 or 30 years since Peter Lewis fi rst established his principles. And maybe we can start by talking about market share. Can you give us some facts and fi gures on this aspect of your performance?

King: There are some 300 auto insurers in the U.S. today and we have grown from being an irrelevant player to the number three writer. We now take in over $10 billion in premiums each year, out of an industry total of $140 billion. The compound annual growth rate in both our revenue and profi ts since we went public in 1971 has been 15% per year. And this performance is completely consis-tent with the performance of our stock, which has provided an average 15% total return to our shareholders over the same period.

Stewart: Have you made any acquisitions?

King: None worth mentioning. We made a $50 million acquisition in 1997 and concluded that there was no benefi t, no value added, from having done it. Our growth has been almost entirely organic; our model works best that way.

Stewart: You say there are now 300 insurers. Progressive is number three with around $10 billion—and I would guess that State Farm and Allstate are probably number one and two. Can we expect to see a lot more consolidation of the industry in the next few years?

King: The auto insurance industry is still a highly fragmented business. The reason we are not consolidating as fast as, say, the banking industry is that this is still mainly a “variable-cost” business. There are scale economies in certain areas, of course. For example, our investment in IT and brand development can certainly be amortized over more busi-ness. But most of our costs vary directly with the volume of business we underwrite. The costs associated with insurance


claims—what we call our “loss costs”—amount to about three-quarters of revenue.

This makes us very different from a manufacturer with high fi xed costs. Such companies are always under enormous pressure to get big quickly and run the factory around the clock. In our case, loss costs move directly with premium volume; and if we have to underprice new business, there is no benefi t to continuing to grow. You’ll go broke pretty quickly selling dollar bills for 95 cents.

Stewart: So your fi xed costs are small relative to total reve-nue and variable costs.

King: That’s right. We have a corporate staff, a claims processing organization, an IT group, and some real estate. And that’s pretty much it.

Claims Handling as a “Core Competency”Stewart: The major challenge, then, is preserving that margin between your revenue and your variable costs—that 96 combined ratio. And one important way you maintain that ratio is through more accurate pricing by having better data and by decentralizing your pricing decisions.

But what are some of the other effi ciencies that distin-guish your operations from those of your competitors, and that help to keep those variable costs down? What about your ability to handle claims? Your customers care about basically two things: price on the front end and getting reimbursed on the back end. Is claims processing something that Progressive does exceptionally well?

King: Our second major source of competitive advantage is claims handling. We have 400 claims offi ces spread across the U.S., and we ask them to compete on cycle time reduc-tions. If we are ever lucky enough to have you as a policy holder, we will give you a wallet card with our 800 number for reporting losses. If you have an accident, you can call us at any time, night or day, and we will go to work as quickly as possible to settle the claim accurately and fairly.

Let me try to show you the importance of having a good claims handling process. Let’s say for the sake of argument that the typical annual auto insurance premium is $700. Given our 96 combined ratio, our product managers price with the aim of earning a 4% margin. On a $700 premium, a 4% underwriting target gives you only $28 of expected underwriting profi t per policy. Now, $28 of underwriting profi t is not very much; it’s the equivalent of, say, one day of storage or rental reimbursement in the event of a claim, or 30 minutes of sheet metal work at a body shop, or 20 minutes of an attorney’s time in the event of litigation.

So, given that we receive 10,000 or more claims a day, the potential for recurring cost savings by doing things fast and right is enormous. We can eliminate massive amounts

of waste through some simple adjustments in process design and by having motivated and well-trained claims adjusters.

Stewart: It sounds like you’re using some of the TQM six-sigma principles to drive out ineffi ciency and waste and to engineer processes that are inherently faster and more effi cient.

King: That’s right. And one thing we have learned from our success is that there doesn’t have to be a tradeoff between cost and service. There is so much waste in our industry that if we can just move claims faster through our claims factory, we can achieve both lower costs and better service.

Stewart: How do you evaluate and compensate people in the claims side of the business?

King: We measure lots of things, but we try not to attach too much weight to any one of them in order to avoid unin-tended consequences. The job of our adjusters is to pay the right amount, neither too much nor too little, and we want to make sure that we don’t create incentives that get in the way of their doing that.

Stewart: So how do you reward those people, and on what basis?

King: Their rewards come mainly in the form of promo-tions and the higher salaries that go with them. And those promotions are based mainly on job results, as measured by something we call “fi le quality.” Each of our 10,000 adjust-ers puts together a fi le for each claim he or she handles. And for each adjuster, the fi les are audited for accuracy, time-liness, customer service, and cost. Of course, the auditors don’t examine every fi le; they use statistical sampling tools to make their judgments. And we go through an extensive calibration exercise to make sure that we use the same scaling system for all fi le reviews.

Stewart: Are the auditors independent in the sense that they work for an outside fi rm?

King: No, we use Progressive employees, but these are people who report up through the chief fi nancial offi cer’s organiza-tion. You can’t have self-graded exams. So the auditors are claims people who leave the line and do a tour of duty with the fi nance organization.

For a claims professional to move up in our organiza-tion, they have to produce a greater volume of what we call “standard fi les.” And what makes a fi le standard is not just being accurate; the important thing is that it be done right the fi rst time.


Stewart: It sounds like this system allows you to evaluate and motivate and promote the best claims adjusters. And I imagine it also gives you insight into the best practices in claims handling and ways to leverage those practices.

King: With 10,000 claims professionals, we come up with new ideas all the time. And having a centralized audit group allows us to share best practices faster.

Specialization, Sales Channels, and the Business ModelStewart: Let’s return to your business model. You’re saying that what distinguishes Progressive’s model from others in the marketplace is your exclusive focus on auto insur-ance. Are you saying that none of your competitors take the same approach?

King: Besides offering other types of insurance such as homeowners insurance and umbrella policies, some of our competitors are pushing to cross-sell fi nancial services to their policy holders in the form of credit cards, banking services, mutual funds, and variable annuities.

Stewart: But it seems like it would make sense for the person who makes the contact with the customer to be in a position to offer other products and services. Why do you fi nd that to be ultimately less effective than being as focused as you are?

King: In the fi nancial services world, search and switch-ing costs are dropping rapidly. It has become much easier for an informed consumer to fi nd the best value in each of several different products and to buy from those providers. So, having just met you, Bennett, I’m still willing to bet that you have a credit card with one company, mutual funds with another, life insurance with a third, and your bank checking account with a fourth.

Stewart: That’s true. So you’re saying that the person who’s interfacing with the client cannot be an expert in every-thing, and once they have to start calling in other providers to help sell a smorgasbord of services, the system becomes a lot less effective than if they were just focusing on selling one thing.

King: That’s right. Don’t forget, there’s an enormous cost of complexity in fi nancial services. Even though Sandy Weill is probably the most skilled dealmaker in recent history, he has not really succeeded in integrating insurance with other fi nancial services. After all, Citigroup ended up spinning off Travelers. And if Sandy Weill can’t do it, there are a lot of other people in our business with a lot less talent who simply don’t have a chance.

Stewart: I understand that complexity creates its own prob-lems in the process of delivering products. But when you’re so focused, how do you develop new clients? How do you create and market brand items? How do you gain market share against your bigger, broader, and more diversifi ed competitors, with their infrastructure and networks?

King: We sell through two basic channels and we have a different advertising strategy for each. We sell auto insurance through 30,000 independent agents. In fact, we do business with more independent agents than any other car insurance company. As a consequence of our having cultivated rela-tionships with them since 1937, independent agents know who we are, and they understand the benefi ts of doing busi-ness with Progressive.

Stewart: But aren’t independent agents shrinking and being swallowed up by the large fi nancial supermarkets?

King: The independent agents have been around as long as there’s been auto insurance, and rumors of their death have been greatly exaggerated. There is a certain entrepreneurial drive required to be effective as a neighborhood agent. And I am skeptical that large companies or rollup artists could ever be successful in creating networks of effective local agents.

Stewart: It gets back to the diffi culty for large companies in providing the sense of ownership and drive that an indepen-dent agent has.

King: There are so many things that an agent has to do right to build a book of business that it can’t all be mandated from someone at the corporate level. And just as an effective agent would not likely be a great employee at a large company, most employees of large companies would not make effec-tive local independent agents.

Stewart: Do you have any of your own agents, or do you work exclusively through independent agents?

King: Two-thirds of our business comes from independent agents, and one-third is sold directly. We have about 1,500 salaried employees who work at call centers and answer the phone. In the direct channel, the power of branding is criti-cally important, and advertising is what makes that work.

Here’s how car insurance works. Bennett, you’ve proba-bly been with the same auto insurance company for quite a while. You may even have purchased your policy from the same company that your parents were insured with.

Stewart: That’s true.


King: Okay. So you are not going to switch insurers unless something dramatic happens. You might switch providers if you have a bad claim experience or a billing problem, or your 16-year-old gets his wheels and it’s prohibitively expen-sive to stay with your insurer, or you have a midlife crisis and buy a Porsche—some sort of shock to your household. And what you do at that point is to solicit three or four quotes and then choose the lowest price on the bid list. You do not pick the lowest price among 300 auto insurers in the U.S. You get quotes from those companies that are recommended to you or that you recognize.

For Progressive to grow, we have to get on that bid list more often than anyone else. And that’s the reason we decided, in the early ’90s, to go to a multi-channel distri-bution approach—and we were among the fi rst insurance companies to do so. What we have discovered since then is that, on the direct channel side, branding absolutely matters, and we spend more than $100 million a year on advertising that asks motorists to call 1-800-PROGRESSIVE or go to www.progressive.com.

Financial Measures and PoliciesStewart: So, to recap, the fi rst distinguishing element of your business model is your conscious decision not to be a supermarket but instead to be super focused. What are some other points of differentiation?

King: I think number two is our passion for measure-ment. Ultimately, we want to measure everything that infl uences our ability to grow as fast as possible within the constraint of the 96 combined ratio. There’s a comment by Lord Kelvin, the British physicist who invented the Kelvin scale for measuring temperature, that I always think of in this context—and it goes something like this: “When you measure what you are speaking about and express it in numbers, you know something about it. But when you cannot express it in numbers, your knowledge is of a meager and unsatisfactory kind.” At Progressive, we revere accurate data. And, as a result, I think we are better cost accountants, and thus better decision makers, than our competitors.

Stewart: At Stern Stewart, we’ve always held that what gets measured gets managed. But it’s remarkable to me how little importance most companies attach to performance measure-ment. They set strategies and manage their businesses without regard to fundamental metrics. So, for Progressive, performance measurement is extraordinarily important and sets you apart from your competitors. What are the fi nancial measures that matter?

King: In fact, Bennett, we have nine explicit fi nancial poli-cies that we try to follow—and that we set out each year in our annual report—and each of them is designed to

reinforce our mantra of “96 and grow.” For example, one of these policies is to ensure that we have enough capital that our premium-to-surplus ratio never gets above 3-to-1; another policy is to maintain a ratio of debt to capital of between 20% and 30%; and a third is to maintain a target asset allocation in our investment portfolio of 85% bonds and 15% stocks.

Stewart: Would you say that you’re fairly proactive in manag-ing your capital structure?

King: We try to make sure we have enough capital, but not too much. We also try to take advantage of the value of the tax shield from levering up. But, at the same time, we’re very careful about not using too much debt. We feel that we have a lot of opportunities for innovation, and our concern is that too much debt could limit our ability to invest in such opportunities.

Stewart: But if you don’t borrow much, and you’re also concerned about having too much capital, then how do you return your excess capital to investors?

King: We sometimes buy back shares. And we do pay a cash dividend, but it’s a very small one, designed mainly to allow some institutional shareholders to hold our shares. We believe there’s little evidence that a company’s dividend policy affects the value of the fi rm. And because share repurchases allow investors to control the timing of their tax liabilities, repurchases are our primary tool for returning excess cash to our shareholders.

Stewart: Has the recent change in the tax code caused you to consider paying higher dividends?

King: Not really. When we asked our investment bankers how many of our owners are taxable individuals—as opposed to corporations or tax-deferred organizations—for whom that would matter, our banker couldn’t answer the question. And because it’s been so diffi cult to get a handle on the tax positions and strategies of equity investors, we have chosen, at least for the time being, to stick with our policy of small dividends supplemented with stock buybacks. Of course, we are more inclined to repurchase shares when we feel that our stock is undervalued. And, as you well know, Bennett, using excess cash to buy back shares is typically interpreted by the investment community as sending a very positive message about future earnings.

Accounting and Disclosure PolicyStewart: That’s right. And in that sense, a company’s fi nan-cial strategy can also be a critical part of its strategy for communicating management’s confi dence to investors.


King: I agree. But I also think that where Progressive differs from most U.S. companies is in its overall disclosure policy, particularly in its approach to calculating and reporting earn-ings. Perhaps the easiest way to demonstrate what I mean is to point to an article that you wrote in a recent issue of the JACF called “How to Fix Accounting.”JACF called “How to Fix Accounting.”JACF

Among the many problems with GAAP accounting, you mentioned the tendency of most companies to use reserve accounting to manage reported earnings by padding reserves when times are good and drawing down on them to prop up earnings in lean times. Well, that kind of earnings manipulation is completely antithetical to our account-ing and disclosure practice at Progressive. For example, in accounting for our loss reserves, which is a major part of our P&L and balance sheet, our aim is to give fi nancial statement users the most accurate estimate of loss reserves humanly possible.

A lot of people may be shocked to hear this, but we actually reward our actuaries based on how accurate their loss estimates turn out to be. The career path and compen-sation of actuaries at Progressive depend on the accuracy of those estimates. They produce the estimates at the end of each calendar year, and it’s pretty easy to look at how those reserves run off and to compare one year, two years, and three years later to see how accurate these initial estimates were. And, to help ensure that this policy gets carried out, our actuaries have complete control over their selections. No one gets to tell them what to do, not even the CEO; if there were a violation, they would call the head of the audit committee in a heartbeat.

Stewart: But, Tom, as a result of taking this approach, isn’t the top management of Progressive effectively volunteering to report more volatile earnings than your competitors, who are likely to be using reserves as a smoothing mechanism?

King: We do have more volatile earnings as a result. But we don’t believe it matters. And consistent with our philosophy, we do not provide analysts with focused earnings guidance, a practice that was unheard of until the Internet bubble burst. In fact, we have never given earnings guidance because we don’t know what the future holds and we don’t want to be painted into a corner. We don’t want to be forced to try to hit some sort of consensus number. Forcing companies to hit their numbers can lead to cases like Enron and all kinds of corporate horror stories.

Stewart: Tom, it sounds like your disclosure policy is an important part of your overall strategy of taking the long view and attempting to maximize long-run value. But given that you don’t forecast earnings per share, what have you done to satisfy Wall Street’s craving for information about the next quarter’s earnings?

King: Starting in April 2001, our solution was to start report-ing on a monthly basis. This way the analysts can update their monthly basis. This way the analysts can update their monthlymodels three times as frequently, which means their earnings estimate should be a lot more accurate. And, as far as I know, we are the only company in the U.S. to do this.

Stewart: Are these audited numbers?

King: No, they are unaudited numbers. But since we operate in only one line of business, any discrepancies between oper-ating results and GAAP earnings can be reconciled without much diffi culty at the end of the year.

Just last month, we also started providing a condensed balance sheet, income statement, and earnings per share statement. The message to a skeptical investor is that we’re telling the truth; and if you had doubts about our telling the truth on a quarterly basis, then we’ll make it three times as hard to pull the wool over your eyes by releasing information monthly. There’s no place to hide.

Stewart: What’s the time lag between month-end and disclosure?

King: Two weeks.

Stewart: You must have a very comprehensive system to provide that kind of turnaround.

King: These are internally developed systems. As I said earlier, we spend $500 million a year on IT, and these systems are completely consistent with our measurement culture. After all, we’ve been in one line of business for over 60 years; so if we couldn’t fi gure this out we’d have a serious problem. And correct me if I’m wrong, but don’t banks have to close their books every night?

Stewart: Yes, but they certainly don’t disclose their informa-tion as quickly as you do. And, Tom, let me say that I think monthly disclosure is a terrifi c idea. It’s completely consis-tent with one of the fi rst principles that we all learned in business school—the idea that the market charges a discount for uncertainty. I would guess that your stock price—or the multiple of operating cash fl ow that your stock price repre-sents—is signifi cantly higher as a result of all this disclosure. Do you have any evidence of this?

King: Well, our stock price is now trading near its all-time high, but much of that has to do with the high level of oper-ating cash fl ow and earnings. But here is one result that I think you’ll fi nd interesting. Since we began this monthly disclosure in April 2001, the volatility of Progressive’s share price relative to that of the S&P 500 has dropped by almost 50%. Now, I hasten to add that I understand that stock


price volatility is not inherently good or bad. But I do think it is a fairly reliable proxy for the level of investor anxiety. So, the lesson here seems to be that if we disclose information more frequently, then we end up reducing uncertainty and our investors calm down—it’s like giving the market a dose of tranquilizers.

Getting the Right InvestorsStewart: Getting back to a topic we touched on earlier, do you fi nd that you shrink your potential investor base by fore-closing access to a much larger group of investors who don’t like the fact that you don’t manage earnings per share?

King: Perhaps, but that’s a deliberate strategy on our part. We are trying to scare off the momentum investors. If we have a clear set of fi nancial goals and fi nancial reporting policies, and we follow those guidelines consistently, we believe that over time we will attract the right kind of investors, sophis-ticated investors who are capable of recognizing that value creation is in large part about making valuable long-term investments—investments that end up maximizing net pres-ent value rather than the next quarter’s earnings.

Stewart: You said earlier that your investment banker couldn’t tell you much about the tax preferences of your investors. But do you have a sense that your investor group is different as a result of your disclosure policies and refusal to manage earnings? Have you been successful in attracting the kinds of investors that you want?

King: Very much so. One major investor is Peter Lewis himself, who still owns 10% of the company—and I don’t have to tell you that having your chairman own a signifi cant fraction of the stock is a great foundation on which to build an investor relations program. Ruane Cunniff, based in New York, has held a signifi cant block of stock for a long time. Another long-term owner is Trust Company of the West. And the Davis funds in New York have held a position in us for years. So our top four owners, who own over a third of our company, are all dedicated long-term holders. They have a thorough understanding of who we are. And, yes, they will call up from time to time. But, as I think you’ll be gratifi ed to hear, Bennett, we have never had an earnings per share never had an earnings per share neverdiscussion with any of these owners.

Despite our best efforts, however, we do have some momentum investors who trade in and out of our stock. One in particular has been in and out of our stock three times in the past fi ve years. Just before they came in for the third time, we actually tried to discourage them from buying our stock. But they came in anyway—and then left again. And then after there was some turnover at their shop and the new analyst wanted to come in for a fourth visit, we put our foot down and said, “No, there’s no point. Please don’t invest in us.”

Stewart: Does Reg. FD prevent you from talking to your long-term holders in any meaningful way?

King: Reg. FD didn’t change things for us a bit. We bristled a little at the documentation requirements in Sarbanes-Oxley, but we’re already measuring everything anyway. We avoid the risk of selective disclosure by using analyst meetings and conference calls to focus on things that don’t fi t into earnings models. And since so much of our information has little to do with earnings, Reg. FD has hardly changed our dialogue with investors.

Stewart: So you can talk about your strategy and policies pretty much with anybody and at any time?

King: That’s right. And we can talk about the likely effects on our business of general economic developments, such as trends in the regulatory environment, the labor market, and information technology. We can help investors understand, and anticipate, the major risks and sources of variability in our business. This ends up reducing investors’ uncertainty and, along with it, the volatility of our stock price.

Budgeting and Incentive CompensationStewart: Tom, you’ve already said that you aren’t big fans of earnings or growth targets. But what about your internal planning—how does your budgeting process work?

King: As you say, Bennett, we’re not big fans of budgets, in large part because we don’t want the push for growth to weaken our pricing discipline. And if I haven’t already made it clear, pricing discipline is one of our core principles. In the early ’90s, our chairman was a man named Al Lerner. He advocated a planning culture in which managers would negotiate a plan at the beginning of the year and then get rewarded for meeting the plan numbers. But Peter Lewis felt very strongly that this budgeting process was counterpro-ductive. He felt that because the world is uncertain—laws change, interest rates move, hurricanes strike—we needed to trust our employees to use their judgment and do their best in response to changes in the external environment. And this difference of opinion led to such a falling out between Peter and Al, both of whom were very successful business people, that it resulted in the dissolution of their business partnership.

Stewart: So this is yet another area in which Progressive differs from the normal management approach in Amer-ica. Most companies plan extensively in the fall, cast their budget in concrete, and pay bonuses accordingly. But your approach is really much more of an ownership model that gives people an open-ended piece of the action and lets them fl ow with that action. Having said that, I’m sure that you


have budgets and plans at Progressive; it’s just that you don’t pay people relative to the plan.

King: That’s true. We have a rolling 24-month forecast, and its primary purpose is capacity planning. We want to make sure that we have enough—but not too many—adjusters, phones, desks, square feet of real estate, dollars of capital, and so on. We don’t want undertrained adjusters trying to handle new business.

Stewart: But do you fi nd that your people don’t take the budgeting process seriously because they’re not compensated on that basis? We are defi nitely in your camp in terms of compensation philosophy, but we hear that concern a lot.

King: That should not be a concern; in fact, we may well be getting more accurate forecasts because we do not make because we do not make becausethem the basis for incentive bonuses. As you know, Bennett, basing bonuses on plans gives managers the incentive to “sandbag,” to understate potential results.

And, as we have learned from long experience, the cost of too much capacity is minor compared to the cost of not having enough. If we have too many adjusters for our antici-pated growth, then we have a little extra payroll that we have to cover; but that’s inconsequential compared to having a stream of claims coming in and not enough trained people to pay the right amount on a timely basis. Similarly, the cost of an idle fl oor in a building for a year or two is not that signifi cant, but the cost of having employees jockeying for space is enormous.

Stewart: So then how does your compensation plan work?

King: We have three sources of compensation. The fi rst, of course, is base salary. We also have our Gainsharing program, which is a profi t-sharing approach tied to growth and profi tability numbers. Every employee in the company participates in Gainsharing, from the CEO to the most recently hired receptionist. Although the target payout is a function of both premium growth and the combined ratio, we always try to ensure that everyone’s cash bonus is tied to profi table underwriting.profi table underwriting.profi table

Stewart: How much variation do you normally see in your combined ratio?

King: Well, different events can throw things off, both favor-ably and unfavorably. In the Gulf War in the early ’90s, for example, the price of gasoline shot up, and several hundred thousand automobile drivers shipped out from North America to the Middle East. As a result, our claims costs plummeted and we were much more profi table than we thought we would be.

But we got into trouble in 1999 and 2000 because, among other things, the cost of medical care started to increase after years of price defl ation. As a result, the Gainsharing payout was zero. And what’s interesting to me about this experience is that almost no one at Progressive quit over this—which confi rmed my own belief that, although money is important, it is in fact not the greatest motivator. The most important motivator is whether you love what you do, have fun doing it, enjoy the camaraderie, and are intellectually challenged. We work hard to create that kind of environment.

Stewart: But sometimes the Board is under tremendous pressure to say, “Look, everybody really dug in their heels, they did a great job in this year of adversity, this is an unusual nonrecurring thing, so we’ve got to override the plan and make a payout.” Did that happen at Progressive?

King: Not at all. In 2000 we had so many things go wrong that as early as February or March the CEO, Glenn Renwick, went in front of everyone and announced, “Gainsharing is over for this year.” He basically said there would be no vari-able cash compensation. But rather than falling into despair, our employees reacted by redoubling their efforts to turn things around.

We also had a number of key employees who were option holders. But even though the stock price dropped from $175 to $45, we never considered repricing the options.

Stewart: So not only did your earnings tumble, the stock price took a real hit as well.

King: Yes, we had a lot of problems simultaneously. But over a 40-year career, you are going to have a couple of outliers, and we just have to address them as they occur. In fact, with-out going into detail, we were able to solve our problems and the stock price went back up to $160. It took a bit of effort, but it also created a tremendous sense of pride and an enor-mous sense of confi dence on the part of the management team in their ability to continue to take risks. Our tolerance for making mistakes is one of our great strengths, because we know we can work together to fi x them.

Stewart: In fact, your company recently made the head-lines for converting your stock option program to restricted stock and discontinuing the options—and you preceded Microsoft in doing so. Can you tell us a little more about your decision to replace the option plan with restricted stock?

King: When we made that decision, which we announced at our shareholders’ meeting on April 18, 2003, all of our options were in the money. Even so, a reporter from the Wall Street Journal called us thinking that we had underwater Street Journal called us thinking that we had underwater Street Journal


options and were trying to correct that situation by institut-ing a restricted stock plan. But this was not at all the case. The reality was that the corporate scandals got us thinking about compensation and governance. In the absence of the Enron scandal, we probably wouldn’t have looked at our option plan, but under the circumstances we decided to do an internal study to try to determine the best way of aligning management behavior with the interests of the owners.

We concluded that restricted stock is a better tool because it does not have a levered payoff function, which limits the incentive for mid-level managers to swing for the fences. And there were other factors: Option contracts expire, whereas stock shares have an indefi nite life. Option contracts don’t pay dividends whereas restricted shares do. Option contracts don’t offer voting rights, whereas restricted shares do. We also found that employees under-value options relative to the cost of dilution to existing shareholders. And with a share of stock, you can look up the price in the paper; but few people are comfortable valuing options.

Stewart: How was that decision received by your employ-ees—and how was it received by the market, especially in light of the fact that you don’t have to recognize the cost of options for accounting purposes?

King: Our employees treated it as a non-event. And the market didn’t seem to react, either. We had certainly shared this information with the market—and we put it in the proxy and it was voted on by our owners—so we weren’t afraid of the accounting treatment.

Stewart: In addition to the compensation programs you’ve already mentioned, do you also use a Jack Welch-style up-or-out reward system where you attempt to cull your work force—one where the best performers get large rewards, people in the great middle just keep progressing, and people at the bottom get their legs cut off?

King: No, we don’t take that approach. First, we try very hard to hire people who will fi t well in the Progressive culture—and that means a customer service orientation, an enthusiasm for measurement and process improvement, and, above all, integrity. Of course, we do make hiring mistakes, and if we fi nd an integrity problem, we’ll get that person out of the company very quickly. So we do have culling of the workforce in that sense; but it is geared to a very small percentage, say 1% to 2% of the workforce, and it’s not a formal part of the process.

By and large, the people who go to work for Progressive end up liking it. The trick is to fi nd the right job for a person—one where they can have a happy, healthy, productive career with our organization. We have found that the most valuable

people in our business are the ones who stay for at least fi ve years. Our human resources people understand that different people want different things; and if you come to work for our organization, we will try to fi nd ways to keep you happy and challenged. For example, an employee may want to relocate to Jacksonville, Florida; another may want to go law school; yet another may want to get involved in claims training; and a fourth may want to move up the hierarchy and take the next available supervisory position. We fi nd ways to keep all four of these people happy and productively employed, despite differ-ences in goals and skills.

Stewart: So when you are looking for a new recruit, how do you explain to them what makes Progressive unique—what’s unique about your culture, your management approach, and your incentive plan?

King: When I interview people for Progressive, I am looking for two traits. The fi rst is a willingness to innovate. Are they truly willing to put their name on something that hasn’t been done before and that has a 90% chance of blowing up? Many people are afraid to do so. I always ask an interviewee to tell me about the greatest professional mistake that he or she can take credit for. And you’d be amazed at the absence of answers.

The second trait we are looking for is integrity. When you make a mistake, you must come clean and say, “I screwed up.” The fi rst few times that you have to admit to a mistake can be kind of painful. But after a while you don’t even notice it. And we have such an analytic culture that a mistake just becomes an interesting engineering exercise—we’ve removed the fear of failure. We simply want to know what happened, and how we can learn from it. George Gilder observed that successful people and companies have more failures than do mediocre ones. We screw up more by 9:00 a.m. than most companies do all day. But those companies don’t take any risk.

Stewart: Can you give us any examples of your own profes-sional mistakes?

King: My biggest professional screw-up was when I was the product manager for the Pennsylvania auto insurance busi-ness. There was a change in the law in 1990 that required price reductions. We found a way to comply with the law and yet have properly priced rates, and it gave us a tempo-rary monopoly. We were growing and earning nice margins, but I had worked so hard to implement our solution that I became risk averse. At a business review, several senior executives said, “Tom, this is a once in a lifetime opportu-nity; don’t waste it. Let’s take some risk. We are not telling you what to do, but you’ve already done A through C. Have you considered doing D through M in addition? If it goes wrong, we are here to help you. You are not talented enough to sink this company.”


But I didn’t listen. So we had this nice little period of profi table growth, but when the window closed it was too late. And now, ten years later, I look back and say, “Boy, was I wrong.” I wish I had listened to those people and taken a lot more risk. But I had the perspective of a mid-level manager; the Pennsylvania auto product was my entire world. I wasn’t thinking like a Progressive shareholder.

Stewart: And what about some of Progressive’s successes?

King: One big success was our pioneering move away from underwriting to pricing. Underwriting means risk accep-tance or rejection at a given price, whereas pricing means that there are no bad risks, only bad rates. We decided we could insure anything for the right price. And we were the fi rst company to say that if you are a licensed driver, we’ll quote you a price. That was a radical idea in the early 1990s, although it has since been copied. And we greatly expanded our customer base, growing our revenues tenfold—and organically, without help of acquisitions—in a little over a decade.

Another success was the idea of being an independent agency company and then opening up our own direct sales operation and confronting the sales channel confl ict. Initially, we got a lot of resistance from our independent agents, and it was pretty painful. But we were able to persuade them that there are a lot of drivers who have grown up in the world of L.L. Bean who want to just pick up the phone and call directly for insurance. We didn’t feel that those drivers would

ever come to us through the independent agency channel. And it turned out that having multiple channels increased our business without eroding the business of the indepen-dent agents.

A third big win for us was our decision to be the fi rst auto insurance company to embrace the Internet. We have a pricing model that lends itself to this sort of interface because it eliminates judgment; that is, based on certain inputs, the price is determined through a certain algorithm. In 1995, we had the fi rst billboard Web site in our industry, we offered quotes over the Internet in 1996, and we had the fi rst online sale in 1997. Today a sizeable share of our direct business comes in through the Internet. And the Internet will offer even greater potential when we fi nd a way to share information with you that you can put to productive use as you try to manage your own fi nances.

Stewart: Those are three great examples. And thank you very much for sharing the Progressive story with us. It’s a great story, one that I think has lots of lessons for corporate America.

tom king is Vice President and Treasurer of Progressive Insurance.

bennett stewart is Senior Partner of Stern Stewart & Co., a global consulting fi rm with headquarters in New York City that specializes in the management applications of economic profi t under its trademarked name of EVA.

Journal of Applied Corporate Finance (ISSN 1078-1196 [print], ISSN 1745-6622 [online]) is published quarterly on behalf of Morgan Stanley by Blackwell Publishing, with offices at 350 Main Street, Malden, MA 02148, USA, and PO Box 1354, 9600 Garsington Road, Oxford OX4 2XG, UK. Call US: (800) 835-6770, UK: +44 1865 778315; fax US: (781) 388-8232, UK: +44 1865 471775, or e-mail: [email protected].

Information For Subscribers For new orders, renewals, sample copy re-quests, claims, changes of address, and all other subscription correspon-dence, please contact the Customer Service Department at your nearest Blackwell office.

Subscription Rates for Volume 17 (four issues) Institutional Premium Rate* The Americas† $330, Rest of World £201; Commercial Company Pre-mium Rate, The Americas $440, Rest of World £268; Individual Rate, The Americas $95, Rest of World £70, Ð105‡; Students**, The Americas $50, Rest of World £28, Ð42.

*Includes print plus premium online access to the current and all available backfiles. Print and online-only rates are also available (see below).

†Customers in Canada should add 7% GST or provide evidence of entitlement to exemption ‡Customers in the UK should add VAT at 5%; customers in the EU should also add VAT at 5%, or provide a VAT registration number or evidence of entitle-ment to exemption

** Students must present a copy of their student ID card to receive this rate.

For more information about Blackwell Publishing journals, including online ac-cess information, terms and conditions, and other pricing options, please visit www.blackwellpublishing.com or contact our customer service department, tel: (800) 835-6770 or +44 1865 778315 (UK office).

Back Issues Back issues are available from the publisher at the current single- issue rate.

Mailing Journal of Applied Corporate Finance is mailed Standard Rate. Mail-ing to rest of world by DHL Smart & Global Mail. Canadian mail is sent by Canadian publications mail agreement number 40573520. Postmaster Send all address changes to Journal of Applied Corporate Finance, Blackwell Publishing Inc., Journals Subscription Department, 350 Main St., Malden, MA 02148-5020.

Journal of Applied Corporate Finance is available online through Synergy, Blackwell’s online journal service which allows you to:• Browse tables of contents and abstracts from over 290 professional,

science, social science, and medical journals• Create your own Personal Homepage from which you can access your

personal subscriptions, set up e-mail table of contents alerts and run saved searches

• Perform detailed searches across our database of titles and save the search criteria for future use

• Link to and from bibliographic databases such as ISI.Sign up for free today at http://www.blackwell-synergy.com.

Disclaimer The Publisher, Morgan Stanley, its affiliates, and the Editor cannot be held responsible for errors or any consequences arising from the use of information contained in this journal. The views and opinions expressed in this journal do not necessarily represent those of the Publisher, Morgan Stanley, its affiliates, and Editor, neither does the publication of advertisements con-stitute any endorsement by the Publisher, Morgan Stanley, its affiliates, and Editor of the products advertised. No person should purchase or sell any security or asset in reliance on any information in this journal.

Morgan Stanley is a full service financial services company active in the securi-ties, investment management and credit services businesses. Morgan Stanley may have and may seek to have business relationships with any person or company named in this journal.

Copyright © 2004 Morgan Stanley. All rights reserved. No part of this publi-cation may be reproduced, stored or transmitted in whole or part in any form or by any means without the prior permission in writing from the copyright holder. Authorization to photocopy items for internal or personal use or for the internal or personal use of specific clients is granted by the copyright holder for libraries and other users of the Copyright Clearance Center (CCC), 222 Rosewood Drive, Danvers, MA 01923, USA (www.copyright.com), provided the appropriate fee is paid directly to the CCC. This consent does not extend to other kinds of copying, such as copying for general distribution for advertis-ing or promotional purposes, for creating new collective works or for resale. Institutions with a paid subscription to this journal may make photocopies for teaching purposes and academic course-packs free of charge provided such copies are not resold. For all other permissions inquiries, including requests to republish material in another work, please contact the Journals Rights and Permissions Coordinator, Blackwell Publishing, 9600 Garsington Road, Oxford OX4 2DQ. E-mail: [email protected].

Documents

Making Financial Goals and Reporting Policies Serve : Corporate Strategy: The Case of Progressive Insurance