State Farm: Behind the Veil

• Barbara Bowers
• July 2001
• 

by Barbara Bowers

State Farm Mutual Automobile Insurance Co. had humble beginnings in 1922 as the brainchild of George J. Mecherle, an Illinois farmer turned insurance salesman, who thought he had a better way to sell auto policies to farmers at lower rates. In the 79 years that followed, the company grew from a small operation in the heart of Illinois farm country to the leading auto and homeowners insurer in the United States, with 25 regional offices, more than 79,000 employees and nearly 70 million policies in force.

Warren Buffett-no stranger himself to corporate success sagas-recently called this "one of America's greatest business stories" and urged business schools to study the company, "because it has achieved fabulous success while following a path that in many ways defies the dogma of those institutions."

But lately, some potholes have formed in State Farm Mutual's path. After four strong years, the property/casualty giant reported in 2000 that its net income from all affiliates, including non-insurance affiliates, had plummeted to $408.1 million, down $626 million from 1999. State Farm Mutual's net worth dropped $2.1 billion to $43.7 billion from the year before, after having risen $4 billion in 1999. State Farm Mutual said the main reason for the downturn was a pretax operating loss of $1.9 billion, which included a $3.3 billion underwriting loss. An unrealized loss of $711.5 million reflected operating results of State Farm affiliates as well.

The company tied the underwriting loss in part to increased loss severity, as well as auto rate reductions, which totaled $672 million for the year. In June, State Farm said it plans to stop writing auto insurance in New Jersey because of continuing losses and unique burdens imposed by the state's insurance regulatory system.

Apart from the financials, State Farm had image problems in 2000. The company was appealing an historic court decision that ordered it to pay a $1.05 billion award to its policyholders for requiring generic parts in auto repairs. That appeal was denied in April 2001, but the company hopes to carry its fight to a higher court. And in June 2000, the television program "Dateline NBC" detailed questionable practices used to deny medical-treatment claims by two medical-review firms that State Farm had employed. The program prompted the National Association of Insurance Commissioners to launch a multistate market-conduct exam of State Farm's auto-injury claims practices. The exam is ongoing.

If State Farm were a publicly traded company and subject to the pressures of edgy investors, its mea culpas might have echoed through the canyons of Wall Street. But as a mutual insurance company, it answers only to its policyholders, who are the owners of the company. Still, some equity analysts who cover State Farm's stock-company competitors-namely, Allstate, Progressive and Geico-wonder how much longer its managers will pursue their strategy of seeking to buy market share with underwriting losses. Eventually, the analysts warn, even the rating agencies that have applauded State Farm for its super-plush capital base and formidable competitive advantages may start pressing the company to improve its operating performance. Currently, State Farm has the highest ratings from A.M. Best (A++), Standard & Poor's (AAA) and Moody's Investors Service (Aaa).

In recent years, State Farm's strategy has led it to maintain low rates in certain states and reduce rates in others, all with an eye toward winning back market share.

Holding On as No. 1

State Farm, the No. 1 writer of private-passenger auto in the United States, has seen its 21.6% slice of business in 1995 drop to 18.9% in 1999. The other top auto insurers-Allstate and Farmers-also have lost market share over the last three years, while No. 4 Progressive and No. 6 Geico, the latter part of Buffet's Berkshire Hathaway, have doubled the number of policies each has written, according to A.M. Best Co. data. Progressive grew from 2.6% of the market in 1995 to 4.8% in 1999, and Geico moved from 2.5% in 1995 to 4.1% in 1999.

"Competition in the insurance marketplace is fierce, particularly the fight for market share in auto," Vincent J. Trosino, president, vice chairman of the board and chief operating officer, said in the company's 2000 report. "We're not only competing with some of the familiar names like Allstate, Farmers and Geico, but also with new ones like Axa Group and Zurich Financial Services-all of which would like to carve away part of the State Farm book of business."

Since 1998, State Farm has instituted $2.7 billion in total auto rate reductions and, since 1997, has given customers $2.6 billion in dividends. The company said that by the end of 2000, State Farm affiliates had gained 1.7 million policies over 1999.

Anthony Diodato, assistant vice president, property/casualty division, A.M. Best Co., said the recent actions State Farm has taken, including rate decreases, underwriting enhancements and dividends, have uniquely positioned the company and adversely affected competitors.

"State Farm has an enviable position of being very overcapitalized and mutual status with no stockholder-earnings pressures," Diodato said. "In addition, State Farm has a superior customer retention resulting from their continued low pricing, well-regarded customer service and policyholder dividends. Competitively, they have lost market share over the past few years. They appear to be using their many advantages to regain lost market share. "

Diodato noted that a number of the other market leaders are also nonstock companies and are well-capitalized, but even these organizations don't have the capital cushion-estimated at $16 billion of excess capital relative to A.M. Best's A++ capital requirements-that State Farm has.

"This capital position allows for more flexibility to competitively price business," he said. "The other market leaders stand to lose market share, since they don't have the pricing flexibility."

However, State Farm has more than just capital strength going for it, Diodato said. "They have a vast 50-state reach, strong data-mining capabilities, diverse product offerings, low-cost operation, acknowledged strength in claims service and many other attributes," he said. "These qualities result in excellent customer loyalty and retention. While their market share fell over the past few years, the combination of these recent actions and capital strength will result in their market share increasing in the future. "

Although Buffett, chairman and chief executive officer of Berkshire Hathaway Inc., may be an admirer of State Farm's success story, he recently took the company to task for swallowing losses to gain customers. In his 2000 report to stockholders of Berkshire Hathaway, Buffett complained that State Farm's price-cutting was unfair to Geico and other insurers. In just one example, State Farm has lowered rates more than 25% in California over the last six years. Meanwhile, Farmers Insurance Exchange, a unit of Farmers Group, and the second-largest writer of private-passenger auto insurance in California, has filed for a rate increase of an average 6.6%, citing costlier claims.

"State Farm-by far the largest personal auto insurer...has been very slow to raise prices," Buffett said. "Its costs, however, are clearly increasing right along with those of the rest of the industry. Consequently, State Farm had an underwriting loss last year from auto insurance (including rebates to policyholders) of 18% of premiums, compared to 4% at Geico.

"Our loss produced a float cost for us of 6.1%, an unsatisfactory result...But we estimate that State Farm's float cost in 2000 was about 23%. The willingness of the largest player in the industry to tolerate such a cost makes the economics difficult for other participants," Buffett said.

Edward Rust Jr., CEO of State Farm, countered by saying that while Geico tries to make insurance a commodity, State Farm doesn't take that approach. If State Farm won more customers in 2000, Rust reportedly said, he'd like to think the important component was service, something he feels that State Farm does well.

Mary Beth McDade, a spokeswoman for Progressive, said the company does not comment on the strategies of other insurers. But she said that Progressive's promise to its shareholders is "to price our product to obtain a 4% underwriting profit." In markets where that profit proves unobtainable, Progressive will adjust its rates, she said.

Allstate declined to comment on State Farm's activities.

Bloomington, Ill.-based State Farm made headlines last November when it announced a new pricing policy for auto rates that will give discounts to drivers of vehicles which State Farm says are shown to be safest. The new pricing policy, which went into effect Jan. 1, offers a "vehicle-safety discount" that replaces the company's "passive-restraint discount" for cars with airbags or automatic safety belts. The new policy applies to 1994 or newer private-passenger vehicles, including SUVs, trucks and larger cars.

State Farm said 36 new vehicle models qualify for both a 20% to 40% personal-injury discount and collision and comprehensive premiums that would be 10% to 40% lower than the standard premiums.

To Alice Schroeder, equity analyst at Morgan Stanley Dean Witter, this was in keeping with several actions that State Farm had taken in previous months, including an unusually large 12.5% rate reduction in physical damages in California, a state that represents 10% of the U.S. auto insurance premiums; a recommitment to its agents in October 2000 that rebuilding market share in its auto business was the company's highest priority; and increasing the portion of agents' cooperative advertising it would pay, meaning the company will now absorb 75 cents, instead of 50 cents, for every dollar that agents spend on marketing.

"We believe that State Farm is in the process of implementing a multifaceted strategy to rebuild market share," Schroeder said in a November 2000 research report, adding that the key points of the strategy are "more competitive pricing and more aggressive marketing." The insurer also is likely to continue funding its growth initiatives through competitive pricing for the time being, she said.

This "newly energized and competitive" State Farm is becoming a more potent force in the market, Schroeder concluded and "will be a limiting factor on other carriers' ability to raise rates in the current inflationary environment."

That's the very concern of investors who think State Farm will continue to use its huge excess capital to limit the amount that prices could rise in the auto insurance business, opined the Wall Street Journal's "Heard on the Street" column on April 25. In Florida, for example, market-leader State Farm notified policyholders last spring of an average 6.4% auto rate hike-the first increase in that state since 1996. However, the increase came in lower than the Florida Department of Insurance's projection of 9.7%, as well as the estimated industry average increase of 9.4%.

But analysts at Lehman Bros. think these concerns are "overblown." In their May update on No. 2 personal lines insurer, Allstate, Lehman analysts start off by asking, "Is State Farm Going to Continue to Be the Bugbear of the Auto Insurance Industry?" Not likely, they respond. According to their calculations, State Farm will struggle in 2001 to achieve what the company considers its top goal-growth in surplus or equity. This is partly due to the weak stock market; just a 1% reduction in the stock market reduces State Farm's surplus by $348 million, Lehman Bros. noted.

"Our argument is the flip side of the one cited in the Wall Street Journal-reduced price competition from the mutual auto insurers," wrote Lehman Bros. The big mutual auto companies like State Farm, USAA and Nationwide do have financial discipline, but the measures these companies use to determine their financial success is different from the stock auto insurers, which care about return on equity, the analysts said. The mutuals "care about book-value growth...and their heavy investment in equities suggests that by their standards 2001 will be a year of poor financial results. These poor financial results, we think, will drive these companies to raise prices."

Underwriting Losses

Underwriting losses have been heavy in the auto insurance business, with industrywide combined ratio for personal lines companies at about 110 in 2000. State Farm Mutual has reported $6.4 billion in underwriting losses and dividends over the past two years in the auto line.

Even the industry leader can lose too much money on underwriting, Lehman analysts said. State Farm and its affiliates reported a combined ratio, including policyholder dividends, of 119.2 in 2000, compared with 110 in 1999. Combined ratio is the percentage of each premium dollar that an insurer spends on claims and expenses.

State Farm has said that it needs to achieve a combined ratio of about 105, on average, which it describes as its break-even point, said Todd Bault, institutional analyst for Sanford C. Bernstein & Co.

Stock companies, on the other hand, need to aim for a combined ratio of 100 to make money. "The rest of the industry-the top companies in the top 10-are not so far from 100," Bault said. "Allstate is already there; Progressive is almost there. Geico had a bad period in 2000, but they've raised rates and they're probably going to be there."

On average, the next big competitors after State Farm "have something like 8% average rate change they need to get back in order to be where they want to be," Bault said. "State Farm's got to get 18% rate to get back to the worst standard where they want to be. It's just out of balance."

This particular number is key to Bault. In his March 23 Bernstein Research report, "Enough Already About State Farm!," he argues that State Farm's "supposed quest for market share vs. profitability compared to other auto insurers has completely failed." He cited State Farm's higher-than-industry-average combined ratio and its loss of market share "while the rest of the top 10 have gained significantly"-33% to 43% in six years.

Even allowing for a lower profitability threshold to fund policyholder dividends, State Farm needs twice the level of price increase to return to sustainable profitability, Bault said. "Current profitability levels are too low to continue pricing for market share," he said.

If State Farm can behave this way-cutting rates to gain market share and not caring about profitability-then the real question is whether the company is succeeding in its strategy. "Yes, they did indeed cut rates because their profitability sank like a stone. But they did not gain market share," Bault said.

A Change in Strategy

Assuming State Farm gets business back, it is expected to incrementally raise its rates, analysts said. But no one knows at what point the company will decide to actively pursue that change in strategy. After all, this is an insurer known for keeping its cards very close to its chest. For one thing, State Farm's top executives declined to be interviewed for this article. For another, some of its own agents can be frustrated in their attempts to obtain information from the company, indicated Robert Lamphier, president of the National Association of State Farm Agents Inc., an organization that the insurer does not recognize.

In August, the company is expected to release the results of its ESS, or Enterprise Structure Study, Lamphier said. "They're keeping this under lock and key," he said, adding that he expects that the announcement will stress the need for restructuring the company and trimming corporate fat. "The one-year sales growth was only 7.2%, and net income dropped 60.5%-that's what ESS is all about," he said.

If State Farm does announce a massive restructuring effort soon, it will be following in the footsteps of nearest-competitor Allstate, now in the midst of a sweeping overhaul that the Northfield, Ill., insurer launched in November 1999. The company said it would reduce annual expenses by some $600 million, leading to cuts of 4,000 nonagent jobs, or roughly 12% of its nonagent work force, by the end of 2000. Allstate said it planned to channel those savings largely into call center and Internet capabilities and phase out company-employed insurance agents, moving them to independent-contractor status.

State Farm, however, has been taking a more leisurely approach in developing its technology capabilities. For some time, consumers contacting State Farm online have been able to receive rate quotes for term life, whole life and auto insurance in 32 states. Beginning last spring, however, State Farm said it would offer auto insurance directly through the Internet in California and renters insurance in Illinois as a pilot program. For the first time, its customers would be able to apply for and bind a contract online.

So far this year, State Farm has been raising rates more often than lowering them. By mid-June, the company had instituted 14 rate increases and four rate reductions. But some analysts argue that these rate hikes aren't big enough. "They're raising rates less than other people, so that would again seem to play towards this goal to gain market share," Bault said. "But again, we have five years where it didn't work. And I don't think it's going to work now."

In its battle for market share, State Farm's expense ratio has deteriorated significantly-signifying the loss of a key advantage, Bault said. "Its expense ratio is now pretty much the same as comparable insurers, around 23% for a direct insurer. It used to have an advantage of probably at least 3 to 5 points of expense. It doesn't have that anymore."

That indicates that State Farm needs to become more efficient. "I have no doubt that State Farm is working on initiatives to do that," Bault said.

To become more lean and mean, he suggests that the giant mutual adopt some of the streamlining measures that stock companies have taken. "They can try to use technology more efficiently, to replace manual processes with electronic processes," he said. "They can do more old-fashioned things like think about restructuring, think about eliminating some people, closing down some agencies-just the basic stuff that you can do."

State Farm also could follow the lead of Allstate and Progressive and develop a multichannel distribution system.

In a mutual, however, there isn't much of an efficiency culture, Bault said. "That's not what it's about," he said. "And if you start to go toward an efficiency culture, even if senior management thinks it's the right thing to do, you will get resistance from people in the company who will say, 'I'm working for a mutual, because I don't want to deal with this aspect of a stock company.'"

That's a challenge that State Farm will have to confront, Bault emphasized. "It's not insurmountable. It will be tough, but they can do it," he said. "Still, it will be a drag on the progress they could make."