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Dan Sacks

Kai Ross

The Allstate Company (ALL) provides a range of insurance products to clients, including auto, homeowner and life insurance. In order to maintain margins in increasingly competitive insurance markets such as auto insurance--where major competitors Geico and Progressive (PGR) offer rate reductions to "switchers"--Allstate has pushed its bundled offerings, hoping to serve as a one-stop insurance provider to its customers. Bundled products may be especially important to build relationships, as "switchers" engender little customer loyalty; after all, customers who switch from one provider to another are likely to leave again.

The insurance business is synonymous with risk, and Allstate has managed its risk to varying degrees of success. The company is a market leader in the auto insurance sector, and it has increasingly pursued higher-risk, higher-profit drivers.

Allstate is also confronting the downside of insurance risk in its homeowners unit, which underwrote policies for many homes along the Gulf Coast in 2005. Allstate bore the brunt of the disastrous hurricane season that year, losing 25% of its assets. One reason Allstate was highly exposed to this catastrophic event was its lack of reinsurance, or (insurance for insurance companies). Since then, Allstate responded by dramatically increasing its reinsurance and by cutting risky homeowner clients.

As with most insurance businesses, a significant portion of Allstate's operating profits come from investing premiums paid by customers before paying out claims (called the float). Some insurance businesses such as auto have minimal float, as the time between receiving monthly premiums and paying claims is relatively short. On the other hand, Allstate's life insurance business runs basically like a mutual fund, with the invested premiums paid upon the death of the claimholder. Investment income from long-cycle insurance is an important part of Allstate's business. In fact, all float incomes are a crucial part of Allstate's business and last year, the company would not have had positive operating margins if it were not for its float investments. Dependence of profit on investing activities exposes Allstate to fluctuations in the equities market as well as changes in interest rate.

Business Overview

Allstate Incorporated is divided into four arms, two of which produce revenue (the remaining two are corporate entities):

• Allstate Protection: Provides non-life insurance; $27.23 billion in premiums for 2007
• Allstate Financial: Provides life insurance and investment products; $1.87 billion in premiums for 2007

Allstate Protection

Allstate Protection creates revenue by selling non-life insurance to policyholders, who pay a premium in order to be compensated for losses they incur. In 2007, 67.7% of Allstate Protection sales were in auto insurance and 22.8% in homeowners’ insurance,^[1] with the remainder falling across other forms of insurance, such as renters’, fire, and selected commercial insurance products.

Every year, about 20% of income from premiums pays for business expenses, including payroll and marketing. This ratio of business expenses to premiums is called the expense ratio. The majority of premium income goes back to policy holders in the form of claims payments; 2005 was an especially bad year for catastrophes: Allstate paid out $5.5 billion in catastrophe claims, a number which dwarfed the industry average on a per revenue basis. By contrast, catastrophe claims amounted to $898 million in 2007.^[2] Adding their expense ratio to the overall loss ratio--including catastrophic losses--resulted in a combined ratio of 105% in 2005 for Allstate Protection. A combined ratio above 100% means the company is paying out more in expenses and claims than the revenue it generates from premiums.

An insurer can spend more on expenses and claims than it receives in premium payments yet still make money; this is because of the float. In the time between receiving premium payment and paying out claims and expenses, Allstate Protection’s premiums are said to float, and the company can invest its premiums (in stocks, bonds, etc.) to earn an additional profit. In 2007, Allstate Protection’s net investment income totaled $1.97 billion. Because Allstate's earnings are tied to its investment portfolio, rising or falling interest rates can determine Allstate's profitability.

Reinsurance

Hurricane risk

The 2005 hurricanes season was so devastating for Allstate that, regardless of investment income, the company lost 25% of its assets and was forced to change its basic operating strategy. Other insurers fared better because they had reinsurance, which insurance companies use to guard against catastrophic situations (basically, insurance companies get insurance). Allstate, on the other hand, had much less reinsurance coverage. Since then, the company has taken on significantly more reinsurance, increasing coverage from $200 million to $880 million by premium.

Allstate was especially vulnerable to hurricanes because of its relative geographic concentration in Florida, Texas, Alabama, and Louisiana, where 10% of the state’s premiums were paid to Allstate. The company has tried to cancel policies in vulnerable states as they come up for renewal, but state governments have taken action to prevent or discourage this strategy, especially in Louisiana and Florida, where the government has forced Allstate to insure all policy holders for 100 days or until they can find a new insurance provider.

Asbestos problems

Yet another factor affecting Allstate's home insurance business is asbestos contamination, which the company is liable for removing. Asbestos is an increasingly important source of high claims for Allstate. In the United States, some 30 million homes, schools, and other public buildings contain asbestos which could need removing.

High-risk, high-value auto insurance

Their auto insurance business, which makes up the majority of Allstate Protection’s revenue, assesses client risk using a variety of demographic and biographic variables. On average, young male drivers with two speeding violations are more likely to get in an accident than a middle-aged woman with a clean record. The risk trade-off is that the riskier male driver is also the higher value customer, since he is paying higher premiums. An auto insurance company can choose to take on more risk—-and potentially higher profits-—by acquiring these high-value, high-risk drivers. This is exactly what Allstate has pursued in the last few years, and high-value drivers have grown from 29% of auto premiums to 48% recently.

Allstate and Customer Retention

Allstate intends to grow and retain customers by employing a bundling strategy. Because the company provides so many lines of insurance—homeowners, auto, house, commercial, fire, etc.—Allstate can sell multiple lines to the same client. Customer retention and bundling insulate Allstate from the intense price competition that is beginning to characterize much of the insurance industry, especially auto insurance. Progressive (PGR) and GEICO both increasingly offer rate reductions to auto insurance customers who switch to them.

In retaining customers, Allstate's network of agents is a critical asset. Allstate depends on its agents, many of whom work only with Allstate (but retain their independent status), to drive its sales. Allstate expects customers will develop a good long-term relationship with their local agent and, as a result, will pay slightly higher premiums in exchange for the comfort of knowing they will always have someone to call in the event of an emergency.

Allstate Financial

Allstate Financial primarily sells life insurance, which work like a mutual fund: claim holders make regular payments which the insurance company invests in stocks, bonds, etc. When the policy holder passes away, Allstate pays out the principle investment and a portion of the returns to the beneficiary. Sometimes, a “variable annuity” (VA) is used whereby the payout is tied to the performance of the investment portfolio but in 2006, Allstate divested its VA business, which had represented only 1.5% of their business.

Allstate Financial generated a far smaller share of revenue compared to the Protection division, accounting for 6.5% of premiums for 2007. However, life insurance netted more than twice the absolute investment returns than other insurance products in 2007 with $4.2 billion in investment income. Allstate has bundled its life insurance product with other offerings with limited success. The life insurance business has represented a slow and steady steam of revenue for Allstate.

Comparative Metrics

Operating Statistics

The following table compares Allstate to a number of its competitors along seven major categories. Premiums sold, claims and expenses paid, and investment income are reported in billions of dollars. The return on premium is the fraction of the premium that does not pay expenses.

Source: Company Data

• All data is for FY 2007.

• Both State Farm and Liberty Mutual, as of March 18th, 2008, have yet to release their respective Annual Report and 10-K.

References

1. ↑ ALL FY2007 10-K Annual Report, page 56.
2. ↑ ALL FY2007 10-K Annual Report, page 50.