Allstate Pivots Toward Growth

Although a low level of catastrophe losses aided  Allstate’s (ALL) fourth-quarter results, we think the finish to the year shows the progress management has made in restoring profitability. In the core Allstate-branded operations, premiums grew 3% year over year, almost entirely from pricing increases. The combined ratio improved to 88.7% from 101.7% last year, but this was because of a dramatic fall-off in catastrophe losses, with comparisons against Hurricane Sandy losses last year. The underlying combined ratio, which excludes catastrophes, ticked up a bit to 87.5% from 86.7% last year, but remained at an attractive level and was basically flat for the full year. Like other insurers, Allstate is feeling the pinch from lower interest rates, although investment income fell only slightly thanks to strong performance in its equity investments. We appreciate the aid these investments are providing, but they do potentially introduce more volatility into results. Overall, the company achieved a 14.5% operating return on equity for the year, a result that supports our narrow moat rating.

In 2011, in the wake of disappointing results, management laid out a plan to restore profitability; it closes out 2013 having largely achieved its goals. With results on better footing, management is content to maintain recent levels of profitability in 2014 and is shifting its focus toward growth. Profitability and growth goals can be somewhat at odds in the insurance industry, and we have a strong preference for companies that focus on profitability, even if it comes at the expense of growth. We would agree that at current margin levels, higher growth would be create value, although Allstate’s reliance on the captive agent channel should limit expectations. Although the company does have exposure to the faster-growing direct channel through its Esurance brand, we think straying too far from its core business model could have negative moat implications. But its Allstate-branded operations still dominate overall results, and we don’t expect that to change anytime soon.

Fears of Agency Obsolescence Are Overblown
Allstate’s captive agent model has been out of fashion in recent years, as industry growth has been concentrated in the direct channel. We believe the addition of the direct channel has bifurcated the auto insurance market among customers with different needs and preferences. The customers that Allstate serves are less likely to shop their policies and value the service an agent can provide to help manage their risks, design customizable plans, and save them money through bundling. Given the value an agent can provide for these customers, we believe fears that the Internet will make agencies obsolete are overblown. Allstate occupies a strong position in this mature niche, which management estimates is about half the market, and we think it can generate solid returns now that it has worked past some pricing issues in its homeowners line. But top-line growth will continue to be difficult to achieve, given the industry shift.

While the agency channel remains Allstate’s bread and butter, the firm has been hedging its bets somewhat. Allstate acquired Esurance for $1 billion in 2011 in order to add an online presence. It also acquired insurance aggregator Answer Financial in this deal, an online brokerage that collects a fee for placement with competitors. Allstate has now effectively entered all subsegments of the auto and homeowners markets, ensuring that the evolution of customer preferences will not leave it in the dust. The agency channel still dominates results, but we would be concerned if Allstate strays further from its core business model, as an overly diversified model in an industry that is not particularly moaty is essentially a guarantee of mediocre results, in our view.

Allstate has also been shortening the duration of its investment portfolio in light of the low-interest-rate environment. This will magnify the short-term stress on this side, but will also better position the company to benefit if rates increase. While we see the potential positive of this tactic, we would prefer that the company accept the current rate environment and simply focus on writing business that is still profitable despite lower investment income.

Captive Agents, Bundling Strategy Contribute to Moat
In general, property-casualty insurers do not benefit from favorable competitive positions. Industry competition is fierce, and the products are essentially commodities. Furthermore, participants do not know their cost of goods sold for a number of years, allowing them to underprice policies without knowing it. Firms have a large incentive to chase growth without regard for profitability, a cycle that repeats itself as competitors are forced to match artificially low prices or risk losing business.

That said, Allstate has set itself apart in personal lines insurance through its use of captive agents and its bundling strategy, and we believe it has a narrow moat. As customers add policies, they are more likely to rely on an agent who can help them customize their policies and save them money through bundling. Each additional policy will allow the customer to save money, as it has been actuarially proved that these policyholders are lower risk, and each incremental policy creates stickier customers. As these customers have multiple policies for a car (or two), a home, and possibly a boat, price shopping becomes more burdensome, making them less likely to switch companies in order to save a small amount on an individual policy. Whereas many of its competitors use independent agents to source sales, Allstate’s captive agents sell only company policies. This allows Allstate to benefit from the stickiness of the customer relationship, rather than an independent agent, and lowers Allstate’s customer acquisition costs. The effectiveness of the company’s bundling strategy can be seen in its expense ratio, which has averaged 25% over the past five years, compared with an industry average of 28% over the same period. Scale also plays a role, as the business model of personal line insurers does not require as many specialized underwriters and companies are able to spread fixed costs over a wider base.

Balance Sheet Leverage Comparatively High
Market rallies have boosted the firm’s investment portfolio, but future losses are possible as the company decides which investments it intends to hold and which it will sell as it restructures its Allstate Financial segment. About half of its investment portfolio is composed of corporate bonds, exposing it to corporate defaults in the event of a major recession. Because of its mixed model, Allstate retains a large amount of balance sheet leverage compared with many of its property-casualty insurance peers, which could magnify the effect of a large loss year from a catastrophe event. Catastrophe risk from unpredictable weather also adds to uncertainty.

Despite sourcing most of its business from its property-casualty operations, Allstate’s balance sheet looks more similar to a life insurance company than its peers because of the much higher balance sheet leverage inherent to the life insurance business model. That said, Allstate’s balance sheet has improved dramatically since the financial crisis, and the firm has taken significant steps to derisk its investment portfolio and operations. At 17%, its equity/assets ratio is toward the high end of its precrisis range. We think the company has reached a point where its leverage is no longer a major concern, and we have changed our fair value uncertainty rating to medium. But it is worth noting that this is still significantly lower than the typical property-casualty company’s equity/assets ratio in the mid- to upper 20s.

Near year-end 2010, the company reintroduced a stock-repurchase program, under which it repurchased $1 billion worth of shares. It has been fairly consistent in repurchasing stock since, and this is now its dominant means of returning capital to shareholders. Given the company’s limited growth prospects, we expect it will return the vast majority of its free cash flow going forward.