State Farm Policyholders Unite!

As a follow up to my recent piece on State Farm’s capital situation, I wanted to expand on the fundamental tensions underlying State Farm and its governance.

State Farm, as you all know, is a mutual. That means its policyholders own it. Normally, owners of a business make the decisions on how to operate it.

However, State Farm policyholders (and most other mutuals) have slipped into a delegated authority model. They “give away the pen” to State Farm management to make decisions on their behalf.

In this way, they resemble a MGA where State Farm executives collect all the rents (steady jobs with high salaries and prestige in the community) while the capacity providers get a barely adequate financial return.

Except in this case, the capacity providers don’t even get an adequate financial return! That’s because all their excess capital has been trapped by the management to invest in stocks and bonds to make the company bigger and more important.

Principal-Agent Conflict

In financial theory, the inherent conflict between investors and management is called the principal-agent problem. No, this has nothing to do with insurance agents!

In this case, the agent is the CEO (or other executive). Much like an insurance agent is supposed to represent the insured, the CEO is supposed to represent the investor, aka the principal.

But, just like an insurance agent, sometimes the management agent puts their own interests ahead of the client.

In a corporation, investors can reduce this conflict by voting their shares. They can vote on an issue directly or to replace the directors.

Mutual policyholders have these same rights. The problem is 99.9% of them don’t know it. But, in a theoretical world, the policyholders would vote out management who doesn’t act in their interest.

Since this never happens in reality, mutual executives have almost unlimited power. That is why they build themselves palatial offices, name sports stadiums, have large employee counts, etc. all with little accountability.

It’s a great gig! But it’s an ethical conundrum because it ignores the needs of the principal they are supposed to represent.

A Failed Agency

After all, the purpose of a mutual is to achieve lower prices through better risk selection, reducing the bloated expenses that come with many public companies, and having a lower cost of capital.

Unfortunately, State Farm doesn’t provide any of these benefits anymore. Their expenses are higher than GEICO and Progressive, they haven’t demonstrated better underwriting performance, and they don’t pass along the benefits of lower capital costs through lower prices, as I showed last time.

I don’t think there is much debate then to be had that State Farm, as an agent, has failed to act in the best interest of its principals.

Whose Surplus Is It?

If State Farm management truly acted as a representative of the policyholders, it would focus on maximizing the return to them, rather than hoarding capital.

If you buy a State Farm policy, you are a part owner and have a claim to some of the surplus that your premiums helped build.

Worse, if you are a former State Farm customer, you helped build that surplus, but got nothing for it when you left. You surrendered your ownership stake.

You might think that long tenured customers or those who pay higher premiums would have greater ownership. From what public information I can find, that doesn’t appear to be true.

Votes are allocated by first named insured. That basically means it’s one vote per household.

You do not get extra votes for having multiple policies. You do not get extra votes for being a 30 year customer vs. a 30 day customer. Your spouse does not get a vote.

State Farm discloses 94M policies, but not how many households. I’ll pick a round number and say there are 50M first named insureds.

This would suggest they each have .00000002% ownership, which is somewhere around $3,000.

The Cost of Organizing

Herein lies a giant challenge for the policyholders looking for influence. How much time and money would it take to organize them to vote in unison for their best interest?

A lot. Management knows this, which is why they can get away with doing very little to appease them.

For example, Disney spent $40M to try to win a proxy vote against Nelson Peltz. This was largely to influence retail shareholders who controlled 600M shares of stock.

Even if you assume, the average retail investor only had 100 shares of stock, that’s still only 6 million investors to contact. State Farm would possibly be 10X that!

It is unrealistic to think policyholders could spend hundreds of millions of dollars on a vote they’re not sure they could win to try to snag control of the company.

So whose surplus is it? For all intents and purposes, it is management’s surplus to do as they please, until someone can find a way to organize the policyholders more cheaply.

You can think of State Farm management like the Harvard endowment. They both maintain a giant investment portfolio, but very little of it gets spent to reduce costs for the current insured or student.

Hedge Fund Re

In that regard, State Farm’s balance sheet may remind you of another approach to insurance. If you remember the trendy “hedge fund reinsurers” that were popular last decade, they looked a lot like State Farm.

Their goal was to write some, but not too much, premium at around 100 CR and maximize float. The idea was the hedge funds could expand their investment business by charging hedge fund fees on insurer’s investments.

When you look at State Farm’s results, they write at around 100, they are under levered on premium/surplus, but fully levered on investments/surplus. They look like a successful hedge fund re!

They can continue to grow surplus in the long run with little contribution from underwriting, as long as markets rise over time.

While State Farm management is not paid directly on assets under management, the ballast from the investment portfolio provides immense job security as there is little pressure to generate an underwriting profit.

So, indirectly, they are paid on the float. They can beat their chests about having the #1 market share without having to worry about generating strong financial returns.

However, there is a vulnerability here which I will return to below.

Reciprocal In Practice

Earlier, I compared a mutual to a MGA, but a better comparison might be to a reciprocal.

Like a reciprocal, policyholders provide the capital and are assessed if there are any shortfalls. However, if there are excess returns, they tend to find their way to the management company, known as the attorney-in-fact, or AIF.

Most successful reciprocals are successful for the management, but not necessarily the policyholders. Reciprocals tend to run at higher combined ratios than corporate owned insurers because they pay excess commissions to the AIF.

The AIF knows the insured isn’t savvy enough to understand that the high “expense reimbursements” are above market and are really a way of pilfering profits that belong to the insured.

Savvy AIFs even pay out small policyholder dividends to make it appear they are being generous to the insured. The reality is that those dividends should be a lot higher and the fees a lot lower.

Like mutuals, reciprocal AIFs have a principal-agency conflict that gets resolved in favor of the agent.

Returning Capital

So how would an honest, ethical agent return capital to policyholders? There are a few ways.

First, there is the way I suggested last time. Return it gradually through lower prices. This would be the most efficient option.

It would help retention, avoid any sudden shocks to surplus, and, assuming price cuts were weighted towards the most loyal customers, be more equitable to those who contributed the most to the current surplus.

The second option is policyholder dividends. This can be done in one big chunk upfront or gradually over time.

The challenge here is I believe all policyholders have to be treated the same. So new customers will benefit as much as 30 year tenured customers. This ends up being a transfer payment from longtime policyholders to new ones.

Another option is demutualization. This is how the life insurers returned excess capital 20 years ago. They made payments to policyholders to persuade them to vote in favor.

The issue here is the policyholders only received some of the benefit. The companies converted with large amounts of excess capital at their IPO which helped drive performance in their early years of trading.

We can probably think of some other ways as well. The lower prices is still the most efficient to me.

The real question is what could convince State Farm to proactively choose one of these options?

One way would be they woke up tomorrow and decided it was time to act as a proper agent and manage the company on behalf of the policyholders.

Or, they might be backed into a corner. How could that happen?

Barbarians at the State

As I mentioned above, a proxy battle for State Farm would be very expensive. State Farm certainly won’t give up control voluntarily. So that leaves one option.

Private equity has the deep pockets to bankroll a proxy fight. They could also capture enough financial upside by taking over the investments to more than justify the cost.

So what would this look like? Someone like Blackstone, Carlyle, or Apollo that has expertise in insurance and running large pools of assets would go directly to policyholders and try to vote out the board.

Imagine the following scenario: Blackstone hires an established industry executive (I have a name in mind, but won’t volunteer that person without asking them!) to lead their new Auto & Home Insurance division.

A Winning Platform

They then send a letter to every State Farm policyholder informing them that:
– they are the real owners of State Farm, but State Farm has kept their profits for their own benefit rather than share them
– they are going to send every policyholder a $1,000 check day one if they win
– they have found a new CEO who will lower expenses and improve underwriting, so they can pass along lower prices on renewal
– all future net income will be paid out as policy dividends
– vote for our board slate and we will make this all happen!

Blackstone wins the proxy vote and assumes management of State Farm. All of the invested assets get moved to Blackstone products. They have successfully created the largest hedge fund re in the world!

So, Blackstone generates enormous fees for themselves from managing investments. It is likely they can improve the returns over State Farm as well, so this generates additional capital.

While the new agent is also acting in its best interest, it has also aligned its interest with the principals!

Furthermore, the new CEO cuts three points off the expense ratio and optimizes the underwriting algorithm. This allows State Farm to be more competitive and start growing again, while also making a slight underwriting profit.

Net result: higher profits, better market share, better prices for customers, and recurring policy dividends.

Blackstone is OK with this generous deal for policyholders, because the float is growing each year, so they are earning bigger and bigger management fees.

Tell me why anyone would vote against this???

Pigs Get Fat, Hogs Get Slaughtered

All good things must come to an end. State Farm has butchered a lot of hogs in its day. It’s now time to adjust to a new world.

It is no longer inevitable that management can run the company for its own benefit. Private equity has gotten big enough that they could take down a State Farm if they are willing to fight for it.

My advice to management is start treating policyholders as their client, rather than as their host to feed off. Cut prices, pay policy dividends, do something that returns a big chunk of the excess capital to who it belongs.

Otherwise, don’t be surprised when one day you are in a proxy fight and come out on the short end of it.

State Farm may be the biggest insurer, but it’s not the best. There is plenty of room for a financial buyer to improve the business while also doing right by the policyholders.

Consider this fair warning. No company is untouchable. Act proactively while you still can. It’s better than fighting a defensive war.

Oh, and if you’re a private equity shop reading this, the advice about hogs applies to you, too. Stealing other’s ideas is like using a me-too rate filing. It’s an expensive way to learn you don’t know what you’re doing.

And if you’re a policyholder reading this, you have the power to take back control of the company. If management isn’t acting in your best interest, vote them out. If enough of you come together, State Farm can return to acting the way a mutual should.