There’s been a lot of talk about the State Farm deal to invest in ADT, much of which I think misses the point. When you invest $1.2B in a company, the rationale isn’t “hey, we might get a few extra customers”. It’s “we expect the investment return to be above investing in other equity investments”.
Buffett doesn’t buy Apple stock because he thinks GEICO employees can be more efficient if they use Macs. He did it because he thought Apple was undervalued.
If State Farm bought a 15% stake in ADT for any other reason that “we think ADT stock is substantially undervalued”, then they’re doing it wrong and wasting policyholder’s money.
Whose Money Is It?
Before we have a broader discussion of State Farm’s capital position, let’s remember one important point. As you likely know, State Farm is a mutual insurer and is thus owned by the policyholders.
That means when “State Farm” spends $1+B to buy a stake in ADT they’re asking – no, wait, they’re actually telling! – every State Farm customer to hand over a few bucks to have a tiny ownership position in ADT.
If your response to that is “wait, can’t I buy ADT stock myself rather than let State Farm do it for me?”, yes, yes, you can. So arguably State Farm shouldn’t be making equity investments at all. They should instead pay bigger policyholder dividends and let you buy the stock yourself if you like.
Keep that thought nearby as we advance through the remainder of the conversation.
Excess, Excess, Excess Capital
So why is State Farm making large equity investments? Because they have more excess capital than Berkshire. That is not hyperbole. I will walk through some calculations below, but State Farm has somewhere between $75-100B of excess capital.
I obviously don’t have access to their capital model so perhaps there are some large risks I am not aware of, but it’s fairly easy to estimate required capital for a personal lines company.
In theory, State Farm should be able to run auto at 3:1 premium/surplus and home and small commercial around 1.5X. In practice, they are probably more comfortable running auto at 2-2.5X and home and small commercial at 1-1.25X.
State Farm writes about $70B of premium with 60% in auto, 33% in home, and 7% in small commercial. From there, we can calculate various estimates of required capital.
|Premium By Line||3X auto 1.5X other||2.5X auto 1.25X other||2X auto 1X other|
|Personal Auto ($42B)||$14B capital||$17B capital||$21B capital|
|Home & Small Commercial ($28B)||$19B capital||$22B capital||$28B capital|
|Total ($70B)||$33B capital||$39B capital||$49B capital|
There would be some other capital required for the life company and potentially for some other smaller operations, but they shouldn’t change the conclusion drastically. It is unlikely State Farm needs more than $50B of capital.
By comparison, they have $140B of surplus! This implies $90B of excess capital. This is way more excess capital than Berkshire.
Let me say it a more shocking way: State Farm’s excess capital is greater than the total surplus of any US based insurer with the exception of Berkshire. Think about how crazy that is. State Farm has more EXCESS capital than pretty much anyone else has total capital!
Who Is State Farm Managed For?
Given this insane amount of capital, I’m sure management feels like it’s burning a hole in its pocket. Who’s going to miss dropping $1.2B on ADT? The policyholders won’t care! (Actually, they may care if they understood and were given a vote.)
So there is clearly a principal-agency problem. Management has every incentive to make vanity investments and little penalty for doing so if they don’t work out because the policyholders have delegated their authority to management (that’s right, if you think about it, State Farm is an MGA on behalf of the policyholders).
What management should do is what I suggested above: pay larger shareholder dividends (or lower prices). Return the capital to the people who contributed it. Otherwise, be bold and do a demutualization!
But that’s probably not going to happen because the policyholders have no voice. So given these constraints, what would be a better way for management to deploy the capital given they won’t do the ideal thing with it?
Build An Empire
While I am typically not a supporter of large acquisitions for the sake of getting bigger, given the alternative to buying a company is State Farm a) earning next to nothing on it or b) spending it foolishly, then acquiring something may not look so bad by comparison.
We have seen Liberty, Nationwide, American Family and other mutuals use excess capital to do acquisitions. Liberty in particular has grown the company substantially through acquisition over the years.
While State Farm could go and spend $2B here and $5B there, with all the capital they have, why not go big or go home? Let me throw out some transformational acquisition candidates, but before I do, yes, I may own stock in some of the names which follow. No, that’s not why I’m listing them, but you should be aware that I may be conflicted (if you really think I have the power to convince State Farm to buy something).
Principal has a $20B market cap. State Farm could offer a 50% premium and wouldn’t miss a beat. There would be no P&C overlap so no risk of negative synergies, but it would allow them to diversify substantially in wealth management as well as adding international markets.
It’s unclear that State Farm wants to be a major 401k provider but it would clearly diversify its earnings stream and potentially create cross selling opportunities.
Ameriprise has a $30B market cap. State Farm could pay $40B for it, no problem. I mean, they could possibly buy Ameriprise and Principal. Not only would it again diversify earnings into wealth management, but it would bring in a horde of independent financial advisers!
State Farm certainly has a competence at selling through advisers so adding Ameriprise would allow them to expand into new markets and create a financial advice powerhouse. The synergies of offering State Farm customers to a wealth management adviser are fairly obvious.
This would be a very significant deal and arguably push the bounds of State Farm’s capacity. Met has a $50B cap so you’re paying $60+B to bring it in. Perhaps you could sell off some pieces to reduce the price tag?
But if you want to add a major brand to the company, aligning MetLife with State Farm would be the insurance equivalent of merging Ford with GM.
Brand power aside, the strategic benefits are a little harder to see given the different distribution channels and MET’s large international presence, but if the goal is to make a splash, this would be a splash.
Now, let’s move to the P&C arena which is probably where State Farm would be more interested. Hartford’s cap is just over $20B, so a $30B check would get it done, easily within its capacity.
Hartford would add a ton to State Farm. There is little personal lines overlap and State Farm I’m sure would love the AARP relationship. The group business would likely benefit from the State Farm name and the potential to add personal lines to the life and disability products.
There would be some overlap in small commercial but Hartford would add technical capabilities State Farm doesn’t have plus a broader client range beyond small business owners who insure their cars with State Farm. There would likely be pretty significant cost synergies here that could make this a home run.
Travelers is at a $40B cap so it is possible it could be bought for $50B, or at least somewhere in the $50s. Here’s the thing: State Farm is probably the only conceivable buyer if Travelers wanted to sell.
There is too much overlap with Chubb or Zurich. It’s too big for Allstate. The big lifecos don’t have the currency. Other than Berkshire potentially, State Farm is really the only option if Travelers were open to an exit, so the premium doesn’t have to be as large as for a Hartford where there are more potential buyers.
Travelers would offer a similar story on the small commercial synergies, also add some personal lines synergies, and allow State Farm to reconsider its captive only approach by keeping the Travelers brand alive in the independent channel.
Basically, with Travelers, State Farm can match all of Liberty’s capabilities and then some. If the goal is to be the most expansive of the mutuals, buying Travelers allows State Farm to do anything and everything out there and at greater scale than Liberty pretty much across the board.
Could It Happen?
Do I think State Farm will look to make a major acquisition like this? Unlikely. They will probably continue to accumulate excess and do little much about it. Perhaps some activist investor will take out a boatload of policies and see if they can exert some influence!
But it is more likely that the excess continues to grow to no purpose because the policyholders are unaware and unempowered. That said, there has never been a war chest this big in the industry.
Just because nobody has had the imagination to think of State Farm has an industry consolidator, doesn’t mean it can’t happen.