League of ITS OWN - A. M. Best

League

Mutuals

of ITS OWN

State Farm, the U.S. property/casualty giant, marches to its own beat.

by Kate Smith

S tate Farm made headlines last year when it posted a $7 billion underwriting loss in its auto insurance line of business. The size of that 2016 loss--it was larger than the GDP of 45 countries, according to World Bank statistics--was stunning. Equally stunning, however, was the impact it had on State Farm's financials.

"Go look at what happened to State Farm's capital after that," said Brian Sullivan, editor of Risk Information Inc.'s Auto Insurance Report. "It did not substantially diminish."

Despite losing more money than some nations have in their entire economy, State Farm still managed to increase its policyholder surplus by $5 billion in 2016 and raise its net worth to $87.6 billion.

Therein lies the enigma that is State Farm. "I don't know how many others could have a $7 billion underwriting loss and grow surplus $5 billion in the same year," said Michael Venezia, senior financial analyst for A.M. Best. Most units of State Farm hold a Best's Financial Strength Rating of A++ (Superior). There are no others quite like State Farm. The Bloomington, Ill.-based mutual insurer is the largest property/casualty insurer in the United States and eighth-largest insurer in the world.With $62.3 billion in net premiums written in 2016, State Farm dwarfs second-place Berkshire Hathaway, whose insurance operations accrued $38.7 billion in NPW. It insures 45 million autos, 27.8 million homes and 7.9 million lives in the United States.That's nearly one in five American homes and private passenger cars. "Against the onslaught of Geico and Progressive and a resurgent USAA and an attacking Liberty Mutual, State Farm has sustained its 18-plus market share in auto for a very long time,"Sullivan said."The gap between them and second place in their two core products is so sizable that no one can honestly see anyone overtaking them in the foreseeable future." To put in perspective State Farm's size, consider

Kate Smith is a senior associate editor. She can be reached at kate.smith@.

this: Its auto underwriting loss alone was larger than all but seven other auto insurers posted in total personal auto written premium, according to the Auto Insurance Report."It's a one-off, crazy, can't-becopied company," Sullivan said.

In a highly competitive and ever-evolving personal lines industry, State Farm has weathered threats and bucked trends. Despite predictions that direct distribution is the wave of the future, State Farm continues to sell its products exclusively through its captive agents. Despite industrywide increases in auto loss frequency and severity, State Farm is slow to increase rates or withdraw from markets.

"They beat to their own drum,"Venezia said."They don't have to immediately react or take aggressive action in any given year because of their size and profile."

Staying Ahead State Farm is a giant, albeit a reserved one. It's not

the first to adopt technology, the first to innovate or the first to react to shifting market conditions.

But it responds fast enough. "Because they're so big, it's almost impossible for them to be innovative,"Sullivan said."They can't try new things very easily at State Farm. First of all, regulators watch them more closely than they do anyone else.You may have a clever new idea that you want to put into underwriting. But if it's wrong, you're talking about one of every five drivers in America! They get a reputation for being stodgy, but that's really unfair given the scale of what's involved here." Once State Farm does adopt something new, it does it well and deploys it quickly. Its conversion to modern pricing methods is a classic example.While Progressive pioneered the use of credit scoring in auto underwriting and pricing in the mid-1990s, State Farm waited until the early 2000s--after it had lost billions within a span of two years--to update its pricing methods.Within 18 months,it had a modern model. "They went from one of the least sophisticated pricing models in the business to having a pricing model that was right there with the rest of the pack,"

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Mutuals

"They don't walk away from customers. They don't walk away from states. They don't walk away from markets. If things get tough, they take a deep breath and fight through them."

Brian Sullivan Risk Information Inc.

Sullivan said."Was it cutting edge? Absolutely not. Was it good enough that they were no longer at a disadvantage? Absolutely.And within 24 months they recovered every penny of capital they had lost.

"It's a perfect example of State Farm.Are they innovative? No.Are they fast followers? No. But can they get the job done enough to outperform their competitors by sustaining their huge market share? Yes, they can get it done enough. All I can tell you is, I've been covering this company for 25 years and they have sustained every attack."

State Farm has the resources to fend off threats. And it uses those resources judiciously.

"The company is fully prepared and equipped to make whatever investments are necessary to ensure it is the most formidable insurer in personal lines going forward," said Bob Hartwig, professor of risk management, insurance and finance at the University of South Carolina's Darla Moore School of Business.

State Farm uses its size and operating model to its advantage. It invests heavily, uses its considerable investment base to generate income to competitively price its products and operates with a long-term view of what's best for policyholders. In other words, State Farm has a lot of money and a lot of patience.

State Farm declined to be interviewed, but provided a comment on the benefit of being a mutual.

"Being a mutual company allows State Farm to keep its focus on our policyholders' best interests, and take a long-term view in business decisions," it said."We build our business through internal growth, not acquisitions.Therefore, we don't need access to the capital market, a motivation that has driven some other mutuals to become stock companies."

Successful Strategy That's not to say State Farm isn't active in the

capital markets.To the contrary, it is one of the most

equity-heavy investors in the insurance industry. "Most companies can't handle the volatility of the

equity markets,"Sullivan said."State Farm is capable of handling volatility.They take a long view.They invest heavily.They don't panic.This is what makes it work."

State Farm's policyholder surplus, a key indicator of financial health for mutual insurance companies, has grown by $26 billion in the past five years, bringing its net worth to more than $87 billion.

At times State Farm has been criticized as inefficient--most notably by Warren Buffett in the early 2000s--for holding too much capital.A counterargument could be made, however, that State Farm efficiently uses its excess capital to create a stable and consistent insurance experience for its policyholders.

"To the extent that your operating model allows you to reduce the amplitude in your pricing cycle," Hartwig said,"that's potentially a competitive advantage in the long run."

Stability--in pricing, service and strategy--is a hallmark of State Farm. It built a campaign around the slogan,"Like a good neighbor, State Farm is there."The pile of capital it sits on allows it to remain "there."

"They don't walk away from customers," Sullivan said."They don't walk away from states.They don't walk away from markets. If things get tough, they take a deep breath and fight through them."

It does so by focusing on the big picture. "The essential thing that State Farm does so well is they don't get fixated on the small numbers," Sullivan said."They look at the big number and they ask: Do I have more capital now than I did a year ago? What are the net results of my investments, my risk taking, my

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State Farm Group (A.M. Best # 000088)

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BEST'S REV)%7s3%04%-"%2

operational excellence? If the whole thing adds up to more money in the bank at end of day than in the beginning, I've won.

"They look at any problems they might have and they say,`Let's not panic. Let's work our way gently

to a solution.'And in the long run that's the smartest

thing to do, because knee jerk reactions are always a

bad idea. So they drive their competitors crazy with

their patience.And their patience is a hallmark of a

mutual insurance company that's well run."

BR

State Farm at a Glance

State Farm Financial Snapshot

Year 2016 2015 2014 2013 2012

Direct Premiums 62,192,180 59,361,685 58,508,587 55,994,246 53,654,237

Net Premiums 62,368,454 59,347,880 57,946,389 55,434,938 52,988,830

Policyholders' Combined

Surplus

Ratio

87,591,334

108.7

82, 659,792

103.3

80,018,849

101.2

75,717,907

99.1

65,282,522

103

Source: A.M. Best State Farm Group, A.M. Best #000088

By the Numbers

65,000 Employees

37,000 Claims per day 18,000 Agents

2016 Top Product Lines of Business

(Net Premiums Written)

7.1% All Other

2.3% Commercial Multi-Peril

7.1%

25.5%

Auto Physical

38.1%

Private Passenger Auto Liability

26.9%

Homeowners

Source: A.M. Best State Farm Group, A.M. Best #000088

Breakdown of State Farm's

84.1 millionpolicies and accounts Mutual Funds: 498 thousand

100 Products sold

Source: State Farm

Health:

867 thousand

State Farm Group, A.M. Best #000088

Lines of Business

State Farm Bank:

2.0 million

Property and casualty insurance Life and health insurance

Life:

7.9 million

Annuities Mutual Funds Banking Products

Source: State Farm

Homeowners:

27.8 million

Source: State Farm

Auto:

45.0 million

BEST'S REV)%7s3%04%-"%2

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