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Inside In Full Allstate: More shots fired in the ‘omniwars’

Earlier this week, Allstate announced the $4bn acquisition of National General, the latest step in its efforts to improve its omni-channel presence and compete for market share...

Gavin Davis

For decades, Progressive and Geico have been winning market share, largely at the expense of exclusive agents as many legacy incumbents have been unable or unwilling to grasp the nettle on any strategic move that would have been perceived as disintermediating its exclusive agents. (For background, see: Let the omniwars begin).

The view of the PCIB team (that I lead) has been that personal lines insurance would follow trends in broader retail and be forced into omni-channel competition. Rather than be defined by a channel, companies must be able and willing to sell products to consumers how they want to buy them, where they want to buy them, and when they want to buy them –whether on mobile, online or in person at brick-and-mortar retail locations with trusted local advisors.

This latent and long-running competitive dynamic had already been accelerating in recent years, but is likely to be transformed into a more acute crisis as the Covid-19 economy turbo charges the move towards online/mobile purchase behavior.

Now, Allstate has for some time pushed an omni-channel strategy with its investors. Its conference call presentations have been a longstanding joke in the investment community with consistent reference to this omni-channel focus with Esurance and Encompass, but with close to 100% of the firm’s value stemming from its core exclusive agent Allstate brand.

The “strategy” may have looked good in an earnings deck as a stated strategy or as an ambition, but simply did not reflect the reality of the company as it was, and did not require equal time on earnings calls or investor pitches.

However, Allstate’s management appears to be intent on narrowing the gap between its stated strategy and reality. Recall, in arguably the first shot fired in the new era of “omniwars”, the company announced that it would be consolidating its Esurance brand into its Allstate brand. Though the company had long tried to preserve the separate direct channel with an arm’s length “Esurance by Allstate”, ultimately the sheer industrial logic of a more efficient advertising spend on one consolidated brand made overwhelming sense when competing against the runaway Geico and Progressive – outweighing the concerns of perceived disintermediation by its agents. Along with cost reductions, the company has outlined ambitions to be more competitive in direct.

This has now been followed by an equally significant move, with the purchase of Nat Gen on Tuesday. Allstate agreed to purchase the company for $4bn, a 64% premium to the trailing 30-day average share price and a significant 2.33x tangible book value. The stated deal rationale was to improve the firm’s competitive positioning in independent agency, where Allstate has only a modest offering with Encompass and Allstate Independent Agents (~$1.7bn in NWP, or ~5% of total Allstate NWP).

Given the dynamics laid out above, the deal makes at least some strategic sense. Allstate has one of the preeminent brand names in the business with an enormous amount of accumulated brand equity and high degree of consumer recognition and trust.

By leveraging its well-respected “you’re in safe hands” brand across more distribution channels, if done right the company simply has more “at-bats” to win new customers where they want to shop. Note, while the captive agency channel has been giving up share to direct, the independent agency channel has remained roughly flat at ~35%, or $125bn of premiums in 2019.

 In many ways, this mirrors one of the key advantages Progressive has been able to use, with both its agency and direct businesses benefiting from the investment in brand equity, while also benefiting from the economies of scale, shared services, accumulated data, claims infrastructure etc across both channels.

If the broad direction of strategy is understandable (though not an obvious slam dunk), the issue for Allstate is really whether acquiring Nat Gen is the smartest way to execute this vision. There are multiple issues and questions raised by Allstate’s latest shot fired in the omni-war.

 

First, from a financial perspective, the deal does not superficially screen as being super expensive at ~12x earnings – possibly for good reason.

Management said on a conference call that the deal was accretive to earnings and ROE in the first year post close, and that expected returns were comparable to a share buyback program.

This hit two of our pet peeves in M&A here at Inside P&C. On accretion, in a near-zero-yield environment, there are few things short of putting cash in a bucket and setting it on fire that aren’t accretive to earnings and ROE (if you’re allowed to look past the deal-related expenses and amortization, which almost everybody does).

The second is that integrating even the highest-quality M&A target (which this is not) carries more risk than a share repurchase program, and therefore should have a higher expected return to account for that risk.

Putting those aside, there does seem some scope to drive cost synergies by combining the two platforms, particularly given Encompass’ historic weak performance. On the financial side, Nat Gen’s quirky capital structure and reinsurance buying will likely be optimized by Allstate and provide some financing synergies, even if it will probably lead to lower leverage and therefore ROE on a reported basis (if not risk adjusted).

One point worth making is that Allstate has faced criticism in the past over its willingness to pay up large amounts for “growthy” businesses with limited near-term earnings contribution. A cynical mind might wonder whether one reason Nat Gen was considered attractive was its low trading multiple that allowed the company to be acquired at only ~11.9x trailing earnings, even inclusive of a significant control premium.

 

Second, that said, the strategic rationale appears less compelling.

If a play into independent agency with the right partner at the right price could make sense if more attractive on a risk-adjusted basis than capital return, Nat Gen appears to be an odd choice of partner to say the very least.

From a business risk perspective, Nat Gen’s business simply skews higher risk. Fundamentally, it is the product of an aggressive roll-up strategy, pieced together by upwards of 18 transactions under the current management team – not some long-running competitive advantage or accumulated brand equity. Though M&A is not inherently bad, there is a long history of latent problems contained in “roll up” strategies (e.g. AmTrust and Tower – more on this below) where often the strategy leads to more emphasis on sourcing and executing deals than on due diligence and integration.

Additionally, Nat Gen’s business appears at risk of being dilutive to Allstate’s franchise. Its auto book is largely non-standard (~75%), which requires a different type of skillset and a different type of sharper-elbowed behavior than Allstate’s traditional preferred customer. Similarly, a significant portion (>20%) of Nat Gen’s P&C underwriting profits are sourced from its lender-placed business, a controversial line of business that carries a significant amount of reputational and regulatory risk (particularly given Covid-19-related issues).

Though this does not make them bad businesses per se, they do seem to carry more risk from a brand and reputation perspective, and seem an odd bedfellow to combine with Allstate’s long-accumulated goodwill and “safe hands” image. One wonders how much Allstate is motivated simply by “urinating in the pool” in Progressive’s non-standard backyard in response to its encroachment into high-quality, bundled preferred Robinson territory.

Ultimately, if the strategy relies on extending Allstate’s consumer brand into new capabilities in an under-penetrated channel, it seems surprising that Allstate appears to have gone for ticket-price value rather than business quality.

 

Third, the “reverse merger” component of the deal raises additional questions around the choice of business partners and future management of this channel.

This management aspect of business risk is perhaps best emphasized by the fact Allstate described the move as a “reverse merger” of its independent agency business by Nat Gen.

This seems an odd move for a company with a… let’s just say colorful background. The company was built by the Karfunkel-Zyskind family, who still owned ~40% at time the deal was announced.

This is the same family that built AmTrust and Maiden – two companies synonymous with controversy over the past decade – one that was taken private after announcing massive adverse reserve development leading to a share-price collapse, another whose share price has dropped to near zero following related adverse development charges.

AmTrust in particular was built with the same model of breakneck M&A, higher-than-typical leverage, and boasts over its superior technology platform (part of which it licensed and then ultimately sold to Nat Gen). The two companies were also initially heavily intertwined with numerous complicated and “unorthodox” deals, including real estate, technology, life settlement investments, reinsurance deals and loans with and to related parties. Though these have been largely unwound, according to its latest 10-K the company still has some of these related party transactions, in particular the loan to ACP Re (another, non-public Karfunkel entity).

AmTrust has also a colorful background with its accounting that seems significant when engaging in M&A for a related party company. In 2018 for example, the firm’s auditors BDO were censored by the SEC, who accused them of conducting a “sham audit”, signing off numbers without reviewing them and then backdating the work once the information was provided. Nat Gen was audited by BDO until 2017.

Similarly, just a few weeks back, AmTrust and its former CFO settled (without admitting guilt) with the SEC over accusations its CFO played games with its reserves that constantly acted like topside adjustments to improve earnings (See: Little Black Book).

This may all seem a little tangential, but it seems to carry two important takeaways.

The first is that, should there prove any negative adjustments from the deal as is not uncommon in even simple M&A, there is a risk that management will look like schmucks that failed to heed obvious red lights from past behavior.

The second is that the company did not really spell out exactly what it meant by a “reverse merger”, who would be running what, and how much autonomy they would have. These seem like important questions for Allstate’s shareholders given the track record and results seen at other Karfunkel-Zyskind companies in recent years.

 

Fourth, given the pattern observed at AmTrust and Maiden, Nat Gen’s reserves seem worthy of higher-than-typical scrutiny.

As noted above, both AmTrust and Maiden – the other two public companies in the Karfunkel-Zyskind-related party trio with Nat Gen – reported breakneck growth through M&A… followed by massive adverse reserve development. One could argue this justifies heightened scrutiny at the very least of Nat Gen’s reserves, albeit with the complicating factor of M&A.

I would note two quick takeaways from a “quick and dirty” look at Nat Gen’s reserves.

The first is that the company appears to have a pattern in its major lines of consistent adverse development that is masked by growth with more recent accident years booked at more aggressive levels than fully developed but smaller accident years.

For example, in private passenger auto liability, the firm booked 64.5% in 2017, despite its most recent fully developed accident years tracking at around ~71% – see table below. Note also the persistent negative development on mature accident years – a pattern also seen in commercial auto liability.

  

 

Additionally – and relatedly – the company just seems to not have a lot of conservatism in the way it sets its ultimate reserves in terms of case and IBNR. To take just one example over the past ten years in private passenger auto liability again, the company averages paid to ultimate loss ratios of 80% in year two, versus 70% for the P&C industry more broadly. Though it’s tough to compare companies on metrics like this due to different claims handling and payment speeds, the persistent combination of (a) lower buffer on accident years relative to industry combined with (b) a persistent pattern of adverse development should raise a red flag at the very least.

I highlight this one particular issue as we think there are legitimate questions to be asked around balance sheet strength which could ultimately make that 2.3x tangible price tag look even less compelling.

 

So what does it all mean?

Ultimately, if you make the bet that your brand is likely one of the long-term winners and well placed to compete aggressively in the omni-wars, the strategic bet to improve capabilities across channels can make sense at the right price. But for Allstate, the choice of merger partner raises significant questions as to who exactly it’s shooting at.

A high-quality merger partner with organic capabilities, long-accumulated agency relationships and a long-term track record might have caused shock waves. Allstate’s brands in the right hands could be a formidable competitor in any channel. As it stands, I would bet this is more likely a deal that will lead to a greater number of sleepless nights down the line for Allstate’s management than for Progressive’s.

 

Inside P&C provides unparalleled market intelligence on the entire US P&C market – from small commercial and personal lines right through to reinsurance and Bermuda. Redeem your complimentary 14-day trial for more premium content from Inside P&C.

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