Telling The Risky From The Reliable

Will Allstate's detailed customer analysis keep the profits rolling in a price war?

It's a good time to shop for car insurance. Just ask Mike and Kimberly Read of Aurora, Colo. They have a pristine driving record, rarely file a claim, and have two young daughters who won't be behind the wheel for years. Still, premiums on their Chevy Beretta and Chevy Blazer had been rising steadily. After comparing rates at 11 insurers, they found a policy from Allstate Corp. (ALL ) with more liability coverage that was $500 cheaper than their existing one with State Farm Mutual Automobile Insurance Co.

What's good news for the Reads may be a bit unsettling for insurance execs. In the late '90s, a rush to grab market share sparked intense price competition. That pushed the industry's combined ratio to 110% in 2000, meaning auto insurers paid out $1.10 in claims and expenses for every $1 they earned in premiums, according to research firm A.M. Best Co. Now, another price war may be under way: State Farm, the market share leader, cut its rates by an average of 4.8% last year. USAA, which primarily serves military families, has lowered prices by 8% over the past year and a half. Overall, after five consecutive years of rate increases, premiums across the group are likely to remain flat or even decline in 2005.

This time, the No. 2 auto insurer, Allstate, is determined not to get sucked into another race to the bottom. Taking a page from fast-growing rival Progressive Corp. (PGR ) (No. 3 by market share), Allstate has gotten smarter about what to charge which drivers, using a technology-intensive "tiered pricing" system. Now, Allstate considers previously overlooked data such as a driver's credit history, takes a deeper look at traditional information like demographics, and better matches the premium to the risk of the customer. The new pricing discipline, combined with an industry-wide drop in the number of claims filed, has helped drive profits. In 2004, Allstate's operating income rose 16%, to $3.1 billion. Return on equity hit 15%, up from 6.5% in 2002.

For decades, Allstate had lumped customers into three main pricing categories, based on basic details such as a customer's age and place of residence. It now has more than 1,500 price levels. Agents used to simply refer to a manual to give customers a price; now they log on to a computer that uses complex algorithms to analyze 16 credit report variables, such as late payments and card balances, as well as data such as claims history for specific car models. Thus, safe bets such as the Reads are rewarded, saving up to 20% over the old system, and high-risk drivers are penalized, paying up to 20% more. It has worked well enough that Allstate now applies it to other lines, such as homeowners' insurance. "With tiered pricing, you're charging the right rate for the customers," says Jay Gelb, an insurance analyst with Lehman Brothers Inc. (LEH )

There's plenty at stake for Northbrook (Ill.)-based Allstate, the largest publicly traded auto insurer, where memories of the last price war are still fresh. Earnings at the company fell from $2.6 billion in 1998 to $1.5 billion in 2001, as Allstate got slammed by an unexpected rise in both auto and homeowners' claims. Progressive, the first to implement a more sophisticated pricing system, has increased its share of the auto insurance business from 5.5% to 7.5%, while Allstate's share has eroded from 15% to 12%. State Farm claims 22%, down from 28%.

Allstate execs promise they'll stick to their pricing system, regardless of how low competitors slash policy rates. Chairman and Chief Executive Edward M. Liddy, at the helm since 1999, figures any losses will be marginal, since Allstate will still be very competitive among low-risk, high-profit drivers, while rate-slashing insurers will likely attract less-profitable, higher-risk drivers.

Analysts say Allstate, which started to introduce some aspects of the tiered-pricing model back in the late '90s, right behind Progressive, will have an early-mover advantage -- having had time to collect reams of data and fine-tune pattern recognition. That's crucial, since "the industry is engaged in what amounts to a technological arms race," says Robert P. Hartwig, chief economist for the Insurance Information Institute, a trade group.

Of course, a new pricing scheme is no guarantee of lasting success. For one thing, more insurers are catching on: State Farm revealed in May that it would start using more sophisticated pricing techniques. Plus, Allstate has to keep up with service innovations, such as Progressive's "concierge" claim centers, which will arrange for a loaner if your car is in the shop. Most important, no matter how Liddy tries to insulate Allstate from a price war, downward pressure on prices could put the squeeze on underwriting margins. Alain Karaoglan, an equity analyst with Deutsche Bank (DB ), estimates that Allstate's combined ratio will jump from 88.8% this year to 91.3% in 2006. Even though the nature of the business is cyclical, Allstate's new pricing discipline means it should be able to avoid any major accidents.

By Adrienne Carter in Northbrook, Ill.

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