Recent pricing increases have continued to restore profitability in auto for Allstate, following a rise in claims driven by a multitude of factors ranging from low gas prices to distracted driving. As a result, the company is generating strong returns. However, we expect mean reversion on this front in the long term.

In the near term, though, the coronavirus has disrupted this process, as quarantine efforts have led to a stark decline in miles driven and claims. Allstate is offering rebates to customers as a result, but the company has seen a short-term boost to underwriting margins while social distancing efforts are in effect. Ultimately, though, we believe there is potential for the coronavirus crisis to restart the pricing cycle at a less attractive point, if gas prices remain low as the economy opens back up.

Allstate's captive agent model is out of fashion, as industry growth has been concentrated in the direct channel. In our view, the customers that Allstate serves are less likely to shop their policies and value the service an agent can provide. As such, we believe any fears that the Internet will make captive agents obsolete are overblown. Allstate occupies a solid position in this mature niche, which management estimates is about half the market, and we think it can generate reasonable returns. But top-line growth will be difficult to achieve absent pricing increases, given the ongoing industry shift, and policies in force growth has been meager in recent years.

We have some concerns that Allstate is prioritizing growth over profitability, as we do not believe the company has a meaningful advantage outside the captive agent channel. Esurance has benefited from growth in the direct channel, but its underwriting results have been poor. Given the importance of scale in the direct channel and the large gap in size between Esurance and the top players, we don't see a value-creative path for this business. The more recent acquisitions of SquareTrade and InfoArmor show the company moving even further from its strategic core in search of growth.

In general, property-casualty insurers do not benefit from favorable competitive positions. Industry competition is fierce, and the products are essentially commodities. Furthermore, participants do not know their cost of goods sold for a number of years, allowing them to underprice policies without knowing it. Firms have a large incentive to chase growth without regard for profitability, a cycle that repeats itself as competitors are forced to match artificially low prices or risk losing business.

In our view, Allstate has historically had a differentiated model through its use of captive agents and its bundling strategy. That said, the company’s historical returns suggest the advantage it gains through this strategy is fairly meager. Further, while the captive agent channel still dominates results, the company has expanded into both the independent agent and direct channel in recent years, and we don’t believe the company has a meaningful advantage in these channels. The company’s life insurance operations have also been a problem area, and while Allstate has reduced its presence in this area, we see its life insurance operations as dilutive to its moat. Considering the whole business, we do not believe Allstate has a moat.

We continue to believe that Allstate has a defensible position in its core captive agent channel. As customers add policies, they are more likely to rely on an agent who can help them customize their policies and save them money through bundling. Each additional policy will allow the customer to save money, as it has been actuarially proved that these policyholders are lower risk, and each incremental policy creates stickier customers. As these customers have multiple policies for a car (or two), a home, and possibly a boat, price shopping becomes more burdensome, making them less likely to switch companies in order to save a small amount on premiums. Whereas many of its competitors use independent agents to source sales, Allstate's captive agents sell only company policies. This allows Allstate to benefit from the stickiness of the customer relationship, rather than an independent agent.

We are increasing our fair value estimate for Allstate to $103 per share from $96, due mainly to time value since our last update. Our fair value esimate is equivalent to 1.5 times year-end book value and 1.8 times book value excluding goodwill and accumulated other comprehensive income. We think the market shift away from the captive agent channel and Allstate's leading position in a mature industry limit its growth prospects. We assume earned premiums increase at a fairly modest 2% compound annual growth rate over our projection period, as we expect recent price increases to fade. We expect the company to produce fairly strong underwriting results in the near term, as it benefits from recent pricing increases and the impact of the coronavirus, but to revert toward historical results over time. Because Allstate is in the business of insuring against weather events, we have included one explicit large catastrophe year for the company. On average, the catastrophes projected during the next five years are a bit higher than the company's experience over the past five years. After a fall-off in 2020, we expect interest rates to bounce back a bit over time and increase investment income, but for this to be largely offset by lower underwriting margins. Overall, this leads to our assumption for an average combined ratio of 97% during our forecast horizon. Our assumptions result in an average return on equity of 13% over the next five years, with returns trending toward the cost of equity over time. We use a cost of equity of 9%.

Like other insurers, Allstate's biggest risks are claims in excess of the amount reserved or material impairments in its investment portfolio. About half of its investment portfolio is composed of corporate bonds, exposing it to corporate defaults in the event of a major recession. Because of its mixed model, Allstate retains a higher amount of balance sheet leverage compared with many of its property-casualty insurance peers. Allstate has significant exposure to natural catastrophes and weather-related losses, which introduces material volatility into its results. Climate change introduces a new point of uncertainty for insurers with catastrophe exposure, and future returns could be impaired if the price response is not adequate. Any eventual adoption of driverless cars could completely upend the auto insurance industry.

Our uncertainty rating is high, given the potential impact of the coronavirus on the business and on capital markets. Like all insurers, Allstate’s profitability and financial strength are tied to capital market conditions, and the coronavirus raises the possibility of outlier events on this front.

We believe stewardship at Allstate is Standard. Tom Wilson has been CEO and chairman since 2007 and 2008, respectively. Heading into the financial crisis, management expanded too aggressively into noncore lines of business, especially in its Allstate Financial segment. For example, the company was selling annuity products through bank channels, which did not fit well with its core strategy of providing protection products to individuals through its captive agency network. This overexpansion hurt shareholders, as equity fell more than 40% during the financial crisis, and the company was forced to cut its dividend. Since then, management has actively derisked its operations and refocused the firm's business lines toward its strengths, which we think were the right steps.

On the other hand, we are concerned that the company's current multichannel strategy might lead it to stray too far from its core business in order to maintain top-line growth, and that management's focus on profitability in legacy businesses might be undone by a focus on growth when it comes to acquisitions.

We believe the acquisition of Esurance in 2011 was made at too high a price and was strategically unsound, as 2 times book value is a valuation that is very difficult to justify for an insurance operation that has been consistently unprofitable on an underwriting basis. While recent pricing actions have materially improved underwriting profitability, the combined ratio for Esurance remained poor, suggesting this line is generating value destructive returns. Further, these pricing actions reduced growth, which could widen the size gap between Esurance and the top players in the channel. With the business a distant number-three player in a channel driven by scale, it's difficult for us to envision an attractive future for it. With hindsight, it is questionable if Allstate had a valid plan for this business at the time of the acquisition.

Allstate acquired SquareTrade, a provider of protection plans for consumer electronics, for approximately $1.4 billion in 2017. The basic strategy behind the deal seems to be in line with the Esurance deal, as Allstate attempts to diversify into new channels to spur growth. Allstate believes the business has substantial growth opportunities still in front of it, and results since the acquisition support this view. We appreciate Allstate’s desire for growth, but we are skeptical of this move, given the company's history with Esurance, and we fail to see a valid strategic connection between Allstate's legacy operations and SquareTrade. The service segment, which houses this business, is not yet a meaningful driver of overall profitability.

Late in 2018, Allstate acquired InfoArmor for $525 million in cash. InfoArmor provides identity protection services to over 1 million employees across more than 1,400 companies. We question the strategic fit of this acquisition, as we see the connection between identity protection and Allstate’s current operations as tangential at best. Further, while Allstate provided only very limited financial information on InfoArmor, the purchase price looks dear at over 8 times projected 2018 revenue.

Overall, we think management's scorecard is mixed. While management has made strides in repositioning the business since the crisis, it was also responsible for the mistakes that created the company's issues, and the current strategy raises some questions. We believe shareholders might be better served if management simply accepted the company's limited growth prospects.