GEICO's Lean, Green Machine

Over the past several years, a small green gecko has become the nation's most popular reptile; if you are at all interested in the business fundamentals that made him famous, read on.

GEICO, a subsidiary of Berkshire Hathaway (NYSE: BRKa) (NYSE: BRKb), is one of the top five car insurers in the nation and could achieve a 6% market share by year's end. It's also one of the fastest-growing insurers, thanks to its direct sales model, which has clear advantages over the more common models that other giants in the industry use.

State Farm, Allstate (NYSE: ALL), Farmers, and Nationwide (NYSE: NFS) market and sell their car-insurance policies through agents. This means that you can't call the company's 800 number and get coverage; you have to go through a middleman. And that middleman is expecting a cut.

GEICO's model allows the customer to call the company direct, bypass the agent, and usually get a lower rate. So if this business model is clearly cheaper, and more competitive, then why aren't others following suit?

Well, State Farm and Allstate have around 17,000 and 13,000 captive agents, respectively, who were trained to exclusively market their company's insurance products. If Allstate or State Farm, in a shot of competitive genius, decided to get an 800 number and cut out the middleman, they would be staring out at an army of their own jobless insurance agents.

Here, then, is what we know: (1) GEICO's business model enables it to consistently underprice its largest competitors, and (2) these competitors would find it very difficult to adopt this model.

Now, getting back to the more important matter: Why do we all see the green GEICO gecko everywhere we turn? As Warren Buffett explains in his most recent letter to shareholders, "A company (in a commodity-type business) holding a low cost advantage must pursue an unrelenting foot-to-the-floor strategy." One of the main ways GEICO has done just that is by ramping up advertising; it spends millions to teach a gecko how to do "the Robot."

The heightened customer awareness of GEICO's lower rates has caused its market share to jump from 1.9% in 1993 to almost 6% today. Looking at it another way, GEICO earned $2.1 billion in premiums in 1993 vs. $8.9 billion in 2004; that's an annual increase of 14% for 11 years. Who wouldn't be dancing after growth like that?

The final point worth considering, however, is that Progressive (NYSE: PGR), with its slightly larger market share, recently ramped up its own direct-sales system. Progressive is in a good position to adopt this system because it uses independent agents who sell policies for many different companies and aren't out of a job if they lose Progressive's commissions.

It will be interesting to see how Progressive's new system competes with the dancing gecko over the next decade. Regardless of the impact, GEICO holds a uniquely competitive position among car insurers: With its 100% direct method, it should continue adding policyholders, rewarding Berkshire shareholders, and making geckos dance for years to come.

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Fool contributor Matt Thurmond owns one Class B share in Berkshire Hathaway and holds no shares of any other companies mentioned.