Source: Company
The Allstate Corporation (ALL -1.72%) has everything investors are looking for: A strong insurance brand in the competitive property and casualty business, with increasing premiums and rising profitability, a cyclical earnings profile, and an encouraging development of its combined ratio.
All three themes justify further upside potential in Allstate's stock, even though the insurance company has already returned close to 20% for investors during the last 12 months.
1. Cyclical insurance business
Property and casualty insurance firms are cyclical businesses, and their stocks are promising investments in a strong economic expansion phase when earnings gradually improve, and when investor confidence is high. On the other hand, insurance businesses are the first investments to get the boot in times of turmoil, as investors gravitate toward defensive industries, such as utilities, to provide downside protection.
In other words, because I expect a strong recovery in the U.S. economy, cyclical businesses like Allstate should benefit from increased premium and earnings momentum during the next two to three years.
2. Improving profitability trend
The property and casualty business is a competitive industry in which many players feel policy pricing pressure.
Source: The Allstate Corporation Investor Presentation Q2 2014.
When evaluating an insurance company, two themes largely stand out: 1) What is the underlying profitability of the policy writing business, and 2) How does the company manage risk? The first question can be addressed by monitoring Allstate's return on equity, which has been steadily increasing during the last six quarters.
In the most recent quarter, Allstate generated an operating income return on equity of 9.8%, which compares against 8% in the year-ago quarter. The gradual improvement in this metric proves that the company is clearly on the right track here for profitability growth as the company continues to see written premium momentum. Allstate's property-liability business saw written premium growth of 5.5% year over year, and there's little that points to slowing growth any time soon.
3. Improving combined ratios
In order to answer the second question, "How does a company manage risk?" investors should look at Allstate's combined ratio. This ratio is quite material for insurance businesses as it reflects upon the underlying profitability of the policy-writing business. The combined ratio indicates how profitable Allstate's underwriting business is as it considers both insurance claims and expenses -- both are items that reduce Allstate's profitability.
Source: The Allstate Corporation Investor Presentation Q2 2014
Generally speaking, the lower an insurance company's combined ratio, the better it selects and prices the risks it puts on its books. Allstate certainly benefits from an improving combined ratio: Its property-liability underlying combined ratio, which adjusts for catastrophe losses, stood at just 84.7 in the most recent quarter, and compares very favorably against a ratio of 89.9 in the same quarter three years ago.
The substantial improvement in Allstate's combined ratio during the last three year indicates prudent risk selection. I expect continued underwriting success going forward.
The Foolish Bottom Line
Allstate is a well-run insurance company that stands out from the crowd with a convincing combined-ratio trend. The insurance company further has attractive upside potential, especially when financial companies rock back into the focus of equity investors who seek out businesses with strong cyclical earnings profiles.
