Think for a second about a company that people willingly pay for a service, only to then hope and pray that they never have to make use of it. What if purchasing that same service was required by state governments and large banks? Sounds like a lucrative investing opportunity, eh?
That's the insurance business in a nutshell. People pay for life insurance, yet don't want to die (which, of course, they'd need to do in order to collect on the insurance). Folks can't get mortgages without property insurance. Without auto insurance, getting behind the wheel of a car is illegal in most states.
Our team at Motley Fool Inside Value is running a contest called "A Stock I'd Love to Own." We're asking readers to submit the companies they'd love to own at the right price. The first business that came to my mind was insurance powerhouse Allstate (NYSE:ALL), a nationwide leader ranked among the tops in financial strength in its industry. Allstate is a stock I'd love to own.
Competitive landscape
With a business model where customers pay their bills and then try their best to get nothing for their money, the insurance industry naturally attracts a significant amount of competition. Allstate's largest direct competitors are State Farm and Progressive (NYSE:PGR). Other competitors include Chubb, Nationwide, St. Paul, Countrywide, and New York Life ... but in truth, that's just the tip of the iceberg. Billionaire investor Warren Buffett's Berkshire Hathaway (NYSE:BRKa) (NYSE:BRKb) is itself an insurance company, and it controls direct insurer GEICO and re-insurance giant General Re, which insures other insurance companies that want to limit their exposure to particularly large risks. (Got all that?)
Risks
Aside from having sufficient capital to pay claims and sufficient scale to allow the law of large numbers to take effect, there are very few barriers to entry in the insurance business. This leads to fierce price competition and an inevitable cyclicality in the industry. High prices invite competition. As competition intensifies, prices start to drop. Combine lower prices with the statistical certainty of an occasional higher-than-expected insurance claim and losses become inevitable. Those losses weed out the weaker companies, thereby lessening the pressure on the remaining businesses. The surviving firms then regain a measure of pricing power, and the cycle begins again.
When competition heats up, sometimes companies cheat to get ahead. Marsh & McLennan (NYSE:MMC), a leading insurance broker, was accused of price fixing and illegal collusion through a bid-rigging scam just last year. Along with Marsh & McLennan, insurance providers AIG (NYSE:AIG), The Hartford Group (NYSE:HIG), ACE Limited, and Munich American were all implicated in that particular scandal.
Increased scrutiny of the industry has dragged other skeletons out of the closet. AIG and General Re are being investigated because of some dealings that were originally treated as finite reinsurance between the two firms. Finite reinsurance is a type of insurance designed to limit a company's exposure to a particular risk. What's being investigated, however, is whether the dealings were actually an attempt by AIG to fraudulently smooth out its earnings.
Allstate has largely avoided these scandals, which is both good news and bad news. While its peers suffered through scandal-driven losses, the company's reputation has remained intact, and its shareholders have flourished. For new investors, however, this is bad news, because those scandals may have created attractive buying opportunities elsewhere.
The Foolish bottom line
Thanks to a banner year and an aggressive buyback program, Allstate might look a bit cheap right now. It's priced at about 12 times trailing earnings. But many of its large competitors have been knocked down by scandal and are just now starting to return to fighting strength. Such renewed hunger from its competitors, along with the insurance industry's cyclicality, suggests that Allstate might not be the value it appears at first glance. Nonetheless, this is an attractive business that could present a solid long-term investment opportunity.
Want to tell us about a company you'd love to own? If you'd like to enter our contest or see which stocks the Fool's other value mavens would love to own, take a no-obligation 30-day free trial to Inside Value. (Full contest rules are available by clicking here.) You'll have access to all of our previous picks, and if you win the contest, you'll receive a free one-year subscription to the service. Runners-up will receive free six- and three-month subscriptions. Click here to learn more.
At the time of publication, Fool contributor and Inside Value team memberChuck Salettaheld no shares in any of the companies mentioned in this article. The Motley Fool has adisclosure policy.
