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Summary of the deal
| Deal | GEICO, Government Employees Insurance Company | ||||||||||
| Time | 1976 – present | ||||||||||
| Price paid | $45.7m for 51%, paid 1976-1980. $2.3bn for the remainder in 1996. | ||||||||||
| Quantity | Initially 1.99m convertible preferred shares ($19.42m) and 1.29m common stock ($4.12m) | ||||||||||
| Sale price | Still part of Berkshire Hathaway | ||||||||||
| Profit | Tens of billions, and counting | ||||||||||
Berkshire Hathaway in 1976
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The GEICO story is a tale of three virtuous circles. The first is what I call the “operating cost virtuous circle”, put in place by the founders Leo Goodwin and his wife Lillian in the 1930s, and built upon by succeeding brilliant managers.
The Goodwins recognised that auto insurance is a very competitive business. Indeed, it is a commoditised industry in which it’s very difficult to charge a higher price by offering a differentiated product. Most purchasers just want the lowest price, and will switch providers at the drop of a hat.
As a result, many insurance companies struggle to make satisfactory returns on capital employed because they are pinned to pared-down prices to maintain volume.
The key, therefore, to raising returns in this sort of business, is to continuously hammer down costs. The question then is how you do that?
The vast majority of companies in the middle decades of the twentieth century adopted distribution methods which involved paying large sums to insurance agents and sales people to sell policies to the ultimate customer.
This middle-man method means that when that commission costs are added to general overheads something like 40% of what is taken in premiums is spent on administration and sales.
GEICO found a way to knock off over one-third of that. This was done through the operating cost virtuous circle.
The starting point has two aspects. First, sell insurance direct to the customer without the need to pay agents. This can be achieved through selling by mail or telephone (and today via smartphones).
As the 21-year old Buffett wrote in an article published in The Commercial and Financial Chronicle titled “The Security I like Best” this direct selling method has another advantage: “There is no pressure from agents to accept questionable applicants or renew poor risks”.
Which leads us onto the second aspect: to sell only to a select group which is known to include a high proportion of safe drivers each with a steady monthly income, who can be target-marketed easily.
GEICO, conscious of competition and very keen to hold on to existing clients had a self-imposed rule that all or most of any cost savings are to be passed on to consumers – Buffett today looks to obtain a maximum 4% underwriting profit on sales; if the figure creeps above this, policy prices are reduced. Thus the customer gains the majority of any savings made on operating expenses.
For the first two decades of the company’s life it prohibited marketing to anyone outside of a prescribed group. You’ve guessed the group from the name of the firm: government employees (including military personnel), who are seen as, on the whole, low-risk drivers. This targeting both lowered marketing costs and reduced the number of claims because this group contained an above average proportion of responsible and sober people.
It wasn’t until 1958 that non-government workers were permitted to buy GEICO insurance. But even then the offer was extended only to civilian professional, technical, and managerial occupation groups.
GEICO, by developing a quality service both in administration and in assisting clients following an accident was, and is, very good at retaining existing customers which helps feed the low-cost model.
High quality of service also helps with another aspect of the business model: having such a great volume of applications allows great selectivity in offering policies only to those offering the greatest likelihood of financial reward relative to the risk of a claim.
Many new customers were, and are, won over because existing customer are so impressed that they recommend it to their friends – another way of lowered customer acquisition costs.
The Confidence Virtuous Circle
This circle occurred during the crisis facing the company in 1976. I need to explain it much more detail later so I’ll not say much more now other than the company was headed for bankruptcy because of a complete lack of confidence by equity and bond investors, and by reinsurers, that it could survive. Faith in the managers and in the balance sheet had evaporated.
It was desperate for equity capital to be pumped-in to survive. If someone had come up with the money then others in the financial markets start to figure that it has a reasonable prospect of long-term viability. This, in turn, generates sufficient trust for it to regain policy holders, and to attract lenders and reinsurers.
But no one would take the first step, leading to a Catch 22, as each potential finance provider waited for someone else to make the very risky move of picking it up off the floor with an injection of ten………..
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