STATE FARM IS OFF THE CHARTS Stunningly rich but less famous than it should be, the giant insurer has built a remarkable record with a stick-to-your-knitting, down-home management philosophy.
By Carol J. Loomis REPORTER ASSOCIATE Mark D. Fefer

(FORTUNE Magazine) – AS FINANCIAL SERVICE companies all over the U.S. flail about, shrinking and waffling over what they want to be, the industry's most successful corporation -- indeed, one of the nation's great businesses -- marches steadily forward, unchanged in character and goals. This marvel is State Farm Insurance of Bloomington, Illinois, and from its low-profile culture rises a batch of high- stepping reasons to grant it notice. Consider: -- In dollar worth, State Farm is bigger than all but a fistful of U.S. companies and has actually been attacked in court for being too rich. -- In the huge, fragmented market for auto and homeowners' insurance, it is the leader by a mile and still gaining. -- And it offers up management lessons on getting close to the customer -- something every business pines to do these days and State Farm does almost without equal. Yet, paradoxically, this capitalistic achiever has the outlines of a Russian collective. State Farm has no stockholders, never has raised a dime in the capital markets, and for its entire 69-year history has subsisted solely on retained earnings. It is a mutual insurance company, owned by its policyholders. Conventional wisdom holds that mutuals are not well run. Why should they be, the cynics ask, given that their owners seem barely to rate the name and that their managers, Lord save us, don't even have stock options? In this case, burn the conventional wisdom. All the evidence indicates that State Farm's management is of star quality and always has been. Yes, the company has its problems -- among them a recent slump in profits, political clamor for cheaper auto insurance, and even a few cranky agents. But management's past record of mowing down obstacles suggests that these too will be cut to size in a deft, State Farm way. Indisputably, the company has the financial power to deal with almost any challenge. Counting all its businesses, which include a large life insurance operation, State Farm last year earned almost $26 billion in premiums, ranking second only to Prudential, which had roughly $28 billion. And in the core measurement of wealth, equity capital, which in this industry is called surplus, State Farm is a far bigger rock than the Rock: State Farm weighs in at $18 billion, Prudential at $8 billion. If State Farm were publicly traded and that $18 billion -- the company's book value, so to speak -- were accorded just a middling price-to-book multiple, State Farm could easily have a total market value of $25 billion. That would put it ahead of the top-dollar financial services company, insurer American International Group (recent valuation: $19 billion), and in a class with such market giants as Johnson & Johnson and Amoco (each just north of $25 billion). In early March, in fact, only 16 U.S. companies, headed by IBM at $75 billion, had a market value above $25 billion. As for State Farm's operating ability, it is so strong that even the competition steps up with applause. Says John J. Byrne, who successively ran insurers Geico and Fireman's Fund (until it was sold by its parent, Fund American, which Byrne still heads): ''I've thought State Farm the single-best- managed insurance company in the country. I had to face that problem head on at Geico. So I gave my troops a slogan: 'Our mission in life is to be the second-best-manage d insurance company.' '' Chuckling at that, Eugene Meyung, whom Byrne hired away from State Farm to take a top job at Geico, says that Byrne's ''second-best'' ploy reminds him of the crafty farmer who brought an ostrich egg into his henhouse and said, ''Look what the competition is turning out, girls.'' But Meyung, now retired, is himself another fervent admirer of State Farm: ''The company is truly run in its owners' interests. When I was there, you were always being reminded, when it came to expenses, that you were dealing with the policyholders' money.'' Paradoxically, again, these coddled owners have been in the clutches of nepotists. Five chief executives have run State Farm, the first two of the name Mecherle (pronounced Muh-HURL): George J., the retired farmer who founded the company, and his son Ramond. Next came a lateral pass, to the family Rust. Adlai H. Rust, a lawyer who had worked at State Farm under the Mecherles, ran the company from 1954 to 1958, and his son Edward B. headed it for more than a quarter-century until he died at 67 in 1985. The sudden loss of this much respected leader shook the company. But there, close by in every sense, was Edward B. Jr., then only 35, who had become a State Farm trainee in 1975 and vaulted by 1983 to the No. 2 job, executive vice president and chief operating officer. This virtual kid promptly ascended to the job of CEO, a move that within State Farm seems to have been largely noncontroversial and indeed almost taken for granted. But the outside directors of State Farm, who are predominantly academics and economists, briefly considered alternatives. These directors knew Ed Sr. as very private, disciplined, and brilliant. They knew the son as more outgoing but unproved as a businessman. Says one of the directors, Burke Marshall, a professor of law at Yale: ''We felt some tentativeness about this matter -- we didn't know Ed Jr. well -- and we discussed whether we should do a national search, maybe bring in someone from GM or the like. But we thought not.'' And how has it gone under young Ed? Says Marshall: ''Splendidly.'' To a degree, that assessment collides with State Farm's recent financial results, which display profits -- $428 million in 1989 and $522 million in 1990 -- way below the norm. But a part of the decline is attributable both to unusually high catastrophe claims (from Hurricane Hugo, the San Francisco earthquake, and various 1990 storms) and to State Farm's decision to respond to the pressure for affordable auto insurance by slowing rate increases for a while. In any case, neither Marshall nor others seem ready to assign any blame to Rust. Says Fund American's Byrne, lugging in yet another ostrich egg: ''I used to tell my Geico managers that our only hope was that Mr. Rust would put his son in charge and that he would ruin the company. Well, it isn't happening.'' DIRECTORS doubtless must weigh their options, particularly where family hand-me-downs are concerned, but the idea that someone might come in from anywhere outside, much less GM, to run State Farm is mind-boggling. The company has a totally home-grown and deeply entrenched culture. Nearly all the top managers have worked there forever, and few people leave. Midwestern unpretentiousness is the mode at Bloomington headquarters, where 6,000 employees work, and seems also to have been exported to the regional organization, whose head count is a huge 49,000. State Farmers in outposts such as metropolitan New York may poke fun at ''scintillating'' Bloomington -- which, with its sister scintillator, the city of Normal, has a population of 92,000 -- but they tend to look as if they could be transplanted there and fit right in. Bloomington, set on dead-flat prairies 135 miles southwest of Chicago, may in fact be part of State Farm's secret. Removed from the ''hurly-burly,'' says director Marshall, management is spared distractions. The city, native son Adlai Stevenson once said, even taught him his most important lesson: ''that in quiet places reason abounds, that in quiet people there is vision and purpose, that many things are revealed to the humble that are hidden from the great.'' Dispel any thought that this is a humble company. You don't rise to $26 billion in revenues, and market shares of around 20%, without deciding you're pretty good. Reason, vision, and purpose, on the other hand, are there in ^ abundance. Purpose is always articulated in terms of the policyholder's interests, sometimes with I-hope-this-doesn't-so und-too-corny apologies. Ed Rust Jr., however, does not squirm at saying it straight: ''Our goal is to take care of our policyholders. That's what we're driven by.'' That goal leads to other goals -- and to odd consequences as well. Because State Farm believes that competition, rather than regulation, will deliver the best value to consumers, it exhibits an almost fanatical devotion to the free market. In industry arguments with state officials about whether rates should be regulated or not, or to what degree, this company is the Great Uncompromiser -- an idealist whose stubbornness sometimes drives its more pragmatic competitors crazy. Says economist Sean Mooney, of the industry's Insurance Information Institute: ''There have been times when the industry was ready to accept a tactical solution, figuring it wouldn't hurt to give in a little. Not State Farm. The free market is a theology with them.'' Another pillar of dogma is the company's resolve to have a strong capital position, which it sees as guaranteeing that its promises to policyholders will be kept. This bias makes the company a conservative investor: no junk bonds, thank you, and no in-and-out trading. With its $18 billion of surplus, State Farm is simply the Fort Knox of the insurance business, and in a world agonizing over the solidity of insurers, that might seem to the good. But ironically, State Farm has been charged in a California lawsuit with having too much surplus. Its adversary is a lawyer, William Shernoff, who claims that State Farm has malevolently built up its surplus by paying too little in the way of policyholder dividends, which insurers use to make what are essentially premium rebates. According to Shernoff, the company holds nearly $7 billion in superfluous capital, and he wants State Farm to disgorge that much to its policyholders, one of whom is his client. In a sense Shernoff is going after State Farm's surplus in the way a raider might were the company publicly owned. So far Shernoff's assault has failed: Dismissing the case before it got to trial, a judge held that he saw no reason to interfere with the directors' business judgment as to how much capital the company needs. But Shernoff has appealed. Meanwhile, State Farm has decided the word ''surplus'' has an unfortunate ring to it and now works at calling those billions its ''policyholder protection fund.'' * By any name, $18 billion in capital is a real hunk when it comes to thinking about profit returns. State Farm has every wish to be solidly profitable and grow in financial strength, so that it can meet the expanding insurance needs of its policyholders -- coverage on more cars, second homes -- and pick up new souls to worry about besides. But what does ''solidly profitable'' mean in the case of a mutual insurance company? THE ANSWER, to cut through some financial intricacies that apply to insurance companies, lies in the growth of a mutual's surplus -- that is, equity. This figure sweeps in not only the company's operating profits but also its investment gains and losses, both realized and unrealized. And changes in equity are the bottom line on wealth gained, or lost, over any period of time. The history shows that in the 1970s, State Farm's compound annual rate of gain in surplus was a superb 23%. For the 11-year period 1980-90, growth was much slower: 14.1%. Those years included the company's record net income -- $1.9 billion in 1987 -- as well as the recent lemons. The overall picture, in any event, is high-grade: 14.1% is an excellent rate at which to have compounded all those billions. In explaining just how State Farm manages to do so well, its executives fasten on fundamentals: ''We have stuck to our knitting,'' says Rust. That means the company hasn't chased into unfamiliar businesses -- into selling mutual funds, for example, or into the stock brokerage world, which has creamed Prudential. Senior vice president Roger Joslin parses State Farm's success somewhat differently: ''This company has always been run by good people. We've not done anything that lawyers, analysts, or business journalists would say is dumb.'' On the contrary, State Farm has done some things that are awesomely intelligent, and foremost among these is its creation of a unique and remarkable marketing organization built around the State Farm Agent. You've heard about him, and increasingly her, in ads: the Good Neighbor, friendly ol' Bill down the street, happy to insure one car or four, cover your house as well, nudge you about life insurance, give you a State Farm windshield scraper for the next ice storm, and answer the phone at 2 A.M. when your 17-year-old -- ''Yeah, he's okay, the idiot'' -- has just totaled the Chevy. What you don't know are the arrangements that put this fellow on Main Street and that even lead now and then to tensions between him and State Farm. Some of these relate to nepotism, which blooms not as blissfully in the field as in Bloomington. The State Farm agent as we now know him did not immediately materialize when George Mecherle, the son of a German immigrant and a Quaker mother, decided in 1922 that rural Illinois folk deserved auto policies not priced at Chicago rates and started ''an honest little insurance company.'' Initially farmers and other part-timers sold his product. But by the late 1940s, State Farm was big business and busting out of Bloomington. The company then began farseeing moves both to decentralize and to recruit full-time agents. Many permutations later, we have the State Farm agent, of whom there are currently 17,500, doing business with about 25 million households, carrying 57 million policies. The agent is not a State Farm employee; he is an independent contractor who has the right to sell the company's products and the obligation to sell nothing else. If a customer walks in who has had too many accidents or speeding tickets to qualify for State Farm insurance, the agent cannot proffer some other company's policies. He simply loses the business. But, collectively, the agents keep plenty, for a combination of reasons. Price helps: State Farm's rates are quite competitive, though seldom the cheapest around. Service matters significantly: Surveys that measure policyholders' satisfaction with the handling of their claims tend to rank State Farm high. In recent Consumer Reports studies, for example, the company trailed certain competitors that do a niche business -- USAA, for one, which sells primarily to military officers -- but outranked its big multiline competitors. Finally, State Farm simply appears to get some mileage out of its close-to-the-customer, Good Neighbor image. For his contributions to this machine, the agent earns a percentage of the premiums he brings in. On auto insurance, he gets 10%, year in, year out. On fire and casualty, which includes homeowners' and also commercial policies (mainly sold to small businessmen), he gets 15%, again every year. On life insurance, the first-year payoff is 30% to 50%, depending on policy type, and lesser sums (sliding to 2%) thereafter. And with these percentages, he can glean sizable amounts. The median take for State Farm agents was $148,000 last year, and the average -- pulled up by 172 agents who did better than $500,000 -- was $169,000. The impressiveness of these figures mounts if another tenet is understood: The company has the right, which it exercises freely but carefully, to add agents in any location. Crowds can form. Observe the State Farm population in a certain small city of 20,000 in the Midwest: It has five agents, whose tenure ranges from six years to 31 and whose take last year also ranged widely, from $67,000 to $329,000. But since these are independent contractors -- small-business men, in effect -- their commissions are reduced by expenses: for rent, office staff, computers that are linked to State Farm's regional offices, giveaways such as those windshield scrapers, and supplies, which the agents may buy from State Farm or elsewhere. The bite taken by these costs varies widely, depending on an agent's efficiency, size, and yen to grow. Typically, though, an agent can net 60% of his gross. Assume that an agent grossing the median, $148,000, clears 60%. That would give him pretax income of $89,000. If he happens to operate in a small city or town -- and a lot of State Farm agents do -- that is a bundle. Many agents, in fact, cringe at the thought of their customers learning just how much they make. Said a small-town agent recently: ''The average annual income in this county is $10,000. I don't need my customers to know I take in more than $300,000.'' For that, of course, he works hard, running a multimillion-dollar business. But his partner, State Farm, provides major help, using 28 regional offices to handle all billing of premiums and to supply such assistance on claims as the agents want. The regional vice presidents who head these offices are the princes of the realm. They operate huge businesses that are largely autonomous, and on the organization chart they report directly to Rust. Even so, most are hands-on when it comes to satisfying policyholders. Says Jerry O. Lane, 55, whose Northeastern region had 1990 revenues of $1.6 billion: ''I see every complaint letter we get. We answer them all, and I do most of the answering myself.'' The regions are also in charge of hiring agents and of encouraging the existing force to lean in whatever direction State Farm would like to see. At the moment, the company is moving to hammer out the dents in its auto insurance operation by reviewing its book of business to make sure all policyholders are paying enough, given their driving habits and family profiles, and by generally stepping up rates. For the agents, this means lost sales and forgone compensation. Yes, says State Farm, jawboning away, but why - don't you make that up by selling more homeowners' policies and particularly more life insurance? Many agents would rather close the store than tackle the time-consuming tortures of selling life, and being independent contractors, they have that option. Nonetheless, the jawboning will continue. NEW State Farm agents are hired with the care one might give to choosing a spouse -- which in a business sense is not too far from what's happening. Candidates lacking an entreprenurial bent need not apply, nor those with blots on their reputation. Today most applicants accepted as trainee agents, a two- year stint, are college graduates, some with business degrees. Ex-teachers have prospered in the agency force, and one of these, John Phelps, 55, of Pasadena, Texas, appears to have been State Farm's top producer last year, pulling in commissions that FORTUNE estimates to have been at least $1.3 million. On the other hand, people who have sold insurance elsewhere are seldom hired, since State Farm believes they are encumbered with bad habits that they resist unlearning. Says Don Rood, the senior vice president in charge of the agency force: ''They don't much like us, and we don't much like them.'' Something in this process works superbly: Of every 100 agents that State Farm hires, 80 are still around four years later. The insurance industry's record is the near opposite: Fewer than 30 survive that long. State Farm's biggest competitor, Allstate, outdoes the industry but still retains only about 50%. For about a decade, the strongest element in State Farm's hiring has been a drive to add women and minorities as agents. True, these folk have for eons been represented in the force. One veteran, Teresa Denning, 79, of Boulder City, Nevada (pop. 13,000), just celebrated her 50th year as a State Farm agent and, by the way, had her best year ever. (''No,'' she demurs, ''I'd just as soon not see my income printed.'') Says she: ''Things were a little bit anti-female in the early days, but that's quietly gone away.'' Actually, not so quietly. State Farm was hit in 1979 with a lawsuit in California that charged it with discriminating against women in the hiring of agents, and after six years of litigation the plaintiffs won. State Farm later paid $421,000 to each of three lead plaintiffs and has since been litigating the individual claims of about 1,000 others (the outcomes of these cases are being kept secret). The company also settled a similar lawsuit in Texas for $11.5 million. Meanwhile, State Farm got cracking on the hiring of women -- there are now 3,000 in the 17,500 agent force -- and minorities, of whom there are 2,000, some of them women. The company has made ''real progress'' in the past ten years or so, says Vincent Trosino, who succeeded Rust as State Farm's chief operating officer. But ''in our first 50 years,'' he concedes, ''we didn't do well.'' Another issue within the field force relates to just where the agent stands at career-end. What's due him then are so-called termination payments that equate to retirement income and that amount to a cut on the renewals he is handing off to another agent. Other than that, the agent cannot benefit from the business he has built up, since he has simply been a contractor and never had the status of owner. This circumstance, though known by everybody to be the rules of the game, has the potential for galling any agent getting on in years. The deeply distressed, however, are likely to be those agents who have a family member -- say a son -- whom they would like to see become an agent and take over their book of business. In effect, such a father yearns to will a business he doesn't own, but certainly thinks of as his, to his child. State Farm in no way objects to well-qualified sons or daughters becoming agents. Many have. But usually the offspring do not take up where their fathers left off; instead, they become agents elsewhere. By such arrangements, State Farm seems to think, it can avoid a nepotistic system in which sons or daughters almost automatically become agents and take over their fathers' books of business. Furthermore, a steady stream of such handoffs would begin to imply that all agents own something they can pass along, and that is certainly not what State Farm believes or wishes to see gain credence. So certain agents chafe and some unknown, though clearly small, number have dramatized their discontent by joining a would-be union, the National Association of State Farm Agents. An occasional dissident is even virulent in his protests. One is Joseph Kelly, 66, an agent in Joplin, Missouri, for 33 years, who rancorously describes State Farm as apparently run ''for the benefit of its management and nobody else.'' If that's the aim, State Farm's executives are clearly botching the job as far as their compensation is concerned. Ed Rust made $599,000 last year, an amount so low on the compensation spectrum for big-time CEOs that he probably ought to fear picketing by the Business Roundtable. Or maybe by Saul Steinberg, whose $6.26 million in 1989 compensation from Reliance Group qualifies him as the best-paid insurance executive around. Rust, poor fellow, probably doesn't even reap as much as that top-drawer Texas agent, John Phelps, and the handful of other agents who gross more than $1 million. The executive pay scale at State Farm punctures Kelly's complaint and provides still one more reminder that money doesn't drive this management. Most probably, the company, like many another achiever, is spurred by nothing more complex than a history of accomplishment and a desire to extend the record. The nation's business schools might well gain more value from studying State Farm than, say, modern portfolio theory. Plainly, multitudes of standard-variety corporations -- the kind with stock and options and $6 million paychecks -- could learn much from this mutual.

CHART: NOT AVAILABLE CREDIT: NO CREDIT CAPTION: BUMPER CROPS This blue-ribbon growth line shows the rate of increase in State Farm's premiums over the company's first three years and over five-year intervals thereafter. Particularly vigorous growth up to 1930 created the elbow above.