The Power of Innovation: How State Farm Grew from a Small Company to a Behemoth

During their latest episode of the VALUE: After Hours Podcast, Taylor, Carlisle, Kagan, and Bennett discussed The Power of Innovation: How State Farm Grew from a Small Company to a Behemoth. Here’s an excerpt from the episode:

Jake: [laughs] Yes, I do. So this week, I was in the Midwest a couple weeks ago, and I often will try to bring a book to read that’s related to that area, if I can. Buffett’s mentioned numerous times how he’s surprised that more people haven’t studied State Farm auto insurance more. He’s mentioned this a few times during the annual meetings.

The company ended 2022 with $131 billion of net worth. And so I’ll just give you a quick quote of Buffett talking about State Farm. “Next to Berkshire, it’s the leader in having net worth. It’s a mutual company, but some guy just figured out that there was a cartel running car insurance. A Farmer from Merna is the name of the book, and he created a system where he took 20 points out or so out of cost. Nobody’s owned stock in State Farm. It’s an insult to capitalism, actually. Everything you learned at the business school says it shouldn’t work because nobody owns it. Nobody’s going public with it.” So I read the book, and I’ll give you some interesting highlights from something that Buffett said we should have done and probably most of us hasn’t.

The book was actually written in 1955. It’s a biography about this founder and his name is George Mecherle, but that’s spelled M-E-C-H-E-R-L-E. He’s German. He was born in Merna, Illinois in 1877 to immigrant parents. He grew up as a farmer. He was actually quite successful. He was an extroverted guy, and he always liked to talk to other farmers about crop prices and new scientific findings about soil management. He lived it. He effectively retired at age 44, and he was leasing out his farm to these tenant farmers. To keep busy, he sold tractors for a while. He discovered that he had a knack for selling to farmers specifically because he was one and he knew what they needed. He believed that city insurance companies were getting over on farmers with higher premiums based upon–

The city driving was just more prone to car accidents. There are fewer cars out to crash into each other in the countryside. He became obsessed with this idea of starting his own insurance company, an honest insurance company is what he always called it. He started this company that was named State Farm the day after his 45th birthday. So I find that actually to be a little bit inspiring. Like, if you’re already getting a few on in age, as some of us are like, “Gosh, this guy started at 45 and–” It’s not quite maybe like, what was the Kentucky Fried Chicken guy when he started.

Tobias: Colonel Sanders.

Jake: Colonel Sanders. Yeah. Anyway–

Tobias: I don’t know, 1970s?

Jake: Yeah, something like that. So farmers had long formed these mutual co-ops for fire insurance to share risk. So by 1890, I think every state in the Midwest had them. And there were these agreements where everyone would pay into a pool. If someone had the bad luck of a fire, let’s say, it would be covered by the group. There were 216 fire mutuals in Illinois alone in 1921, which is the year before they started State Farm. But no one had ever taken that concept of a mutual and applied it to auto insurance. Autos were making the transition at that time from toys to actual necessity of American life. Here’s how the economics worked of what State Farm constructed, $15 was paid as a onetime membership fee. $19 were paid for the first six months of the premium, and then $1 from each renewal premium went to this private company that was owned by Mecherle.

In fact, actually, several years passed before he was ever even close to sufficiently compensated. Like, he practically worked for free for a long time, but then eventually, it proved to be very lucrative for him. But he had this insight of adding a $10 deductible, which, if everybody’s done insurance before, they understand what that means. But it was an ingenious solution, because what it did is it kept a lot of these little petty claims from being filed. And also, the farmers, they probably had to pay for their own minor repairs, so they probably drove a little bit more carefully.

This company was able to operate 40% cheaper than stock company competitors because he had actually figured out a bunch of stuff here. The first thing is that he had this novel idea of collecting premiums every six months instead of annually, and that actually lined up a lot closer with the farmers cycles of when they would have cash, which was important. And also, it allowed them to change rates faster. If you’re too slow to change rates, that’s either you’re overcharging and they find someone else or you’re undercharging and you’re not getting paid for the risk that you’re taking.

They centralized billing and collections at the home office in Illinois, which was previously done out in the field by agents. And those agents would get the money and they’d have it for 45 to 75 days, typically, so they had float on you in a way which obviously not helpful. And the $15 membership fee didn’t require reserves against it, like, traditional premiums that you would write by regulation. So State Farm could actually grow faster than a lot of the other companies. They found a source of capital, basically. The new members paid for their own acquisition costs effectively with that $15 membership and they were very careful about who they selected to underwrite. And that allowed them to discriminate a lot of bad underwriting risks. Like, they wouldn’t cover drunk drivers. They appealed a lot to the high moral farmers. This is how a mutual kind of worked. I don’t know, if you guys have ever seen this before.

But that $19 premium deposit, let’s say, that the share of the cost that year were $10. And so that leaves $9 left over from premiums. There would be a credit that was created of $9 for the user, for the member, and then they would have to add a fresh $10 to restore the premium deposit, and then it would repeat every renewal period. The customers actually felt like this really strong loyalty and they would display the State Farm insurance medallion on their automobiles and people would brag about it, which kind of hard to imagine nowadays, right?

So anyway, let’s just talk a little bit about how well this took off, like, boy, they really caught lightning at a bottle. Started in 1922. After six months, they had 1,300 policies enforce, and that created $29,000 in revenue insurance premiums, which is about $500,000 today, adjusted for inflation. Six years later, they’re at 69,000 policies. That’s like a 94% CAGR for six years. This is like an early hyperscaler for everybody [Tobias laughs] who likes those kinds of businesses.

By 1944, they had over a million policies, which is a 35% CAGR for 22 years. And in 1951, when George Mecherle passed away, it was at 2.2 million policies and $119 million in underwriting revenue. And by the time the book was written in 1955, they were at 3.4 million policies. So wrapping this whole thing up, there’s this beautiful Emerson quote that’s in the book that really sums up State Farm and George Mecherle and it’s, “An institution is the length and shadow of one man.” He was the guy for State Farm. Like, he was totally the driving force to get it going and turned it into this behemoth that defies the laws of capitalism and this mutual system.

Tobias: That’s fascinating, JT. Did they tell you what he did on the asset side?

Jake: There was a guy who was managing that, and I think it was primarily just in bonds. Like, it was pretty generic time period, they weren’t that creative.

Tobias: Safe.

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