Benjamin Graham on Insurance Economics

Graham narrates the GEICO investment in his memoirs as a near-accidental encounter. The founder of Government Employees Insurance Company had approached Graham-Newman seeking capital; the partnership negotiated the purchase of approximately half the company for around seven hundred thousand dollars. Graham writes that the deal was an unusual step for the partnership, which had historically preferred workouts, arbitrages, and liquid-asset plays rather than building a new insurance franchise. The transaction immediately created a regulatory problem. The Securities and Exchange Commission informed Graham-Newman that an investment fund was not permitted to hold more than a small percentage of an insurance company, and the partnership was required to distribute most of the GEICO stake to its own shareholders. Graham writes that the forced distribution turned out to be one of the most valuable involuntary decisions the partnership ever made, because the recipients held on through the post-war growth years and the position multiplied hundreds of times in value over the following decades. Graham treats GEICO as both a triumph and a paradox. He had paid a price that turned out to be a tiny fraction of what the company would be worth; the analytical framework had identified the underlying low-cost-operator advantage of GEICO's direct-selling model. But he also notes that the magnitude of the gain was not in any sense forecast by the partnership at the time of purchase. The lesson Graham draws is that the analyst can be right about the business and still badly wrong about the size of the payoff.

Ben pointed to the dictionary, which defined "tranche" as a slice, such as a slice of cake. Ben said: "If I told you the answer, you might have soon forgotten it." Some 45 years later, the senior author of this sketch still remembers that a tranche is a portion of an underwriting. The depression years thinned the ranks of bankers, brokers, and analysts. Shrewd Wall Streeters, however, realized that the disoriented markets of those times were creating many buying opportunities. Over the years thousands came to Ben's class and to hear him analyze undervalued securities. Many wanted his keen mind to review issues they believed worthy of consideration. Ben so enjoyed teaching that often he would remain after class for half an hour or longer responding to questions from his fascinated students. These classes in security analysis were held continuously until Ben's retirement from Wall Street in 1956. So many successful people from the world of finance were attracted to this class that Columbia's Business School grew in stature as the achievements of the faculty became better known in the financial community. Simultaneously Ben found time to teach for a decade at the New York Stock Exchange's School, now known as the New York Institute of Finance.Irving

sold by direct mail to the consumer at a reduced rate, as no commissions had to be paid to insurance agents. The policies were available only to government employees, a group that fortunately averaged fewer claims than most. The company had exceptional growth during its first dozen years and this continued after the Graham-Newman purchase. In 1958, it was decided to offer insurance to professional, managerial, technical and administrative workers, as well as government employees. This broadened the market from 15 percent of car owners to 50 percent. Again, these new policyholders also turned out to be preferred risks. In the following years, growth and profitability continued at an exceptional pace until GEICO became the nation's fifth largest automobile insurer. However, the days of 15 percent underwriting profit margins were over; GEICO was now so large that insurance commissioners would grant rates aimed at producing only a five percent underwriting margin, the same rates granted to other large insurance companies. Starting in 1974 costs rose as inflation accelerated. Adding in the problems of no-fault insurance and low rates, losses skyrocketed and GEICO's net worth dropped from $144 million at the start of 1975 to $37 million at the end of the year. A great many changes have been made and it is expected that 1977 will see GEICO return to profitability.

The letters record that Graham-Newman's GEICO holding, although reduced by the SEC-mandated distribution, remained a meaningful position and a focus of the partnership's attention. Graham and Newman took board seats and involved themselves in the company's underwriting and finance. The letters describe GEICO's growth in premium volume and policyholder count, and note that the company's direct-to-consumer model was producing underwriting profits that other insurers could not match. The letters are explicit that Graham-Newman did not forecast GEICO's later dominance. The partnership's analytical case at the time of the 1948 investment was that the company was a low-cost operator with disciplined underwriting, in an industry where most operators were neither. The letters do not project the twenty-five-year outcome; they project a sound business bought cheaply. The lesson the partnership drew, in retrospect, was that soundness and price were sufficient and the growth bonus was a free rider. Graham-Newman's letters also disclose the moment in the early 1970s when GEICO's underwriting discipline broke and the company nearly collapsed. Graham writes, in later correspondence, that he had been retired from Graham-Newman by then and was not involved in the rescue, but that the episode confirmed his view that even a low-cost operator can be ruined by underwriting for growth rather than for profit.