Thomas V. McKernan, chief executive of the Automobile Club of Southern California, knows a thing or two about management theory.
In the late 1980s, McKernan enrolled in the business doctorate program at the Peter F. Drucker Graduate School of Management in Claremont.
He got an added benefit: After Saturday classes, management guru Drucker would ask McKernan for a ride to his home a few blocks away.
There, parked in front of a plain vanilla ranch home on a quiet street in leafy Claremont, one of the great minds of corporate theory gave McKernan an earful.
McKernan then was Auto Club’s chief financial officer. He was searching for ways to get his nonprofit “mutual benefit corporation” turned around. It was on the brink of financial disaster.
Drucker knew lots about big corporations, but not the quirkiness of something like the Auto Club, which has no owners and is run with members’ dues for their benefit. Unlike a public company, it doesn’t pay dividends.
The duo talked for hours.
“I learned to reflect a lot more,” McKernan said. “I learned that the biggest problem successful organizations have is that they build in rigidity to change in very subtle ways. Unless you are constantly challenging yourself, and the organization, you are going to end up like Sears or General Motors.”
A few years after McKernan’s conversations with Drucker, he took over the Auto Club helm.
Drucker’s words must have sunk in. Costa Mesa-based Auto Club is in the best financial shape of its 106-year history,despite a move this summer to cut auto insurance rates, potentially lowering yearly net income by $133 million. The cuts, Auto Club’s deepest, amount to 7% off the annual bills of its nearly 1 million policy-holders. They go into effect Dec. 1.
Auto Club said it was the first insurer to cut rates under a plan put forth by California Insurance Commissioner John Garamendi. Under pressure from Garamendi, several big insurers have cut rates here after shifting focus to safety and driving records rather than where a driver lives.
The rate cut, which McKernan said he sees as a chance to gain market share, comes as the Auto Club has seen record surpluses in recent years. It has accumulated a reserve of nearly $3 billion for its insurance business, its largest ever.
The Business Journal’s Pat Maio talked with McKernan about the Auto Club’s insurance business.
What’s behind the Auto Club’s decision to cut automobile insurance premiums?
In the 1980s we went through a difficult time. There was lots of competition, not for our road services so much but for our insurance. Our prices for auto insurance were high at that time compared to competitors. We had a very high quality product, but things had changed in Southern California. There was a lot more fraud during that era. We were doing things to get efficient. But we found ourselves losing market share in the 1980s.
How much share did you lose?
We lost 40% market share in insurance between 1982 and 1990. We went from 1.3 million cars insured to a little less than 900,000 cars insured in that decade. Today we stand at 2.2 million cars insured.
You’re credited with tripling membership and expanding into other states,14 at last count with more than 9.5 million members. What is your objective in cutting auto insurance rates?
My role has been to get the team together to say we’ve got to change. We started in 1991. The graph was going down on members who had auto insurance. If we extended it out, we would have been out of the insurance business by the end of the 1990s at the rate we were going. Members loved us, but our prices were just high.
We had to change the culture. You want to bend the graph, not break it. The Auto Club began a series of rate cuts beginning in 1993.
When we started making changes (in the early 1990s), we started bringing prices down to get more competitive in the marketplace. At some point, not only did we get parity, we went below most others.
In 1988, we had a 12% rate increase. In 1989, we had another 6.8% increase. Nothing occurred again until 1993, when we started the turnaround process. Then we lowered rates 5% in 1993, again in 1994, and then we started to bring them down throughout the 1990s. We had to get more competitive on price.
That was part of what was needed to do a turnaround. We were doing lots of things in the organization to achieve that.
What is a prudent level of rate cuts?
Once we get to a surplus level we think is prudent for all the risk we are taking, then there’s a question in an organization like ours over how much we need for net income, because we don’t have shareholders. Once the board and everyone feels this is prudent given the risk,such as the current surplus of $2.7 billion ,we have to ask whether our members should get the benefit as a result of the low cost structure.
So we decided to take the net income number down. It was $252 million last year, and $246 million the year before. If everything in the business stays exactly the same, then the $133 million (from the 7% rate cut in premiums) will come out of the profit.
The $2.7 billion surplus reported in 2005 was the highest ever. It’s actually pushing $3 billion right now. We are having another very good year financially.
How do you balance cuts with the need for capital spending?
We need to earn investment income, and the more we earn on investment income,taking prudent risk, not high risk,the more competitive we are from a price standpoint as well. This plays into our overall price competitiveness.
We are putting somewhere close to $100 million in revamped phone services, to give better service, and computer systems to give better service and better Internet service. This began about two years ago. We are about midway into the spending program.
Can you give a forecast on the market share you hope to build as a result of the rate cut set to become effective Dec. 1?
If you look at the market on a statewide basis, we hold about 9% in California. But our focus is primarily Southern California, so if you extrapolate on a SoCal basis, we think we have 14% to 15% of the market. And we think that the more price competitive we are, the larger the market share we can get. It’d be great to get it to 20% in SoCal.
We don’t have a specific market share goal, but we do have a goal of insuring a minimum of 30% of the membership base. It’s about 27% now. But we are growing membership at a rate of about 200,000 members a year. So in terms of households, it’s about 120,000 for California only.
Were you the first in California to embrace the new Garamendi regulations?
Yes.
Why did you take the industry lead on this, given that there were others who pursued litigation?
Well, we could have done just a rate decrease. But there would have been some dislocation in the market had we not.
So if you put a rate reduction and at the same time adopt regulations, it would work out better. About 88% of our insured will get a rate reduction with the remaining 12% getting an increase of less than 5%. But our thought process was that these regulations are going to be the law. The commissioner has the authority, if he does it properly, to put the regulations in place to interpret Proposition 103. That’s pretty clear to us.
What are you seeing anecdotally following your announcement to lower rates and embrace the regulations?
The market is pretty static in general. It’s growing maybe 1.5% a year. That’s household formation for auto and homeowners insurance. This is why you are seeing more advertising on television. When companies are performing well, you see reductions in prices to gain market share. You know where a lot of the money is going? On television. That’s why you are seeing so much more advertising. We are spending somewhere between $10 million and $12 million this year through the first quarter of 2007. But it’s about a third to 50% less than what others are spending.
Is this the biggest ad budget you’ve had to spend on TV?
Yes. But other companies are spending a lot more to get market share that way. You can’t speak to every single company, but Mercury and us are growing in the 5% to 6% range here in California.
Most of the other carriers are growing much less than that. And there are others who are declining. This is year-over-year growth. Last year, Mercury was growing even faster. It’s slowed down this year.
Did your phone banks light up when the price decreases were announced?
The price decrease doesn’t happen until December, but we saw a big flurry of calls. All of those announcements made this summer led to people calling us and asking for quotes.
Phone calls into our call center in Costa Mesa have run at about 4,500 a day on average. Beginning in early July, it jumped to 6,300 to 6,500 and ran at that level for a month, or five weeks. It’s come back down, but we are still running at a higher level than we did at a comparable period a year ago. Of course, we started more advertising, and that has impact on it.
