(MONEY Magazine) – When Edward Liddy became CEO of Allstate in January 1999, he embarked on a campaign to reinvigorate the nation's second-largest property and casualty insurer (behind State Farm). He cut costs, began selling insurance directly to consumers over the phone and the Internet, upgraded back-office technology so Allstate's agents could more effectively process policies and claims, and expanded the company's banking and investment services.

Unfortunately, those initiatives have yet to show up on Allstate's bottom line. In February, the Northbrook, Ill.-based insurer reported its third consecutive annual profit decline. Much of last year's poor performance was caused by an increase in payouts due to bad weather, a surge in toxic-mold claims in Texas and poor performance from its investment services arm. Allstate also suffered from its reluctance to raise rates, a move designed to keep it competitive with chief rival State Farm.

It's no surprise that investors aren't happy with Liddy, the financial whiz who helped shepherd the spin-offs of Allstate, investment firm Dean Witter and real estate broker Coldwell Banker, when he was chief financial officer at Sears in the 1990s. Shares of Allstate have gained just 3% since Liddy took over vs. 19% for the average property and casualty insurer in the same period.

But Liddy is busy attempting to bring profit growth back to the Good Hands People, and signs do point to a rebound. While further terrorist attacks could wreak havoc on the insurance industry, the post-Sept. 11 world has created new opportunities. Not only are people stocking up on more types of insurance, but state regulators are more receptive to insurers' requests for rate hikes. State Farm, which lost $5 billion last year, just raised its rates, and that has allowed Allstate to follow suit. Liddy recently sat down with MONEY writer Nick Pachetti to discuss Allstate's strategy.

Q. How has Sept. 11 affected the insurance industry?

A. It's been profoundly affected. No company has priced into its product the cost of terrorism. It's never happened in this country, so it's not what we'd call an insured risk. The risk is, if more of these events happen, there wouldn't be enough capital or surplus in the industry to pay those claims.

Q. Should the government step in as insurer of last resort?

A. Definitely. That's what the federal government does with flood insurance. Likewise, the federal government should protect citizens from acts of terrorism. What can an insurance company do to prevent terrorism? If an insurer is advising a company on workers' comp, it can give good ideas to reduce exposure to workers' comp, but it doesn't have any experience with terrorism.

Q. How has Sept. 11 impacted Allstate, specifically?

A. We got out of the commercial business years ago, so we didn't have much exposure to the terrorist attacks. Q. From a strictly financial point of view, what risks does Allstate face from the possibility of more terror attacks?

A. The risk for us going forward is nuclear, biological and chemical attacks like an anthrax one over a major metropolitan area. That would be a severe issue for personal-line carriers with regard to homeowners insurance. If you had to restore a home to pristine condition so it was anthrax free, we worry, because we have nothing in the price of our product to cover that kind of disaster.

Q. Is that why you've been selling more financial services, to hedge against this?

A. Broadening our strategy certainly gives us more growth potential and a less volatile income stream, which should translate into a higher multiple for our stock. But we expanded financial services because we wanted to leverage our great brand name and our 12,000 agents who are connected to 14 million families in the U.S.

Q. Can you compete with big companies like Citigroup?

A. Certainly in life insurance. Our life insurance, Allstate Financial, had after-tax operating income of $527 million. That's a good-size company. But we're not going to compete with companies like Merrill Lynch that target high-net-worth customers. We're going after Middle America--people with salaries of $50,000 to $100,000--those to whom we already provide homeowners and auto insurance.

Q. The insurance business in the U.S. is pretty much a zero-sum game. But you want to grow your property and casualty business by twice the rate of the industry. How do you plan to do that?

A. By taking market share. There are 1,400 companies we compete with in property and casualty. The top five have 45% market share. The smaller companies don't have the brand name Allstate does. They also don't have the sophisticated underwriting technology, so they aren't getting a price that's appropriate for the risk they're undertaking. If the industry is growing by 3% to 4% a year as a result of population, auto and home growth, we can at least do that and take a little market share.

Q. Okay. But why now?

A. Homeowners insurance, for example, is an underpriced product--the industry let pricing get away. Now we're at a point in the cycle where rate increases are the norm, and I think they'll continue through 2002, maybe early 2004. We recognized this early.

Q. Actually, analysts say you were slow to request rate hikes.

A. I would quibble with that characterization. We usually have a combined ratio below 100 in the homeowners business [combined ratio measures the amount a company pays out in claims and expenses for every dollar of premiums it takes in]. Others are at 116, which means they're losing 16[cents] on the dollar. For years, we had cost pressures but they were offset by really good weather. In late 2000 and 2001, the pressure continued on repair costs, but then mold came along and we had a spate of bad weather. So we got hurt. When you're generating a good return, state regulators aren't interested in talking to you about rate increases. When all of a sudden you're generating less of a return, then you can talk to them about rate increases.