The Battle to Preserve Agency/Broker Value

As economic stagnation and current rate pressure weakens performance and as supply starts to outstrip demand for acquisitions, agencies and brokers must be prepared for deteriorating valuations. As the next few years will be characterized by an increasingly difficult and competitive landscape, many independent agency principals will finally be forced to decide whether to run the agency as a business or continue running the agency as a funding mechanism to support a personal lifestyle.

The current economy is in a state of flux. While all financial indicators point toward a hardening of rates, insurance agents and brokers should not let excitement take root. Any rate stabilization or hardening will not increase the agencies top line revenue and earnings, but merely ease the pain. Rate increases are sure to be offset by a reduction in insurable assets, payroll and risk.

Public brokers have either gone private, sold or have taken a hit to earnings and/or market capitalization. Many banks have sold their insurance operation and most that remain are reevaluating their investment in insurance. Carriers are executing plans to cull out the poor performers from their agency plant. Independent agency ownership remains too narrowly held and the age of the average owner is increasing. Throw in a potential doubling of the capital gains rate, a threat of national health care and you have a marked increase in the number of sellers. Buyer demand remains strong, but there are fewer in number and they are becoming increasingly more selective.

Those who have embraced strategic planning, financial management discipline and organic growth initiatives will remain highly-valued entities. Those stuck in molasses or more focused on their golf handicap will realize a substantial decline in valuation multiples during the next three years. Agencies interested in remaining independent must prepare for the battle ahead in order to preserve agency value.

Insurance Companies

During 2008, total property/casualty net written premiums are expected to decline for the first time since 1943, falling 0.3 percent. For the past few years, Wall Street has pushed insurance companies to increase return-on-equity (ROE) to align with other Fortune 500 companies. While the company returns strengthened in 2006 and 2007 due to the minimal catastrophic losses, projections indicate that the ROE gap between Fortune 500 companies and the average P/C insurance companies will widen once again in 2008.

Despite the declining ROE forecast for companies as a whole, individual company executives are aggressively trying to execute strategies to maximize, or at least preserve, ROE. The major areas of focus for P/C company executives revolve around:

1. Focusing on operating metrics to enhance underwriting discipline by customer and industry (which means knowing when to say “no” to unprofitable customers).
2. Easing business transactions via technological and process improvement.
3. Establishing a differentiation platform relative to products/services.
4. Culling out agencies with inferior field underwriting, declining premium growth, no organic growth plan, no perpetuation plan or chronic poor loss experience.
5. Allocation of capacity, aggressive underwriting and growth support to best of breed growth-oriented agencies, supported through regimented joint company-agency planning and service initiatives.

In search of their own survival, many insurance carriers are striving for market share growth, better loss experience and improved operational efficiencies. While difficult to accomplish, hitting the trifecta revolves around aggressive rate pricing and aggressively managing the distribution system by aggressively working with fewer high performing agencies that can deliver. A byproduct of the plan is that soft pricing will not subside in 2008. P/C rates remain adequate for most carriers on their core business despite the fact that the softening and substantive premium rate relief may not occur at least until 2010.

Agencies and Brokers – The Buyers

The pace of consolidation did not ease in 2007. On the contrary, publicly announced transactions increased from 2006 to 2007, seeing the second most number of transactions since Gramm-Leach-Bliley opened the floodgates for banks in 1999.

The emerging trends behind the consolidation of 2007 created a dynamic shift in the supply/demand dynamics for 2008 and beyond. First, public brokers were the big winners of the acquisition market last year. Public brokers consummated 35 percent of all publicly announced transactions in 2007 versus only 24 percent during 2006. Their 82 deals were a drastic increase over the 63 deals they did in 2006. They also increased their total acquired revenues by over 30 percent.

Former public brokers USI, HUB and HRH have all sold within the last 20 months. Some of the remaining public brokers like Marsh, Aon and Willis have not historically been acquisitive (other than the Willis-HRH deal) and we do not expect that to change dramatically over the next 12-months. Public broker demand has narrowed primarily to Brown & Brown and Arthur J. Gallagher.

Last year’s public broker activity has no doubt come at the expense of banks which saw their percentage of total insurance transactions fall to 22 percent, their lowest level since 1999. The illustration on N34, “Number of Publicly Announced Transactions: Banks vs. Public Brokers,” compares the number of deals consummated by the two leading buyer segments.

Many banks have struggled with their insurance strategy over the past year for a number of reasons. Some banks have divested, like Bank of America, Commerce, BNC Corp, Capital One, and Union Bank of California. Others will follow. The reasons prompting past and future divestitures are vast. Many banks that absorbed a sharp hit to earnings and surplus due to the mortgage meltdown have been encouraged or even required by investors to redirect focus to core bank offerings, versus complementary endeavors such as insurance. Other banks simply need capital at a time when agency valuations remain above the historical trend. Others have simply changed strategic focus or paid handsomely for foundation agencies that did not deliver. Now the federal government is deciding which banks will eat and which will be eaten. Such continued bank consolidation will inevitably spur more bank divestitures of insurance brokerage divisions.

We expect companies such as Wells, BB&T and BancorpSouth to stay true to their aggressive acquired and organic growth strategies. However, many others are making the decision to exit the insurance brokerage business. There are fewer bank buyers and fewer bank deals in the pipeline and the opportunity to capture foundation agency pricing with a bank is a shadow of what it was during the past decade.

During 2007, private equity firms injected over $4.5 billion into insurance brokerages. With capital market challenges, limited access to debt, higher cost of available debt and the sliding financial performance of many agencies and brokers, the massive private equity craze has come and gone. There is a stable of gold plated private equity firms that have access to debt that will continue to execute their strategy, but in sheer numbers of buyers, the groundswell of new entrants has dropped to a trickle. As we move through 2008, the total private equity dollars invested in insurance brokerage from new entrants will decrease substantially relative to 2007 and private equity acquisition will largely be limited to the proven buyers that have deployed capital and are in the game.

Ascension, Evercorp, HUB, and USI all made sizable investments in agencies in the first half of 2008. These buyers and a handful of others that have secured debt financing and deal approval will acquire and expand during 2008 and the industry will witness an increased number of transactions from this buyer group. However, continued access to readily available capital could pose a challenge.

Simply stated, the market will witness a decline in buyer demand in the future that will negatively impact the average agency in the form of price and structure.

Agencies and Brokers – The Sellers

Over the past few years, the number of quality sellers was marginal relative to the buy-side demand. As a result, the last several years were characterized by record premium pricing as the public brokers, banks, private equity firms and independent agents all aggressively competed for the limited supply of quality deals. During the next three years, several trends will surface, creating additional pressure for many agency owners to consider selling, thereby increasing the supply of sellers.

Agency Ownership and Age — Many agencies cannot cash-flow internal perpetuation because too many agency owners retain too large an ownership position for too long a period of time. A regimented transition of ownership enables the stock of retiring shareholders to be acquired without placing too large of a financial burden on any one individual or the agency. If this burden is too large or if the owners wait until they are too old, agency owners generally make the decision to sell.

Soft Market — The difficult rate environment, carrier tiering to cull out weak agencies and the inability of the average agency to sustain organic growth are all factors prompting many agencies to sell. In this market, more agency owners are concluding that they do not have the personnel or capital resources to fund continued growth. Some that do are not willing to execute a plan to deploy those resources to drive growth.

Political Changes — A Democratic president, along with a filibuster proof Congress, could be in the White House in 2009 and the threat of an increase in the capital gains rate is very real. Regardless of the outcome, fear prompts action and many agency owners are not willing to risk the tax consequence of prolonging a sale.

National Health Care — While the proposals and plans for executing national health care are convoluted, retail agencies with large health books-of-business fear having commission income legislated off of their income statements. Even if nothing changes, continued dialogue regarding a change in the system will create uncertainty and in turn hinder value.

Decline in Agency Value — Pricing will not decline for all agencies, but the average agency will take a hit over the next three years as the sharp increase in seller supply outpaces diminishing buyer demand. High-quality agencies will continue to command a premium and they will be considered a diamond in the rough in turbulent times.

Summary

For those owners who are proactively looking at agency ownership as an investment and have embarked on a long-term asset management initiative to execute principles that drive value, the current valuation and pricing multiples will remain intact. These quality agencies will remain in high demand by buyers and will win the battle to preserve agency value.

Agencies whose performance and value is dictated primarily by external market conditions such as pricing, buy-side demand, and the overall economy will be in jeopardy of declining valuation multiples. Our challenge to agent and broker principals is to control your own future. You can not directly control the economy, investment returns, premium rates, or supplemental income. You can control the long term financial discipline and value of your organization. Are you willing and able?

Topics Carriers Profit Loss Agencies Property Casualty