The Market Cycle and Acquisitions

Every reader likely already knows interest rates are rock bottom. Some are even nominally negative and the prime rate has not changed in six years. That is a record! Exposure growth overall is normal, neither strong nor poor overall. Although in some lucky sectors, and for the lucky agents writing those sectors, exposure growth is quite strong. Other sectors are not so strong. Overall, exposure growth is just normal. The U.S. economy is strong, relative to the myriad of weak economies. However, GDP growth is just about normal. Insurance rates are marginally increasing, excluding property specific to wind/hail prone areas. All in all then, times are stable and boring.

Stable and boring are always more enjoyable with time and nostalgia. Presently, stable and boring often brings to the surface anxiety.

The anxieties agencies, brokers, and carriers are experiencing include:

1. The economy is not going to grow enough to make the individual, the agency or the company, look good. To look good, three options are available:

• Work hard, work smart, achieve.
• Appear to work hard, appear to work smart, and appear to achieve without really achieving, which is feasible with all the money floating around.
• Cheat. recently covered the story of a young man who did just that for some time under the noses of several insurance regulators.

2. Rates are not going to increase enough to make the individual, the agency or the company, look good. To look good, three options are available:

• Word hard, work smart, and achieve.
• Appear to work hard, appear to work smart, and appear to achieve, which is feasible with all the cheap money floating around. Definitely a good time for posers.
• Cheat.

3. The insurance market is changing faster than ever. Some $6 billion is being spent annually on property/casualty advertising alone. Social networking is a new force that is completely foreign to at least two generations in this industry. Apps are crucial and many key executives in all parts of the industry still cannot fathom insurance apps. New players to this staid, old industry are popping up, including hedge funds owning insurance brokers and insurance companies.

Acquisition Trends

The most common strategy in this environment is to acquire, acquire and then acquire some more. 2015 is set to be a huge year for insurance merger and acquisition (M&A) activity. The players are indeed following this age-old script. The market today is fantastic for sellers with some buyers paying unreal prices.

Even assuming these prices are somehow reasonable, not just a speculative play (a very large “just”), and the buyers will earn a legitimate ROI (the funny new measures they are trying to convince markets to accept do not count), what if the premise for their purchases collapses?

The industry has almost three times more surplus than in 1996. Also, rates and exposures are slow growth, so paying 35 percent to 50 percent more for acquisitions than five years ago cannot be justified by growth rates. All else being equal, if no large rate increases occur years will pass before the industry absorbs its entire surplus.

Furthermore, this is surplus today. Insureds and investors are using more forms of alternative insurance programs, both primary and reinsurance markets. This generates more total surplus and leaves some current surplus effectively unused.

Also, the fundamental premise of insurance is being turned upside down. The foundation of insurance is based upon the law of large numbers and the assumption the specific next loss cannot be predicted. That premise is no longer entirely true on a casualty basis and soon will be much less true on a property basis. Very accurate loss prediction, relative to insurance history, is just around the corner thanks to new technology. One result will be a lot more surplus, billions more of surplus, will be created as exposures actually decrease.

True Hard Markets

To the chagrin of many insurance experts the P/C market does not turn hard based on poor profits. True hard markets develop based on a lack of surplus. In other words, profits have to be negative long enough to take surplus to the edge. With surplus seemingly infinite, the market is likely to remain soft then for at least the length of a medium insurance career.

However, the surplus is not spread evenly. According to a recent report, 30 percent of carriers, by their own admission, lack extra surplus. If 30 percent have no fat, then the other 70 percent are very, very fat.

This brings me back to M&A. If a person is running a fat carrier, why engage in M&A (excluding a unique, choice piece of technology/market)? One can skimpily let the market drive customers because a company lacking surplus in this cash flooded world also likely lacks quality management, the ability to afford quality people, and the ability to invest in technology, social marketing, and compete with $6 billion advertising. The strong companies can exacerbate the low rate/low growth market because they have the wherewithal to underprice their balance sheet challenged competitors.

Most agency acquisitions are based on the assumption of X percent growth. But if the market does not grow, or even declines and becomes deflationary, what happens to the value of that acquisition? Sellers do not sell because they see a rosy future of 25 percent EBITDA and 10 percent annual growth and buyers rarely bring resources that make up for the seller’s inability to grow. The publicly traded brokers for example have purchased approximately 400 agencies in the past five years and their average annual organic growth rate, excluding sales to self, international sales, etc., is 1 percent per their 10k’s.

If the buyer is a hedge fund or publicly traded, the savior might be even lower financing costs. If the cost of capital declines more than rates decline, then buyers might do alright. The positive ROI, if achieved, will be gained by financial leverage though, not better, smarter management, leadership, or strategy. It is difficult for me to believe the hurdle rate can go any lower but if Central Banks continue loving deeply in debt entities more than responsible entities, borrowing to afford high prices will remain feasible.

My observation is that more than one such buyer has confused their seeming success. They think they are better operators rather than understanding they are making money on a leverage basis. Might a better strategy be to design a better product, work hard and sell more?

Buying something, especially with borrowed money, and then seeing rates deflate, makes that purchase much, much more expensive.

But simply generating growth one sale at a time is not affected similarly. Doing so requires much more effort because Central Banks dispense easy money rather than easy intelligence and work ethic.

Buying more and more is not a competitive advantage in an easy money environment. When 30 percent of companies have no excess and so many acquisitions are occurring, which takes away focus from true sales, the opportunities are unlimited. The competition is hamstrung!

Topics Mergers & Acquisitions