The consolidation of insurance agencies has played a prominent role within the industry over the last 30 years. Now more than ever, however, such activity increasingly influences the average size of distributors, the scope of services they can provide and the diminishing number of alternatives available to consumers. Underwriters, agencies, brokers, risk managers and insureds are all acutely aware of agency consolidation and how it affects margins, volume commitments, service and relationships. Awareness by itself, though, stops short of understanding. By understanding the current marketplace, buyer demand and agency supply, an organization will be better apt to deal with continued consolidation.
The soft property/casualty market is well established. Insurance premium growth of 4.7 percent during 2004 hardly registers compared to the hard market peak of 14.8 percent during 2002. The projected 2005 premium growth of 1.2 percent provides no relief. The soft market began when interest rates were flat, companies were posting underwriting losses and surplus had suffered a multiple year decline.
Improved metrics are adding fuel to the fire. P/C insurance company surplus improved during 2004 and P/C underwriters enjoyed the first underwriting profit since 1978. While the recent hurricanes will indeed impact company surplus, the surplus drop will at best level sliding premium rates. To top it all off, on Sept. 22nd the Federal Reserve raised the benchmark federal funds rate for the eleventh time since June 2004. What does this mean? You guessed it cash flow underwriting. While you have seen cash flow underwriting before, carrier appetites in this cycle are markedly different.
As insurance company CEOs claim that rational pricing discipline will prevail and that balance sheets cannot absorb further softening, actions speak louder than words. While interest income on surplus can offset a portion of the rate reductions, insurance companies will attempt to drive operating efficiency by continuing to increase volume requirements.
Fewer appointments with more volume per agency will improve operating margins, absorb additional rate reductions and create increased capacity for larger players that have the production staff to drive insurance company market share. Those agencies that have failed to reinvest in their production staff and now are incapable of organic growth are going to have a difficult time in this cycle. Increased capacity is going to be reserved for those that have good loss ratios, have sufficient and growing volume with key carriers and those with an organic production force that can drive premium growth.
Based on the above, one would expect many agencies to sell en masse. On the contrary, the number of insurance brokerage sellers is down through the first eight months of 2005-170 brokerages sold in first eight months of 2004 compared to 125 for the same period in 2005.
Buyers coping with Sarbanes-Oxley and Eliot Spitzer lead the industry rationale as to why the slow down has occurred. This is not entirely true. Buyers are desperately attempting to pursue acquisitions to maintain growth. But the pool of quality sellers is also thinning and they know it.
The demand for insurance agencies is as strong as it has ever been. Public broker CEOs, bank executives and independent agency owners are all in the game. Pricing by the various buyers remains strong for peak performing agencies with brokers paying an average of 7.23X EBITDA (Earnings Before Interest Taxes Depreciation and Amortization) and banks paying around 8.0X EBITDA for foundation agencies and 6.8X for subsequent transactions. For various reasons, each segment continues to seek acquisition candidates during the remainder of 2005 and beyond, which has kept acquisition pricing steady.
The public brokers will continue to buy because they have to. Price to earnings ratios are falling. Organic growth rates are slowing with premium increases. The average organic growth rate (commissions and fees) of the public brokers during the first half of 2005 was approximately 1.4 percent (excluding Marsh); hardly enough to satisfy Wall Street revenue and earnings growth targets. Their appetite for product and service diversification through such mediums as wholesalers, benefits shops and seasoned risk managers continues. Public brokers have achieved efficiencies in the transaction analysis, closing and integration processes. They know how to make acquisitions work and are committed to acquired growth.
Banks continue to target insurance agencies because they want to. In general, over 70 percent of bank insurance executives report that acquired agencies have attained the base level of profitability that was expected at closing. They are experiencing strong performance metrics relative to other brokerage segments and realizing stated strategic goals of expanding non-interest income, providing customers more products and solidifying their position as a trusted service provider. Banks have the experience, capital, resources, core customer base and CEO commitment necessary to drive continued acquisitions.
The number of bank acquisitions slowed during 2004 and early 2005 relative to prior years, but for good reason. They were focused on integrating and leveraging acquired agencies as they continue to progress within their insurance lifecycle (acquire, integrate, leverage). Banks are steadily refilling acquisition pipelines and acquisition activity is once again at the forefront of their insurance expansion plans. Eighty-eight percent of the Bank Agency NetworK executives report that they plan on acquiring another agency within the next 24 months with aggregate acquired brokerage revenue in excess of $300 million. To put things in perspective, consider the fact that a $300 million revenue broker would rank as the nation’s 12th largest.
More and more independent insurance agencies are looking to acquire due to synergistic roll-in opportunities. Independents drive a large portion of M&A activity because they can merge a seller’s books of business and personnel relatively seamlessly. While independent agency buyers were historically more reactive to such opportunities, they are becoming more proactive in their searches. Such buyers are seeking to keep pace with competitor growth by capitalizing upon new markets, increased leverage with current underwriters, a more diverse suite of customer services, and return to the agencies historical roots of a sales driven culture.
The supply side has fueled M&A activity over the last several years as independent agents needed to sell. Many agencies typically sold due to the lack of defined business plans, unorganized sales cultures, lack of recruiting to replace talent, little investment in the balance sheet and an undisciplined approach to transferring leadership, books of business and stock. To be sure, the aforementioned issues continue today and will cause continued consolidation from the independent agency sell side.
High performing agencies that sold, on the other hand, did so to align themselves with well capitalized partners, gain access to value added resources, achieve liquidity, to be on the front edge of the consolidation of the financial services industry or to gain access to bank customers as an outlet for new business production. While there will always be poor performers throwing their hat in the ring, quality agency sellers are becoming increasingly rare for a few reasons.
Many agencies inclined to sell already have.
There is a diminished opportunity for agency owners to become foundation agencies and lead insurance expansion within many buyers’ geographic footprint.
Agency owners are focused on increasing their value over the next five years to maximize sales price. Since many high quality agencies have already sold, they feel the demand and subsequent pricing will only increase for the remaining A-players.
Sellers are now searching for the right fit (culture, products, opportunity) in addition to price.
Independents are proactively courting competing seller’s staff and clients.
And, while guaranteed transaction percentages have remained constant, potential sellers are uncertain of earn-out pricing performance given the soft market.
Despite increased regulation and litigation, buy-side appetites are increasing. The large public brokers and banks know how to react quickly to such issues and they have. What the regulation and litigation has done, however, is discourage the entry of new, big, public brokers. Sarbanes-Oxley is a significant added cost if a corporation wants to go public. Additionally, it has proven quite difficult to accumulate the necessary critical mass using venture capital funds. Therefore, we do not expect to see the entry of new, large, public brokers. We do expect to see continued insurance growth by existing brokers and committed banks.
At the same time, the number of small agencies will continue to decline. In addition, the average age of current agency owners continues to increase. That alone will drive their numbers downward.
Together, the drive for revenue growth by the public brokers and banks, enabled by efficiencies in commoditizing small commercial and personal accounts, will ultimately offset the sell-side delay and provide for continued, if not accelerated, acquisitions in the near future. The result will be a bulge in the number of middle market distributors. This will create a “mega-middle” whereby we will eventually see an influx of agencies in the $4 million to $10 million, and $10 million to $50 million ranges.
Patrick Linnert is vice president for the insurance consulting firm of Marsh, Berry & Co. (Concord, Ohio). He can be reached at Patrick@marshberry.com, or at (440) 392-6568.