by Robbie Smith, November 2001

National Underwriter

The tragic events of September 11 accelerated changes in the insurance business that had begun months earlier.  Increases in property and casualty pricing, coupled with the softening in the general economy, were already impacting insurance carriers, agents and brokers.  The significant loss of surplus from the 9/11 events coupled with an already compelling need for "rate relief" for carriers has lead to a frenzy in the marketplace that has created problems and opportunities for the brokers.  The problems and opportunities, taken as a whole, seem to be providing a unique window for agents and brokers that may impact the market value of an independent agency and the merger and acquisition activity that has been taking place.

The problems created by the marketplace for agencies are rooted in the significant work needed to find replacement coverages with adequate limits and appropriate coverages while trying to control consumer costs.  The remarketing activities, the coverage analysis and comparisons and the search for alternative solutions has resulted in a significant increase in the workload at the typical firm.

The opportunities are created by the enhancement of income from selling commissionable products at higher prices.  The enhanced commission income may provide the cash flow needed to "fix" problems that have gone un-addressed by many agencies, including hiring new producers, new automation or upgrading office space.  These changes could also positively impact the profitability of an agency which increases the attractiveness of the agency to a third party buyer. 

Will these problems and opportunities result in an increase in the level of merger and acquisition activity, or serve as "red flags" to buyers to delay or abandon an acquisition strategy?  Let's first look at the historical motivation of the buyers and sellers and draw some conclusions about the future.

The buyers of agencies have generally fallen into three broad categories:  banks which are attempting to diversify its sources of income and product offerings; national brokers which are using acquisitions as a way to enter new geographic areas, achieve economic enhancement through combining offices, or gain expertise that can be "franchised" throughout the broker's organization; and regional agencies/brokers which are using acquisitions to enter new areas or as a basis to grow to a sufficient size to ensure long-term viability with clients and carriers.

The stock price and market capitalization of many banks have suffered significantly over the course of the last 12 months with the softening economy and the reduction in interest rates.  The soft economy has reinforced the need for banks to diversify its revenue sources.  But the economy has also depressed the primary currency that banks have used to purchase agencies -- its stock.  Banks that were trading at 18-19 times their earnings one year ago are now trading at 13-14 times earnings.  The consequence of this change is that to achieve the same valuation, significantly more shares of bank stock must be offered in exchange for the agency shares to achieve the same valuation.  Bank CFOs are reluctant to offer deflated currency when they believe the price will recover in a short period.  Bank senior management is also being pulled away from ancillary business activities, such as insurance, to refocus on its core business - banking.

The net impact of these changes for the bank buyers will vary from bank to bank.  Most will continue as active acquirers of agencies, even if there is a short "lull" in the pace of activity.  If there is a lull in activity, it will be because banks elect to focus on their core business while letting the rapid changes taking place in the insurance business settle down.

During the time the stock price of banks has generally gone down, the stock price and market capitalization of the Public Brokers, especially the brokers which are active acquirers of agencies, have gone up significantly.  Brown & Brown, HRH and Gallagher have all enjoyed huge increases in their market cap since January 1st.  During the same period the S&P 500 has decreased almost 20%.    While some of these increases in the Public Broker valuations are attributable to the management skills of the officers of these companies, it is clear that investors believe that the insurance price increases and the revenue increases to the brokers will more than offset the reduction in payroll, receipts and values that are a reflection of a soft economy.

Many of the Public Brokers have used their enhanced currency (their stock) and the reaction of investors to acquire quality agencies.  But with the positive motivation to pursue acquisitions, Public Brokers appear to be more selective in the firms that they are acquiring recognizing that a failed acquisition of any size will impact their share price.

Many of the same factors impacting the Public Brokers are impacting the regional brokers.  There will be a clear "revenue lift" due to insurance pricing increases.  But the regional brokers (which do not have a stock currency for acquisitions that can be valued daily in a public market) will not enjoy the immediate enhancement of its stock as these firms are generally valued on an annual basis, and their stock is not as "liquid" as the stock of banks or Public Brokers.

But the regional brokers remain a good alternative for many sellers.  Some selling agencies do not have the type of operations that will result in a successful bank-owned agency; some are not be willing to give up the autonomy that the Public Brokers often require; or others may believe that they need to join a larger firm in order to gain access to carriers, but are not ready to "sell out".  The regional broker can be a good way for the seller to ensure access to insurance carriers while maintaining its private ownership.

So if these are the changes that are taking place with the buyers, what is going on with the sellers? All businesses go through a predictable "life cycle" that include addressing the succession of ownership.  In 2000 and 2001, many principals accelerated their plans for the sale of the business because the valuation of the business, expressed as a multiple of revenues and earnings, reached 15-year highs.  A recent study by the American Bankers Insurance Association in conjunction with Reagan Consulting reported that of the acquisitions by banks in the prior 12 months, 63% were completed at revenue multiples of 1.50 times revenue or more and 27% were completed at multiples of 2.00 times revenues or more.  Pricing at these levels have compelled agency owners to sell their business.

At the same time as valuations reached record levels, the formation of new independent agencies has reached record high levels.  A recent study completed by the Independent Insurance Agents of America suggests that as many as 15% of the agencies that exist today have been formed since 1995.  These statistics indicate a reversal of a trend that had showed a decrease in the number of agencies nationwide.
 
The recently completed Best Practices results (available on-line at www.reaganconsulting.com) completed annually by the Independent Insurance Agents of America shows the Best Practices Agencies enjoyed significant increases in revenues, profits and productivity in 2000, and interim numbers complied by Reagan indicate that this trend will continue through 2001.  The summary results are simple:  good agencies are working harder, are more productive, have better growth and better profitability than any time in recent history.  These factors will result in one quantifiable outcome -- greater value.

So what does the future hold in store for the buyers and sellers of agencies?  All buyers of agencies, whether publicly traded banks, Public Brokers or privately owned regional brokers, are "earnings sensitive" buyers.  This means that selling agencies have to deliver to the buyer a predictable revenues and earnings that will grow over time. Those organizations capable of achieving growth in revenues and earnings will achieve the greatest valuation.
 
Finally, whether a particular agency is considering selling in the next 12 months or never, this market creates great opportunities to re-invest in its business.  Agency principals should take great confidence in the value of growth oriented, profitable agencies.  Now is the time to be adding new producers to the sales force.  Now is the time to make significant upgrades to your automation.  Now is the time to increase the quality of your staff.  Now is the time to consolidate premium volume with companies critical to your long-term success.  If the independent agency system will take advantage of this unique opportunity, it can ensure its viability for years to come.

Robert C. Smith is a former principal of Reagan Consulting, Inc., an Atlanta based management consulting firm that serves the insurance distribution system.