Simple supply and demand dynamics driving desperation ofwould-be buyers

There is a perfect storm brewing in the insurance industry thatwill drive deal fever over the coming decade. The need for revenueand earnings growth by banks and publicly-traded insurancebrokerage firms is fueling an unforeseen demand for acquisitionswhile there is an inadequate supply of sellers.

Public brokers have become the victims of Wall Streetexpectations, banks are far from filling out their geographicfootprint, and independent agencies have their hands full drivingorganic growth, let alone funding for internal perpetuation. Whilethe converging black clouds create fear for some, they createopportunities for others.

This article aims to outline the market, the drivers ofconsolidation and the implication on the distribution system soagents can better plan for the road ahead.

The soft market is in full swing. Insurance premium growth is afar cry from the hard market peak of 2002. Despite a deluge ofcatastrophic losses, which more than doubled over the prior year,property-casualty insurance company surplus improved during2004.

Insurer performance was buoyed by the first underwriting profitin 26 years, and a combined ratio of 98.1 percent clearlydemonstrates that rates are adequate.

Meanwhile, the Federal Reserve has raised the benchmark federalfunds rate for the ninth time in a year.

When stronger surplus, rate adequacy and an increase in interestrates converge, you get a marked increase in investment income and,hence, cash-flow underwriting.

If the stock market gains momentum, rates will free-fall.

However, given investor pressure on insurers to maintain theircurrent rates of return, companies will not burn profit as in priorcycles. The increase in interest income on improved surplus willoffset much of the coming rate reductions.

However, the balance of the softening will be supported by afocus on enhancing operational efficiency. To accomplish this,insurers will increase agency volume requirements and maintainfewer appointments.

Agencies that have failed to reinvest in their production staff,and are incapable of organic growth, are clogging the arteries ofthe carriers, which will weed out such firms at an increasedrate.

Expanded capacity will be reallocated and reserved for agencieswith good loss ratios, commitment to volume increases and anorganic-growth culture that supports profitable premium growth.

Given these metrics, one would expect many agencies to throw inthe towel and sell. In reality, the number of merger andacquisition transactions involving the sale of agencies andbrokerage firms during the first six months is down substantiallyfrom the same period last year.

Many speculate that new compliance standards and the insurancebrokerage contingency fee scandals have spurred the slowdown.Nothing is further from the truth.

The slowdown is not a response to demand but to supply. Buyersare desperately pursuing acquisitions to maintain growth, butsellers are becoming scarce and are in high demand.

Five years ago, supply and demand were balanced. Poor and peakperformers were motivated to sell to achieve liquidity nirvana asagency value was at a 15-year high. Today, while poor performersare waving the white flag, quality agency sellers are becomingincreasingly rare.

Most quality agencies that were inclined to sell have sold.Those that remain are less motivated to align with a bank becausethere is less opportunity to become a foundation agency and lead amajor market territory.

Aligning with a broker is not as attractive to some agenciesbecause of the contingency fee scandals and the concern a buyer'sshort-term focus on profits could spell agency staffing cuts.

Quality agencies capable of organic production that remain infavor with underwriters are content to remain independent. Theirindependence is driving long-term value, given that high demand andlimited supply will sustain valuations for the foreseeablefuture.

The continued soft market will drive banks, and brokers, tobecome more desperate for acquisitions, further dwindling thesupply of agencies.

As a result of this reality, sellers recognize they havealternatives. The current situation will keep valuations strong. Asa result, they can do deals on their terms and when there is aunique cultural fit.

This acquisition demand is reflected in the price agencies canreceive. Including earn-out consideration, pricing metrics remainstrong for peak performing agencies.

Brokers are paying about 7.25-times EBITDA (Earnings BeforeInterest, Taxes, Depreciation and Amortization) and banks arepaying around eight-times for foundation agencies (and 6.8-timesfor subsequent firms in market transactions). Despite the softmarket, the price for quality agencies is up slightly over 2003figures as public brokers and banks fight over the drainingpool.

Driving the need to acquire, for brokers, is the difficulty togenerate enough organic growth, which has continued to drop overthe past four years. To justify market growth expectations, theyhave been forced to disclose their current deal pipeline and theexpected annual acquisition growth to the investment community.This only serves to feed the need for more deals.

These experienced buyers have entered this difficult market witha well-oiled acquisition machine.

To achieve and exceed earnings growth targets, brokers have beenacquiring high-margin, lower-EBITDA multiple targets such aswholesalers. To diversify revenue, brokers have been scrounging toacquire benefits agencies.

They have also leveraged margin growth by fine-tuning theintegration of acquired agencies to wring out operationalefficiency at a faster rate. The need for speed to post revenue andearnings growth has shortened the deal closing process to less than45 days in some cases.

Banks continue to target insurance agencies to drivenon-interest income, complete the build-out of the insuranceoperation footprint, and to create an integrated financial servicesconsultative solution platform aimed at the commercialmarketplace.

While some may mock the bank's strategy, bank-owned agencies areposting impressive organic growth rates. The rationalization thatbanks will get in, then out of the business has dissipated. Thetop-30 bank-owned agencies have acquired their way to amass morethan $3 billion in p-c and group health revenue in five shortyears.

The storm is raging and change is the only constant. Onecertainty that will prevail through this sea change is that thosewho can produce will not perish.

Agencies that prepared for this opportunity created apredictable organic-growth culture supported by accountability,discipline and a process to proactively over-serve the customer.Such agencies will not only survive during this cycle but willthrive and be highly sought after by a seemingly endless number ofbuyers.

Agencies of this caliber will be in the coveted position of bothremaining in control of their destiny and maximizing agencyvalue.

Those who have not prepared are running for shelter.

John M. Wepler is a shareholer and executive vice president withthe agency management consulting and investment banking firmMarshBerry, based in Concord, Ohio. MarshBerry owns and operatesAPPEX (Agency Peak Performance EXchange and BANK (Bank Agencynetwork).

Quotebox, with mug:

“Agencies that have failed to reinvest in their productionstaff, and are incapable of organic growth, are clogging thearteries of carriers, which will weed out such firms at anincreased rate.”

John M. Wepler

Callout:

The storm is raging and change is the only constant. Onecertainty that will prevail through this sea change is that thosewho can produce will not perish.

Flag: Breakdown

Head: 2004 Growth Rates By Segment

Caption:

Bank-owned agencies are posting impressive organic growth rates.The top-30 bank-owned agencies have amassed over $3 billion in p-cand group health revenue in five years.