Can you remember a year that started with more uncertainty for property-casualty insurance agents and brokers than 2008?

Certainly 2005 qualifies, since the crusade by Eliot Spitzer--then New York's attorney general, and now its governor--to expose bid-rigging and contingency fee abuse by major brokerages and their carriers was in full force, and the resulting fallout was still being assessed.

But for my money, 2008 wins the uncertainty prize.

The Council of Insurance Agents and Brokers recently reported in their quarterly survey that the third quarter of 2007 was the worst quarter yet in our now four-year-old softening property-casualty market.

Even worse, the Insurance Information Institute recently forecast that 2008 will be the toughest pricing environment for the industry (personal and commercial lines) in 65 years!

And if that's not enough, the presidential election this fall is the most wide-open race in more than a generation, with neither party fielding a clear favorite.

Of course, such uncertainty is even more troubling for those agencies and brokerages considering an even bigger but more personal change in the year ahead--a merger or acquisition. How might the concerns cited here and other potential problems impact the M&A environment?

Questions about M&As always begin with pricing. From our vantage point, agency acquisition pricing is holding steady at recent historically high levels.

Despite the fact that 2007 was the worst for public brokerage stocks in over 15 years, public brokers are still hungry for acquisitions and are willing to pay a premium for key targets.

Banks also remain active, despite the fact that their stocks were clobbered in 2007 by fallout from the subprime fiasco.

Multiples of EBITDA (Earnings Before Interest, Taxes, Depreciation and Amortization) being delivered by buyers still range from 6.5-to-9.0 for most deals, with 75-to-80 percent of that guaranteed, and the balance deliverable in the form of an "earn-out"--typically payable after one-to-three years if the seller hits certain performance targets.

Notably, given the soft pricing of the p-c market--and the resulting growth challenges faced by agents and brokers--certain buyers have recently been structuring their deals with slightly lower earn-out performance targets than in the past.

Perhaps it seems counterintuitive, but buyers want sellers to earn significant earn-out dollars. Why?

An attainable earn-out is a tool used by buyers to keep a seller's head in the game after the deal. If earn-out targets are set too high, they can potentially lose their motivational impact on seller behavior.

So, in today's soft market, single-digit annual growth during an earn-out will earn a seller more money than it would have in past years.

Here are the key issues we see driving M&A premiums in 2008.

o A sales culture is the most valuable attribute an agency can possess.

Everybody in the industry is struggling to grow organically. In 2007, the public brokers' nonacquisition growth rates averaged only about 2.8 percent, marking the fourth-consecutive year in which organic growth averaged 5 percent or less.

I suppose 2.8 percent sounds horrible--until you consider that commercial p-c premiums contracted industrywide by more than 10 percent in 2007!

Since agencies with a true sales culture find a way to grow even in the worst of markets, they consistently command the highest valuation multiples in the marketplace. Investors demand growth, and will do what it takes to acquire firms that can grow regardless of market conditions.

o Profit margins are key--the higher, the better!

Buyers are hungrier for high-margin business than at any time in history. Does this sound like an overstatement?

The fact is, with each passing quarter, today's brokers must defend their performance to an audience of Wall Street analysts--or more recently, as in the case of USI and Hub, their private-equity investors.

In our information-rich society, investors are armed with more comparative data than ever before. The result is that broker management teams find themselves explaining, over and over, why they can't produce margins anywhere near the 38.7 percent EBITDA margin generated by industry leader Brown & Brown.

Well, adding a low-margin acquisition certainly doesn't help their cause!

What does this mean in practical terms?

Some buyers aren't even interested in a stand-alone acquisition that cannot generate a 25 percent EBITDA margin following the deal's closing. They'd prefer 30 percent or higher if possible--and can sometimes get significantly higher than that if they can consolidate the seller's operations.

Moreover, in the past, buyers typically refused to pay high-end EBITDA multiples for high-margin agencies, believing that high margins couldn't be sustained. Today, this is no longer the case.

Buyers seem to perceive less risk in high-margin agencies than in low-margin ones, perhaps because they believe the steps necessary to reform a low-margin agency will create an employee morale crisis after an M&A closing.

o Specialty business is king.

Our industry has for many years been in the midst of a long-term trend toward client-type specialization. Savvy agents have capitalized on this trend by focusing on a particular industry and then delivering customized knowledge, service and products to customers within that niche.

Agents have been richly rewarded for their specialization. They've achieved higher hit ratios on new business, had better account retention on renewals, and often generated higher profits in their specialty business than in their general business.

But since this has been going on for years, you might ask, what's newsworthy about it?

What is newsworthy is how much more buyers are willing to pay for specialty business than general business. By our calculations, a block of specialty business is frequently valued at 25-to-50 percent more than a comparably sized block of general business, since it is more profitable and can be projected to grow more quickly.

o Location, location, location!

National insurance brokerage buyers care more about geography than you might think. As acquisition opportunities present themselves, buyers must continually ask the question: In what geographies can we grow our business the fastest?

From an investment standpoint, aside from those places they've strategically targeted for expansion, brokers normally want to focus their growth investments in places where demographics are moving in a favorable direction.

Over the past generation, there have been two major population shifts going on in the United States. First, there has been a continued flow of people to the big cities from rural areas. Second, there has been a steady migration south and west.

Contrasting Electoral College maps of 1960 and 2004 shows a startling increase in the influence of California, Florida and Texas over the past 44 years. It is no secret those states (and those around them) have been hotbeds of acquisition activity in recent years--and this trend shows no signs of abating.

What does all of this mean? Check the infographic accompanying this story for our predictions. But the bottom line, as always, is that the top-performing agencies and brokerages--those that adopt best practices--will come out on top in any M&A deal.

with image of two business people shaking hands:

Special Reports /

Soft Market Challenges Won't Put Brakes On Agency Merger & Acquisition Activity

Related Stories

Recommended For You