Although three ratings agencies are reticent about debt incurredby Willis North America Inc. in its planned acquisition of HilbRogal & Hobbs, announced last week, they believe thetransaction in the long run will enhance the broker's businessprofile, especially in North America. The $2.1 billion takeoverboosts Willis' revenues by some 30 percent, but the broker remainswell behind Aon and Marsh.

Under the terms of the definitive agreement, Willis will acquireall of the outstanding shares of common stock of HRH for $46 ashare–50 percent in cash and 50 percent in stock–in a transactionhaving an equity value of approximately $1.7 billion and anenterprise value (or total purchase price) of about $2.1billion.

The transaction is expected to close in the fourth quarter of2008, subject to customary closing conditions, including regulatoryand HRH shareholder approval.

HRH is a leading middle-market, U.S.-based insurance broker witha large-account portfolio, according to a joint statement, whichnoted that HRH generated $800 million of revenues in 2007–$57million from its international operations, which are based inLondon.

Willis produced nearly $2.5 billion in total brokerage revenueslast year, including retail and reinsurance commissions and fees.On a pro forma basis, the combined entity would have generated some$3.3 billion in brokerage revenue for 2007–a boost of nearlyone-third, but still leaving Willis behind Aon ($6 billion) andMarsh ($5.4 billion) in brokerage revenue.

“The HRH footprint in the United States will result in asignificant expansion of Willis's already extensive retailplatform,” said the joint statement. “The combination will boostthe contribution of North America to Willis's overall revenues from30 percent in 2007 to an estimated 45 percent on a pro forma basis,enhancing the mix among its North America, International and Globalsegments.”

The deal, according to the statement, “also will positivelyrebalance Willis's business lines mix, with the reinsurancebusinesses–which in 2007 accounted for 15 percent of Willis'srevenues–going to 12 percent of the revenues of the combinedcompany.”

However, following the announcement of the $2.1 billion deal,rating agencies were quick to cite their concerns:

o Fitch Ratings placed Willis North America Inc. and WillisGroup Holdings Ltd. on “Rating Watch Negative.”

o Standard & Poor's Ratings Services dropped thecounterparty rating of Willis Group Holdings Ltd. to a“triple-B-minus” from “triple-B.” It also listed the outlook onWillis as negative.

o Moodys Investors Service placed Willis North America Inc.under review for possible downgrade.

While Fitch expects the operating performance of the combinedentity to compare favorably with the other major brokerages, “thisdeal, with all the uncertainty and the integration risks thatattends it, will reduce the clarity in that regard,” GregoryDickerson, a director at Fitch Ratings in New York, told NationalUnderwriter.

“That being said, our ratings action…was really based on theexpected material increase in financial leverage at Willis tofinance the deal, and Willis was already the most highly leveragedof the insurance brokers that we rate, so it was the moreaggressive leveraging that was more of a driver of the ratingaction,” he explained.

Indeed, from a competitive positioning standpoint, the mergerlooks like a “sensible step” for Willis, added Mr. Dickerson.“Merging with HRH will augment the company's North Americanpresence, particularly in the middle-market space. So they'll growthere, which should be a positive,” he said.

Bruce Ballentine, vice president and senior credit officer onMoody's insurance team, said the transaction should improve theWillis business profile, but may weaken its financial flexibility.“If the deal goes through as expected,” he said, “we expect todowngrade Willis by one notch in recognition of the increasedfinancial leverage.”

Pat Regan, chief financial officer at Willis, told NU that“obviously we've borrowed money to do the transaction, so theyreflected that in their rating–but importantly, we're stillinvestment grade.”

He added that Willis “talked to the rating agencies andexplained the rationale of the structure to them. I think all therating agencies in their write-ups said positive things about thedeal structure and our management track record of delivery andexecution.”

Mr. Regan estimated it will take about a year for the mergedcompany–which will be named Willis HRH–to get its ratings backwhere they were before the merger, or higher. “[Fitch and S&P]both said that as we integrated over time and started generatingthe synergies we've talked about, they can see us getting to onenotch above where we were,” he noted.

Willis expects to double its North American business, and willalso bring a global footprint and specialist expertise to benefitHRH's retail network, Joe Plumeri, chairman and chief executiveofficer of Willis Group Holdings Ltd., said in a conference calllast week.

Outside the United States, he explained, “we'll be adding HRH'sLondon-based operations to further expand the range of ourspecialty expertise and blend in with the things we do inLondon.”

“It's really the best of both worlds for our clients,” he added.“We bring global reach and expertise, while HRH brings added talentand local market presence. All this should translate intosignificant value for our shareholders.”

Willis expects to achieve annualized synergies of $100 millionin 2010 through integrating operations, he said. This onlyrepresents about 8 percent of North America's pro forma 2007expense (on a combined basis), and about 3 percent of the pro formafor the combined companies on a global basis.

Moody's last rating action on Willis was in March 2007, when itassigned a “Baa2″ rating to a $600 million guaranteed seniorunsecured net offering of Willis North America Inc. Willis's ratingwill move to a “Baa3.”

Moody's said it expects to downgrade the Willis ratings by onenotch, in recognition of “the integration and financial riskassociated with a sizable leveraged acquisition.” These risks,Moody's added, are elevated by the general price-softening in theproperty-casualty insurance market and the weakening overalleconomy.

At Fitch, Mr. Dickerson also noted that “we are in a softeningrate cycle that will dampen growth and crimp margins for theseinsurance brokers.” The current cycle, he said, will make it moredifficult for Willis to “digest this acquisition and maintain whatwe would consider to be the superior levels of operatingperformance that Willis has historically demonstrated, relative tothe other brokers.”

However Mr. Regan countered that “even in the current softmarket, there are many opportunities.” He said Willis brings HRHits global expertise, “which they didn't have access to before,”along with “much greater access to industry 'specialisms,' whetherthat be aerospace, energy, construction, marine, financialinstitutions, real estate–so we think that in itself providesgrowth opportunities.”

He added that Willis is excited about the “critical mass we getin big-growth areas,” including Texas, Florida, the New York/NewJersey region, California and Chicago. “We felt we were in thetop-three broking companies in five out of the top-20 insurancemarkets before the deal, and now we're in the top-three in 15. Soit really transforms our presence in those big cities.”

Mr. Dickerson at Fitch said the soft market could have an evengreater impact because Willis has to forgo HRH's $40-to-$50 millionin contingent commissions after three years, according to anagreement made with the New York Attorney General's Office andInsurance Department.

Willis agreed to give up contingency fees when New Yorkauthorities, after an investigation, accused the biggest brokeragesof using them to mask kickbacks from insurers with which theyrigged bids.

“The world's a little bit different now than it was whencontingents went away in 2004, or the start of 2005,” said Mr.Regan. “Certainly for us as a company, we've done a whole programof what we call 'shaping our future marketing.' So we are much morecoordinated in how we place business now, the terms and conditionswe ask for our clients, and how we get paid by the insurancecompany.”

He added that “we're much more confident now with our ability tocoordinate our market efforts. And the fact that we're placingsomething like $20 billion in the North American insurance marketsnow on a combined basis, we're very confident that over thatthree-year period, we'll at least make up in base commissions whatwe lose in contingents.” In other words, he explained, “over thatthree-year period, we get to phase down the commissions and buildup the base commissions. It's the same dollars–just paid in adifferent form.”

Willis HRH will combine Willis's 70 locations and HRH's 140locations, giving it 210 offices and about 750,000 employees, Mr.Regan said, noting that very little overlap is expected.

The new Willis HRH organization in North America will be led byan Office of the Chairman, including Don Bailey (now CEO of WillisNorth America) as chairman and CEO, F. Michael Crowley (nowpresident and chief operating officer of HRH) as president, andMartin L. Vaughan III (now chairman and CEO of HRH) as vicechairman of Willis Group Holdings.

“Detailed plans are being developed to combine the twocompanies,” Willis noted in a statement. “The integration will beled by Mr. Bailey, effective immediately, to ensure a smooth andseamless process.”

HRH's Mr. Vaughan said in the joint statement that thecombination has the full support of his board of directors andsenior management team. “Our complementary footprint and Willis'sstrength in important global specialties…make our two companies anoutstanding strategic fit,” he said.

The joint statement added that the deal will boost employeebenefits business from 10 percent of Willis's current revenues to13 percent of the combined company.

Willis estimates that the transaction will be 7 percentaccretive to cash earnings per share in 2009, 10 percent in 2010and 14 percent in 2011. It is expected to be 3 percent dilutive toGAAP earnings per share in 2009, 2 percent accretive in 2010 and 6percent in 2011.

“It is the company's intention to buy back over time themajority of the shares issued as part of the transaction,” thestatement noted.