Every once in awhile in the world of investment banking, an ideais born that creates unexpected wealth. Unfortunately, not allinnovations have positive long-term consequences, as witnessed bythe recent demise of mortgage-backed securities.

Managing general agents–especially those managing sizable booksof property and casualty programs for insurance companies–havesuddenly become a hot commodity for mergers and acquisitions.Insurance carriers, brokers, other MGAs and private equity firmshave become caught up in a wave of bidding to acquire MGAs.

Why program MGAs, all of a sudden?

In an overcapitalized insurance market, with premium-to-surplusratios at an all-time low, and with the soft market gainingmomentum, an insurance company's acquisition of a program MGA orprogram administrator (PA) offers a quick boost to premiumvolume.

Furthermore, the current decline in investment income putsadditional pressure on carriers to use their excess surplus toproduce some kind of reasonable return.

In theory, specialized programs are expected to be lesssusceptible to the vagaries of the soft market in contrast to MainStreet business. Insurance brokers and larger programadministrators, faced with stagnant revenues, can continue to growby PA acquisition.

In addition, private equity firms, awash with capital that needsto be invested, can purchase PAs with the expectation that intwo-to-five years their interest can be resold at a handsomeprofit.

Insurance companies have emerged, however, as the mostaggressive acquirers. Some M&A brokers, having recognized thecarriers' desperation for premium growth in order to deploy theircapital, have turned the situation into an opportunity to boosttheir PA client valuations to astounding levels.

Instead of focusing exclusively on the profits of the PAoperation, the new approach is to identify the underwriting profitsof the business written by the PA and require bidders to offer amultiple of earnings on both profit streams–underwriting profit aswell as total agency profit.

This is particularly effective if a sizable amount of historicunderwriting profit can be identified on the PA's book ofbusiness.

In any event, this approach favors acquisition almostexclusively by an insurance company which, upon acquiring the PA,can cancel existing carrier contracts, move the business “in-house”and thereby benefit from both streams of income.

Recently, PAs have been sold to insurance carriers for anoutrageous multiple of their agency earnings thanks to thetwo-income approach. Underwriting profits often significantlyexceed agency profits.

Naturally, selling owners are likely to be delighted with theefforts of their brokers, whose fees soar along with the largervaluations.

Given that the insurance companies willingly pay to acquire thebooks of business, why should anyone be concerned?

The above transactions can be viewed as capitalism operating atits most efficient level, and it is not the intent of this author–aproponent of the free-market economy–to question our economicsystem.

On a more philosophical basis, however, there are a lot ofconcerns that come to mind.

In the program business world, the relationship between theprogram administrator and the company requires a unique level ofcooperation and trust. Underwriting guidelines, rates and forms aredeveloped through hard work and input on both sides. A successfulprogram is typically the result of years of joint developmentefforts.

When a PA abruptly drops its existing carrier, almost all PAcontracts grant ownership of records and expirations to the PA,meaning that it will be difficult for the carrier that has beenreplaced to effectively compete against its erstwhile source ofbusiness, especially in a soft market.

Certainly, PAs should eventually replace carriers where there isnot a good partnership fit. Likewise, carriers should do the same.However, replacing carriers in order to sell the underwritingprofit to other carriers could in the long haul have an adverseimpact on PAs.

Cynical carriers may, in the next hard market, insist upon PAcontracts that limit or eliminate the PA's ownership of records andexpirations. Yet it is through this ownership that there is abalance of power between the PA and carrier.

The carrier will work hard to keep profitable business becausethey know the PA has the right to move it, and the PA will workhard to make money for the carrier because they know they will havea difficult time replacing a contract cancelled for lack ofprofitability.

Absent full ownership of records and expirations, the PA couldspend years developing a book of business, only to have the carriergo after it directly–or, alternatively, the carrier could leveragethe PA midterm into accepting lopsided terms.

Another potential result of paying multiples of both agency andunderwriting profit–assuming the market continues to soften–couldbe that carriers will inherit lower-than-forecasted profits on bothincome streams. If this occurs, carriers could take extreme actionto recoup their sizable investment, including laying off the PA'sstaff or drastically re-underwriting the book of business.

Most successful PAs have prospered as effective entrepreneurialorganizations that can adapt quickly to opportunities andchallenges in an ever-changing marketplace.

Once they are under the umbrella of an insurance company,however, there can be a tendency for the business to be neglected,since the acquired entity has no other options. Perhaps this is nota problem for the owner who wishes to retire soon, or who is notconcerned for the staff that helped them achieve past results.

However, for owners and staff expecting to stay for awhile, thismay be a bitter pill to swallow.

Good results or bad, the culture of a PA is not always easy tointegrate within an insurance company operation.

Furthermore, if insurance companies that have bought PAs chooseto unload them for pennies on the dollar due to poor performance ora bad fit, this could depress future valuations. (In the past,there have been cases where divestitures of acquired PAs byinsurance companies, at reduced valuations, have occurred.)

Notwithstanding the above arguments, there have certainly beensome very successful acquisitions of PAs by insurance carriers thathave worked for all parties, short term and long term. As in anyacquisition scenario, chemistry and the size of the cultural gapbetween the organizations are key determinants of success.

All this author is suggesting is that the two-income approach toPA acquisition, while creating record valuations, may have adownside for the industry and the participants that few, if any,have considered.