Many agency and brokerage buyers are concerned about acquisition targets with significant small group health business, but that business is not anathema to all buyers.

Buyers mostly are concerned about small groups of 50 or fewer lives but also with groups of 100 or fewer lives, according to consultants.

“The belief is that a lot of that business will go to the state-run exchanges” if those facilities do open as currently planned in 2014 under the 2010 health care reform law, said Tim Cunningham, a principal at OPTIS Partners L.L.C. of Chicago.

Cunningham sees agencies taking discounts of 40 percent to 60 percent on the value of their small group business. “If you're a seller and you have that business, expect it to be discounted,” he said.

Buyers, however, will not discount the value of that small group business unless it represents about one-third or more of a seller's revenue, said John Wepler, president of consultant Marsh, Berry & Co. of Willoughby, Ohio.

Among the small percentage of agencies that generate most of their revenues from benefits business and primarily work with small groups, valuations are being discounted 70 percent to 90 percent, experts agreed.

“Some folks are giving it no value, which isn't right—it won't go to zero overnight,” said Lou Caltavuturo, a partner with consultant Dowling Hales in New York. Caltavuturo suggested that agencies focus on moving to larger groups.

Agents and brokers who place benefits business took another blow this summer when the National Assn. of Insurance Commissioners refused to support their effort to exclude their commissions from the medical loss ratio calculation that will determine health insurers' profits, said insurance industry consultant and investment banking advisor John Wicher, principal at John Wicher & Associates in San Francisco.

The Patient Protection and Affordable Care Act required the U.S. Dept. of Health and Human Services to develop calculations on the percentage of revenues that health insurers must commit to medical expenses.

If a health insurer meets or exceeds the prescribed percentage—or medical loss ratio calculation—it may retain the remaining percentage of revenues to cover other expenses and as profit. If the insurer's medical expenses do not hit the prescribed MLR, the insurer must rebate the difference to its policyholders.

Under the regulations the HHS unveiled last November, insurers writing groups of fewer than 100 must meet an 80 percent MLR. Insurers writing larger groups face a more restrictive 85 percent MLR.

Because producer commissions will not be treated as a pass-through expense in calculating MLRs, health insurers will have to continue paying producers' commissions out of the 15 percent to 20 percent of revenues the new health reform law allows carriers to retain to cover non-medical expenses and keep as profit.

“That's a huge deal,” because it will continue to exert pressure on the commissions insurers pay producers, Wicher said.

As a result, producers will have to turn to clients to make up that revenue loss, he said. “For agents and brokers with books of commission business of under 250 lives, they could be facing a real challenge.”

Their valuations and attractiveness to buyers will depend on them moving to a “fee-based value proposition with clients” and assuming more risk in a merger or acquisition by accepting a deal with a heavier loading on the earn-out based on business over one to three years rather than up-front cash, Wicher said.

Other observers agree.

“As the exchanges roll out, we see a role for brokers” in consulting with small businesses on their plan options and providing services, such as plan enrollment, said Ken A. Crerar, president of The Council of Insurance Agents & Brokers.

Atlanta-based Digital Insurance Inc., for one, is looking for health-related acquisitions. “Digital loves that end of the market and gives you full value for it,” said Dowling Hales' Caltavuturo.

Digital completed 10 acquisitions over 14 months through September, five of them this year, according to Mike Sullivan, Digital's executive vice president and chief marketing officer.

Digital will “look for small group and middle-market business,” Sullivan said. “We believe that small group business is not going away.” Instead, state exchanges will add complexity to the health insurance buying process for small groups, which will need advisory services that will generate fee-based income for agents, he said.

Sullivan said that Digital does not discount the valuation of agencies with small group business that it finds attractive.

However, Digital typically does not pay “as much up-front money” to sellers.

“And if this is an exit strategy for owners, we have zero interest in that acquisition,” he said. While the earn-out elements of Digital's acquisition deals typically are based on a three-year period, Digital wants former owners to stay around five to 10 years

“But no one does what we do post-transaction to allow firms to grow,” Sullivan said.

Eric Haglund, the former owner of Digital's first acquisition, is thrilled after his initial year with Digital. Haglund completed the deal for his Lawrenceville, Ga. agency in June 2010. He would not say how Digital valued his small group business, but he said the negotiation was not “adversarial” and that the calculation “was quite easy, frankly.”

After the deal was completed, Haglund spent the next 6 months integrating as well as servicing in-force business—split about evenly between groups with less than 100 lives and larger groups. He did not attempt to write new business.

Aided by Digital's marketing and technology support services, Haglund, now a principal with Digital, began focusing on generating new business only in the second half of the year. Even so, he increased his revenues 24 percent compared with his top line during the last full year he was independent, he said. The new business was split evenly between small and large group business, he said.

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Can Group Health Business Ruin Your M&A Prospects?

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