The low interest rate environment put pressure on interest-sensitive financial products over the past 2 years, lowering profitability across the insurance industry as a whole. While interest rates are beginning to increase, the impacts of rising rates will not be felt until 2015 at the earliest.1 However, modest improvements in the US economy and the onset of a hard pricing cycle within the primary insurance market are expected to enhance industry performance moving forward as demand for insurance products expands in conjunction with increasing purchases of homes, vehicles, and health coverage.
With industry analysts anticipating the continuity of the recent hard pricing cycle, agents and brokers are set to capitalize on growth as firms in the industry diversify away risk by expanding into new markets abroad and offering new or higher priced services. As a result, industry valuations have moderately improved and are expected to trend in line with real gross domestic product (GDP) growth over the 5 years to 2019.2
Overview of Economic Conditions
The insurance market as a whole is cyclical in nature, as the general level of economic activity and real GDP plays a significant role in determining demand for insurance products.3 Interest rates, GDP, and per capita disposable income are underlying macroeconomic metrics that have a substantial impact on the insurance industry.
Interest rates moved lower in early 2013 and were a primary reason for the depressed valuations of insurance brokers and agencies. While the Federal Reserve has begun a gradual tapering of its bond-buying program, the impacts of rising rates will not be felt prior to 2015.4 "From a broker perspective, the current low interest rate environment should result in a heightened focus on general account business preservation and increased diversification on carrier relationships."5
In periods where GDP growth is below average, both businesses and individuals typically reevaluate insurance needs and reduce spending on insurance products. However, GDP figures are currently improving in the United States, showing signs of improvement in Europe, and flourishing in Asia and Latin America due to increasing middle class disposable income.6 This onset of economic growth, both domestically and abroad, presents an opportunity for organic growth in the insurance market.
In the United States, per capita disposable income increased 1.17 percent in May 2014 over the same period last year. As personal income grows, the need for insurance also expands with purchases of cars, homes, and other assets that need to be protected. An increase in per capita income also allows individuals to broaden their coverage because they can afford higher premiums.7 The property and casualty insurance market in particular reacted to the recent improvements in the economy and industry by increasing premium prices, yielding a 3.1 percent jump in revenue in 2014.8
As a result of improving economic conditions, demand for insurance coverage is expected to expand, if not remain stable, moving forward.
Merger and Acquisition (M&A) Activity
The agent/broker segment continues to be the insurance industry's most active segment in M&A. However, during 2013, M&A activity across the industry as a whole decreased due to "differing buyer/seller value perceptions, ongoing regulatory uncertainty, mediocre economic performance, and some companies' preference to reinvest capital into the business or to satisfy shareholders with stock buybacks and dividends."9
The low interest rate environment poses two dilemmas in the M&A landscape: lowering valuations and reducing private equity (PE) investments in brokers and agents. On one hand, low rates may negatively impact investment returns, which are critical to profitability, making it difficult for prospective buyers to justify a premium valuation and forecast improved post-acquisition results. Alternatively, the low interest rate environment facilitates debt financing for deals. Traditionally, PE buyers prefer acquiring insurance brokers over underwriters, as brokerage is not asset-intensive and does not tie up capital for long periods of time. However, due to the low interest rate environment, PE firms are now looking to invest in annuities and life insurance businesses instead. This is primarily because liabilities in these businesses may be backed by assets and PE firms can invest in higher-returning assets than insurers typically do.
Both the number of M&A transactions and the average deal value of each transaction in the industry decreased in 2013 in comparison to 2012. In 2012, a total of 299 agent/broker M&A transactions closed, while only 248 transactions occurred in 2013, mostly because of the decline in public broker activity.10 Industry expansion was primarily driven by smaller deals in emerging markets as firms strive to capture growth and diversification from the emerging middle class in Asia and Latin America.
Extensive M&A activity is expected to continue over the 5 years to 2019 as firms try to increase market share and build economies of scale.11
Competitive pressures from direct insurers and online brokerage businesses continue to dampen industry profit margins. Insurers are attempting to reduce reliance on brokerages and agencies by selling products directly to customers. Online brokerage businesses also continue to reduce costs and capture new customers. Traditional agencies and brokers are taking counteractive measures by positioning themselves as insurance advisory experts. As a result, the industry has experienced an uptick in employment and wage costs as firms look to hire more skilled labor to provide advanced consulting and risk management services to complement insurance sales.12
The home ownership rate in 2014 decreased 0.2 percentage points to 64.8 percent from the same time last year, posing a threat to industry growth as a decline in home ownership typically translates to lower demand for insurance. This decrease may be attributed to the shortage of stock of houses at the beginning of 2013 that drove prices up. However, the inventory shortage began to soften in February as a result of new construction helping inventory return to traditional levels.13
The number of registered cars influences industry demand for individual automobile insurance. Thus, as improving macroeconomic factors bring customers back into car dealerships and renew demand, the anticipated increase in number of motor vehicle registrations over the 5 years to 2019 at an annualized rate of 1.2 percent represents an opportunity for agents and brokers.14
Brokers play a substantial role in distributing health insurance policies, and a significant portion of small firms (2 to 50 workers) purchase health benefits through agents or brokers. The continued overhaul of the healthcare environment under the Affordable Care Act should help increase service demand for employee benefits and consulting businesses of insurance brokers.15
Industry analysts reference enterprise value (EV)-to-earnings before interest, taxes, depreciation, and amortization (EBITDA) multiples when discussing valuation metrics for insurance brokers and agents. Multiples reflect the level of risk associated with a company as well as growth prospects. In this article, we focused on next 12 months (NTM) EBITDA multiples. Figure 1 presents a graphical analysis of the trends in EV-to-EBITDA multiples from June 30, 2012, through June 30, 2014.
For purposes of analyzing current market valuations, we compiled valuation statistics for the following group of publicly traded companies (the "Industry Group") that is representative of the agency and broker segment of the insurance industry:
Arthur J. Gallagher & Co. (AJG)
Aon, Inc. (AOC)
Brown & Brown, Inc. (BRO)
Marsh & McLennan Companies, Inc. (MMC)
Willis Group Holdings (WSH)
The following charts illustrate the average forward EV-to-EBITDA multiples based on the NTM and the projected long-term earnings per share (EPS) from the second quarter of 2012 through the second quarter of 2014.
Figure 1: Average Industry Group Forward EV-to-EBITDA Multiples Based on NTM as of March 31, 201216
Multiples increased overall in 2013 in line with the stock market, rising as high as 10.4 times. The expansion of multiples over this period was partially driven by positive consumer and business sentiment and restored accessibility of capital markets to fund acquisitions. Figure 2 shows the underlying EPS growth associated with the forward EV-to-EBITDA multiples. The decline in both multiples and EPS growth in the first and second quarter of 2014 is partially due to a decrease in Brown & Brown's market capitalization, which was caused by a buyback of company shares.
A vital aspect of valuing firms in cyclical industries, such as the agency and broker insurance industry, is properly capturing the long-term effects of economic ups and downs on the company's business. Because valuation is ultimately tied to earnings and cash flows in the measurement year, the resulting value greatly depends upon where in the cycle that year falls. If the measurement year is an up (down) year, the resulting value could be high (low) compared to normalized economic conditions.
The discounted cash flow (DCF) method is a commonly used valuation methodology that forecasts company cash flows and discounts these earnings based on a minimum required return rate expected from stakeholders in the company to yield a present value. Choosing appropriate growth rates for the forecast, normalizing earnings and cash flows in the year upon which the forecast is built, and choosing more stable earnings streams are three methods to address cyclicality in a DCF valuation.
The assumed growth rate in the DCF plays a significant role in the ultimate valuation, particularly due to its impact on the terminal value estimate. The calculation of the terminal value is based on the Gordon Growth Model as discussed in my May 2011 article, " Impact of Hard Market Expectations on Agency and Broker Value." One important factor to remember is that the growth rate should reflect the steady-state perpetual growth and should not reflect any bias resulting from higher (or lower) than normal short-term growth estimates in order to properly capture the average rate of an entire business cycle. For instance, a growth rate in excess of the growth rate for the entire economy should be "assessed carefully, as this implies the firm's share of the total economy will eventually rise to unreasonable levels."18
One can normalize earnings in a DCF valuation by calculating the average earnings over a period (5 to 10 years—depending on the length of a business cycle). By utilizing an average earnings stream, valuations capture both the busts and booms of an economic cycle, accounting for volatilities in the course of the business cycle.19
"Operating income is less volatile than net income and revenues have less variance than operating income." Thus, utilizing EBITDA or revenue multiples for cyclical companies over price/earnings ratios provides a more discernable valuation over time as these multiples can still be computed during an economic downturn and are far more stable over time.20
While the industry continues to face headwinds from the challenges produced by low interest rates and intense competition within the industry, organic growth is expected to increase for the industry moving forward under improving macroeconomic conditions. As per capita income grows, agents and brokers may take advantage of opportunities to raise premium prices and capitalize off renewed demand in the market overall.
1 "2013 Top 10 Issues for Insurance M&A in 2013," Deloitte.
2 "IBISWorld Industry Report 52421: Insurance Brokers & Agencies in the US" (Mar. 2014).
3 "Marsh & McLennon Annual Report for Fiscal Year Ended December 31, 2013," Morningstar.
4 "2013 Top 10 Issues for Insurance M&A in 2013," Deloitte.
5 "Impact of Low Interest Rates on Insurance Carriers and Brokers," Andesa Services.
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