This article is an update to my June 2016 article, "Recent Trends in the Valuation of Agents and Brokers," and considers how recent economic and industry conditions and demographic trends are impacting the mergers and acquisitions (M&A) environment and market valuations of agencies and brokers.
Many agencies and brokers have experienced steady growth over the past several years due to improving macroeconomic conditions, beneficial legislation, and a hard market resulting in increases in insurance premium prices. Industry revenue is primarily driven by commissions, which in turn is affected by the pricing of premiums and the volume of transactions. Over the past 5 years, a hard market has resulted in higher premium prices in the property and casualty (P&C) and health insurance market. Along with rising consumer disposable incomes, agents and brokers have achieved higher commissions in a relatively steady demand environment.1
Increases in auto insurance premiums are expected to be a significant driver of P&C premium changes in the coming years as the frequency of distractions while driving escalates and the proliferation of more advanced technology in vehicles results in rising auto loss costs.2 As a result of competition and higher frequency of catastrophes, which devastated profit margins, P&C underwriters were pushed to increase premium prices in order to improve profit margins and strengthen their balance sheets. Accordingly, premiums in the P&C market expanded 8.3 percent from January 2014 to March 2018.3 Higher catastrophe and auto claims in early 2017 were exacerbated in the second half of 2017 as insurers were severely affected by various natural disasters, including three hurricanes that impacted the United States (with insured loss estimates ranging from $75 billion to $100 billion).4 While the ultimate result of these catastrophic events is still to be seen, the insurance industry has already suffered significant losses, leading to a hardening of prices over the past several months, a trend that is expected to continue into 2018.5
Demographic factors impacting the industry include the US homeownership rate climbing to 64.2 percent in the fourth quarter of 2017 after successive declines over the past 13 years. This bodes well for the industry as an increase in homeownership rates typically leads to higher demand for insurance, driving commission growth for agents and brokers. In particular, this expansion in homeownership marks an important shift in the preferences of millennials, who previously favored renting as opposed to owning. Homeownership among households headed by someone under the age of 35 rose from 34.7 percent the previous year to 36.0 percent, representing the largest increase among all of the age groups.6
Additionally, per capita disposable income in the United States rose 1.6 percent from February 2016 to February 2018,7 driven by improving economic conditions and a decrease in the unemployment rate. Real disposable income advanced 0.6 percent from December 2017 to January 2018, just after the Tax Cuts and Jobs Act (TCJA) was signed into law on December 22, 2017. Going forward, consumer spending is likely to be supported by the lower tax rates and sustained by low unemployment rates.8 Per capita disposable income is expected to grow at an annualized rate of 2.8 percent from 2018 to 2023, driving demand for insurance policies as they become comparably more affordable. However, the recent repeal of the Patient Protection and Affordable Care Act's individual mandate via the TCJA may reduce the subscription rate as consumers who choose to drop their health insurance policies no longer have to face a potential fine.9
Mergers and Acquisitions Activity
With 537 announced deals in the United States, 2017 represented the most active year recorded in terms of M&A activity for the insurance industry. However, aggregate deal value dropped 26.0 percent from $7.3 billion in 2016 to $5.4 billion in 2017. Additionally, the acquisition of USI Insurance Services LLC by Caisse de dépôt et placement du Québec and KKR & Co. LP for $4.3 billion in March 2017 represented approximately 80.0 percent of the year's total announced deal value.10
Private equity (PE) firms have become more active in the segment in recent years and now account for the majority of deals. A relatively newer category of buyers, PE-backed buyers (PE-backed firms and privately owned firms with significant M&A support), accounted for more than 60.0 percent of transactions in 2017. Out of the group of targets, P&C firms comprised approximately half of the total announced transactions, driven by the large supply of P&C firms and the desire of many baby boomers seeking to exit their positions and retire.11
The combination of strong interest from PE firms, a relatively large supply of sellers, low-cost of debt, and the appeal of benefits from scale and efficiency in an expanding economy, creates a conducive environment for transactions.12 Firms that tend to have predictable cash flows, safeguards that mitigate downside risk, and high margins are particularly attractive to PE investors.
Also spurring transactions, some insurance agents and brokers are looking into the acquisition of managing general agents (MGAs). Acquiring an MGA may be a less expensive way for a broker to get access to certain functions ordinarily handled by issuers such as binding coverage, underwriting and pricing, appointing retail agents within a particular area, and settling claims.13
Enterprise value (EV) to earnings before interest, taxes, depreciation, and amortization (EBITDA) multiples continue to be the most prevalent when assessing valuation metrics for insurance brokers and agents. Transaction multiples typically reflect the level of risk associated with a company as well as growth prospects.
For purposes of analyzing current market valuations, we compiled valuation statistics for the following group of publicly traded companies (Industry Group) that is representative of the agency and broker segment of the insurance industry.
Arthur J. Gallagher & Co.
Brown & Brown, Inc.
Marsh & McLennan Companies, Inc.
Willis Towers Watson PLC
The graphs below illustrate the average next 12-month (NTM) EV-to-EBITDA multiples (Figure 1) and the projected long-term earnings per share (EPS) from the first quarter of 2016 through the first quarter of 2018 (Figure 2).
Figure 1: Average Industry Group Forward EV-to-EBITDA Multiples Based on NTM14
EBITDA multiples have expanded and remain strong relative to historical levels but appear to be leveling out in the second half of 2017 and first quarter of 2018. EPS growth has been in a relatively stable range, increasing in the first quarter of 2018 with the passage of the TCJA.
Multiple expansion in recent years has been primarily driven by a positive economic landscape and low interest rates that provide relatively inexpensive debt to finance acquisitions. Consistent with this trend, the average EBITDA margin for the Industry Group has remained relatively unchanged at approximately 22.0 percent from 2013 to 2017,16 suggesting a widening gap between profitability and valuation multiples. While organic growth potential is highly valued in the industry, many of the acquisitions in the past few years have focused on both organic growth and bolt-on acquisitions. As such, buyers are often willing to pay a premium for a perceived platform company with a strong management team and the infrastructure that will be able to expand both organically and through additional bolt-on acquisitions. Value is created through synergistic benefits such as the ability to cross-sell and scalability. Meanwhile, armed with a high valuation themselves and attracted by the appeal of potential cost synergies and relatively cheap financing, large brokerage and agent firms continue to play an important role in the M&A landscape as acquisitions provide a way to achieve significant growth.17
Other Market Observations
In addition to the trends outlined above, lower tax rates stipulated by the TCJA should allow companies to generate more free cash flows, increasing the availability of funding for acquisitions. However, more highly leveraged buyers might face a challenge with the new tax law as section 163(j) of the new tax code limits the tax deductibility of net business interest to 30.0 percent of adjusted taxable income (which is defined as EBITDA for the tax years beginning after December 31, 2017, and before January 1, 2021, and defined as earnings before interest, and taxes thereafter). This limitation may negatively impact certain companies with high leverage and/or with low forecasted profitability. However, the provisions and implications of the TCJA are wide-reaching, and its effects on the industry are yet to be determined.
Technology remains a major driver of change in the industry as intense competition and new platforms place downward pressure on margins. Insurance brokerage and agency firms seeking to maintain competitiveness in the industry are focusing on developing technology to establish closer relationships with clients and differentiate themselves from competitors. Many firms are developing digital and social media tools to adapt to general demographic changes and enhance product customization as well as relationships with insurance providers.18
Finally, as with any client service industry, the capabilities and expertise of the workforce is an important driver of value. The industry has faced challenges in recruiting young talent in recent years. As such, it is more important than ever to identify young talent early on and implement appropriate training and support systems to develop the next generation of leaders.
The market has been characterized by favorable macroeconomic conditions, technological improvements, rising auto losses, and higher interest rates in recent years. Additionally, the industry has experienced hard market pricing conditions during the last 5 years, and the hard market environment is expected to continue for at least the next couple of years. However, despite high valuations, M&A activity in the insurance broker and agent segment is thriving, as evidenced by a record number of transactions in 2017. Valuation multiples have expanded and have reached a 5-year high supported by a positive economic environment, low interest rates, and increased PE firm activity. Thus, consideration of how much longer these underlying drivers will support the continued increase of valuation multiples is warranted. When analyzing a specific transaction, in addition to financial performance and metrics, both buyers and sellers should also carefully scrutinize the underlying value drivers of a business, including technology, client base, talent pool, potential synergies, and growth potential.
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1 Industry Report 52421: Insurance Brokers & Agencies in US, IBISWorld, February 2018.