This article provides an update of recent trends in the valuation of agents and brokers (prior article dated August 2014). We will discuss the recent industry conditions and outlook, the mergers and acquisitions (M&A) environment, market valuations, and valuation considerations.
The overall market for insurance agents and brokers has managed to post modest growth the past 2 years despite a persistent soft cycle and heightened competition from direct insurers and online brokerages, with industry revenue growth of 2 percent and 2.6 percent in 2014 and 2015, respectively.1 Since commissions comprise a majority of the industry's revenue base, key factors that drive growth include insurance premium prices, overall demand for insurance, and the utilization of agents and brokers as channels for purchasing insurance.
Insurance Premium Prices
After experiencing a prolonged soft cycle spurred from the "Great Recession," property and casualty insurers were anticipating hardening rates, which would typically last 2 to 3 years with rate increases ranging from 15 percent to 30 percent on a year-over-year basis, driven by declines of surplus in the industry and increased demand for insurance.2 While rates did firm to a degree, the hard market failed to fully materialize as a result of low interest rates attracting new capital and increasing capacity.
Commercial property/casualty insurance rates have actually declined since the third quarter of 2014, although the decline appears to be slowing.34 While a limited soft market seems unlikely given the excess market capacity, more sophisticated underwriting capabilities have appeared to control market swings from reaching extremes in either direction. Furthermore, despite the increased capacity keeping rates low, customers are beginning to exhibit an interest in purchasing additional coverages, which presents an opportunity for cross-selling products.5
Overall Demand for Insurance
As the macroeconomic landscape improves, the associated risks created by growth and innovation lead to higher demand to insure the underlying assets. Below is an analysis of the macroeconomic factors that have the largest impact on the demand for insurance.
In the United States, per capita disposable income rose 4.7 percent from March 2014 to March 2016.6 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, particularly in the case of life, property, and casualty lines. Per capita disposable income is anticipated to moderately expand over the next 5 years.7
The home ownership rate fell from 64.8 percent in March 2014 to 63.5 percent in March 2016, presenting a threat to industry growth, as a decline in home ownership typically translates to lower demand for insurance and, therefore, lower commissions for agents and brokers.8 This decrease may be attributed to stringent mortgage standards and rising home prices.9 Home ownership is anticipated to continue its decline through 2020.10
The demand for commercial coverage and workers compensation insurance increases as unemployment declines due to the larger pool of employees. Unemployment has steadily improved from a weak recessionary base of 10 percent in October 2009 to 5 percent in April 2016, aiding industry commissions and growth.11
The number of registered cars influences industry demand for individual automobile insurance. The improving macroeconomic factors, such as rising populations, lower unemployment, and low interest rates, bring customers back into car dealerships and renew demand. The number of motor vehicle registrations increased 2.1 percent and 1.8 percent in 2014 and 2015, respectively, and is anticipated to continue to grow over the next 5 years at an annualized rate of 1.2 percent.12
Utilization of Agencies and Brokers
The industry continues to face competitive pressures from direct insurers attempting to reduce reliance on brokerages and agencies by selling products directly to customers and online brokerage businesses taking advantage of lower cost online sales. Traditional agencies and brokers have counteracted this trend by positioning themselves as risk management and insurance advisory service experts. Companies in the industry have sought to hire highly skilled employees to offer these more advanced complimentary services, which has, in part, contributed to industry wages growing 5.9 percent since 2013.13 This strategy has proven successful, as brokers and agencies have managed a modest level of organic growth despite headwinds from a soft reinsurance market and flat or declining premium rate changes in the primary property and commercial insurance segment.14
The Affordable Care Act and the corresponding overhaul in the healthcare environment accelerated the migration to a more advisory role in order to help clients navigate the increased complexities and impact on their businesses.15 However, regulation also poses a threat to the industry, as the Department of Labor recently announced new legislation that will require retirement advisors to abide by fiduciary standards and act in the "best interest" of the client.16 It is anticipated that the new standard will cause major operational and strategic implications to create the systems, processes, and oversight functions needed to comply with the ruling.17
The overall insurance brokers and agencies industry is anticipated to expand 2.3 percent over the next 5 years, as measured by revenue, as the improving economic conditions and growing demand for advisory services will outweigh more intense competition and stricter regulation.18
Merger and Acquisition Activity
After a downturn in mergers and acquisitions (M&A) during 2013, activity has rebounded with fervor over the last 2 years, increasing approximately 33 percent in 2014 and 26 percent in 2015.19 The spike in deal activity was primarily driven by improving economic conditions and a low interest rate environment facilitating debt financing, which made M&A an attractive option to increase market share and spur growth.20
Furthermore, there is currently a finite number of suitable sellers, but a robust group of capital intensive buyers are creating a seller's market. Historically, private equity (PE) firms have been the third most active group of buyers, accounting for just 21 percent of transactions in 2008; however, PE firms accounted for the majority of deals in 2015, with the total amount representing an increase of 53.2 percent over PE-backed transactions in 2014.21 Driving this trend were high-retained capital levels, high volatility in the equity markets, and the potential for bolt-on transactions for PE firms with existing platforms.
In the near term, the active deal environment is expected to continue, given the slow organic growth environment; the rising age of many agency and brokerage equity holders; the low market share concentration; and the substantial number of small, specialized firms focusing on niche markets. However, the high valuations may be tempered by an inability to achieve expected returns and a larger pool of potential sellers.
Industry analysts reference enterprise value-to-earnings before interest, taxes, depreciation, and amortization (EV-to-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 the next 12 months (NTM) EBITDA multiples. Figure 1 presents a graphical analysis of the trends in EV-to-EBITDA multiples from January 1, 2014, through March, 2016.
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, PLC (AON)
Brown & Brown, Inc. (BRO)
Marsh & McLennan Companies, Inc. (MMC)
Willis Tower Watson PLC (WLTW)
The following charts illustrate the average NTM EV-to-EBITDA multiples and the projected long-term earnings per share (EPS) from the first quarter of 2014 through the first quarter of 2016.
Figure 1: Average Industry Group Forward EV-to-EBITDA Multiples Based on NTM22
Multiples remained fairly stable in 2015, as the Industry Group was able to weather the major global headwind of foreign exchange rates against a strengthening US dollar. Most companies managed modest organic growth in the range of 3 percent to 5 percent, in addition to strong acquisition revenues.24 Figure 2 shows the underlying EPS growth associated with the forward EV-to-EBITDA multiples. The decline in EPS growth in the first and second quarter of 2015 was partially due to softening premium rates and heightened competition putting pressure on profit margins. To maintain profit margins, the Industry Group has recently shifted its focus to cost cutting and acquiring specialized firms serving niche markets where margins are higher (such as cyber insurance).25
We have discussed the importance of normalizing earnings in the valuation of agencies and brokers due to the cyclical nature of the industry. Another vital area of consideration is the analysis of risk factors associated with a particular agency or brokerage to assist in the determination of an appropriate discount rate and potential adjustments to valuation multiples.
One way to assess risk is to perform an analysis of the company's financial performance over time and relative to its peers. This provides an indication of historical growth, liquidity, leverage, and profitability, all of which influence the value of a company's equity and the appropriate valuation multiples relative to peers. One of the most important aspects to consider is the volatility of revenue and profitability (typically measured by EBITDA margin), as inconsistent and fluctuating levels are considered more risky by potential buyers. Typically, data is not readily available for private companies, so comparable publicly traded companies can be utilized as the peer group, as these companies are exposed to similar market forces and represent a portion of the universe of likely buyers.
The Industry Group experienced significant variance in revenue growth (including organic and acquisition revenue) over the last 2 years, ranging from a decline of 0.5 percent to an increase of 29.6 percent, with an average of 8.9 percent growth.26 EBITDA margins ranged from approximately 15 percent to approximately 30 percent, with an average of approximately 23 percent, since 2014.27 The wide range of growth and profitability exhibited by the Industry Group exemplifies the importance of understanding the underlying drivers and the relationship between the two. For instance, although AJG had the highest revenue growth, it came almost entirely from acquisitions, and AJG experienced the lowest EBITDA margin of the Industry Group.2829 While AJG demonstrated an ability to grow revenue, there is the risk that too much focus placed on the topline has led to less efficient operations and brings into question management's strategic ability to create growth organically if the current level of M&A becomes unsustainable.
As much of the value of an insurance brokerage is inherently contained in the firm's customer base, it is also imperative to review a subject company's customer concentration and historical customer attrition rates. An agency or broker that relies heavily on a single client or even a small group of clients is potentially riskier, as the loss of one or more of these accounts can drastically impact future earnings. Additionally, an analysis of the historical customer attrition rate provides an estimate of the remaining customers in each subsequent year and a glimpse into the quality of services provided by the agency or brokerage.
Finally, since insurance agencies and brokerages provide professional services, a key driver of value lies in the firm's workforce. Given that the average age of agents and brokers continues to rise, it is important to examine how close key producers are to retirement and whether the firm is invested in training the next generation of producers and managers. Workforce utilization of technology is also increasingly important in order to be more attractive to customers, insurers, and potential acquirers.
Although there are numerous other risk factors to consider in the valuation of an agency or brokerage, the factors already discussed provide a starting point in determining company-specific risks applicable to the development of the appropriate rate of return required by a potential buyer and any required adjustments to the derived multiples.
The insurance agents and brokers industry is facing a major shift in market dynamics due to the technological advancements increasing competition, major healthcare reform altering the needs of consumers, and a changing regulatory environment requiring costly compliance functions. To compete and foster growth in the new conditions, agents and brokers must be willing to challenge traditional operations and utilize the opportunities derived from the disruptive market trends to innovate and adopt sustainable long-term strategies. Agents and brokers have begun adjusting to the changing landscape by positioning themselves in a more advisory role, but they must continue to embrace value-add services and emphasize customer service.
The widespread market consolidation, in conjunction with increasing technological capabilities, presents companies with the opportunity to reach previously untapped or underserviced markets. Companies that truly understand the critical risks and value drivers underlying their business or a potential acquisition target will be able to take advantage of the opportunities to capitalize on the recent industry trends.
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1 IBISWorld Industry Report 52421: Insurance Brokers & Agencies in the US, March 2016.
2 Dimmling, Rudy, Hoeg, Greg, "The Hard Market That Wasn't," Insurance Journal, September 2015.
3 "2016 Marketplace Realities Spring Update," Willis Towers Watson, April 2016.
4 "Commercial P/C Market Index Survey," The Council of Insurance Agents & Brokers, May 2016.