When analyzing any business, it is important to understand the specific drivers that enhance and diminish its value. The insurance industry involves certain valuation issues unique to the industry, and depending on the segment a company operates in, some valuation drivers may be similar or different.
There are generally four distinct types of segments within the insurance industry: (1) agencies and brokers, (2) property and casualty insurers, (3) health and life insurers, and (4) reinsurers. The focus of this article is to give greater insight into the valuation of insurance agencies and brokers and the market's current pricing of these businesses. Future articles will address the other three industry segments.
Below is a group of publicly traded companies (the "Industry Group") that are representative of the agent/broker division of the insurance industry:
Arthur J. Gallagher & Co. ("AJG")
Brooke Corp. ("BXXX")Brown & Brown Inc. ("BRO")
Hilb Rogal & Hobbs Co. ("HRH")
Marsh & McLennan Companies ("MMC")
National Financial Partners Corp. ("NFP")
Willis Group Holdings Ltd. ("WSH")
Current market data for the Industry Group obtained from Capital IQ, a division of Standard & Poor's, can be used to calculate valuation multiples. A valuation multiple compares a company's equity value or market value of invested capital (MVIC) (i.e., total interest bearing debt plus the equity value) to an earnings stream such as revenue, earnings before interest, taxes, depreciation, and amortization (EBITDA), or net income (earnings). Analysts can calculate a value for a firm by deriving multiples from data on similar publicly traded companies or recent transactions involving similar companies.
Depending on the company being valued, adjustments could be made to account for company-specific factors. The resulting multiple can be applied to the firm being analyzed to arrive at an indication of value. This article will discuss concepts relating to valuation multiples.
While there may be exceptions, the value of most agents/brokers is driven substantially by three primary drivers: growth, profitability, and customer relationships. These drivers are discussed in detail below.
Growth can typically be classified into two categories: organic growth and acquisition-related growth. Organic growth is generated by the firm's existing business, whereas acquisition-related growth is achieved by buying new businesses. Given that acquisitions can be a key source of growth for many insurance brokers, it is often important in valuing the business to distinguish between organic growth and acquisition-related growth. Agencies and brokers both generate revenue largely through commissions paid by insurers. Commissions for agents and brokers are typically established as a percentage of the premium associated with the type of insurance placed.1
Given that insurance premiums can be volatile depending on macroeconomic factors,2 revenues for agents/brokers can vary widely. That said, and recognizing that new customer relationships can be costly and difficult to obtain, high levels of organic growth are normally unsustainable. As such, a significant portion of revenue growth for agencies/brokers is often achieved through acquisitions.3 During 2006, 158 acquisitions were executed by large public and private brokers.4
One factor that can greatly influence the profitability of an agency/broker is the quality of the firm's workforce. A broker/agent firm's workforce has the responsibility of generating revenue from the agency/broker's customer relationships, and as such it holds significant value for the firm.5 The efficiency with which an agency's workforce is able to turn those relationships into revenue drives profitability.
In analyzing profitability, an issue arises regarding which earnings stream on which to base the valuation multiple. Often, revenue multiples are discussed by management of agencies and brokers in considering valuation issues. However, revenue multiples do not take into consideration the unique profitability of the firm. Nevertheless, from an acquirer's point of view, historical profitability is less of a concern given that the acquirer will likely model its own cost structure on the target's operations. As such, in cases with small companies where an acquisition is a possibility, revenue multiples are often relevant metrics for determining value.
However, before relying on a revenue multiple, one should consider what role the target will play in the acquirer's business. For example, if a small local agency were acquired, it might continue operating semi autonomously as a local branch of the acquirer. In this instance, the cost structure will probably remain the same, and, therefore, metrics that directly consider profitability, such as EBITDA or earnings multiples, should then also be considered.
Strong customer relationships tend to enhance the value of an agency/broker. It is important to note, however, that relationships that have been institutionalized to the agency/broker are typically more valuable than relationships between the customer and an individual member of the firm's workforce. If customers have developed a relationship with the firm rather than a particular salesperson, then the agency/broker will generally have higher customer retention.
Given the importance of customer relationships, companies with covenants not to compete in place for key sales personnel tend to have more value than those without them because of the greater customer (and even employee) retention as a result of the covenants. Customer retention is especially important to consider under acquisition scenarios given that key personnel may leave the firm once it has been purchased. To mitigate this, acquirers have increased the use of earn outs in recent years.6
An earn out is a variable portion of the purchase price which is paid depending on management's post-acquisition performance. Usually, by retaining key personnel and compensating them based on company performance, key personnel are more likely to stay with the firm and maintain its customer base.
In addition, the increased use of earn outs in recent years has resulted in an increase in the average multiple at which transactions have been executed. "The use of earn outs can result in increasing the valuation multiple but shifts business risks from the buyer to the seller based on future performance."7 Given that the earn out is not guaranteed, the price actually paid for the business may be lower than the multiple indicates if the earn out benchmarks are not achieved.
The following graph shows the MVIC-to-EBITDA multiples for the latest 12 (twelve) months ("LTM") for the Industry Group.
As illustrated, the current average valuation for large public insurance brokers is approximately 10 times EBITDA. However, the range varies from a low of 7 times EBITDA to a high of roughly 14 times EBITDA. These differences can be attributable to a variety of factors including company-specific issues, such as growth strategy and strength of customer relationships, and workforce. Additionally, current market trends can affect the value of a particular stock.
One factor that has likely influenced the valuations of certain agencies/brokers is the possibility of private equity buyouts. Public brokers have experienced a wave of private equity buyouts resulting in an increase in multiples as investors have bid prices up in expectation of an acquisition premium.8
NFP is trading at the high end of the range with a multiple of 14 times EBITDA while AJG is trading at a multiple of 7 times EBITDA, representing the lowest multiple of the Industry Group. According to some analysts, NFP has followed and will continue to follow an increasingly aggressive acquisition strategy9 which might explain its high valuation, assuming its acquisitions have been accretive. With regard to AJG, analysts argue based on leveraged buyout analyses of various firms in the industry, the firm is less likely to attract private equity buyers than others,10 which may contribute to its lower EBITDA multiple compared to its peers.
Typically, private equity groups purchase agencies/brokers with consistent cash flows and a large amount of debt capacity.11 Analysts note that AJG's business does not appear to possess these qualities, at least relative to other firms in the industry.12
Multiples for small independent broker/agencies are often different from those of the large public companies. Typically, larger broker/agencies have less risk than smaller broker/agencies giving them a higher relative multiple. However, smaller agencies/brokers that are high performing relative to their competitors can achieve multiples similar to the Industry Group as well. In 2006 public brokers paid upwards of 8 times EBITDA for high performing agencies, and in some deals, multiples of greater than 10 were paid.13 Various factors such as supply/demand and competition among acquirers for top performing agencies/brokers can influence the transaction multiples in the agency acquisition market.
When valuing a smaller, privately held broker/agency, multiples derived from publicly traded companies, such as the Industry Group, and comparable transactions can be used as a starting point. However, due to the variation in risks between one private broker/agency and the next, a variety of company-specific factors, in addition to the valuation drivers discussed previously, should typically be considered. Such factors might include additional risks such as customer concentration or key-man risk.
Many factors—including growth, profitability, customer relationships, and company-specific risks—can influence the value of the broker/agency. Additionally, recent transactions and the market's current valuation of similar publicly traded companies should typically be considered in the valuation of a broker/agency. However, it is important to be aware of various forces, such as private equity buyouts, that are affecting the market's current valuation of similar companies as these forces may not pertain to the company being valued.
Future articles will address the other three industry segments: property and casualty insurers, health and life insurers, and reinsurers.
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1 Background on Insurance Intermediaries, Insurance Information Institute (2004): 7.
2 Lucas M. Parris, "Understand the Value of Your Insurance Brokerage" (2007): 6.
3 Robert J. Lieblein, Insurance M&A Insights 2007 Industry Sourcebook. (Cincinnati: The National Underwriter Co., 2007).