Impact of Hard Market Expectations on Agency and Broker Value

Valuation Framework

A firm's valuation is generally driven by its profitability, growth prospects, and risk profile. To help illustrate the relationship between these three drivers and value, presented below is an equation known as the Gordon Growth Model, which is commonly utilized in the valuation profession.

CF represents next year's expected cash flow, k is the discount rate, which reflects risk, and g is the expected growth rate. The Gordon Growth Model can provide a helpful framework for analyzing valuation issues, particularly on a simplified basis.

Key Economic Factors

Trends and expectations in the marketplace influence valuations through one or more of the valuation drivers shown above. With respect to insurance agencies and brokers, some of the primary factors impacting these drivers are macroeconomic forces, policy pricing, competition, political/regulatory factors, and expectations for each of these going forward.

The current state of and outlook for the economy impacts agency and broker valuations by influencing expected profitability, growth prospects, and perceived risk. While the U.S. economy has shown significant signs of recovery over the past year, unemployment rates are still high relative to historical standards, with the national level equal to 9.2 percent as of March 2011. ¹ As a result, there is potential for increased demand for insurance products as the economy continues to improve and the unemployment rate decreases. In fact, some industry analysts see this as being one of the key catalysts for the predicted upcoming hard market. ² The impact of declining unemployment on valuations will depend on whether or not growth prospects and profitability are affected to a greater or lesser extent than expected, since current valuations, in theory, should already reflect current expectations for growth, profitability, and risk.

As noted above, policy pricing is also a significant driver for agencies and brokers. The pricing of insurance policies directly affects the growth potential and profitability of agencies and brokers, because commissions are generally based on a percentage of total premiums written by the insurer. As mentioned previously, some industry analysts predict a hard market over the next couple of years, which would result in higher premiums. ³ Two of the factors driving increased pricing expectations are decreasing unemployment, as indicated previously, and catastrophe losses.

With regard to catastrophe losses, insurance companies were negatively impacted during 2010 as catastrophe-related insurance claims exceeded $43 billion, compared to $27 billion in 2009, making 2010 the seventh costliest year for insurers. ⁴ As a result, industry sources indicate that insurance companies will be forced to raise prices to make up for these losses and replenish reserves. Agencies and brokers could benefit from higher premiums via increased commissions, which present an opportunity for growth. Valuation multiples already incorporate expectations for future price increases; however, multiples also reflect the uncertainty regarding timing and whether or not the increase will actually be realized. As the market begins to see the price increases actually occur, this uncertainty will be alleviated, which, in theory, would suggest an increase in valuation multiples, assuming all else is equal.

While some analysts expect pricing to increase, competition in the insurance agency and broker industry remains high and could intensify going forward. Greater competition (and/or low barriers to entry) affects valuation as it leads to lower expected profitability and growth prospects, and it could present an additional risk factor. Recently, insurance providers have sought out alternative distribution channels, now selling directly to insureds without the involvement of agencies and brokers. For example, Liberty Mutual increased its sales force to bypass agencies, while Geico invested in its website to sell products direct to consumers online. Others have created in-house servicing capabilities to compete with the risk management business of agencies and brokers. In response to increased competition, agencies and brokers are emphasizing their expertise to compete with the direct-sales models and shifting toward knowledge-based services rather than solely being an intermediary in the process. ⁵

Political and regulatory factors are also likely considered in current valuations of agencies and brokers. The insurance industry is highly regulated, thus increasing risk to insurance companies. For example, the health care reform law that recently passed led to greater uncertainty as insurance companies attempt to determine the full meaning of the law. One facet of the regulation that could significantly impact agencies and brokers is the medical loss ratio provision. This provision mandates that insurance companies spend 80 to 85 percent of premium revenue on medical care, with the remainder available for administrative expenses, which would include broker fees/commissions. As a result, insurers have been cutting commission payments to lower their administrative costs, with some insurers cutting brokerage fees by 20 to 30 percent since January 2011.

Currently, insurance companies are lobbying for an exemption from the regulation; however, it is unclear whether any will be granted. The uncertainty related to the law increases the risk profile of agencies and brokers and may significantly lower expectations for future profitability. ⁶

These key factors impact the growth potential, profitability, and risk of agencies and brokers, thus influencing valuations. With the predicted hard market in the upcoming years, some industry sources forecast revenue growth of 2.3 percent in 2011 and 5.0 percent annually through 2016. ⁷ However, as noted above, competition and political uncertainty continue to impact the risk profile of these companies, which may be negatively impacting valuations. All of these factors and others deemed relevant by the market yield the current valuation multiples exhibited by agencies and brokers.

Market Valuations

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.
• Aon, Inc.
• Brown & Brown, Inc.
• Marsh & McLennan Companies, Inc.
• National Financial Partners Corp.
• Willis Group Holdings

Industry analysts often reference enterprise value (EV)-to-earnings before interest, taxes, depreciation, and amortization (EBITDA) multiples when discussing valuation metrics for brokers and agencies. Included below are two charts illustrating trends in EV-to-EBITDA multiples.

Chart 1

Chart 2

The first chart illustrates average forward EV-to-EBITDA multiples and the projected long-term earnings per share (EPS) growth rates as of 2004 through 2010 and the year-to-date period of 2011 based on data provided by Capital IQ. The second chart illustrates average forward EV-to-EBITDA multiples compared to 1-year volatility for the Industry Group over the same period. For purposes of this analysis, 1-year volatility is utilized as a proxy for the risk associated with the Industry Group. Low volatility is assumed to suggest a low-risk profile, while high volatility indicates greater risk. According to the valuation framework presented previously, higher forecasted long-term growth rates and lower volatility would suggest higher valuation multiples. On the other hand, periods with lower projected long-term growth rates and higher volatility would typically have lower valuation multiples.

As shown in the two charts, the decline in multiples between 2006 and 2009 appeared to be attributable to a decline in the expected long-term growth rate and an increase in volatility, which were at least partially influenced by macroeconomic factors. Since then, volatility (and presumably risk) has declined to levels similar to those seen during 2004 and 2005. However, expectations for long-term growth have continued to fall and currently appear to be well below 2004–2005 levels. Nevertheless, agencies and brokers are currently exhibiting multiples similar to what they were during 2004 and 2005. This could be an indication that current valuations reflect a higher level of growth than is actually expected (i.e., the market may be overvaluing agencies and brokers relative to historical valuations given the level of expected growth). If this is the case, in the event a hard market comes to fruition, valuations may not have as much upside potential as some might think. However, it remains to be seen how the market will price the various impacts to the valuation drivers that we have discussed.

While some analysts expect a hard market in the coming years, there is uncertainty regarding the impact to valuations of insurance agencies and brokers. Based on the valuation framework presented in this article, as the effects of a hard market are realized, valuation multiples would tend to increase as uncertainty regarding expectations is alleviated; however, given the level of current valuations in light of the relatively low growth expectations, the impact of a hard market may be more modest than some analysts expect.