Power Play

Own a brokerage and feel like selling? It is unlikely any solid business will have much difficulty finding a buyer… or an equity partner… or someone to advance a bit of working cash.

It appears mergers and acquisitions (M&A) activity involving brokerages – whether insurer to broker or broker to broker – is likely to still have some legs over the next year to two.

Of course, brokerages are not the only operations up for grabs these days. But what does all this activity ultimately mean for insurers, brokers and consumers who are looking for (and expecting) ever-increasing choice, flexibility and responsive service?

DRIVE TO BUY

John McArthur, president of John C. McArthur & Associates, Inc., says the increasing level of insurance broker activity is being driven by the want for increased market share. McArthur has headed two major insurance groups before getting into consulting work, where his current focus is M&A transactions, almost exclusively involving insurance brokers, with almost all of his clients partially owned or financed by major insurance groups.

A large insurer like Intact, for example, likely needs to write $600 million to $700 million worth of new business every year just to keep the top line flat, McArthur suggests. “There’s just not that much new business around, so the only way they can accomplish that is to get their arms around other insurance companies’ portfolios,” he comments.

“In this continued low-interest rate environment, which is with us now for some time, we’re seeing a recognition by industry participants that underwriting profitability needs to remain a focus and that means gaining economies of scale through operations, but also through, importantly, underwriting,” says Catherine Code, senior advisor to Deloitte’s Financial Advisory Practice.

“Companies will continue to acquire brokerages,” adds Greg Purdy, managing partner with Pathway Partners Ltd. “There is significant pressure to gain more control of distribution,” Purdy says. “We may see some transactions on the company side that have a long-term strategic aspect to them. We may see companies positioning themselves more broadly as financial service providers,” he adds.

“I believe there is an increased chance the larger purchases may go the route of broker to company,” Karen Slaunwhite, executive director of the Insurance Brokers Association of Nova Scotia, says.

However, Peter Morris, vice president of Strategic Resource Consultants, suggests that moves by insurers to acquire brokerages may be tailing off, perhaps “because the insurers who wish to own brokerages are reaching the saturation point in terms of their holdings.”

Randy Carroll, chief executive officer of the Insurance Brokers Association of Ontario (IBAO), also reports that activity is down, this time for broker-to-broker transactions. That said, the activity that has been taking place over the course of 2013 and into 2014 shows some real positives for the broker channel, Carroll suggests.

“There has been a bit of a shift, where we see more brokers partnering up with brokers and remaining as independent operators than we have seen brokers selling to insurers, losing their independence,” Carroll comments.

Be it insurer or broker, what brokerages are attractive targets?

“I don’t think there would be a brokerage out there that wouldn’t be attractive,” says Carroll. “It would be attractive at what cost?” Factors such as location, mix of business, loss ratios and longevity of staff will be among those that come into play, he notes, “which are all part of that determining factor of what the multiple looks like.”

McArthur suggests that targets run the gamut, “all the way from that very small mom-and-pop shop or even books of business controlled by producers who have an equity position and want to retire and are prepared to sell that.”

RECENT ACTIVITY

Perhaps the most interesting – certainly among the largest – of recent or planned transactions are the purchase of State Farm Canada’s property and casualty and life insurance business by Desjardins Group, the Travelers Companies Inc. acquisition of The Dominion and the reported sale of Noraxis Capital Corp., a network of 17 regional insurance brokerages, by RSA Insurance Group.

Citing the Travelers/Dominion deal, Morris says “although there is now one insurer where there once was two, it’s not as though they were head-to-head competitors beforehand. If anything, for brokerages that previously had only one of these carriers in their office, there is now an opportunity to tap into the lines of business offered by both.”

John Belyea, chief operating officer at Moore-McLean Insurance Group, does not expect consumers or brokers to see much difference as a result of the deal. “Travelers in Canada wasn’t playing in the personal lines market; they weren’t playing in the small office package market. They were a much more specialty lines underwriter, larger corporate risk, and your typical insurance broker didn’t even do business with them.”

The influence of the planned Noraxis sale, however, may not be so clear. “It’s a collection of very large brokerages that is very appetizing, particularly for a party that’s not in our marketplace right now, to be able to get in in one fell swoop and have a significant presence, a significant foothold,” Belyea suggests.

“The anticipated sale of Noraxis will alter the commercial lines landscape in Canada,” Purdy predicts. “Many suspect that a U.S.-based brokerage will purchase the business. This is causing some commercial lines brokerages to re-evaluate their growth strategies.”

Some transactions, though, appear to be about investment, Morris says, citing the move by La Caisse de depot, a pension fund manager in Quebec, to invest in commercial insurance broker, BFL Canada. Among La Caisse’s goals? To help the broker grow its presence and focus on acquisitions.

IMPACT ON INDEPENDENCE

Despite insurer consolidation to date, Belyea does not think the impact on brokers through to their clients has been significant. Even with Intact’s growth, for example, he notes that with “the size of the p&c industry as a whole, they still do not have anywhere near the market share you typically see in the market leader in other industries, even in other financial services businesses,” he notes.

“We’re still in a highly fragmented market in Canada, with the top five still representing less than 50% of premium volume,” Code points out. “And so further consolidation on many levels will help to improve the stability and the risk diversification and capital strengths of the industry,” she suggests.

One way that brokerages may be affected relates to their ultimate independence and ability to offer consumers choice. Consider that with brokers looking to play by making acquisitions themselves, they are likely to need banking, funding or equity partners given the current multiples for brokerages.

If it makes sense, brokers may get some capital from their insurers, if that is in the minority, “without losing their independence,” Carroll suggests.

McArthur, however, is not convinced that is possible. “The brokerage is expected to place more business with the insurance company that is financing the deal,” he argues.

Brokerages “will favour the company that brought them to the dance, whether it’s a loan or an equity position.”

In light of the “extraordinary high prices that brokers are changing hands at for the moment,” McArthur says that in most cases, it could take a buyer 10-plus years to pay off the loan through the cash flow the business generates. If an insurer assumes a 25% equity position, however, it may be possible to pay off the loan in, say, seven years.

That agreement is likely to include right of refusal for the term of the loan, and maybe a couple of years more, he reports. The result? “Insurance companies are getting a stranglehold on distribution in Canada,” he c
ontends.

What Morris finds particularly troubling is when a brokerage arranges to place all its personal lines business with the acquiring carrier and the other markets in the broker’s office are then used for commercial lines business only.

“The consumer may continue to believe that their ‘broker’ is shopping the market on their behalf. In fact, the consumer will be insured by the acquiring carrier regardless of whether or not it is to the consumer’s advantage,” he says.

Carroll disagrees insurer funding arrangements will adversely affect customer choice. “If we had a capital crunch and capital wasn’t available elsewhere, it might be a concern, but it’s not,” he says. In line with their code of ethics, brokers must ensure “the decisions that they make are in the best interests of the consumer,” not themselves or “insurers just because they are a funding partner.”

Purdy says there will “absolutely” be an impact on customer choice as consolidation on the insurance company side will reduce the variety of products available.

But Belyea expects that for there to be a real impact on consumer choice, “you need an RSA to go to Aviva, or Aviva to Intact, in terms of bringing that mainline, large multi-line insurer and consolidating into another insurer.”

“Larger organizations, both on the broker and company side will benefit from scale,” Purdy points out. “As the consumer continues to change in how they purchase insurance, we will see shifts towards more marketing and investment in branding,” he expects.

Independent brokers realize that they need to get bigger and make acquisitions themselves, says Belyea. Size can help, he explains, because it gives very large brokerages clout with insurers. “They have to play with you.”

Belyea notes, however, that if a brokerage is looking to grow and become a large regional player, for example, “there has to be an element of specialization. That doesn’t mean you do just one thing. Maybe you do three, four even five things very well, and that accounts for maybe 80% of your business.”

Jessica Goldberg, a partner in Deloitte’s Monitor Deloitte Practice, sees “brokers more proactively looking to partner with each other, both across geographies and potentially within the same geographies. Given the low interest rate environment, there’s an abundance of capital in the system that might be helpful to support those kinds of transactions.”

MULTIPLE CONCERNS

But wanting is not necessarily getting. Current multiples is having an influence on who the players are.

“Compared to any other potential purchaser, an insurer has the opportunity to earn income not only from the operation of the brokerage but, in addition, from any underwriting profit it earns on an increase in premium written. This allows an insurer to be able to justify paying more for a brokerage than any other bidder,” Morris says.

Belyea suggests that current valuations are artificially inflated. He notes that in 2002 when insurers stopped giving out funds for portfolio transfers “brokerage values dropped by about a quarter overnight. There’s a risk that can happen.”

McArthur puts the current multiples for independent brokerages at about 3 to 3.5 times, although he is not convinced those numbers will hold much longer. If the owner of a smaller brokerage is being offered 3.25 times now, McArthur says, he would recommend the owner take it, citing factors such as eroding market share because of competition from direct writers, the mandated auto rate reduction in Ontario and inflation in the loss cost area.

“I think there’s been a bit of inertia in doing anything because there’s always a belief that valuations will get higher,” Belyea says. “I’m not sure I would bring that to the bank right now because there could be a moderation, and maybe that’s going to encourage some to sell.”

Beyond Noraxis, Purdy says that “there has been a marked change in the activity level of Johnson (part of RSA Group since 1997), which has been an active buyer at premium multiples. With Johnson reducing its purchases, we may see a reduction in the multiples being offered.”

That may be good for brokerages looking to grow. With the potential for multiples to come down, says Purdy, “we should see more traditional broker-to-broker deals, as many have been priced out of the market in the past few years.”

Slaunwhite suggests “broker-to-broker transactions are definitely a positive option for the brokerage community, the industry as a whole and, ultimately, for the consumer as a broker provides the consumer with choice and the broker will find the product that best meets the individual needs of the client.”

Carroll says it is difficult to say if a multiple is inflated or not, emphasizing the “determining factor is how bad the individual who’s purchasing actually wants to buy the brokerage.”

Talking to brokers who have actually sold, he says, shows that there are many variables that need to be taken into account. These include associated costs, retention after the transaction, and determining what is discounted because there are certain aspects of the book of business that do not stay with the book.

“What I have seen is we’ve had brokers that have been successful in competing with those multiples with insurers who have not been willing to ante up to match what brokers are offering,” Carroll says.

A lot of that has to do with the way the transactions are being funded. “There used to be short tails on funding,” he notes, citing terms of five to 10 years, but there are now “more flexibilities with regard to the term of repayment.”

Belyea suggests longer amortization periods, sometimes 15 years, are of concern. “Brokerages are potentially putting themselves at financial risk by taking such a leap. It wasn’t that long ago that if a brokerage didn’t pay itself back within five to seven years after you acquired it, you didn’t acquire it; it didn’t make sense.”

PERSONAL AND COMMERCIAL

“Long term, I don’t see how independent brokers – whether they’re partially owned by an insurance company or financed by an insurance company or not – can continue to compete in the personal lines business with the direct writers,” says McArthur. The largest brokerage is likely to have an expense ratio of 30% or more, compared to about 18.5% to 23% for direct writers.

Citing the move by the Ontario government to reduce auto premiums by 15%, Morris says there are questions as to the long-term profitability of auto insurance in the province. “This being the case, you would expect there would be less interest in acquiring an insurer or brokerage that is heavily exposed in this area.”

While McArthur’s view about brokers in personal lines using traditional models is none too rosy, he suggests the commercial side is an entirely different animal. “Direct writers are really not in that space,” he says, adding that “commercial lines is a very complex area and there’s a niche for professional advice.”

McArthur says he is starting to see a trend in which brokerage owners are spinning off their personal lines business and focusing on commercial lines.

Purdy, too, believes there will be “a shift more towards commercial lines-oriented brokerages,” he says. “The challenge for brokers is to get to the table as most transactions are determined by carriers and not taken to an open market.”

ABILITY TO COMPETE

To compete, brokers need to go through a process of change, says Carroll, emphasizing the status quo as it relates to the distribution model is not an option. “Customers aren’t traditional anymore,” he says. “Brokers need to make changes within their models so that it allows the consumer to deal with them the way that the consumer wants to deal with them.”

Says Carroll, “The easier I can make it for the consumer, the happier the consumer is going to be, the more referrals I’m going to get and the longer I’m going to keep that consumer on the books.”

Purdy agrees. “Brokers are and will nee
d to continue to respond to the changing consumer. They will need to spend more effective time communicating with their clients. This will take on different forms as social media is more broadly used and technology evolves,” he says.

The more sophisticated-thinking brokers understand that in order to play effectively going forward, “they’ll need to do more and different things around things like mobile, online and telematics,” says Goldberg.

For truly independent brokers, Belyea suggests that there is “a wonderful opportunity” to obtain a competitive advantage in the marketplace.

“Consumers, whether it’s an individual, a personal consumer, whether it’s a corporate consumer, are going to want to know they’re dealing with an organization that is truly independent and is going to act in their best interest and not just move their book, their coverages, their policies, to Insurer A because Insurer A happens to own them, control them, and wants that volume,” he says.

But questions remain. “What we don’t know is if you’re independent and don’t have those connections, where does that leave us with respect to certain markets? It’s clear right now that acquisition opportunities which used to flow through insurers, they will not direct them to a brokerage that they do not feel is, quote, in their hand,” Belyea suggests.

“The value of having an independent consultant, from a consumer’s perspective, is more important today than it ever has been,” Carroll says. “We’re moving away from a commodity model back into an advice-based model,” he says.

But Belyea sees a rough road ahead for internal perpetuation. “We’re seeing owners now have an expectation that they’re going to get three times for their shares. You cannot sell a business to your own employees and other shareholders at a three times valuation. The math just doesn’t work, unless you run this thing out 15, 20 years,” he says.

Something closer to about 2.25 for a decently run brokerage would help foster internal perpetuation, Belyea offers. “I think us brokers are getting a little greedy because we’re seeing these valuations and by doing so, we’re actually putting at risk our independence and the existence of the true independent broker.”

DOWN THE ROAD

So how are things looking a little farther down the road?

“The move by RSA to divest itself of Noraxis will make it unlikely that RSA will be bidding on other insurance brokerages anytime soon. The withdrawal of a major insurer from the broker-acquisition market may take some steam out of the market to purchase brokerages,” Morris predicts.

With Johnson now out – citing the issues in the United Kingdom – “I think you might see a slight softening in terms of price, but there’s still a great demand,” Belyea comments.

On the commercial side, “I think we will see some larger U.S.-based brokerages acquiring Canadian operations, particularly in commercial lines,” Purdy points out.

Belyea notes he is curious to see if the more traditional American model – where only a certain percentage of the price is guaranteed up front and the brokerage must hit growth targets to earn it way up to the higher valuation – is going to play in Canada.

If it does, “the model for independent brokers acquiring other independent brokers makes sense,” he suggests.

McArthur says he believes that as soon as interest rates start moving up, “we’re going to see significant rate increase. And that will then cause the price being paid for brokerages to drop. From now until then, it’s a seller’s market.”