We have written this piece to share our observations on issues that have an impact on mergers and acquisitions (M&A) activity in the Canadian Property and Casualty (P&C) Insurance Industry. These observations are based on divestiture processes we have been engaged on, discussions with other industry advisors, brokers and underwriters who have recently been involved in transactions. While we make no predictions on the direction of pricing, or the number of transactions one might expect in the coming years, there are changes in the marketplace that are worth noting. More specifically, we will address Private Equity, On-line distribution and family and/or management buyouts.
Private Equity (PE) owned brokerages have been active in the marketplace for a number of years. They are aggressively competing with other buyers for a shrinking population of available brokerages as they execute their roll-up strategy.
A typical PE approach is to buy a business, improve management systems and then grow the bottom line through sales initiatives, bolt on acquisitions and efficiency improvements, with the end goal of selling in four to seven years. The increase in value comes from improving total earnings before interest, tax, depreciation and amortization (EBITDA) and increasing the scale of the operations.
PE firms that are active in the Canadian P&C environment are all following the same playbook, with some notable exceptions. Their offering can be attractive in that they often do not require the brokerage to change its name, they leave most of the internal systems in place and they give the brokerage owner the opportunity to roll some equity into the PE fund with the expectation of a second payday. With a shorter investment horizon, it makes sense that the focus would not be on making longer term investments in the brokerage. The goal is squarely focused on increasing EBITDA and scale.
This strategy requires that the PE firm buys at the right price. There is a perception that PE firms pay the highest prices, which we think is incorrect. PE firms are disciplined purchasers and their strategy depends on buying at the right price to ensure an appropriate return on exit. Understanding the motivation and goals of a purchaser is an important part of any divestiture process.
On-line Insurance Distribution
On-line distribution of P&C Insurance is already impacting M&A activity and pricing. At the moment, the attention is focused on personal lines books. We believe the market is feeling the increased risk of disruption from direct to consumer platforms. It is our experience that potential purchasers are more careful when evaluating personal lines books of business as they are looking at the ability to sustain the business as insurance distribution evolves. They are also evaluating how effectively that book might be transitioned into broker controlled on-line platforms.
It is our view that consumers understand that insurance is a complex product with serious consequences if they do not buy right. The broker has an important role to play in recommending the right product to the customer. Having said that, consumers are still demanding more effective ways to purchase insurance and price is always at the forefront.
Recently, we have seen some impressive on-line platforms that work well with a broker distribution model. The bottle neck and dilemma faced by both brokers and insurance companies, is how the on-line platforms are to interface with the insurers in a standardized manner. Application programming interfaces (API) describes the technology that allows the on-line platform to access and communicate the underwriting and policy issuance process at the Insurance Company. The business drivers for the P&C industry are the speed in which a policy can be issued and the expanded ability to reach existing and new customers in an efficient manner.
In Canada, brokers have generally been successful in defending against pure direct insurance distribution models. Despite that, brokers must be prepared to develop more efficient ways to deliver insurance to the consumer while still being able to provide the consumer professional advice if needed. At its core, a brokerages’ value is directly related to the cash flow that can be earned from the book of business and the risk associated with either growing or losing that cash flow. New forms of distribution create both opportunities and risks. Brokers and Underwriters are now faced with the decision of how to use technology to protect their current customer relationships, as well as attract new customers.
Those brokers who are able to use on-line distribution as part of their service offerings will be well positioned to both grow, as well as protect the enterprise value of their businesses. Many brokers are addressing this issue, but it remains to be seen exactly what it will look like.
In the meantime, the market appears to be bifurcating. Certain purchasers are well positioned and willing to purchase large personal lines books while others are considerably more cautious and would prefer to focus on commercial lines.
Family Transition and Management Buy-Outs
The orderly transition of a brokerage to either family members or existing management is one of the most exciting and growing areas of our practice. While the concept is simple, it requires a considerable amount of planning and preparation.
The first, and most important part of the process, is for current ownership to commit to the process of transition. To be clear, it is easier to prepare a business for sale and run an auction to get the highest price and best terms than it is to transition ownership. An ownership transition plan can be complicated, delay the ultimate monetization of your life’s work and be frustrating to put in place.
Having said that, the benefits can far outweigh the costs. The brokerage owner can develop and execute a staged exit plan well before their retirement. Money can be taken off the table while you are still young enough to enjoy it, and it allows a new generation of leaders to take what you built to the next level with new energy and ideas. It has been our experience that a well-executed transition plan can leave the current ownership and the organization in a good place financially and emotionally.
A transition plan typically addresses:
- A personal financial plan
- A pricing analysis
- A financing plan
- Terms and conditions of the deal
- Income tax issues
- Shareholder agreements
It is our advice that both a family transition and a management buyout be undertaken as an arm’s-length transaction at fair market value. There are many ways that a vendor can facilitate their family members transition to ownership without lowering the price.
One of the changes in the industry that has allowed more management transitions to take place is the increased availability of capital. As banks and other lenders have become more comfortable with the underlying value of an insurance book of business, they have been more open and are actively offering loans and other forms of financing to facilitate these deals.
In closing, we would like to stress that there continues to be great opportunities for brokers in P&C insurance distribution. Yes, there are changes to distribution channels and how brokers transition to new owners, but the fundamental need for insurance products remains and the reliability of cash flow will continue to fuel demand for well managed books of business.
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