When it comes to the valuation of insurance brokerages, is the going rate driven up by the presence of insurance companies as potential purchasers? Certainly this is the feeling of many within the brokerage community. Just because many people believe this to be true doesn’t necessarily make it so. But I think there are valid reasons to explain why an insurer might pay more for a brokerage than what another buyer would offer.
Certainly an insurer has deeper pockets than most other buyers. This doesn’t mean an insurer will outbid competing purchasers just because it has the money to do so. At the end of the day, an insurer owes a duty to its shareholders to pay a justifiable price for any purchase it makes. The question, then, is whether there are factors that would justify an insurer paying a higher price compared to other bidders. I would argue there are such factors.
Typically the selling price of an insurance brokerage is expressed as a multiple of commission income. In reality, though, the driving factor in valuing an insurance brokerage – or virtually any other business for that matter – is earnings before interest, taxation, depreciation and amortisation (EBITDA). A company’s EBITDA provides a good approximation of the company’s cash flow. Since a buyer will look to pay for an acquisition out of the purchased company’s cash flow, before making an offer it is important for the buyer to have an idea what its cash flow will be. Once a potential bidder has determined its expected EBITDA from a purchase, the offer price will be a pre-determined multiple of EBITDA.
In deciding what multiple of EBITDA to offer, the market for insurance brokerages is driven by many of the same factors common to all markets. Chief among these is supply and demand. For many years now, the number of brokerages looking to buy has far outstripped the number of brokerages looking to sell. I would argue it is the imbalance of supply and demand, more than anything else, that has driven up the price at which brokerages are being traded. Even when the owner of a brokerage is planning to pass ownership to other hands, it is often the case that there is a natural buyer waiting in the wings. It could be a younger family member or it could be an unrelated employee who is already working in the brokerage. The presence of these natural heirs apparent reduces the number of brokerages that go on the open market. This reduces the available supply which, in turn, adds to the imbalance between supply and demand.
So any buyer, whether an insurer or another brokerage, should expect to pay a premium to acquire a brokerage in today’s market. Why would an insurer feel justified in offering more than other bidders? I think there are a few reasons.
One is to lock up its position within a brokerage. Heidi Sevcik, President and CEO of Gore Mutual Insurance Company, cited this as one of the reasons for Gore’s recent purchase of Howard Noble Insurance. According to Ms. Sevcik, ‘This acquisition was really about continuing that partnership and, more importantly, securing that broker in the broker channel.’ It would be difficult to put a price tag on this factor, and I am certainly not suggesting Gore drove up its offer in order to secure its position in the brokerage. Still, a desire to lock up its position in a brokerage could lead an insurer to pay an enhanced price for that brokerage. Especially in a marketplace where your competitors are securing positions within key brokerages, an insurer could be forgiven if it was prepared to pay highly for a brokerage as a part of a strategy to defend itself against the purchase of a key brokerage by another insurer.
An increase in income from underwriting profit is another factor that might cause an insurer to outbid other buyers. Any buyer of a brokerage will take ownership of the brokerage’s commission income. However, the underwriting profit the brokerage earns is something that is only available to an insurer: a purchasing brokerage would not have access to this cash flow. Assuming the purchasing insurer is already one of the brokerage’s markets, that insurer would already be capturing the underwriting profit from its existing share of the brokerage’s business. If, however, by taking an ownership position in the brokerage, an insurer is able to increase its share of the brokerage’s underwriting profit, that increase in underwriting profit is an income stream that is only available to a purchasing insurer. And, of course, this increase in the purchasing insurer’s market share within the brokerage comes at the expense of all the other markets within the brokerage. As noted by Ms. Sevcik during the CEO panel at the IBAO convention, a change in the ownership of a brokerage quite often leads to an insurer losing its book of business within the brokerage to a competitor.
Another possible reason for an insurer to outbid other potential buyers is the issue of contingent profit commission (CPC) payments. Any purchaser of a brokerage will capture future CPC payments made to the brokerage. The difference for an insurer that owns a brokerage is that, instead of that insurer’s CPC payments going out the door and into the hands of a third-party owner, those future CPC payments will now stay within the family – either the insurer itself or a sister company within a financial group. This repatriation of its CPC payments could end up being a significant factor for an insurer when figuring out what to pay for a brokerage.
There is no evidence that insurers take any of these additional factors into account when determining what to pay for a brokerage: those decisions are made behind closed doors. Still, if it is true that insurers will pay more for a brokerage than other potential bidders, the factors I have cited here would help explain why that might be the case.
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