The soft market is in full swing. Insurance premium growth is a far cry from the hard market peak of 2002. Despite a deluge of catastrophic losses, which more than doubled over the prior year, property-casualty insurance company surplus improved during 2004.

Insurer performance was buoyed by the first underwriting profit in 26 years, and a combined ratio of 98.1 percent clearly demonstrates that rates are adequate.

Meanwhile, the Federal Reserve has raised the benchmark federal funds rate for the ninth time in a year.

When stronger surplus, rate adequacy and an increase in interest rates converge, you get a marked increase in investment income and, hence, cash-flow underwriting.

If the stock market gains momentum, rates will free-fall.

However, given investor pressure on insurers to maintain their current rates of return, companies will not burn profit as in prior cycles. The increase in interest income on improved surplus will offset much of the coming rate reductions.

However, the balance of the softening will be supported by a focus on enhancing operational efficiency. To accomplish this, insurers will increase agency volume requirements and maintain fewer appointments.

Agencies that have failed to reinvest in their production staff, and are incapable of organic growth, are clogging the arteries of the carriers, which will weed out such firms at an increased rate.

Expanded capacity will be reallocated and reserved for agencies with good loss ratios, commitment to volume increases and an organic-growth culture that supports profitable premium growth.

Given these metrics, one would expect many agencies to throw in the towel and sell. In reality, the number of merger and acquisition transactions involving the sale of agencies and brokerage firms during the first six months is down substantially from the same period last year.

Many speculate that new compliance standards and the insurance brokerage contingency fee scandals have spurred the slowdown. Nothing is further from the truth.

The slowdown is not a response to demand but to supply. Buyers are desperately pursuing acquisitions to maintain growth, but sellers are becoming scarce and are in high demand.

Five years ago, supply and demand were balanced. Poor and peak performers were motivated to sell to achieve liquidity nirvana as agency value was at a 15-year high. Today, while poor performers are waving the white flag, quality agency sellers are becoming increasingly rare.

Most quality agencies that were inclined to sell have sold. Those that remain are less motivated to align with a bank because there is less opportunity to become a foundation agency and lead a major market territory.

Aligning with a broker is not as attractive to some agencies because of the contingency fee scandals and the concern a buyer's short-term focus on profits could spell agency staffing cuts.

Quality agencies capable of organic production that remain in favor with underwriters are content to remain independent. Their independence is driving long-term value, given that high demand and limited supply will sustain valuations for the foreseeable future.

The continued soft market will drive banks, and brokers, to become more desperate for acquisitions, further dwindling the supply of agencies.

As a result of this reality, sellers recognize they have alternatives. The current situation will keep valuations strong. As a result, they can do deals on their terms and when there is a unique cultural fit.

This acquisition demand is reflected in the price agencies can receive. Including earn-out consideration, pricing metrics remain strong for peak performing agencies.

Brokers are paying about 7.25-times EBITDA (Earnings Before Interest, Taxes, Depreciation and Amortization) and banks are paying around eight-times for foundation agencies (and 6.8-times for subsequent firms in market transactions). Despite the soft market, the price for quality agencies is up slightly over 2003 figures as public brokers and banks fight over the draining pool.

Driving the need to acquire, for brokers, is the difficulty to generate enough organic growth, which has continued to drop over the past four years. To justify market growth expectations, they have been forced to disclose their current deal pipeline and the expected annual acquisition growth to the investment community. This only serves to feed the need for more deals.

These experienced buyers have entered this difficult market with a well-oiled acquisition machine.

To achieve and exceed earnings growth targets, brokers have been acquiring high-margin, lower-EBITDA multiple targets such as wholesalers. To diversify revenue, brokers have been scrounging to acquire benefits agencies.

They have also leveraged margin growth by fine-tuning the integration of acquired agencies to wring out operational efficiency at a faster rate. The need for speed to post revenue and earnings growth has shortened the deal closing process to less than 45 days in some cases.

Banks continue to target insurance agencies to drive non-interest income, complete the build-out of the insurance operation footprint, and to create an integrated financial services consultative solution platform aimed at the commercial marketplace.

While some may mock the bank's strategy, bank-owned agencies are posting impressive organic growth rates. The rationalization that banks will get in, then out of the business has dissipated. The top-30 bank-owned agencies have acquired their way to amass more than $3 billion in p-c and group health revenue in five short years.

The storm is raging and change is the only constant. One certainty that will prevail through this sea change is that those who can produce will not perish.

Agencies that prepared for this opportunity created a predictable organic-growth culture supported by accountability, discipline and a process to proactively over-serve the customer. Such agencies will not only survive during this cycle but will thrive and be highly sought after by a seemingly endless number of buyers.

Agencies of this caliber will be in the coveted position of both remaining in control of their destiny and maximizing agency value.

Those who have not prepared are running for shelter.

John M. Wepler is a shareholer and executive vice president with the agency management consulting and investment banking firm MarshBerry, based in Concord, Ohio. MarshBerry owns and operates APPEX (Agency Peak Performance EXchange and BANK (Bank Agency network).

Quotebox, with mug:

“Agencies that have failed to reinvest in their production staff, and are incapable of organic growth, are clogging the arteries of carriers, which will weed out such firms at an increased rate.”

John M. Wepler

Callout:

The storm is raging and change is the only constant. One certainty that will prevail through this sea change is that those who can produce will not perish.

Flag: Breakdown

Head: 2004 Growth Rates By Segment

Caption:

Bank-owned agencies are posting impressive organic growth rates. The top-30 bank-owned agencies have amassed over $3 billion in p-c and group health revenue in five years.