Furthermore, the current decline in investment income puts additional pressure on carriers to use their excess surplus to produce some kind of reasonable return.

In theory, specialized programs are expected to be less susceptible to the vagaries of the soft market in contrast to Main Street business. Insurance brokers and larger program administrators, faced with stagnant revenues, can continue to grow by PA acquisition.

In addition, private equity firms, awash with capital that needs to be invested, can purchase PAs with the expectation that in two-to-five years their interest can be resold at a handsome profit.

Insurance companies have emerged, however, as the most aggressive acquirers. Some M&A brokers, having recognized the carriers' desperation for premium growth in order to deploy their capital, have turned the situation into an opportunity to boost their PA client valuations to astounding levels.

Instead of focusing exclusively on the profits of the PA operation, the new approach is to identify the underwriting profits of the business written by the PA and require bidders to offer a multiple of earnings on both profit streams–underwriting profit as well as total agency profit.

This is particularly effective if a sizable amount of historic underwriting profit can be identified on the PA's book of business.

In any event, this approach favors acquisition almost exclusively by an insurance company which, upon acquiring the PA, can cancel existing carrier contracts, move the business “in-house” and thereby benefit from both streams of income.

Recently, PAs have been sold to insurance carriers for an outrageous multiple of their agency earnings thanks to the two-income approach. Underwriting profits often significantly exceed agency profits.

Naturally, selling owners are likely to be delighted with the efforts of their brokers, whose fees soar along with the larger valuations.

Given that the insurance companies willingly pay to acquire the books of business, why should anyone be concerned?

The above transactions can be viewed as capitalism operating at its most efficient level, and it is not the intent of this author–a proponent of the free-market economy–to question our economic system.

On a more philosophical basis, however, there are a lot of concerns that come to mind.

In the program business world, the relationship between the program administrator and the company requires a unique level of cooperation and trust. Underwriting guidelines, rates and forms are developed through hard work and input on both sides. A successful program is typically the result of years of joint development efforts.

When a PA abruptly drops its existing carrier, almost all PA contracts grant ownership of records and expirations to the PA, meaning that it will be difficult for the carrier that has been replaced to effectively compete against its erstwhile source of business, especially in a soft market.

Certainly, PAs should eventually replace carriers where there is not a good partnership fit. Likewise, carriers should do the same. However, replacing carriers in order to sell the underwriting profit to other carriers could in the long haul have an adverse impact on PAs.

Cynical carriers may, in the next hard market, insist upon PA contracts that limit or eliminate the PA's ownership of records and expirations. Yet it is through this ownership that there is a balance of power between the PA and carrier.

The carrier will work hard to keep profitable business because they know the PA has the right to move it, and the PA will work hard to make money for the carrier because they know they will have a difficult time replacing a contract cancelled for lack of profitability.

Absent full ownership of records and expirations, the PA could spend years developing a book of business, only to have the carrier go after it directly–or, alternatively, the carrier could leverage the PA midterm into accepting lopsided terms.

Another potential result of paying multiples of both agency and underwriting profit–assuming the market continues to soften–could be that carriers will inherit lower-than-forecasted profits on both income streams. If this occurs, carriers could take extreme action to recoup their sizable investment, including laying off the PA's staff or drastically re-underwriting the book of business.

Most successful PAs have prospered as effective entrepreneurial organizations that can adapt quickly to opportunities and challenges in an ever-changing marketplace.

Once they are under the umbrella of an insurance company, however, there can be a tendency for the business to be neglected, since the acquired entity has no other options. Perhaps this is not a problem for the owner who wishes to retire soon, or who is not concerned for the staff that helped them achieve past results.

However, for owners and staff expecting to stay for awhile, this may be a bitter pill to swallow.

Good results or bad, the culture of a PA is not always easy to integrate within an insurance company operation.

Furthermore, if insurance companies that have bought PAs choose to unload them for pennies on the dollar due to poor performance or a bad fit, this could depress future valuations. (In the past, there have been cases where divestitures of acquired PAs by insurance companies, at reduced valuations, have occurred.)

Notwithstanding the above arguments, there have certainly been some very successful acquisitions of PAs by insurance carriers that have worked for all parties, short term and long term. As in any acquisition scenario, chemistry and the size of the cultural gap between the organizations are key determinants of success.

All this author is suggesting is that the two-income approach to PA acquisition, while creating record valuations, may have a downside for the industry and the participants that few, if any, have considered.