Insurance Brokers Navigating Difficult Markets
Insurance broker valuations look attractive amid persistent market headwinds.
Insurance brokers have been buffeted by a variety of headwinds in recent years. Soft insurance pricing, a bad recession, record-low short-term interest rates, and an upheaval in regulatory treatment of commission revenue came together to negatively impact the brokers. The arrival and persistence of these factors has tested the patience of investors. But the difficult environment has also produced attractive valuations in an industry we view as fundamentally attractive.
Brokerage margins and revenue growth have been depressed compared to their longer-term performances, and we think this group can produce better growth as well as higher profitability in a more normalized environment. We like the economic 'moatiness' of the brokers as a general rule; this is a business with low capital requirements playing an important intermediary role that produces value and good margins by aggregating buying power. Brokers can also help insurers economize on marketing costs and manage adverse selection and moral hazard. They are a relatively safe financial services sector investment, as well.
The recent headwinds may not turn to tailwinds soon, but patient long-term investors may find it worth the wait. We think investors with a longer perspective can find significant value in this sector today.
To grasp the broker's current situation, we need to understand the four factors that have weighed on results in recent years.
Weak Insurance Rates
Persistently weak insurance premium rates have weighed on broker revenue. Commission volume depends on the premium revenue delivered to insurance companies, and commercial premium rates have been declining for about six years now. But the insurance market is notoriously cyclical, with periods of declining rates interrupted by intervals of sharp price increases. For some perspective, here's a look at one industry survey worth keeping an eye on, a quarterly survey by the Council of Insurance Agents and Brokers (www.ciab.org) that has been conducted since 2000. This chart shows the average rate change for commercial market insurance rates paid for middle-market accounts. When markets harden, as they did in 2000 and 2001, the increases can be pretty significant.
A Bad Recession
Insurance brokerage is fairly steady but not an especially recession-resilient business. The demand for insurance never goes away, but the volume and profitability of distributors certainly depend on economic conditions. For example, all the publicly-traded brokers provide intermediation, claims processing and consulting services that depend on employment growth. And the larger firms have developed global footprints that have been exposed in recent years to the sharpest contraction in international trade since the Great Depression. More generally, weak real estate and other asset values have dampened the wealth preservation demand for insurance. The recessionary impact on the brokers has been joined at the hip with soft insurance rates, and the coincidence of these headwinds stands in marked contrast with the 2001 recession, which developed amid hardening insurance markets and rising premium rates.
Near-Zero Short-term Interest Rates
The Great Recession has seen Federal Reserve monetary policy produce an extended period of the lowest short-term interest rates since the Great Depression as well. As intermediaries, brokers earn investment revenue in part on the float from funds paid by clients through the brokers to insurance companies, and in turn, as insurance companies pay funds to brokers for claims payments to their insured clients. Low short-term interest rates have sharply curtailed their related investment income.
Regulatory Developments and Commission Revenue
Issues here date back to 2004, when various state authorities found fault with industry compensation practices. Brokers' commissions have long included base as well as supplemental or 'contingent' commissions. The latter can reflect the volume and/or profitability of business delivered to insurance companies. These commissions can be abused, but they first developed as a way to help align the interests of brokers, customers, and insurance companies in developing good risk management practices and controlling loss costs. We don't view them as inherently bad, but various state authorities began banning the larger publicly-traded firms from receiving them beginning in 2004, even as the vast majority of smaller firms in the fragmented industry were allowed to continue to take them.
We haven't had a clean break with the past, and we don't expect all of these headwinds to disperse immediately, but we have seen some incremental improvements in certain areas.
Weak Insurance Rates are Staying Weak, With Some Exceptions
There has been little change in trend on this front. Industry surveys and reports from the brokerage firms suggest premium rates continue to soften, in general, even after the significant first-quarter catastrophe losses. A few years ago, we were anticipating some hardening in rates following the shock to carrier capital following the investment crisis of 2007-08. But that simply hasn't come to pass, as capital markets have rallied sharply and reversed many of the investment losses taken during the crisis. Another important reason has been government support propping up the weaker insurers that otherwise would have exited the market. Some business lines have seen firming prices in 2010, but the overall industry still suffers from excess capacity and it may take quite some time for this to change. We expect it to change over time.
An Economic Recovery Has Been Developing
The U.S. economy stopped contracting in mid-2009. Employment has been rising, albeit relatively slowly, while international trade has been growing again. As noted above, labor markets matter for the brokers in some important ways, and one reason for the relatively weak recovery in payrolls has had specific implications for the brokers as well. The brokers' employment-related business lines like workers' comp, human resource consulting, and claims processing services have yet to recover, and the pace and sustainability of economic recovery more generally has come under greater question in recent months, particularly with the troubles in Europe. But like the implications of persistently weak insurance rates, we think the still-tentative economic recovery strengthens the long-term investment case for the brokers, as valuations appear driven more closely by recent weakness rather than future potential.
Commission Regulatory Uncertainty Being Resolved
There has been more progress on this score for the brokers than in the other factors. In July of 2009, Arthur J. Gallagher (AJG) won over the Illinois Attorney General to its arguments that the ban on its contingent commissions didn't make sense, at least in part in light of the widespread continuing practice among smaller brokers. Gallagher's previous agreement forbidding those commissions was scrapped. In turn, the other publicly traded brokers have reached agreements with regulatory authorities allowing them to take this compensation again. The market had already been developing alternatives to replace the lost income, and some firms aren't going to take these payments, at least explicitly. But the new environment and the emphasis on transparency still looks like a plus after the uncertainty on this score in recent years.
So the headwinds have been easing, a bit, and from a longer-term perspective, we think the fact that the rain is still falling in a few places spells opportunity for patient investors. Below is a look at the brokers we cover. At recent prices we like Arthur J. Gallagher (AJG) and Marsh & McLennan Companies (MMC) the most right now.
Bill Bergman does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.