By Catherine Oak, CRM, CIC
Minding Your Business
The insurance industry is so intertwined into the economy and society, that just about any noticeable change in either will have some impact for the insurance industry.
That is why it is imperative for agency owners to watch and learn about major trends when they start. Following are the seven key trends that insurance agencies should be tracking for 2020.
- Natural Disasters’ Effect on Insurance
Insurance companies will need to rethink the underwriting and models used in areas prone to natural disasters. The spread of concentrated housing into previous rural areas has exacerbated the losses due to natural disasters in recent years, whether its hurricanes in the east, tornados in the mid-west or fires in the west.
The typical approach by insurance companies after a natural disaster is to apply for rate increase and/or plan modifications, non-renew risks in disaster prone areas or add more underwriting restrictions. However, insurance regulators are pushing back and demanding more from the insurance companies. In response to the wave of non-renewals and cancellation in fire-prone areas, California imposed a one-year moratorium that prevents insurers from canceling customers in areas impacted by recent wildfires.
The consulting firm Milliman estimates that the combined 2017 and 2018 wildfires in California wiped out about twice the underwriting profits made in the state for the past 26 years! Needless to say, carriers see California as no longer profitable and subject to extreme risk exposure. So, regulators will need to work with the insurance companies to strike a plan that works for both the insured and the insurers.
A big issue for California, as well as many other states is that regulators base the pricing of insurance on historical experience, not projections for the future. The California wildfires of 2017 and 2018 were anomalies that bypass the current method of pricing insurance.
Insurance agencies don’t have a lot of clout to help resolve this problem at the high level, but they can help their own clients with a few small steps. Educating the client on how they can mitigate risks to fires, floods, hurricanes, etc., is very helpful. We also advise agencies to review with the client the limitations of their current coverage and then offer any new options available. People will still need insurance, despite the regular threat of natural disasters. So, agents will need to work with the way the system works now.
We advise agency producers to draft a letter to clients letting them know of the limitations of the coverage they can now provide, such as Fair Plans or Lloyd’s of London coverage to make sure that if another natural disaster occurs, the agency’s E&O exposure and coverage is not at stake.
- Health Care Act Legislation
Now two years into the Trump administration, there is still no major legislative change to the Affordable Care Act (ACA), but some changes did occur. Despite the lack of new legislation, the few executive actions that President Trump did eliminate the re-imbursement to health insurance companies that President Obama allowed via Executive Order. Any losses the companies face are no longer subsidized. Thus, the insurance companies increased their 2018 and again in 2019 rates to cover previous losses in anticipation of these change. Also, the 40% tax on high-cost employer plans (Cadillac tax) has been pushed out to 2022.
With the Democrats in charge of the House, it is hard to predict what will happen. Bottom line is that the major changes brought in by the ACA, such as accepting pre-existing conditions, will remain and only minor changes are likely to occur.
Employers are getting squeezed on the cost of health care. According to PricewaterhouseCoopers, health insurance premiums are expected to rise by 6 percent in 2020. Companies are taking a hard look at affordable options, such as high deductible health plans, which can be paired with health savings accounts. Telemedicine is also on the rise. This “virtual care” allows employees/patients to consult with a medical provider via a computer, smartphone, or tablet, usually at a much lower cost.
First, most agencies offer insurance to their employees. Any changes to the Affordable Care Act or the cost of health care in general will affect the firm’s employee benefits expenses. Changes also impact those agencies that sell health insurance. It is possible that a change to the current system could affect premiums, commission rates and even the ability to sell health insurance!
- Insurtech Technology
It seems that some Insurtech firms are becoming more receptive to working with agents rather than find ways to eliminate them, at least for now. The insurance industry seemed like a ripe target for these new startups to “disrupt” the industry by cutting costs and generating profits for their new ideas. The current distribution and service channels (i.e. insurance agents and brokers) were one of the areas of focus.
However, the role of sales and service staff at insurance agencies was underestimated and the system is very complex, thus, it is not easily replaced with an algorithm. Many Insurtech firms with the big dollars backing them focused on breaking into the insurance company side since it seemed like it had the most potential to make the largest amount of money. The smaller startup firms see that their best approach is to make incremental improvements to the current system and not re-invent the wheel.
One such example is Indio Technologies which solved a perennial problem for agents by turning the application and renewal process into a fully digital, modern customer experience. The firm was acquired by Applied at the end of 2019 and it is expected to be integrated. Smart Harbor is another firm that developed products and services specifically for independent agencies, such as a mobile app that customers can use when buying insurance. Insurance Technologies Corporation purchased Smart Harbor in August of 2019.
One thing to expect for 2020 is a fair amount of M&A activity as the insurance companies and service providers to the insurance industry buy up the new competition.
With all these new startups, there might be some more options and real improvement in available software for agencies that make the job of the service and sales staff easier. The 20+ year wait for helpful agency automation seems to be over. However, in the long-run, as Insurtech settles down and understands the parameters of the insurance industry, there will be a revived focus on streamlining the sales and service process. Insurance agencies need to incorporate new technology sooner rather than later, because it will be a game changer with respect to productivity and efficiency.
- Market Conditions
Overall, the insurance industry was resilient for 2019 and should continue to do well for 2020. Both commercial and personal lines are seeing a hardening of the market. MarketScout reported that U.S. commercial property/casualty insurance rates rose 4% on average in the third quarter of 2019, up from 3% during the second quarter. By industry class, habitational and transportation businesses saw the highest average rate increases at 6% and 7.5%, respectively. Deloitte reported that the hardening property/casualty market is a worldwide phenomenon, with increases in all major geographic regions for the third straight quarter of 2019.
A key driver to the current hard market in personal lines is related to the losses from recent natural disasters. It will take at least a year or two for insurance companies and regulators to work out the new approach to risk assessment, underwriting and pricing.
Commercial auto will continue to face challenges as the claims frequency and severity trends continue to point upward. Interestingly, technology is both part of the problem and part of the solution since distracted drivers result in more frequent and more severe accidents. However, the growth in use of telemetrics in vehicles should reduce accidents.
Expect most lines to show rate increases of at least 5% during 2020. The one exception will be Workers’ Compensation, which on average will remain steady or decrease during 2020. Various sources report that workplace injuries have been declining, while the combined loss ratio in most states is well under 100%, which creates the current soft market. The new law in California which has a tighter definition of an independent contractor will create a flood of new employees that will be covered by Workers’ Comp, and the long-term impact is not clear at this point.
For 2020, the independent agent should pay close attention to the market trends because their clients will notice the rate changes and start looking around. Agencies that have competitive carriers will do well and can pick up new clients from their competitors. However, during a hard market, eventually all carriers will raise their rates, so don’t focus on selling by price alone. Work with the clients well before the renewal date to assess their true current risks and offer solutions that will differentiate your agency from the competition.
- 2019 M&A Activity & Pricing
M&A activity is expected to continue during 2020, according to our discussions with key acquirers. As long as insurance agencies remain profitable, there will be buyers. The current prices paid by publicly traded brokers, large regionals and agencies funded by private equity firms are already extremely high and will likely continue to be high for the valuable, desirable firms. Since the supply is dwindling, the prices may be even higher for those that remain if they fit the profiles of the key buyers today.
Acrisure and HUB continue to be the leaders of national broker purchases. Acrisure completed 100 transactions in 2019 and management expects to do the same level in 2020, maybe slightly more. Their volume hit almost $2 billion in 2019.
HUB closed 70 transactions in 2019, which was an all-time high. They expect to close about the same number in 2020. They are a buyer that really helps agencies with producers, markets and handle some of the internal HR and accounting operations, too.
Assured Partners is very competitive and closed over 50 transactions this past year and expect to do the same next year. They have revenue earn-outs that are very attainable.
Foundation Risk Partners, a somewhat new buyer, first acquisition done November of 2017. This past year they did several acquisitions and will continue that trend in 2020. They are very competitive and we hope to work with them more this coming year.
Arthur J. Gallagher picked up their pace this year especially in California. They will be aggressive nationwide and are especially looking for the right people to grow in areas they have not been in before.
A really nice mid-size national broker, Risk-Strategies is based out of Boston. They did 25 deals in 2019, which was one of their biggest years! They are being more selective in buying agencies with specific niches, like employee benefits, healthcare, real estate and transportation agencies. In 2020 they expect to do another 20 to 25 transactions!
Brown & Brown did 20 deals in 2019 and expect to have the same amount of activity in 2020. Main offices are Chicago, Atlanta, Boston and Chesterfield, MO.
BroadStreet Partners, NFP and a new one Relation are funded by private equity and venture capitalists. They continue to aggressively solicit and buy independent agencies and have large amounts of capital to pay well.
Private equity firms have been buying up insurance agencies for their investors. This makes a lot of sense because the return on investment is typically 20% to 30% plus, which is greater than most other available investments today.
Private equity firms are paying typically 8 to 9 times EBITDA as down payments! In addition, there are usually earn-out bonuses that can also be significant as a multiple of EBITDA or topline, which we prefer for our clients. When the value is translated to a multiple of revenue this means 2.75 to 3.5 times revenue! Sometimes the down-payments require at least 10%-25% of the acquirer’s stock and can also be required on at least one of the large buyer’s earn-outs.
Local peer buyers and internal buyers cannot compete at the high prices and multiples since they need to pay out of cash flow. So, there will continue to be a price differential between those that receive offers from the “well-funded” buyers and those that sell internally or to local competitors.
However, some independents prefer not to sell to a much larger, often publicly traded firm. Often the existing firm often is completely transformed a few years later, and not always for the better. There is often a sense of pressure to produce and write larger accounts is expected. These criteria are not a good fit for many even medium size service oriented independent agencies. In addition, producers in these acquired agencies have to sometimes write commercial lines and benefits accounts that are over $2,500 for some and $5,000 in commission for other acquirers to get paid! However, there are other acquirers that leave the agency alone and not even change it’s name, such as Acrisure, and Broadstreet.
Sellers today still get prices from other peer independents in the 1.5 to 2.0 times range, if there is at least close to a 25% to 30% profit margin. As a multiple of EBITDA (earnings before interest and depreciation) these values are in the 6 to 7 range. In the earn-out portion of the “price” the seller is expected to grow the business, not just maintain it. Terms based on future growth should be discounted when determining value based on cash today. So, if an agency “gets” 1.75 to 2.25 times revenue today, this is actually a “price” closer to 1.3 to 1.6 times revenue, projected three years out.
With the economy continuing to improve and the ability to get credit lines from banks, the value of agencies and sale pricing is still very good with independents and national firms, especially because there are so many acquirers. There is often misunderstanding about what the “real prices” being offered are. Some of the deals have a sizable portion of the “price” based on earn-outs for future performance.
- Internal Perpetuation Can be Difficult
If an owner sells internally, it is usually for less than the value of an external sale. There is risk that the internal candidates might not work out, nor do they often have the money to do a buy-out. Often the retiring principal needs to finance the deal for the internal candidate.
It is often hard for small and medium sized independent agencies to internally perpetuate. The next generation often does not have the management and sales skills set to be able to retire the majority owner.
The terms for internal purchases are still typically 20% to 30% down, with the buy-out over 5-10 years, depending on the agency’s cash flow and whether or not the internal buyer has any money of their own. An internal buy-out rarely has an earn-out component, so the value should be conservative, to not jeopardize the internal buyer being able to use the agency’s cash flow to pay the loan off over time. Buyers often want the retiring owners to move on after a few years, so then they can manage the firm, without their influence.
- Tax Law Changes May Occur
From the insurance agency perspective, tax reform has had its initial and perhaps biggest impact directly on the owners and employees for their personal income taxes. This includes any changes to corporate taxes, since the majority of agencies are privately held.
The corporate taxes were reduced and then offset that with elimination of some deductions.
With a new presidential election in full swing, there is no guarantee that the lower tax structure that President Trump put in place will continue. For agency owners this also includes whether or not capital gains will be at its current low federal rate of 20%. Some agencies looking at the sale option are concerned about this and may decide to cash in on their investment before the election occurs to guarantee the lower rates.
Being proactive and knowing how current trends will affect the firm is the first step. Managing the agency in a way that exploits these trends will then allow the firm to succeed. Agency owners need to establish business and marketing plans. Good commun-ication within the firm is imperative! Having meetings and planning sessions is a good way to get everyone involved and headed in the right direction.
Oak & Associates knows that the key trends in this article are important for owners to pay attention to for the coming year.
Please contact Oak & Associates if purchasing a Sales and Marketing or Business Planning template is of interest or if a planning session is desired.