The Price Isn’t Right
Reader challenges reasons for surge in broker mergers and acquisitions that were explored in July’s Best’s Review.
- October 2019
I found Jeff Roberts' article “A Perfect Storm” in the July edition, describing the hot merger and acquisition market in the brokerage sector interesting. I will argue that the “Perfect Storm” article leaves out one major contributor to the market's irrational exuberance, the fact that the property/casualty sector is experiencing its first major upturn in 15 years!
The late Jack Byrne of Geico, Fund American and White Mountains fame, expressed it best decades ago when he said that insurance is a lousy business. This especially applies to the brokerage sector.
When I was an analyst on Wall Street following the industry, I pointed out to investors that insurance is a safety net for the economy. This more or less explains executive vice president at MarshBerry Phil Trem's observation that the industry is recession-resilient. If something has value, it will be insured, with one of the variables being self-insurance. When insurance prices rise quickly, policyholders will increase the amount of self-insurance, including policy deductibles that they are willing to carry. The fly in the ointment, of course, is there are some 900 insurance underwriters chasing what amounts to a fixed amount of premium.
With my view that insurance is a safety net for the economy, I used to advise clients that they could easily visualize the industry's pricing adequacy by comparing written premium growth with the growth rate of nominal GDP (unadjusted for inflation) as a proxy for the growth rate of insured values. If the replacement cost of my house increases by 5%, then I should anticipate a similar increase in the amount of premium my insurer demands. This follows for other lines of business as well.
If we look back, we see the annual growth rate of premiums has lagged nominal GDP since the last year of the last major upcycle, 2003, with only a few years when there was parity until 2018. Going all of the way back to 1960, all of the major underwriting cycle upturns are clearly visible.
What is especially notable from the Annual % Change chart is the increasing length of the industry's downturns, followed by wrenching upturns. This is perhaps more visible if we simply plot the annual difference between the two curves from year to year as shown in the Difference: Premium Growth vs. Nominal GDP chart.
One point to bear in mind is that the annual difference between written premium growth and GDP is cumulative. For example, if GDP growth in Year One is 5% and premium growth is only 1%, the implication is that pricing, broadly speaking, is deficient by about 4%. But next year, if GDP again grows by 5% and premiums only grow by 1%, the cumulative level of discount is now 8% (4%+4%). This is why the extended downcycles the industry experiences are so corrosive and why the brief periods of upturn are simply not enough to allow weaker companies to sustain the next downturn.
When I retired from my Wall Street career in 2003, I exclaimed as I went out the door that I had no interest in following the industry's coming downturn. Based on the data illustrated by the charts I provided, my concerns were well placed.
If we simply compare GDP now with the industry's written premiums, GDP (again, unadjusted for inflation) since 2003 has grown by 180% while written premiums have grown by 151%, a difference of 29 percentage points. But until the industry's spike last year, that difference was 33 points (170% versus 137%). Since brokerage commissions roughly follow written premiums, this tells us that, over the past 16 years, brokerage has been a negative growth business in real terms.
It appears very clear to this writer that the current enthusiasm in the M&A market is driven by the irrational belief among buyers and their capital providers that the upcycle will continue, while those very astute sellers see the opportunity to escape at a peak.
Michael A. Smith
267 Horace Mills Rd.
Wells, ME 04090