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Blue Skies Breaking for Insurance Brokers

Better days lie ahead for insurance brokerage firms.

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The publicly traded insurance brokers continued to swim upstream in the first half of 2009. The weak economy, softening insurance rates, and uncertainty over regulatory treatment of commission revenue continued to weigh on their results. However, we've been thinking that the brokers were a good place to look for value. We don't expect these three factors to be with us for long, even though waning market sentiment damped valuations through 2008 and into early 2009. 

The brokers' stock prices have participated with the market rally since March, and the gap between our fair value estimates and their market prices has narrowed significantly. But we still have one of these firms ( Arthur J. Gallagher (AJG)) rated at 5 stars or our Consider Buying price, with another ( Marsh & McLennan (MMC)) close to that recommendation (see the table below).

Looking ahead from here, there are a few things about which we can be optimistic. Brightening or at least less-dark economic prospects, scattered early signs of firming in insurance premium rates, and favorable regulatory developments point to improving results in the balance of 2009 and into the coming years. This article will briefly review how tough the external environment was in recent years, where things have been heading recently, and the implications of recent important regulatory developments.

Head Winds Turning to Tail Winds?
You might think that insurance brokers are a relatively insensitive to economic cycles and financial crises, but they've had a tough road to hoe in recent years. Part of the pressure arose from how weak employment was in the latest recession. In the United States, payroll employment losses have been so severe that we've only got as many jobs out there as we did at the outset of the last recession (in 2001). That's pretty severe, along with the largest recessionary increase in the unemployment rate since World War II. The brokers that we cover derive a significant share of their business from head-count-intensive business services such as workers compensation coverage, benefits processing, and employee benefits consulting, where revenue and margins depend on volume. The large-scale job losses in our latest recession put the hurt on those businesses. But the economic malaise has had a wider, more profound impact. The publicly traded brokerage firms are perhaps better described as risk management services firms, and during times of lower risk-taking and wealth reduction like the 2007 to early 2009 interval, there simply is reduced demand for risk management and wealth-preservation services.

The brokers have been swimming upstream for a few reasons aside from the economy. Brokerage commission revenue is joined at the hip with insurance premium rates, and the insurance markets have generally been soft in recent years. That has been partly because of weak economic growth, but we think the degree of weakness has also reflected independent influence from insurance cycle effects. Insurance rates have tended to recover after past recessions, however, and we expect them to do so again after our latest one is over.

A third variable has also been damping the results at the brokers. Their revenue models have been in upheaval since a spate of interventions from state authorities, beginning with the case that New York state pursued against Marsh & McLennan in 2004. Brokerage compensation has long included commissions dependent in part on the volume and profitability of coverage that a broker places with an insurance company, but most of the larger firms were effectively forbidden to take this compensation, at least directly, for several years. The larger firms have had some good recent news on this score in 2009, however, relating to a regulatory agreement Arthur J. Gallagher recently reached with Illinois state authorities that we will discuss below.

As harsh as the 2004-08 period was, 2009 hasn't exactly been a bowl of cherries, either. But we have seen improved operational performance at the brokers, in part because of painful decisions to batten down the hatches and produce more efficiently. Revenue growth slowed from 2007 into the first six months of 2009 for all but one of the firms ( Willis Group (WSH)), and the simple average revenue growth rate for the group fell to low-single-digit levels in the first half of 2009. Operating margins were moving south in 2007 and 2008, but that trend appears to have been arrested so far this year. Looking to the latter half of the year, we've been anticipating firming insurance rates and economic growth leading to somewhat higher revenue growth and better margins. Higher insurance rates have yet to take hold in general, but the property markets have at least stabilized, with significant increases in property catastrophe rates, and the markets for directors' and officers' liability coverage has certainly firmed up, particularly for financial institutional clients. We're likely going to need to have stronger economic growth than we've seen thus far this year to have the brokers meet our expectations for 2009 and 2010, but we think that is coming.

Anticipated Regulatory Action Arrives
While announcing its second-quarter earnings in late July, Arthur J. Gallagher disclosed that it had reached agreements with the Illinois attorney general and the Illinois director of insurance allowing the firm to accept contingent commissions again, so long as arrangements are fully disclosed to clients. Gallagher and competitors Marsh & McLennan,  Aon  (AOC), and Willis had been laboring to devise ways to replace this previously high-margin revenue stream, a significant factor depressing operating profitability in recent years. One reason why the bans didn't make a lot of sense had to do with how widely they applied; another large broker,  Brown & Brown (BRO), hadn't been under such a restriction, nor were the legion of smaller independent firms that operate in this fragmented industry. 

Rewarding brokers for placing profitable business with insurance companies directly through these commissions is a contentious issue, even among insurance-purchasing professionals, but we think the Illinois regulatory decisions were a rational result for consumers and market efficiency as a whole. It looks increasingly likely to be repeated by similar agreements in relevant jurisdictions.

We've been expecting some rationalization and leveling of the playing field as part our thesis on the brokers, and we're pleased to see statements from regulators in other states that suggest bans will be revisited elsewhere, as well. We have yet to boost our profitability and margin assumptions for the brokers in light of this news, in part because we were already expecting developments along these lines. But the bias is to the upside, at least with respect to this factor alone, and we look forward to watching how things play out.

Another Broker to Watch
We like the insurance brokerage business for a few reasons and respect the way the brokers can aggregate buyer power and enhance competition in the insurance industry. There's another publicly traded broker out there that could be worth watching from that perspective, particularly given where it is located. That company is  CNinsure (CISG). "Make no little plans," advised famous architect and urban planner Daniel Burnham. Well, CNinsure's goal is to develop the largest insurance intermediary in China. CNinsure believes the role of brokers in promoting competition and market efficiency is relatively untapped in this potentially huge, rapidly growing market. We aren't currently recommending the stock, which is trading near our fair value estimate. But our fair value uncertainty rating on CNinsure is very high, which includes an upside as well as a downside.

Bill Bergman does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.