A Quadruple Whammy That Likely Won't Last

Many factors have weighed on insurance broker returns in recent years. The soft economy, along with lower real estate and other asset valuations, have reduced risk exposures and insurance demand. Softening insurance prices have accompanied the reduced demand, and brokerage commission revenue depends on insurance company premium income. Bans on contingent commissions (which depend on the volume and profitability of business delivered to insurance companies) by some state authorities constrained compensation, and uncertainty about regulatory treatment of compensation also weighed on the market. Lower short-term interest rates have sharply curtailed float returns that brokers earn on funds held in their role as intermediaries.

But the economy has started to recover from the Great Recession. Insurance rates have stabilized and have actually moved modestly higher in recent months, at least according to one industry survey. The largest brokerage firms have reached new agreements with state regulatory authorities that allow them to receive contingent commissions again. While most of the larger firms have stated that they won't take these payments explicitly, they are more likely to accrue greater "contingent" compensation indirectly (and legally); nevertheless, the simple removal of those bans has been a plus.

There is one factor still sitting on the table. This one highlights the difficult external environment facing one publicly traded broker-- Brown & Brown (BRO)--in some very interesting ways that may spell opportunity for investors.

Brown & Brown has been one of the fastest-growing and most profitable publicly traded brokerage firms in North America in the past two decades. Brown has put together a successful record acquiring smaller brokerage firms and accumulating buying power in ways that help its clients as well as its producers. Brown's leaders have led the development of a high-performance culture with proven results.

However, the last two years have been especially hard on Brown. One issue facing those considering investing in the company has been its flagging growth relative to its peer group. Could it be a sign that the acquisition machine has started running low on gas? Are internal issues at least partially responsible for the loss of momentum?

In recent conference calls with investors, Brown's leaders have pointed to the economy. In this case, they aren't just using it as a convenient excuse. Brown & Brown has developed a distributed and decentralized national network of producers, but its home state of Florida and other Southeastern states still account for about one third of total revenue. It's no secret that Florida has been hurt relatively hard in the recession, but just how hard may not be fully appreciated. The chart below depicts the difference between the average unemployment rate for Florida, Georgia, Alabama, and South Carolina and rate for the United States as a whole since 1976. Since the Great Recession got under way at the outset of 2008, the unemployment rates in the Southeast have risen markedly faster than the rate for the U.S. as a whole. In fact, the past two-year period has been unlike anything experienced for these states since these data series began (in 1976).

There are a number of related reasons why this has been the Big One for Florida and the Southeast. The housing crisis has been particularly acute for Florida, in part because construction is such a large portion of the state's economy. And Florida has been experiencing net out-migration for the first time since just after World War II. But another factor holds some interesting perspective for Brown & Brown. The sharp decline in short-term interest rates driven by Federal Reserve monetary policy has reduced Brown's float income, like the other brokers. And while no broker has been immune to the weakening economy, the especially weak Florida and Southeastern economies have been weak partly because of, and not just despite, sharply lower short-term interest rates. Florida has a high share of retirees in its population, and reduced investment income has played a significant role in curtailing their spending as well as economic growth in and around the state.

Insurance rates aren't likely to decline forever, and nor will the economy. Record low short-term interest rates are not going to be a permanent feature of the investment landscape either. Put it all together and you have a proven company working hard to succeed under very difficult conditions that we don't expect to last. In turn, Brown & Brown's stock looks relatively cheap and has has been trading close to our Consider Buying price of $15 in recent weeks.