Although, in general, growth is essential for agencies to retain markets and profitability, unrestrained growth via acquisition can be perilous. Getting big through internal growth, although slower and less glamorous, does work, says Chris Burand.
How big does an agency need to be to prosper and to be safe from extinction? Small shops (with less than $500,000 in revenue) must undoubtedly grow (excluding some Specialty and Non-Standard Auto agencies). These small agencies have books of business too small for companies to make a profit. Given companies' recent loss ratios, many companies probably can't break even on anything less than $250,000, and they might even require as much as $500,000 in premium.
Some might argue that small agencies make up for their lack of size with quality (i.e. better loss ratios). This might be true in some cases, but not overall. Besides, companies are interested in volume first, underwriting profit second. To satisfy companies' hunger, agencies need a minimum of $1 million in written premium with their top Standard Lines companies (perhaps less for local or regional carriers).
At the other extreme, dozens, maybe even a hundred or so, agencies, brokers, and banks are trying to grow really huge as fast as possible. Although one or two might succeed, most will fail because they're growing primarily through acquisitions — and most acquisitions don't earn the buyer an adequate rate of return! Every study I've seen for the past 25 years confirms this conclusion.
Most of these major acquirers of agencies are effectively consolidators. As in other industries, insurance agency consolidators (including many banks) are paying sky-high prices and driving the market for agency sales. They're able to pay high prices because their stock prices are high — and their stock price is high because the market believes that these consolidators can achieve higher profit margins by generating greater efficiencies, negotiating higher commissions from companies, implementing professional management, and so forth.
A consolidator usually buys many agencies in an ever expanding and rapid fashion so that growth remains high. By doing so, they book new revenues before expenses, creating the impression that they're achieving higher profits.
Because the consolidator's stock price is always under severe pressure to grow, they're willing to pay high prices so they can get many deals done quickly. If enough acquisitions are completed rapidly enough, the major stockholders can often sell out before their stock crashes. Once consolidators stop growing quickly, their share price usually drops like a rock, their stock is devalued, expenses catch up, and they go bankrupt.
Rapid growth at the price of bankruptcy doesn't make sense (unless the real goal is to grow fast enough for a major shareholder to sell out before the crash). Getting big does not make sense for other reasons as well. For example, a Wall Street Journal (7-13-00) report on a 40-year study of 20 industries found that all giant global corporations (except those in the semiconductor industry) had a steady decrease in market share concentration. Smaller, more nimble firms were always able to find ways to gain market share. Another study showed that almost every company with the leading share in its market had lower profit margins. Why work so hard just to get big? Are the bragging rights worth it?
On January 27, 2001, The Economist wrote:
“The record of most other banks that have pursued Mr. McColl's [Chairman of Bank of America] strategy [of acquiring lots of banks] strongly suggests that beyond a certain size any economies of scale in operations are easily outweighed by diseconomies in management and, especially by the need to pay over the odds to strike a deal in the first place.”
Being all things to all people is a heavy burden — and if it's mandatory for success (which it seems to be, based on the premiums that so many banks are paying for agencies), investors might find many great opportunities to sell short.
Unrealistic expectations of cross-selling is another “bigger is better” trap. Many financial firms are buying other financial firms today because they believe that consumers want to buy all their financial services and products from one vendor. The problem with cross-selling is that the provider must be the best at all services they offer. Being the best in one area is tough enough —leading the pack in all categories is almost impossible.
Banks and insurers in many European countries have been trying for years to sell one-stop shopping and have never lived up to their own expectations. So far, the U.S. has proven to be no different.
Banks make a good example because they have bought and are buying so many agencies. If they can't satisfy customers with their banking services and provide better results with mutual funds, I don't believe that most can succeed selling insurance. After all, banks selling insurance is a far greater stretch than banks selling banking services.
Consolidators and bank-owned agencies are providing opportunities for other insurance agencies. Good producers will leave banks and consolidators when their salaries are cut. Customers will leave when producers leave, when service crashes, when their expectations are not met, and when nimbler, smaller, and more personalized competitors offer superior service. For example, The Economist reported that every time Bank of America would make an acquisition, one particular competitor would open a nearby branch to capture all the newly acquired firm's dissatisfied customers!
An article in the April 16, 2001 Albuquerque Journal cited another example. Wells Fargo purchased First Security, and then sold 22 branches to Bank of the West. Meanwhile, a competitor, First State Bank, opened 40% more new accounts in one month alone, primarily due to the Wells Fargo and Bank of the West acquisitions, as customers left due to poor service.
Growth generated by costly methods (acquiring other business, underpricing business, and creating complex cross-selling programs) usually doesn't work. Once engaged in these methods, these entities must grow significantly to justify their costly, high-risk strategy. Expansion through internal growth, although slower and less glamorous, works and has continually proven to be the most profitable method for growing a company.
However, although growth is important (especially for small agencies), there's no extreme pressure or need for privately held, non-consolidator, non-bank owned agencies to grow quickly. With rates increasing, most agencies should easily achieve 8% to 10% annual growth. Smart, profitable, internal growth will inevitably provide bigger profits and higher agency values.