Commercial purchasers of insurance often hire insurance brokers to search for the best coverage from a price and quality standpoint. In return for their services, insurance brokers receive a commission that is a percentage of the premium. Insurance brokers bear no underwriting risk; the primary risk of an insurance broker is that margins get squeezed when P&C rates go soft. This has the countervailing advantage for investors, that after a major catastrophe, the brokers will always do well, because rates rise, and the brokers have no risk of getting tagged for claims.

Part of the story for the insurance brokerages has been the continuing acquisition of small “Mom-and-Pop” insurance brokerages. Twenty years ago, the insurance brokerage space was fragmented. There is still a decent amount of fragmentation today, but now there are major firms that define the sub-industry.

Among the biggest firms, there are sometimes other business lines that form a significant part of the total enterprise. Human resources consulting, benefits consulting, risk management consulting are common ancillary enterprises. Less common are asset management services, and owning insurance companies, but some of the bigger firms do those.

Expense control and discipline in acquisitions are critical aspects of a successful insurance brokerage, as the lack of either one will impair long term earnings power. Our biggest concern with acquisitions is that the prices paid to “roll up” smaller insurance brokerages will eventually rise to levels that make their purchase uneconomic, but the purchases will continue in a foolish attempt to gain market share.

The insurance brokers had a great run of growth through the nineties. Since 2000, their performance has been flat for a number of reasons: underperformance of non-insurance brokerage operations, and slowing organic growth. With P&C premium rates moving from slow positive growth to flat at present, flat performance from the sub-industry for the near term is what we would expect.

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Bringing it to the Present

Some things I got right here, and others wrong.  On net, the group didn’t do much since I wrote the above in 2004.  But almost all of the little companies got acquired, often by private equity, even a few that I thought were garbage.  The big players suffered through the scandal of contingent compensation, while the little players ignored the threat successfully, because the threat from Spitzer and other AGs would not stand up in court.  The big players buckled under the load of bad PR.

So, among the publicly traded companies five remain — Marsh & McLennan, Aon, Willis Group, Brown & Brown, and AJ Gallagher.  I own none of them, and looking at the valuations and soft P&C insurance markets, I have no interest at all.  Short them if you like, though I won’t.

One closing note, contingent commissions have returned.  In any sort of business transaction where there are multiple parties at the table, be aware of who is allied with whom.  Do not assume that there are neutral parties.  Who is paying whom?  If buying from someone, be skeptical about trusting the opinions of “neutral parties” that are paid by them.