Changes in the U.S. economy may be having significant effects on insurance agency valuations. Growth continues to rebound from the pandemic-induced slump of the first half of 2020. Gross domestic product increased at a 4.3% annual rate in the fourth quarter of 2020 and at a 6.4% rate in the first quarter of 2021. Consumers who were housebound (and not spending) last year because of pandemic fears are leaving their homes and opening their wallets. This is boosting businesses’ sales and driving demand for workers, which increases company payrolls.
At the same time, there are signs that years of relative price stability may be ending. Consumer price increases have been picking up steam since the beginning of the year. They rose 5.0% in the 12 months ending in May 2021, the largest 12-month increase since right before the onset of the financial crisis in 2008.
What experts think?
Economists forecast continued strong growth for the rest of the year, but they are less certain about whether inflation will persist. Either outcome or both should produce higher commercial insurance premiums. If a manufacturer’s sales rise from $10 million to $11 million, liability insurance premiums based on those sales will go up if the insurer leaves rates unchanged. If commission rates stay the same, a 10% premium increase should produce 10% more commission income for the agency. The same goes for payroll-based lines such as Workers’ Compensation.
Economic growth and consumer inflation aside, the recent hardening in some markets is essentially insurance rate inflation that can also raise premiums and commission income. David Tralka and Robert Pettinicchi of InsurBanc refer to this as “a built-in cushion for agencies.”
If an agency in this situation can service its book of business without adding to staff, it should see an accompanying boost to its earnings before interest, taxes, depreciation and amortization (EBITDA). Agency valuations, often expressed as multiples of EBITDA, should increase accordingly even without rising multiples. An agency that was worth 16 times EBITDA of $1 million will be worth more at 16 times EBITDA of $1.1 million.
However, inflation increases salary costs as well as revenue. “The question becomes is there a lag time between when the commissions go up and when agency owners have to increase the employees’ pay,” says consultant Jon Persky of Optimum Performance Solutions. “Agencies still need to make sure that their revenues are growing faster than their expenses.”
One consequence of higher inflation that could impact agency valuations is rising interest rates. The Federal Reserve may raise rates to ward off an inflationary spiral, or investors may demand them to offset inflation risk. Persky says there’s an inverse relationship between agency value and interest rates. Tralka and Pettinicchi are more emphatic: “Quite simply, low rates drive transaction activity and fuel higher value multiples.” Higher rates would do the opposite.
To protect their investments, agency owners should carefully manage salary costs, Persky says. “The biggest expense in any agency is payroll. Anything they can do to make agencies more efficient, whether it’s being more automated, potentially using offshore servicing centers, just having a workflow analysis of their agency done – whatever they can do to increase revenues without a corresponding increase in payroll is going to benefit them from a value standpoint.”
Well-managed, efficient and technologically savvy agencies will always attract buyers’ interest, whatever the economic environment. Rising premiums, whether a result of growth, harder markets or general inflation, can make those agencies more attractive. However, inflation is a challenge to business owners. Good management practices are essential to making sure that agency values rise with price levels.
