Hail the insurance middleman

Disintermediation they call it. From television stations to retailers and real estate agents, the internet has displaced old business structures for new lean models. Industry profits have fallen and middlemen are being squeezed.

You’d think that insurance broking, a classic middleman business, is headed the same way. If you’re looking for home insurance, why drive into town to join a queue when you could check out iSelect.com.au or Choosi.com.au?

Nope, it doesn’t make sense. But the commercial market, where Austbrokers and Steadfast operate, is different. Here, almost 80% of insurance is written through brokers, with plenty of reasons to think it’s going to stay that way.

The remaining 20% of commercial insurance hasn’t leaked online but is written directly by the insurer, usually to large multinationals. The Internet has barely touched this industry.

Complexity moat

Chart 1 explains why. Insurance brokers help match customers with insurers, and in return receive a commission from the insurers for each policy they write. That part is simple. The complexity is in the insurance requirements of customers.

The construction contracting business I used to run, for example, required at least four different types of insurance; workers’ compensation, public liability, motor vehicle insurance and income protection.

For that simple list we needed someone to sift through the hundreds of policies and pick the ones that suited. It’s the same for thousands of businesses across the country, from your local newsagent to Woolworths.

Scrutinising insurance policies is a laborious nightmare that anyone with a modicum of commonsense would pay to avoid. Brokers take the pain away by being well versed in the latest rule changes and policy loopholes. Brokers can create a product that fits the customers’ needs, one that isn’t easily sold online.

The advantages of using a broker don’t stop there. As they write more business they can wrangle better deals for clients from insurers. This is an industry where size matters, especially in Australia where about 70% of the insurance market is controlled by just four businesses: IAG, Suncorp, QBE Insurance and Allianz.

The industry is also characterised by high levels of loyalty. It’s estimated that less than 10% of clients switch brokers each year and the income stream isn’t bad either; each year a broker receives anything from 5% to 25% of a policy’s premium.

Policy price rises

As the insurance industry emerges from one of the worst claims seasons in a decade, insurance prices are pegged to rise, which is good news for brokers. Longer-term insurance pricing tends to rise with inflation, offering inflation protection, too.

The business has other attractions. Other than an office with a few computers and comfy chairs, there’s limited capital requirements. After paying rent and wages, revenues flow through to free cash flow, which can be paid out as dividends.

All of this makes for potentially attractive businesses, but there’s one more factor that swings it; with a broker’s size determining their bargaining power, there’s a strong incentive for them to grow. This is driving consolidation in the sector – industry leader Aon, for example, has in the past five years bought four large broking businesses – but the industry remains very fragmented.

Aon and Marsh & McLennan, the world's two largest brokers by revenue, control less than 10% of the insurance broking market, offering plenty of potential for consolidation. Australia’s two listed brokers, Austbrokers and Steadfast aim to exploit.

Austbrokers listed in 2005 and Steadfast lists next month and both are attractive businesses. Let’s find out why.

Austbrokers consists of a network of 43 broking businesses in which it owns substantial equity stakes. Collectively, it writes $1.4bn worth of premiums ('gross written premiums', or GWP) a year, focusing on small to medium enterprises. It also owns a small insurance business and a ‘premium funder’ which grants loans to pay for insurance.

On listing, Steadfast will be of a similar size. Its network comprises 279 broking businesses and, after listing, it will own equity stakes in 58 of them (typically 50% stakes). Its network writes around $3.7bn of insurance, with the portion it owns representing $1.3bn.

Each has been steadily bringing together local brokers to help resist competition from larger international groups such as Aon, Marsh and Jardine. Unlike their US counterparts though, they’ve chosen to take part-shares in broking businesses rather than buy them outright.

This makes sense, allowing them to leave the owners with enough skin in the game to keep them interested. There are similarities here to other franchise businesses, such as Dominos Pizza, where having a motivated owner-manager is critical to productivity and profits.

Austbrokers has bought cleverly. Since listing it has purchased stakes in 11 brokers at around 10 times free cash flow and has managed to boost free cash flow margins from a very respectable 20% in 2005 to over 35% today.

Organic growth

Combined with organic growth, this has helped earnings per share rise from 26 cents in 2005 to a forecast 46 in 2012. The share price, unsurprisingly, has rocketed from $2.00 to nearly $11.00 over the same period.

Until now, Austbrokers has had the market to itself. With Steadfast’s arrival, the market prices for broking businesses may rise but the company has been extremely clever in mitigating the risk that this may pose.

Company founder and current managing director Robert Kelly has coaxed ex-QBE chief Frank O’Halloran, who oversaw 125 acquisitions at that company, on board as chairman. Steadfast’s track record is light compared with Austbrokers but this is a smart way of addressing it.

With $75m in cash raised from the listing and the possibility the company will take on debt or raise equity to further fund growth, Steadfast is on a fast growth tack. If we look back in five years and wonder where it all went wrong, the answer may well be here.

The risks are many: they may overpay; they may take on too much debt; and they may fail to integrate small businesses into larger ones. This is a particular concern as Steadfast shifts from being a buyers' group to owning stakes in the brokers themselves. But with only 6% of the broking market each in Australia these businesses could double in size without much trouble.

Potential Steadfast investors are being asked to pay around 15 times estimated 2013 free cash flow to get a slice of the action. This strikes us as fair. The business should lift margins as it integrates its recent acquisitions and grows earnings organically. And the recent acquisition of White Outsourcing – a business process improvement company – and its planned development of ‘Steadfast Virtual Underwriter’ – a proprietary IT system should help.

If you can get shares through the float we recommend you SUBSCRIBE. If Steadfast lists below $1.20 we’ll switch to buy. Watch out for an update after the float.

Austbrokers also holds appeal but is more expensive. Superficially it trades at a similar price of 16 times forecast 2013 free cash flow, but, after several years of impressive margin expansion, that multiple is not as easily justified. We may even see a pull back in these margins, which might offer us the opportunity to upgrade below $10.00. For now, HOLD.

Note: If you are considering buying Steadfast and already own Austbrokers, we recommend you keep the total portfolio exposure to below 8%.