Arthur J. Gallagher: Insurance Broking - [Business Breakdowns, EP.148]

0:03This is Business Breakdowns. Business Breakdowns is a series of conversations with investors and operators diving deep into a single business. For each business, we explore its history, its business model, its competitive advantages, and what makes it tick. We believe every business has lessons and secrets that investors and operators can learn from. and we are here to bring them to you. To find more episodes of Breakdowns, check out joincolossus .com. All opinions expressed by hosts and podcast guests are solely their own opinions. Hosts, podcast guests, their employers or affiliates may maintain positions in the securities discussed in this podcast.

0:45This podcast is for informational purposes only and should not be relied upon as a basis for investment decisions. I'm Zach Fuss, and today we're breaking down Arthur J. Gallagher, referred to as Gallagher or AJG, a global insurance brokerage. To break down Gallagher, I am joined by Mike Hayward, a portfolio manager at WCM Asset Management. AJG was established in 1927 when Arthur James Gallagher started his insurance brokerage. And today, his grandson, Patrick Gallagher, serves as CEO. Patrick started with the business as an intern in 1972 and took over as CEO from his uncle, Robert Gallagher.

1:25Pat Gallagher's father, John, held the role of vice chairman when his son was named CEO. Just to highlight how deeply involved the Gallagher family has been in the growth of the business. AJG is one of the largest insurance brokerages by revenue, exceeding $10 billion, competing with the likes of Marsha McLennan, Aon, and Willis Towers Watson. During this conversation, we discussed the company's successful acquisition and integration strategy, the strength of the insurance brokerage industry, and how the shifting industry dynamics will impact the durability of their competitive advantage. We hope you enjoy this breakdown of AJ Gallagher.

2:02Mike, thank you for joining us to break down AJ Gallagher, a business that's been particularly impressive in its performance over a long period of time. I understand it's a business that's been a family controlled and run for over 100 years, fascinating company and broader insurance brokerage industry that people probably aren't as familiar with as one would think. I thought maybe just to start, for a business like this, it's always helpful to start with the basics. So just simply, what does this business do? Thanks for having me, Zach. So at a basic level, Gallagher is an insurance broker. That means that they act as an intermediary between somebody or a business that needs insurance and somebody who writes it.

2:51That would be a carrier like AIG or Chubb who can take that risk onto their balance sheet. I guess if you take a step back and ask what the purpose of an intermediary in this industry is, that's a fair question. But consider that most of where Gallagher and the other large brokers are acting as an intermediary is in commercial lines where the risks are more complex, there's multiple carriers, it's significantly less homogenous and standardized than personal lines that you would be familiar with, like an auto policy. And so if we were to zoom out on the industry broadly, can you kind of take me through the value chain and who the major players are between carriers, brokers, personal lines, commercial lines?

3:44There's like a lot of moving parts. And so I think it's helpful if we can distill it down to the parts that matter and who we're going to focus on today? The total insurance industry right now is probably about $7 trillion of premiums globally. About half of that is life insurance and half of that is PNC. And within the PNC bucket, loosely half of that is commercial insurance, which is typically the pool that we'd be interested in for these commercial insurance brokers. If you look at the drivers of revenue for all these companies over time, they're all fee and commission based, where the commissions are on average about 10 % of the value of those premiums.

4:26The brokers themselves don't take any risk, underwriting risk onto their balance sheet. And so when you think about the macro drivers of this business, it's really how that premium pool develops over time. And you can think of that in terms of what's called exposure and rate. Exposure is essentially the value of the property and liabilities being insured. So that's driven by things like property values, number of employees, things like that. And so the loose tether that that would have is to nominal GDP. When you're talking about rate, that's essentially the amount of money that the carriers are charging in order to ensure that exposure.

5:12And that typically operates on its own unique cycle. So in insurance parlance, you talk about a soft market referencing periods where rates are declining, a shallow or flat market, and then a hard market where rates are rising. If we look at some of the major players in the industry, you do have the likes of Marsh and Aon. Marsh is the biggest insurance broker in the world at the moment with the group revenue of about $22 billion, although some of that would be in unrelated consulting activities. You've then got Aon at loosely $13 billion of revenue. And Gallagher is now the third biggest insurance broker in the world.

5:55They did about $8 .5 billion of revenue in 2022, and they'll come in with about $10 billion of revenue in 2023. You mentioned it, but more More specifically, where does Gallagher lay and what is their specialty? So maybe to start, we can talk about some of the business segments that Gallagher has underneath its umbrella, and then focus a little bit more on the retail broking segment because that best typifies what Gallagher does. So at a high level, the business does both broking and risk management under their brand Gallagher Bassett. That's a lower margin business and essentially helps Fortune 1000 companies and carriers get their workers' compensation cost of claims down, among other things.

6:49Within broking, Gallagher operates both in the US and internationally. That's about a 65 -35 split with the international portion being mostly in the UK and the Antipodes. But more interestingly, underneath broking, you have what's called retail. That's about 45 % of broking. Wholesale, that's slightly less than 10 % of broking. Reinsurance is slightly more than 10. And employee benefits is about 20. Retail is essentially the model that we described, whether an intermediary between a carrier and a client. Wholesale is essentially a broker for a broker. So they don't deal with the end clients. They only ever deal with the carrier and a retail broker.

7:41Reinsurance broking refers to a broking model between a reinsurer and an insurance company where insurance companies want to pass some of the risk off their balance sheet to a reinsurer, essentially insurance for an insurer. and employee benefits is things like broking for healthcare plans for employees. In the retail segment, you've got companies like Marsh and Aon, where their customers are typically very, very large, but you've also got players like Gallagher and Brown and Brown who play in that mid -market. The higher end of the market's more consolidated and went through its consolidation period, really in the late 90s and a little bit in the mid 2000s, whereas the mid market is dramatically more fragmented.

8:36So in the listed space, you've got Gallagher and Brown and Brown, but privately, you also have some PE backed roll ups that look quite similar to Gallagher and Brown and Brown, some privately listed businesses. And you also have a very, very long tail of independent brokers and agencies that serve that market. So one of the things that kind of strikes me about this business, it intuitively seems like it'd be somewhat commoditized. You and I can put up a shingle, form a relationship with the carriers and then go and do this. What is special about this business? I'd been the secret source of Gallagher really down to three main things.

9:18And we can go through each of those in turn and spend a bit of time on them. I'd say the first is just the broader industry dynamics. They've been very durable and favorable over a long period of time. The second would be Gallagher's ability to deploy all their excess free cash flow into M &A, which has added value over time. And the third specific to Gallagher would be really the culture of the company and how well that aligns with what they do. So maybe to take the industry dynamics first, I think if you take a step back and look at the stock performance of listed broking peers, you would notice that they've outperformed the S &P and other broad indices over almost every time period, 30 years, 20 years, 10 years, and even more significantly of late.

10:17So you've got to ask yourself, what is special about this industry? I think we got to it a little bit when we spoke about the high -level drivers, but underneath the fact that they're a toll booth on the insurance industry, essentially, it's important to note that all of these companies have incredibly high retention rates. The retention rates are about 95%. The business is very, very sticky. And so the revenue of these companies is driven by insurance premiums, which tend to be very economically defensive. And despite andulations in the insurance cycle, have grown over time. And if you look at Gallagher's revenue specifically, you can see that there's a between their organic growth over time and the insurance cycle.

11:11But what's pretty remarkable is just the stability of their organic growth. In flat to soft markets, it's generally been about four to 6%. In hard markets, it's been significantly higher than that. So it's about 10 % at the moment. And even during the GFC, it only declined about 2%. percent. Their total revenue, so including M &A, has been positive every single year since 1963, except for 2020 during the COVID period. You can only trace back the filings until their IPO in 84, but you can go back and look at some of the high -level numbers in a book that was written about the company called the Gallagher Way and see that this was a growth company during the 70s, the 80s, the 90s, and even in the last couple of decades.

12:08I think the stickiness comes down to the fact that this is a relationship business. There really isn't a need for the customer to switch providers unless they do something that's actively negative. And there are some scale benefits here unlike some other services businesses that you might think of, partly because of the commission -based structure, partly because especially in recent times, there's benefit to analytics that's becoming increasingly important. And of course, having a very, very large pool of premiums, which you aggregate, helps you in your negotiations with the insurance carriers.

12:51I guess maybe the short answer is I don't quite know why the industry has been so good for so long, but there is something to the fact that Gallagher was founded in 1927, and it's been an excellent business for almost that entire period. Survived the Great Depression, and as referenced earlier, has been a growth business for a very long period of time. And you can say the same for some of the other brokerage businesses, which trace their roots back to 50 to 100 years ago. You've mentioned a few times that retention is very good for this business. Can you explain why that is? If I think about my personal experience of buying insurance, I don't feel particularly loyal to a broker or an insurer.

13:39And I just choose the policy that gives me the best deal. Why would it be any different in commercial? So I think you are better off thinking about the relationship that you might have or a business might have with other professional services businesses as an analogy here rather than thinking about standardized personal lines like an auto policy. I think, as an aside, incidentally, the US market, even for very standardized personal policies, does actually remain quite intermediated. And there's some structural reasons for why aggregators have taken off less than they might have in markets in the UK.

14:22But it is true that in personal lines, you've seen substantial disintermediation and direct channels have gained share to the benefit of the likes of Geico Progressive who have strong direct offerings. Maybe getting back to the question, perhaps a tax advisor or CPA is a better analogy here to use, at least for a mid -market broker. The broker has a key advisory role that they play for the client. They need to understand the client's risk profile. They need to understand the various forms of coverage that match this. They need to understand the carriers, have relationships with carriers, have knowledge about things like policy wording, and be able to source the best rates in the market even when policies aren't necessarily standardized.

15:13Even the simplest of businesses need multiple forms of liability and property insurance, and sometimes the types of coverage that the business needs will change over time because their own business evolves and because new risks like cyber emerge over time. Clients might not know if they've got coverage gaps, if they're overinsured, if they're underinsured, and it's unlikely that they'll have comfort on the rates that they're getting. I think maybe something that helps demonstrate that there is some level of expertise and tailoring required here is just the fact that Gallagher themselves sets itself up into 27 niche practice groups, for example, one that serves K -12 education, one that serves real estate and hospitality, et cetera.

16:03And the fact that such a structure exists does show that it's optimal to have some level of specializations who provide adequate risk advice to the client. I think maybe on top of the fact that there's a specialist advice that the brokers are offering the clients. I think unlike some services, like maybe a real estate broker, there's an ongoing service requirement here. So they're going to need to buy insurance at least once a year, and they're going to need to be covered constantly. And so if you combine those two factors, it means that the client's got an ongoing relationship with the broker, and the broker can build knowledge of their operations and risk management needs and effectively build trust with a client.

16:49So when you add all that up, it starts to feel to some degree intuitive why status quo bias does exist in this industry. The client needs an active reason to change broker, like a breach of trust or poor client service. And most of the time, a good broker is not going to offer the client such a reason. And then why do you think that the market has underappreciated how sticky this business model really is? Not just for Gallagher, perhaps, but for its peers. I mean, everybody is starting to see the benefits of some multiple expansion. So I'm just curious kind of what may have changed. I guess there's a couple of ways one could speculate on that.

17:33One is just that if you look at some of the sell -side research, these are generally covered by insurance analysts. Insurance is seen as a somewhat technical topic for a lot of generalists, even though these brokers are fairly simple businesses at a high level. Because of the capital intensity and commoditized nature of the insurance business, a lot of these businesses that would generally trade or price to book, but have an earnings multiple in the single digit range. And so broking businesses would always trade at a significant premium to them, even if they're undervalued. And so maybe the magnitude of just how much of a premium a capital light toll booth in the industry should be valued at relative to a carrier has been something that at any one point in time is maybe harder to spot.

18:27I think maybe another reason in more recent times has been the fact that the industry did go through one challenging period from the early to mid -2000s when these brokers were earning contingent commissions. Essentially, that means that the carriers were paying the brokers for some performance metrics that business that they brought them were achieved. Marsh in particular was making a lot of money off contingent commissions. They generally weren't paying the producers in the same way from these contingent commissions. And so it was incredibly high margin. And Eliot Spitzer went after Marsh in particular, but the idea of contingent commissions.

19:10And for a while in Marsh's case, these went away and collapsed the margin structure for a period. And there may have been some hangover from that period in the stocks. It seems like M &A is core to Gallagher's strategy. I think they do tens of tucking acquisitions each year. Can you just describe that part of the strategy and how it's been so creative to their business model? Maybe just before we get there, I think one other reason that some of these brokers have been good for a long period of time is that the industry went through a consolidation period. When we're talking about brokers like Marsh and Aon, that consolidation period was really in the late 90s and then culminated in the mid -2000s when Aon bought Benfield, which is the equal biggest reinsurance broker in the world alongside Guy Carpenter, which is Marsh's brand.

20:16And that consolidation has been slower to take place in the mid -market. And as you point out, really key piece of Gallagher's strategy is the tuck -in M &A that they do. So Gallagher has been a prolific acquirer for a very long period of time through both these tuck -in acquisitions and sporadic larger deals, which tend to be opportunistic in nature. So the recent acquisition of Willis Re, which we may get onto being maybe the best example of that. When we're talking about the tuck -in acquisitions, they do about 30 to 50 a year. That number's grown a little bit over time, but has been a very, very consistent feature of the company.

21:00And the market structure is really what allows them to do that. The mid -market is served by thousands of independent brokers and agents. And despite the fact that Gallagher has done so many deals alongside others that have engaged in a similar strategy, there are probably still about 19 ,000 of these independent brokers and agents left. So it'll take a very, very long time for Gallagher to reach the end of their M &A runway. I think asking why this works is an interesting question. So maybe at a basic level, integration seems to be fairly seamless in this industry, especially when we're talking about these smaller tuck -in acquisitions.

21:46It's a very tried and true strategy for Gallagher, but also for others. And it just seems to have worked over time. I guess there's other features of the industry which make it amenable to a roll -up strategy. I think the fact that retention rates are high, that it's very economically stable and predictable really help this sort of a strategy. And I think that while there is competition for these deals, there's a limited number of players in the market for whom this makes sense. Multiples have expanded. And so it's always a worry when you've got such a strategy that essentially the returns on that capital spent get bid down over time.

22:31If we look just five years ago, Gallagher specifically was paying about seven times EBITDA for their token acquisitions. And the side, I think EBITDA or sometimes EBITDA, which they use in this industry, is a fair number to use just because they're capital light. Unless you think the business is going to flee. I think X -ing out the amortization is a fair way of doing things. Those multiples have expanded to about the 10 or 11 times level in recent times with competition from PE and other acquirers. But I think that still makes sense for Gallagher. It's fair that incremental returns on organic growth are close to infinite for this kind of a business.

23:23But if you compare the opportunity cost of either buying back stock, which is what some of the larger consolidated brokers do, and doing these deals, I think that a starting yield of about 7 % or 8 % and strong, stable, organic growth from there is a value -added use of capital. And there's some nuances with Gallagher around some of their alternative energy and clean coal investments that they've historically made, which give them substantial tax credits, which essentially allows them to buy down that multiple a bit. I think what's also important to talk about is why the sellers sell to Gallagher or one of the other players in this space.

24:10I think you get different kinds of sellers. So some of the owners of these brokers and agents are essentially selling to PE in order to take their own out and essentially exit the business. Gallagher tends to refer sellers that are kind of in it for the long haul and essentially see the writing on the wall with respect to how much they're going to need to spend in data and analytics and might just have ambitions to grow their businesses a bit more going forward. And there's various ways that Gallagher can help them achieve that. I think something else to think about is that producers or the client -facing people in these businesses are commissioned.

24:59So while Gallagher earns commissions, the producers tend to earn about 25 % of those commissions. And so it could be perfectly economically rational if the seller thinks that they can grow their business more to sell it to Gallagher for a somewhat attractive multiple to Gallagher, but then grow their business substantially, subsequently to doing that. The M &A success is a function of strong integration, alignment of incentives. I guess the way that they capture this is what they call the Gallagher way. Sometimes it's difficult to articulate why company culture matters, but I think it is unique here.

25:41What can you share with us to help us better appreciate what the Gallagher way really means in the context of this business? Yes. Culture is really key to the Gallagher story. It's something that they're very, very front -footed about and something that they've emphasized for a very, very long time. And so maybe the history of the company is a good place to start. The business was started by Arthur or Art Gallagher in 1927. He was the son of an Irish immigrant and he was working at another broker and essentially became disillusioned when he was a top performing salesman in that office, but somehow was getting paid less than some of his peers who were perceived to come from upper echelons of society.

26:33And so right from the start, he really felt that broking is a relationship business, that it's a sales business, and that sales and your service to the customer are really what makes it tick. And so the culture that he kind of pioneered from the beginning really always had that front and center. And Gallagher's always rewarded the producers in the business well, and has always taken a very strong stance with respect to treating their customers well. The business has been in the hands of the Gallagher family for basically the entire history. It's pretty remarkable that they've only had three CEOs during that coming on 100 years of business history.

27:24So Art Gallagher founded the business and his son, Bob Gallagher, took over the reins of the CEO in the early 1960s. The current CEO, So Pat Gallagher is Bob Gallagher's nephew, so Art Gallagher's grandson, and he's been in place as the CEO since 1996. So that stability of leadership, stability of family involvement has been incredibly long running. You talked about the Gallagher way. That was something that is their way of describing the culture of the business. It was formally written down by Bob Gallagher in 1984, just prior to the IPO of the business. And if you look at them, you can kind of see that they are pretty cumbersome, fully written, kind of contradict each other at times.

28:20But I think what it really captures is the essence and spirit of this company and the key aspects of the culture, which are its sales orientation, its customer service, its very outwardly aggressive and competitive spirit, but very inwardly collaborative nature of the company. And just reading through a book that's also called The Gallagher Way, which the company periodically publishes, you can see that this is a really long running feature of the company. When we were speaking to Doug Howell, the CFO, who's incidentally also must be one of the longest running S &P 500 CFOs in place, having been there since 2003, we kind of asked him for examples of this.

29:13And he talked about how their head of real estate in hospitality, Alex Glickman, who sits in California, will help somebody in Minneapolis sell a real estate commission, even though the business is kind of organized into local offices and under these industry practice groups. They'll speak to each other about how that commission gets split. Head office doesn't really get involved in these conversations. Now, if you think about how to scale something like that to 50 ,000 people, I think it really has to be something that's part of the core DNA of the company to really keep that spirit alive between the employees.

29:57All right, you've done a good job, I think, at explaining the key features of the business, but can you spend some time walking us through the financial model, any key numbers or KPIs that we should pay attention to? As previously referenced, Gallagher's revenue is about $10 billion from a combination of fees and commissions. And within the brokerage space, it's a bit more commission -oriented than some of its peers. About 60 % of the revenue that Gallagher generates is paid out as compensation to staff. So their costs are heavily skewed to compensation, as you would expect. And about half that compensation or about 20 % to 30 % of commissions paid out to the producers specifically.

30:39So that tends to be a pretty variable portion of compensation that moves up and down largely in line with the revenue that Gallagher generates. The rest of their operating costs are split between other staff costs, which are maybe more back office oriented, things like people doing tasks like policy checking, and then other costs that you might expect, so T &E, technology costs, et cetera. Those latter costs tend to be a bit more fixed in nature. So Gallagher's margins tend to expand with the level of organic growth being a key variable there. Gallagher talks about needing at least 4 % organic growth in order to see some level of margin expansion, and they would expect about 50 to 75 basis points of margin expansion going forward.

31:34But in recent years, they've seen materially more than that because a combination of factors. Firstly, a lot of efforts that have been put in place to offshore some of their back office costs with what they call their senses of excellence in India. Secondly, during the COVID period, some costs like T &E moving down or going away for a brief period of time. And then, of course, in recent years with inflation and with a confluence of factors that have been very favorable to the industry, their organic growth, which had averaged about 5 % for the previous decade, has actually been about 10 % in the double digits in certain periods.