Arthur J. Gallagher (AJG)

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William Haddad

Dan Pan

Arthur J. Gallagher & Co. (NYSE: AJG) is the world's largest third-party property/casualty claims administrator and the fourth largest insurance broker based on revenues. ^{[1] [2]} As an insurance brokerage, Gallagher acts as a middleman between companies seeking coverage for risks and insurance companies willing to insure them. Commissions from selling insurance constituted 54% of their total revenue in 2007, with the rest coming from administrative and investment management fees.^[3] AJG specializes in niche and middle market insurance in industries such as not-for-profits, religious institutions, and shopping centers. ^[4] 88% of their business comes from the United States and the remaining amount is focused in the U.K., Canada, Australia, and Bermuda. ^[5]

AJG has been active in acquiring businesses for its brokerage division. Since August 19, 2008, AJG has acquired interests in 6 other businesses. The most recent acquisition occured on October 10, 2008, when AJG announced the purchase of a 40% equity stake in Specialized Broking Associates, a Western Australian broker that specializes in the energy, construction, and mining industries. ^[6] Conversely, AJG has decided to wind down its Financial Services segment and anticipates having divested from it by the end of 2008. ^[7]

Company Overview

AJG has been divesting its Financial Services segment in favor of growth in Brokerage business. ^[8] Since 2005, total revenues and net earnings have increased by 13.6% and 350.6% respectively. ^[9] The large increase in net earnings since 2005 were due to large litigation expenses in 2005. Excluding those one time expenses, net earnings have decreased by 42.3%. ^[10]

Business Segments

AJG 2007 Total Revenue by Segment ^[11]

• Brokerage (69% Total Revenue): As an insurance brokerage, Gallagher acts as a middleman between companies seeking coverage for risks and insurance companies willing to insure them. 78.3% of the brokerage division's total revenues come from commissions earned on the sale of insurance. ^[12] The two divisions within brokerage are the retail insurance brokers, accounting for 80% of total revenues, and the wholesale insurance brokers, representing the other 20%.^[13] In retail brokerage, AJG helps sells insurance to niche industries such as agribusiness, marine businesses, and product liability. ^[14] In the wholesale division, AJG acts as a managing general agent or underwriter for an insurer. ^[15] This lets AJG to operate an insurer's business in a certain geographic region. ^[16]

• Risk Management (27% Total Revenue) provides claim settlement and administration for businesses that self insure their risks. ^[17] Gallagher charges fees for these administrative services. The companies that AJG does this for tend to be large Fortune 1000 companies. ^[18] The most popular type of claims AJG works with are workers compensation claims (70% of total revenue) followed by auto liability (26%) and property related (4%). ^[19] Growth in this department is expected to come from attracting new clients as well as outsourcing claims departments. ^[20]

• Financial Services (4% Total Revenue) manages investments which AJG has made in other businesses. Since 2003, AJG has been closing down this part of the business and expect to have divested from it by the end of 2008. ^[21] This segment included investments in an asset management firm, a clean energy company, and certain tax advantaged investments. ^[22]

Business & Financial Metrics

In 2007, AJG's net earnings rose 8.02% but still remained below their net earnings of 2003 and 2004. ^[23]The litigation of 2005 caused AJG to incur over $209 million in expenses and a decrease of net earnings that year of 83.66%.^[24] Since 2003, net revenues have risen every year including a 10.42% increase in 2007.^[25]

^[26]

^[27]

Key Trends and Forces

Regulation Prevents Contingent Commissions

AJG and its three largest competitors(Willis Group Holdings (WSH) , Aon (AOC) , and Marsh & McLennan Companies (MMC) ) have all made agreements with regulators that they will not receive commissions contingent on volume or profit. Contingent commissions are paid by insurance companies to brokers to encourage the broker to sell more of that company's insurance. This creates a conflict of interest because the broker has motives other than the customer's best interests when recommending types of insurance.^[28] AJG and the others agreed to these new regulations following an investigation by the Illinois Attorney General and a Multi-District Litigation proceeding in U.S. District Court.^[29] Under the agreement, if AJG acquires a new company, that company can only receive a contingent commission for a three year period following the acquisition. By taking the agreement, AJG avoided going to court on the issue and admitted no wrongdoing but did pay $26.9 million into a fund for eligible policyholder clients.^[30] AJG does not disclose how much of its income comes from contingent commissions, but this settlement puts AJG at a disadvantage to other insurance brokers who are able to receive contingent commissions. ^[31] Additionally, AJG has also received subpoenas for information about its risk management from the Attorneys General of New York and Connecticut.^[32] Even if AJG does not incur more regulation, the costs associated with the litigation can be significant as it was in 2005 when AJG had $209.8 million in litigation and contingent commission matter and claims handling obligations. ^[33]

Soft Insurance Market Hurts Profits

After two consecutive years of lower-than-average hurricane losses, insurance carriers are cutting prices to win new business. ^[34] According to the Council of Insurance Agents & Brokers in Washington, premiums for commercial property/casualty insurance decreased 11% in the 3rd Q of 2008 from a year before. ^[35] As the price of insurance decreases, the commissions AJG earns for selling the insurance also go down. Continued softness in the insurance markets means reduced commission revenue for AJG.

Dependence on Acquisitions Leads to Idle Cash

AJG has demonstrated its willingness to expand via acquisitions both in word and practice. Since 1985, AJG has made 183 acquisitions with 3 coming in January 2008 alone. ^[36] As the softness in the insurance market continues, the values of potential takeover targets will only become more attractive for AJG. ^[37] However, if no attractive opportunities are available, AJG would have a large position in idle cash, which has no prospect of increasing shareholder value. As of September 30, 2008, AJG maintained $249.6 million in cash and cash equivalents and $1.74 billion in current assets. ^[38] These are assets which could potentially be used in acquiring another business.

Competition

The six largest brokers of business in the world and the U.S. are AJG, Marsh & McLennan, Aon, Willis, Brown & Brown (BRO) , and Wells Fargo (WFC).^{[39] [40]} AJG is the world's largest 3rd party property/casualty claims administrator and the fourth largest insurance broker based on revenues. ^{[41] [42]} The insurance market is fragmented, with the large 50 insurance companies controlling only 20% of the market. Thus, AJG does not compete with a select number of firms for the same business. Rather, AJG competes against any number of players in the insurance industry for the numerous insurance products it offers. For example, AJG outlines over 20 niche businesses in which it sells insurance. In each of those businesses, AJG is competing against different companies. Thus, there does not exist a compact list of businesses with which AJG competes the most often.

References

1. ↑ Kevin Edison and Karen Tucker (July 16, 2007). World’s 10 largest insurance brokers.
2. ↑ Kevin Edison and Karen Tucker (July 16, 2007). 100 largest brokers of U.S. business.
3. ↑ AJG 2007 10-k pg. 3  
4. ↑ AJG 2007 10-k pg. 4  
5. ↑ AJG 2007 10-k pg. 2  
6. ↑ Arthur J. Gallagher & Co. Acquires an Equity Interest in Specialized Broking Associates Pty Ltd (October 10, 2008).
7. ↑ AJG 2007 10-k pg. 5  
8. ↑ AJG 2007 10-k pg. 5  
9. ↑ AJG 2007 10-k pg. 17  
10. ↑ AJG 2007 10-k pg. 17  
11. ↑ AJG 2007 10-k pg. 3  
12. ↑ AJG 2007 10-k pg. 3  
13. ↑ AJG 2007 10-k pg. 4  
14. ↑ AJG 2007 10-k pg. 4  
15. ↑ AJG 2007 10-k pg. 4  
16. ↑ AJG 2007 10-k pg. 4  
17. ↑ AJG 2007 10-k pg. 5  
18. ↑ AJG 2007 10-k pg. 5  
19. ↑ AJG 2007 10-k pg. 5  
20. ↑ AJG 2007 10-k pg. 5  
21. ↑ AJG 2007 10-k pg. 5  
22. ↑ AJG 2007 10-k pg. 6  
23. ↑ [AJG 2007 10K pg. 17]
24. ↑ [AJG 2007 10K pg. 17]
25. ↑ [AJG 2007 10K pg. 17]
26. ↑ [AJG 2007 10K pg. 17]
27. ↑ [AJG 2007 10K pg. 6]
28. ↑ Gallagher settles compensation probe for $27 million (May 18, 2005).
29. ↑ AJG 2007 10-k pg. 8  
30. ↑ AJG 2007 10-k pg. 8  
31. ↑ AJG 2007 10-k pg. 10  
32. ↑ AJG 2007 10-k pg. 10  
33. ↑ AJG 2007 10-k pg. 17  
34. ↑ Andrew Frye (July 18, 2008). Brown & Brown Leads Brokerages Lower on Profit Drop.
35. ↑ Commercial P/C Premiums Continue to Drop in Third Quarter (October 22, 2008).
36. ↑ AJG 2007 10-k pg. 9  
37. ↑ Andrew Frye (July 18, 2008). Brown & Brown Leads Brokerages Lower on Profit Drop.
38. ↑ AJG 3rd Quarter 2008 10Q (October 30, 2008).
39. ↑ Kevin Edison and Karen Tucker (July 16, 2007). World’s 10 largest insurance brokers.
40. ↑ Kevin Edison and Karen Tucker (July 16, 2007). 100 largest brokers of U.S. business.
41. ↑ Kevin Edison and Karen Tucker (July 16, 2007). World’s 10 largest insurance brokers.
42. ↑ Kevin Edison and Karen Tucker (July 16, 2007). 100 largest brokers of U.S. business.
43. ↑ Yahoo Insurance Brokers Overview