There Is No Magic In MGAs

I’ve been around the insurance business long enough to remember when MGA was a four letter word.

It wasn’t as bad as it was thought then, but it’s also not as good as the regard it’s held in now. MGAs are flawed structures, but they do have some benefits.

Just as the industry forgot all the benefits 20+ years ago, it has forgotten all the flaws now.

The core purpose of an MGA is for when a producer is able to source a distinct book of similar business do to a specialization, such as preschools or firetrucks or yoga studios.

Often, these distributors don’t have (or want) the capital to underwrite or the stomach to take risk, so they become an MGA to pool similar risks for specialist underwriters. The underwriters agree to support this because they recognize the skill the MGA has in understanding this niche class and sourcing production.

In other words, the underwriters know the MGA is able to access the risk in a way that they can’t and likely has some specialized knowledge or data about the quality of each client.

In these cases, “giving away the pen” to an MGA can make sense, especially if the MGA also retains some of the risk or receives profit based contingent commissions.

What does not make sense is being an MGA writing commodity business with no distinctive advantage. Why would a reinsurer back that – other than because it’s a soft market?

No, this is not going to be another rehash of dumb reinsurers backing insuretech MGAs. Instead, I’m going to review the newest dumb trend in MGAs: financial engineering.

Financial Engineering

To be clear, yes, insuretechs deciding to be MGAs and arb reinsurers was also financial engineering. But that was Financial Engineering 101. Today’s topic is Financial Engineering 311 – Making 3 Out Of 1+1.

If you haven’t guessed yet, I’m going to discuss the Fidelis and AIG high net worth “breakups”. If you’re not familiar with them, they both have the same premise – the big, bad balance sheet is holding back our valuation. The market doesn’t understand the value we bring. If we only “get rid of” the volatility, we would be worth so much more.

The argument, as it goes, is rather than have a combined entity trade at say 1.3X BV, we can have the balance sheet trade at book and the MGA at 15X EBITDA (or more!).

Of course, there is an investment banker behind the curtains who explains why this all makes sense and is sustainable. (Narrator: It wasn’t sustainable – trust me, I can see the future.)

First, the valuation difference is a trade, not a permanent advantage. I’ve told plenty of companies to spin off or sell units before, but those were secondary businesses, not their core operation. You don’t disrupt your business model to game a short term trading differential.

More importantly, the math doesn’t work. What it really does is create a favored entity (the MGA) over the stepchild entity (the balance sheet) and the management team hitches its engine to the favored one so they can paid better. This isn’t being done for the shareholders!

Let’s do an example:

Investment Banker Math

We’re going to create a company writing $1B of premium on $1B of capital at a 96 and supposing they’re worth 1.3X BV, or $1.3B.

	Traditional	MGA	Dumb B/S
GPW/MGA rev	1000	300	1000
LR	66		66
Acquisition Ratio	14	14	30
G&A Ratio	16	8	8
CR/EBITDA	96	80	104

So let me explain some of the columns. Hopefully, the traditional one is easy enough.

For the MGA, even though they’re paying 14% to their distribution, they’re going to pay themselves 30%. Why? Because that’s what MGAs do!

Let’s assume the 16% of G&A belongs 1/2 to the new MGA and 1/2 remains with the underwriter. That means, of the 30 points, they’ll pay 14 out to their brokers and 8 to their staff, leaving 8 of profit for a 27% EBITDA margin (8/30).

This means our new MGA has $80M of EBITDA! If we value that at 16X, it’s $1.3B of market value.

Why that’s the whole market cap of the company! Magic! As long as the insurer isn’t worth 0, we win!

How The Math Falls Apart

But there are a few problems with this magic math. First, To get that $80M of EBITDA for our MGA, we took $80M of underwriting profit out of our carrier. It now has a 38% ER (see last column) and a 104 CR.

But that’s OK, because that’s still worth more than 0! You can get 80% of BV for that, so that’s $800M and since our MGA is worth $1.3B, then we created $800M in market cap!

No, you proved why bankers shouldn’t be trusted with this garbage analysis.

The “EBITDA” comes from an arbitrary decision to push $80M of profit from the underwriter to the MGA. Is that truly a market transaction? Why would the carrier agree to suffer losses to benefit the MGA?

A true market price for the MGA fee would be 22%, not 30%. This would let the carrier remain at a 96 CR…and the MGA would have $0 EBITDA and be worthless.

You can’t just steal value from one part of the company to enrich the other!

The Real World Intervenes

Unfortunately, there are more problems than bad math. There is a good chance the parts are worth less than the whole in reality.

First, with the integrated carrier, the business knows it has a home for the risk. If the MGA and carrier are truly independent, the carrier can always decide to non-renew or reduce capacity.

After all, why would it want to write at a 104? And what other market would want to write at a 104? Or even the old 96 that was producing the substandard valuation?

To get an outside carrier to write the program, might require a 92. How are you going to pull that off? And before you say, oh, we can make underwriting improvements or, we can raise price, uh, couldn’t you have done that before creating the MGA???

So the MGA has opened itself up to the risk of the Reinsurer’s Veto.

What about the carrier? Is it going to now diversify and write outside business? If so, where will it get the capital for that when it’s now valued at 80% of book?

Will it instead have no choice but to be a captive reinsurer for the MGA? It seems like it.

Wait, I’ve seen this movie before? Remember when Tower created Castlepoint? And Amtrust created Maiden? How did those movies end?

Oh, right, the captive reinsurers got stuffed with all the bad risk and eventually collapsed. So maybe instead of 80% of BV for our new reinsurer, we should choose 20%?

Real Value Creation

Alright, let’s try one more exercise. What if the new entity raised prices 20% to help the reinsurer make more money?

This would be great, right? The MGA would now make 20% more fees! Yes, as long as it can hold the clients hostage, it would make 20% more fees.

In the real world, if this was possible, they would have done it already. So, in all likelihood, a lot of clients would walk. I’m going to assume a third leave (if it were less than this, they would have taken the rate hikes previously as you’ll see).

	Traditional	MGA	Dumb B/S
GPW/MGA Rev	800 (+20% rate/-33% PIF)	240	800
LR	55 (20% rate hike)		55
Acquisition Ratio	14	14	30
G&A Ratio	18 (10% $ cut)	9	9
CR/EBITDA	87	56	94

In our first example, the entity was making $40M of underwriting profit. By aggressively shrinking to fix pricing, they are now making $104M! This is real value creation!

Now, we can debate if they’d lose even more of their PIF taking such large hikes relative to the market, but let’s be generous for now and assume they only shrink by 1/3. Of course, most managements would be mortified to shrink so much, but if you’re really trying to create value, this is how you do it.

The MGA Must Sacrifice For The Greater Good

We have also created a dumb reinsurer that can make money after paying the MGA 30% so we now have a viable answer to how we’ll sustain capacity for our MGA.

All good, right? Unless you’re the MGA owner. Their EBITDA has been cut from $80M to $56M due to the reduced top line and slightly higher expenses.

Here’s the thing though. The entity is worth a whole lot more. The reinsurer is now worth over $1B and the MGA is worth say $800M, so you’ve got a combined $2B of market cap now! See, this is why we needed an MGA!!!

Except for one thing. If we kept the existing structure, and improved the CR from 96 to 87 by shrinking, we’d have added 7% to ROE.

If we assumed earlier the old entity (at ~10% ROE) was worth 1.3X BV, wouldn’t this new, more profitable entity be worth close to 2X BV, which is…also $2B. Funny how that works!

How Value Is Created

So what did we learn today? Value is created by improving profitability, not by creating artificial structures.

The MGA split-off approach only benefits the bankers who get paid fees and the MGA execs who steal profits from the underwriter to fund their higher valuation.

There is no free lunch and magic is just an illusion.