For more than a year, buyers took several different approaches to acquiring employee benefits firms while the debate over healthcare reform raged on.

Some were opportunistic, acquiring larger firms or those focused on large accounts. Others continued courting benefits firms while never getting to the altar, and some took the tough stance of not acquiring any benefits business at all until there was some resolution.

Not only did the slowing economy force many agencies to rethink their employee benefits offerings, many industry observers have been speculating for months that healthcare reform would likely also increase the number of mergers and acquisitions among those firms offering benefits solutions. Now that historic legislation known as the Patient Protection and Affordable Care Act has been signed into law, will M&A go gangbusters for benefits?

Many in the industry believe there will be streamlining in all things healthcare, and that affects brokerages handling employee benefits, especially those serving small groups. Regardless of how you define small-group business—100 lives or fewer, 50 or fewer, even 25 or fewer—the consensus among industry participants and observers is that firms focused on small groups are at risk of losing revenue, shrinking, failing or being acquired if they do not change and rise up to meet the challenges the bill imposes. 

One threat to firms with a small-group focus appears to be the creation of health insurance exchanges, which become effective in 2014. Small businesses with up to 100 employees can purchase coverage through an exchange. Agencies that rely on commissions from health insurance policies from this client base are at greater risk of experiencing declining revenue or, worse, becoming obsolete. Smaller businesses may still need the assistance and expertise of a benefits broker when choosing coverage within the exchange, but how much will the broker be paid for this different service and what will this service look like? Because of this, firms concentrated on small-group business may be less attractive as a merger partner, especially to larger brokerages.

One of the major provisions of the new law concerning insurers could affect agents and brokers as well. The legislation requires health plans to report medical loss ratios—the percentage of an insurer’s premium spent on clinical services, quality and other costs. If less than 85% is spent on approved services for the large-group market plans, or 80% for individual and small-group plans, the law requires that insurers provide rebates to consumers for the difference. This would take effect in 2011. If insurers don’t meet MLRs and have to provide a rebate, they will seek to cut costs somewhere.

The concern for agents and brokers is the perceived risk of declining revenue or the inability to manage compliance. One M&A insider likened the legislative particulars to a “compliance tsunami.” Many agencies that are focused on small-group business are smaller businesses themselves, and they simply do not have the capacity to handle the “compliance tsunami” or have the ability to survive declining revenue.

Historically, benefits firms have enjoyed higher profit margins than pure property-casualty agencies, even if they weren’t growing organically. One reason for the boon in benefits-firm acquisitions in 2008 was that a lot of p-c firms wanted to diversify and either enhance or build benefits operations. Unlike benefits brokerages, p-c firms have been in a quagmire of a soft market for several years. Now the tide is beginning to turn. As more client services are demanded of benefits providers, both from customers and insurers and at a greater cost, profit margins will get squeezed. 

Greater service demands coupled with lower premium to brokers (less commission) will likely compress margins of pure benefits firms, making them more comparable with those of well run p-c firms. As margins between benefits firms and well-run p-c firms align, so will the multiples used for pricing transactions, thereby ending “premium pricing” for benefits firms. Some firms will succeed and sell at fair value while many of those unprepared for these changes will sell at a discount.

Over the past year, larger firms have targeted smaller independent benefits brokerages or those with benefits offerings, mostly those under $2 million in revenue. The demands of the healthcare reform bill—expand coverage through exchanges if need be, control healthcare costs and improve the healthcare delivery system—do not bode well for the smaller, independent benefits brokerage. However, several leading benefits consultants believe that significant changes are coming to healthcare distribution regardless of healthcare reform legislation.

If brokerages continue to operate without making changes to their business model to meet the challenges of legislation or the future healthcare distribution model, revenue will decline substantially and they will be forced to exit the market. Firms that recognize that remaining independent is no longer a viable option will seek a transaction partner at a time when the risk of declining revenue and profits is high and buyer demand is weak.

Those firms that adapt to the new environment will grow stronger. Those focused on growth, product and service diversification, and technological efficiencies will ultimately increase revenue and profits through enhanced and creative business models. Well run companies excel at solving problems and managing challenges. Is your employee benefits business ready for the future?