Insurance broker deals - are you deploying your cash effectively?
May 18, 2015
Is your calculation of Threshold Condition 2.4 impacting value?
Despite a "steady" reporting season across the insurance industry, deals activity in the broker sector was still relatively high in Q1. With this in mind I thought I’d examine another way to maximise value within the sector - one which my team and I have been surprised not to see more focus on by sector investors.
Adequate resources
The Financial Conduct Authority’s (FCA) Threshold Condition 2.4 (TC2.4, formerly Threshold Condition 4) says that "The resources of [a broker] must be appropriate in relation to the regulated activities that [broker] carries on or seeks to carry on". In short, insurance brokers must always have enough cash (not assets) available to fulfil their regulatory obligations (ie to perform an orderly wind-down) in the event that they cease to trade tomorrow.
Cease to trade tomorrow?
While the likelihood that any particular broker would cease to trade so abruptly is remote (and even if it did whether that would cause any significant market impact as business moves elsewhere), the FCA wants this position to be considered and provided for - after all, no one expected the Lehman Brothers situation.
Restricted cash
Since the FCA's “Dear CEO” letter in February 2010 all UK insurance brokers have been required to calculate a minimum level of cash they must hold to ensure they are able to perform an orderly wind-down in the event they cease trading. Large brokers, those refinancing, or those engaged in merger and acquisition (M&A) activity would have had the provision tested by the FCA. By ensuring the provision is on their deal “to do” list firms can pre-empt issues which may impact deal value - such as delays in obtaining change in control permissions.
Across the sector a number of estimation methods and assessment types exist with little consensus. The cruder are based on a percentage of revenue, say 5%, or a period of expenses, say 3 months. But this does not take into account the underlying nature of the broker.
The impact on financiers and investors
For investors excess TC2.4 provisions reduce the assets available for growth and ultimately for dividends. For finance providers TC2.4 balances are required to be excluded from any securitisation, exposing a risk to financiers who hold charges over broker assets.
Brokers are starting to re-assess their TC2.4 positions to confirm cash is deployed correctly and effectively throughout their business. They are doing so by:
- Refining their assessment: where firms have previously taken a revenue or cost approach, preparing a business focused assessment may reduce the required TC2.4 amount.
- Re-assess post-merger: there are usually significant economies of scale that can be achieved in a TC2.4 position following a broker acquisition. New groups may tally the original TC2.4 amounts of each entity following a merger. This does not need to be the case. An updated assessment reflective of the combined group will typically see a significant reduction in the combined TC2.4 amount.
- Re-assess post-restructuring: where a firm has undertaken significant steps to restructure their business, for instance closing branches or rationalising costs, the effective benefit of this exercise has often not been reflected in its TC2.4 assessment. An updated assessment reflective of material restructuring steps may also produce a significant reduction in the required TC2.4 assessment.
On a recent TC2.4 assignment I conducted each of the above factors was applicable and the updated assessment saw a TC2.4 balance reduction for the combined group of 40% - over £2.2m.
To what extent would you benefit from reassessing your TC2.4 allocation? Share your thoughts below or schedule a meeting to discuss your situation in confidence.
