Brown & Brown Inc (BRO) 2012 Q3 法說會逐字稿

Good morning, and welcome to the Brown & Brown Incorporated third-quarter earnings conference call. Today's call is being recorded. Please note that certain information discussed during this call, including answers given in response to your questions, may relate to future results and events, or otherwise be forward-looking in nature and reflect our current views, with respect to future events, including financial performance. Such statements are intended to fall within the Safe Harbor provisions of the Securities Law. Actual results or events in the future are subject to a number of risks and uncertainties, and may differ materially from those currently anticipated or desired, or referenced in any forward-looking statements made as a result of a number of factors, including those risks and uncertainties that have been or will be identified from time-to-time in the Company's reports filed with the Securities and Exchange Commission. Third, our additional discussions of these and other factors affecting the Company's business and respects are contained the Company's filings with the Securities and Exchange Commission. With that said, I will now turn the call over to Mr. Powell Brown, our President and Chief Executive Officer.

Thank you, Lisa. Good morning, everybody. We're pleased with our organic growth in Q3. It was in line with our expectations, and there are some positive signs within our retail division that you'll hear about. Rates are up in many places, flat in some places, and rarely, but periodically down. We also closed one acquisition, as you know, in Q3, for $5.8 million in revenue. With that, I'll turn it over to Cory for our financial report.

Thanks, Powell. Now that we've had three straight quarters of positive internal growth, we definitely have a trend. Most importantly, our largest division, retail, had a second consecutive quarter of positive growth, with expanding margins, and that trend is expected to continue. Our net income for the third quarter of 2012 was $49.5 million, and that's up 12.1% over the third quarter of 2011. Correspondingly, our net income per share for the quarter was $0.34, and that's 13.3% increase over the $0.30 of last year's third quarter.

From a revenue standpoint, conditions and fees for the quarter increased 16.7% to $303.8 million. That's up from the $260.4 million in last year's third quarter. As always, included in our press release is our normal table that summarizes the total growth rates, and the internal growth rates from our core commissions and fees, which excludes profit sharing, continued commissions, and guaranteed supplemental commissions, which we refer to as GSCs. We received $12.1 million of profit sharing continuing commissions, which represented a net increase of about $4.8 million from the $7.2 million that we earned last year in the third quarter. The vast majority of this net increase was from our Arrowhead operations.

For the fourth quarter of 2012, we estimate that we may receive between $2 million and $3 million, as long as the hurricanes behave, and they stay away from Florida for the rest of the year. Additionally, we accrued $2.4 million of guaranteed supplemental commissions for the third quarter of 2012. That is $540,000 less than the $2.9 million that we accrued for in the third quarter of 2011. As we have mentioned in previous conference calls, this reduction is due to the fact that several of our insurance carrier partners have reverted back to their profit sharing continued commission contracts, beginning this year in 2012. So presumably, if the carriers' loss ratios remain stable, this revenue should flow back to us in 2013 in the form of profit sharing contingencies.

Now, looking at the internal growth schedule, we had a positive internal growth rate of 1%, which is much stronger than you would initially perceive by just the raw number of 1%. For the third quarter of 2012, our total core commissions and fees increased 18.2%, or $44.3 million of core commissions and fees, but within that net number was $41.8 million of acquired revenues. That means that we had $2.4 million more of commissions and fee revenues on a same store sales basis. We view this 1% organic growth as consistent with the trends that we saw developing in the second quarter, when our organic growth was 3.2% on a consolidated basis. The difference is, in the organic growth from 3.2% to 1%, centers primarily on the wholesale brokerage division, and three separate program division operations. The wholesale division grew organically $1.1 million in the third quarter, as compared to the $3.4 million that they grew in the second quarter. This slightly-lower growth is due to lower increases in the coastal cat property rates than what we saw in the first half of 2012. We continue to expect increases in the coastal cat property rates during the fourth quarter. However, it will be at rates more similar to what we saw in the current third-quarter numbers.

The first of the three program operations that we would like to highlight, due to their differences from the second quarter, is Proctor Financial. Proctor had $1.2 million organic growth in the second quarter. However, this quarter, they had a $300,000 decline, as compared to the prior year. Proctor continues to have an outstanding year of new business. However, the flow of revenue from their clients can be uneven at times, as was the case this quarter. We expect much of this quarterly difference to flow in through the fourth quarter.

Proctor has a very good pipeline of potential new clients, also. It is important to note that the Proctor team is doing an excellent job. They have not lost a single client this year, and they have picked up several new clients. Proctor's revenue recognition is highly-dependent on their clients' processing of their loan portfolio computer files, and approving which loans are placed ultimately in the program. This quarter, we had several of their clients, for different reasons, get backed up on their loan file processing, and thus have delayed some of Proctor's revenues to be recognized.

The second program operational highlight is our operation that provides facultative reinsurance products to certain insurance carriers. One of our larger clients decided to self-absorb more of their underwriting risk, and chose not to renew two large facultative reinsurance treaties, and as such, that represented nearly $1 million of less commissions for us. Once again, our folks in this operation have done a great job over time. In fact, this is one of our operations that has had positive internal growth each of the last four years, and that's during our economic Armageddon set-in. So this was a tough quarter for them, but I'm confident that they will find new accounts to write.

The last program that did not have as a good a quarter in the third quarter as they did in the second was our operation that provides E&O coverage for the financial services industry. They also provide claims and administrations for such claims. They had a $200,000 positive growth in the second quarter, but a $600,000 downdraft in the third quarter. Half of this differential is due to the claims files that we have closed, which is great for our clients, but the number of new financial services claims, obviously, in this period is down from where it was from the 2008 to 2011 period. And therefore our claimed revenue is down. The other part of the drop was a large account that we helped design a larger FIR attachment point and thus reduced the premium and the related commissions on that account. So, it wasn't a lost account. It was just a restructure of existing.

On our Arrowhead operations, we treat their operations as acquired operations, and thus they are not reflected in our official internal growth numbers. However, on a standalone basis, their internal revenue growth for the third quarter was 13%. This growth came primarily from their earthquake DIC program, as well as their personal property program. If you were to take Arrowhead's raw numbers and just add them into our internal growth numbers as if they were here for both years, our internal growth rate would go from 1% to 2.2%. Additionally, as we have discussed on several webcasts during the last quarter, we are very proud of the Arrowhead team and their success at winning the right to operate a new auto aftermarket program that's underwritten by Zurich. This program, which would be new organic growth for Arrowhead, is estimated to bring in $20 million to $25 million of revenue over the next 12 months.

Now for the most important aspect of our internal growth numbers. That is, as we mentioned, the largest division, which is retail. They had a positive growth this quarter of $1.4 million, and that is up from the $400,000 growth that they had in the second quarter. We believe that this trend will continue, as well as the margins that came as a result.

Moving on to our investment income, investment income decreased by less than $100,000. And then our other increase -- our other income decreased by approximately $1.7 million, and that was a combination of less books of business sales plus litigation settlement income that we received last year. Our pretax margin for the third quarter of 2012 was 26.9%, compared to our pretax margin of 27.9% in the third quarter of 2011. 60 of those 100 basis point differential was due to that line item called change in estimated acquisition earnout payables. With our positive internal growth revenues, our core organic -- our core operating profit margins, when you exclude the impact of acquisitions, the contingent commissions, GSCs, as well as the sale of books of business, it increased by approximately $1.6 million. And I will expand on that margin change in a minute.

Employee compensation and benefits as a percentage of the total revenue was 49.3%. That's an increase over the 48.7% cost factor in the third quarter of 2011. The total dollar increase on a net basis in employee compensation and benefits was approximately $22.8 million or an 18% increase, of which, out of that $22.8 million, $18.2 million was attributable to the just the new standalone acquisition since last year. Therefore, excluding the impact of these standalone acquisitions, we had $4.6 million of additional compensation on a kind of a semi-same-store sales basis.

Of this increase, $1.9 million was due to our one-time -- our new one-time 2012 additional producer commissions paid to our retail division commission producers for their growth of their 2012 production in excess of 5% over their 2011 production. Additionally, $800,000 of that increase also came from the salaries of new producers and staff teammates. $900,000 was due to an increase in our group health insurance cost. And $400,000 was additional payroll taxes. Our non-cash stock-based compensation cost was up on a net basis $1 million, which was due to the new grants under our stock incentive plan, and the majority of these were issued in the beginning of the year to folks in our Arrowhead acquisition.

In the current quarter, other operating expenses decreased as a percentage of total revenues. 40 basis points was the drop, and that was to 14.4% of total revenues in the current third quarter, and that is compared to 14.8% ratio in the third quarter of 2011. The other operating expenses increased $5.3 million, and that's a 13.9% increase over last year. However, the new standalone acquisitions added $7.9 million of that total $5.3 million cost. And therefore, the change in our existing same-store actually had a decrease in other operating expenses of $2.5 million. This net decrease primarily related to $1.3 million in lower legal fees, $1.1 million in lower claims in E&O charges, and $1 million less in cost savings from our occupancy and office rental cost.

Now from a standpoint of an EBITDA, which we don't really talk about but I think it's important to kind of look at it with just basically the revenue numbers that we have in our internal growth schedule. If you look at the last year's third quarter, we had $260 million of revenues, and we had an EBITDA dollar amount of $92.2 million. And that is basically taking our total revenues, taking out our employee benefit cost, the non-cash stock grant compensation, or other operating costs. So it basically excludes amortization, depreciation, interest, and that change in acquisition earnout. That was a 35.4% margin. Those same margins at the end of the third quarter of 2012, we had $303.8 million of revenues, our EBITDA was $106.4 million, and that's a 35% margin.

Trying to reconcile between those two, if you look at our acquisitions, we had $41.8 million of new acquisitions. On a blended basis, our standalone acquisitions came in at an EBITDA margin of about 29.3%. That added $12.2 million to last year's $92.2 million. Additionally, we had about $3.7 million of additional contingencies and GSCs on a net basis, and generally, that came in somewhere around 85% flow in. So that was a little over $3 million added to it. We did have -- on our investment and other income, it went down by $1.7 million, and that is 100% impact on our EBITDA. So $1.7 million comes out.

If you look at our organic growth, that came in at $2.4 million. And generally, I'm just estimating that -- let's just say that 50% of that falls into the EBITDA, because some of that may come in as new business where we are paying our commissions at 40% versus maybe increasing clients premiums that we pay out at only 20% -- so that would be another $1.2 million. We did sell about $2.9 million, as reflected in our internal growth schedule. And generally when we sell a piece of business from having to pay the producer, the 20% renewal, but there is not necessarily -- depending on what you are selling -- not necessarily a lot of drop-off of other costs. So I have just estimated an 80% factor there that would take out about $2.3 million. So really, what's left on a consolidated basis is about $1.6 million of increased EBITDA.

Now, when we issue the 10-Q, obviously, you will have financial statements of each of our business segments, and you will be able to walk through a very similar analysis. But essentially, in our retail division, we saw the EBITDA margin generally move up by almost $2 million. Likewise, the program division, because it had the most revenue that got sucked out, did have a compression in their margins from 45% down to 42%. And so that pretty much explains that. The one number that is probably difficult in that analysis on a segment basis to look at is what is the EBITDA margins of our acquisitions relating to each of the divisions. Generally, on the retail divisions for the third quarter, we had about $8.9 million of acquired revenues. That came in at an EBITDA margin generally at about 25.7%. That is on core, excluding the contingencies and GSCs.

On the program side, the $21.5 million of acquired revenues that we came in, came in roughly at about a 36% margin. We had a small amount of acquisition wholesale, and actually came in at nearly a 45% margin. Our services grew, which obviously is the lowest margin on the TPA services. That $10.8 million of acquired revenues came in generally at about 19.5%. So the point that we have made, that as internal growth, especially in the retail division, starts to gradually move up like we expect, the margins and the leverage of our Company is very much intact, as we have talked about.

Moving on, if you look at our amortization depreciation aggregate, it was up $3.1 million from last year, and that's primarily due to the new acquisitions. Interest expense increased $400,000 over the prior year as a result of the increased borrowings of the $200 million that we did as a result of the Arrowhead acquisition. Our change in the estimated acquisition earnout payable was a debit this quarter or an expense of $858,000. And that is compared to a credit or an income item last year's third quarter of $810,000. Basically, there is a $1.7 million swing in GAAP income, and that's really almost $0.007.

Our effective tax rate for the third quarter of 2012 was 39.4%. It is down from the previous quarter, primarily because we had an $800,000 tax refund that we received on a prior year amended tax return on some tax plane that we had. This is a discrete item specific to the third quarter that came in. It's nice to have it, but on an ongoing basis, for the fourth quarter and future quarters, we still expect the normal tax rate to be at 40.3%. And that is due because of the higher state income tax rates that we have as a result of our larger California exposure. To conclude, we ended up with net income of $42.5 million, which is a nice 14.7% increase from last year's third quarter. With that financial overview, let me turn it back to Powell.

Thanks, Cory. Great report. I would like to review now our operations, starting with retail. We were up 100 basis points in Q3, versus 30 bps up in Q2. In Florida, we look at it in three segments. South Florida property up 4% to 8%, general liability up 1% to 4%, auto rates are down slightly to up slightly, exposure units typically in South Florida are flat. In Central Florida across the I-4 corridor, property rates are up 1% to 10%, GL and auto rates are typically flat to maybe up 3% to 5%, exposure units are flat to up 3%. In North Florida in the Panhandle, property on the coast is up 5% to 10%, typically inland property is flat to down, GL is flat to up 2%, auto is up 3% to 5%, exposure units there are typically flat.

In the Southeastern United States excluding Florida, coastal property is typically up 10%, maybe slightly more. The property inland is up 2% to 5%. GL and auto are up, either flat or up to 5%, and work comp rates are typically plus 5% to plus 10%. Exposure units, payrolls, and sales are flat to up 5%. In the Northeast, excluding New York City construction, which we will talk about in a moment, property rates are up 5% to 10%. GL is flat to up 5%, auto and work comp are typically flat, auto might be up a little bit. Work comp rates could be up as much is 10%, depending on where you are. Exposures typically are flat across the board.

In the Midwest, property rates are up 3% to 5%, and GL is flat typically to maybe up 2 points. Auto is flat. Work comp rates are up 2% to 10%. I would say payrolls and sales are up 4% to 10% in the Midwest. In the West, property is flat to up 10%, GL and auto are flat to up 5%, work comp other than California comp is up 5% to 10%, and exposure units are typically flat to maybe up slightly. I am going to discuss CalComp in the programs area, but I think one office that I called in preparation for this call this morning summed it up. It said that their clients now are either starting to grow or they already have gone out of business. And so it is upward now, hopefully, and they are seeing a little push.

In terms of the employee benefits area, small group is under pretty significant rate pressure, 5% to 10% or more. Large group, you hear a lot about flat to 5% rate increases on certain accounts, certain parts of the country, not good experience, might be 10% or more. But typically, the number of employees on the plans are flat. In the personal lines area, we continue to see rate pressure on homeowners, particularly in light of the performance of that line with our risk-bearing partners. In the wholesale segment, it is up 2.8% this quarter, versus up 10% in Q2.

Coastal property, RMS 11 is still a big impact. I would say that rates are typically up 2% to 10%, but I hear about large accounts where the rates are being cut, meaning rates go down. Without a wind event this year, we think property rates in the E&S space will flatten out in 2013 until we get to the next year's storm season. Liability rates typically -- except for two classes, it's sort of business as usual. Rates are typically flattish, maybe up slightly. Every once in a while you hear of a rate up 5% to 10% depending on loss experience.

All rates in Florida liability in the E&S world are flat. The two exceptions, New York City contracting continues to be its own little hard market, both in primary and excess, and habitational countrywide, we continue to see upward pressure in that segment. Carriers are looking more carefully at their accounts with losses, and everyone is looking for products liability coverages. Professional liability real estate is up 5% to 10%. Lawyers are flat to up 10%. The D&O private company rates are flat. Public company primary rates are up 5% to 10%, and yet the excess layers are down, and that can offset the increases in the primary. Financial institutions, D&O is up 10% to 15%, and employment practices liability up 5% to 10%. We continue to see a spike in claims activity, and wage and hour coverage is getting harder and harder to place.

On a binding authority basis, the third quarter was very similar to the second quarter. All carriers are trying to get rate, but the rate increases are really on cat driven property and certain GL classes such as habitational accounts and bars and things like that, while vanilla -- plain vanilla accounts are still seeing very, very competitive pricing, especially on new business. Renewals are flat to up maybe a couple points on these preferred classes. Rates on cat property in older buildings and on the coast are maybe up 5% to 10%. Inland property, better construction, flat, and there is some decreases that our carriers are willing to go for because they want to write this business. Most carriers have tried to build in rate increases, slight rate increases on GL, but we're just not seeing that much of it. Our estimate for the fourth quarter is probably more of the same, especially since there has not been a wind event here in Florida and we don't think there will be one this year. RMS 11 continues to wreak havoc in the binding authority area, but we think that rate pressure will flatten out there as well in the spring, in light of no events this year.

On the programs area, as Cory alluded to, we were down 3.3% versus up 7.1% in Q2. If you look inside many of our programs, not all but many, you would say that exposures are up slightly, rates are stable. We have strong new business, and we are very pleased with our strong carrier partners. That said, you have CalSurance, which does a lot of professional liability in the financial services sector, and it's been slower to come back, as we all know. Proctor Financial, as Cory elaborated on, they are writing lots of new business, but it's uneven revenue flows. Arrowhead, the earthquake market continues to be steady, both on commercial and residential.

Now for California comp update. Overall, the rates are firming. Rates are up 10% to 15% overall. Large national carriers that are not work comp specific seemed to be pulling back. Specific specialty work comp carriers are picking up that slack. That's an opportunity for us. On the regulatory front, the WC IRB proposed initially a 12% rate increase on 11.

There was a Senate bill that has been introduced -- there is. It's called SB 863. It deals with work comp reform and cost cutting. Thus, the state has amended the proposed rate increase to just plus 11%. And now the state fund, who is the largest writer of work comp coverage in the state of California, is proposing rates that are flat to down 1%. I think this is a bit -- really a question of who blinks first. We also, though, are seeing the first signs of positive audits, meaning additional premiums in California, as opposed to return premiums.

In FIU, citizens rates, just to give you a flavor here in Florida, are up 10% on the smaller accounts, as you know. But those accounts that are A rated, those are TIVs over $10 million, are flat. And allegedly, these rates will be reviewed in January. As many of you may know, there is a push here by our governor to depopulate citizens. And there are several very interesting proposals in front of them right now, with proposals to take out large numbers of policyholders in the spring. I don't know if any will happen, but that is also sitting out there. Back with FIU, other markets are pushing typically higher deductibles in the E&S space, and the ex-wind business continues to be very, very competitive.

In the services space, we were up 7.7% versus 10.1% in Q2. NuQuest and Advocator group again had great quarters, and I would like to say thank you and kudos to Tracy Lazzopina and Mike Crowe and all of their teammates, because they both had great quarters. On the acquisition front, we acquired one business this quarter for $5.8 million in San Antonio, Texas, Texas Security general agency. We are very pleased that their team has joined Brown & Brown. I would tell you, and someone will ask, as I always like to say, our acquisition pipeline is good, and it's a little bit like fishing. Some day the fish are biting and some days they aren't, but we are always fishing. Having said that, the election process seems to be piquing a lot of people's interest in combining with a larger firm like ours.

In wrapping up, I would say that carriers all want rate in certain lines. Sometimes they get it, sometimes they don't. As we look into next year, we think there is still some rate pressure in certain areas but moderating mostly across the board, except in workers compensation and homeowners. Finally, we are pleased with our 1% internal growth this quarter. Retail is up again 100 bps versus 30 in the last quarter. The vast majority of our operations are moving up, especially retail. Having said that, if Arrowhead was in the IG calculation, we would've had 2.2% internal growth. With that, Lisa, I would like to turn over to you, and we will start with our first question.

(Operator Instructions)

Our first question comes from Keith Walsh with Citi. Please go ahead.

Good morning, everybody. First question for Cory, I'm not sure if I missed this in the commentary, but can you just remind us, the bonus program? How much did that impact EPS and margins in the quarter, and how do you accrue for it? Is it accrued on a quarterly basis? If you could just give us some color around that. And I've got a follow-up.

Yes, it is accrued on a quarterly basis. This quarter, in the third quarter, we increased it by $1.9 million. We expect for the whole year it to be between $6 million and $8 million, and I think we're on track for that. So that's it.

Okay. And then secondly, for Powell, Arrowhead seems to be growing, doing very well. Can you talk a little bit about what is going on there? Is there a business mix or geography issue, why it seems to be doing better than maybe other parts of retail? Thanks.

Sure. Good morning, Keith. I would tell you that what we are seeing is, number one, we buy businesses and invest in businesses because they have good people, and good people develop and run good businesses and attract more good people. And so over a long period of time, Arrowhead has developed a reputation for doing a very good job in running programs for our strategic partners that we work with there at Arrowhead. That is the first thing.

The second thing is, they work, as you know, in three or four areas that are not easy to work in. There are four big markets, prior to the addition to the automobile aftermarket program, our California quake, both residential and commercial, non-standard auto, and workers compensation in California. Those are not easy classes of business to begin with, and so we have -- so there is lots of -- it's discombobulated in many of those markets, which creates an opportunity for us. Then enter the opportunity with Zurich on top of that, which, as Cory said, is going to be a $20 million to $25 million revenue piece for us next year. And we are going to start getting revenue this month, but we really think it will start flowing in really come 1/1, and that $20 million to $25 million will really start next year on a run rate.

And so there are also, finally, Keith, there are some carriers who we believe see us as an option to efficiently distribute their product in a manner that maybe they would be doing it a little differently. That doesn't mean it's bad, it just means they would do it a little differently than we could with our technology platform and the distribution force into our agents. And so we think all of that is very positive, and we are very pleased with the acquisition. And as you know, we are really pleased with organic growth with 13% for the quarter. Hello, do we have another question?

We do indeed. Our next question comes from Sarah Dewitt with Barclays.

Hi. Good morning.

Good morning, Sarah.

When I exclude some of the unusual timing issues from programs, I get organic growth in the quarter of about 1.7%. How long do think it will take you to get back to mid single-digit organic growth? And is that the right level to be thinking about in terms of when you can start expanding the margins?

If you remember, Sarah, in September at investor conference, we said that we anticipated internal growth to be in the range of the first and second quarter for the second half of the year. That would be Q2 -- I mean Q3 and Q4. And as Cory said, actually, when you look inside some of our numbers, we actually have improvement in margins in areas already. But in aggregate -- remember, we say what it is, we take the good with the challenges -- it is basically, as Cory said, it's 35% EBITDA versus 35.4%.

Well, if you go back into what Cory said, there is just one line item that I would direct you to. That's $1.9 million of additional expenses accrued this quarter. That's all you have to look at. And so there is already improvement, and we believe that as we continue to grow -- assuming the economy does what we hope, Sarah, so if you've got something we don't know about, that would be great -- but we think that we can continue to see incremental improvement. And as we grow our business organically, more quickly, that will help us lift the margins more quickly.

Okay. And then on the sales incentive program, do you expect to start up another incentive program next year?

The answer is we don't know yet, but I said a year ago and I have said repeatedly that we would like to continue to do things that stimulate desired performance, and we are going to pay those people who help us drive this Company to the next level. You can interpret that any way you want. But I have said that our program is a one-year plan, and we are not quite to be doing the same plan next year. But we reserve the right to do something that would stimulate growth and in less dollars over an extended period of time.

Great. Thanks for the answers.

Thank you.

Our next question comes from Greg Locraft with Morgan Stanley.

Good morning. Thanks. What is your appetite to buy back stock versus -- it sounds like there is going to be a pickup in M&A in the very near future. How do you guys think about capital deployment?

Well, Greg, we don't like to use the terms never or always. However, up to this point, effectively we have never done a stock buyback, except when you talk about employee stock purchase plan, which is being technical. But we have always thought that we were better off to hold our cash. And we thought that we would be able to deploy those in high-quality investment opportunities to grow our business. That's a nice way of saying we don't think that hard about stock buybacks. I would not like to say never or always, as I said again. But we are focused on taking our earnings, paying out an appropriate amount in dividends, and keeping the rest in the bucket so we can invest in our business.

Okay. And then back to M&A. In the commentary, you alluded to -- is it because of the change in or potential change in tax regime would result in effectively more deals being closed in the fourth quarter? Or how should we be thinking about M&A? Because it sounds like that should be picking up.

Here is what I would say, Greg. First of all, we have been in situations where there has been potential changes in tax or tax reform and changes before in the last several years and never seem to get much lift. There's a lot of commentary around the presidential campaign, as we would all imagine. And so, I don't believe anything and we don't believe anything until it is done, but I would say that there is an increased interest in potentially combining with a larger firm like ours out there. And so we are talking to everybody, as we always do, as I said earlier. The acquisition pipeline is always good, and you can ask me a year from now, and it will probably be good, just like it was good a year ago.

But people sell their businesses at different times for different reasons, and the good thing about it is we can buy them. We have the cash to do it, number one. We do what we say and say what we do, and we do it quickly. And that is known, and people appreciate that. That doesn't mean they have to culturally fit with us or anything else like that, but we are one that we can do it if we want to. And so that's a good thing, and we feel very positive about the outlook between now and the end of the year and into next year. I don't think it's a next 90-day thing. That's not what I'm saying. I just think that there's a lot of activity, and we didn't do that many in the third quarter, and I hope to do more, we hope to do more in the fourth quarter.

Great, thanks a lot.

Our next question comes from Arash Soleimani with Stifel Nicolaus.

Just a few quick questions. The Zurich business, the aftermarket program, to what extent do you expect that to impact the margins within the programs division? And how long do think it would take for those margins to sort of catch up with the existing program division margins?

We have basically said that on that $20 million to $25 million of revenue for the first two years, that it's going to be probably about a 10% margin. And then we think that that will move up into the more normal range. But we are very pleased -- there is, I think it's 150 teammates that joined us. Through that, about 90 to 100 are in Kansas City. I was there a week and a half ago and met all of our teammates. And so we are very pleased with that. And what also happens is, as we grow the business, Zurich has said they want to double the business in five years, that will also help us lift the margin. There are a couple good things going on there.

Great, thanks. And also, in terms of your employee benefits business, we've seen Arthur J. Gallagher partner with the corporate exchange recently, we are seeing Aon working on one. Are you seeing within your own clients any desire to join the corporate exchange? And if so, do you guys have a strategy for the long term?

We actually -- there are other firms, as you have alluded to, that have created their own exchanges. We have taken the position that we're not going to form our own exchange. And I'm not as familiar with those other organizations, what they're doing, but we're not in the risk-bearing business. We do not want to be in the risk-bearing business. What we want to be able to do is evaluate options for our client and propose solutions.

One of those might be going to an exchange. And if in fact they go to an exchange, then we will probably get paid either in a traditional manner or maybe some way that is yet to be developed. But we are evaluating the cost of going to those exchanges on behalf of our customers. We're talking about options when it gets to 2014. But as we have said before, we do not want to be a risk bearer, and we believe that there will be a multitude of options that we will be able to bring to bear for our customers. We think options are good as opposed to putting all your eggs in one basket.

Okay, thanks. And lastly, from the last two releases, I know there's been some kind of reallocation between retail programs, both wholesale and services. Is that available for the fourth quarter of '11 somewhere?

I'm not really sure I follow what you're -- are you referring to the fact that we have retail as just one segment? I'm not sure I understand your question.

The last couple quarters with the releases, it looks like some of the commissions within the segments have been restated or shifted a little bit when we look back at the prior year.

Okay, I understand what you're saying. That's right. We had three small programs that were in the program side that moved over into the wholesale segment. But basically, at the end of this year it is over, you will basically have all the numbers. It's not a lot of movement, but it was three small operations. The quarters will show you those restated numbers. It's not a huge amount.

Okay. And within wholesale, is the slowdown in organic, is that at all related to business going from a slower shift from in business from the standard market to the NS market, or is that still progressing pretty well?

Yes, it is progressing well. What I think it's a function of, simply, this is oversimplified, but pretty simply stated, is the rates at which the renewals are going up year-over-year are moderating. And so remember, you hear about rate increases in the standard market, and the pressure on rates in the standard market has not been going on as long as it has in the E&S markets. What I mean by that is, using the investment communities' vernacular, they have been up year-over-year substantially in the E&S space. The comps become a little tougher, not bad, I'm just saying they become a little tougher, and rates aren't going up as much. So that moderates the growth on the top line.

Great. Thank you so much for your time.

We'll take our next question from Josh Shanker with Deutsche Bank.

Thank you very much. My questions -- first of all, the earthquake program at Arrowhead, when did that incept, and how many quarters will you be getting organic growth out of that?

We did the acquisition of Arrowhead on January 9 of 2012. So effectively, organic growth will actually start next January, meaning this -- first quarter of next year with Arrowhead.

Embedded in it, though, like as an adjustment, you also in addition to the Zurich program started an earthquake program since acquiring Arrowhead?

No. We have a residential quake program and a commercial quake program. And I don't know where you are picking that up, but we have not --

Those are programs that Arrowhead has had for years. And so that's -- but when you compare the internal growth numbers that I gave you, if you just take their numbers when they weren't part of us and compare it to the third quarter numbers and you do an internal growth schedule just for them independently, that is the 13%. And the growth of that came from primarily the earthquake program and the DIC.

And part of that reason is, as you will remember, back in the late summer, there were all these swarms of earthquake that kind of hit Southern California. And anytime the earth starts to move, you will obviously get people that start saying, maybe I ought to be buying earthquake. I'm kind of biding my time, it's been 20 years since the last earthquake. You get stuff like that. So it basically is internal growth there, not new program development.

I was going to say, we are working on new programs there all the time. But just as a clarification, the -- both quake programs are long-standing programs.

Right. And the auto aftermarket, it will begin showing new revenues for Arrowhead a little bit in October, but you will really start in November and December. Now, from an internal -- official internal growth schedule, we will continue whatever revenue they get from that auto aftermarket in November and December are going to be lumped into Arrowhead's quote acquired revenues and so won't really reflect the internal growth for this year. Next year, when Arrowhead now is with us 12 months, we're going start showing their total numbers as compared to the numbers that they reported in 2012, and that will be part of our internal growth. For the fourth quarter, we will do the similar thing we did just now, that we will tell you what Arrowhead's internal growth was on a standalone basis, so you will have essentially both numbers.

Understood, understood. And it's a small point, but I'm trying to model that 1Q '13 growth number in programs. The buying habits that increase the amount of earthquake purchasing which has led to a lot of the growth at Arrowhead, I assume that after one year or so, that will probably decelerate. Or maybe I am mistaken, that that would persist for a while. Or should I think that Arrowhead will have13% growth plus Zurich in 1Q '13?

No, remember, like I said, when we acquired that business, we said -- and you may recall that we thought that business could grow at mid to high single digits. That is what we said. They had an exceptional quarter, number one. Number two, to answer your question specifically, what increases the buying habits of people buying earthquake coverage? Earthquakes. If in fact there is an earthquake, the number of people that buy earthquake coverage will go up dramatically. You would find it interesting that in earthquake zones, I have been told by our teammates, that typically only around 13% to 15% of people in those zones buy earthquake coverage. And so in the event that there is a claim, if there is an event, more people will buy earthquake coverage. That is number one.

Number two to your question, why would people buy earthquake coverage from us, i.e., other than someone else, the answer is, we are typically the second or third largest provider of earthquake coverage in the state of California behind the California Earthquake Authority and possibly one, maybe two other non-admitted markets. And then us, meaning Arrowhead. And so, long-winded answer of saying that they may have earthquake coverage placed elsewhere and they can't get the appropriate limits, or maybe the terms and conditions on our program are better than the program that they have.

Understood. And then one final question on Zurich. Can you talk a little bit about how it came to be that you struck up the relationship with Zurich? I'm interested to see how Arrowhead picks up new programs and what we can think about the future for how those might be added going forward.

Josh, what you've just heard us describe is unprecedented. I don't know of anybody picking up a program, not that it hasn't happened, but I can't think of one off the top of my head. I don't want you to think that this is some emerging trend. We would love it to be an emerging trend with us, and we are capable of doing it, because we have a platform to do it now. However, we have had a long-standing relationship with the Zurich as an organization. With the acquisition of Arrowhead, that relationship almost doubled in size. And then on top of that, this came on top. We have had a very good relationship with that strong partner over a long period of time, and it has grown substantially in terms of volume over the last year via the acquisition of Arrowhead and us picking up this program to distribute on their behalf.

Did they propose it to you or you propose it to them?

Well, let's put it this way. We're always talking to our strategic partners about how to grow our businesses. I might say that could be mutual discussion.

And the bottom line was that Arrowhead was able to show Zurich that we can better distribute their product and more efficiently and allow them to focus on the underwriting. So it's a win/win all the way around. It works very well.

Very good, more win/wins coming your way.

Hopefully.

Thank you.

Our next question comes from Matthew Heimermann with JPMorgan.

Hi. Good morning, everybody.

Hi, Matthew.

I think most things have been covered. Just one quick numbers question and then a question about next year. With respect to Zurich, just curious if you could give us a sense in terms of, A, how the revenue progresses quarter to quarter. Is there any seasonality in the revenue that we need to think about? And two, for modeling expense purposes, what is the -- how much of the expenses are SMB versus G&A, just a rough sense? You have talked to margins, but just curious of the expense makeup.

I tell you, we're going through the budget process right now for next year. So quite frankly, I don't have that kind of detail yet. And we'll be going through that. But their preliminary estimates, I just have to stick with the fact that it starts out at the 10% margin, somewhere between 10% and 15%. And on the future conference calls, we will be able to give you a little bit better idea when we get through the whole budget season.

That is fair. And then, just when we think about growth for next year, I would be curious whether or not -- if we're going to see further growth improvement next year, how much, from your perspective, is rates versus the economy? In other words, I guess -- put another way, do you feel like the economy is a more important factor to growing your business next year, or pricing?

The former. And so remember, Matt, to go back. Throughout this period of time, we have said that exposure units made up probably 75% of the economic downdraft when we came through the last four-and-a-half or five years, and 25% would be rate. I would tell you that that is typically the same. You can have little nuances where someone else earlier alluded to more accounts flowing into the E&S market in certain segments. Yes, that helps on a temporary basis, but if you want the macro effect, we are a business, as you know, that is a proxy for the middle market economy. As the economy improves, that helps our business improve.

And just with respect -- I guess I am thinking Florida more specifically, but I guess you could take this generally too, is how important or material going forward is the fact that the housing industry looks to be stabilizing? I say Florida because obviously that potentially has some implications with both consumer and business there, but more broadly as I think about contractors, other small businesses that potentially cater to that end market.

If you think about it, let's go back two interesting -- an interesting statistic, and then I'll answer that question. If you look at all the economic recovery since 1945 in the United States of America, the southeastern United States has led it out every time. And housing has been a big part of that, relative to the construction and investment in our individual communities around in the southeastern United States. In this particular economic recovery, as you know, based on Federal Reserve data, the southeastern United States was the last of the Fed segments to lead out in terms of growth. That's number one.

Number two, the construction business is lumpy in places like Florida specifically. And I go into offices and ask people, how are your contractors doing? And some of them say they're doing well and they see upticks. Some of them are down a little bit. But the prevailing thing, Matt, is this. They don't have a lot of work in the pipeline nine months out, and that is what scares people. That doesn't mean there won't be more work, I am just saying they don't have a good clear view into the next, let's say, two years, because in prior cycles, you have a one-and-a-half and two-year pipeline for really good contractors.

So, I would tell you that the economy seems to be better here in Florida. People feel good. If you go to a restaurant, you would see a lot of people in a restaurant out on a Wednesday or Thursday or Friday night. And the thing I like to say, and I know this resonates with you particularly in New York, is in February, at 4.30 in the afternoon on a Thursday, it's going to be dark and cold in New York City. On that same Thursday at 4.30 in the afternoon, it's going to be sunny, beautiful here in Florida. And we have a somewhat more attractive tax climate here. What I mean by that is people are going to want to continue to come to Florida. And that bodes well for the housing industry, and people will go out and build homes and condos. And so I think that's a positive thing, long term. It is just slower in the recovery than any of us would like, but we're just doing our part in trying to sell insurance and do all the best things we can for our existing customers and our new customers.

That's helpful. And then that nine-month visibility, I would be curious how that compares to the beginning of the year.

I would say it's similar, Matt. And let me give you an example. Let me give you a real example. I have a friend who runs a large contractor, and this is in the southeastern United States, and they were very large before the slowdown, and they came down to maybe a third of their size at the peak. And now they are probably about half of their size when they were at their peak, and they don't have one thing in the pipe, nine months from now. Not one. That scares them. It would scare me too. And this is a firm that is a very fine firm and they literally -- mid-2000s, they would have two years of stacked up work coming out their ears. That is just one example, but I'm just saying, that is not that uncommon.

Okay, thank you for that.

We'll take our next question from Ray Iardella with Macquarie.

Thanks and good morning. First question, I guess. Is there anything to read into the level of divested revenues through the first three quarters, I guess, looking at it, $9 million compared to $4.3 million last year and then $2 million the year before?

No. We did have some rather large books that we did decide that it was best to sell at the beginning of the year. But I would not read -- you have those things here and there, and this year, it was just a few larger ones.

Okay. The other thing to -- going, Powell, to your commentary last quarter about the difference in pricing between regionals versus nationals, is that something you're still seeing? And could you try to quantify the spread, generally speaking?

I would say that broad-based statement, regionals tend to be more laser focused in areas of the country that they are based in and that they have a lot of knowledge about and classes of business they feel really comfortable in doing. Yes, I think there continues to be a difference. It can be pronounced, Ray, on some accounts. And it can be not pronounced on other accounts.

Let me give you an example. You might have -- let's pick a good one. You might have a food distributor. Not everybody wants food distributors. But if you had a food distributor and the national carrier wanted a 10% rate increase and the regional carrier felt good about food distributors in their so-called region of the country, they may do it for flat, they may do it for 3%, 5% up. Or in some instances, they might go down on the rate.

I don't think there's one way to say -- I hate to say that, Ray, you can't give any specifics, it's more generalizations. But I would tell you that typically, regional companies are more competitive than national companies if they want to be, particularly on certain classes of business in areas around the country. I would say the pricing -- there is not one statement, it's 5% difference. It is not like that. It could be the same on a bunch of accounts. They could be 10% less. They could be closer than that. But it just depends on the account, the loss experience, where you are in the country.

Got it. That is a fair statement. The other thing, Cory, going back to your commentary about contingents in guaranteed supplementals, is what you are thinking about, is all else equal? If the loss ratio of your risk-bearing partners stay the same from this year to next year, contingent should actually increase, given the switch from supplementals to contingents? Is that the right way to think about it?

On that portion of it. Basically, the carriers that used to pay us GSCs, they stopped paying us GSCs this year. They will calculate what the loss ratios -- what the contingent amount would have been earned for this year, and they are going to pay it in 2013. But since it is loss ratio based, you can have a big loss at the end of the year, and therefore we can't accrue it, and we have to wait. Theoretically, if everything stays the same and we do what we think we should do, those GSCs that quote were eliminated from the current year 2012 revenues should naturally flow in, into the contingencies.

Okay, that is helpful. The only other question, and maybe a quick numbers question, the facultative reinsurance program that you had referenced, how large is that usually on an annual basis in terms of revenues?

About $3.5 million.

But $2 million now.

Okay, thanks again for all your answers.

Our next question comes from Brett Huff with Stephens Incorporated.

Good morning, Powell and Cory.

Hi, Brett.

Couple quick questions. A lot of the stuff has been gone over, I just want to dive into the organic growth question again. Cory, just remind me if these numbers are right. Wholesale, you said, was $1.1 million of organic growth this year -- this quarter versus $3.4 million last quarter. Is that right?

That's correct.

That's about roughly 100 basis points. And you mentioned that you thought that that would stay lower. You thought it would be in a similar range in 4Q. But you also said, and Powell, you may have alluded to this, that the rate increases are maybe switching more from wholesale to more regular admitted business. Did I hear that right? Could that pick up some of the rate slack?

No. The implication was -- is, remember, there has been pretty significant rate pressure for a longer period of time, Brett, on the wholesale segment. And I was trying to give you the nuance of saying the rates in that segment are coming down now. And so the year-over-year comparisons are different. In the standard market, the rates have not been going up as long, but still rates are in some lines of business up. But they could be moderating too, we believe, into next year.

Okay. Got you. And then, Cory, on the Proctor, it was a swing of $1.2 million of organic growth in 2Q and a $300,000 decline this year, so $1.5 million or so. You mentioned that a good chunk of that would flow in, in 4Q. Am I hearing that right?

Yes, and exactly how much of that flows in is still a large part dependent upon how the clients process it. So clearly, the $300,000 that's down for this quarter just from prior year, and then some level of that will flow in higher. It is going to be somewhere above $300,000 up to $1 million.

Okay. And then in terms of the Zurich business, Powell, you talked about how the margins are going to kind of evolve on that. Is there anything different in how -- when you use Arrowhead's distribution capability to go from the $150 million or so, I think that that business is now to double that, that incremental dollar of revenue shouldn't have a characteristic -- certainly any lower than your existing incremental margins. Or maybe it should be higher. Is that fair?

I think that you're moving in the right direction.

I'm curious, when you say that they might be 10% to 15% margins for the first couple of years, that seems like that would assume pretty minimal growth.

Like I said, we have, as you know, an arrangement in taking over this program which would probably have the margins stay in that area with nominal growth. If the growth is quicker, then we don't know what those are. We are not trying to be evasive, but we are trying to be -- basically say, this is what we know.

As Powell mentioned, we've got about $165 million in premium in this program. The people that were Zurich employees that are now going to become Arrowhead Brown & Brown employees, that is a set number. We believe that can double that program with the folks who are now joining us from Zurich plus the folks that are currently at Zurich, we can grow that without adding anything else. And so over time as we grow the program to double, the margins will move up correspondingly.

Okay. And then in terms of -- Cory, I think you called out an estimate on the incremental margins on the retail business. Was that 50% was your assumption? Is that right?

Yes, on the internal growth dollars, I'm just using a hypothetical 50%. And then on the cell business, I have thrown in 80%, which may be a little aggressive.

Brett, I also wanted to clarify, I think the program premium is about 140.

Okay. I'm sorry. Thank you.

I could be wrong, but it's somewhere in between the 140 -- I am thinking it is 140. But one way or the other, it's a very big program, and we are very pleased.

Okay. And Cory, on those incremental margins for retail, it's that incremental margin, given that you had the distribution channel in place in retail, incremental dollars should happily mostly flow to the bottom line. Right?

That is right. This is a little bit different than -- the number I am using here is a conservative number. And I know that we had talked about how our leverage in retail can be higher than that on the first incremental dollar. And then as time goes on, we may have to add another CSR or something like that. But for this purposes, I'm using some rounded numbers to prove out the margin growth. You can play with it whichever you think, but that is what I have used right now.

Okay. That's what I need. Thanks for your time guys, appreciate it.

We'll take our next question from Eric Fraser with Goldman Sachs.

Thanks, good morning. Two quick follow-ups. First on the economy, can you talk a little bit more about the middle market? It sounds like exposures are mostly flat. Can you talk about where you are seeing some improvement that could drive the retail growth?

Sure, let's start by saying where is it -- there are some obvious and maybe some not so obvious places where it is a challenge. And then let's talk about where you are going to see upticks. Historically, people would say Florida, Michigan, the southwestern United States, all places that we have large concentrations of business, would be tough areas to operate. I said earlier that Florida is starting to see a little light at the end of the tunnel, and I think it's better, not good, but it's better. In southwest Florida, Fort Myers, Naples area, the economy is a lot tougher down there than a lot of people realize and think, because you think that there is a lot of people that retire from the Midwest that are well-to-do. And therefore, the economy has to be good, and it's just not that good. Conversely, when you say -- when I said in the Midwest, which includes Michigan, we're seeing uptick in exposure units in a lot of our offices, 4%, 5%, 6%, 8%.

So I think, Eric, to answer your question, I think it's more of a broad-based scenario where we benefit from exposure increases in and around New York City, we benefit from exposure increases in the Pacific Northwest. We benefit from in Florida anywhere. The Pacific Northwest was the last to go into the slowdown, and they are probably one of the last to come out, and so places like Portland that have still a very significantly high unemployment rate. But businesses seem to be doing better there. I would say the general statement, if I made a comment on the middle market economy of America, and I'm not an economist, is this. What we're seeing in our customers is that they are replacing newer vehicles with older vehicles. But they are not expanding their fleet sizes. And they are watching carefully and being very, very selective on how they invest in major capital improvements in their business.

Sure, okay. That makes sense. And then back to the bonus incentive comp plan, how much of the gross this year would you attribute to that plan? Or said another way, would growth have been lower if you didn't have that plan in place this year?

We don't know the exact answer to that. But what is important, Eric, that you know is this. There are a lot of our teammates that have worked really hard over the last five years, and they have kept every single one of their accounts, and the size of their books of businesses have shrunk because of shrinking exposure units. And so, we did this for two reasons. Number one, we did it to drive and stimulate growth, but we also did it for a reward for desired behavior, in the sense that its been a tough five years in growing businesses, as you know, at least in our space. And so this was an opportunity to say thanks to everybody that is pushing really hard in our system and give them a reward. We have not broken it out, but I can tell you either way, we are happy with the results.

Right.

I think you have a producer force that is very, very focused.

And one last one, if I could. In terms of the services growth there, can that piece of internal growth continue going forward?

Don't know, we would like to think so. We've got some great leaders in there, but once again, it is lumpier in that space, and so I don't know the answer to that.

Great. Thanks.

We think we can grow organically, we just don't know if we can replicate those that have been released the last few quarters.

Sure thing. Thank you.

And we'll take our final question from Chris [Lycam] from William Blair.

Good morning, Chris.

Two quick ones for you guys. I might have missed this in your initial commentary, but on audit premiums, what kind of general trends are you guys seeing, and when do you think that could become a tailwind? Are you thinking it could turn positive next year?

What we are seeing is we are beginning on some accounts to see additional premiums, which is positive. And we're not seeing as many significant return premiums. So I have said, starting early part of this year, Q1, Q2, it's really about a 16-month lag, a 14 to 16 month lag. Chris, as you know, because if you bind an account in April of this last year, then it renews next April and the carrier has May and June to go out and do the actual audit. So it's going to be 60 to 90 days after that that you would have the additional premium. And all of those are not concurrent on April 1 or October 1. They come in April 15, April 1, April 30, anytime you have an effective date. I would say that the trend, if the economy continues to do what it seems to be doing, if it continues to perk along and go up, I think that is positive on that.

Great. And then, just wanted to get into benefits real quick. What general percent would you give as a percent of total retail business is the benefits practice? And then, what sort of demand environment are you seeing on that front? Is that a headwind or tailwind for organic in the retail business?

Last year, we did $608 million of core revenue in retail. There was $190 million of employee benefits in there. This year, we are probably on a run rate of about $230 million in employee benefits. That is number one. Number two, we think employee benefits right now is a very positive thing to internal growth. We're talking to all of our existing customers and specifically new customers about it, because there's all kinds of confusion around health care reform and what happens when and who does what and who is responsible for what and how do I get fined if this happens or do I get fined? A lot of it is, we have to hold our customers hand, which is what we do, and educate them and walk them through the process to get them what's in the best interest of their teammates. And so we see it as a very positive thing.

Great. And then, what you said rates were contracting in the small lives market. How much of your benefits business would you put in the small lives versus the larger --?

Not contracting, I said they were up 5% to 10%.

Okay. I thought you said there was pressure on rates in the small --

No, pressure upwards, sorry. Upward pressure, I meant. I am going to answer the question specifically. Of the $190 million of revenue last year, about a third of that business was ancillary business, so call that group life, group dental, group vision, disability, et cetera. Of the two-thirds that are left, just over half of that is large group. That's in excess of 50 lives. Just slightly less than one -- let's call it -- slightly less than a third of that business is smaller group. And so depending on the part of the country you're in, some of that business used to be on commission. And we have seen a lot of that move from a commission-based business to a per head per month. The only way we get more revenue is when they add new teammates. That is number one.

Number two, we are seeing in smaller businesses, particularly blue-collar businesses, where people are just dropping the coverage. They say -- I know this sounds crazy -- they just say, let the government figure it out. And that is real. I am not making that up. So people that are good hard-working citizens, but they basically say, this is just too crazy, and they just drop the coverage. We are seeing that too.

Very helpful, thanks a lot.

Thank you.

And there are no further questions. I would like to turn the conference back over to our speakers for any additional or closing remarks.

Thank you, Lisa. No additional remarks, and I hope everybody has a wonderful quarter, and we look forward to talking to you after Q4. Good day.

That concludes today's teleconference. Thank you for your participation.