Berkshire Hathaway
Re: "Opportunity" at MMC and AIG

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By RoughlyRight
October 20, 2004

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The Marsh situation is a bad one. I read Spitzer's lawsuit over the weekend. Before reading it I was cautioned to remember that lawsuits are written to be very one-sided. The lawsuit states a fair number of specific instances where Marsh essentially controlled the outcome of who won insurance business. Marsh apparently strong-arms insurance companies for Marsh's benefit, not the client's. Three employees of insurance companies have already pled guilty to being complicit with Marsh's schemes. At the heart of the matter is something generally known as contingency fees. Marsh is paid by insurance companies to direct business their way.

Contingency fees are legal in the insurance industry and they are widely used in compensating insurance brokers. However, the incentive allows obvious conflict-of-interest biases (or worse) since the contingency fees are paid to the benefit of the broker and not the client. Insurance companies hate paying the fees since they often feel like they're being blackmailed to do so. Again, that being said, contingency fees have been paid for decades and are legal. Obviously the abuses are not.

In the firestorm of the Spitzer's lawsuit, Marsh has elected to suspend receiving contingency fees. This, in itself, will have a significant short-term impact on Marsh's income. While Marsh has yet to break this out, the estimates are there will be a hit to earnings of 10 to 30%. Marsh was set to have a conference call this morning to discuss the impact to earnings, but they cancelled the call last night. They said they'd report their expected impact in an SEC filing instead and maybe have a conference call later this week or next week. The large insurance company, AIG, and another insurance company mentioned in Spitzer's suit have said they will likely stop paying contingency fees (to anyone). AIG stated that they expected brokers like Marsh would come up with some other way to replace this revenue and that insurance would not end up any cheaper to clients.

At Friday's $29 price, the free cash-flow yield is 10.2% based on the trailing 12-months cash-flow. But, how cheap is cheap in this case? Even if 30% of their income disappears, the earnings yield is still 7.1% at $29 a share. However, this seems like a situation where more bad news is likely to follow.

Marsh is huge. Their insurance brokerage is equal to about the next 7 competitors combined. If nothing else, the bad press is certainly having an impact. Other insurance brokerages are salivating at the business that they might be able to pick up (if they themselves are not found guilty of wrongdoing). The biggest problem in rationally analyzing this situation is guessing how widespread the abuses are within Marsh. Is it a few bad apples or has bid-rigging, etc., been encouraged from the top?

Marsh McLennan (MMC) is the parent company. The brokerage Marsh is one of three subsidiaries. The CEO of Marsh was replaced on Friday. He was replaced by a guy who was apparently Spitzer's boss at one point and has a very good reputation. Also, a law firm with close ties to Spitzer has been hired by Marsh to represent it. Spitzer, on the other hand, spoke very negatively about the senior management of Marsh when he announced the suit.

How much business leaves Marsh because of the bad publicity? This is what I find amazing about these types of situations. When Merrill Lynch, Morgan Stanley, and others were basically found guilty of significantly misleading investors a few years ago, there was big publicity, some fines paid, etc. However the firms survived just fine and they are now reporting record earnings with much higher stock prices. When Putnam (another Marsh McLennan subsidiary) was basically found guilty (along with others) last year of allowing late trading in their mutual funds, Putnam's assets fell from $250 billion under management to $240 billion under management. No big deal. So, if Marsh survives legally (and I have seen no one suggest that they will not), then they will probably come out of this fairly intact if these past examples are any indication.

MMC has been a big stock buy backer. In the first 6 months of this year, they net bought back $300 million of stock on reported earnings of $835 million. They also paid $325 million in dividends. The dividend yield, by the way, is now over 4.5%. The CEO of MMC has not sold any shares in the last year.

It's going to require some patience, but I think the stock will do well from these levels.


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