TWST: It is your view that the insurance brokers have become increasingly rich. Would you elaborate on your thoughts about the outlook for that segment, and also comment specifically on your two downgrades recently?

Mr. Iardella: We downgraded Aon (AON) and Gallagher (AJG) back in early May, so a little bit over a month ago. And really, the thought process there, I think people were getting very excited about commercial property and casualty insurance pricing, particularly on the property side, and also pretty upbeat on the economy — two of the things that really drive revenues for the insurance brokerage group. So just looking at valuation — they were trading around nine times EV to EBITDA — the thought process was fundamentals don’t justify the valuation at that point in time. It's not to say if we get an improving economy globally — including the U.S., and then, commercial P&C pricing continues on the current trajectory — that valuation couldn’t move higher. I just think the stocks had moved a little bit ahead of where they should have been. So that's kind of the thought process on the insurance brokerage group overall.

More specifically about Gallagher and Aon: first on Aon, during the first quarter, I think investors and I were positively surprised on the organic growth side of the story for Aon, but more important, the margins just weren't there for me. The company is making a lot of investments both on the insurance brokerage side and the consulting side of the business. I believe the investments are good for the story longer term, but at this point where we are in the insurance cycle and where we are in the economic cycle, I like companies that are going to be able to grow organically and expand margins. And it just didn't seem like the margin expansion story is setting up well for Aon in 2012.

Now, you can argue that margins will improve next year, and you should be in Aon for 2013. At the same time, I think I need to see that these investments are actually paying off in terms of organic growth and margin expansion, and then I can get more constructive on Aon longer term.

And then, for Gallagher, it goes back more to my macro view as I think expectations were a little bit ahead of themselves. Gallagher was trading well above the group average — the nine times EV to EBITDA number that I threw out earlier — and I think organic growth is moving in the right direction, 3% to 4% at this point in time. But I think people are expecting that to continue to move much, much higher. And like I said, I just don't think we are actually there yet in terms of the macro environment for any of the insurance brokers. So that was really the reason for the downgrade of Gallagher, in particular. Plus, Gallagher had been one of the best-performing insurance brokers over the past year at the time of our downgrade, so I think the stock had reacted well to pretty impressive results Gallagher was reporting.

TWST: That all being said about the brokers, you do have "outperform" ratings on a few of them. What sets those companies apart from their peers?

Mr. Iardella: What I am looking for with any of the insurance brokers, as I said before, is organic growth and margin expansion. And looking at the underlying business for Marsh & McLennan (MMC), they'd clearly been the best-growing, from an organic revenue perspective, insurance broker of the group over the past, I would say, 12 to 18 months, and I think that's really going to continue.

So I think MMC has that going for them on the topline side, but also they have been able to deliver meaningful margin expansion over that same time period. I think that trend is going to persist as well, because management's focus is on controlling expenses, and basically growing expenses at a slower pace than organic revenue growth to drive margin expansion. I think that's important. Like I said, for the brokers, it’s not just about growing for the sake of growing, but to grow to expand margins, increase EBIDTA, and ultimately increase their EPS. I think these are all important things that you need to see in these companies to drive multiple expansion.

The other company that's not necessarily a pure insurance broker, Fortegra Financial (FRF), similar story, I think they are going to have a very strong organic growth trajectory in 2012 and in 2013, and I think that the management team understands that they need to control the expense line. Because Fortegra’s businesses are maturing, I don't think they need to invest a lot in these businesses, so I believe a lot of the revenue growth is going to fall through to the bottom line. So those are two of the insurance brokers that I really like right now.

More recently, we upgraded Willis (WSH), and that's a risk/reward story in my view. And the thought process there is there has been a lot of speculation within the market that Willis could be at some point acquired by another player, and I think the downside to the stock is very limited. At the same time, the fundamentals in the business are improving and should improve over the next few quarters. So I think valuation had pulled back meaningfully and I don't see a lot of downside, but also believe, as the fundamentals improve, the stock moves higher from here. So I like the risk/reward in that particular insurance broker with limited downside and some upside over time, which is attractive in my view.

TWST: You do cover a few segments of the insurance sector. Which ones are you more bullish about right now?

Mr. Iardella: I don't cover any of the pure reinsurers that have exposure to property-cat business, per se, but I would say within the stocks that I cover, I prefer the specialty insurers. And really, within that space, I think there are a lot of companies that still have strong balance sheets from a reserve perspective. So I believe favorable reserve development is actually going to help drive earnings for these companies for periods to come.

I'd throw Allied World (AWH) in there and ProAssurance (PRA) as two names that fit that bill. They both have specialty business and are also more casualty focused. It appears that premium rates in that part of the market are starting to improve, and at the same time, like I said, the reserve releases are going to support earnings.

In addition, the specialty insurers have a lot of capital, which supports a buyback, other types of capital management or M&A opportunities. In that regard, the specialty insurance segment actually sits pretty high in my rankings in the space.

So like I said, it's more about capital. It's more about reserves and it's more of the niche business focus that I think should allow them to outperform. And then, from a valuation perspective, they screen pretty attractive as well.

TWST: What do you believe are the most meaningful metrics by which investors should evaluate insurance companies?

Mr. Iardella: For the insurance brokers, cash is a meaningful metric for the brokers. These companies generate a lot of cash, so I tend to look at EBITDA; and to account for the differences in capital structure, I tend to look at enterprise value. Capital structures change for these companies over time. Debt-to-total-capital ratios can range anywhere from 25% to even 50% for the group. So EV-to-EBITDA multiples are definitely the way that I look at the insurance brokers. I think it's meaningful to look at p/e ratios, but I like I said, the more meaningful metric in my mind is EV to EBITDA.

In terms of insurance underwriters, obviously price-to-book multiples and how they relate to ROEs or book value growth, but also take a step back and say, “What is driving book value growth?” Going back to my comments before about the specialty insurance group being able to have active capital management programs, as a lot of these companies are trading at discounts to book value. Share buybacks are going to be accretive to the book value. So I think there are two drivers — book value growth from their operations and from capital management, and then, what type of ROE can you actually achieve and what does that mean in terms of price-to-book multiple? So I think there are lots of ways to increase the share price for a lot of these companies, and it's not necessarily just increasing the multiple — it's actually about driving book value growth.

TWST: What do you believe are some of the most common or most detrimental misconceptions people tend to have about investing in insurance that a savvy investor may want to learn more about?

Mr. Iardella: Generally speaking, pricing is what a lot of investors tend to look at within the space. As pricing moves higher, certainly that's a positive for the group overall, but I also think it's important to look at how price actually compares to loss cost trends. And that's really important because if you are getting price, certainly your top line is going to move higher, all else equal. But unless price is exceeding loss cost trend, there is no margin expansion in the business.

So I think while we are in the current environment where pricing is moving higher. We've just started to see more recently — I'd say, over the past quarter or two — price exceeding loss cost trends. So that's going to lead to margin expansion for these companies, but we haven't seen sustained price increases above loss cost trends for quite some time. Underwriting margins should move higher from here. But at the same time, we need sustained pricing in order to continue on this path of improving fundamentals within the business.

TWST: In addition to what we've discussed regarding the brokers, what other important headwinds are you monitoring?

Mr. Iardella: I think Europe is obviously, I don't want to say an issue, but something that should be kept on the radar screen for both insurance brokers — and to a lesser extent, underwriters. For the brokers in particular, revenue is based on insurance pricing and exposure, and exposure is GDP growth for the most part. And the insurance brokers aren't really going to drive any type of revenue upside if the economy remains weak in Europe and around the globe. For the global brokers like Willis, Aon and Marsh & McLennan, they all have very similar exposure to Europe. It's about a third of their revenues. So I think that's something that investors should continue to pay attention to. For the insurance underwriters, Europe is less of an issue.

Certainly, you have to look through the investment portfolios. You have to get a sense of where they are writing their business because the exposure decline can certainly impact. Also for the underwriters, I think we have to be mindful of loss cost trends because they could turn out to be a headwind at some point. We have been in an environment where frequency and severity have been pretty benign. So if that trend changes, that could certainly be a headwind for the group.

As it seems right now, I would say there are less headwinds from a topline perspective for the insurance underwriters, but the real question is: "Is there going to be any underwriting margin expansion for the group?" And right now, it's setting up to look like there will be at some point in the future.

TWST: What's your outlook for M&A for the sector over the midterm, and are there certain types of deals or even specific potential transactions investors should be keeping an eye on?

Mr. Iardella: It's a tale of two cities, if you will. For the insurance brokers, there continues to be pretty active M&A. The sector overall is pretty fragmented. There's about 26,000 independent agents and brokers within the U.S. alone, and to be a top 100 insurance agent or broker in the U.S. by revenues you only have to generate about $18 million in annual revenue. So there are a lot of small independent agents and brokers within the U.S. that are probably looking at some point to consolidate with a larger partner.

So I think in terms of small but frequent types of M&A transactions within the insurance brokerage space, that's going to continue. We've seen it over the past couple of years, it slowed down a little bit during the recession in the U.S., but it picked up more recently, and I actually expect that to continue.

In terms of larger deals within the space, there have been a couple recently. So I think there is some appetite out there, but I also believe a lot is going to depend on the outlook fundamentally for the brokers, and I point to the economy and the pricing environment, and that's really what's going to potentially drive transactions going forward in my view.

In terms of the insurance underwriters, there is always an argument that there needs to be M&A within the space. I don’t really expect an environment where there is going to be a meaningfully active M&A any time soon. Right now, where we are in the reserve cycle. It's very difficult for any company to get comfortable with another company's balance sheet. There is asymmetrical information from buyers and sellers, and I think buyers are particularly aware of that just given where the industry’s reserves had been in the early 2000s. So I think that's going to be potentially a headwind for deals getting done.

But on top of that, valuation continues to be something that some of the companies cite as a headwind, but I think there still needs to be some type of compression in terms of the spread between multiples that buyers and sellers are willing to consider.

TWST: The majority of your stocks are "neutral" rated at the moment. What macro and/or company-specific changes will you be looking for in order to consider upgrades on some of your stocks?

Mr. Iardella: In terms of some of the macro trends that I'd look for, a continuation in commercial P&C pricing trends would be a positive for the group, but I think the other bigger macro trend in terms of brokers is some stabilization in Europe and the global economy.

More recently, I would point out China and India as two economies that continue to produce weaker year-over-year GDP growth, but it's still relatively attractive growth compared to some of the more developed economies. However, the economic environment may be a headwind for the insurance brokerage group overall.

The other thing I'd point to in terms of the insurance underwriters, I think there is still too much excess capital within the industry, and that's why I think companies with strong balance sheets and capital positions will likely buy back shares and increase their dividends. I think that's all a positive, but it’s unlikely that we will see a similar magnitude of price increases as the industry experienced in the last hard market until you see the supply of insurance or industry capital levels decline. Right now, the industry needs a catastrophe or series of events that can remove capital out of the industry. And then heading into hurricane season or the height of hurricane season, I should say, that's certainly something that we would look for that could potentially take capital out of the industry.

TWST: Which two or three stocks from your group would you recommend as the best ways to get exposure to the sector right now, and what do you like about them?

Mr. Iardella: In terms of gaining exposure to the sector overall, I continue to think Allied World is one of the better insurance stocks to own and the rationale is a few things. First, going back to my commentary about strong balance sheets and redundant reserves, I think Allied World certainly fits that bill, and they recently announced a new $500 million share buyback program, and that's anywhere between 15% to 20% of their market cap. So the company is committed to utilizing its excess capital, and I think it’s a meaningful way to drive book value growth.

Secondly, the company’s business mix is pretty attractive with about a third in reinsurance and two-thirds insurance. And I think the company has been able to capitalize on some of the more favorable pricing trends in the reinsurance industry, but at the same time, keep its insurance focus, which is really sort of the bedrock of Allied World’s strategy. So I think they are being opportunistic on the reinsurance side, and I believe that's what investors want to see companies do at this point in time.

And then, in terms of valuation, this is a company that is trading at a discount to book value, and I think actually book value is understated given the company’s reserve position. So if you are looking for an insurance underwriter to own at this point in time, I think Allied World is a good place to be because of the exposure to both insurance and reinsurance.

In terms of the brokers, I still like MMC here. And really, the thought process is the organic growth has certainly been the most impressive over the last 12 to 18 months, and I think that's going to continue. They have the most exposure to emerging markets out of all the global insurance brokers.

And more importantly, with the insurance brokers overall, the group has control over their expense base. The expense base of the insurance brokers is really just people. The insurance underwriters don't actually have that much control over their expenses as losses are the majority of their expenses. So the insurance underwriters can't necessarily control their margin destiny, if you will, but the insurance brokers can. And really, the ability for the insurance brokers to do that has to do with management.

I would say this new management team at MMC, which came in 2008, has expanded margins meaningfully, and that was in revenue growth environments that were less attractive than today. So as the top line continues to improve, I think the ability to expand margins actually gets easier for the management team.

So once again, I like companies within the insurance brokerage group that can grow revenues and expand margins, and I think MMC actually is set up very, very well for that.

TWST: Thank you. (MES)

Note: Opinions and recommendations are as of 06/15/12.

Ray Iardella

Vice President & Senior Analyst

Macquarie Group Limited

125 W. 55th St.

22nd Floor

New York, NY 10019

(212) 231-1000

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