Good afternoon. Welcome to Arthur J. Gallagher & Company's third quarter 2017 earnings conference call. Participants have been placed on a listen-only mode. Your lines will be open for questions following the presentation. Today's call is being recorded. If you have any objections, you may disconnect at this time. Some of the comments made during this conference call, including answers given in response to questions, may constitute forward-looking statements within the meaning of the securities laws. These forward-looking statements are subject to certain risks and uncertainties discussed on this call or described in the company's reports filed with the Securities & Exchange Commission. Actual results may differ materially from those discussed today.
For reconciliations of the non-GAAP measures discussed on this call, as well as other information regarding these measures, please refer to the most recent earnings release and the other materials in the investor relations section of the company's website. It is now my pleasure to introduce J. Patrick Gallagher, Chairman, President, and CEO of Arthur J. Gallagher & Company. Mr. Gallagher, you may begin.
Thank you, Darren. Good afternoon, everyone. Thank you for joining us for our third quarter 2017 earnings call. With me this afternoon is Doug Howell, our Chief Financial Officer, as well as the heads of our operating divisions. Before we dive into our performance during the quarter, I want to start with some comments regarding the recent hurricanes, earthquakes, and wildfires that have caused so much devastation over the past 90 days. The insurance industry is now fully engaged in the long process of putting everything back together. I'm really proud of how our professionals have handled our customers' situations and, in some cases, even while dealing with their own losses and unfortunate circumstances at the same time. We've already helped our clients with thousands of claims related to the hurricanes alone.
Unfortunately, there will likely be more claims filed over the coming weeks driven by the wildfires in California. 2017 could be one of the costliest insured natural catastrophe loss years on record, with catastrophe modeling firms estimating more than $100 billion of insured losses from the U.S. hurricanes and Mexican earthquakes alone. In my opinion, this is the time for our industry, the insurance industry, to shine as losses get paid and lives get put back together. I'm honored to work in an industry responsible for such an important task. I'd like to go on to my comments regarding our third quarter. In our usual fashion, Doug and I are going to touch on the four key components of our value creation strategy. I'll address three of those. Number 1, organic growth. Number 2, growing through mergers and acquisitions. Number 3, maintaining our very unique Gallagher culture.
Doug will touch on the fourth, which is improving our productivity and quality. Once again, the team delivered on all of our strategic priorities. I'm extremely pleased with our performance in the quarter and through the first nine months of 2017. First, let me make some comments on our brokerage segment. Third quarter organic growth was 3.5% all in. Base commission and fee growth was 3.7%, with supplemental and contingent coming in flat as we had forecasted at our September 15th investor day. Let me give you some more detail around the organic growth in the quarter. Domestic retail property and casualty was just a touch below 3%. Domestic wholesale was flat. Employee benefits was around 2%, but there was some negative timing we expect to catch up in the fourth quarter.
U.K. and Bermuda property and casualty was over 5%, with some positive timing from the fourth quarter that about offset the negative domestic timing. Benefit timing. Canada and South America was 3%. Last but not least, Australia and New Zealand really crushed it with over 8% organic growth. Let me move to the rate environment. I recently returned from The Council of Insurance Agents & Brokers annual meeting, where I met with many insurance carriers. Based on my conversations with carriers and consistent with what I'm hearing from our folks in the field, there's likely to be some modest hardening in the property rates coming. Carriers are reacting rationally by focusing on those catastrophe-exposed lines, and they are not just looking for rate increases across the board. Having said that, we are also seeing many casualty lines continuing to firm.
While it does take some time for price increases to be reflected in our results, internal pricing data does indicate some upward movement in pricing. In addition, over the last month, I met with our international leaders from our U.K., Canada, Australia, and New Zealand operations. Let me give you some details on international property casualty pricing, as it does vary quite a bit by geography. For example, Australia and New Zealand are experiencing about 5% upward move in pricing. Our U.K. retail and Canada operations are seeing a stable rate environment, and London specialty continues to see pricing in negative territory. Finally, on the topic of rate, our internal data shows global PC pricing flat in the third quarter. That's an improvement over the second quarter.
With our own data confirming what I'm hearing from carriers and the feedback I'm receiving from our folks on the ground, I think global pricing could continue to increase and be a possible small tailwind for our business. I remain optimistic that we can deliver full year 2017 organic growth similar to or perhaps even better than our 2016 result. Adding the potential for some modest increases in rates, I think 2018 brokerage organic could even be better than 2017. Second, let me talk about brokerage merger and acquisition growth. We completed six tuck-in brokerage acquisitions this quarter at fair prices. The average size of the six tuck-ins we completed in the quarter was $6 million in annualized revenue. Through the first nine months, we've completed 27 tuck-in mergers, and our weighted average multiple paid is about eight times. Our pipeline of potential merger partners is very full.
Looking at our internal merger and acquisition report, I see over $250 million of revenues associated with around 50 term sheets either agreed upon or being prepared. Not all these acquisitions will close, but I feel good about our ability to continue attracting our typical small tuck-in acquisition partners at fair prices who value our capabilities and know that we can be better together. I'd like to thank all of our new partners for joining us, and I extend a very warm welcome to our growing Gallagher family of professionals. Let me wrap up the Brokerage segment. The team posted 8% total adjusted revenue growth on 3.5% organic. Adjusted EBITDA growth of 8%, and adjusted EBITDA margin was 27.9%, up five basis points over the third quarter in 2016. Really strong results for the Brokerage team.
Next, I'd like to move to our Risk Management segment, which is primarily Gallagher Bassett Services. Third quarter organic growth was 10.2%, which benefited from about two points of favorable audit fees. Of the 8% organic, we saw about 8.5 in the U.S. and about 6% international. In the U.S., we had a nice lift from our insurance carrier and captive books, and internationally, we had excellent sales in New Zealand and the U.K. Regardless of geography, our customers can see that we are delivering superior claim outcomes. With year-to-date organic over 5%, I'm pleased with how Risk Management has rebounded from 2016. Far this year, our Risk Management team has completed three acquisitions, including one during the third quarter. The third quarter merger partner was a U.S.-based trucking-focused claims adjuster.
This particular franchise has a specialized service offering that will be very complementary to our Risk Management segment's operations. A great example of the type of partner we're trying to attract. Finally, let me talk about our culture. October 2nd marked Gallagher's 90th anniversary, and all of our global operations took time throughout the day to commemorate this special occasion. While clearly a time to celebrate on all that we have accomplished as an organization, we decided to mark our 90th anniversary by setting a company-wide goal of 90,000 hours of charitable work over the next 12 months. Our company is committed to our local communities, and in any one of our locations around the world, our culture hangs together. A culture that is grounded on a rock-solid foundation of ethics, superior client service, dedication to our community, and encapsulated in the Gallagher Way.
I'm confident our culture will thrive for another 90 years and beyond. All right, an excellent quarter, a really great first nine months of the year. I'll stop now and turn it over to Doug. Doug?
Thanks, Pat. Hello, everyone. A really terrific third quarter, the highlight of which is that our Brokerage and Risk Management segments combined to post 4.6% organic growth. That is really, really excellent work in this environment. Today, I will touch on some modeling items using the CFO commentary document that we post on our website. I will provide some comments on margins, clean energy, M&A, and cash. As Pat said, I will wrap up with some comments on productivity and quality, one of our four value creation strategies. First to page two of the CFO commentary. You will see that most all of the third quarter 2017 actuals came in very close to the estimates we provided during our September 15th Investor Day. We really appreciate everyone that attends or listens to our quarterly updates, and those of you that spend the extra time to update your models after those meetings.
Our next IR day will be on December 12th. Let's move to page two of the CFO commentary, to foreign currency. With the dollar weakening relative to fourth quarter 2016, FX should now flip to a small tailwind here in the fourth quarter 2017. You will see how we expect foreign currency to be about $10 million of tailwind in the Brokerage segment revenues in the fourth quarter, which will offset the headwind during the year and end up with only about $20 million of headwind for the full year. That is the impact on revenue, you will see there is not really that much impact on EPS. Turning to page five of the CFO commentary. We have given our best guess as to roll-in revenues for mergers that we have completed through yesterday, and we will update this information on our December 12th IR day.
Like I said last quarter, we understand making an estimate for roll-in revenues is a difficult pick, it can be really quite sensitive on EPS, time is well spent on this. Let's move away from the CFO commentary back to the earnings release to page five, to the Brokerage segment margins. For the year, we are up 57 basis points. This quarter, just like last year's third quarter, also in line with what we said on our September 15th IR day, we effectively held margins flat, actually up about five basis points. You will note on that page also that we would have posted about 30 basis points of margin expansion if you exclude new mergers which do not have the seasonality that we do. We saw that same situation in the second quarter, if you recall.
Our second and third quarter margins are higher than what our new mergers are coming in at for the full year. Looking forward, last year Brokerage adjusted margins were 25.8% in the fourth quarter. At today's FX rates, that would be about 25.5%. Last year, fourth quarter, we posted 30 basis points of expansion on about 3.5% organic. It feels like we could have a similar result in the fourth quarter of 2017 if we again hit 3.5% organic. Let's move to the Risk Management segment. As Pat said, a really terrific quarter, admittedly a bit noisy. You will read in the release, the way we think about it is to strip out revenues of about $4 million of audit fee timing that came from the fourth quarter, also take out $3 million of special items and operating costs.
You'll end up with 8% organic and about 17.5 points margin. Even without the noise, those results are terrific. As we look forward to the fourth quarter, risk management organic, however, will be challenged by the shift of the $4 million of audit revenues from the fourth quarter into the third. We also, again, expect little to no performance bonus income, which was $1.4 million last year. When you stack up those fourth quarter headwinds, we're seeing fourth quarter of 2017 organic of around 2% in the risk management segment. That would still bring our full year in at around 5%. Sure, a little up and down by quarter, but looking like a great year nonetheless. As for fourth quarter margins, with 2% organic, margins should come in between 16.5 and 17 points, which would still result in achieving our full-year target margin of over 17%.
Let's turn now to the corporate segment. First, to clean energy. We had an excellent third quarter of production, our earnings came in a bit over the high end of our estimate. You'll see on page three of the CFO commentary that our fourth quarter estimates are right at what we provided on our September 15th IR day. There's really no news there. However, I always must mention that weather can move those estimates by a few million dollars either way. At September 30th, we have over $600 million of tax credits on our balance sheet, effectively a $600 million receivable from the government. This asset will reduce our future cash taxes paid for many years to come. As for cash, at September 30, we had around $275 million of available cash on our balance sheet.
With our strong cash flows, it looks like we can fund all of 2017 M&A with free cash and debt. Now let me shift back to some comments on our productivity and quality initiatives. The systems and processes we've developed over the last decade have allowed us to significantly control our workforce headcount. In the last two years, on a middle and back office base of about 16,000 associates, we're only up 200 positions, excluding acquired businesses. If our headcount would have grown in lockstep with our organic growth over the same period, we would have grown by over 1,100 positions. Yes, we've grown our offshore centers of excellence a bit, but those positions carry substantially lower costs. What's more exciting is our quality has dramatically improved over that time. A couple examples.
First, several years ago, it took us a couple days to turn around a certificate of insurance, our quality was in the mid 80% range. Now we can turn a certificate in 30 minutes, quality is over 99%, that's on over 2 million of certificates issued over the last year. That's really meaningful for a contractor that's trying to get his crew working to get something in 30 minutes. As another example, we now check commercial policies for accuracy in under 80 minutes, also at over 99% accuracy. That's down from several hours a few years ago, if you go back a decade, frankly, it was a hodgepodge process that frustrated our clients. We've solved that problem, I believe that we're the absolute best at this in the business. To put that in perspective, we're reviewing about 200,000 policies a year.
Finally, our efficiency, quality, and headcount discipline enables to think differently about real estate. Over the last five years, we have substantially modernized and right-sized our real estate footprint. Looking forward, we have some sizable opportunities coming in the fourth quarter. I'll have some estimates of the one-time charges and expected future savings by our December 12th investor day. All of this shows the power of our scale and our constant focus on getting better, faster, and cheaper. Those are my comments. We had really great organic this quarter, solid execution on our M&A program, excellent operational discipline and margin expansion, we have a really strong cash position. Back to you, Pat.
Thanks, Doug. Darren, we're ready for some questions and answers. Hopefully answers.
Thank you. This call is now open for questions. If you have a question, please pick up your handset and press star one on your telephone at this time. If you are on a speakerphone, please disable that function prior to pressing star one to ensure optimum sound quality. You may remove yourself from the queue at any point by pressing star two. Again, that's star one for questions. Our first question is coming from Elyse Greenspan of Wells Fargo. Please proceed with your question.
Hi, good evening.
Good evening.
My first question, I was just hoping to get a little bit more color just on how you guys are seeing the market. Obviously, there's a pretty big delta out there in terms of the potential insured losses from the third quarter events, what we've actually seen disclosed, and I think that's led to a lot of dialogue around how much price we could actually get out there. You did allude to the potential for firmer prices in the U.S. What kind of magnitude do you think that we could see? Do you think that this is dependent upon seeing insured losses and reported losses get close to about that $100 billion figure that's been floated around?
Well, Elyse, this is Pat. I think it's pretty early in the game right now. These losses are still very fresh. One thing we know from the past is an awful lot of the modeling firms, those models don't necessarily hold up when it comes to these catastrophes. We don't know. I think probably the $100 billion is somewhere close to what reality will be. There's plenty of capacity beyond that. We are seeing people already talking to our folks, in particular, around catastrophe-exposed property. It's not across the board, but they're saying, "Look, we're going to need increases," and it's reasonable. We've had about 23 quarters, by our estimate, of decreasing property rates. That was fair. It was fair because the clients really weren't putting a bunch of losses into the market.
To see something on the order of 5% to 15% to 20% wouldn't be unreasonable.
Okay, great. In terms of the organic growth outlook, in the prepared remarks, were you trying to point out that the organic could end up around 3.5% also for the fourth quarter? In terms of the go-forward view, you were saying 2018 could look a little bit better than 2017. What type of price are you factoring into that outlook, just so we can have idea of if prices exceed a certain level, what could be additive to your initial view?
Yeah. All right. Let's clarify. I said that if we had three and a half points of organic growth in the fourth quarter, we probably could post about 30 basis points of margin expansion. I was just giving the sensitivity. If we're at three points, probably not much margin expansion. If we're at four points, maybe a little bit more. That was the context of that. I wasn't really prognosticating on what the fourth quarter organic would be, but right now it feels a lot like the second and third quarter.
In terms of what kind of pricing expectations you guys are thinking about when you say, next year could be a little bit better than this year?
I think that it's one of those things that last year, maybe in all of 2017, we might end up getting a headwind from rate of maybe a half a point to a point. If you think that next year feels a lot like this, maybe you'd see it go up another half a point to a point.
That's an all-in view, meaning if there's any impact from the storms on your level of contingents, you've kind of factored that in when you were letting us know that?
Yes. Right.
I know that you guys let us know at your investor day that the supplementals and contingency, they came out in line with your expectations of to be about flat. I guess why were you expecting them to be flat, and do you have any kind of initial view on what we could expect in the fourth quarter?
Rates have been decreasing slightly over the past year plus. Loss ratios are up and contingents are contingent. I think that as you go into next year, we'll have to see what the catastrophes themselves are not going to have a huge effect on that. They may in our wholesale side, but across the PC operation globally, shouldn't be that big an impact. If rates don't firm or at least hold stable, loss ratios will rise, and there'll be pressure on contingents.
Yeah, in this quarter in particular, it was a couple of million dollars in our wholesale operations domestically on a couple of our programs, not related to the catastrophes, just on some of the general liability lines and some of the lesser property lines in certain spots, but primarily casualty lines. That's why we said that domestic wholesale was about flat this quarter, and that's also the reason why contingents are about flat.
Okay, that's great. Thank you very much.
Thank you, Elyse.
Our next question comes from Kai Pan of Morgan Stanley. Please proceed with your question.
Thank you and good afternoon. By the way, thank you for making this call this afternoon, making our life a little bit easier tomorrow morning.
Well, thanks for being on, Kai.
Yeah. The first question, follow on Elyse question on pricing outlook. I just wonder, what do you tell your brokers right now, your producers out there to say, in this environment, how should we help our clients? From your past experience, you were experiencing big catastrophe losses or potential rising prices. Is the environment for you to sort of like a better or worse environment for you to retain your customers or gain market shares?
That's a great question, Kai, and one of the things we realized is we've probably got about 12 to 13 years of new hires that have never had to take a price increase to a client. We've broadened terms and reduced prices. One of the things we're doing is putting out into the field some real training. Those of us that are a little longer in the tooth have been through three or four hard markets, and nothing makes a client more unhappy than a surprise. The idea that pricing is likely to move around these catastrophes, and again, being able to explain to a client that for 23 quarters, we've brought you cheaper prices, which you deserved. Balance sheets were flush. Now you're going to have a $100-plus billion payout. It makes some sense.
By the way, pricing and catastrophe exposed areas of Florida at July 1st renewals were about equal to or less than 1992 when Andrew hit. To go back and say, "You know what? It's time to reload these balance sheets in a 5%-15% increase" is not unwarranted. You got to get out in front of that early, because if you surprise a client, they're not happy. We don't have people that have been trained in this, so we're working on it really hard.
All right. In the past, in this environment, do you think you will be able, on top of the price increase, you'll be able to sort of gain market share?
Yes, definitely. There's no question about it. There's nothing better than consternation in the market for our professionals to go out and solve some problems.
That's great. Then just two quick follow-up for Doc, one is on the clean coal. Do you have any sort of indication what is the 2018 going to be like, higher than the current levels or going to be sort of you'll reach steady state levels?
Yeah, I think we've said that we're pretty close to steady state. Most of our plants have put in production. The program's got another four years running on it, we're pretty close to steady state on that. Obviously, there's administrative favorability to coal right now, hopefully the plants will run a little bit more than we had originally projected. Right now, we see flat to up just slightly.
Okay. The other one is any comments on the pending accounting changes, how would that change your sort of income statements for 2018?
We're still working on it. I think it's probably premature to comment on it.
When will we be able to find it out, is that the end of fourth quarter?
I think we should have something late in the fourth quarter. We should have some ideas, and certainly early in the first quarter. Clearly, there'll be movement by quarter, because it'll level out some of the seasonality that's been in our business. What the actual impact is on full year results, we're still working on that.
Okay, great. Thank you so much, and good luck.
Thanks, Kai.
Our next question comes from Joshua Shanker of Deutsche Bank. Please proceed with your question.
Yeah, thank you. I wanted to follow up a little on Kai's questioning about talking to clients and whatnot. One of the underwriters mentioned earlier on a call today that positive property pricing could lead to the inverse in the other longer tail lines as you try and work through an entire package for a customer. What do you think happens as you raise property prices? Is that bad for the casualty pricing cycle, or where do you see us going right now?
I think what you've got is a different market than we've seen. I've been through four market cycles, and I've been saying this since 2005, I think that the general market cycle is dead. I think you're going to have mini market cycles based on lines of coverage. Workers' comp is soft. Rates are going down. Makes sense. The claims are better. Property looks like it's probably going to go up a bit. You got transportation, trucking and auto, it's definitely going up. I think by line across the board, rates are going to move based on basically what needs to happen on that line. I do not believe that higher prices on property, especially when it comes to catastrophe-exposed property, are going to have any impact on casualty at all.
Okay. That was very forceful. Additionally, looking at the pipeline on acquisitions, and you've been now in the markets for a while overseas, are you finding the markets in the U.S. equally fertile to ones overseas? Is the Gallagher name out there to the same extent that people know that you want to find good people to join the team? Where does that stand within the next few years where the focus will be on bringing new team members on?
Tremendous opportunities. Go back to 2014, I think basically everybody had a wait and see attitude around whether Gallagher could truly integrate and have operations in New Zealand, Australia, Canada, and the U.K. Those people are all aboard. We just finished our engagement survey globally. We had 93% participate in taking our survey. 95% of the people that answered the survey said they understood the Gallagher culture to be unique and important, and that's across those geographies. The name is getting out there more and more. Tuck-in acquisitions, the pipeline is growing and is solid in every one of those locations. We're seeing opportunities in New Zealand, Australia, Canada, the U.K., and Latin America, and of course, in the United States it's very robust.
Thank you very much. Perfect answers.
Thanks, Josh.
Our next question comes from Ryan Tunis of Credit Suisse. Please proceed with your question.
Hey, thanks. Good evening, guys.
Good evening.
Just following up more, I guess, on the conversation with some of the clients and thinking about maybe some of the unintended consequences of higher rates. I guess one thing I'm curious about is all these quarters where you've gone back with lower property prices, do you think that most of your clients have been able to get a lot of those clients to respond by buying more of other types of insurance to arguably with some of the savings from that rate? Is one of the difficulties in this conversation, if that's true, do you think if you're passing through 10%-20% rate increases, could there be an organic offset from them maybe buying less elsewhere?
Well, clearly, we have in fact sold more insurance around the fact that rates have decreased over that period of time. People have extended both their limits and what they're buying. One of the greatest examples, of course, is cyber. I think you could see some cutbacks. There are some clients that will say simply, "I paid X last year. I'm paying X this year. You tell me where I'm going to cut back." I don't see that being a predominant thing, especially when you think about, first of all, your catastrophe-exposed property is one line of cover in a multi-line coverage map. If that goes up 5%-15%, it's not really impacting whether you want the casualty limits at $150 million or $100 million. I don't see that.
There could be some pressure, I think that carriers seem to be very reasonable in the approach they're taking now. After 9/11 in 2001, that was our last knee-jerk, full-on hard market. It's been 16 years, that's not what we're seeing here.
Understood. That's helpful. Just maybe a little more color on what's going on in Australia and New Zealand. Sounds like the pricing commentary's pretty good there. At this point, I guess, how big is that book for you guys?
About $300 million between Australia and New Zealand. We're seeing pricing increases down there of around 5%, a little bit more. I think the real spark in what's happening down there is that we've been together now for three years, I think that they're seeing that the Gallagher sales and service model is helping them sell more customers too. It's not just a rate story down there.
Okay. My last one was, appreciate the commentary on maybe being able to accelerate organic growth next year, hearing Doug talk about some of those efficiency initiatives, is there a level of organic growth that you think you need to be able to get, even if it's not acceleration, where you think you can still get margin expansion in 2018 given those efficiency initiatives?
Our standard answer on that is it's pretty tough to show any margin expansion unless you've got more than 3% organic growth. I think that we've always talked about how we're starting to have some of our other locations like Australia, Canada, and the U.K. come onto our service platform. That will provide a little bit of lift next year. Remember, even if we got to the optimal point out, we're talking about $25 million to $30 million extra of EBITDA from those locations. From that standpoint, the chassis can certainly handle a heck of a lot more weight. I think that we can be in a position of, if we're at 16,000 associates now, maybe it's 16,000 associates in two years even. I think that we've got the capabilities there.
There's some pretty exciting stuff that we're doing internally with a lot of what you might refer to as Insurtech or service tech. I think there's lots of opportunities there for us still to get better. More importantly, our quality. At every point, we're measuring quality now. That's something that we absolutely know is very hard to replicate. We've been working on that for 12 years now.
Thanks for the answers.
Thanks, Ryan.
Our next question comes from Adam Klauber of William Blair. Please proceed with your question.
Afternoon, guys.
Hey, Adam.
A couple questions. One, on the liability casualty side, are you seeing a tougher legal environment? Is that, to some extent, what's flowing through some of the tougher casualty results these days?
I don't know if I would say there's a tougher legal environment. I've been around since asbestos started really raising its ugly head, and I think CTE is going to raise its ugly head, and I think that the plaintiff's bar is pretty darn good at finding places to go. I wouldn't call it any tougher. I'd just say it's continuing to be a very litigious, the U.S., in particular, is a very litigious location.
Yeah, I don't know if it's a frequency or severity issue on that, Adam. That's probably a better question for the carriers that really have deep knowledge on what's coming in on the claims side. I'm not seeing any runaway settlements happening. If it's anything, it's a frequency issue, and the frequency issue would be triggered by economic growth because more things happen, more things can go bad. If it's a frequency-led charge that's economically driven, I wouldn't know if that's necessarily because of the legal environment.
Okay. That's helpful. As far as all the catastrophes, Lloyd's in particular, they're not the only ones, but taking some pretty big lumps. How big of a partner are they for RPS? Are they top five, top three?
Probably top four.
Okay. My understanding is Lloyd's in particular is pushing hard for rate. Would you say that's true?
Yes.
Yeah.
Yeah.
Yep. Okay. As far as the balance sheet, it looks like net debt to EBITDA has crept up moderately in the last year. I guess what level are you comfortable with going forward?
Well, I think that right now our net debt to adjusted is probably about the same, Adam. We've been running between 2.5 and 2.6 on a covenant basis, and that's been pretty steady on an adjusted basis. In fact, I don't know exactly what you're looking at. It might be the way you're deducting some of the cash that's on the balance sheet. I don't know if you're picking up restricted cash or not, but I can tell you that we've been pretty steady right now. On a covenant basis, we feel investment grade is somewhere between 2.5 times and 2.8 times, and that's about where we'd like to be.
Okay. That's helpful. Finally, for the first nine months of this year versus last year, has operating cash flow grown materially?
Yeah. As you know, it's very hard to find that from the GAAP cash flow statement. Yes, obviously, our cash flow is up substantially. Integration is behind us. Building our new office building is done and behind us. Just cash flows off the business as we grow more are up. Yeah, we are substantially stronger cash flow today. Now operating cash flow has grown just nicely with respect to our organic. As we grow organically, our cash flows do it. As we expand margin, our cash flow, but kind of the one-timers that we've been spending cash on are behind us at this point.
Okay, great. Thanks a lot.
Thanks, Adam.
Once again, ladies and gentlemen, if you'd like to ask a question, please press star one on your telephone keypad. Our next question comes from Mark Hughes of SunTrust. Please proceed with your question.
Yeah. Thank you. Good afternoon.
Good afternoon, Mark.
The question of Lloyd's, I assume they're pushing on cat exposed property. Are they pushing on casualty as well?
No.
Okay.
Mark, the specialty market in the U.K. is soft.
Okay. How about domestically in the E&S market?
No, property.
Okay.
Casualty's flat.
Did you touch on the benefits, with the health reform on/off again, et cetera? Is that having much of a difference? How has that performed organically?
Organically for the quarter, we were about 2%. As we said, we had some stuff that sort of moved to the fourth quarter. Organically, we're doing well. The consternation around the ACA is both good and bad for Gallagher. The confusion and the compliance requirements are good for Gallagher because we are out consulting with our clients. The bad news is that the confusion and the compliance drag our people away from just going out and knocking on doors and getting new business. It's a plus and a minus. Overall, I would say the ACA is a big plus for Gallagher because it is complicated, and now you've got the president basically saying that subsidies to insurance carriers are going to be withheld. You've got insurance carriers that have basically committed to rates for 2018.
You've got all kinds of compliance rules around the carrier's loss ratios and things like that that are kind of in flux, and it's creating a bunch of consternation, which I think will flow through to next year depending on what happens with whether or not the subsidies are in fact killed, which will put immense stress on the whole system a year from now. It's good for Gallagher and bad.
I think one of the things, Mark, just to look at it this way, the capabilities that we have in our Gallagher Benefit Services unit, the consulting capabilities or the tools that they have really allow us to distinguish ourselves since we're out there competing many times with somebody that's substantially smaller than us. The smaller benefits broker doesn't have near the resources, capabilities, or the expertise that we have, and eventually they have to make a choice. Either they sell to us and join us because they want our resources, or they watch their clients eventually come our way. I think that scale matters in this, expertise matters. A lot of these small benefit brokers are terrific sales folks. They've got great relationships with their customers.
As a result of that, they look to us to join through mergers because they know that we can be better together. There's that opportunity for us as a broker that's growing substantially, to bring on more smart people that really are good benefits folks that just want our capabilities. To me, I see it as a positive on that side when you look at the M&A aspect of it.
Thank you.
Thanks, Mark.
Our next question comes from Bob Glasspiegel of Janney Montgomery Scott. Please proceed with your question.
Good afternoon and happy anniversary. You guys don't look 90 years old.
You haven't seen us from the inside, Bob.
That's right. Especially in your new location, which was quite impressive.
Well, thank you.
Thank you for-
It's the same place we left 26 years ago.
That's right. No, thanks for the tour. I also didn't think I was going to hang around long enough to see you throw the word tailwind, whether it was pricing or foreign exchange. It seems like you've been using headwinds a lot more. Now that you think you're going to have some tailwinds in property, a couple questions. What does that mean to you as a company, as how you manage day to day? Do you do anything differently in a hardening property market than a softening property market? Did you say, this is the second question, did you say that, Doug, that rates cost you 50 basis points in organic in 2017, or did I misunderstand that?
In 2017, we'll probably end up about 50 basis points in organic, as a result of rates. Last year was more like a full point in 2016. I think we'll come in.
50 points negative, you're saying?
Yes, that's correct. We've recovered probably half a point this year.
Right. If we said we were in a hard market for property, does that get you to what?
Maybe another point next year.
It'd get you 50 bps. It'd be 100 bps swing from minus 50 to plus 50 if you get to that sort of environment?
That's right.
Pat, how would you run the company differently if you knew that for sure? Would you hire more people? Would you move people in the property, or do you just let it all go to the bottom line?
Bob, I think the main thing right now that I'm concerned about is making sure that the people that have joined us over the last 12 years really get out in front of their clients. Again, I don't think it's a jolting hard market similar to 2001, 9/11, but any kind of price pressure on the upwardly mobile price, we've got to be out explaining to clients why it's happening. Memories get really short. Everybody that survived a hurricane or a huge flood this month, they're shaking their head, I get it. By April, they're going to be saying, "What are you talking about, you're bringing me a rate increase?" You got to be out talking to those April renewals and those July renewals now. That's a training exercise.
I don't think it's big enough to say that what we do is take this. I'm not looking at this as a windfall. In fact, if anything, I'm looking at it as something that really we have to just take a moment and make sure people can explain why the market is dynamic. Our people are smart people. By the way, our buyers are smart people. They'll get it.
There's no deferred investing that you would now consider in a great scenario that I'm trying to create for you where things are improving and your organic could be growing 4%, 4.5%, if you get 100 basis points win. There's nothing that you need to invest in or there's no resources you need to service this from your perspective?
No.
No. The real interesting thing will be is next year when a lot of customers are showing up to rate increases. I think that people have a tendency to shop more when their prices are going up, and I think that lets our folks get in there and demonstrate our capabilities from somebody that's been opening up their mail and getting price decreases for 10 years. All of a sudden now they'll take that appointment. You'll see that happening. We got to protect ours to well inform them. For those other brokers out there that are asleep at the wheel, that's our opportunity to come in and show our wares, and they are terrific capabilities that our clients will really like to see.
That's actually a really good point. I would hope that we would see some increased opportunities around the fact that our competition in particular, and you know this, we now measure and we know that 90% of the time when we go out to compete on an account, we're competing with a smaller broker. This is our opportunity to go out and say, "Hey, we really can help you navigate this market. There's a change in market. We're very good at this. We're one of the largest property placers in the excess and surplus market. We know what we're doing. We've got the guns. Let us help you.
Great. Thank you.
Thanks, Bob.
Our next question comes from Arash Soleimani of KBW. Please proceed with your question.
Thanks. Just had a quick question. I know you've said multiple times that you're competing against firms that are smaller 90% of the time. I'm just curious, how does that percentage change when you look outside the U.S.?
It's about the same.
About the same. Okay. The other question I had, when you look back at KRW in 2005, it looked like the property cat index in the U.S. had gone up in 2006, but then went down in 2007 and 2008. Would you expect it to behave similarly this time around, or is there any reason you think it would perhaps be different?
Depends on how much capital flows in.
Okay.
If a whole bunch of capital moves to Bermuda and starts taking cat risk, it'll soften quickly.
Right. Makes sense. All right. Thank you for the answers.
Thanks, Arash.
Our next question comes from Paul Newsome of Sandler O'Neill. Please proceed with your question.
Good evening, everyone.
Good evening, Paul.
One of your peers, or actually one of the insurance companies, suggested that sort of a key component of whether a market that gets really hard or not is whether or not the MGAs are essentially abandoned by some of the reinsurance backers. My question is, do you agree with the premise? If so, how do you think that might, may or may not unfold? Is there sort of a certain time that we should be looking at that happening and get any thoughts about just the importance of MGAs?
Well, first of all, the premise is absolutely right on. By the way, we're the largest MGA in the U.S., so that's a really important market for us, and those programs are critical to us. Again, remember, this is not a knee-jerk across the board, all ships are rising on a high tide. This is catastrophe-exposed property that had a bad 90 days, that's going to need to have some balance sheet replenishment. This is not a threat to the industry in terms of the size of the loss. There's plenty of capital to pay it, and we're not seeing stress on our MGAs that are outside the cat property market at all.
The answer to your question is, yes, if in fact what you said occurred, where across all the whole MGA book things got withdrawn or capacity got withdrawn, that would be pretty traumatic, but that's not what's happening.
That's great. Thank you.
Thanks, Paul.
As a final reminder, ladies and gentlemen, if you would like to ask a question, please press star one on your telephone keypad. Our next question comes from Kai Pan of Morgan Stanley. Please proceed with your question.
Thank you for the follow-up. Just a larger picture question. I know you traditionally have been focusing on middle-market clients. Do you have small business insurance clients, and how have you been serving them? Do you see that as a growth opportunity for you? There's a lot of talk about that in the marketplace.
Yes, we see that as a huge opportunity for us. In fact, we've had a project afoot for the last 24 months, pardon me, on a global basis, looking at how we service and change the way we service small business from doing it the way we handle middle market and upper middle market business into very specific service centers that will do it better with a higher level of quality and will allow us to drive substantial margins, which we will then invest in the marketing around that and really try to drive small business into the company. We think there's a tremendous opportunity in small business, and that's both on a benefits and property casualty basis on a global basis. These efforts are afoot in Canada, the United States, Australia, New Zealand, and the U.K.
Could you size it in terms of the potential sort of like opportunities in terms of percentage of overall book?
I don't think I can off the top of my head, Kai.
All right. Thank you so much for your time.
Thanks, Kai. Darren, it looks like that's about it, huh?
There are no further questions at this time.
All right. Let me make just a quick closing comment. I want to thank you again for being with us this afternoon. In closing, I am extremely pleased with our 2017 performance thus far, and I believe we will have a very strong finish to the year. We look forward to speaking with you again in January, and thank you all for being with us this evening. Thank you, Darren.
This does conclude today's conference call. You may disconnect your lines at this time. Thank you for your participation, and have a wonderful day.