Acquiring An Insurance Agency

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ACQUIRING AN INSURANCE AGENCY

by Carol Hammes

The buying and merging of insurance agencies continues to be a hot trend. Traditional buyers, such as larger local agencies, regional firms, and national brokers, are being joined by newly interested contenders, such as banks, insurance companies, and venture capitalists. Before a potential buyer jumps into the fray with both feet, it's important for them to first determine if a business combination will help enhance their strategic business or perpetuation plan. If the answer is affirmative, the next step is to identify and evaluate potential acquisition candidates.

Once the decision has been made to proceed with the acquisition of a particular agency, it's time to start figuring out how to do the deal. You may have found the best possible agency for you to acquire, but if you do it the wrong way, it can easily be the biggest mistake you'll ever make.

Potential growth rate is the first of three key elements in the valuation process. Before deciding how much to pay, you'll need to determine the probable growth or attrition rate under new ownership. The average agency loses between 7% and 12% of its book each year due to sales, mergers, deaths, staff changes, and so on. While there are no exact nationwide statistics, the common wisdom is that the attrition rate doubles in the first year after an acquisition. Depending on the circumstances, the retention experience for the book of business or agency that you're acquiring could be much better or much worse than that.

To determine what growth rate (if any) should be used in this particular situation, a buyer has to evaluate historical trends, the type of business, and the effects of the insurance cycles and the economy. For smaller books that are relatively homogenous, it may be appropriate to look at the entire book. When projecting growth in larger agencies or where there are significant differences in types of account, it's best to apply a separate growth rate to each of the elements being considered. One of the more common breakdowns is regular Commercial lines, small Commercial business, Personal lines, Group, Individual Life/Health, and contingents. Note that in some deals, contingents aren't included in the valuation process, and often the Individual Life insurance isn't even included in the purchase.

The second element to consider is the risk that the anticipated growth rate might not be achieved. The major items to examine in evaluating the effect of a change in ownership on the projected commission income include the mix of business and type of accounts written, insurance company relationships, organizational structure and procedural issues, and personnel and sales management. Remember that the purpose of this analysis is to help you establish the element of risk involved in the acquisition of this specific agency.

  • Mix of business and accounts written. Examine the relationships that the agency has with any single account producing more than 2% of the total revenues, or with any group of accounts that together produce more than 15% of the total income. Are there special connections between the seller and those businesses that relate to religion, politics, nationality, age, family, or some other characteristic that doesn't apply to the buyer? Is it possible that the seller has retained the business because he or she hasn't been diligent with collections?
  • Look at the receivable/payable ratio. Many of the existing accounts may be staying with this agency because they're allowed to pay whenever they feel like it. What will happen when you tighten up on collections? Do your personnel have the level of technical expertise required to service this business? Is there a substantial amount of income derived from Health insurance, Workers Compensation, Malpractice, or other lines that are vulnerable to regulatory or legislative changes? Does the agency write a lot of Nonstandard Auto or other business that tends to have a shorter-than-average life span? Is a substantial amount of business handled by a non-owner producer?
  • Insurance company relationships. Review the premium volumes and loss ratios with the major carriers and the relative chances of keeping those markets after the acquisition. If a significant amount of business has to be re-marketed, the attrition rate will be higher. If your income projection contains contingent income, you need to evaluate the source companies and their volume and loss ratio requirements to determine the chances of receiving comparable bonuses in the future.
  • Pay particular attention to specialty companies or to those that write more than 40% of the total volume. Will you be maintaining the same types of relationships with these companies? Are there special arrangements that might not be applicable after the sale? Are contracts and/or exclusive territories assignable? Does the insurance company contractually have the right of first refusal to buy the accounts that you think you're acquiring? Is the seller current with the company payables? What is the trust ratio? Even if you aren't taking on the outstanding liabilities, you could get stuck having to make good on past obligations to retain the company contract.
  • Organizational structure and procedural issues. Review the files for proper documentation and other E&O concerns. Look at how the book of business has been serviced in the past and by whom. This review is crucial if you're planning to acquire the entire agency, but it's important even if you're just buying the expirations. Any change that you might make in the type or level of service provided to the customers will affect the retention rate and therefore the growth potential. How have account servicing responsibilities been assigned? If you plan on changing that, what impact will it have on the customers, particularly the older ones? Has the seller been efficiently using a state-of-the art computer system, or will you need to put a lot of resources into upgrading or changing systems and procedures?
  • Personnel and sales management. If the producers haven't been subjected to reasonable sales management discipline and are accustomed to sitting on a marginal book of business, it may take awhile to get them on track. If the salespeople and service reps haven't been adequately trained or managed, the accounts could be in pretty bad shape. You might not want to keep the accounts and/or the people, but if you do, it may take a lot of extra work to get the client files cleaned up and the staff retrained. This housecleaning will take time away from the production of new business.
  • What about compensation levels and perks, such as autos and entertainment reimbursement? If current commission percentages are too high and you try to reduce them to a more affordable level, will there be a mass exodus? Do the producers you want to keep have assignable employment contracts with some sort of nonpiracy protection? Are the contracts tied to a deferred compensation arrangement that allows producers to buy the unvested portion of the book and leave with it? If there are no written contracts spelling it out, is there some question of where the actual ownership of the accounts may rest?

After analyzing the agency's book of business, company relationships, and internal management style and procedures, you'll be in a better position to assign a risk factor to this transaction. Weigh all of the information that's been reviewed, and rank this situation according to the following scale:

  • Little risk involved and very good chances of achieving the projected growth rate -- 8
  • An average situation with no extraordinary features -- 6 or 7
  • High level of risk involved, with substantial attrition possible -- 4 or 5

Once you've determined the potential growth rate and the risk that this growth might not be achieved, you're ready to address the third key element in valuing a business combination-the anticipated after-tax earnings.

The price you can afford to pay should be based on the profit you'll be able to make from the purchased business. Depending on what you plan on doing with the book of business or the agency, the anticipated profits may be higher or lower than the current owner has been realizing. It's important to recognize that your expenses and projected profit margin might be significantly different from what other potential buyers could achieve. It's therefore crucial in the valuation process to determine what your expenses will be. If you get involved in a bidding war and end up agreeing to a price that requires total payments greater than the cumulative available cash from the acquired agency, the difference will have to be made up either by the profits from your own agency or by each of the owners personally. This situation might be acceptable for a short period of time, but it will quickly become uncomfortable and eventually, impossible to sustain.

To determine the anticipated earnings, start with the revenues that will be generated. Include the direct commissions after figuring in attrition and growth potential, and then decide whether it would be appropriate to also include fees, contingent income, rollover bonuses, and investment income. Often prospective buyers include contingent income in the valuation process but usually at a five-year average. If the profit-sharing amounts have varied widely over the period, a prudent buyer would probably leave it out altogether. The seller is rarely given credit for the rollover bonuses that the buyer may receive from insurance companies as a result of the acquisition of the book, but this could be a point of negotiation. The disposition of contingents for the first year after the sale is also often part of the negotiating process.

After projecting the anticipated revenues, subtract operating and sales expenses-they will be under your ownership, and the result will be the estimated pretax profit. The preliminary discussions that you should have had with the sellers regarding their future compensation needs will be instrumental in determining these expenses. There also might be changes in employee benefit costs, sales and office payroll, dues and subscriptions, travel, entertainment, and automobiles. Generally the resulting pro forma pre-tax profit will be in a range of 15% to 25% of revenues. It could, however, be as high as 40% or more in consolidation situations where the buyer will not have much of an increase in operating expenses.

The anticipated earnings for valuation purposes will be the pro forma profit minus state or federal income taxes. In successive years the revenues and expenses may increase or decrease, so you should do the projection for at least eight years in preparation for valuing the business. The value of this insurance agency to you as a buyer under these circumstances will be the sum of the anticipated earnings over a reasonable period of time. To determine what's reasonable, go back to the risk factor and convert that factor into years. If the situation isn't very risky, use seven or eight years. If it's an average agency, it should pay for itself out of its own earnings in six or seven years. If this time period seems short, consider the fact that the average account will probably only stay on the books for seven years. Do you really want to still be paying for business after most of the revenues that you would receive from it are gone?

The following chart provides a simplistic example of how this process would work. Assume that you're buying an agency with $500,000 in commissions and have determined that a 2% net growth is appropriate. The risk here appears to be average, so 6.5 years of earnings seems reasonable. Although the agency has only been showing a profit margin of 5% over the past five years, some of what could have been left in was taken out by the owners in bonuses at year end. You have calculated that your pro forma profit margin could be 20%. Our example uses a state and federal tax rate of 30%, but the rate could be anywhere from 15% to 40%, depending on the size of the agency and the state in which it's located.

Commission

Expenses

Profit

Taxes

Earnings

$500,000

$400,000

$100,000

$30,000

$70,000

$510,000

$408,000

$102,000

$30,600

$71,400

$520,200

$416,160

$104,040

$31,212

$72,828

$530,604

$424,483

$106,121

$31,836

$74,285

$541,216

$432,973

$108,243

$32,473

$75,770

$552,040

$441,632

$110,408

$33,122

$77,286

$281,541

$225,232

$56,309

$16,893

$39,416

Sum of Earnings:

$480,985

 

As a prospective buyer, you could afford to pay a guaranteed price of $480,985 for this agency under these conditions. After the potential tax deductions for amortizing expirations and covenants are taken into account, the resulting sum of the earnings will be slightly more than one time the commissions. If the anticipated growth rate was higher, the profit margin higher, the taxes lower, or the number of years greater, the value could be as high as $1,000,000 for a buyer with a different set of circumstances. This is a good illustration of why using a multiple of commissions or revenues isn't a smart way to value an agency.

Because sellers tend to be more comfortable with the traditional commission multiple, however, you may find that converting the numbers to such a multiple will make the negotiation process easier. But this should only be done after you've determined what you can afford to pay, based on your own plans for managing the acquired agency. Relying strictly on a multiple can be extremely dangerous because it only looks at the top-line revenues and ignores expenses that may vary substantially for different potential buyers. You must focus on the bottom-line results as you expect they'll be under your ownership.

If the seller is willing to take some of the risk by having all or part of the price based on retention of the accounts, the earnings projection can be used to determine what percentage of commissions can be paid over what period of time. By removing the second element of the equation, the buyer can figure the pricing over a 10-year period. In the above example, the total amount of earnings over the maximum of 10 years (for a relatively risk-free investment) would be approximately $800,000. Spreading payments out over five years would translate into 32% of the retained commissions for five years ($800,000/5 = $160,000/$500,000 = 32%). By accepting the risk (and also the rewards of potential growth), the seller could end up with a lot more than in the guaranteed cash price scenario.

In some situations the payments can be as much as 40% of retained commissions over four or five years. But in most cases, paying more than 35% a year would be too much of a stretch. The earnings projection in our example would only support 20% a year at the most without some infusion of capital on the front end. To offer an earn-out at the 32% rate that we calculated you would have to be willing to dip into your agency's retained earnings initially or to borrow some money from an insurance company. Right now many insurers are offering good interest rates and some forgiveness of the principal. There are also some lucrative rollover bonuses available.

When circumstances are such that a straight earn-out deal is not appropriate or acceptable to the seller, there are other ways to entice a seller who's going to be involved with the new agency for a couple of years. Here are some suggestions:

  • Structure a production bonus that pays a certain percentage of total commissions received on the portion that exceeds the earnings projections.
  • Pay the seller a finder's fee for new accounts brought to the agency. In most cases it won't be advisable to pay the person as a servicing producer on the renewal of those accounts, but a hefty new-business commission percentage might be in order.
  • When a branch is being acquired and the seller is being retained as a manager for a few years, set up a separate profit center with a bonus arrangement that pays a large percentage of the profits exceeding the earnings plan. This will provide a reward for higher commissions, lower expenses, and/or both.
  • Agree to a slightly higher guaranteed price, but with installments to be reduced if the commissions don't remain at predetermined minimum levels.
  • Hire the former owner to perform management functions (company relations, computer installation, sales or customer-service training, acquisitions). Pay this individual a combination of salary and results-oriented bonus based on a formula in keeping with the assigned tasks, such as increasing contingent income, revenue per employee, or commission per producer or CSR.

This article was reprinted from The Middleton Letter with permission from Carol A. Hammes, CPCU. Carol Hammes can be reached at The Middleton Letter, P.O. Box 1347, Lisle, IL 60532, (630) 515-1044, E-mail

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