Agency Acquisitions: Let The Buyer Be Smart

AGENCY ACQUISITIONS: LET THE BUYER BE SMART

Every independent agency in the country will experience a change in ownership at least once in its lifetime. Close to one-third of agencies have perpetuation plans that anticipate an internal transfer of ownership interest as the next step. The remaining organizations are potential acquisition candidates for outside buyers. In either case, those who will be acquiring the ownership-internally or externally-need to make sure that they are doing so wisely.

Every agency today is unique. It is different than other agencies and it is no longer the same organization that it was ten years ago. What worked well when you acquired the last agency or when you bought out the last retiring owner is not necessarily right now. Nothing can be taken for granted and everything must be taken into consideration. Whether you are planning to purchase or merge with another agency or whether you are going to be taking an ownership interest in the agency in which you have been working, you owe it to yourself and to the agency to conduct a complete review of the operation.

The balance of this article presents a methodology to facilitate this review. Although the discussion is addressed to a prospective buyer, the approach can also be used by a prospective seller to determine what should be done with his or her agency to identify weaknesses and to develop a plan to address them in order to enhance the value and increase the price that can be obtained.

Any evaluation of an insurance agency should begin with a review of the past five years' worth of financial statements. Compare income and expense ratios with standard percentages recorded by other agencies to determine where the past experience varies from the norm. These standard percentages are published every year in the December MIDDLETON LETTER as well as by other organizations. If you are reviewing another firm for possible acquisition, compare their ratios with the recent experience of your own agency.

In reviewing the income and expense statements, you should determine the answers to the following questions and to the questions that come to mind. The key is to identify all potential strengths and weaknesses of the operation.

• Has the compound growth rate in revenues (net of acquisitions) been less than 8%? If so, what is the reason for this stagnation? Conversely, a growth rate of more than 15% indicates that many of the accounts are relatively new. This will stimulate investigation into the overall stability of the book of business.
• How much income has been derived from new life insurance commissions? What is the life renewal income projected to be and who will own the vested portion of the life renewals? Often life insurance is not included in the sale of property-casualty books of business so it is important to remove historical income from this source before projecting cash flows if that will be the case.
• How much of the income was derived from fees or from association programs? Will these relationships be 'purchased' along with the insurance expirations? How stable are they?
• Over the five year period under review, has profit-sharing income averaged less than 8% of the prior year's property-casualty commissions? Why? This could be an indication of poor agency underwriting or insufficient volume with major carriers. If contingent income was a substantial contributor to agency income in the past (over 12% of total revenues), what is the prognosis for the future? Will recent loss experience impact profit-sharing income adversely for the next three years?
• The amount of interest income on premium float should be more than 3% of revenues unless the agency has less than 50% of its premiums on the agency bill. If income from investments has been at or above that percentage, collection practices may have been lax in the past. This could result in above-average attrition when tighter controls are imposed.
• What percentage of revenues was paid to outside brokers or producers who own their books of business? What are the arrangements and do you want the relationships to continue? (Note: if the broker is receiving 50% or more of the commissions, you probably want to terminate or at least renegotiate the agreement). Be sure to adjust the gross commissions to account for those expirations that are not owned by the seller and are not being purchased in this transaction.
• Has office payroll expense been averaging less than 18% or more than 22% of total revenue? What does this indicate about the overall efficiency of the operation and the level of servicing that is currently being provided? What impact will this have for the future? If the agency is overstaffed or understaffed or staffed with the wrong types of people, you may have to address personnel issues right after the transaction has been completed.
• What other expenses have been significantly below or above the standards? Why does the variance exist? When evaluating another agency, determine where the expenses are higher or lower than your own. Why? Pay particular attention to travel, entertainment, dues, promotion, owner's compensation, and employee areas of ownership 'extras' or 'perks.'

It is important to review the agency balance sheet even if the transaction will not include the purchase or merger of corporate stock since the balance sheet can provide indications about how well the agency was run in the past. Compute the current ratio (current assets divided by current liabilities). In an agency with proper liquidity, this ratio should be slightly more than 1:1. Use the receivable ratio (accounts receivable divided by accounts payable including pre-billed items) to help assess the collection practices. If this ratio is more than 55%, the buyer of the book of business or the agency will need to tighten up on collections and should anticipate the cost of additional efforts in changing the habits of the insureds, and perhaps a greater attrition rate than would be experienced in an agency with a history of better management of cash flow.

Another important number to compute is the tangible net worth of the agency. Many balance sheets will appear to be strong, with a large amount of stockholders' equity. This number can be artificially inflated by intangible assets such as expirations, covenants, goodwill, and customer lists which must be subtracted from the stockholders' equity to obtain the tangible net worth. This is the true measure of the book value of the corporation and, in a well-run agency, will be equal to 2.5 months worth of the agency's expenses.

If the buyer will be taking over the balance sheet through a merger or purchase of corporate stock internally, a thorough evaluation needs to be made of all actual and contingent liabilities.

Consider the following questions as well as others that may arise:

• Are there any pending or potential EEOC suits or fiduciary problems with an Employee Stock Ownership Trust or other retirement plan?
• Review any E & O suits. What do they tell you about past management practices? Is E & O coverage adequate?
• Review accounts receivable carefully to determine which are potentially uncollectable.
• Determine if there is an applicable tax loss carry-forward that might be applied in projecting the cash flow for valuation purposes.
• Look at all deferred compensation and buy/sell agreements critically to make sure you are aware of all commitments.
• Determine whether appropriate life and disability insurance is in force on key individuals and/or how much it will cost to maintain such coverage.

The review of the financial statements should reveal certain areas that need further investigation. Depending upon how the transaction is structured and the intended disposition of the book of business, certain aspects of the agency will need to be evaluated to decide whether the acquisition will serve the intended purposes and also to help you determine the appropriate price to pay.

COMPANY RELATIONSHIPS.

Review the premium volumes and loss ratios with the major carriers for the last three years. Are there vulnerabilities with respect to the percentages of total premium placed with the various insurance companies? In an average retail agency with no unusual marketing needs, 80% of the premium volume will be placed with no more than six or seven carriers, and no one carrier will have more than 40% of the agency's volume.

Is the agency in danger of losing contracts because of insufficient volume or loss problem? Will the existing agency contracts be assigned to the buyer? What synergy is there with the buyer's insurance companies? If there is duplication, review the agency contracts to determine which is the most favorable with respect to commission levels and bonus arrangements. Are there special arrangements that might or might not be applicable after the sale? What contingent income has been received from each carrier for the past three years? What type of policy processing and claims service is the agency receiving from the major companies, how competitive are the rates, how do the agency personnel feel about the company, and how do the branch personnel feel about the agency?

ACCOUNTS WRITTEN AND MIX OF BUSINESS.

Examine the relationships with any accounts producing over 1% of the total revenues. Those that appear to be questionable for any reason should be treated separately in the transaction, perhaps by paying a certain percentage of renewed business only and not guaranteeing anything up front. Are any of the major accounts currently handled by a producer who is not an owner? If so, is there an enforceable employment agreement that can be assigned?

Does the average size of the accounts written coincide with the size of accounts already handled by the buyer, or does it satisfy a need identified in the business plan? An agency accustomed to handling large commercial accounts may have difficulty assimilating small commercial and personal lines accounts on a cost-effective basis, so the expense factors in the projected cash flows used for setting a price will have to be adjusted accordingly. Likewise, an agency with little technical expertise among the existing personnel will need to add staff (and payroll cost) to handle larger and more complex accounts that may be acquired.

What is the average age of the personal lines insureds? If the seller is 70 years old, his accounts may be also, leaving little chance for expansion and indicating a much shorter expected life of the policies. What is the age of the person making the buying decision in the commercial risk, and how long can those people be expected to be in that position? Was the business written because of political or religious affiliations of the selling owner? This is not necessarily a negative factor if the seller is going to be around, but it can be a critical element in the retention of the business if he is retiring soon after the transaction is completed.

How many one-policy accounts are there? When most of the accounts have been expanded fully, the price should be adjusted downward since there is little opportunity for the buyer to sell more coverages and leverage the book of commissions. On the other hand, if the book is made up of almost all one-policy accounts, what type of accounts are they? Can they be expanded? What does it tell you about the historical sales, underwriting and management policies of the agency?

Review premiums and commissions by line of business to determine what the mix of business is and whether it fits the needs of the buyer. How much nonstandard business is there? It is critical to know if a significant amount of the book is made up of speciality lines such as malpractice or trucking with which the buyer's staff may have little experience. Is there a substantial amount of the volume in lines such as worker's compensation that might be affected by regulatory or legislative changes?

PERSONNEL.

In a situation where a going concern is being acquired, the existing staff of the buyer and seller must be analyzed and a plan developed for eliminating duplications which can occur even if the acquired agency is to be operated as a stand-alone operation. Functions such as Accounting and Data Processing, for instance, can be effectively centralized in most operations. What are the relative skill and experience levels of the employees? What do each of these people want to do? How can they best fit into the new operation?

A review of the productivity levels of each office will help evaluate the respective service levels and the effectiveness of each of the management and organizational structures. A standard measure of productivity is to compute the firm's average revenues per employee and then to compare this number with the revenue per employee figure of the comparably-sized agency. Care must be taken not to rely on this, or any, measurement too heavily for decision-making, since every agency is unique. But it does provide a rough guideline for determining how many people should be needed to handle a book of business.

What is the general morale of each of the offices? What will combining the two employee groups do to that morale? How can adverse reactions be avoided or mitigated? We recommend that you involve the employees as much as possible in the early stages of organizational decision-making in internal ownership transfers as well as in outside acquisitions. And keep them informed on an on-going basis to the extent that it is feasible.

ADMINISTRATION.

In situations where an existing operation is going to be maintained and sometimes also in fold-in arrangements, other aspects of the agency must be included in the evaluation, such as: location and appearance of the office, available square footage, ownership of the building or lease arrangements, condition of equipment and furniture; existing automated systems and compatibility with or superiority over buyer's systems; organizational structure and personnel policies (vacation, holidays, benefits, salary administration, and performance evaluation); effectiveness of procedures for handling insurance-related functions, accounting, and clerical jobs such as mail, filing, and switchboard.

Once the review has been completed, you will be in a much better position to decide if you want to go ahead with the deal. You will also have the basis from which to prepare a projected cash flow to determine how much the agency is worth to you. Remember, an agency should pay for itself out of its own cash flow in six or seven years. DON'T OVERPAY!!!