Here's a quick investment quiz: Which of the following investments will provide the best financial return over the next five years?
- Microsoft stock
- Coca-Cola stock
- Citigroup stock
- A newly hired Property & Casualty producer
The answer is D. No kidding.
Assuming their price/earnings multiples remain at the current level, the three stocks listed here are projected over the next five years to generate annual returns of approximately 25%, 16%, and 15%, respectively. Certainly these are healthy returns-but they're pretty meager compared with what a newly hired producer should generate even if he or she's mediocre: a compound annual return exceeding 50%!
The truth is, most agency principals underestimate the economics of producer hires. Let's look at a typical example: You're evaluating whether to hire Jeff, a young person who's interested in P/C production and clearly possesses the personality for it. You sit down to evaluate how much he's going to cost. You come up with these estimates:
Producer Costs*
Salary/Commission $50,000 Until validation/33% of commissions thereafter
Benefits 10,000 20% of salary/commission
Total producer pay and benefits 60,000 40% of book when validated
Other operating costs (selling
and overhead) 15,000 (Assumed to grow at 15% per year)
Support costs (CSR, claims,
administrative) 7,000 (20% of commissions produced)
Total $82,000
* Note: Depending on the size of your agency and the type of business you write, the figures shown here and expected annual performance may need to be increased or decreased. As long as the expense percentages are the same, it won't materially alter the results.
As you're looking over the numbers, you realize that the only way you're going to break even the first year is if Jeff somehow writes $82,000 in new business. You know you'll be lucky if he writes half that amount. But you hire him anyway, since you know deep down that you must grow your agency to survive.
Jeff accepts the offer and goes to work. Nice kid, but not the world's greatest producer. Rather than home runs, he hits singles and doubles. The first year, he produces a total of $35,000 in new business. The second year he exceeds that by $35,000. The third year, he does it again. In fact, for five years, he grows his book by exactly $35,000 per year so that by the end of five years, he controls a book totaling $175,000.
During this five-year period, you haven't fared well. You lost $47,000 pretax (which equates to $30,550 after tax) on Jeff the first year, $21,250 the second year, barely broke even the third year, and so on. By the end of five years, you finally were able to recoup your early-year losses to the point at which you've finally gotten back your investment and earned an aggregate return of $5,762. Here's a chart showing your five-year results.
Five-Year Earnings Performance
Cumulative
After-Tax
Year Revenue Expenses Pretax Profit Earnings*
1 $ 35,000 $82,000 ($47,000) $30,550)
2 70,000 91,250 ( 21,250) ( 44,363)
3 105,000 100,838 4,162 ( 41,657)
4 140,000 110,813 29,187 ( 22,685)
5 175,000 131,235 43,765 5,762
* After adjustment for taxes at assumed 35% tax rate
While Jeff's a nice kid, Microsoft appears to have been a better use of your money. And for many agency principals evaluating a producer hire, this is where the story ends.
That's a shame, because a huge element is missing. It's true that on a cash-flow basis, Jeff has generated a negligible return. But every account that Jeff has written also has an asset value, which should be factored into the analysis.
Let's assume that when you hired Jeff, you required him to sign a nonpiracy agreement. You're now the proud owner of an asset valued at $262,589 (which has been computed by multiplying the fifth-year pretax profit by a capitalization factor of 6.0). This $262,589 should be included in the computations, regardless of whether Jeff's book is actually sold at the end of five years.
Now the complete picture emerges, and it's radically different from the last conclusion. When the $262,589 asset value is added to the five-year cumulative earnings of $5,762, the total five-year return jumps to $268,351. If this is compared with the $44,363 in after-tax losses incurred in the first two years (which represents your 'investment'), the net result is a five-year internal compound annual rate of return of 71%!
The return is so high for two basic reasons: The first reason-the inclusion of the asset value-is obvious. But another reason is almost as compelling: The investment in Jeff was made on an entirely pretax basis. We're fortunate to be in an industry in which investments in growth are primarily people-related, and thus immediately tax-deductible. In essence, you can force Uncle Sam to subsidize roughly one-third of your investment in the growth of your agency. (He won't do that on your investment in Microsoft.)
There are, of course, some important caveats to this analysis. First, with a great many firms competing for a limited universe of sales talent, finding producers can be a real challenge, and the search can be costly, whether you conduct the search yourself or pay someone to do it for you.
What's more, your hired producer success rate (defined as the percentage of producers who succeed for you in the long term) will be the single most important factor affecting your economic returns for producer hires. The wisdom to know when to cut your losses on a bad hire is extremely valuable, given that most firms have a success rate of less than 50%.
CONCLUSION
When you look at the complete economics of investing in producers, new hires can be startlingly attractive. Many agency principals have avoided hiring producers because they focused on only the short-term cash flow implications, rather than both the cash flow and the asset value.
So the next time some stockbroker calls with a hot investment tip, you can politely hang up the phone knowing that your best investment opportunity-one on which you have insider information! -- is reinvesting your profits back into your agency.