An agency owner called me the other day and asked about doing a cluster. I asked if I might guess at what his accountant or attorney had advised about creating a cluster contract. I suspected that the accountant or attorney recommended that the cluster be set up as a shell LLC to hold or own all the company contracts, with all the money passing through this holding company to the individual agencies, and profit-sharing determined by some prearranged formula that involved premium per company. He said, “Yes. How did you know?”
I further suggested that his accountant or attorney probably failed to mention any governance requirements for the individual agencies, buy-sell covenants, trust fund/money covenants, or dissolution provisions.
I could see his look of disbelief through 1,300 miles of telephone lines, as he said, “How did you know? Am I ever glad I called today, because we were about to sign the papers and no one ever even mentioned these key points!”
After reviewing dozens of cluster contracts, I have yet to find one written by an attorney who understood insurance agencies well enough to do the job right. Cluster contracts among individual agencies or groups of agencies (not necessarily the major cluster-type agency organizations) are almost always grossly inadequate. For example, what happens in a three-agency cluster when one member can't pay their companies? Most cluster contracts make the other two liable de facto, with no recourse. These contracts almost never require members to maintain certain financial requirements or include checks on their financial condition. Considering that 40%-50% of agencies are out of trust (have a trust ratio less than 1.0), this is a huge issue.
Another example involves protecting the other members if something happens to one of them. Even if a buy/sell clause is included, are the terms feasible? With most cluster contracts, they are not. Similarly, if a member wants to retire, can they do so without being held hostage by the other members?
Clusters are ripe for mismanagement and for having one member take advantage of others. A simple example of this is when one member practices poor up-front underwriting, causing everyone's contingencies to plummet.
Even without mismanagement and unfair play, cluster contracts generally are fixed in concrete. They're written as if circumstances never change; that no one retires, dies, becomes ill, or gets a divorce. In addition, they're often fixed so that even changing carriers voluntarily isn't feasible.
Cluster contracts are also written as if nothing will ever go wrong, even though we're in insurance — a business that exists only because we know things will go wrong.
It's interesting to see how virtually every attorney and accountant who writes cluster contracts makes the same mistakes. If you're considering joining or forming a cluster, you need someone who knows insurance intimately and can consult with your CPA and attorney to design a contract that makes sense. Fixing a broken cluster or de-clustering agencies when things go wrong (which is inevitable) is one of the most expensive projects an agency will ever undertake, especially if any party is disgruntled.
If you're participating in a cluster or thinking of joining or forming one, do it right and hire people who know how to do it right. Otherwise, you're asking for trouble!