Banks And P/C Insurance Agencies Reality Check — Part I: Do Your Due Diligence

DUE DILIGENCE

Due diligence includes three elements: financial, legal, and operational. Because most banks are well aware of financial and legal due diligence, I won’t discuss them here. However, I’m not suggesting that either should be ignored or minimized.

OPERATIONAL DUE DILIGENCE

Operational due diligence rarely receives adequate consideration and is frequently ignored. Operational due diligence includes peer review/benchmarking, competition, employees and their skills, and most important, the variations in culture between banks and insurance agencies.

PEER REVIEW/BENCHMARKING

Peer review/benchmarking helps align expectations with reality. Expectations, such as unrealistic hopes for economies of scale, are often set too high. For example, one large bank asked if I thought they could get an extra percentage point of revenue from insurance companies by bringing their size to bear in negotiations. I replied, 'Yes, but you’ll inevitably lose that point through extra expenses.' They didn’t hear anything past 'Yes.' If they had, they’d have carefully considered my analysis of large broker results that show an average five-year pretax profit margin of approximately 10%. That average then decreased to 8% before the hardening Commercial Lines market started to add some points to the bottom line (Note: these increases are expected to continue for one to two years at the most).

The 10% profit margin closely matches independent agency profit margins which, when adjusted for owner bonuses (to minimize taxes), easily equal 10%. All major industry benchmarks show that independent agency profit margins, even after owner bonuses, average 5%-8%. If adjusted for owner perks and bonuses, pretax profit margins would equal at least 10%. Thus, even the larger brokers show no sign of having gained any sustainable economies of scale. According to Bain and Company, ' … narrower focus and concentration of resources on a single core business, rather than proliferation of investments in hot markets, proved the most frequent road to sustained, profitable growth.'

If a large entity makes more, it’s because they’re better managed, not because they’re large. So did this bank make that extra profit point? No. Instead it’s made a series of disappointing announcements about insurance sales and profits and has reorganized at least twice in less than 24 months.

An article in the January 27, 2001 issue of The Economist expanded on the lack of economies of scale. According to the article 'The record of most other banks that have pursued Mr. McCall’s [Chairman of Bank of America] strategy [of acquiring many banks] strongly suggests that beyond a certain size any economies of scale in operations are easily outweighed by diseconomies in management and, especially by the need to pay over the odds to strike a deal in the first place.'

Another reason to focus on peer review/benchmarking in due diligence is to enable the acquiring bank to know whether its acquisition target is well run. Buying an agency that under-performs its peers without realizing it is a painful mistake many banks have made. The situation is worse if the bank doesn’t have a remedial plan to fix the agency. For example, if due diligence reveals that an agency has poor growth and poorly performing producers (less than $250,000-$300,000 commission each), the bank must realize that the producers will not be magically transformed just because a bank provides thousands of warm leads. The lack of leads is never a legitimate reason for a producer’s poor performance (no matter the size or nature of the marketplace) and such producers will never succeed just because someone starts providing them leads. The buyer needs a more comprehensive plan to remedy the situation.

Peer review is also important because many agency owners don’t realize just how poorly their agency is performing. If the buyer depends on the seller’s perspective or their conversations with the producers, they’ll never realize the problems they’re buying. This is especially true of many small agencies, which are favorite targets of community banks.

COMPETITION

A buyer should also assess the acquisition target’s competition. This involves determining what other banks and agencies are doing currently — and what their response to the acquisition might be.

For example, The Economist article pointed out that every time Bank of America would make an acquisition, a particular competitor would open a nearby branch to capture all of the newly acquired firm’s disaffected customers! They knew the acquisition would result in upset customers and they wanted to present a warm, welcome, and readily available solution. They succeeded.

Many agencies have discovered that clients of recently acquired agencies (especially those acquired by banks) are easy pickings. As one agency principal said of his longtime main competitor, 'The . . . bank’s acquisition of . . . was the best thing that ever happened to us in two ways. First, we no longer have to compete with them for the best new accounts. We get those accounts now 100% of the time rather than 50% of the time. Second, they’ve become a fantastic source of new business. Their clients leave voluntarily and/or we sell them on leaving. Selling them on leaving is easier now that the bank owns them.'

Carefully assess all competitors because no matter how meager they might seem, sometimes the best way to get an inert business moving again is to scare them into action — and a bank’s acquisition of an agency could be the fright they need.