Enhance Business In Difficult Times: Manage Finances

Successful agencies act in seven areas to enhance business during difficult economic times: marketing, prospecting, sales management, compensation, diversification, debt management, and collection and credit management.

The systematic production of new business is essential in tough times. An independent agency trying to succeed without focusing on new sales is like a football team trying to win without any passing. Managers must act as coaches and provide their agencies with the right plays.

To be efficient is to do the thing right; to be effective is to do the right thing. An agency's resources have the best chance of winning if they are bolstered by an underlying marketing campaign. To use another football analogy, hard blocking and hard tackling are admirable, but it sure is nice when the coach sends in the right play.

In most cases, agencies that are effective marketers find out what Commercial risks their companies like and want to write. As simple as it sounds, that's probably half the battle. Some agencies put together special mass-marketing programs in cooperation with their carriers; others get exclusives.

The simple act of learning what your company will and will not write is a useful step. To learn what other agencies are doing, even those in other territories, is also helpful.

Successful agencies are systematic and relentless in their prospecting activity. It borders on sin to invest money and effort to develop leads and then discard those leads. If a marketing manager and an agency have worked together to identify leads, those leads should be followed up with diligence. Successful agencies exhaust their leads; they keep a record of the percentage of leads turned into new business.

Sales management is the most poorly performed management function in most independent agencies. Sales management means leadership, supervision, and monitoring of sales activities.

Many agency owners don't know their new-business commissions for the past month, quarter, or year. That operating philosophy won't cut it today. Effective sales management, above all other things, requires frequent, factual, and honest monitoring of producer activity. Monitoring is 10 times more important than books full of psychology, inspiration, and closing techniques.

Your agency should keep a close eye on all sales activities. Sales management techniques differ, but whichever one your agency subscribes to, use it.

Compensation formulas and routines vary widely. No matter what formula is used, however, successful agencies strike the right balance between meaningful incentives and profitability.

When agencies run into profit trouble and the problems are not debt and/or real-estate related, they almost always concern personnel. Personnel expenses usually amount to between 60% and 75% of an agency's commission income. Effective compensation is thus critical to profits and, perhaps more than ever before, profits are critical to survival.

Consultants who specialize in compensation work in a minefield, since agencies' compensation decisions are frequently entangled with family customs and relationships, paternalism, precedents, and biases.

Setting up a good compensation structure depends on taking the time to understand your agency's unique situation, its recent financial results, and the many human factors that affect recommendations and implementation. No two agencies are exactly alike, but ones with successful compensation plans frequently employ the following methods:

Determine who will have general management responsibility. Generally, the percentage of commission income that should be allocated to general management ranges from 15% in smaller agencies to 4% or 5% in larger ones. It is important to concentrate on who actually does what job.

For sales compensation and, in larger agencies, sales management, there should be only one 'deal' in the agency; that is, the owners should pay themselves on the same basis they use to pay producers. The benefits of doing so go far beyond mere financial savings. Avoid the compulsion to have every account in the agency coded to someone. If owners are basing their self-payment on Personal Lines renewal commissions or small Commercial renewal commissions, they are usually paying themselves from profits.

The third general component of owner cash compensation is the distribution of profits. Other than good sales activity, no practice is healthier for an agency than to maintain rigorous profit discipline. Once pre-tax profit is determined, it then can be divided.

As stated earlier, the most poorly performed management function in the independent P/C agency is sales management. One cause is ineffective producer compensation. Of all the operating expense errors agency owners and managers can make, faulty producer compensation seems to be the most severe and most frequent.

If the error is overcompensation, the problem often stems from the fact that agencies generally have operated at reasonably profitable business levels while their profit-center information, or cost accounting, is primitive at best. This leads many agencies unknowingly to use profits generated in other aspects of the business to subsidize producers.

Many compensation tools work, as long as one keeps some basic operating economics in mind:

Most agencies operate with an effective expense ratio (before producer-related expenses) of 55% of commissions, plus or minus a few points. Of each dollar of a producer's income, keep the expenses associated with employing that producer to no more than 40 cents. Leave at least a nickel for the bottom line - maybe another 5 or 10 cents of contingent commissions and miscellaneous income.

The 40 cents should cover all expenses associated with employing the producer, not just cash compensation. This makes sense only if the agency owns all the accounts, so that it will enjoy the benefit of growing value if its profit margin is modest.

It's complicated to choose one of the various combinations of salaries, bonuses, commission splits, and so forth that will, over time, generate compensation within reasonable limits. Trying to provide sufficient incentives to the producer while maintaining critically needed profits for the agency is truly a balancing act.

Figuring out the right formula involves a whole list of assumptions about retention rates, commission rates, internal office productivity, and the like. Fortunately, software programs (the Producer Compensation Manager is just one) are available, which allow agencies to experiment with many combinations.

Some agencies keep a producer's base compensation, whether in the form of a salary or a portion of ongoing renewal commissions, at a level equal to 20% to 30% of that person's Commercial Lines commissions, and allow for a new-business incentive equaling 35% to 60% of first-year commissions. Then, within a three- or four-year period, the producer's compensation falls in line with the guidelines just stated.

Perhaps the biggest error made in producer compensation is to pay a significant renewal commission on small Commercial and Personal lines. Agency managers frequently make this mistake because they confuse a producer's need to earn a living with a method of compensation. Consider paying producers a salary in lieu of renewal commission on small accounts as a financing bridge. Even if it amounts to more money than the renewal commission formula would bring in over time, the compensation plan will be more economically sound.

Review the numbers of accounts handled by each CSR. This is very telling in Personal Lines but not always so revealing on the Commercial side. As the industry leans more toward transactional filing and agency-company interface, account-handling abilities are improving. The best Personal Lines agencies are still at less than 1,000 per CSR (with claims people included in the CSR head count).

Determine the multiple of average CSR commission income to average CSR salary. This is particularly useful in Commercial Lines. In Commercial Lines, I recommend a multiple of 7:1, but understand two things. First, this is an average number, meaning that it can't necessarily be applied to any one person, such as a person assigned to handle all small BOPs. Second, in the current soft market, many well-run Commercial agencies cannot achieve a multiple of seven.

With these guidelines in mind, most agencies can manage to keep CSR compensation within the limits needed to achieve satisfactory profits while remaining competitive in the local labor marketplace.

It is usually quite profitable for an agency to explore financial products, specialty lines, and niche markets. An agency is somewhat less susceptible to competition if it diversifies into specialty insurance coverages and financial services.

Diversification, a way to spread risk and reduce volatility, is hardly a new idea, yet it is still new to think of applying diversification solely to an income stream. Much of an agency's value is enhanced by the diversification of its customer base. Since most insurance agencies deal with thousands of customers on a dollar-for-dollar basis, an agency tends to be a more valuable business than a manufacturer that depends on the same revenue stream.

Specialty lines and niche markets provide sales and profit opportunities. Agencies should get company information to write certain Personal or Commercial lines of business the competition does not write. This takes work on the agency's and the company's part, but it's well worth it for both.

Some degree of diversification, properly managed, is characteristic of successful agencies. Agencies that choose to stay exclusively with traditional P/C lines should be assured that within a major line of business there is proper diversification among accounts, programs, and carriers, and that significant portions of the business are not controlled by non-contracted producers.

Debt management refers to the agency being the debtor - the one that owes the money. As a practical matter, it is probably wise to be careful about debt, but from a purely financial viewpoint, debt is neither good nor bad. It is simply a form of capital that needs to be structured properly. There are all kinds of ratios to indicate when a business is properly or excessively leveraged.

For most privately owned businesses, including insurance agencies, debt is not permanent, meaning that the agency must budget for the repayment of principal. Therefore, from a cash-flow perspective, debt is a more costly item to private businesses than it is to public businesses and must be managed more carefully.

The most common sources of insurance agency debt are the following:

• Obligations resulting from agency acquisition
• Obligations resulting from agency perpetuation (for example, the retirement of a former owner's interest)
• Obligations resulting from the acquisition of capital equipment (computers, vehicles, office furnishings, and the like)
• Obligations resulting from producer financing (with the creditor most often being an insurance company)
• Obligations resulting from a line of credit (with the creditor almost always being a local bank)

Most types of credit are recorded on an agency's balance sheet. Other obligations - usually deferred compensation or deferred-commission obligations resulting from various merger, acquisition, or retirement arrangements - frequently do not appear on balance sheets.

To say that successful agencies manage debt well means that through good analysis, good advice, or good instincts, they know how to avoid being overly committed. They know the difference between investing and spending, and they face up to the differences between profit problems that are truly temporary and those that aren't. Examples of legitimate temporary needs are those associated with a seasonal business or a one-time conversion from agency billing to direct billing. More often than not, however, cash shortages are caused by fundamental operating problems and cannot be helped by borrowing.

Many ways exist to measure and evaluate debt and other aspects of an agency's capital structure. The following is just one that agencies can use. It's not very sophisticated, but it is useful, especially for agencies in the middle of perpetuation planning.

If the debt service obligations (principal and interest) total 10% or less of the agency's regular operating income, they are manageable. Even in difficult times, a reasonably well-run agency can generate a pre-tax profit rate of at least 15% of total operating income. When debt service obligations are between 10% and 15% of the agency's regular operating income, they need to be carefully considered and properly scheduled; in the right circumstances they can still be prudent.

When obligations exceed 15% of income, however, the agency should be monitoring cash flow carefully every month. In such situations, seemingly minor operating problems can create a major crunch.

Most traditional lenders to insurance agencies - retired owners, banks, insurance companies -have been burned at one time or other in the last few years. Many of these creditors have learned the hard way that some cash-flow projections were at best naive and in some cases highly suspect. They have learned that the collateral of an agency can be very soft.

Debt capital can be a regular part of a well-run agency's financial structure. However, to manage it properly and to get credit in the first place, agency owners must improve their financial-management information significantly to demonstrate that they truly understand their week-to-week and month-to-month cash flow and can make informed and realistic commitments to ever more careful lenders.

Independent agencies are in the business of extending or arranging credit for premium-paying customers. Most agencies use accrual- based accounting, which is proper for most businesses but has its quirks: When an invoice is sent, the business declares it has received income. Effective credit management makes 'the rubber hit the road' and turns paper income into cash.

There is no right way to manage this function in an independent insurance agency, but certain characteristics continually show up in agencies doing it well: attitude, knowledge, clear policy, mechanics, and integrated processes.

An agency's credit practices usually emanate from the attitude of the agency's owner(s) and/or operations manager. Those who are good at collecting payment generally express two attitudes: (1) astonishment that other agencies can allow themselves, in effect, to buy their customers' insurance for them; and (2) the conviction that agencies sell coverage, not paper, and that customers should be billed when coverage starts - not later, when the policy is ready.

The right attitude is necessary but not sufficient. Agencies that manage credit well tend to know about the trade-offs and mechanics of various payment options. They have an informed point of view about premium financing, carriers' direct-bill options, installment options, and payment plans that fit specific types of business. They expect and demand that insurance coverage gets paid, and they make payment as easy as possible.

Clear credit policies ensure that agency personnel conduct their business so that the right practices are implemented. In some agencies, the credit policy is stated in a few simple sentences. In others, it takes the form of a multi-page manual describing time frames and mechanics. In agencies that manage this function well, a policy exists, is serious business, and is understood by key personnel.

A major element of effective collection deals with ongoing and systematic mechanical operations. Producers need to communicate with customers and prospects about payment arrangements, but effective implementation results from relatively simple mechanical systems. The key: In agencies that manage credit effectively, principals are not afraid to send out cancellation notices. Conversely, in agencies that are ineffective at credit management, cancellation notices build up (and debt accrues), and the bookkeeper does not have permission to mail them until the principal says so.

Finally, in agencies that manage credit well, collection practices are fully integrated with the entire renewal-processing regimen. Pulling expirations and the various reviews and controls all point to a billing action before the renewal date, whether or not the policy is ready for delivery.

Agencies that succeed in bad times as well as good do not always maintain model offices, have perfectly engineered compensation/incentive plans, and so on. They do tend to stay on top of current events and technology, and they communicate openly.