FINANCIAL MANAGEMENT IN AN UNCERTAIN MARKETPLACE
by Carol Hammes
It takes a lot of planning to attain higher growth rates and lower expense levels. The first step in the process is to evaluate past experience. This document by Carol Hammes uses average agency financial ratios to analyze income, expenses, and balance sheet status.
The events of September 11, 2001 will have a profound economic impact for many years to come. The airline industry was one of the first to start showing signs of difficulties, canceling flights and laying off workers almost immediately. But when the final toll is taken, the insurance industry might bear the greatest burden.
First, the insurance companies and brokerage firms located in the WTC lost hundreds of key personnel. These people will be difficult, if not impossible, to replace. The shock and depression faced by their colleagues might continue for years, adversely impacting productivity industry-wide. The enormous task of recreating policy and underwriting information that was destroyed will only add to the productivity problems.
The greatest financial problems, however, will result from the claim settlement process. Experts estimate that if losses don’t exceed $50 billion, most insurance companies will be able to remain solvent. But the events have already pushed Reliance into full bankruptcy and there’s no way to determine whether others will follow. Insurance agents will have to monitor company performance much more frequently and be prepared to replace coverages quickly —a difficult task, given that the Commercial marketplace was tightening even before 9/11. Instead of the vast overcapitalization that was threatening to keep the hard market short-lived, availability will shrink further and premiums will probably increase more dramatically than anticipated. Even agencies with access to willing markets will find placement activities more time consuming.
The good news is that when premiums go up, commissions generally follow. Average commission income per account will be higher than it has been during the past decade, allowing revenues to increase faster than most expenses. The bad news is that the entire economy is suffering, reducing payrolls, business expansion, products produced, and other peripheral items that go into the rate making process. It’s always prudent to evaluate the prognosis for the local economy and for your targeted niches carefully. Make sure that the projected income is conservative enough to withstand serious economic downturns (for individuals as well as businesses) while taking into account the expected rate increases in Commercial Lines.
In these uncertain times, agency principals must manage their operations and the sales process carefully. Revenue growth depends on the ability of producers and service personnel to acquire and retain business efficiently. To make this growth profitable, keep agency expenses as low as possible. Expense management begins with personnel management. With compensation at more than 60% of revenues, the more commissions employees generate per compensation dollar, the higher the resulting profit. The balance of this document, together with the charts below, uses average agency financial ratios to analyze income, expenses, and balance sheet status.
FINANCIAL ANALYSIS — INCOME AND EXPENSES
The first four composite groups in the charts present average income and expense ratios for agencies nationwide, some good and some not so good. Use the figures as initial guidelines to determine where your agency stands, not as absolute goals. Every agency is unique and there might be some very good reasons why your results don’t track with the averages. Compare your preliminary 2001 numbers to the appropriate peer group (arranged by revenue size, not premiums). If you haven’t completed such a comparison in the past we recommend that you also prepare the prior four years’ results in this format to see how your ratios have changed. This extended analysis will provide a much better basis for projecting income and expenses into the future.
The purpose of the income and expense comparison is to identify variances from the norm and to determine whether the divergence is acceptable, desirable, or a sign of potential weakness that might require corrective action. Remember, every missing percentage point in income (particularly in contingents) and every unnecessary percentage point of expenses reduces profit margin by the same percentage. These 'lost' points can add up fast.
The fifth column on the chart has pro-forma numbers for a well managed agency in the year 2002. In the past, our readers have been confused about the significant difference between several of the average percentages and the corresponding pro forma recommendations. For example, we’re suggesting that you try to achieve at least 25% of the agency’s income from Life and group business. The averages run from 7.9% to 12.5%. We recognize that an agency can’t change its business mix overnight. But you should consider increasing your income from these sources in your long-range planning. They’re generally much more profitable than writing P/C Lines.
Another major difference is in the recommended executive payroll, which we’ve set at 5% versus 15.1%-25%. Most agencies in the average composite groups are privately held firms in which the owners take part of the profit as excess compensation. A pro-forma strips out any compensation that’s not directly related to the principals’ performance as agency employees. These excess amounts fall to the bottom line as an indication of true profit. Other actual expenses that might involve ownership perks, such as travel, entertainment, or advertising/promotion, have also been adjusted in the pro-forma percentages. After removing the ownership return, the profit margin for an average agency should be between 18% and 25%.
Most of the categories in the composite are self-explanatory. They correspond to standard financial reports produced by the major computer systems. Some items might need to be clarified to make sure that you’re comparing apples to apples. Brokers Commissions are only those commissions paid to outside people who are primarily associated with another organization. Note that we’ve removed this expense from the pro forma since we’ve found that traditional brokerage activities are expensive to maintain and often reduce contingent income and increase E&O exposure. Employee producers and independent contractors who work only through this agency are included in Sales Payroll. In the pro forma column sales compensation for owners is included in this category with management compensation in Executive Payroll. Employee Benefits includes payroll taxes, group insurance, 401(k), and other retirement plans. Workers Compensation costs are included in the Insurance category.
To compute revenues per employee, take total revenues including contingents and investment income and divide them by the number of people working in the agency, including owners and producers. Compensation per employee includes all 1099, W-2, and employee benefits expenses for in-house producers, employees, and owners. The difference represents the per employee amount left over after compensation costs to cover overhead expenses and the contribution to profit.
FINANCIAL ANALYSIS — BALANCE SHEET
The 'Key Balance Sheet Ratios' chart presents composite ratios for an average agency’s balance sheet and recommended ratios for a well-managed agency. While the income and expense statement provides an ongoing history of the revenues and expenses during the past year, the balance sheet presents a snapshot of the firm’s financial position as of a certain date. When making the balance sheet comparison, use the last day of the fiscal year after you’ve made any thirteenth month adjustments. For this comparison you might find it appropriate to make further changes in the actual statement to present an accurate picture of the agency’s financial condition. Remove any notes receivable from owners or clients that you most likely won’t collect in the near future. Officers’ Life insurance is often included in other assets, but if there’s cash value available you might want to move it to current assets. Convert securities to market value if they’re carried at cost.
A current asset is cash or an asset that you can convert to cash within a year. Current liabilities are those debts that you must pay within a year, including the current portion of any long-term debt. If the statement doesn’t itemize the current portion, make a ballpark estimate when computing the current ratio. The best measure of an agency’s collection practices is the receivable/payable ratio, including pre-billed items in accounts receivable and accounts payable.
Average ratios went up this year after several years of positive downward improvement, which indicates that agencies might be slipping in their collections. The trust ratios for all peer groups remain higher than 100% — but just barely. This important indicator of financial health measures whether the agency is using its clients’ money to finance its operations — a practice that’s frowned on by most state insurance departments and many insurance companies. The trust ratio should remain above 120% throughout the year. Tangible net worth measures the equity in the firm and should be positive within five years after an acquisition.
The late Carol Hammes, principal of The Middleton Group, was one of the Independent Agency System’s most widely respected management consultants. She will be sorely missed.
| THE MIDDLETON GROUP |
| Average Agency Income & Expense Composite Ratios for 2001 |
| Suggested Pro Forma Ratios for 2002 Budget |
| | | | | | |
| | Actual 2001 Averages | Suggested |
| | Under | $600,000 | $1,500,000 | Over | Pro Forma |
| Agency Revenue Size Range | $600,000 | $1,500,000 | $4,000,000 | $4,000,000 | 2002 Ratios |
| | | | | | |
| P-C Commissions & Fees | 84.4% | 79.8% | 78.6% | 79.1% | 65.0% |
| Life & Group Commissions | 7.9% | 10.5% | 12.5% | 11.9% | 25.0% |
| Contingents | 5.5% | 6.7% | 7.1% | 6.2% | 7.0% |
| Investments | 1.1% | 1.7% | 1.3% | 2.0% | 2.0% |
| Miscellaneous | 1.1% | 1.3% | 0.5% | 0.8% | 1.0% |
| TOTAL REVENUES | 100.0% | 100.0% | 100.0% | 100.0% | 100.0% |
| | | | | | |
| EXPENSES | | | | | |
| | | | | |
| Brokers Commissions | 0.9% | 0.8% | 1.0% | 3.8% | 0.0% |
| Travel & Entertainment |
Login or Register (for FREE) to gain access to thousands of other great articles.
There are no comments posted.
|