We have lost count of the number of telephone calls that we have received recently asking us what the going rate is for the sale of an insurance agency. 'Just give me a multiple,' they say. Considering the fact that we saw agency values and sales ranging anywhere from 0.6 times to 2.2 times the prior year's Property-Casualty commissions in a recent year, coming up with an appropriate generic multiple is difficult. For those who nonetheless insist upon using a handy (albeit potentially inaccurate) rule of thumb, we suggest the average of that range, 1.1 times commissions, and use it for any purpose, because it probably works as good as any other arbitrary number they could pull out of the air.
Many agents, however, would prefer to have a more definite idea of what their agency (or the one they are thinking of acquiring) is worth. Market conditions, agency profit margins, operating expenses, tax considerations especially with respect to the depreciation of expirations and covenants, and the law of supply and demand have all tended to lower the relative value of insurance agencies over the past ten years. Everyone wants to know how low it has gone. And is the downward trend slowing or beginning to reverse itself? Whether the reason for the valuation is related to internal perpetuation and retirement buy-outs, funding for Buy-Sell agreements, or external acquisition purposes, it is extremely important for agency owners to routinely review their valuation methodology.
Overpricing of acquisitions and/or excessive retirement payments has been the number one cause of financial failure for independent agencies during the last decade. In other words, the quickest way to bankruptcy is to acquire yourself into it. Don't let this happen to your agency. Develop and maintain an appropriate measurement of value of internal and external use and resist the temptation to deviate from your approach when you get caught up in a bidding war.
The process of properly valuing an independent insurance agency can be complex and is often overwhelming when it is necessary to cover all of the bases required by the courts and the IRS. Management consulting firms that value insurance agencies as part of their services prepare extensive documents that review all of the valuation guidelines listed in Revenue Ruling 59-60 as they relate to the subject agency. They then apply anywhere from two to six different valuation tests depending upon the size of the agency and the purpose for the valuation. The result is a report that can easily be in excess of 50 pages and often loses the average reader (and many judges) well before the conclusion is reached. When you cut through all of the background details and appraiser jargon, however, the process really is not all that difficult. Even if there is a valid reason to have an independent third party appraise the agency every year or two, agency owners can and should go through an abbreviated valuation calculation of their own. No outsider can know your agency as well as you do.
The balance of this report suggests three fundamental approaches to valuing an insurance agency. Provided that the person applying them carefully and unemotionally evaluates the specific organization, any of these methods can be appropriate at one time or another depending upon the purpose for the valuation. While there are different judgment calls that may have to be made if a separate book of business is being valued rather than the stock of a going concern insurance agency operation, the basic methodology can be applied to almost any situation. The IRS definition of fair market value is 'the price at which the property would change hands between a willing buyer and a willing seller when the former is not under any compulsion to buy and the latter is not under any compulsion to sell, both parties having reasonable knowledge of relevant facts.' Sometimes, the potential buyer will be known and sometimes the appraiser has to use a hypothetical buyer, but any valuation approach that simulates what the informed third party will pay for the agency will do.
INDUSTRY MULTIPLE APPROACH
The simplest and most common method for valuing an insurance agency has involved a multiple of commissions or revenues. There is nothing inherently wrong with this approach, especially when you are valuing a smaller agency or book of business that is primarily comprised of small to medium-sized Property-Casualty accounts. But you must make sure that you are selecting the right multiplier and applying it against comparably calculated commissions or revenues. In other words, you need to apply apples to apples or you could end up in deep trouble. Multiples are most frequently applied only against Property-Casualty commissions that do not include contingents. If fee income, Life, Group or Health commissions are valued in this manner, a different (and usually lower) multiple may be applied. When the valuation multiplier is applied against total agency revenues including investments and contingents as well as all operating income, the multiplier is lower still.
To use the industry multiplier approach intelligently you have to start with a little external research. What is the going rate for comparable books of business in your marketing area? Find out what buyers have paid over the last two years on a present value basis. [Paying $40,000 per year for five years for $100,000 in commissions is not two times. If you do not understand this concept, educate yourself before you go any further.] Then compute an average multiplier based upon actual deals in your part of the country. Let's assume that the result is 1.1 times total commissions including Life and Health as well as Property-Casualty. The next step is to adjust the average multiple to take into account the specific agency situation. One of the biggest mistakes that you can make in using the multiple approach is to assume that all agencies are equal. In reality 'some agencies are more equal than others.'
It is necessary to add to or subtract from the average multiplier to take into account those qualities of the subject agency that vary from the norm. For example, some (but not all) of the characteristics that can result in multiplier subtractions include:
- heavy concentration of accounts in one industry, religious, or ethnic group;
- heavy concentration of business in one line or type of business particularly if it is a volatile line;
- volume spread thinly with many insurance carriers;
- more than 40% of premiums with one company;
- poor loss ratio experience;
- poor collection practices;
- low productivity and/or morale of employees;
- high level of operating/personnel expenses;
- high proportion of agency business controlled by one producer who is over 60, in poor health, etc.;
- potential inadequacy/inability to enforce to non-piracy restrictions (or lack thereof).
Agencies with some or most of these characteristics would have a multiplier of something less than the average (perhaps .9 or 1.0 times) If, on the other hand the agency is above average with respect to potential attrition factors, it could have a multiplier of more than 1.4 times commissions. Sometimes different multiples should be applied, one for each portion of the book of business-personal lines, commercial lines, group, life, contingents. In acquisition situation (as opposed to valuation for internal buy/sell consideration when you must place a definite value on the agency) a higher multiplier may be applied if the seller is willing to take some or all of the risk of retention. Thus, the multiple would be applied against renewed commissions over one to seven years rather than against the prior year's actual commissions on a guaranteed basis.
RETURN ON INVESTMENT APPROACH
Most professional appraisers do not rely heavily on industry multiples because they only relate to the top line income rather than to the relative profit potential of the particular agency. An agency that can produce a 30% profit on $200,000 in revenues is usually worth more to a buyer than one that produces a 10% profit on $400,000 in revenues, and only part of that variance can be taken into account with an adjustment to the multiplier. A more exact method for valuing larger or more complex agencies is to look at the bottom line as it would be under the ownership of the actual or hypothetical third-party buyer. The underlying assumption in using the return on investment approach is that any investment should pay for itself over a certain period of time. The appraiser first needs to determine the projected cash flow of the agency and then must decide how many years' worth of that cash flow should go towards paying for the agency before the buyer would start to get his own return on the investment.
SUBJECT AGENCY PROJECTED CASH FLOW
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Actual
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Year 1
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Year 2
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Year 3
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Year 4
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Year 5
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Year 6
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Year 7
|
|
|
|
|
|
|
|
|
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REVENUES
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$500,000
|
$500,000
|
$500,000
|
$500,000
|
$500,000
|
$500,000
|
$500,000
|
$500,000
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Minus Expenses of:
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|
|
|
|
|
|
|
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Selling Expenses
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$45,000
|
$25,000
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$25,000
|
$25,000
|
$25,000
|
$25,000
|
$25,000
|
$25,000
|
Office Payroll
|
$110,000
|
$100,000
|
$103,000
|
$106,090
|
$109,273
|
$112,551
|
$115,927
|
$119,405
|
Exec/Sales Payroll
|
$175,000
|
$125,000
|
$125,000
|
$125,000
|
$125,000
|
$125,000
|
$125,000
|
$125,000
|
Employee Benefits
|
$42,750
|
$36,000
|
$36,480
|
$36,974
|
$36,484
|
$38,008
|
$38,548
|
$39,105
|
Compensation Exp.
|
$327,750
|
$261,000
|
$264,480
|
$268,064
|
$271,757
|
$275,559
|
$279,475
|
$283,510
|
Operating Expense
|
$85,000
|
$80,000
|
$80,000
|
$80,000
|
$80,000
|
$80,000
|
$80,000
|
$80,000
|
Administrative Exp.
|
$15,000
|
$10,000
|
$10,000
|
$10,000
|
$10,000
|
$10,000
|
$10,000
|
$10,00
|