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Finding A Compatible Business Combination
  FINDING A COMPATIBLE BUSINESS COMBINATION by Catherine Oak Over the past few years, many firms have entered into a merger, acquisition, or some type of cluster arrangement with another firm or a producer with a book of business. And often the venture has turned out to be unsuccessful. Many mistakes are made because the participants don't take enough time to effectively evaluate the business combination they're considering. This can cause real problems for all parties involved. Firms make the wrong decisions for many reasons. Among the more common reasons are: (1) not having enough information about the other party to make an astute decision; (2) searching for a quick fix for a loss of markets, or (3) finding a deal with a price that 'seems' good. A recent IIAA study reported that only 46,000 independent insurance agencies exist now, compared to 53,500 five years ago. The study also indicated that 26% of these remaining businesses have been acquired or merged with another firm in the past few years. COMPATIBILITY ISSUES The most difficult part of creating a successful business combination is determining whether the parties are compatible and if a combined entity will be an improvement. Many firms think the key to a good deal is the price. This is far from true. Determining the appropriate price is much easier than finding a suitable party to conduct an ongoing business relationship with. It's like trying to find a good mate-it isn't easy! To find a suitable, compatible business combination, several key areas need to be discussed in the 'schmoozing,' 'romancing,' or 'courting' stage. The parties can explore these key areas themselves, but it's advisable also to have a third party involved, who is respected by the parties (a consultant, board member, CPA, or attorney, etc.). This article addresses the key areas that all parties need to explore, and the steps that should be taken to accomplish a successful business combination. KEY COMPATIBILITY AREAS TO EXPLORE 1. Major Strengths and Weaknesses of Each Party Each party should list its major strengths and weaknesses and then exchange the lists with each other. The goal: to see if each party will complement the other by minimizing weaknesses and maximizing strengths. Such an analysis may make it apparent that the combination will not help improve the problems each firm faces-may even make each party's weaknesses worse. 2. Personal Goals and Wish Lists of Owners Each owner in each firm should make a list of personal goals and wish lists for the future. If the owners are nearing retirement, they should also be very specific about when they expect to retire, what future duties they want to have, what price they expect for their stock, and what 'perks' they expect to continue receiving until full retirement (for instance, office, car, travel and entertainment expenses, and so on). If the owners want to perpetuate internally, their expectations for their buyout need to be realistic in relation to the cash flow available from the firm's activities. Internal perpetuation might not be an alternative if the appropriate perpetuation candidates aren't available to manage the firm and sell and service new accounts. Moreover, the firm might not be able to support the financial burden of the buyout of the retiring shareholder. In either case, a sale of the firm to a third party or a merger or cluster arrangement may be necessary. 3. Operational Structure of Each Firm If two firms' operations are set up too differently, a business combination might not work. A firm's organizational structure often reflects the philosophies of management and the talents of the individuals employed. A successful business combination combined into one location can merge the best of each party's organizational structures and employees. Melding the best structures and employees is the most difficult aspect of any business combination. Each party is usually too close to its own operations and employees to be able to pick and choose which ones are better for the new entity. A third party can greatly assist. Examples of varying operational structures include the following: Having a small commercial accounts unit that services and sells all accounts under a certain size, instead of having all CSRs handle small accounts Functioning on an alphabetical basis instead of by producer unit Centralizing the marketing/placement function instead of having producers doing their own marketing Having separate individuals handle claims, versus producers handling most servicing of accounts-or hiring qualified technical CSRs to support producers, freeing them up for new sales The philosophies on these operational issues need to be explored, and an agreement reached on how the combined entity would handle each of six functions for Life, Group, Personal and Commercial lines: sales, marketing, placement, client service claims, accounting, and administration. AUTOMATION In conjunction with the operational issues, the extent to which automation will be integrated with the systems and procedures of the firm need to be determined. Which computer system will survive the business combination? 4. Financial Strength and Productivity Ratio for Each Party A number of ratios should be calculated separately for each party to assess how well run each firm is before joining together. Combined ratios can also be calculated-but if ratios are determined separately first, each party will know whose firm is adding to the efficiency of the new operation and what weaknesses need attention. The ratios should be compared to those of other agencies of similar size and agencies writing comparable accounts. The results should also influence the values placed on each entity, since they reflect the management of the current operations (profitability, staffing, expense controls, working capital, and so forth). The ratios should include the following as a minimum: Expenses by line item as a percentage of revenues Revenue, expense, and profit per employee P&C or Life/Group commissions per producer and per CSR For each line of business: Commissions per account Commissions and accounts per CSR Servicing cost per dollar of commission Return on investment Collections (aged accounts receivable history) Working capital Trust ratio Debt to inquiry And so forth 5. Market Analysis Each party should create a list of the top 10 insurance companies it represents, along with certain information on each carrier: premium or commission volumes, three years of loss ratios and contingency commissions paid, volume commitments made, preferred status or special profit-sharing agreements, solvency of carrier, and years appointed. This helps the parties understand the current situation and their weaknesses before getting together with the carriers to renegotiate contracts for the new entity. 6. Book of Business Analysis The book of business written by each firm should be analyzed. What split does each firm have by line of business? A complimentary combination may be the best, rather than more of the same. For example, one firm might not have any Life and Group business, and may need in-house experts to sell the leads. What target markets, areas of expertise, and specialties do the producers in each entity have? How well developed are the existing accounts written by each firm? What's the attrition rates of the accounts by line of business? What classes of business are the top 10 commercial accounts, and how much volume do they represent? Is there much non-owned or brokered business that may affect markets represented? 7. Compensation, Perks and Contracts for Owners, Producers, Managers, and Other Employees Each party needs to know the compensation and perks the other party provides to its producers and employees. How the owners compensate themselves is also extremely important. It's essential to determine a new compensation plan for owners before putting the new entity together. It's often difficult to change compensation plans, especially for key employees (owners, producers, managers), without adversely affecting their desire to stay in the new entity. On the other hand, it's also difficult to have one entity support two very different compensation plans for owners, producers, and key managers-or salary differences for employees having similar jobs. Each firm should also share the contracts signed by the firm's partners, producers, and other employees. Today it's also becoming more common for all employees to sign non-piracy agreements to protect the firm's book of business and trade secrets. Some contracts may allow producers to vest in their books of business, some may have covenants not to compete or non-piracies, and some may actually allow producers to obtain equity (stock options) in the firm at a later date. The new entity should come to an agreement about the standard contracts that need to be signed by producers and all employees. 8. Growth in New Production What kind of real growth (in number of accounts versus commissions) has each firm experienced for the last three years? Where is the growth coming from, and can it be expected to continue? Is there anything on the horizon that will lead to a real decline in revenues (such as loss of a market, change in a commission structure from a carrier, loss of a program)? 9. Perpetuation What kind of perpetuation plan is currently in place in each firm? Are there any employees who are good perpetuation candidates and who could continue the current owners' management and production capabilities? When will the existing owners be retiring, and what are their expectations for a buyout? Is there a buy/sell agreement currently in place for a buyout that the parties will have to live with? 10. Reputations and Synergies of the Parties Last but definitely not least are the reputations that the firms (and especially of the principals) enjoy in the community, with carriers, and with insured clients. It's important for all parties to have similar morals, philosophies, goals, and desires. These things are difficult-if not impossible-to change later on. Also, the parties need to feel a certain synergy when they're all together in the same room 'romancing' or 'courting' each other in the compatibility discussions' various stages. As with a romantic relationship, the chemistry has to be there. SUMMARY If the 10 key areas in this article are explored from the beginning, it should be clear whether compatibility exists and the business combination will work. These issues should be identified and discussed honestly and openly. A good business combination will result only if this process is followed and these 10 areas are determined to be workable. A third party may be needed to facilitate this process. Catherine Oak, along with Bill Schoeffler, runs Oak & Associates in Glen Ellen, CA. Their consulting firm specializes in agency management, automation, clustering, errors and omissions, evaluations, mergers, and producer compensation. You may E-mail Oak at [email protected] or call her at (707) 935-6565.

Making The Most Out Of An Agency Business Combination
MAKING THE MOST OUT OF AN AGENCY BUSINESS COMBINATION by Carol Hammes It’s what comes after the handshakes that counts. INTRODUCTION You’ve done the groundwork for a successful combination of agencies (acquisition, merger, or cluster). But what comes after the handshakes will be even more critical in determining the eventual outcome. The initial evaluation and structuring process will determine much of what needs to be accomplished. Parties involved have made an emotional and financial commitment to invest in this course of action. You owe it to yourselves to follow through for as long as it takes to maximize the payback on this investment. Here’s how: KEEP THE SELLER INTERESTED Most transactions involve at least one owner who is selling their ownership interest as part of the deal. In some situations, the buyers might prefer that a selling owner disappear (quickly) after the sale. However, it’s usually better to have the sellers stay involved for a while by building a retention or growth incentive into the purchase price. If you want the seller to take a hike, don’t include any incentive — except perhaps one that pays them to stay away! The simplest and most common incentive is to buy the book of business strictly on a retention basis. Determine the appropriate percentage using the pro forma cash flow that you developed and adjust this for timing considerations. If the seller wants the money over a shorter period, the percentage of renewal commissions paid can be higher. But the total amount paid out might be lower than if the payout period is longer. For example, in a fold-in situation, you might be able to afford as much as 40% of renewal commissions for three years. An alternative that might provide more money for the seller and a longer period of involvement would be to pay 30% for five years. Since the buyer must take the tax deduction for the expirations and covenant payments over 15 years, more and more transactions will probably be structured over longer pay-out periods. If a straight earn-out deal isn’t appropriate, there are a number of other ways to keep the seller involved over a period of time. Here are some suggestions that can work for both external acquisitions and those in which the interest of a retiring owner is being purchased internally: Offer an employment contract that pays the person a percentage of the commissions as a servicing producer on the book of business. Structure a production bonus that pays a certain percentage of total commissions received on the portion that exceeds the cash flow projections. Pay the seller a finder’s fee for new accounts brought to the agency. In most cases, it’s not wise to pay the person as a servicing producer on the renewal of those accounts, but a hefty new business commission percentage might be in order. When a branch is being acquired and the seller is being retained as a manager for a few years, set up a separate profit center with a bonus arrangement that pays a large percentage of the profits that exceed the plan. This will provide a reward for higher commissions, lower expenses, and/or both. Agree to a guaranteed price, but with installments to be reduced if the commissions do not remain at predetermined minimum levels. Hire the person to perform management functions (company relations, computer installation, training of salespeople or CSRs) and pay a combination of salary and results-oriented bonus based on an increase in contingent income, increase in revenue per employee or commissions per producer or CSR, or some other formula that tracks with the tasks that have been assigned. You can also add non-monetary incentives to keep the seller interested in the ultimate success of the transaction. For example, you might want to include them in the agency planning process, hand out a title such as Vice President, provide an office, or simply ask for their advice from time to time. PLAN FOR THE TRANSITION It’s important to anticipate reactions from those parties both inside and outside the agency that the transaction will affect in some way: Agency employees, insurance company managers/reps, vendors, accounts, and prospects. 1. Spread the Word! In general, the more information that you share with employees of all the agencies involved and the more input you solicit in advance of the actual transfer, the more positive the transition will be. Some people handle change better than others, but everyone feels additional stress when facing the unknown. If you can reduce the mystery surrounding your plans, you’ll receive more support from the key players and less disruption from those who are determined to subvert the efforts. Of course, premature announcements can also be damaging, so there’s a fine line to walk Experience has shown that it’s usually better to err on the side of sharing too much, rather than sharing too little. Those of you who have been witness to agency employees hearing about a sale from a company underwriter know what we’re talking about. If the transfer of an insurance company contract is instrumental in the decision to do the deal, the buyer will have been involved in discussions with the branch manager at the outset of the negotiations. Companies that are shared by at least two of the agencies involved should also be contacted before closing with regard to the future treatment of contingent calculations and commission scales. Because most companies have a variety of agency contracts, you’ll want to lobby for the most advantageous one. When the acquiring agency has an important or preferred relationship with a carrier, find out if this company has a problem with the other agency before you finalize the deal. Is the acquisition worth losing an important market? The other companies involved do not need any special advance contact. You’ll need to decide which vendors to use for office supplies, advertising, phone, cars, etc. — but that can usually wait until after the transaction has been completed. If the agencies involved have different automation systems, some advance planning and contact might be necessary. When suppliers are also agency clients, you might need to take special measures before the public announcement to decide what, if anything, might change about the relationship and then to communicate this information to the vendor-clients involved. Most existing accounts and prospects will first hear about the business combination through the news story and/or ad in the local newspaper, cable TV, or radio. How you present the situation will leave a lasting impression so it’s important to plan the announcement carefully. In a merger or cluster, there might be a new name and new management philosophy that can be shared. If one agency is being acquired by another, it might be better for public relations purposes to refer to it as a “merger” or “affiliation,” rather than a “sale.” In addition to the general announcement, each client and prospect in all of the agencies involved should be sent a letter describing the business combination and its purpose. Even if the insured is associated with the “surviving” agency, it’s important to provide reassurance that nothing will change, or that the changes will be an improvement. This would also be a good opportunity to solicit additional coverages on Personal Lines and small Commercial Lines accounts. 2. Review All Accounts: Immediately after closing, review all larger Commercial Lines accounts. Within the first month, the seller and the new producer should visit all accounts in the selling agency that produced more than 1% of the total agency commissions. The purpose is to get acquainted and do a risk management review of the exposures and coverages. Accounts that produced from .5% to 1% of agency commissions should receive a similar visit within the first three months. Any other Commercial Lines accounts that produced more than $3,000 or so in commissions in rural areas, or $5,000 in urban areas, should be visited before the first renewal to let them know that the new agency wants to keep their business. PLAN FOR THE FUTURE Since you’ve done the acquisition, merger, or cluster to enhance your opportunities for growth and profitability, you need to develop a business plan that addresses the new options and defines who needs to do what for the agency to pursue the most advantageous course of action. Use the attached Worksheet as a starting point in the planning process. Add the revenues, total number of employees (including owners, producers, and former owners if they will be working at the agency more than 30 hours a week), number of producers, Commercial Lines commissions, Commercial Lines staff, Personal Lines commissions, and Personal Lines staff. Use these basic standards to compute the productivity measurements for the combined agencies, compare them to the average agency standard, and then project future needs based on anticipated revenue and commission growth. This involves several elements. Staff Restructuring Some employees might not be comfortable with the new organization and decide to leave. If you determine how many people you need in the agency and in the major departments, you’ll know in advance whether you’ll need to replace those who quit, and, if so, what type of candidates you should look for. When several stand-alone agencies are being combined, certain positions will invariably be redundant. In a cluster or merger situation, you’ll also face the problem of who is to be in charge at the top management level. Each agency had its own management structure and now one person must be given the responsibility for managing each of the functional areas of the agency. It’s critical that you discuss this and decide where the responsibility and authority will reside before the agencies combine. Perhaps one former owner can be the Sales Manager, one the Operations Manager, one the Marketing/Company Relations Manager, one the Financial Services/Health Manager, etc. But where will the buck stop for real? Although the new organization will not need two Office Managers, a higher level job position of Operations Manager might be called for. An agency with automated accounting in which the CSRs do the invoicing will probably only need one person in bookkeeping unless it’s larger than $2.5 million or so in revenues. One receptionist with a part-time back-up can handle all but the very largest agencies. You might be able to reduce the number of people handling claims — or you might have the luxury of deciding whether to separate the claims function from the service function and set up a new Claims department. The combined agency might be large enough to have an Administrative department handle the clerical duties of the CSRs. This might also be the time to create a new type of sales position that’s dedicated to servicing accounts (perhaps those of a retiring owner). You might also have the opportunity to differentiate between the types of CSRs, with some dedicated more to sales, others to technical processing, and still others to marketing/placement. Growing so rapidly, can easily compound over-staffing situations and end up adding more of the wrong kind of bodies. Having a management plan will reduce the chance for error. It will also allow the individual employees to see how the business combination can benefit them. With more specialization and differentiation in the types of jobs, they can see the advantage of continuing their education because there is indeed “room to grow” in the agency. Procedures As part of the initial planning for the new agency operation, be sure to conduct a complete review of all procedures. Sometimes organizations are forced into this evaluation because everyone had a different computer system and they are all converting to one. But even if there’s not such a dramatic need, this is an ideal time to track down and eliminate the duplicate work and the lost delegation opportunities. It’s far better to come up with a new “better” way than to force one group of employees to adopt a set of procedures that don’t seem to be an improvement over what they did in their agency. The morale problems that can develop from the battle over “ours versus theirs” can literally destroy all of the hoped-for economies from the merger. Company Relations The new strategic plan should also address company relations. Draw up a chart with the combined premium volumes, policy counts, and loss ratios for each carrier represented. Decide which companies you want to grow with in what lines of business, who is hot on what types of accounts, and where there might be sales opportunities for the agency if additional markets were obtained for certain lines or niches. At the end of the first calendar year, present your plan for growth to selected companies, old and new. Renegotiate contracts with the lead companies based on the new volume levels. The agency might now qualify for Top-of-the-Heap status — or, at the very least, you might be able to get some better commission rates. Use the merger as a catalyst to pursue actively the type of company relationships that the agency needs. BUSINESS COMBINATION PLANNING WORKSHEET Average Agency A Agency B Combined 12-Mo. Plan 2-Yr Plan Revenues             # Employees             Rev/Employees $72,000           # Producers             Rev/Producer $240,000           Commer.Comm.             Commer.Staff             Commiss/Staff $165,000           PersonalComm.             Pers. Staff             Commiss/Staff               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.

Valuation And Structuring Of Business Combinations
VALUATION AND STRUCTURING OF BUSINESS COMBINATIONS by Carol Hammes There are three key elements that must be considered when valuing and structuring a business combination between insurance agencies. In the August issue of The Middleton Letter we addressed the first of these items, the growth potential of the agency. Before deciding how much to pay, you need to determine a probable estimated growth rate under the new ownership. In making this determination a buyer has to evaluate historical trends and ownership considerations as well as the type of business that has been written and the effects of the insurance cycles and economy on that business. The second major factor to consider is the risk that the anticipated growth rate might not be achieved. A book of business that has been relatively stable under one situation may have a much greater attrition rate under new ownership. The average agency will lose around 6% of its personal lines clients and 8% of its Commercial lines accounts every year due to normal attrition. Under the best circumstances, the attrition rate will usually double during the first year after the sale of the agency. In situations when the seller is staying on as a producer or when the agencies have merged or clustered with the same personnel, there will probably be less disruption. But if the book of business is being moved to a new location for servicing and if that servicing will be done by different people, attrition could be much higher. The following are some major items to consider in evaluating the effect that the change in ownership could have on the projected commission income. The information necessary to make this assessment should be available if you obtained the bulk of the items included in the Acquisition Checklist that was printed in the August issue. Remember that the purpose of this analysis is to help you establish the element of risk involved in the acquisition of this particular book. Insurance Company Relationships. Review the premium volumes and loss ratios with the major carriers and the relative chances of keeping those markets after the acquisition. If a significant amount of business has to be re-marketed, the attrition rate will be higher. If your income projection contains contingent income, you need to evaluate the source companies and their volume and loss ratio requirements to determine the chances of receiving comparable bonuses in the future. Pay particular attention to specialty companies or to those that write more than 40% of the total volume. Will you be maintaining the same type of relationship with these companies? Are there special arrangements that might not be applicable after the sale? Are contracts and/or exclusive territories assignable? Does the insurance company contractually have the right of first refusal to buy the accounts that you think you are acquiring? Is the seller current with the company payables? Even if you are not taking on the outstanding liabilities you could get stuck having to make good on past obligations to retain the company contract? MIX OF BUSINESS AND ACCOUNTS WRITTEN Examine the relationships with any single account producing more than one percent of the total revenues or any types of accounts that together produce more than fifteen percent of the total income. Are there special connections between the seller and those business that relate to religion, politics, nationality, age, family or some other characteristic that does not apply to the buyer? Is it possible that the seller has retained the business because he or she has not been diligent with collections? So does your personnel have the level of technical expertise required to service this business? Is there a substantial amount of income derived from Health insurance, Workers' Compensation, Malpractice or other lines that are vulnerable to regulatory or legislative changes? Does the agency write a lot of nonstandard Auto or other business that tend to have a shorter than average life span? Is a substantial amount of business handled by a non-owner producer Internal Organization and Personnel Management. Take a look at how the book of business has been serviced in the past. This review is critical if you are planning on acquiring the entire agency but is also important even if you are just buying the expirations. Any change that you might make in the type or level of service provided to the customers will have an impact on the retention rate and therefore on the growth potential. If the existing salespeople and service reps have poor morale or if they have not been adequately trained or managed, the accounts could be in pretty bad shape. You may not want to keep them or, if you do, it may take a lot of extra work to get them cleaned up. This housecleaning will then take time away from the production of new business. After analyzing the agency's external relationships with insurance companies and accounts and the internal relationships with employees, you will e in a better position to assign a risk factor to this transaction. Weigh all of the information that you have reviewed and rank the situation according to the following scale: [ ] Little risk involved and chances of achieving the projected growth rate are quite good - 8. [ ] An 'average' situation that does not have any extraordinary features - 6 or 7. [ ] High level of risk involved with substantial attrition possible 4 or 5. Once you have determined the potential growth rate and the risk that this growth will not be achieved, you are ready to address the third key element in valuing and structuring a business combination, the anticipated cash flow. The price that you can afford to pay should be based upon he profit that you will be able to make from the purchased business. Depending upon what you plan on doing with the book of business or the agency, the anticipated profits may be higher or lower than the current owner has been realizing. It is important to also recognize that your expenses and projected profit margin might be significantly different than other potential buyers could achieve. It is therefore critical in the valuation process to determine what your expenses will be. If you get involved in a bidding war and end up agreeing to a price that requires payments greater than the available cash from the acquired agency, the difference will have to be made up either by the profits from you own agency or by each of the owners personally. This situation might be acceptable for a short period of time but it will quickly become uncomfortable and eventually be impossible to sustain. To determine the anticipated cash flow, start with the revenues that will be generated. Include the direct commissions after figuring in attrition and growth potential and then decide whether it would be appropriate in this situation to also include contingent income, fees, and investment income. Subtract operating and sales expenses as they will be under your ownership (usually between 75% and 85% of the revenues) and the result will be the estimated pretax profit. The anticipated cash flow will be the profit, minus state, or federal income taxes, plus noncash expenses such as depreciation. In successive years the revenues and expenses may increase or decrease so you should do the projection for at least ten years in preparation for valuing the business. The values of this insurance agency to you as a buyer under these circumstances will be the sum of the anticipated cash flow over a reasonable period of time. To determine what is reasonable, go back to the risk factor and convert that factor into years. If the situation is not very risky, use seven or eight years. If it is an average agency, it should pay for itself out of its own cash flow in a six or seven year period of time. If this time period seems short, consider the fact that the average account will stay on the books for seven years. Do you really want to still be paying for business after the revenues that you would receive from it are gone? Once the initial cash-flow projections have been made, adjust the forecast to reflect the way the transaction will be structured. In an installment purchase, tax deductible interest will have to added to the expense projections. If amounts are to be allocated to expirations and covenants, tax deductions will be available that may allow the buyer to pay more for the agency. If the seller is to be paid as an employee, those payments and the associated employee benefits must be included in the cash flow. For planning and pricing purposes, the chart on the following page presents some of the more common structuring options and the tax treatment allowed by the recently enacted Omnibus Budget Reconciliation Act of 1993. The new legislation finally resolved the issue of deductibility of expirations that had been a serious source of disagreement between the IRS and those insurance agents who had taken the depreciation deduction over the past several years. An agent can now write off 100% of purchased expirations and goodwill, making it unnecessary to document the value of each of these allocations. Since the purchased good will wasn't a deductible expense previously and since the IRS had been disallowing most of the deductions for expirations, this guaranteed deductibility is good new. But the bad news is that the deductions must be taken over fifteen years, twice the life of the average book of business. A buyer will probably have to pay for the expirations and goodwill over a much shorter period of time than the tax deduction can be taken. This time lapse must be built into your cash-flow projection and will affect the amount that you can afford to pay for the agency. Another consideration that must be taken into account ins the change in the length of time, that noncompete covenants can be amortized. Previously the covenants could be deducted over their useful or contractual life, usually three to five years. Now they must be written off over 15 years. The buyer will probably have to pay for the covenant during the period of time that it is in force but must spread the deduction out over a significantly longer time span. Because the seller has to pay ordinary income tax on this time and will receive capital gains treatment on the sale of expirations and goodwill, it will probably be in everyone's best interest to minimize the amount allocated to the covenant and place more on the assets, just the opposite of what was advisable several months ago. One way to get around the 15-year amortization period is to allocate a larger portion of the purchase price to a consulting contract or employment agreement. These can be written off as the payments are made but they can involve extra expenses for payroll taxes and employee benefits that must be taken into account. They can also affect the seller's receipt of social security benefits. As part of the negotiation process the buyer and seller will have to weigh the pluses and minuses of each allocation and a compromise will have to be reached. There are many ways to structure a transaction and, with some careful consideration, both sides can be comfortable with the amount of money that is changing hands and the level of risk that they each are taking. Once the negotiations have been completed, the buyer should revise the cash flow estimates one more time to make sure that the deal is still affordable in light of the compromises that have been made. If the seller is willing to take some of the risk by having all or part of the price based upon retention of the accounts, the cash flow can be used to determine what percentage of commissions can be paid over what period of time. In some situations the payments can be as much as 40% of retained commissions over four or five years. But if your cash flow indicates that fixed expenses are going to be high, paying more than 30% a year could be too much of a stretch. In that case you would be better to offer the lower percentage but over a longer time period. Because sellers tend to be more comfortable with the traditional commission multiple, you may find that converting the numbers to such a multiple will make the negotiation process easier. This should only be done, however, after you have determined what you can afford to pay based upon your own plans for managing the acquired agency. Relying strictly on a multiple can be extremely dangerous because it only looks at the top line revenues and ignores expenses that may differ substantially for different potential buyers. You must focus on the bottom-line results as you expect them to be under your ownership. When dealing with multiples, the cash flow projections should still be adjusted at every turn of the negotiations, particularly if there are other prospective buyers. If a competing agent offers 1.5 times the last year's commissions, do not attempt to meet or increase the multiple until you are absolutely sure that you can afford to do so. Remember, the quickest way to bankruptcy is to acquire yourself into it! STRUCTURING OPTIONS The following are general guidelines that may not be applicable to all situations. Professional advice must be obtained from legal counsel in your state prior to and during the transaction. METHOD-ALLOCATION Tax Free Exchange of Stock. ADVANTAGES/DISADVANTAGES Seller defers taxes until new stock is sold. Buyer does not have significant cash outlay./ Sale of stock can be restricted for 2-3 years and seller takes risk of decrease in value. Buyer assumes liabilities of seller. Buyer assumes same basis in the assets as the seller had. METHOD-ALLOCATION Stock Purchase ADVANTAGES/DISADVANTAGES Seller pays tax only on gain. Seller may defer some taxes by electing installment sale provision. Corporate seller does not have double taxation problem inherent in asset purchase. / Buyer must use after tax dollars. Buyer assumes liabilities of seller. METHOD-ALLOCATION Covenant Not to Compete ADVANTAGES/DISADVANTAGES Buyer can amortize for tax purposes. / Tax deduction must be taken over 15 years. Ordinary income treatment for seller. METHOD-ALLOCATION Employment Contract ADVANTAGES/DISADVANTAGES Payments are tax deductible for buyer. Seller can carry medical insurance coverage and other employee benefits through the agency. / Buyer must pay employee benefits, payroll taxes, and worker's comp premiums. Seller cannot receive social security benefits if payments are over the limit. Must withstand IRS scrutiny of reasonable compensation. METHOD-ALLOCATION Consultant ADVANTAGES/DISADVANTAGES Payments are tax deductible for buyer. / Seller cannot receive social security benefits if payments are over the limit. Must withstand IRS scrutiny. METHOD-ALLOCATION Deferred Compensation ADVANTAGES/DISADVANTAGES Payments are tax deductible for buyer. Seller's social security is not affected since this is ordinary income. // Must legitimately be for past services rendered for which adequate compensation was not received at the time. Seller does not receive capital gains treatment. METHOD-ALLOCATION Expirations/Asset Purchase ADVANTAGES / DISADVANTAGES Seller pays tax only on gain. Buyer can depreciate for tax deduction and may purchase on a retention basis. / Tax deduction must be taken over 15 years. Seller pays 'double' tax if C corporation. METHOD-ALLOCATION Goodwill/Use of Name ADVANTAGES/ DISADVANTAGES Seller pays tax only on gain. Buyer can depreciate for tax deduction. / Tax deduction must be taken over 15 years. METHOD-ALLOCATION Fixed Assets. ADVANTAGES/ DISADVANTAGES Seller pays tax only on gain. Buyer can depreciate for tax deduction. / Must be reasonable allocation for tangible assets acquired. METHOD-ALLOCATION Commission Expense. ADVANTAGES/ DISADVANTAGES Payments may be tax deductible for buyer. Buyer does not have to pay for business that does not renew it is set up on a percentage of retained commissions. / Seller cannot receive social security benefits if payments are over the limit. Should not be used if seller is incorporated or if book of business is substantial. Deduction may not acceptable to IRS since it may be viewed as capital expense. 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.

Combine Incentive Compensation With Employee Evaluations
Wouldn't it be nice to have employees looking for more business to handle, or helping to innovate to permit more work to be accomplished without the addition of staff? An Incentive Compensation Program (ICP) accomplishes this goal — but it takes a few years of education to teach the employees that this is really as simple as it sounds. Al Diamond offers tips on how you can accomplish this. An Incentive Compensation Program (ICP) can remove the subjectivity from the process of increasing compensation for performance. ICPs are usually constructed based on advances in productivity (revenue per employee) combined with department and/or agency profitability. If the individual manages a larger book of business (i.e., service employees) or manages their function for a larger client base (i.e. administrative employees) while their department and/or the agency maintains appropriate profit levels, raises are automatic and can actually be tracked by the employees, themselves. If an individual is more productive and if the department and/or the agency is profitable, that individual shares in this success through salary adjustments corresponding to the productivity increase. The “Merit Raise” system in which we have been raised is often less concerned with merit than with management's perception of an employee, combined with the frank realities of budgetary limitations. A variety of rating systems have been developed to establish some form of objective criteria under which the merit system can operate. Unfortunately, those very numerical rating systems must be based on a manager's estimates of employee performance. Because agency growth (overall productivity) and profit predetermine the amount available for raises, the ICP is firmly based in budgets. A specified percentage of revenue is predetermined to be the total staff compensation level. Employees earn raises by virtue of their productivity gains within the budgetary limits. The ICP also avoids the subjectivity of traditional merit raise programs. Evaluations become tools for employee development, rather than the rationale for the level of raise being given. Managers can't forsake their duty to evaluate employee performance. The manager's job is to identify an employee's weaknesses and correct them through a development plan and to help employees further develop their careers to make them more productive for themselves and for the agency. Whether or not you choose to pursue ICPs in your business, the key to employee development and retention lies in a combination of equitable compensation, fair evaluation, and genuine appreciation for the efforts made by the staff. Please understand that your actions, not your words, reflect your feelings. Some managers express appreciation verbally, then publicly criticize or demean employees. Employees recognize that managers' actions truly reflect their feelings. Compensation can be fair and equitable only if the agency has the revenue and profit to afford raises and if the employees understand the ingredients that result in their pay raises. If they believe that their raises are determined subjectively and that management is more concerned with enhanced profit than with fairly paid employees, they'll view all raises with suspicion and won't accept any evaluation as an honest review of their performance. In the past, all evaluations have been tied to pay raises. Management couldn't provide a glowing evaluation and a meager pay raise without using the agency's poor financial condition as the reason. Most of the time, employees simply don't believe the agent because it appears that there's always enough funding for the agent's discretionary expenditures. One of the reasons for developing the ICP concept was to de-mystify the compensation game. Employees monitor their own progress and the agency should provide further input on its profitability throughout the year. If there's no growth or profit, the employees themselves can identify the reasons for lower raises than desired. It's essential to separate evaluations from pay raises. As long as evaluations are done only when pay raises are due, the employee hears whatever critique is being offered with an ear that's listening for what the evaluation means to their pay raise. If you determine compensation advances by objective means, you can use evaluations for their intended purpose: To evaluate historical performance and to further develop the employee's career. We suggest these changes to evaluation programs: Evaluate three or more times each year (two, at a minimum). Employees don't want to hear what they're doing right or wrong once a year. They'd like to hear praise often and to hear criticism when it's used to help them, not attack them. Evaluations are also one of a manager's most important functions. We might be insurance professionals, but the most successful of us are also management professionals. Just as you didn't learn insurance easily, quickly, or haphazardly, neither can you learn how to be a manager quickly, easily, or haphazardly. Most managers feel uncomfortable evaluating performance because it's an event, rather than a process, so ... Make evaluations a process, not a project. The process of evaluation should include an analysis of historical performance (since the last evaluation) in accordance with the employee's job description. The job description should list all major activities for which an employee is responsible in their job and the measurements of success for each. The process also includes a development program that both attacks any weaknesses uncovered and determines the development path to further strengthen the employee in the future. Make evaluations a shared process. The best evaluations provide a form that includes the points of the job description, the success measures of each, and a place to evaluate performance in each area. Both the manager and the employee should complete the form (independently) and compare and discuss the results together. Critique — don't criticize. Most employees will be harder on themselves than will the manager. Your job is to critique their performance and help them improve soft spots and further develop strong areas. Remember that this is a development exercise that has to do with them becoming better employees and is not connected to pay raises. More important than the historical evaluation is the development plan. Develop another form for this tool. The form should identify areas of perceived weakness and areas of desired development. After the historical evaluation, both the manager and the employee should take the form and complete it individually. Make the shared results a basis for future evaluation. The development plan to which both employee and manager agree must be implemented between this evaluation and the next. For this reason, evaluation development plans run between three and six months long (depending on how often you evaluate). The creation of non-threatening evaluation systems and objective compensation programs will differentiate the exceptional agency from those who experience unexpected and frequent turnover. The excuse might be that the employee has moved for money. The reality is that the departed employee did not feel that their former employer was fair. That perception, whether grounded in reality or not, can be clarified through an ICP and Employee Evaluation Program.

Combining Insurance And Financial Services: Reality Check
COMBINING INSURANCE AND FINANCIAL SERVICES: REALITY CHECK by Carol Hammes After the Barnett decision in Florida and the subsequent passage of the Gramm-Leach-Bliley Financial Services Modernization Act, a flurry of activity began to create broader financial service organizations that provided insurance together with other products. Carol Hammes evaluates the bank/agency relationship.   Financial institutions have been in the insurance business for many years, with some states granting savings and loans and banks in small towns the right to have insurance departments and with seven large 'grand-fathered' national bank holding companies allowed to remain in the insurance business after most were shut off. There were more than 4,000 financial institutions in the insurance business before the courts and legislation opened the doors to the rest of them to take the plunge into combining the various types of financial services. Although most of these initial banks and S&Ls were only selling credit life and annuities, a number of them attempted to make a go of it in the Property/Casualty arena. In fact, back in the 1980s almost half of the members of the IIA of North Dakota were bank agencies. So, the convergence of banks and insurance isn’t new. It’s now become much more widespread and actually almost trendy. It was something that the banks had been fighting long and hard to do and something that most agents’ associations had been dead set against — which made it all the more attractive for banks. Once they got the opportunity to do what they’d wanted, many financial institutions altered their strategic plans (or scrapped them altogether) and set out to find the pot of gold at the end of the insurance rainbow. For the past decade banks have faced shrinking profit margins from their traditional products and services. Financial institutions have been looking for ways to expand their activities, improve account retention through selling more products, and finding additional income to help cover overhead. Selling insurance as part of a full financial services package seemed to be a logical choice for this expansion. Even 20 years ago banks and insurance agencies were developing ways to try to get around the existing regulations by creating joint marketing entities. The overworked term 'synergy' kept popping up as the excited participants made their plans to work together to sell insurance to the bank’s existing client base. For a number of reasons, most of these joint ventures died within two years. Perhaps the so-called synergy was (and is) more myth than reality. BANKS IN UNDERWRITING The merger of Travelers with Citigroup was seen as the premier indication that full financial services would be the wave of the future. Less than four years later Citigroup divested itself of the Travelers Property Casualty Corp, after admitting that they might’ve failed to recognize essential differences between banking and Property/Casualty underwriting. It’s important to note that Citigroup retained the Life and annuity company. The spin-off of the P/C company allows Citigroup to focus on distributing products through other insurers and will allow Travelers to grow by making acquisitions. At least that’s the party line. In short, Citigroup discovered very quickly after the 1998 merger that underwriting P/C insurance doesn’t yield the same returns as do other financial services. The high volatility of the P/C business simply didn’t fit the mold that Citigroup wanted as part of its overall strategic plan. They needed a minimum of 10%-12% organic growth and, with the dramatic cycles in the insurance business, that type of growth can’t be guaranteed or even expected. Whether other financial institutions will decide to get into insurance underwriting is unknown. Most of the trade press coverage indicates that they’ll be very cautious, understanding that the risk involved in underwriting is relatively alien to the banking business. Yes, they’ll take a risk to make a loan, but do they want to commit millions in capital to pay claims after a hailstorm, hurricane, fire, or terrorist attack? Although actuarial science is quite sophisticated, reality can be a very different story. The current shaky status of many reinsurance companies should also give bank executives pause for thought in thinking about the P/C business. Our guess is that we won’t be seeing too many financial institutions entering the underwriting side of the business within the next several years. BANKS IN INSURANCE SALES — JOINT VENTURES Many financial institutions have decided to get their feet wet before they jump wholeheartedly into insurance sales. They don’t want to make the capital outlay to buy an existing agency, and they lack the expertise to start one from scratch. Many agencies also want to pursue a lower-key relationship with a bank, maintaining their independence while taking advantage of the perceived sales possibilities in a joint venture. Sometimes the motivation is simply to make sure that the bank doesn’t make a deal with a competitor. So, the bank and the agency enter into joint marketing ventures, hoping to sell insurance to bank customers through a variety of sales approaches and hopefully having both sides profit from the alliance. Most of these arrangements have proven to be less than satisfactory and have been disbanded within two or three years. The average independent agency has a pro forma profit of around 19%-20% before bonuses to owners. When you split the profit with a bank, each side gets less than a 10% return — and that’s after several years of setup costs and initial marketing initiatives that are almost sure to outstrip the return. The best that you can hope for is a break-even status at the end of the third year. If both parties are accruing ownership in the new insurance accounts at 50%, the increase in equity value might be enough to offset the low level of annual return. But most of the time, to make the dollars work out, the marketing program must be set up to increase the commissions written far more rapidly than the average 6%-7% growth rate of the average insurance agency. And the sales and servicing operation for smaller Commercial and Personal Lines business must be structured to produce a much higher profit margin than in a traditional insurance agency operation. To have a successful joint venture with a bank, you must identify what customers you want to reach and develop a program that provides the most cost-effective way to do it. For medium to large Commercial accounts that bank loan or trust officers might prefer, the traditional approach of using a producer, account manager, CSR and support staff should work — provided, of course, that you get the bank personnel to make those referrals. But for smaller accounts a telemarketing/direct mail approach using only several companies and perhaps company service centers will be the only cost effective way to sell and service the business. The insurance companies should have an 800 number for claims reporting even if they don’t have a service center. There should be complete upload and download capabilities, as well as online quoting and policy issuance. Premium payments (if not direct billed through the insurance company) should be made through automatic account debit. Handle marketing activities as efficiently as possible on the smaller accounts. Alert bank customers to the availability of insurance products through leaflets in monthly statements, a computer terminal and phone in the bank lobby, requests for quotes on ATMs and on the bank’s Web site. Make follow up calls after each inquiry or expression of interest and at least every six months thereafter. Once a policy is written give the sales reps specific goals to write additional coverages for the accounts within the first 12 months. Both parties need to understand that, for the joint venture to make money (or at least break even) you won’t be in a position to write insurance for every single bank client. It’s extremely important that all bank personnel understand this fact. The best loan client might not be a good insurance risk. The underwriting process might exclude the bank’s president, who might not understand why the agency can’t write his Auto coverage even though his 16-year-old son has three tickets and has just been given a Corvette. One of the bank’s major clients might have a small Commercial account with high activity that only produces $250 in commission. It would be detrimental to the success of the joint venture to write much (if any) of this business. The insurance agency principals need to be able to demonstrate and explain this reality to the decision-makers at the bank. BANKS IN INSURANCE SALES: BUYING AGENCIES Although the landscape is littered with the bleached bones of bank insurance agency acquisitions that have gone awry, banks are still continuing to buy agencies. However, most have learned some harsh lessons from their predecessors that paid three times commissions (or eight times pro forma profit) for insurance agencies, only to realize a year or two later that they weren’t going to make any kind of a return at all — and sold them back at 50 cents on the dollar. Most sophisticated larger buyers of agencies are paying six times pro forma profits for their acquisitions. Some buyers will pay a higher multiple (up to seven times pro forma earnings) if the agency has strategic importance to them. For example, if the agency is the bank’s first insurance acquisition, they might want to use key management personnel to help them develop their 'core' agency. Some banks might add something additional for the commissions they think they’ll get from selling insurance to their own accounts. However banks that have had any experience with insurance will put this future income on a contingent or bonus/earn out basis. They know that selling insurance to bank customers isn’t as easy as it might seem. The bank’s customer list can provide thousands of leads. But that’s all they are — leads. Most agencies already have a large group of warmer leads because they haven’t rounded out their existing accounts. The average Personal Lines customer buys four insurance policies and the average independent agent only has 1.5 of them. Why would anyone think that agents who haven’t done a good job of rounding out their own business would do a better job of selling insurance to the bank’s customers? One of the largest bank insurance agencies, owned by BB&T based in North Carolina, has been in the insurance business for nearly 80 years and barely has 5% penetration selling insurance to the bank’s customers. If a bank is buying an insurance agency it shouldn’t count on the commissions that might come from merging the financial services businesses and expanding accounts in the structuring process. If the account expansion happens, great. But structure the deal to pay the agency principals and producers for their participation in this growth. It’s simply not good business practice to count on this growth and include these projections in the initial pricing. CULTURE CLASH Selling an agency to a bank can be an alluring option for smaller agencies that are having trouble meeting volume requirements from insurance companies but lack the capital to buy or merge with other firms. It can also be attractive to larger agencies that are having problems finding people or capital to maintain a viable management and ownership perpetuation plan. Unfortunately, selling the agency to a bank isn’t always a marriage made in heaven. Any time that an independent agency is sold the principals have adjustment problems. In many cases, they’ve owned their own firm for 40 years or more — and once you’ve called all the shots it’s hard to work for someone else, much less a bank. The significant differences between the insurance agency environment and the bank culture, with its almost constant meetings and long list of rules, can create an enormous shock. Sometimes serious disagreements can erupt over both small and large decisions and the brilliant marketing plans fall by the wayside while the parties figure out a way to move off dead center. At the heart of the issue is the fact that many bankers still have a problem with the concept of selling. As a result of the major changes in the banking industry during the past decade, they know they have to learn how to sell their own products, as well as understand the insurance sales process. But they seem to have a hard time embracing the concept. If the CEO of the bank pays only lip service to the 'new sales environment,' this lack of commitment will pervade the entire bank and eventually the acquired insurance agency operation as well. And when it turns out that a good insurance producer starts to make more money than the CEO due to the agreed on commission schedule, the bank executives can get more than a little nervous. The unique relationship between an independent agency and its suppliers is also hard for bankers to understand. The focus on meeting premium volume commitments while maintaining low loss ratios, sometimes at the expense of writing business for a bank board member, can become a real stumbling block. The potential for jeopardizing the bank’s relationship with some of its primary customers is a real concern, particularly if bank personnel blame the agency for the problem because they don’t clearly understand the underwriting requirements imposed by insurance companies with whom it’s necessary to maintain relationships. The hard market in Commercial Lines might put additional strains on bank personnel/agency personnel relations because the bank personnel might not fully understand why the account can’t be placed in the standard markets or why the premium is double what it was last year. Trying to combine financial services makes sense on paper. But it’s been a tough road so far for most that have tried it. Whether it’ll eventually turn out to be the best thing for the banks, the agency principals, their customers, and their employees remains to be proven.