I HEAR many agencies brag about how successful their clusters have been--but I rarely hear anything from those involved in all the unsuccessful ones. (By "cluster," I am referring to a limited number of agents who combine certain aspects of their operations and collectively do business within a relatively small territory-rarely statewide.) Keep in mind that every time a cluster is created, it eventually must be dissolved, which usually is quite problematic. Agencies involved in clusters often do not have a clue about the mess that awaits them until it is too late to do anything about it.
The two most common reasons I hear agents give for forming clusters are to gain access to companies and to increase contingencies. The first reason does make some sense for very small agencies. However, if company access is the main reason for forming a cluster, joining a national or regional cluster or agency network probably makes more sense. Furthermore, these larger clusters and networks aren't affected by eventual breakups to the degree smaller clusters are. Indeed, these larger groups often give members the option to sell their book of business to the cluster upon their retirement, in accordance with a predetermined valuation formula.
Agents who don't find the idea of joining a large cluster or network acceptable should consider accessing companies through brokers instead. This often is an easier and better solution to the market-access problem than a cluster is. Additionally, brokers generally pay reasonable commissions.
Joining a cluster to obtain larger contingencies might make sense if doing so enables the participants to meet carrier volume requirements. For example, consider two agencies that each have $1 million of premium with the same company and make $20,000 in profit sharing. They might make more by combining their volume in a cluster. Before doing so, however, they should examine the company contract to determine if they'd really be coming out ahead.
After analyzing hundreds of contingency contracts, I can attest that many carriers do not pay a materially higher percentage for extra volume. For example, in 12 contingency contracts I analyzed, the average profit-sharing bonus was 1.13% at $1 million of premium, a 50% loss ratio, and 5% growth. If two separate agencies with these results formed a cluster, the analysis showed the combined $2 million of premium would increase the bonus to 1.35% (assuming the loss ratio and growth stayed the same). That would increase each agency's contingency bonus by $2,200. Is that enough to offset the drawbacks of having partners and incurring the extra costs and liabilities of a cluster?
There is a common, erroneous assumption that all companies pay much higher contingent commissions for higher volume. Some do, but most pay only marginally higher bonuses-and clusters come with costs that may more than eat up those increases. Those costs include the following:
--Dedicated management: Clusters need strong managers to look after company relationships and other aspects of running the cluster. Those without them often are walking time bombs. Clusters with strong management can create a lot of value, but such management costs money. A manager with considerable ability and knowledge must be hired. He or she must be given broad authority over the member agencies and must be paid well. Typical annual salaries for such managers start at $75,000.
Without a good manager to look over such matters as the placement of business with insurers, some cluster members may be tempted to place less desirable risks with the cluster's companies--thereby ruining contingencies and carrier relationships, and defeating the purpose for which the cluster was formed.
--Errors and omissions exposures: Clusters create a Pandora's box of E&O issues. Who should provide E&O coverage for a cluster? The answer depends on its legal structure and the name in which the company contracts are held. If company contracts are held in the names of different cluster members, do all cluster members have E&O coverage when writing with all companies?
While dedicated cluster management can help reduce E&O exposures, they still are greater than for typical agencies. One reason is that to minimize E&O exposures, the cluster's member agencies must use integrated, uniform procedures, but such integration rarely occurs, which potentially exacerbates exposures.
--Agency value: Eventually every business must be sold or die a depressing death. Does a cluster enhance or detract from an agency's value? It could do either. Given the sloppy manner in which most cluster agreements are written, the value usually decreases. Many agents in clusters haven't discovered this yet because they haven't tried to sell their agencies.
Extra revenue derived from the cluster's combined volume may increase a member agency's value, but its value depends more on the terms of the cluster contract and the condition of the cluster's other agencies. For example, I recently heard about a cluster agency that was selling its book to an agency outside the cluster. Unfortunately for the other cluster members, a key company said it would pull its contract after the sale, because the remaining cluster members had insufficient volume to qualify for it. What does the loss of that carrier do to the value of the remaining agencies? Potential problems like this must be addressed in the cluster contract, but often they are not.
--Cluster contracts: A good cluster contract will cost at least $10,000 to create-after your attorney and accountant learn enough about clusters to prepare one properly. In fact, I have seen contracts that cost as much as $25,000 to draft. The contract must be reviewed with scrutiny, and all probable scenarios must be considered. Some cluster contracts appear innocent, but actually are de facto Ponzi schemes, because the first member out often is OK, but the remaining members rue the day they joined the cluster.
Final thoughts
If you are thinking of joining a cluster, stop daydreaming about money growing on trees and carefully consider each of the issues outlined above. Then decide whether the benefits outweigh the costs.
