By Timothy J. Cunningham and Daniel P. Menzer, principals, OPTIS Partners LLC

The economic turmoil of the last few years, compounded with the lingering soft market, has affected the value of virtually every insurance agency. While some have created incremental value despite market conditions, most have experienced a decline in value. But without a formal assessment of the risks, projections, and current balance sheet of the firm, you can't ever know how your agency and your investment are weathering the storm.

A fair market valuation (FMV) is a thorough review of a business's financial and operational attributes, performed by an independent financial expert. The FMV takes into consideration the inherent risks of the general marketplace as well as the specific risks of the particular firm.

Annual FMV reports are generally recommended when an agency reaches about $5 million in annual revenue as a tool to help manage the agency's growth and enhance its value. Agencies of this size usually have multiple owners, producers and other interested parties that can benefit from the information and insight provided by an independent consultant.

The recession has been tough on valuations. From December 2007 to December 2009, the aggregate value of the top four publicly traded insurance brokers fell nearly 20 percent, with only one showing an increase over the period:

For privately owned agencies, a fair market valuation (FMV) is the primary means of determining total value, revealing more than your mental comparison to publicly traded firms.

The FMV process has five parts:

o Review and analysis of the historical financial results and the firm's key contractual commitments and obligations
o Determination of potential cash flow from operations. A 5-year projection of revenue, earnings and cash flow is prepared based on historical performance and current market conditions
o Risk assessment regarding the stability of projected earnings based on production information, quality of personnel, economic climate and other factors
o Balance sheet evaluation for net working capital position and other assets or liabilities affecting overall value.

Read "M&As net surprising gains in 2009"

If an agency is owned by an employee stock ownership plan (ESOP), federal ERISA regulations require ESOP shares to be valued annually by a qualified independent appraiser. But even if your agency doesn't have an ESOP, a FMV is useful to agency principals to determine the updated value of the business and identify areas to improve agency value.

For example, an agency can change its compensation structure to create a more goal-oriented and accountability-focused reward system for producers and support staff, or standardize its office supplies purchasing system to focus on savings.

FMVs are also useful for:

1. Estate planning, to monitor the value of assets passing from one generation to the next--or in final estate liquidation, to establish the basis of the business being distributed
2. Perpetuation strategy planning, to set the value of the business as the basis for ownership redemption or transactions between owners
3. Establishing the value component of transactions, based on buy-sell agreements between agency principals, or so new agency principals may buy shares
4. Valuation of donated ownership interests for tax purposes
5. Determining the extent of key man life insurance to protect agency value.

Establishing a routine of annual valuations, and ensuring continuity of the appraiser, can provide meaningful trending information. A FMV can also validate steps taken by management to generate incremental value growth. In light of such findings, your appraiser can become a valued business partner and trusted advisor.

Read an article, "State of M&A: Dead calm after the perfect storm?"

Many firms are qualified to provide FMV analysis. Most are generalists who provide this service across a variety of business segments. But there are also specialists who work exclusively in the insurance distribution arena and understand the unique characteristics of the industry and the agency businesses. Be sure to investigate the valuation professional's background before making a selection.

Other situations that should prompt management to consider updating the agency's valuation analysis include:

o Expected shareholder transactions, either on the buying or selling side. Ideally, the valuation would be performed at least a year before any transaction to give all parties an opportunity to weigh each aspect of the valuation process
o Unusual producer and/or staff departures resulting in the possible or actual loss of accounts above normal attrition rates
o Increase in the number of producers and/or support staff, resulting in significant new business
o Significant changes in insurance company premium volumes, mix of business, contingent commission levels, concentration of revenue, or other activities
o Unusual changes in the economic environment or insurance marketplace.

Barring any of these situations, obtaining an updated FMV every few years is generally sufficient. Without the reality check of a current FMV, agency owners can make missteps in planning the agency's long-term interests. Knowing the value of your business--and what steps to take to protect or enhance its value--is simply prudent business.

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Tim Cunningham and Dan Menzer are principals with OPTIS Partners, LLC(www.optisins.com), a Chicago-based investment banking and consulting firm providing M&A, valuation and strategic consulting services to firms in the insurance distribution sector. Tim is a member of the American Agent & Broker editorial advisory board. The authors can be reached at 312-235-0081, cunningham@optisins.com, or menzer@optisins.com.

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