Its A Sellers Market For Successful Agencies

Agencies with revenue of less than the $6.1 million average will find insurance companies looking for larger volume, will have difficulty competing with peers, and will face an equally difficult time attracting and retaining quality staff.

Some agencies sell for opportunity, but most sell due to poor employee management and nonexistent financial management. Today's average agency cannot perpetuate because it is plagued with a weak balance sheet, a dependency on contingents (bonuses paid by insurers based upon underwriting profit) and an inability to develop proper staffing.

Few of these agencies practice fiscal responsibility. To perpetuate ownership, agencies need to demonstrate tangible net worth (stockholders equity, less intangible assets) of at least 20 percent of revenue. While perpetuation is possible with less, inadequate balance sheet strength impairs perpetuation.

An agency without sufficient emergency surplus creates unacceptable risk to a redeeming shareholder (who typically holds the note) and invariably causes that shareholder to push for a sale.

Today, the average agency has tangible net worth to revenue of 12 percent. However, unencumbered net worth is considerably less.

Fixed assets (for example, office furniture and equipment) represent 7.3 percent. Fixed assets are not liquid and are typically overvalued given a limited market for used computers and cubicles.

Meanwhile, notes receivables from shareholders (funds borrowed by the owners that are owed back to the agency and booked as a receivable on the balance sheet) total 5.1 percent. The shareholder receivables on the average balance sheet, born from providing tax preferable loans to owners to support an inflated lifestyle, are not liquid and are seldom collectible.

This leaves a deficit balance of unencumbered net worth equal to .4 percent of revenue, which is hardly enough to survive, let alone reinvest back in the business.

The fragile condition of the average agency today is compounded by a dependency on contingents to generate cash flow. Given that contingents are inherently volatile and are not entirely under the control of agency management, this dependency creates tremendous vulnerability.

In the average agency, cash flow represents 7 percent and contingents represent 5.9 percent of revenue. Successful agencies will generate profit and cash flow without contingents and will make the difficult, and often expensive, decision to retain earnings to build a strong balance sheet.

What is the key to successful perpetuation?

Aside from the above and the obvious–strong leadership and a sales orientation–the solution is developing a self-starting entrepreneurial culture supported by a staff capable of making decisions with little management oversight.

The key is the right combination of whom you hire and whom you fire. Who you hire will determine your success. Who you fire will determine your ability to perpetuate that success.

Think of employees you have fired that have liberated the possibility of perpetuation. One bad seed can spoil the bunch, and unsuccessful agency owners are too slow to make critical and often difficult employee decisions.

While the number of transactions declined during the past two years, the trend will reverse during 2002.

Banks acquired fewer agencies given new accounting requirements adopted in 2001. Pooling-of-interest accounting was terminated, and now all transactions are purchases, which require acquirers to allocate a portion of the purchase to identifiable intangible assets, which are amortized against Generally Accepted Accounting Principles (GAAP) earnings over their useful life.

The interpretation of this rule and the impact on post-closing earnings was unclear during 2001, delaying virtually every acquisition deal by a bank of an agency in progress. (We know of no single deal that was taken off the table; deals were just delayed.)

The acquisition by banks of agencies will increase during 2002. Banks want to acquire the leading agencies consultative selling style and the solutions-oriented relationships they have built with their customers. Banks are driven to attain the coveted "trusted advisor" relationship agencies have with their customers.

Banks see this as integral to achieving future growth in the commercial areas of cash management and lending, and the wealth management areas of private banking, investments, estate planning and trust. Banks must also combat pressure from Wall Street to diversify net margin risk by expanding non-interest income.

Mergers by insurance brokers increased during 2001 and will continue during 2002. Brokers on the sidelines between 1996 and 1999, who witnessed dramatic consolidations between banks and agencies, can now compete on pricing given inflated price to earnings (P/E) multiples contributed by the hard commercial insurance market. Brokers are now more attractive to sellers because of the hard market and insurance company instability.

Banks provide prospects, and brokers provide market capabilities.

In a soft market, a banks customer list is coveted as agencies have numerous company alternatives, but have difficulty generating business, as insureds tend to remain with their incumbent agent. In a hard market, however, brokers are attractive as their market access can enhance an agencys ability to retain existing customers and capitalize on new business opportunities.

The number of broker transactions during 2002 will explode as brokers have more transactions in process than ever before. Estimates by Marsh, Berry indicate that the leading global and national brokers have over $1.2 billion of insurance revenue under review for acquisition.

During 1998 and 1999, it was again in vogue for insurance companies to acquire personal lines books of business. Interest has diminished given poor post-closing retention resulting from rolling business. Financial services firms, outsourcing companies and securities firms will continue to acquire as they attempt to cross-sell between differing financial services industries.

Banks target management talent and tend to acquire successful agencies to establish their footprint in the insurance industry. During 2001, these foundation agencies received premium value of slightly more than eight times pro forma EBITDA (earnings before interest, taxes, depreciation and amortization), given their quality and their enviable negotiation position.

The average multiple paid by a bank already in the business totaled 6.69 times pro forma EBITDA during 2001. To compete, brokers have increased pricing to 6.72 times pro forma EBITDA, which is the highest broker pricing in 10 years.

Brokers will outpace banks in terms of acquisition activity during 2002 due to their aggressive acquisition appetite, enhanced attractiveness and comparatively high P/E multiples, which will enable a further increase in acquisition pricing.

Whether considering a sale, an acquisition or perpetuation, understanding value is critical. To provide owners with an engine to estimate value, marshberry.com created a Web-based "Value Estimator." This online product provides financial models, information and instruction to guide an owner through a "do it yourself" estimate of value.

The five-step process includes entering or importing financial data, making adjustments to reflect true earnings, projecting earnings potential and assessing risk in the eyes of a hypothetical buyer. Understanding value through such a process enables an agency owner to be more knowledgeable about perpetuating, selling or determining the value of an acquisition target.

Understanding factors behind consolidation and agency value are critical to an agencys future. If agency principals focus on building the proper balance sheet, enhancing core profitability and fine-tuning their staff, they can control the future regardless of their divestiture or acquisition goals.

John Wepler is senior vice president and partner with Marsh, Berry & Company Inc., headquartered in Concord, Ohio, a national management consulting firm dealing exclusively with banks, insurance agencies and companies.

Reproduced from National Underwriter Property & Casualty/Risk & Benefits Management Edition, April 1, 2002. Copyright 2002 by The National Underwriter Company in the serial publication. All rights reserved.Copyright in this article as an independent work may be held by the author.