HISTORICALLY, independent insurance agencies have owned two intangible assets: their customer lists and their company contracts. Few valuations separate the values of the two, since they are integrated. Some company contracts increase an agency's value (though not by 100%, as is sometimes claimed), while others do little for it or even decrease it if the contract is not easily transferable. This may happen, for example, when an agency writes a material amount of business through a company that advises it will pull its contract if the agency is sold. Such issues are usually considered in a valuation, but separate values are not generally calculated.
What happens to an agency's value if it does not own any company contracts? I'm not talking about an agency using a broker model, in which the agency represents just a few companies and works through MGAs for most of its markets. In such a situation, the relatively lower agency commissions and minimal contingencies are easily identified and factored into valuations. But how is an agency's value affected when it does not own any company contracts because it is part of a cluster?
Like all good valuation answers, the answer is, "It depends." To learn the effect of not owning any contracts, we have to look at how the cluster affects profit, growth and risk, which are the three keys to all valuations (along with the buyer's or appraiser's perception of these factors), and the quality of the agency's balance sheet.
Profits
Many agencies join clusters and give up their contracts to consolidate volume and thereby increase contingency income. They assume that if they double volume, they will more than double their contingency bonuses. However, an analysis of 12 regional and national companies showed that on average, the contingency increase is much less dramatic. For example, for an increase from $2 million to $4 million in written premium (at a 50% loss ratio), an agency would increase its contingency bonus as a percentage of written premium, all else being equal, from 1.35% to 1.52%. In a cluster consisting of two agencies, each agency would receive just half of that 0.17 percentage-point increase, which equals only about $3,500. Agencies considering a cluster should carefully review their contingency contracts to be sure they will earn enough extra money to make a cluster worthwhile.
According to the latest GPS Study (The Academy of Producer Insurance Studies, 2002), the national average contingency income for agencies with less than $500,000 in revenue represented 3.77% of their revenue. For agencies with more than $2 million in revenue, contingencies are only 4.7% of revenue-just one percentage point more than the smaller agencies. From a written premium perspective, $500,000 in revenue at 12% commission requires $4.2 million in premium, whereas $2 million in revenue at 12% commission requires $16.7 million. To get that extra point of contingency bonus, an agency must quadruple its volume. If a cluster is involved, the bonus is still split between owners.
Material gains may be made through significant planning and negotiation; otherwise, expectations may greatly exceed reality. On the other hand, for very small agencies, contingencies can increase significantly within clusters, simply because the agencies may now qualify for them.
Growth
Cluster arrangements do not necessarily affect growth in a particular direction. I have seen cluster arrangements significantly reduce growth because the integration was so poor and company management philosophies were so divergent. I have also seen growth increase when the agencies and companies involved were good matches and the cluster was properly planned.
Risk
The risk associated with an agency that doesn't own its company contracts has a great effect on agency value. For example, consider a member of a cluster that desires to sell itself outside the cluster but does not own its contracts. If a prospective buyer does not represent the same companies, what is the risk that a number of accounts will be lost upon the sale? Will as many buyers even be interested in buying such an agency?
This is a major problem with many clusters in which a holding company owns the company contracts, rather than the individual agencies (which is the usual requirement of insurance carriers). In most cases, the seller cannot get full price when the buyer is an agency representing other companies. (A possible exception might be if a good producer comes with the deal). An alternative is to sell to the agency's cluster partners-if the partners are interested, can afford the price, have the required staff/production capacity (which can be an issue if the buyer is a one-man shop, which is often the case with clusters), and want to get bigger.
Even if a sale between cluster partners is acceptable to all parties, cluster agreements often do not adequately address such a transaction, and agreeing on a price can be a big issue. This could lead to serious trouble for the seller because a deal may not be workable between partners, and yet, outside the cluster, the selling agency may have limited value. At this point, the seller is often trapped.
Balance sheet
A good balance sheet enhances value, and a poor one diminishes it. In clusters, the balance sheet can have an effect similar to that of the buy-sell agreement. The balance-sheet value for most agencies is mostly attributable to three components: cash, accounts receivable and accounts pay-able. Within a cluster, accounts receivable and accounts payable for all members usually are run through a central account held by the holding company (even if not, if the company contracts are owned by the holding company, all members remain responsible for all other members' payables). The way most cluster agreements are written, when one member gets behind on its payables, all cluster members are responsible for all other members' company and customer liabilities. What happens when a seller learns that another member has spent too much of its customers' money, putting the cluster out of trust? No buyer will pay full value in this situation.
Franchise clusters, because of size and the extra benefits some provide, are slightly different, but the basic problems may still exist. An agency that becomes part of a franchise is limited in terms of whom it can sell to for a full price. That may or may not be acceptable, depending on the situation. Even the balance-sheet issues apply. (I strongly encourage all agencies considering joining any kind of franchise cluster to examine the franchise's balance sheet, including audit statements for off-balance-sheet liabilities, before signing the agreement and annually thereafter.)
At some point, these parent organizations will have extreme power over an agency's ability to sell. All cluster agreements should be designed with this in mind. Unfortunately, most are missing this key component. The sad fact is that very few accountants and attorneys adequately understand insurance agencies and are therefore unqualified to organize clusters unaided. If some form of a cluster is best for you-and it definitely is for some agencies-make sure the benefits of the cluster are not outweighed by the negative effect of a poor cluster agreement.
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