MOST agency owners agree that now is a great time to be in business. That's not to say that running an agency is easy, but the results have never been better. Agency revenues, including contingencies, are at an all-time high, as are profits. The average $3 million dollar (revenue) agency generated operating earnings of 14.5% in 2005, even after some additional owner return in the form of payroll and other perks. With business going so well, many agencies have placed perpetuation, whether internal or external, on hold.
Meanwhile, projected record insurer surplus levels, an expected underwriting profit in 2006 (which would be only the second since 1978), and a strengthening economy signal a continuing soft market. Analysts are projecting a 3.8% increase in premiums for 2006, hardly enough to support many agencies' top-line growth goals of 10% or more. Additionally, most agencies' new-business production capabilities are not strong enough to make up the difference. The hard market of the early years of this decade enabled many agencies to get by without creating a true sales culture. But many agencies now feel the lack of such a culture.
The most pressing challenge facing insurance distributors in 2006 is spurring new-business production to drive organic growth–or finding a partner that can. This will be a watershed year for many independent agencies, which must determine how much of their earnings they want to reinvest in infrastructure, including production talent, to fuel growth and build organizational viability.
In evaluating 2006, agencies also should consider the long-term sustainability of their current revenue stream and its associated profit to determine how much they need to invest to achieve future goals. Each agency ultimately must decide if the investment in producers and developing a sales culture is worthwhile, or whether it should consider selling to a third party.
The buyers
Since 1999, the average annual number of publicly announced deals in the insurance agency marketplace has been 219. The fuel for this consolidation has been the merging of the financial services industry and the need for many buyers to provide clients with a differentiated insurance solution. Last year saw a decline in the number of deals, to 202 from 243 in 2004. Motivated by record profits, many firms chose to stay independent, and the supply of agencies for sale dropped as a result. This trend continued in early 2006, with 28 announced deals during the first two months, a 45% decline over the same period in 2005.
Another major reason for the decline in deals is a marked reduction of the number of bank/agency transactions. In most cases, leading banks in the insurance business used 2005 to integrate and leverage already acquired insurance operations. Despite this internal focus, banks are steadily refilling acquisition pipelines because of the financial returns they gained from past acquisitions. Over 70% of Bank Agency Network executives report that the earnings produced by their acquisitions have exceeded what they expected at closing. Additionally, 88% of these same executives indicate they plan to acquire another agency within the next 24 months, with aggregate acquired brokerage revenue anticipated to exceed $300 million.
The public brokers also made fewer acquisitions last year, primarily due to earn-out considerations and purchase-price risk assumption. Public brokers' demand for acquisitions did not slip, but rather a change in the transaction process, coupled with record agency earnings, gave sellers pause. In most transactions, the selling agency owner looks to transfer the risk of the continuation of the earnings stream to the public broker. When a broker seeks to put more of that risk back on the seller via a post-closing earn-out structure, the agency owner has to reconsider. Another example of a change in the process has to do with how public brokers view contingencies. Prior to 2005, contingencies did not receive the scrutiny they do now, and this has affected how public brokers view an agency revenue stream's value. In many cases, the brokers' increased scrutiny has led potential sellers to decide to retain the risk rather than sell.
Agency-to-agency transactions also declined last year. Since many such transactions do not make it into the public record, this statistic can be misleading. However, it is safe to say that historically the volume of such acquisitions has lagged behind those of banks and public brokers, which have greater access to capital to fund acquisitions. In 2004, there was a significant increase in agency-to-agency acquisitions, driven by the increased demand of regional, typically privately held, brokers. They were able to locate smaller firms in their marketplaces that wanted to keep their agencies in the hands of a local entity. In those instances, the agency owners were able to earn the value on the business and retain the local culture.
The decline in agency (and regional broker) transactions since 2004 may be attributed to the increase in multiples paid by competitors. Selling agencies can command a premium via an auction process, rather than look for a financial buyer with a strategic interest in the acquisition. In the auction process, local agencies and regional brokers are pitted against the national brokers and banks, and the buyer is generally the highest bidder. In such cases, the public brokers or banks are able to pay the additional premium. This is reflected in the multiples of EBITDA (earnings before interest, taxes, depreciation and amortization) paid by different buyers, as based on a Marsh Berry transactional analysis. It found that in 2005, banks on average paid an 8.03 EBITDA multiple for "foundation" agencies and a 6.82 multiple for subsequent agencies. Public brokers paid a 7.42 multiple on average, and agencies bought other agencies for a 5.62 multiple.
As previously stated, the demand for agencies has not decreased. Banks continue to seek additional agency talent and financial return through acquisitions, which they consider a key component to growth in 2006. Public brokers need to meet market growth expectations in regard to revenues and earnings, which they cannot entirely satisfy through organic growth. Their continuing demand for agency acquisitions is reflected in the increase in the EBITDA multiple paid in 2005, to 7.42 from 7.23 in 2004. Therefore, we firmly believe acquisition activity will increase in the second half of 2006, as buyers seek to hit earnings targets.
The sellers
To get the most for their agencies, owners must perform annual due diligence. Among the factors affecting agency value are the timing of an owner's retirement, execution of agreements with key individuals, the ability to generate profit without relying on contingency income, the collection processes and staffing levels. By annually reviewing these factors, management will be able to implement changes to improve the agency's transactional value, whether for internal or external perpetuation.
Most agency owners understand that value can be significantly affected by the timing of retirement. Internal perpetuation must be viewed as a continuous process rather than a discrete event. To maximize value in an internal transaction, an owner often must commit seven to 10 years to the firm following the stock sale to provide time to transfer management responsibilities, leadership roles and client relationships. These key transfers can stabilize revenue and earnings, which in turn often are vital to funding the transaction (particularly if the buyer is purchasing the agency in installments). Also, the seller's commitment reduces the risk of the transfer and gives the buyer additional security.
An external transfer involves a much shorter time commitment by the owners, typically three to five years. In general, agency value is increased with a seller's longer employment commitment. The seller can continue to run the operation and/or serve in a production capacity. Buyers are willing to front more capital if they feel a seller remains involved and committed to the purchased agency's ongoing success.
Another sometimes overlooked issue is whether the agency has appropriate producer or employment agreements with key individuals. Many agency owners feel they should receive value for the entire amount of commissions and fees on the agency's books. However, the lack of appropriate noncompete or non-solicitation agreements can result in reduced value. Such agreements give a buyer confidence that the agency controls its own book of business. Many times a seller is surprised to discover that a buyer does not view ownership of the agency's book as being entirely in the hands of the stockholder but rather as at least partly in those of a producer who has not executed an agreement with the agency.
Buyers also look for agencies that have a record of generating a profit before contingency payments. An agency that can produce a profit from core commissions and fees is seen as a valuable commodity, since it has aligned its expenses with recurring, predictable income. As I stated at the beginning of this article, the average $3 million agency generates a 14.5% operating profit–but that includes 9.4% from contingencies. Therefore, the average agency's profit is 5.1% before bonus income. Agencies that rely on contingent income to cover ordinary expenses will be seen as less valuable, especially given current regulatory scrutiny of contingency payments. We recommend that an agency prepare an annual budget that shows a profit before contingency payments.
In recent years, many leading insurance agencies have shored up collection procedures to strengthen their balance sheets and cash flow. Most high-performing agencies pre-bill their accounts receivable and hold producers accountable for delinquent payments. The best 25% of agencies have an average collection period of -1.3 days, indicating that they are pre-billing their agency-bill business and collecting premiums prior to the effective date of coverage. Another significant change is agencies' shift from agency bill to direct bill to improve staff efficiency and reduce bad debts. In 2005, the average agency had 59.7% of its P&C and life/health business on direct bill. The days of agencies acting as a bank for key clients are over. That has increased the value of agencies in the eyes of buyers. Agencies that are good collectors command a premium because of their greater cash flow, smaller bad-debt write-off and fewer E&O claims. Agency owners who are looking to sell should review their collection policies and, if subpar, implement procedures to improve collections.
Finally, compensation is the single largest expense within an agency. A buyer will look at staffing levels to determine if reductions can be made to improve earnings. Most sellers would rather leave the tough decisions regarding staff reductions to a buyer. In sidestepping this task, however, an agency owner may lose out, since a buyer may not give a seller full credit for the potential staff reductions in the determination of EBITDA. A buyer will ultimately ask, "If staffing changes can be made in a pro forma to increase earnings while not materially affecting growth, why haven't the current owners already made them?" Most buyers are not in the turn-around business. They look for confirmation that they are buying well-run agencies, not charity organizations they'll have to convert.
To sum things up, the demand for acquisitions by banks, public brokers and agencies is still growing. Meanwhile, the average age of agency owners continues to increase, as they delay the execution of perpetuation plans. Together these factors ultimately will offset the recent reduction in deals and lead to an increased, if not accelerating, rate of acquisitions.
Agency owners should develop their exit strategies and review their plans annually. The reviews will enable them to implement "best practices" to improve profitability and growth. Additionally, a potential buyer will see such an agency as an efficient operation that requires minimal change. Only by reviewing and acting upon sound plans will owners be able to position their agencies as marketplace leaders and maximize transactional value.
Paul Vredenburg is senior vice president of Marsh, Berry & Co., Inc., a management consulting firm for public and private insurance distributors. Mr. Vredenberg can be reached at paul@
marshberry.com.
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