Tag Archives: assessment

How to Understand Valuation Reports

Most owners of small businesses, many executives/owners of medium businesses and even quite a few executives/shareholders of large businesses think the most important aspect of a business appraisal is the final number. The business is worth X dollars.

Obviously, the dollar amount is important. Getting the right dollar amount is even more important (I make this distinction because, in my experience, some business owners/executives and even quite a few bankers do not understand or sometimes even care about the difference between A Number and the Right Number). However, the number is arguably, especially if contested, only half of the requirement.

Depending on the reason for the business being appraised, the actual valuation report MUST meet specific parameters. If the report does not meet these parameters, the value arrived upon by the appraiser may be found meaningless or an opportunity to litigate by tax authorities or plaintiff attorneys. Just arriving at a reasonable number is completely inadequate if the report parameters are missing. It is kind of like buying the wrong insurance policy. The coverage amount might be right, but coverage may not exist because the policy is wrong.

Matching the correct report with the need is vital. Not knowing or understanding the difference makes business owners vulnerable to con jobs. And many business owners are conned each and every year.

How to Avoid Being Conned
First, I advise hiring an accredited business appraiser. All accredited business appraisers must sign a code of ethics, and most believe in their code. Some, though, do not quite believe in ethics as much as others. Some run the same con, but with accreditation. To be fair, I think some complete their reports mistakenly because they do not know any better. They are like insurance people with credentials who can barely spell insurance, much less business income coverage.

The better path is to understand the three basic types of Fair Market Value reports and to also understand the huge difference between Fair Market Value (FMV) and Fair Value (FV). FMV and FV are not synonymous. I have seen agency owners, and even accountants and attorneys treat these critical terms as if their meaning was the same. However, many courts treat the values calculated using these two terms quite differently.

See also: 3 Myths That Inhibit Innovation (Part 3)  

Relative to the three types of valuation reports (there are other types that are generally less applicable to most agency owners that I won’t address here), generally there is (exact terms vary depending on the professional association standards to which the appraiser is credentialed or belongs and sometimes depending upon the court, if being litigated):

  1. Summary reports, which are often referred to as letter reports (the entire valuation is in the form of a letter) or short-form reports. These reports contain little detail.
  1. Informal or Calculation Reports. The report writing standard, the analysis, the degree of confidence that applies to these reports are all relatively low. The margin of error is relatively high. The cost of these reports should therefore be relatively low. These reports rarely discuss the applicability of different valuation methods.
  1. Detailed, Written Reports. As the name implies, these are highly detailed reports usually combined with considerable analysis and a thorough discussion of the applicable valuation standards. These should cost the most, all else being equal.

Do not confuse a low price with high quality. Some appraisers charge a stiff penny for lower-quality reports because the customer does not understand the relatively low quality. Customers tend to think the appraiser just charges less. They think they are getting a Cadillac for the price of a Chevy. They are really just getting a Chevy that might not even be new.

The con occurs when appraisers fail to offer clients options, especially the most rigorous option, and clients do not know they are comparing apples with oranges when one proposal is for a lightweight appraisal and the other proposal is for a high-quality, heavy weight appraisal. One cannot always tell by the price, either, because the con is to charge as if the lightweight appraisal will be of high quality but just enough less money to get the job.

Courts have recognized this problem to some extent. For specific purposes, especially estate taxes, the courts can actually penalize the appraiser. For most purposes, though, once the valuation contract is signed, the damages will fall on the client and not the appraiser.

I am not suggesting all reports need to meet the highest standard, because they do not. When someone truly needs a decent, back-of-the-envelope valuation that has a large margin of error that is acceptable to all parties, a low-standard report should suffice. If litigation, a sale, taxes or compensation are directly tied to the value, then usually the best option is to spend the money and obtain a high-quality valuation right from the get go. Having a low-quality report in the hopes that everyone will agree can only complicate the situation if a high-quality report is eventually required. Then one may find it necessary to explain all the factors the low-quality appraisal inadequately addressed.

My key point, though, is that it pays to understand some basic valuation differences. It pays to understand that a low-quality report has severely limited acceptable uses, including that one cannot easily dispute the resulting value because the margin of error is so acceptably high. If the calculated value is $1,000,000 plus or minus 50%, then any value between $500,000 and $1,500,000 is okay.

See also: 5 Ways Data Allows for Value-Based Care  

These are not easy differences for the uninitiated to understand, either. My short summary is a summary of thousands of pages of textbook differentiation. Sometimes, especially when the attorneys and accountants involved do not understand the differences, I think clients should consider hiring someone to just explain their valuation report options. The complexity goes far beyond getting a home appraised, and choosing the wrong standards rarely is beneficial to any party other than the attorneys involved.

You can find the article originally published here.

2 Shortcuts for Quantifying Risk

Most companies that take up risk management start out with subjective frequency-severity assessments of each of their primary risks. These values are then used to construct a heat map, and the risks that are farthest away from the zero point of the plot are judged to be of most concern.

This is a good way to jump-start a discussion of risks and to develop an initial process for prioritizing early risk management activities. But it should never be the end point for insurers. Insurers are in the risk business.  The two largest categories of risks for insurers — insurance and investment — are always traded directly for money.  Insurers must have a clear view of the dollar value of their risks. And with any reflection, insurance risk managers will identify that there is actually never a single pair of frequency and severity that can accurately represent their risks. Each of the major risks of an insurer has many, many possible pairs of frequency and severity.

For example, almost all insurers with exposure to natural catastrophes have access to analysis of their exposure to loss using commercial catastrophe models. These models produce loss amounts at a frequency of 1 in 10, 1 in 20, 1 in 100, 1 in 200, 1 in 500, 1 in 1000 and any frequency in between. There is not a single one of these frequency severity pairs that by itself defines catastrophe risk for that insurer.

Once an insurer moves to recognizing that all of its risks have this characteristic, it can now take advantage of one of the most useful tools for portraying the risks of the enterprise, the risk profile. For a risk profile, each risk is portrayed according to the possible loss at a single frequency. One common value is a 1 in 100 frequency. In Europe, all insurers are focused by Solvency II regulations on the 1-in-200 loss. Ultimately, an insurer will want to develop a robust model like the catastrophe model for each of its risks to support the development of the risk profile. But before spending all of that money, there are two possible shortcuts that are available to rated insurers that will cost little to no additional money.

SRQ Stress Tests

In 2008, AM Best started asking each rated insurer to talk about its top five risks.

Then, in 2011, in the new ERM section to the supplemental rating questionnaire, Best asked insurers to identify the potential impact of the largest threat for six risk types. For many years, AM Best has calculated its estimate of the capital needed by insurers for losses in five categories and eventually added an adjustment for a sixth — natural catastrophe risk.

Risk profile is one of the primary areas of focus for good ERM programs and is closely related to these questions and calculations. Risk profile is a view of all the main risks of an insurer that allows management and other audiences the chance to compare the size of the various risks on a relative basis. Often, when insurers view their risk profile for the first time, they find that their profile is not exactly what they expected. As they look at their risk profile in successive periods, they find that changes to their risk profile end up being key strategic discussions. The insurers that have been looking at their risk profile for quite some time find the discussion with AM Best and others about their top risks to be a process of simplifying the detailed conversations that they have had internally instead of stretching to find something to say that plagues other insurers. The difference is usually obvious to the experienced listener from the rating agency.

Risk Profile From the SRQ Stress Tests

Most insurers will say that insurance (or underwriting) risk is the most important risk of the company. The chart below, showing information about the risk profile averaged for 31 insurers, paints a very different story. On average, underwriting risk was 24% of the risk profile and market risk was 30%. Twenty of the 31 companies had a higher value for market risk than underwriting risk. For those 20 insurers, this exercise in viewing their risk profile shows that management and the board should be giving equal or even higher amounts of attention to their investment risks.


Stress tests are a good way for insurers to get started with looking at their risk profile. The six AM Best categories can be used to allow for comparisons with studies, or the company can use its own categories to make the risk profile line up with the main concerns of its strategic planning discussions. Be careful. Make sure that you check the results from the AM Best SRQ stress tests to make sure that you are not ignoring any major risks. To be fully effective, the risk profile needs to include all of the company’s risks. For 20 of these 31 insurers, that may mean acknowledging that they have more equity risk than underwriting risk – and planning accordingly.

Risk Profile From the BCAR Formula

The chart below portrays the risk profiles of a different group of 12 insurers. These risk profiles were determined using the AM Best BCAR formula without analyst adjustments. For this group of companies on this basis, premium risk is the largest single category. And while there are again six risk categories, they are a somewhat different list. The risk category of underwriting from the SRQ is here split into three categories of premium, reserve and nat cat. Together, those three categories represent more than 60% of the risk profile of this group of insurers. Operational, liquidity and strategic risks that make up 39% of the SRQ average risk profile are missing here. Reinsurer credit risk is shown here to be a major risk category, with 17% of the risk. Combined investment and reinsurer credit is only 7% of total risk in the SRQ risk profile.


Why are the two risk profiles so different in their views about insurance and investment risks? This author would guess that insurers are more confident of their ability to manage insurance risks, so their estimate of that risk estimated in the stress tests is for less severe losses than the AM Best view reflected in the BCAR formula. And the opposite is true for investment, particularly equity risk. AM Best’s BCAR formula for equity risk is for only a 15% loss, while most insurers who have a stock portfolio had just in 2008 experienced 30% to 40% losses. So insurers are evaluating their investment risk as being much higher than AM Best believes.

Neither set seems to be the complete answer. From looking at these two groups, it makes sense to consider using nine or more categories: premiums, reserves, nat cat, reinsurer credit, bond credit, equities, operational, strategic and liquidity risk. Insurers with multiple large insurance lines may want to add several splits to the premium and reserve categories.

Using Risk Profile for Strategic Planning and Board Discussions

Risk profile can be the focus for bringing enterprise risk into the company’s strategic discussions. The planning process would start with a review of the expected risk profile at the start of the year and look at the impact on risk profile of any major proposed actions as a part of the evaluation of those plans. Each major plan can be discussed regarding whether it increases concentration of risks for the insurer or if it is expected to increase diversification. The risk profile can then be a major communication tool for bringing major management decisions and proposals to the board and to other outside audiences. Each time the risk profile is presented, management can provide explanations of the causes of each significant change in the profile, whether it be from management decisions and actions or because of major changes in the environment.

Risk Profile and Risk Appetite

Once an insurer has a repeatable process in place for portraying enterprise risk as a risk profile, this risk profile can be linked to the risk appetite. The pie charts above focus attention on the relative size of the main types of risks of the insurer. The bar chart below features the sum of the risks. Here the target line represents the expected sum of all of the risks, while the maximum is an aggregate risk limit based upon the risk appetite.


In the example above, the insurer has a target for risk at 90% of a standard (in this case, the standard is for a 400% RBC level; i.e. the target is to have RBC ratio of 440%). The plan is for risk at a level that produces a 480% RBC level, and the maximum tolerance is for risk that would produce a 360% RBC. The 2014 actual risk taking has the insurer at a 420 RBC level, which is above the target but significantly below their maximum. After reviewing the 2014 actual results, management made plans for 2015 that would come in just at the 440% RBC target. That review of the 2014 actual included consideration of the increase in profits associated with the additional risk. When management made the adjustment to reach target for 2015, its first consideration was to reduce less profitable activities. Management was able to make adjustments that significantly improve return for risk taking at a fully utilized level of operation.

Agent: What’s Your Plan This Year?

“What do you want to be when you grow up?” I used to get that question all the time. I would say I wanted to be a doctor, a lawyer, a successful businessman. I always had an answer, but I never had a plan. I would have benefited a lot from having the person follow up and ask me, “How are you going to get there?”

“How did you get into the insurance industry?” If you ask 10 insurance agents that question, nine times you get the same answer, “I just fell into it. I had no plan to be in the insurance business.”

I’ve spent most of my insurance career working and dealing with agents, and, while they have action items to grow their businesses, almost all of them don’t have a formal planning process. Instead, they react to issues the day they are confronted by them.

It’s natural to wait and react. But the best organizations in any industry always have a plan. They don’t react; they act with discipline and focus.

This article can provide you with a road map for designing your current-year business plan and your long-term plan.

A plan has to be something basic that you can live by during the year — not a 25-page document that gets put in a desk drawer and forgotten. Instead, it’s a short document that sets forth the path you want to take for your agency in a given year. Plans change. They always do, based on what actually happens. But having a plan allows you to be in control of your business.

Is it too late to have a plan this year? No. There is still plenty of time. Here’s a model I’ve used to develop several successful business plans.

1.         Start with an assessment of your business year-to-date. How’s your year going compared with last year? Is production up? How about profitability? Spend time analyzing your book of business and understand the difference between your results for the year-to-date period this year vs. last year. This shouldn’t take too much time.

2.         Identify your gaps. Profitability might be up but new business production down. Why is new production down? Is it taking more leads to generate a sale? Is a new competitor pulling business away from your agency? Understand your situation. Focus on the big issues.  Nothing is ever going to be perfect, including your business.

3.         Develop solutions. This is the toughest part of any planning exercise. It’s usually easy to identify a problem. It takes a lot more thought to come up with a solution, especially one that requires you to change the way you conduct your business. Try to identify little changes you can make. Pick a new lead source and experiment with it first. If it works, then incorporate it into your day-to-day operations. Implement several small changes at once. I call them “initiatives.” They are more like experiments. If they don’t work perfectly, that’s okay, because can always learn something new about your business that you can apply to your next initiative.

Let’s say new business production has fallen. It is taking your agency more leads to close a sale. One way to increase production is to increase the number of leads. That will probably increase costs because you have to purchase more leads or need additional staff to generate new leads. That will hurt your agency’s profitability.

Yet, that’s what most people do. I call it the “Do What You’re Doing, Just Do It Better” strategy. It typically fails.

Instead, focus on new tactics. Change the way you are conducting your business. Experiment, experiment, experiment! Try different initiatives. You will typically know if they are working fairly quickly. Don’t be afraid to stop doing something if it is not working. Move to the next idea and continue to iterate.

In our example, a new initiative might be to target a specific group of potential customers based on criteria you develop that makes them attractive customers. Another initiative might be to develop an affinity group that you can then target for new business. If the initiative works, you can incorporate it into your business. If it doesn’t — and you will typically know within 30 to 60 days — move on.

4.         Create check points. You can’t expect what you don’t inspect. Track your agency’s results on a daily, weekly and monthly basis. Meet with your staff consistently. You want to create a culture of accountability.

5.         Be transparent. You need to share your plan with everyone at your agency. Make sure your team is incorporating the overall plan into their day-to-day duties. Have you properly communicated and delegated specific initiatives to your staff? Is your customer service rep up-selling? Is your receptionist setting appointments when the office is quiet? If people don’t know what you are trying to do, they will just do what they think you want them to do.

6.         Stay focused. Plans fail when people lose focus. Your job as the leader of the organization is to keep the organization on the right path. A well-defined plan provides the framework to make sure you are staying the course. It enables you to make sure everyone is doing what needs to be done.

Nothing lasts forever. Yet it is surprising how few agency owners have a long-term plan for their business. Most agencies die a slow death, keeping the agency owner a prisoner of her own business as the staff leaves and she tries to hold on to renewal commissions as long as possible.

I attribute this common situation to the fact that most agency owners don’t have a long-term plan for their agency and for their personal life. In the early years of an agency, everything is focused on producing new business. As the agency matures, the service requirements of operating a P&C agency create daily challenges that keep the agency owner’s attention occupied. It’s easy to procrastinate until it’s too late.

Stop reading this article. Grab a pen and paper and answer the following question: How do you want to leave your business? As a thriving organization that survives you? A business you can pass on to your children? To your junior partners? A business that you can sell? What’s your vision for the future of your agency?

Spend some time today and put together your plan for the long-term future of your agency. Knowing where you want to be tomorrow, today, will make it more likely you will end up where you want to be.