Tag Archives: burand

Why Low Loss Ratios Can Be the Wrong Goal

Many agency owners take great pride in generating low loss ratios year after year. These agencies are often very, very profitable — they are the perfect cash cows, in business school parlance. But, in my experience, their growth is painfully slow. Often, their agencies are not managed closely, beyond the focus on loss ratios. And the agencies are often small. 

These agency owners are not happy with the many carriers who have deemphasized loss ratios. They cannot fathom why any carrier would not LOVE their good loss ratios. The result has become stressed, or even fractured, agency/company relationships.

These agency owners do not understand that loss ratios that are too low (and each company will define “too low” differently) are not in some companies’ best interests. How can too high a profit margin be bad?

  1. When loss ratios are too good, it may mean rates are too high, resulting in too little growth. Companies, particularly stock companies, need to show growth, especially after the softest market in industry history.
  2. If growth is too slow, companies may be losing market share. Company management often has considerable pressure to attain specific market share.
  3. Loss ratios that are too low may also mean that profit is not being maximized.

Maximizing profit is not the same thing as achieving a high profit margin. The former is in dollars, and the latter is in percentages. This is a crucial difference between running a company and running an agency, and agency owners are well-served to understand it. If a company wants to maximize profit, it might want to increase revenue by lowering rates even though that would mean higher loss ratios. For example, if a company has a 35% loss ratio and $100 million in premiums, its gross profit (excluding expenses) might be $65 million. However, if it decreased its rates and subsequently increased premiums to $125 million at a 45% loss ratio, it would generate $68.8 million in gross profit. That is a $3.8 million improvement.

Many agency owners would like to increase their books 25% and go from a 35% loss ratio to a 45% loss ratio, too, but those that focus on low loss ratios probably will not get their share of that 25% growth, yet their loss ratios will still increase.

Frustration at agencies greatly increases when companies price to a 55% , or higher, loss ratio. The company still makes plenty of profit at a 55% loss ratio (if it does not, then the company has serious expense issues that go far beyond the points of this article). However, agency owners make most of their money in contingent bonuses from carriers for growth, retention, low losses and so on, and profit sharing by carriers declines precipitously at 55%. The agency owners' lifestyle is curtailed. The value of their agencies is impaired. Their business model is in shambles.

If a company is truly pricing to a loss ratio in the mid-50s or even higher, agency owners might consider doing business with different carriers whose philosophies more closely match theirs. Easier said than done, obviously, so maybe a better solution is updating their business model. Growth is more important today to many carriers. Sitting on a cash cow annuity for a decade or more is not as feasible as it once was, and wishing otherwise will not help.

Many companies desire fast growth because:

  1. Some executive bonuses are tied to fast growth.
  2. The company is being set up to sell.
  3. The company has reserving issues and needs the extra premium to dilute the effect of a reserve increase. Growth is only a temporary solution, but companies have used it forever. The fast growth, which makes executives look heroic, is almost always created by low, unsustainable rates that eventually result in higher loss ratios. Nonetheless, growth is initially far more important than profit. (The smartest executives are gone by the time the problems arise, leaving their successors to sort out the mess.)

Agents doing business with companies that emphasize growth may want to evaluate whether there is risk to the agency and its clients. If so, creating a plan to offset these risks can create excellent opportunities.

Agents can fight reality, and fighting will feel good for masochists, but few will be able to avoid doing business with at least a few growth-focused carriers. Don’t keep telling carriers how short-sighted they are. Capitalize instead by understanding their perspective and using your resources to deal with the carriers you choose.

NOTE: None of the materials in this article should be construed as offering legal advice, and the specific advice of legal counsel is recommended before acting on any matter discussed in this article. Regulated individuals/entities should also ensure that they comply with all applicable laws, rules and regulations.     

What Happens When an Agency Owner Dies?

I have unfortunately worked with the families, estates and partners of several agency owners who have passed away.  Most of the deaths occurred unexpectedly.  In all cases, the person who passed left the family, estate and partners with far more problems than necessary.  So, my question to you is this: If you passed away tomorrow, what problems would you leave behind?

One situation I absolutely dread is when I have to tell a family the agency is not worth anything near what the recently passed relative (usually the father) said it was worth.  Agency values are not what they once were. So, you may be telling your partners and loved ones that the agency is worth more than it really is, a practice that, while possibly innocent, is still cruel.

Get your agency valued using real world values so everyone’s expectations are realistic.  Put yourself in your family’s and partners’ shoes.  The income from the agency will be eliminated upon the sale.  Will the agency’s sale be enough to support their standard of living? 

You will uncover problems such as bad debt.  I have seen a number of agency owners die with sizeable accounts receivable that were quite old and totally uncollectible.  These debts may total 20 percent, 25 percent, even 30 percent of the agency’s commissions.  Even if an agency is worth some high multiple, those bad debts have to be deducted.

You will also find issues that you can address, sometimes rather easily. It’s horrible when a widow learns that her husband did not really own all the business on the books.  He always meant to get around to fixing his producers’ contracts but died before he did. As you get your agency valued, however, you can confront the issue and correct it. There have also been situations where all the important accounts are written by the deceased, and there is no one in the agency to take over those accounts.  Those key accounts most likely will not stay with the agency, so its value is not going to be what the estate may have thought.

Another example: keeping lousy books.  It is not imperative for an owner to keep good books and good data.  It is smart, and it is a good business practice, but it is not imperative.  However, if a person dies and the books are poor, the agency is not going to sell for full price.  Who will pay full price for an agency for which no one knows the true income and the true state of its balance sheet? 

Getting a valuation will force you to look at issues such as contracts and books—in time to fix any problems.

I know many readers are thinking these things never happen, but they do. How do you know you do not have similar issues if you have not had your agency valued by a competent appraiser? 

Two other issues to focus on:

Agency Ownership

Do you really own your agency?  I have seen a number of situations where the agency’s contracts were so poorly written that the agency did not clearly own the business on its books.  Maybe the owner knew this at one time and had forgotten because nothing bad had happened.  On a day-to-day basis, it didn’t really matter. But when the agency is being valued, especially when it is being valued because the owner has died, it does matter, and that is not when anyone wants to discover the problem. As more and more clusters develop and even age, this is going to be a bigger and bigger problem.

Buy-Sell Agreements

What happens when a person dies with a bad buy-sell agreement with his partner?  Unless luck and goodwill are in plentiful supply, nothing good happens.  The partner may have been the greatest, most unselfish person on earth, but is his or her family just as unselfish?  This is important because, at least for a time, the dead partner’s family will be partners, too.

For example, what happens when the surviving partner realizes the buy-sell agreement poorly defines value?  This may leave the door open for the dead partner’s estate to claim any amount of value. I have seen, more than once, claims of two times premiums!  It is not always that the other side is greedy; often, they are just uneducated about the insurance world. Combine that with grief and a feeling of immense vulnerability, and they may not want to settle for a reasonable value.

Another great example is where the agency’s balance sheet is poor and the estate’s trusted advisor discovers some rule of thumb that agencies are worth some multiple of commissions, but fails to understand that balance sheet deficits, especially trust ratio deficits, must be deducted.  If you have ever tried to buy out a partner at full price while the agency has a trust ratio deficit, you will know how difficult it is to make payroll and other payments.

The readers of this article have the opportunity to fix a wrong before the wrong occurs.  The pain survivors feel when a loved one or partner dies is already immense.  Why exacerbate it by leaving them a business in a mess?

What Is The Difference Between Intrinsic Value And Market Value Of Insurance Agencies?

I have been valuing insurance agencies for a long time. I have been valuing them using both the Intrinsic Value and Market Value methods most of the time. For anyone interested in reading a brilliant description of these two methods, I suggest reading the article, “Musings on Markets” (September 7, 2011), by Professor Aswath Damodaran of the NYU Stern School of Business.

Intrinsic value is usually determined using one of several versions of the discounted cash flows method (the exact definition of cash flow varies, but all are intrinsic). This method states a firm's value is determined by the firm's future expected cash flow, discounted for time and risk.

In theory, market value also emphasizes cash flow. However, my experience is that most practitioners, especially when applied by agency owners but also some consultants, so inadequately account for cash flow and the risk that something will go wrong so that for all practical purposes, cash flows are disregarded. This makes market value agency appraisals purely speculative. Sometimes the result is an under valuation. More often the result is a value exceeding reasonability. Sometimes market value and intrinsic value are materially the same. After all, a broken clock is correct twice a day and 730 times a year. Most people would say being right 730 times a year is an awesome record.

A good example is the real estate boom and bust. The intrinsic value of the real estate never supported the market value. Many analysts and promoters became quite innovative in their development of “intrinsic” metrics that supported the market values, but the basic cash flow never supported the market value. The real estate investment only made sense if one could flip the investment at an adequately higher price before the market crashed.

The same force occurred in the market for insurance agencies. Very few agencies have an intrinsic value exceeding two times today or five years ago or ten years ago. If a business appraiser or a business broker sees someone who wants to believe an agency is worth more, the list of rationalizations, justifications, fictitious economies of scale, insightful product diversification strategies, and capital plays (interesting since capital is arguably free in some forms today) are infinite. If someone shoots holes in all these arguments, then ultimately the business broker will play their ultimate card: “We're so much smarter that we can make this work.”

The fact is the intrinsic value did not justify the price paid by many agency buyers five years ago. The strategies that caused the buyers to believe the values were justified were mirages of wishful thinking. The market was overheated and for whatever reasons, if buyers wanted to be in it, they had to pay a high price. There is and was nothing else to it.

The fascinating difference between intrinsic and market value for insurance agencies is that the intrinsic value should remain in a rather narrow band because:

1. Profitability in a well-managed agency is stable. By well-managed, I am excluding firms that are 100% or more dependent upon contingencies for their profits. In these agencies, profitability will vary wildly depending on their contingencies. Otherwise, expenses do not vary much year-to-year in well-managed agencies and therefore, profitability is stable.

2. Sustainable growth is humble. When you read about an agency growing 10% to 25% annually, ask, “How many annuals?” In other words, how long have they truly achieved such significant growth? Also, what risks are they taking? The Property & Casualty industry grows at approximately the same rate as the U.S. economy because the Property & Casualty industry insures America's economy. That rate is approximately 3% annually.

The Property & Casualty industry is not a growth industry and it has not been one for decades. To pretend otherwise is like an older model choosing the right makeup, the right lighting, and the optimum angle to look ten years younger. In fact, the evidence is strong that firms who grow multiple times faster than average have a higher than normal probability of cheating. Often the cheating is not malevolent, but it is still cheating.

3. Risk is comparatively moderate. The insurance agency business is one of the least risky businesses. It may feel risky, but compared to most other businesses, it is quite safe.

These three factors combine to create periodic value fluctuations, but within a rather narrow band on an intrinsic basis. This is why owning an agency is a great business in tough times while maybe less appealing in great times. So why is the fluctuation so much more on a market value basis? Speculators. The speculators may be banks, brokers, private equity, other agencies, but they are speculating. This creates some issues because speculators use market value plus twenty percent or so for their values. They have a tendency to build price without adequate regard for supporting cash flow or risk. This is why a boom takes years to build and the resulting bust can take just a few weeks.

The fact that speculators pay too little attention to cash flow and risk has two significant consequences. The first is that speculators value good agencies and bad agencies too similarly. The result is they pay too much for bad agencies and sometimes fail to purchase the best agencies because they're not willing to pay an adequate premium for quality. Now, some really smart speculators have learned that certain kinds of supposedly bad agencies do not actually have post acquisition bad results. One should not confuse these two situations.

The second consequence is when inadequate attention is paid to cash flow and risk upon acquisition, speculators eventually cannot or do not pay enough attention to building the people and systems necessary for organic growth. This is readily apparent in some brokers' results today.

Whether you should or should not emphasize market value over intrinsic value depends on your position and the market cycle. As a seller in good times, the market value will usually be your best deal because this industry has blessed sellers with an infinite supply of irrational buyers. Their numbers grow and constrict with the seasons, but rarely are they in short supply for long. The only exception to this is the really good agency. A market value may rarely adequately capture the true value of these agencies' cash flows and risk. Internal perpetuation is almost always the best course for maximizing their value.

If you are a buyer, a brutally honest intrinsic valuation is the best way to manage your risk. Market value should be entirely secondary. Always remember that no acquisition is better than a bad acquisition and since roughly every study ever done shows that 75% of acquisitions are failures when truly tested, this rule is worth cementing in your brain. The exception is that if the buyer has such a bad situation that a bad acquisition can hide their current dilemma, then maybe make the bad acquisition.

Outside Looking In

I found myself arguing an extremely silly point with an agency owner at a conference.  Everyone but the agent saw the silliness of his argument.  I explained the point every way imaginable, to no avail.  I could see from the looks on others’ faces, they were tiring of him not getting the point either.  If he had been one of the audience members watching someone else argue, he probably would have seen the errors in his thinking, too.  But, sometimes you just have to be outside looking in to see a point.

As a consultant, I very often find myself facing this type of situation.  The four points below are the most common positions held by agency owners that create immovable and serious roadblocks to their agencies’ success.  If any of these sound familiar to you, take a step outside of the situation and look back in.  You might see your position in a different light.

1.  We must write small accounts because you never know which one will turn into a large account. This commonly expressed position presumes an inability to identify clients with great potential versus those with no potential.  This means agencies believing in this philosophy should write absolutely as many small accounts as possible. 

An average agency abiding by this philosophy has at least 1,000 small accounts and maybe one, over 10 years has grown big.  But let’s say there are two accounts that grow big.  So out of 10,000 renewals, two get big.  Can the agency write enough large accounts to cover the 1,000+ small accounts that soak up huge amounts of time, effort and expense?  If so, this may be a great strategy.  If not, it is time to rethink the agency’s strategy.

2.  We do not use coverage checklists because we might leave something off.  The belief here is that if you don’t have a list, you can’t leave coverages off.  This presumes nothing is left off when a checklist is not used.  So if an insured does not get the correct coverage because the producer does not use a list and the absence of a list means the coverage wasn’t necessary to offer, then by default, the customer could not have needed the coverage and therefore, the uncovered claim is just a figment of their imagination.  Right?  If you believe this, then keep on going without using coverage checklists.

Another perspective is that if the agent does not use a coverage checklist, there is no need to recommend coverages a customer needs.  In other words, if I don’t know the customer needs a coverage, I don’t have a responsibility to offer the coverage.  For a peddler of insurance, this makes perfect sense because peddlers only take orders.  Why pay commissions to peddlers?  Web sites are quite capable of taking orders and issuing policies.

3.  We do not need to hold our producers accountable.  The reasons given for not holding producers accountable are numerous and include that accountability might make them angry.  What is the price of an angry producer?  In some cases, say $500,000 commission producers, not making them angry might be a good strategy.  But is the price reasonable for not making $100,000 producers angry?  An incompetent producer may leave the agency or become a good producer through accountability.  Either way, the agency may find itself way ahead by enforcing accountability.

Other common reasons given are that they are nice guys and that they have never been held accountable so it is unfair to do so now.  That is fair enough.  But to be really fair, if the producers are not held accountable, why hold anyone accountable?  Why hold the customer service representatives (CSRs) accountable?  Why hold new producers accountable?

Another reason given is that by holding them accountable, the ultimate outcome is that they would be fired and the emotional trauma of firing a producer is too much.  That makes sense.  Of course, if you are not going to fire a producer, how can you fire a CSR?  Is their trauma any less?

Then there are the producers that should hold themselves accountable negating the need for management to do so.  How well is that working in your agency?

4.  All agencies have the same value as a multiple of sales or EBITDA.  I am often asked, “How much are agencies worth today?”  This presumes that all agencies are alike, all agencies are commodities and nothing is special about any agency.  Is this correct?  Is there nothing special about your agency?

Let’s assume some common multiple applied to all agencies.  If one agency is losing 10 percent of its commissions annually and another agency is growing by 10 percent, then they should have the same multiple.  The same goes for the agency that has a 25 percent profit margin versus the agency that has a -5 percent profit margin.  Even the agency that has $1,000,000 of extra cash on its balance sheet versus the agency that has spent $500,000 of trust monies will have the same value. 

The question presupposes such material differences do not exist.  It’s like someone is asking, “What’s the value of a 2005 Ford F-150?”  They expect I can look up the blue book, ask how many miles the agency has on it, the condition of the body, and whether it has any extra features.

Quite often, the agency owners who ask this question have problematic agencies and the reason they ask the question this way is because they do not want their problems taken into consideration in the valuation. 

I do not believe any reader likes the logical result of these incredibly common beliefs and practices.  I’m not going to argue these ideas are wrong.  If you share these beliefs, take a step outside and look back in.  Think through the complete concept and if you still believe in it, then go for it 100 percent!

The Adversity of a Desperate Market

In almost 25 years in this industry, I have never seen such desperation. One of the unfortunate results is that many good agencies that have worked hard, done things well, and are not grasping at straws, are still at a competitive disadvantage. It is much like the situation faced by the most responsible citizens bailing out the most irresponsible or incompetent (take your pick) individuals and companies.

The categories in which this is occurring are widespread. Here are some important examples:

1. Certificates of Insurance. The changes to certificates have caused widespread carnage, frustration, anger, and virtually every other negative emotion imaginable. One item that is not being discussed much publicly is the difference between agencies following the rules versus agencies that are not following the rules. In particular, the question is whether to issue certificates that violate contracts, copyrights, and regulations. There is no question some agencies are doing so knowingly or, if ignorant, they are living in a deep, dark hole.

Neither companies nor associations nor many regulators (the Wisconsin Department of Insurance is a notable exception and there may be others of which I am not aware) have done much to correct the abusers. The result is that sometimes the agency willing to violate the rules, contracts, and copyrights make sales they would not otherwise make. By being silent on this issue, companies, associations, and some regulators are assisting the irresponsible — and the responsible are paying the price.

2. Premiums payable. An even more verboten subject is whether all companies and brokers are truly requiring all agencies to pay premiums on time. My theory, based on my experience, is they are not. I understand that many companies are so desperate to hang onto whatever premium they can that they would prefer to work this out rather than lose their premiums. But the best agencies lose as a result because this amounts to a handout.

3. Giving away free services. The debate that is occurring between agencies and brokers and even among regulators on whether it is ethical for agencies to give away free services such as loss control in order to get accounts is eye-opening.

The average agency makes zero dollars of profit on a commission basis per the last Growth and Performance Standards (GPS) study by the National Alliance Research Academy. So how do these firms plan on increasing their costs without going broke? Free services require significantly good management and good cost accounting methodology, which are severely lacking in most agencies and even large and supposedly sophisticated brokerages. I suspect many of these accounts will cost the agency much more than it makes — either that or the free services being offered are not that real.

More than one agency/brokerage advertises services they don't deliver. Sometimes they don't deliver because they don't actually offer the service. Sometimes they have the service but the producers won't deliver it because the producers have to pay for it through a lesser commission.

On the other hand, the desperation of this market has clearly changed buyers' perspectives of what they are buying. They understand better now that the insurance policy is only one aspect of their purchase. So moving forward, it is no longer an issue of whether these services need to be offered to adequately complex commercial accounts. Burying your head in the sand while thinking important clients will never demand these services is pure denial of reality. The real issue is what price an agency will charge for these services.

4. Companies buying into agencies. Companies cannot figure out how to grow themselves, but they are convinced they can grow agencies so their strategy is to buy into agencies. Insurance companies may not be able to grow, but they have a lot of excess cash and are desperate to invest that cash, just like they are desperate to grow. It is too early to know, but the question worth asking is whether an agency owned wholly or even partially by a carrier will treat all carriers equally? Will they treat other agencies equally?

5. Rising rates in a poor economy. Most people in this industry have never experienced a hard market in a poor economy. Customers will shop harder than ever when rates rise. They will be susceptible to promises that they don't need limits and coverages. They'll be susceptible to buying insurance from poorly rated carriers and ignorant agents. The question is, what are you doing to protect yourself and your agency when the market turns hard in a poor economy?