Tag Archives: insurance agency

Dinner With Warren Buffett (Part 2)

If you read our most recent article, “Dinner With Warren Buffett,” you’ll already know that I’ve truly earned the title “insurance nerd” after dreaming about hours-long insurance conversations. After I woke up, we started this series to share Warren Buffett’s insurance industry wisdom from his annual letters to shareholders. Last week, we talked about the fundamentals; today, we’re going to share three challenges of the industry and two of its strengths.

Challenges of the Insurance Industry

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1. Dismal Economics:

In the 1987 letter, Buffett explains that the insurance industry is “cursed” with “dismal economic characteristics” because there are hundreds of competitors, easy entry and a product that cannot be properly differentiated for a durable competitive advantage. This makes personal lines insurance a “commodity-like” business where, in his opinion, only a company that enjoys a cost advantage or one that operates in a very small niche can sustain high profitability levels in the long term.

He goes on to explain that Berkshire’s differentiator is its ability to be the low-cost provider in personal lines through Geico and its financial strength for large specialized commercial lines and reinsurance. Competing on cost is always challenging in our industry, and maintaining financial strength in a turbulent world is also a feat not to be taken lightly.

We think it’s funny that he talks about dismal economics when he has made most of his billions in our beloved industry, and he’s very clear in the letters that Berkshire will always be heavily invested in insurance. However, we love insurance not because it’s a great investment but rather because it’s a great place to work, one that’s interesting and rewarding and one where we are being a positive influence in the world. In that sense, we are very different from Uncle Warren, who sees insurance simply as an investment vehicle. If you see it only as a financial investment, some of its characteristics would make it tough.

2. Commoditization of the product can lead to poor returns:

“Insurers have generally earned poor returns for a single reason: They sell a commodity-like product. Policy forms are standard, and the product is available from many suppliers, some of whom are mutual companies (‘owned’ by their policyholders rather than stockholders) with profit goals that are limited. Moreover, most insureds don’t care from whom they buy. Customers by the millions say, ‘I need some Gillette blades’ or ‘I’ll have a Coke,’ but we wait in vain for ‘I’d like a National Indemnity policy, please.’ Consequently, price competition in insurance is usually fierce.” — 2004 letter, page 5.

We’ve written about the commoditization of insurance before. Personal lines insurers are particularly aware of the struggles in that arena. Agents fight against it, regularly, and some companies are actively innovating to move away from this strategy. Some of the bigger companies add features to their policies that they hope others will be slow to follow, and newer companies, like MetroMile, aim to change the industry, but ultimately policies and endorsements must be filed and thus can be copied by competitors. Ironically, Buffett’s own billions in advertising spending for Geico, almost exclusively focused on price, have done more to commoditize our industry in the eyes of the customer than anything else in its ingrained characteristics.

3. Maintaining underwriting discipline at the expense of growth is a challenge unique to the insurance industry:

“Most American businesses harbor an ‘institutional imperative’ that rejects extended decreases in volume. What CEO wants to report to his shareholders that not only did business contract this year but that it will continue to drop? In insurance, the urge to keep writing business is also intensified because the consequences of foolishly priced policies may not become apparent for some time. If an insurer is optimistic in its reserving, reported earnings will be overstated, and years may pass before true loss costs are revealed. […] Finally, there is a fear factor at work, in that a shrinking business usually leads to layoffs. To avoid pink slips, employees will rationalize inadequate pricing, telling themselves the poorly priced business must be tolerated in order to keep the organization intact and the distribution system happy. […] [Underwriting] is not labor-intensive, and… we can live with excess overhead. We can’t live, however, with underpriced business and breakdown in underwriting discipline that accompanies it.” — 2004 letter, page 5-7.

Stock companies, particularly, will have challenges in maintaining underwriting discipline. If certain markets cannot show growth because of underwriting or capacity restraints, it requires that a clear picture be painted for stockholders to justify why the company has exercised this restraint. In addition, companies should be wary of laying off employees because of a temporary downturn.

We think this one long paragraph really captures the spirit of the insurance industry and the innate contradictions of always pursuing growth. Uncle Warren’s professed philosophy for the Berkshire companies is to only write business that is expected to be profitable and to always be willing to stand by and accept premium declines if the market is soft and proper rates can’t be secured. We love that he professes to be willing to carry excess staff during quiet times, instead of endless waves of rightsizing and rehiring, and we think all insurance companies should consider similar policies.

Advantages of the Insurance Industry

1. Profits can be outstanding if you manage your business well.

“It is not easy to buy a good insurance business, but our experience has been that it is easier to buy one than create one. However, we will continue to try both approaches since the rewards for success in this field can be exceptional.” — 1978 letter, page 5.

Whether one buys or creates an agency or a carrier, managing the insurance portfolio well will typically lead to high payouts. The business also has the opportunity to truly provide for its customers, and it is very rewarding beyond the financial aspect at that time of need. On the carrier side, where Buffett focuses, ultimately it comes down to float: Premiums are received up front, and losses aren’t paid until later, sometimes much later, allowing him to invest and multiply those funds.

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2. You will never be bored.

“You can get a lot of surprises in insurance.” — 1978 letter, page 6.

Finally, the element of surprise in insurance is exciting! Most people think of it as a boring, unchanging industry. But, particularly now, the industry is ripe for disruption. Beyond that, if you work for a carrier, you never know what your agents will call you with, and if you’re an agent or service representative, you never know what your customer will call you for. We are learning something every day and know that we will to do so throughout our careers! It is one of the best aspects of the profession.

Digital Is Not Enough; Nor Is Paperless

The service of risk management within insurance companies needs to innovate. Today, a small fraction of commercial customers take advantage of risk management services provided by insurance agencies. And insurance companies are fine with this, as they have limited supply — or people — that can provide risk management services.

But what if the same high level of risk management services could be offered to all customers of an insurance company?

How would an insurance company go about offering widespread, and high-quality, risk management services?

The Solution to Better Risk Management Is Your People (Plus Technology)

Insurance agencies currently engaged in risk management services have a distinct advantage: the accumulated knowledge of its people that provide contract reviews for customers.

I had this epiphany as I was reading through a slidedeck titled “Innovation is almost impossible for older companies,” which states:

“People have acquired skills that, at moments, have given significant advantages to companies in order to prosper.”

Insurance agencies now must figure out how to harness the risk management skills of its people in new ways. The alternative is scary for my insurance professional friends, because someone else — someone with new technology and a new supply of risk management knowledge — will figure it out instead. Insurance companies could quickly be out-innovated, as occurred to the taxi industry.

For some time, the taxi industry had skills that allowed it to prosper. Taxi companies used technology and money to set up phone numbers that could be called to request a ride; these companies also stockpiled just enough cars and drivers to meet the minimum level of demand. But then Uber came along and created a better technology that connected riders to a different (and bigger) pool of drivers. The taxi industry got out-innovated.

Insurance agencies are composed of people who have acquired risk management skills. My friends in the industry can review contracts with the best of them. But each of them has a limited capacity to complete contract reviews based on hours in the day. So not all customers get risk management services (either because they don’t know about them or don’t want to pay for them).

A technology will come along that will expand the supply of risk management services. One insurance consultant thinks that technology will be a computer avatar that analyzes and predicts risks independently.

I think the idea of an independently functioning risk management avatar is misguided. I am reminded of a quote from Zero to One, written by the founder of Paypal, Peter Thiel:

“Better technology in law, medicine and education won’t replace professionals; it will allow them to do even more.”

Better Technology Will Allow Insurance Professionals to Do More

I continue to be drawn to the word “collaboration” as I envision the future of insurance technology. Recently, I spent time evaluating software solutions in the insurance industry. All of the solutions I reviewed are focused on step one, what I call “Make it Digital.” Only within the last five to 10 years have insurance carriers and agencies gone paperless, and the insurance software companies are filling this need.

Digital is not enough. Paperless is not enough. Insurance technology must connect people and the knowledge that they create. Don’t think about just connecting to your customers. Think about connecting your team.

Imagine if your entire risk management team could work as a living, breathing entity to assess and evaluate risk. When Agent Jim in Kansas City has a question about liquidated damages in Texas, he should be able to quickly identify work completed by Agent Bob in Dallas dealing with this exact issue. He can then evaluate the work and bring Bob in on any follow-up questions.

I have yet to find an insurance carrier or agency that has figured this out.

This is where the opportunity lies in insurance technology: collaboration.

Should You Sell the Business — or Not?

If you’re thinking about selling your business, try not to make it a hasty decision. Take a step back and consider all of your options. Details like, if you should sell, if you should sell right now and what you need to consider before selling are just a few of the considerations to make before reaching a final decision.

So, is it time to sell your business? Here are some of those important questions to ask yourself to help figure out:

Is my business ready to sell?

Most businesses need at least two years of preparation before being listed on the market. This is to make sure your books are in order, tax returns are organized and the company is presented in its best condition to potential buyers. Trying to do these things in the month before you sell could reduce the selling price of your company or compromise the sale altogether.

How much is my business worth?

Many business owners wait too long before deciding to sell. Businesses should be sold before their technologies are outdated or they suffer a decrease in sales. It’s important to sell while operations are still strong, to get the best valuation.

What are the current market conditions?

Before deciding to sell, take a look at the market conditions for your industry. You may want to sell immediately, or you may wait out what you hope is a dip in the market so you can get a higher return a few years down the road. In 2006, for example, a carpentry company would have sold for three to four times as much as it would have after the financial crisis. Sometimes, even if your business is prepared for sale and with a good valuation, market conditions force you to rethink your plans.

Can I cope with the changes?

As a business owner, you have most likely poured yourself into your job. If you sell, are you personally prepared for the transition from business owner to the next opportunity on your horizon? This decision is primarily personal but is an important factor to consider in whether you should stay or go.

Am I willing to stay on if the buyer wants me to?

Sometimes, to ease the transition between owners, new buyers ask that the previous owners stay on in a consulting role for a predetermined amount of time, usually six months to a year. Having the prior owner stick around can help avoid any dips in business during the transition. For you, however, is it worth it? You should figure that out ahead of time so you don’t fold under pressure conditions when you just want to close the deal.

What are your deal breakers?

Would you consider alternatives to a cash sale? Who gets the rights of intellectual property created during your time at the company? Will the new owner keep your current employees? These are all questions to consider sooner rather than later so they can be resolved before you’re near a deal.

Ultimately, one of the best investments you can make when considering the sale of your business is to build a team of trusted advisers. Accountants, attorneys and insurance agents are just a few of the specialists who can be supremely helpful. These professionals have an understanding of each moving part and, more importantly, of how they all play together.

A successful exit or transition strategy takes preparation and a wealth of time. It involves taking inventory of all aspects of your business and personal life to form an integrated strategic plan.

After considering all of the questions, it’s time to come to a decision about whether the timing is right to maintain or sell your business. No matter what decision you come to, remember that preparation is the key to taking a successful step into the future.

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?