AGENCY FINANCIAL MANAGEMENT
Don't let the true financial picture be obscured by rate increases
By Paul J. Di Stefano, CPA, CPCU, and Thomas Pepe
The questions which have been most often asked in the last few months are: Will the hard market continue and for how long? Fortunately, insurance is one of the few industries in the United States that still has pricing power. At this point in the P-C cycle, it is not irrational to speculate that the hard market will soften, possibly much sooner than many would expect or like. This may sound overly negative but in fact may be a realistic scenario, although no one really knows. We can all speculate about under-reserving for losses or losses sustained by the reinsurance market, but as we all know, the insurance marketplace has its own dynamics.
Some agency principals seem to remain positive in the near term while being more cautious in the longer term, while others are operating in a fashion that would lead one to believe that the party will never end. In light of the uncertainty, how can agency principals effectively plan and budget?
A good starting point is to look at how the national brokers approach this issue. They put prospective pricing issues in proper perspective when budgeting and planning, believing philosophically that pricing should not be confused with the true organic real growth of an agency.
It can be very misleading for agency principals to look at monthly agency profit and loss statements and simplistically come to the conclusion that, "This is great. Our numbers are up substantially from last year" and make strategic decisions accordingly. For instance, renewal premiums could be up substantially while the agency's core book of business is shrinking, and what then happens if prices soften to the year 2000 level? The issue at hand is how to effectively analyze what is actually happening and effectively budget and plan.
The sales planning process should begin with the agency's producers, who should provide a detailed sales plan for the upcoming year. By making the producers an integral part of this process, the agency gets the producers committed to what they are going to do the following year. This plan should be done by month so that you can monitor it and provide the proper guidance to the producer. Projected price increases and decreases should not be taken into account during this stage of the planning process in order to focus on new business production.
Production plans should highlight targeted consumer markets and identify the carriers willing to write the related type of risks. Producers should submit a monthly prospect report, which should detail their activity in the prior month. This report is very important since it can be used as an additional monitoring device. It should be cumulative for the whole year so that the producer's closing rate can be computed directly from the report.
The agency's financial manager should provide agency principals with a report comparing the plan to actual results by producer. The financial process begins with the agency's monthly P&L. The financial statements summarize the actual revenues and expenses but unfortunately do not give agency principals sufficient details regarding revenues other than a breakdown between contingencies, interest income and commissions.
The following analysis of commission income should be an integral part of your management reports. Agency principals should not consider management reports complete without this detail. The following representative reconciliation is based on a calendar first quarter.
Commission revenues @ 1/1/03 $2,000,000
New business 1/1/-3/31/03 100,000
Lost business 1/1-3/31/03 (50,000)
Price increases (decreases) 1/1/-3/31/03 300,000
Commission revenues @ 3/31/03 $2,350,000
The above reconciliation shows the agency principal what is really occurring in the agency with regard to new business. In this case pricing increases are hiding production weakness.
Most agency principals receive a monthly report showing revenues by producer or line of business (i.e., the breakdown between personal and commercial lines). Unfortunately, this type of report could be very misleading in a hard market.
In fact, to get a good reality check, have the agency's income statement prepared on the following basis:
Net revenues
Less: salaries & benefits
Less: operating expenses
Net profit (loss) before price increases (decreases)
Price increases (decreases)
Net profit (loss)
A case in point is a recent transaction in which Harbor Capital Advisors represented the seller. The agency had been growing annually by 30% in 2001 and 2002. The transaction structure contained an earn-out for our client for approximately one third of the purchase price. The biggest question which the selling principals had to address was whether they could realize the entire earn-out. After expressing much confidence, the seller became concerned about the future. The way in which the issue was resolved was by going through a similar analytical process.
The agency's financial manager should play a key role in the analysis process. In summary, the bottom-up approach to planning or evaluating an offer to sell that contains a contingent component is critical if one expects to make an objecting assessment. We have, however, observed many cases where agency principals are not aware of how these reports can be generated. Having performed this analysis for many clients, we at Harbor Capital Advisors can assure you that it can easily be done.
The authors
Paul J. Di Stefano, CPA, CPCU, is the managing director of Harbor Capital Advisors, Inc., a New York-based national financial and management consulting firm which offers services to the insurance industry. Services include agency appraisals, merger and acquisition representation, strategic and management consulting.
Thomas Pepe is an associate director for Harbor Capital and was previously president of A.J. Gallagher of New Jersey. Tom was a partner at the time of the sale of his agency to A.J. Gallagher and spent six years with A.J. Gallagher. Harbor Capital Advisors, Inc., can be reached at (800) 858-2732. Its Web site is www.harborcapitaladvisors.com.