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Agency Financial Management Dealing with market risk Carrier issues affect valuation By Paul J. Di Stefano, CPA,CPCU The stability of independent agencies is influenced by a variety of factors, and this reality underlines the need for careful strategic planning as well as ongoing monitoring of agency performance. To a great extent, agency performance is a function of the marketplace, and a critical factor is having ongoing access to carriers that are willing to write the agency’s business. When we think about carrier availability, we may focus on what happens in a soft market when some standard insurers write more exotic risks, only to withdraw from those classes when prices become inadequate to support the resulting loss experience. As the underwriting cycle turns, most of us have become familiar with this kind of roller coaster ride. In fact, however, carriers routinely exit standard lines of business, and they do so for a variety of reasons. Some agency principals believe that, just because a line of business has been profitable, the carrier will continue to write the line. Although this is not an unreasonable assumption, we all know that carriers may cut back on writing even profitable lines of business if their capital becomes impaired or they lose their reinsurance. Even more routinely, carriers cancel agents even when their business is profitable, if the volume of that business is too small to justify the cost of processing it. Finding a replacement market is difficult in the best of circumstances, and it is likely to be more difficult when an agency lacks a strategic plan, especially if no perpetuation plan is in place. The risk of losing a market is an inherent part of owning an agency, and one that the principals cannot completely control. Knowing where your agency stands with its markets, and having volume distributed appropriately among carriers, however, are ways to mitigate this risk. Unfortunately, we continue to see situations where agencies are forced to sell after they have lost one or more important markets. Under these circumstances, an agency risks losing leverage in sale negotiations. We have seen several cases recently where agencies heavily involved in program business have received notice of cancellation. One such agency had two carriers writing the business. One carrier canceled its agreement with the agency, and a year later the second carrier issued a provisional notice of cancellation. Only then did the agency principals became extremely concerned and give Harbor Capital the dual assignment of finding a replacement carrier as well as looking for a buyer for the agency. Fortunately, we were successful in accomplishing both objectives, but we do not recommend this “dodging the bullet” approach. When another client found himself in a similar situation, our immediate focus was on arranging a sale because this client was on a much tighter schedule with regard to issuing nonrenewal notices. Our goal was to open discussions with buyers that could move very quickly. Fortunately, our client had a profitable loss history and we were able to bring several buyers to the table with markets that could immediately underwrite the upcoming renewals. In a third case, a client was heavily dependent on one market for a large portion of its business. When this carrier’s rating was downgraded, our client was able to re-underwrite the business with other markets, but only at the cost of much time, effort and distraction. These examples underline the need to evaluate your agency’s position in the marketplace and to consider the impact on the agency’s valuation if market issues develop. Although most agencies will not experience a severe impact with the loss of one market, the loss unquestionably will have a measurable effect on valuation. In some situations, the way to address perceived market vulnerability may be to engage in an orderly process of seeking a sale or merger. In other cases, realistically assessing those vulnerabilities can lay the groundwork for actions that protect the agency from future dislocations. One such action would be reducing the concentration of business with any one market. The examples above show why principals should carefully assess their agency’s vulnerability to the loss of a market, or even the loss of a major client. In some cases we have seen, the agency’s largest client represents 20% to 40% of commission income. The loss of that client can have major consequences for an agency’s financial health. In the worst case, overnight all or most of the agency’s profit margin can be lost. Addressing vulnerabilities before they become major issues can preserve agency value by creating options and alternatives and, at a minimum, spread the risks associated with agency ownership. * The author |
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