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Building Equity Value Analyzing agency profitability Using benchmarking as a tool to assess an agency's financial growth By Mike Kish Several factors in today’s insurance industry put unusual pressure on insurance agency owners and their employees. They also could produce staggering consequences to the industry as a whole. The aging workforce—As the first of the baby-boomer generation (generally considered to be those people born between 1946 and 1964) begin to hit age 60, retirement looms on the horizon for millions of business owners and employees. This demographic is very apparent in the insurance industry as the average age of agency owners continues to rise. Combine this with the fact that insurance agencies as a whole have done a poor job of attracting young talent and you have an industry-wide succession planning crisis. Soft P-C rate environment—With estimated net property/casualty written premium growth of 1.8% in 2005 (ISO) and industry analyst estimates for 2006 coming in around 3% to 4% on average, most insurance agencies across the country (excluding those with significant catastrophic exposures) cannot count on premium increases to fuel growth. The soft market is exposing the fact that agencies that fail to reinvest in their production staff and fail to put into place sales training, mentoring, processes and procedures, and a system of accountability will find themselves in trouble. These procedures are necessary for the creation of a consistent organic growth engine that will drive agency growth into the future. Agency consolidation— The table below illustrates the significant insurance agency consolidation in recent years, broken down by types of acquirers. More than 1,500 insurance agency transactions were announced during the seven-year period ending December 31, 2005. This consolidation has helped to create larger and larger insurance agencies with more clout and sophistication than ever before. As this activity continues, your agency will be facing tougher competition and you will have a harder time competing if you do not continue to grow in size and sophistication. Carrier tiering—Another factor that agencies have been dealing with is increased pressure from insurance companies for good business and more premium volume. This issue becomes increasingly apparent in a soft market. Many insurance companies price business at a loss in order to buy market share to take advantage of increased investment opportunities. Writing good business and increasing premium volume with your carriers will be critical to the long-term growth opportunities of each agency. Proactive planning and measurement Agency owners need to proactively plan for the future. One key element of business planning is performance measurement and benchmarking. This article will look at profitability measurement. There are many ways to measure your profitability performance, with the most obvious being the bottom-line profit margin of the agency. The problem with this is that many agencies intentionally try to reduce the bottom-line profit to reduce tax liability—or for other reasons. In order to estimate the bottom-line profit potential of your agency, you can either develop a pro forma income statement or use a ratio we call the reward ratio. A pro forma income statement involves making adjustments to your actual income statement to remove non-recurring items and discretionary expenses that are essentially excess owner return. Common adjustments include removing a large account lost, adjusting contingent income to a multiple-year average, adjusting owner compensation to market rate, and eliminating discretionary travel, entertainment, and automobile expenses. The goal of the pro forma income statement is to determine the profit or profit margin your agency could achieve if non-recurring and discretionary owner compensation and expenses were eliminated. This analysis is similar to what buyers would go through to determine the profit they could achieve post-closing on an agency acquisition in order to determine the price they can afford to pay for the agency.
The most common pro forma profit measurement utilized is earnings before interest, taxes, depreciation and amortization (EBITDA). The average pro forma EBITDA of insurance agencies that sold during 2005 ranged from 22.3% to 27.6%, depending on the type of buyer. While constructing a pro forma income statement is a great way to measure and benchmark the bottom-line profit potential of your agency, it can be a time-consuming process. The reward ratio (See Table #2) is a shortcut measurement that can be utilized to get a rough estimate of the profitability of your agency. The reward ratio is calculated as: pre-tax profit plus executive payroll plus production payroll divided by gross revenue. The reward ratio estimates for every dollar of revenue how much is available to be paid out to owners either through payroll or profit distribution. One flaw is that there is likely non-owner production payroll included in this ratio that is not truly available to be paid out to owners. In addition, there could be other discretionary expenses that are essentially owner return that are not being captured in this ratio. While it is not perfect, this ratio is simple to calculate and provides at least a good estimate of how profitable your agency is, and it can be easily benchmarked against your peers. The average reward ratio for top performers is around 0.55.
While understanding the profit potential of your agency is important, understanding your strengths and weaknesses in the various areas of revenue growth and expense management is even more critical. Having a good handle on your performance in these areas will allow you to determine what areas you need to focus on to continue to drive and increase your profitability over time. Listed below are several ratios that are good indicators of your performance in these areas. Total commission and fee growth rate—Being able to consistently increase your commission and fee income will be critical to maintaining strong relationships with your insurance carriers and give your agency a chance at internal perpetuation at a fair value. Table #3 illustrates the average total commission and fee growth rates and Best 25% average for various revenue ranges in 2005.
Contingent income—While contingent income has been unfairly demonized by certain regulators and even some insurance brokers, the reality is that contingent income represents a large percentage of the average agency’s profit. Measuring your agency’s receipt of contingent income as a percentage of total property/casualty commission income as compared to your peers can give you a good idea of how well you are being rewarded by your insurance companies for providing good underwriting results and premium growth. Table #4 reflects contingent income as a percentage of property/casualty commission income for the average agency and Best 25% for various revenue sizes in 2005.
Expense control Controlling payroll expenses is critical to increasing the profitability of your agency since total payroll typically accounts for between 45% and 60% of total revenue. Producer compensation—Bench-marking producer compensation as a percentage of commissions and fees is often difficult because agency owners are typically producers and are often paid in a different manner than the rest of the production staff. One simple way to benchmark producer compensation is to look at the new and renewal commission rates paid to your producers. The chart above displays the average new and renewal commission splits paid to commercial producers at various revenue ranges. The graph above indicates that on average, larger agencies have a greater disparity between the commission split they pay on new and renewal business. The fastest growing agencies also generally have a large spread between the percentage they pay producers on new and renewal business. Several other factors influence overall production payroll, such as the percentage of business handled by the service staff at no commis-sion, minimum account size thresholds, and whether or not the agency pays commission on personal lines business. Service staff compensation—A good way to measure and benchmark your service staff compensation is to measure your total service staff payroll as percentage of total commission and fee income and compare that with the results in Table #5 below.
Service payroll includes all per-sonnel directly engaged in the servicing of customers including service representatives, account handlers, underwriters, technical support personnel, raters, claims specialists and placers/marketers. Managers of service personnel are also included. It is important to keep in mind that you may have higher than average service payroll because you provide more value-added services than the average agency. For example, you may employ full-time loss control specialists, claims management specialists, and risk managers that the average agency your size does not. The key is to look at your producer compensation model in conjunction with your service payroll to see if you are controlling these expenses on a combined basis. Support staff compensation—Similar to service payroll, a good way to measure and benchmark your support staff compensation is to measure your total support staff payroll as a percentage of total commission and fee income and compare them to Table #6.
Support payroll includes staff members with managerial or administrative positions or duties (other than sales and service managers). This includes all full-time general managers, office managers, treasurers, controllers, bookkeepers, accountants, accounting clerks, data processors, word processors, mail clerks, secretaries or receptionists. Non-compensation costs—One way to measure and benchmark your performance in controlling non-compensation expenses is to look at your non-compensation costs (all pre-tax expenses except payroll and benefits) as a percentage of commission and fee income and compare the results to Table #7.
As the insurance industry becomes increasingly competitive, change is the only constant. It is more important than ever to proactively plan for the future of your agency and constantly benchmark your performance against your peers to see how you stack up. By understanding your profitability metrics and the drivers behind those numbers, you will be better prepared to maximize shareholder return, increase agency value, plan for perpetuation reinvestment, and ensure long-term sustainability. * The author |
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