Building Equity Value

The hard market may be here

Enjoy it, but don't count on it

By Craig Niess

We are starting to see signs of increased commercial lines renewal rates. In the third quarter of 2011, rates for major commercial lines renewals increased across the board for the first time since 2003—the end of the last hard market. (See chart on page xx.) In addition to the increased rates on renewals, we are seeing a shift in some key underlying market fundamentals, indicating that a hardening of the market is likely.

Underwriting losses continue to mount and will approach $25 billion when 2011 figures are finalized. The 2011 commercial lines underwriting performance will be the worst since 2002. Workers compensation underwriting results will be the worst they have been since 2000. Surplus capacity continues to deteriorate, and hard markets historically have followed periods where surplus growth declined.

It is important to note that hard market cycles are not only few and far between, but short-lived as well. In the past 40 years, we have witnessed only three hard market cycles: 1975-1978, 1984-1987, and 2000-2003. During these hard market cycles, many agencies rode the easy money wave, as rates, revenues and agency values increased despite the fact that most agencies operated with a "business as usual" mentality.

­­­­­­The following sections highlight some of the actions successful agencies have taken to drive growth and value instead of waiting for the market to do the work for them.

Contingent income. Many agencies have come to rely on contingent payments to bolster earnings and increase owner compensation, while at the same time insulating them from the unpredictability of premium rate changes in the market. For agencies in our PHP group, contingents account for an average of between 7% and 9% of gross revenues, depending on the size of the agency. This represents a substantial portion of top-line revenues, and they can be integral in supporting pre-tax profits and owners' compensation.

A reduction or elimination of contingent income would have a profound personal impact on the average agency owner and in some cases deliver a crushing blow to the agency's balance sheet. The less you rely on contingents to make your agency profitable, the better. Contingents should be viewed much like the hard market—enjoy them, but don't rely on them. The best agencies do not need contingents to be profitable, but rather view them for what they are—bonuses.

Agency reinvestment. Whether or not the market hardens, the best-run agencies continually reinvest in their personnel and systems. This is certainly easier to accomplish during hard market cycles, where cash is accrued more easily, but given the scarcity and brevity of hard market cycles, the business plan should consider reinvestment no matter how the market is performing.

The best-run agencies budget for new employee hires. A useful rule of thumb dictates that agencies budget 3% of EBITDA (earnings before interest, taxes, depreciation and amortization) for hiring the next generation of employees. A continual focus on hiring, training and retaining quality employees will go a long way to ensure that all options are on the table when the organization considers perpetuation of agency ownership.

Watch retention carefully. Account retention is the foundation for strong revenue growth. And in a hard market, retention can be more difficult as clients experience rate increases or outright cancellations. These kinds of market disruptions are not always typical of hard markets, but as many of us know to our chagrin, they have occurred and are usually on a line-by-line and class-by-class basis. It is imperative that you watch the market carefully to determine if any of your accounts could be affected by severe market dislocations and plan accordingly. Warn clients well in advance of the possibility of rate increases and let them know that you are looking for other markets for their business.

Don't forget, your top clients are your competitors' top prospects. You cannot afford to lose these accounts by taking the relationships for granted, especially when those accounts are experiencing the stress of a hard market. The best performing agencies are using the following tools to measure and protect their retention rates.

Service timelines and stewardship reporting—In an effort to reduce the risk of losing larger, more sophisticated accounts, high-performing agencies have implemented value-added service timelines and corresponding stewardship reports. This helps to:

1. Differentiate the agency and institutionalize the delivery of value-added services

2. Formalize the agency-insured relationship with tangible services

3. Provide fee-based services to protect revenue in soft market cycles

Book segmentation—By determining who are the best and most profitable clients, the agency can deliver a higher level of services to them, instead of providing deluxe services to all customers, carte blanche, and rendering some of those accounts unprofitable.

Organic growth. Although critical, a focus on retention alone will not ensure agency viability. New business production remains paramount. The core difference between average and high-growth agencies is not in retention rates (which remain pretty consistent) but in the fact that high-growth agencies write twice as much annual new business.

High-growth agencies understand that external market conditions are beyond their direct control, and that the best way to outpace stagnant economic conditions is to proactively and continually tune the new business production engine. This engine will enable the agency to prosper under any market conditions, and hardening rates will have a multiplier effect as both sales and rates climb in tandem. One of the most effective ways to drive organic growth is to bring sales management discipline to the organization.

It is incumbent upon executives to instill a culture that focuses on new sales. They must give their associates the right organizational policies, practices and tools to promote sales team success. High-growth agencies focus on three key areas that lead to organic growth success: planning, infrastructure and hiring.

Conclusion

Although we don't know for certain if a hard market is upon us, we do know that the best agencies will not rely on external forces to control their destiny. Through diligent planning and execution, the best agencies will maintain profitability regardless of the size of contingents, reinvest in the people and systems necessary to promote growth, increase their retention rates, and focus on external growth to drive their agency to a future of prosperity.

The author

Craig Niess is a consultant at Marsh, Berry & Company. He can be reached at (440) 392-6584 or at craig@marshberry.com