By Jon Persky, Optimum Performance Solutions, LLC
P&C premiums are finally starting to increase, especially in commercial lines. But does this mean that the value of your insurance agency will increase? It depends on a number of factors.
Type of accounts
Let's assume you own an Agency with $1 million of commission income, that has an EBITDA (Earnings Before Interest, Taxes, Depreciation and Amortization) of $300,000 and that it has been valued by a qualified appraiser at $1.5 million (5 times EBITDA).
If rates increase by 5%, assuming 100% retention, your commissions are now $1,050,000. Most people would assume that since the agency was worth $1.5 million it should now increase in value by 5% to $1,575,000 ($1 million x 1.05%). But let's look at the numbers in more detail.
If the $50,000 increase was in personal lines and no commission is due a producer and no other expenses have been incurred, the EBITDA has increased to $350,000. At the same EBITDA multiplier of 5, the value of the agency has increased to $1,750,000.
On the other hand, assume the $50,000 increase in commissions is commercial lines and it is the agency's policy to pay producers 40% new and 30% renewal. A $50,000 increase in commissions will also result in an additional $15,000 due the producers on the accounts. This results in an increase in EBITDA of $35,000. So now you have an EBITDA of $335,000. Applying an EBITDA multiplier of 5 results in a value of $1,675,000.
Another critical issue is retention. If rates are increasing, it is reasonable to assume that your customers may be more active in shopping their business. It this occurs and the agency's retention rate decreases, it will have a mitigating effect on the increase in EBITDA. Failure to maintain the same retention rate will reduce the increase in agency value.
Interest rates are another factor impacting agency value. Interest rates are at historic lows and can't go anywhere but up. When they do go up, buyers will demand a greater return on their investment, which will mitigate increases in agency value.
An agency with a book of business but with an inactive sales force is nothing but a wasting asset. Rates may go up, but the failure to produce new business can result in a decrease in net commissions, depending on the retention rate. Most buyers of agencies want to purchase an agency with a strong new business production history.
If the economy improves dramatically, most agencies should see an increase in commissions, which will result in increased agency value. However, if the economy continues to limp along or falls back into a recession, clients could go out of business or push them to reduce coverage, change limits, etc., all which could result in a drop in commissions. While a rate increase could help mitigate this decrease, the net result could be lower premiums, lower commission, and a lower value for the agency.
Agencies For Sale
Don't assume that all tides lift all boats equally. If agency values increase as a result of rate increase, it may motivate better agencies to consider selling. This results in an increasing supply. If you are one of these "better" agencies, that's great. But if you are an average to less than average agency, an increasing supply could actually reduce the number of interested, qualified buyers.
Even if your agency benefits by increasing rates, how much will end up in your pocket? The capital gains rate will increase from 15% to 20% on January 1, 2013 unless Congress changes the tax code. Additionally, effective January 1, 2013 there is an additional 3.8% tax on capital gains in excess of $250,000 for a married couple, $200,000 for an individual which is a result of additional taxes from the Obamacare legislation.
If you are debating whether to sell in 2012 vs. 2013, the change in the tax rates is significant. An agency must increase in value by roughly 12% if it is sold in 2013 for the seller to put the same amount in his pocket as he would if he sold in 2012. It's doubtful rates will increase that dramatically in such a short timeframe.