The last few years have been good ones for independent agencies, by and large. And for some, the financial and operating results have been truly outstanding. The outlook is still good for those that remember the fundamentals — localness, investment in people, customer focus, systematic selling, and capital improvement. But there are challenges ahead. And not very far ahead. In fact, you can already pick up the scent. The challenge I have in mind for this piece is the one to agency profit. But the sun is still shining — and that’s the time to fix the leaky roof. Some background points:
- Let’s remind ourselves that profit to a private business is the only source of permanent capital. Profitability is not just a “benchmark,” a way to keep score. It’s lifeblood. It is to your business what oxygen is to a runner. You can go anaerobically (sprinting) for only so long. Then you cramp up and fall. Long-distance runners need to be aerobic, taking in as much as they use. And growing businesses need to take in a little more than they use.
- In most businesses, a big portion of annual profit — say, half, to keep things simple — is already spoken for due to debt, taxes, and other commitments. So, losing only half your profit from this year to next could mean losing all your real margin. Beyond that, you start eating your seed corn; or, in the prior metaphor, running anaerobically.Profitability is not just a “benchmark,” a way to keep score. It’s lifeblood.
- Agency profit is in the interest of all stakeholders. This is not just a subject for owners. Now, here’s the impending challenge, as I see it. Some of it is obvious, but some is subtle. Price competition is under way in most lines of commercial p/c business, and the rate of increase in employee-benefits pricing seems to be abating. Moreover, since a lot of catch-up ball has already been played in homeowners and companies are competing for personal-auto premium, growth in these lines will probably be limited to “creep.” So, softening premiums implies softening commissions. That’s the obvious part. And hardly alarming.
The more-subtle part is the likely impact on operating profit. It’s subtle because we find that many agency owners don’t fully appreciate the concept of operating leverage. The fact is that the operations and infrastructure at most agencies have a life of their own. Expenses are not automatically responsive to revenue declines. Only commission-based sales compensation has a stabilizer built into it. That’s good, but it’s not enough.
Now add some human nature to the mix. Up through about the year 2000, expense disciplines at independent agencies were pretty good. In fact, they were too good. A dozen years of soft markets had not only held down operating expenses but curtailed all kinds of important investments. Well, nothing will free up discretionary spending like two or three years of good (in some cases, great) growth in revenue, profit, and agency value. Investments in people, infrastructure, and image have gotten under way at a lot of agencies, and rightly so. Thus, for many agencies, expenses are not only up but accelerating. I’ll use a math image — the curve is not only sloped upward, it has shifted upward at all points.
Now, add one more thing. Losses don’t really care about premiums. There are no automatic stabilizers here either. Thus, contingent commissions are vulnerable right when agencies might need them most. There is a lag here admittedly, but not a very long one.
This is not a time to overreact or underreact. The sky is not falling. But the math may be harsher than it first appears, and it’s all related to leverage. In the same way that the decline in the equity value of a leveraged asset is proportionately greater than the fall in its total value, the decline in profit in coming years may be proportionately much greater than the decline, or even the slowing rise, in revenue. Seemingly moderate negative developments in revenue from one year to the next can easily eliminate half the previous year’s profit — and half is all you’ve got because the other half is committed.
This is not the time to abandon your investment in good people and other key resources. But it is the time to deal with unproductive parts of your business — people, departments, and, perish the thought, customers.
The roof is leaking a little for most of you. Fix it now. Don’t find yourself up there in the rain. The glue doesn’t take very well, and it makes you look bad.
News About Our Team
Many of you have worked with Everett, who has been with us for almost three years. What you may not know is that he has been pursuing his business-valuation certification by the American Society of Appraisers. Clearly, the designations by the ASA are the most rigorous and prestigious in the field of private-company valuation. You don’t have to be licensed to practice in the business-valuation field, but we believe strongly in the merit of professional certification. Everett has a few more steps to go in the process, but we just received word that he has successfully completed the last in a series of examinations. Doing so in conjunction with a more than full-time work schedule is an admirable achievement.
As you prepare for next year, we want you to be aware that BHBCo has an additional consulting resource to offer you — Dominic Setaro. Dom joined us earlier this year, after having served for several years as the controller of The Daniels Agency in Pawling, New York, which included The Settle Agency of Danbury, Connecticut. Daniels merged last year with another client of ours, Rose and Kiernan of Albany, New York. Dom worked extensively on that merger as part of his responsibilities as the Daniels controller, and he assisted the newly formed firm after the merger. You can be sure that the principals of both those agencies would speak highly of Dom’s work and his professionalism. Prior to his work in the insurance world, Dom was director of accounting and related services for a major Connecticut municipality. Most of his work inside BHBCo to date has been helping with the financial analysis connected with our valuation and M&A assignments, but he is available to help our clients directly as well, both on-site and from our office. The Daniels Agency was an AMS user, and Rose and Kiernan is an Applied user, so Dom has had good exposure to both and great experience with AMS. So, if you have projects/problems in the area that I would generally call “financial administration” and you think Dom might help, tell us about those needs and we will get a proposal out to you. I am confident that Dom will help you get to a solution that is effective and economical. Dom is experienced, smart, industrious, resourceful, and a pleasure to work with. What’s not to like?
Burke Ink, October 2005