The Cluster Option: A Short Survival Guide

It’s back! The soft market for commercial lines is hitting much of the nation. Personal lines markets are getting tougher on underwriting in certain parts of the country and some even are withdrawing altogether. Of course there is the perpetual demand from the companies for higher volume. Legislative actions to reform health care, workers’ compensation and auto insurance are always on the agenda. Profit margins are dropping.

The average agent or broker may feel that they are a mere cork bobbing on the ocean. Running an agency is tough! If a firm is not growing it will soon disappear. Many agents need to consider some action in order to survive.

The first step needs to be to work on internal growth. This usually begins with hiring new producers. However, finding a good producer is difficult and hiring a bad producer is costly. But even if a firm has the sales staff it might not have the most competitive markets, or clout with its existing markets.

The next step is to look for external solutions. Two options are to sell the agency or merge with another. Both these option will require the loss of a lot of independence. An owner might not be ready to sell or to have a few other business partners.

If an owner would like to remain in the business for several more years and enjoys being on their own, then there is another option to explore. Many firms find it useful to form an association or cluster with other agencies.

In these turbulent times, many agents are not sure what is the best solution to their woes. There are clear differences between merging versus clustering, versus acquiring. There is no one correct answer–each situation will have its own proper course. It is important, however, to be well informed about all the options that are out there.

What is a cluster?
A cluster is a group of agents and brokers forming a joint venture or association to market and place their individual books of business as part of a larger book. The objectives in forming clusters include:

While achieving one or more of these objectives, each cluster member can maintain independent ownership of their accounts or agency. Clusters can take many forms depending on the needs of the members and limited only by creativity. They range from all cluster members housed in one office and the members share the staff, to each cluster member maintaining their own office and staff. For smaller agents, the advantage of clustering can be summarized in one word–survival.

Pros and cons of clusters
One major concern with clusters or associations is the lack of commitment. The clustering versus merger option can be compared to living together versus marriage: you are partners, but there is no real commitment.

When a cluster member leaves with their book of business, a void is created with markets, shared expenses or shared personnel. This could be fatal to a small cluster. It is important that all members share a common vision for the cluster and are willing to put in the time to make it succeed. The proper screening of members and creative cluster contracts can mitigate problems of uncooperative members or prevent members from leaving. Ideally, cluster members should have the same approach to underwriting a risk.

A cluster is typically managed by a committee of owners. Each owner has his or her own ideas–often rigid ones–established from having been a sole owner for many years. Cluster members need to operate as a team with a few leaders in order to be successful. Unless each participant is a good team player or is willing to place the ultimate executive authority with a few individuals, there can be an inability to develop basic functional goals and implement decisions.

Accounting can be handled two main ways–centralized or local. At a minimum the commissions from the companies should go through a centralized accounting system. If the local accounting approach is used then the commissions by each agency will be the primary expense categories. For a centralized accounting system detailed expenses for each agency are paid out of the common accounting system.

A cluster may not be able to obtain the extra influence with carriers unless one or more of its participants already have an existing preferred relationship. An insurance company will have to approve of each participating firm in the cluster before agreeing to establish a relationship with and a new contract in the name of the cluster. Often, those firms desiring to cluster have small books of business, existing placement problems or loss ratio issues with key markets.

Insurance companies are, naturally, aware of this threat of adverse selection. Most insurance companies would rather deal with merged organizations versus cluster groups. There is very little upside for companies to deal with a cluster rather than each individual agency. Clusters need to work with the companies while in the formation stage and share the cluster business plan and member screening process. Open communication between the cluster and the companies is imperative.

Sometimes a cluster can be used as a prelude to a future merger. It is a good idea because it will allow the two firms to get to know each other before a formal joining of forces. If it does not work out, the separation will not be as traumatic because a cluster is easier to dissolve than a merged entity. For some owners, however, the initial commitment is important, so this two step approach may not be desired.

For those owners that are fiercely independent, even clustering will not sit well. Small firms with market access problems can still tap some of the regional or national aggregators. These are businesses that are essentially general agencies that allow firms to access most of the key markets. An agency that sells non-standard business can easily place business with a preferred market–albeit at a significant cut in commissions. Firms that choose this route can be independent without having to be part of a cluster.

A final thought
Associations or clusters, when properly organized are a good option. The dilemma is that many are not properly organized because of some of the reasons already discussed. Since clusters often fail to fulfill the expectations of owners, it may be recommended that firms consider eventually merging as the alternative to a continuous cluster. When properly structured, a merger will bring in more long-term benefits than clustering.

The distribution system for insurance is constantly evolving because of events outside of the control of the agency owner. Many agencies will need to consider restructuring the way they do business in order to survive. Whether an owner decides to merge, join a cluster or acquire, all alternatives and issues should be carefully evaluated.

Catherine Oak and Bill Schoeffler are partners in the consulting firm Oak & Associates.