Benchmarks and Value

Many of the benchmarks readers see in this industry have never been tested for validity. No one knows if the metrics matter.

Metrics should not be used if their value is untested. I see many insurance companies and insurance agencies make bad decisions resulting in damaging performance because leadership aspires to some metric they’ve been led to believe is important. The metric in some cases is useless and in others, the metric is inversely important in that by pursuing that metric, performance actually deteriorates.

Growth above a certain percentage is an excellent example of perverse metrics. A.M. Best annually publishes its impairment report, which shows excessive growth is a leading cause of carrier impairments. One might say premium growth is like medicine. The right amount is healthy and too much destroys.

Using growth as a metric then, the consultant or CFO preaching the value of growth should be saying something like (for example purposes only): “Our growth is 4% and we need to increase it to 6% because between 5% and 15% growth, value increases. However, we need to be careful not to exceed 15%. Carriers growing faster than 15% too often become financially impaired because organically growing surplus at 15%-plus annually is nearly impossible.” I’ve made up these numbers – I have not tested them – but this should give the reader an idea of how performance metrics should be stated and used. (In reality, growing organic surplus more than 15% annually is quite rare.)

A major weakness of agency performance metrics is that the data is collected by survey. The fact is, agency owners mispresent their numbers in those surveys. Not all of them do this and not all purposely misrepresent their data. But I’ve been analyzing agency financials, not survey data, for 30-plus years and most agencies’ data are materially lacking in quality. The survey data is even worse.

Another major weakness in most of these agency and carrier benchmarks is the use of averages. Averages have no value without testing the underlying data patterns. Averages are only applicable if the data pattern shows a normal curve (which you’ll find in testing peoples’ heights, for example). Normal curves rarely exist in performance-based environments. In performance-based environments, you typically find Pareto curves, colloquially known as the 80/20 rule. In this pattern, a few really good performers materially skew the average making the average fairly useless and often worse, completely misleading.

I’ve back-tested the most common benchmarking surveys and, in many categories, the averages are actually impossible to attain in the real world. This is because the wrong tool, the “average,” is being used.

One CEO recently said that because he didn’t understand statistics, he’ll continue to use averages even if it is wrong. Brilliant. That’s why he must be paid big bucks. Should you ignore the right medicine just because you don’t understand chemistry?

Relying on the wrong metrics is often more likely to damage than improve an agency or carrier. Ignorance of statistics is dangerous medicine.

What Does Matter? The Answer Varies.

To determine three key factors that affect insurance brokerage values, I used the audited, publicly available 10-Ks of the seven publicly traded brokers/franchise independent agency model distributors. I obtained the data from Seeking Alpha.

I used single factor regression analysis, and I tested both the change in stock price and the P/E ratio. P/E ratios are similar to the multiples of EBITDA you hear about relative to what regular agencies are selling for. If you hear someone say, “Agencies are selling for 8 times EBITDA,” conceptually, that is close to a P/E ratio of 8 times, although the definition of earnings is materially different.

My goal was to identify what factors correlate – I did not test for cause, only correlation – to a higher multiple. I tested for profit margins (nearly a 0% correlation with all five profitability measures), growth, and so on. The correlations were all random – except for the current ratio. In other words, profit didn’t correlate to a higher stock multiple. Neither did the growth rate. The current ratio measures how well a company’s current assets outweigh their current liabilities. And that measure had an almost perfect correlation of 0.9 (1 is perfect and 0 is completely random, and quite a few measures tested were close to 0).

This result seems to indicate that the brokers who manage their current liabilities relative to their cash and premiums receivable are valued much more highly than those who are lax. This makes sense and likely applies to regular insurance agencies, too.

I then tested the same factors again to learn whether a correlation exists with the change in stock prices. The results were largely the same in that many metrics had zero correlation. However, two factors had fairly strong correlations, though not as strong as the current ratio.

The first correlation surprised me. The slower the year-over-year revenue growth rate, the greater the increase in stock price. In fact, the growth rates seemingly most valued were substantially less than the industry’s average.

The second correlation that mattered somewhat more was the profit margin available to ordinary shareholders, including extraordinary items. The more profitable the broker, the more their stock price increased over the last two years. Yet this particular measure of profit showed a margin of less than 21% for all the brokers.

A major caveat is that this industry only has seven publicly traded insurance distributors. That said, taking the three factors that have high correlations with value in total, the market seems to be valuing distributors/agencies/brokers that manage their balance sheet well with moderate growth and moderate profit margins the highest.

As for carriers, the results are more complex and vary materially by line of business. In other words, the carriers growing more quickly in one line might be succeeding because they manage their expenses extraordinarily well (true) but not succeeding in another line because the competition is bent on buying market share by underpricing their products. Smart carrier executives manage their companies by line of business.

If you want to increase the value of your organization, use the correct metrics. If you need the correct metrics, let me know. I am fairly certain I possess the best metrics, but beware, these metrics are strong medicine.