The Balance Sheet Is the Most Important Financial Statement

The balance sheet is preeminent in financial audits by its placement at the front of audit reports. The balance sheet is what insurance regulators and raters are supposed to first focus upon, because it is a measure of whether an insurance company can pay claims. Revenue does not pay claims.

Surplus pays claims and you find surplus on balance sheets.

Balance sheets tell a reader if an insurance agency has embezzled client funds or otherwise inappropriately spent client trust monies. A balance sheet identifies whether an agency has the money with which to withstand a catastrophe and afford the development of new producers.

A good balance sheet is a good indication of whether a company can withstand a cyber-attack or the abandonment/escape/defection (depends on one’s perspective) of key producers and their books of business. A balance sheet is essential to continuing to run the business as normal while paying attorneys gobs of money to fight on your behalf.

A good balance sheet indicates whether the company can get a loan with which to expand or make an acquisition. A good balance sheet is like a good credit score. We all know that credit scores are highly correlated to a person’s probability of default and even getting into an accident.

Well, the balance sheet should be the most important financial statement and it is meant to be the most important financial statement. A critical weakness of the balance sheet is that the human brain generally does not relate constructively to measuring assets versus liabilities. This weakness is especially lacking among people with sales brains and CEO brains. These people focus on top line revenues, not even bottom line revenues much less the balance sheet. This is not a snide remark, but reality.

Many CEOs know they need to focus on the balance sheet. They know it is important. Some even understand it (I’m not being facetious; I’m being literal, based on discussions I’ve had with CEOs who did not understand their own balance sheet, especially if their balance sheet indicated financial issues). Salespeople generally have no clue about balance sheets — they can only focus on the next sale.

Corporate balance sheet importance has also been diluted by the Federal Reserve’s extraordinary money printing press, enabling weak companies to continue to exist, especially if these companies are too big to fail. So many companies with junk bond level ratings would have otherwise failed by now. Combine this structured de-emphasis on the balance sheet with the reluctance of human brains to engage with the decidedly unsexy balance sheet, and we have a recipe for fraud and incompetency hiding beneath financial engineering and sales hubris.

Loss of Surplus, Pension Funds, Private Equity

Some insurance companies have lost 20%-35% of their surplus in the last two years (2021-2023). And yet their loss of surplus is not in their press releases or descriptions of why they are leaving states. Instead, the headlines focus on losses, but those states’ loss ratios really are not materially worse than normal. Poor regulatory environments provide awesome opportunities for carriers to exit hundreds of millions of dollars of premium because they are lacking a good balance sheet, i.e., lacking surplus, under the guise of regulatory incompetency.

I’ve seen carriers recently subtly blaming rating companies that do consider surplus. Somehow or another their message is, “We have the ability to grow regardless of what the rating company says!” Reality is that the company in these situations can only grow if they grow irresponsibly because an insurance company cannot ever grow responsibly if it does not possess both adequate surplus and surplus of adequate quality. It is in an agent’s best interest to know if the carriers with which it is writing are growing responsibly. The balance sheet is a critical data point.

From what I am seeing on the broker side, the balance sheet has taken somewhat of a backseat simply because so much money, partially as a courtesy of the Federal Reserve, is chasing agency/broker acquisitions. Pensions, who are funding a huge portion of the private equity acquisitions, need to increase their returns because the Federal Reserve kept interest rates too low for them to meet their future obligations, so they had to look for other investments. The balance sheets of many of these serial acquirers are extremely weak from a traditional perspective. The debt-to-equity ratios, the interest coverage ratios, and so forth are almost off the charts. A regular agency could never get a loan from a regular bank with these ratios.

The bet the pension funds and private equity are making is that someone will always provide some form of additional financing. Historically, that has been someone figuring out that the value is even higher than what the PE firm has valued it and the existing PE firm figuring out that it is such a great investment that it needs to be sold. This is the buyout model or cashout model or what is known as the exit model, but exits have been a little more difficult since interest rates have risen. (A small number of PE firms actually are building real, self-sustaining brokerages that actually cash flow and use additional funding to build out that model, rather than simply buying more agencies.)

The alternative thought process, catching on more now, is that someone will always be available to lend the PE buyer more money, so that while the balance sheet ratios indicate a high degree of risk, no one is going to call the loans, and if lenders do call the loans, someone is going to be willing to offer a replacement loan. So, the amount of debt is immaterial provided interest payments are on time.

Financial engineering is often required in these models. I encourage readers to read “These Are the Plunderers,” by Gretchen Morgenson and Joshua Rosner, for more information about how this works. The book focuses on insurance company deals, but the concept largely applies everywhere. The goal with these strategies is to de-emphasize the balance sheet so that cash can be removed leaving the problem to the last buyer to hold the bag, like a game of musical chairs.

When this happens, the firms with the best balance sheets should have a strategy to pounce. A carrier CEO asked me why any carrier should care about an A+ rating or even an A rating from A.M. Best, since agencies don’t seem to care? Great question, and agencies should care. The reason to be A+ is so that when other carriers are laying off premium because they don’t have surplus, you can pounce. You have the balance sheet to support growth when others must shrink to their surplus.

Agents have the same opportunity because many of buyers cannot afford to support organic sales growth, though that is their focus, because they don’t have the balance sheet to support growth. They will, and generally do, grow at the rate of rate inflation, and nothing more. Agents and brokers with better balance sheets, a solid strategy to pounce, and the ability to execute should have a field day over the next three years.

Balance sheets are not sexy, but they are the foundation with which growth is built. Pay attention to your balance sheet. My analytics even suggest Wall Street values brokers and some carriers higher that actually have better balance sheets.