MarshBerry: Decreasing Agency Balance Sheet Value – Positive Impact?

Despite significant optimism about key market fundamentals, year-over-year agency valuation increases and agency performance metrics, ownership perpetuation continues to be the biggest long-term challenge to independently-owned insurance agencies, according to the MarshBerry 2013 Market & Financial Outlook Survey.

The survey also found that while in spite of the strongest (revenue) growth in recent history and a significant percentage of agency owners indicating higher profitability, agency balance sheets as measured by average tangible net worth, dropped as a percentage of net revenues in 2012 — and continues to drop into 2013.

In June, MarshBerry launched the 28th Annual Market & Financial Outlook Survey in conjunction with Insurance Journal. The survey comp

iled anonymous general independent agency information along with financial, market, carrier and technology data. The survey results indicate there is an optimistic outlook for the insurance industry. For most lines of business, commission income is growing and the survey respondents are expecting profits to be similar or better in 2013 compared to 2012.

Decline in Tangible Net Worth

Taking a more granular look at the potential driving forces behind the decline in average tangible net worth, we observed the following trends:

1. Interest rates steadily decreased over the last six years, due to the Federal Reserve’s loose monetary policy, which includes the still present unconventional “Quantitative Easing (QE)” program, to stimulate the tepid U.S. economy. 2012 marked the lowest average return on U.S. Treasury securities at five and 10-year constant maturity. (Federal Reserve Bank http://www.federalreserve.gov/releases/h15/data.htm)

2. U.S. domestic banks have reported increasingly stronger demand for commercial and industrial (C&I) loans over the last two years due in part to banks easing their lending standards. (Federal Reserve Economic Data Board of Governors of the Federal Reserve System “Senior Loan Officer Opinion Survey on Bank Lending Practices” http://www.federalreserve.gov/boarddocs/SnLoanSurvey) With interest rates at historically low levels, many firms are taking advantage of cheap borrowing to finance their business activities. These loans are typically used for funding needs related to merger and acquisition financing, investment in plant or equipment, accounts receivable, or inventories, among others.

3. Long-term debt on the balance sheet has slowly crept up over the last few years also contributing to the decrease in average tangible net worth, which is calculated as total equity less intangible assets. Long term debt typically relates to acquisition strategy, and internal perpetuation strategy (i.e., external financing).

(The data is from a proprietary financial management system of Marsh, Berry & Co. Inc., Perspectives for High Performance – PHP. Agencies subscribe to the PHP reports and data from each subscriber is updated every quarter. The system calculates critical financial and productivity ratios and compares these ratios to the Average Performance in the group. Balance sheet ratios are averaged over a four quarter period.)

4. Cash on the balance sheet has steadily increased over the last several years, while the average debt retirement ratio has decreased indicating an enhanced ability to meet debt obligations. Cash flow is calculated by the sum of pre-tax profits and non-cash expenses less average current portion long-term debt. Average debt retirement ratio is calculated by dividing average long-term debt by net revenues. This trend echoes one of the many effects of the Great Recession that businesses are cautious and continue to hold on to or increase their cash reserves while paying-off debt.

5. Weighted average owner age has decreased in 2012 compared to 2011. Weighted average owner age is calculated by taking the percentage ownership of a shareholder and multiplying it by the shareholder’s age. The summation of all shareholders represents the weighted average owner age. A decrease in this ratio may signify perpetuation of ownership, although the overall trend seems to be increasing.

The decrease in agency balance sheet value, while seemingly negative at face value, may be an indication that agencies are taking advantage of positive market conditions — including low interest rates and available external financing — to reinvest in their agency, whether it be for acquisition growth and/or perpetuation of ownership through an internal sale. If this is the case, we believe that agencies should strive to maintain a tangible net worth ratio of 15 percent to 20 percent of revenues. Whether the goal is to perpetuate internally or grow through acquisitions, a strong balance sheet is often both necessary and beneficial.

Agencies should carefully consider the use of cash and debt leverage to determine how to best enhance growth, profitability and perpetuation of ownership, and remain a viable force in the distribution system.

The MarshBerry 2013 Market & Financial is now available for $199 at http://info.marshberry.com/marketfinancialoutlook. The report enables independent insurance agencies to highlight key agent and broker performance trends from 2007–2014. The five core chapters offer a market overview and outlook on:

1. External Environment Perspectives

2. Carrier Relationships

3. Growth and Profit Perspectives: By Revenue Size and By Region

• Total Commission Income – Overall, Organic and New Business Growth Rates (Property & Casualty; Life & Health; Fee Income)
• Non-Commission Income (Contingents; Overrides; Investments)
• Growth Strategy
• Profit
• Grofit

4. Operational Perspectives

• Expense Management
• Information Technology/Technology Investment
• Human Capital

5. Perpetuation

Connell is a senior consultant for MarshBerry. Email:Molly.Connell@MarshBerry.com. Phone: 440-392-6584.