Moat Associates

An Introduction to Business Lending Opportunities and Observations on Workout Strategies (if needed)

The independent insurance agency business has been, is, and should continue to be, an excellent source of loans for commercial banks, insurance companies and other lending institutions. Blessed by an increasing base of prospects, an economy that demands insurance, social and economic inflation that increases premiums the insurance industry has seen a half a century of uninterrupted growth in premiums.

Compensated by commissions based on these premiums the independent agent has enjoyed a unique opportunity for growth in both his/her agency’s income and its value. While the last twenty years have seen marked shrinkage in the number of independent insurance agencies, the primary cause has been a continuing pattern of mergers resulting in fewer but, overall, larger average sized agencies. Among insurance companies and industry experts this trend is expected to continue. It is this merger activity and the resulting larger agency that provides lenders with the opportunity to build a portfolio of highly profitable, mid-size ($500,000 to multi-million dollar) loans and insurance companies with the opportunity to access sources of larger premium sales.

Given a business with consistent and generally increasing cash flows, substantial off-balance sheet value and a marketplace hungry to absorb the weak or fallen, why have so few professional lenders been why have some agency owners and their lenders suffered losses? For those fearing current losses, where are the opportunities for recovering their investment? This article will offer a dozen suggestions for the lender interested in building a loan portfolio in this market, the insurance company that sees support for agency acquisition as a premium growth opportunity and lenders and agency owners sensing or experiencing financial trouble.

1. To make Good Loans to Independent Insurance Agents

Rethink Classic Loan Lending Standard:

Most conventional lenders are hesitant to make loans to the independent insurance agent because they fail to see the hidden value in such a borrower.

Steeped in a culture that emphasizes asset backed loans and lacking an understanding of the independent agency business most lenders fail to see the hidden, yet substantial and tangible, value in an insurance agency. This trepidation is increased when faced with a lack of audited financials, a typically small reported net worth, a business often reliant on a single individual and the number of agencies seen to be “going out of business.” For the lender willing to look past these misunderstood indicators, the independent insurance agency or broker offers an excellent opportunity to build a successful loan portfolio. For those that take the time to learn about this market they will find that the true value of the agency exceeds, most often far exceeds its book value. Furthermore, there is, in most cases, a ready market for the purchase of the agency or its principal asset, its book of business (known generally as its “expirations” and recognized as its customer base).

Understanding this combination of hidden value and recovery opportunity should give even the most conservative lender confidence in the security of its loan principal.

Undertake a Sound Business Valuation

The basis for a sound valuation of an independent insurance agency or broker is an understanding of the insurance agency business. While it is true that the Four Cs of good lending are operative (Capital, Cash Flow, Capacity and Character) one is best advised, at least initially, to seek the support of a person or firm with an expertise in such a valuation. Most lenders quickly learn that there are no reliable “rules of thumb” for making an insurance agency valuation and, probably more troublesome, many quality agencies, appear to violate most basic lending requirements.

Consider:

• The typical independent insurance agency functions, quite successfully, reporting a book value (shareholder’s equity) well below the amount of the loan being requested.
• Many independent insurance agencies that have grown through a successful acquisition program report negative net tangible worth.
• Many independent insurance agencies continue, and have done so for long periods of time, with minimum, even negative, working capital.
• Most independent insurance agency owners enjoy total compensation that appears excessive because it equals or exceeds the salary of the presidents of the very banks from which it seeks a loan.

True, conventional appraisal factors will be the foundation of a sound valuation. However, each must be considered in the context of this specialized business.

• To what extent does the subject insurance agency’s growth reflect the insurance industry cycle?
• While ageing of receivables is well within generally accepted standards, does detailed analysis suggest anything worrisome about how the agency actually sells business?
• Representing large, well-known insurance companies is commendable but do recent loss ratio trends within the agency or marketplace signal trouble?
• Are increasing profits really sustainable?
• Is there a market for this agency or its book of business if the agency should get into trouble with its loan?

A failure to evaluate these and many similar questions correctly can lead to a deficient valuation opinion, a questionable loan or a lost opportunity through an inappropriate denial.

While not generally included in a regular fair market valuation a valuation done to support a loan request should include specific analysis and commentary regarding exit or recovery opportunities for the subject agency. While rather unusual, nonetheless there are situations where the economic value of an agency will be difficult to achieve. These arise for many reasons among which are: the agency’s location; its size – depending on its marketplace, “bigness” as well as “smallness” can be a problem; its emphasis on a specialty product or line of business; the industry cycle and even its personnel policies, especially salary levels.

Know the Purpose of the Loan

Notwithstanding a sound valuation, the purpose for the loan should affect the ultimate lending decision.

In this writer’s experience the owners of independent insurance agencies most often seek loans for one of the following four reasons:

• to fund an acquisition
• to finance an improvement in the business’ operations or facilities
• to solve a unique cash flow need that has arisen
• to finance a family emergency

Fortunately, the desire to fund an acquisition is the most predominant reason for seeking outside financing. These should be, and have proved to be, the easiest, the largest and the most successful loans to make. The opportunity to perfect a security interest in the value of the combined agencies should provide a margin of security well above the amount of the loan. The most common risks associated with loans made to support acquisitions arise from the “merger” experience, or lack thereof, of the acquiring agent, and the adequacy and appropriateness of the valuation, pricing and terms of the acquisition itself.

Loans made to finance an improvement in the business’ operations or facilities are of a nature common to most commercial lending institutions. Most typically they involve the purchase or improvement of the office facilities (real estate) or the purchase and installation of computer hardware and systems. Here again, the “hidden” value of the agency is usually greater than the value of the loan thus the burden of the valuation falls on a careful assessment of the sustainable earnings capacity of the subject agency. Loans for the purchase of real estate while few, involve a wealth of significant issues well beyond those related to the accurate valuation of the agency itself but typically within the experience of most commercial lenders.

Occasionally agents seek financing to overcome cash flow problems arising within the agency or to fund personal or family necessities or emergencies. In the case of the former, understanding how the agency developed a cash flow problem and differentiating its need for fiduciary cash from operating cash are critical both to the granting of a loan and to the steps needed to make the loan successful. While unattractive on the surface, these loans can be made successful, particularly if the lender carefully appraises the value of the agency and takes adequate steps to perfect its security interest therein. Loans for college or to pay for uninsured medical emergencies occasionally arise and, subject to their size compared to the value and sustainable earnings expectations of the agency are not beyond doing successfully.

Establish Covenants and Conditions Appropriate to the Insurance Agency Business

The covenants and conditions related to the loan will tend to fall into two broad categories: those that are “typical” lender protections and those that follow the purpose of the loan and reflect issues germane to the insurance agency business.

Among the plethora of general covenants will be found:

• access to regular financials and tax returns, the usual cover ratios
• limitations on owner/executive compensation including bonuses and “perks,”
• maintenance of minimum working capital
• timely payment of principal and interest
• limitations on certain purchase expenses
• limitations on the sale of assets (especially expirations)

Among the covenants that should be considered when making loans to independent insurance agents are:

• access to annual insurance company premium and loss ratio reports,
• details of all amounts,  both direct and indirect, paid to owners or members of their families,
• timely payment of accounts current or bordereau obligations (payments to insurance companies),
• maintenance of trust funds separate from working capital funds,
• immediate notification to the lender in the event of the loss of either of its two largest accounts or insurance companies.

As one might expect the individual characteristics of each agency, especially those that rely on specialty products, programs or markets, may dictate the need for special covenants.

Continue Reading with Business Loans for the Independent Insurance Agent Part 2: Spotting Trouble on the Horizon