Business Valuation Methods; Insights on Insurance Agency Valuation
The business valuation of an insurance agency or insurance brokerage requires an in-depth knowledge of the internal workings of an agency and a wide-ranging understanding of the insurance agency environment. Most insurance agency valuation reports are vulnerable because the “expert,” lacking close experience with the insurance agency business, has relied extensively on general information and standard text book valuation methodologies.
Issues Affecting a Defensible Insurance Agency Valuation
Daubert and Frye
Rule 7021was amended in 2000 to expand Daubert2 by providing that a witness may only testify if: i) the testimony is based upon sufficient facts or data; ii) the testimony is the product of reliable principles and methods; and, iii) the witness has applied the principles and methods reliably to the facts of the case. The result is that Daubert standards have become the law in federal courts and over half of the states regarding all expert testimony.3 An expert testifying to insurance agency valuation is at risk when failing to show that his facts, data, principles and methodologies are grounded in insurance and not simply found in general business references.
Support for Critical Assumptions
Unfortunately, data related specifically to the operation of privately-held insurance agencies is minimal at best and too often flawed. Accordingly, valuation data used to support key assumptions should be specifically cited as to source and reviewed for appropriateness.
Business Valuation Concerns: Discount for Lack of Marketability (“DLOM”)
Arguably this the most important discount in any company valuation. In insurance agency valuations it is probably the one most easily attacked. Lacking experience in the business and, in particular, knowledge of insurance agency acquisition activity, most generalists use broad statistical data. My experience is that in most instances, the result is to exaggerate, often substantially, the DLOM.
Common Methodology Mistakes in Insurance Agency Valuations
Determining Sustainable Earnings – Normalizing Earnings
A technique used by many evaluators to determine the business’ sustainable earnings is to average earnings over a recent period. “Averaging” doesn’t do it. Obviously, internal revenue and expense trends, whether upwards or downwards, are significant. So too, are many external factors such as the underwriting/pricing cycle and the local economy. And of course, pro forma adjustments, especially assumptions regarding owner/employee compensation for which there is little public data, and adjustments for one-time revenues and expenses, need careful scrutiny.
Use of Inappropriate Valuation Methodologies
Many classic methodologies simply don’t apply when valuing an insurance agency or brokerage. Price to Sales ratios is particularly inappropriate if the expert should reference premiums as the sales factor. Price to Sales based on commissions has long been recognized as a means of expressing value but not for calculating value. Price to Book ratios fail to have any validity primarily because accounting principles ignore the intangible value of the agency’s book of business. As a result, the appropriateness of each proposed methodology employed must be assessed.
Ownership (Control) of Expirations
The foundation for any insurance agency or brokerage value is its commission renewal income. This requires an understanding of the nature of the business entity and the issue of control and/or “ownership” of the expirations.
1 Federal Rules of Evidence
2 Daubert v. Merrell Dow Pharmaceuticals, Inc., 43 F.3d 1311 (9th Cir.1995)
3 The Frye standard remains the law in jurisdictions including, but not limited to, California, Florida, Illinois, New York and Pennsylvania. Under Frye, the only relevant criterion was whether the technique had been generally accepted within the relevant scientific community.