Moat Associates

Do You Really Have An Insurance Valuation Expert?

Planning Your Cross-Examination of an Expert on Insurance Agency Valuation

Whether one is presenting or cross-examining an expert’s valuation report there are several issues that are important to success.  Typically, these fall into the following categories.

1. The expert’s knowledge of the insurance industry and specific type of business in which the subject company is engaged.
2. The valuation process.
3. The breadth and quality of information relied upon.
4. The choice and weighting of valuation methodologies.
5. The opinion – reasoned, credible and legal.
6. The “readability” of the report.

The Expert’s Knowledge of the Insurance Industry and Specific Type of Business in which the Subject Company is Engaged

While judges seldom dismiss an “expert” for lack of specific experience, a careful examination of one’s credentials regularly helps a judge or jury distinguish between competing opinions.

• Has he/she done any other insurance agency valuations?  If yes, when, how many and for what purpose?  If not, how is his/her experience applicable to this assignment?

• Are the expert’s credentials and the courses relied upon applicable to the insurance industry and subject company?  As of this writing, no formal designations or general courses apply specifically to insurance or include many, if any, references to the issues and nuances of the insurance industry.

• If expert has not worked in the insurance industry or not done M&A transactions of insurance agencies what are the sources of information on which the valuation is based and does that data include specific insurance agency information?

Common Expert Shortcomings:

• Claiming general valuation experience. Simply being a professional (actuary, lawyer, accountant) who “has worked on insurance agencies” is seldom, if ever, enough.   While most valuation professionals have done many valuations it is likely that very few, if any of these, has been of insurance agencies or brokerages.  Although there are many courses on business valuation there are very few that even reference insurance agency/brokerage valuation problems and even fewer that deal exclusively with this subject.  This writer has been privileged to be among the very few who have given extensive courses on the subject.  With minimal investigation the effective attorney should be able to show that general experience may not be useful in the valuation of the subject insurance agency.

• Relying on inappropriate references. Most text material is unrelated to an insurance valuation, improperly used or, upon full review, is taken out of context.  While there are several excellent texts on the subject of business valuation very few offer any reference to the issues related to the valuation of insurance agencies and brokers.  Where such references occur, they are usually “rules of thumb” which are subject to defeat on analysis.

• Limited, if any, direct exposure to the insurance agency business. Many accountants, called upon to value an insurance agency, rely on their experience in “auditing” one or more agencies.¹ As most agencies buy compiled statements there is no “auditing” done and, generally, little, if any, actual on-site analysis or review.  “Generalists” regularly miss the nuances in an insurance agency’s operations that can greatly affect the credibility of the valuation conclusion.

¹ Attorneys should distinguish among audited, review basis and compiled statements.

The Valuation Process

The scope of the process will reflect the depth of analysis and the substance of the report.

• How was the information obtained? If there was a formal questionnaire it should be reviewed to ascertain how comprehensive it is and to see if anything was omitted from or used incorrectly in the final report.

• How was the information examined? Who described the sales philosophy, product emphasis and the relationship with the largest accounts?  Was someone interviewed regarding the financials – preferably the independent accountant or at least the agency’s internal financial manager?

• Was there an on-site visit? If not, how did he/she judge the impact on value of: Office location, utility and general attractiveness; Quality and experience of staff members; Level of automation that was available and being used?

Common Deficiencies in the Valuation Process:

• Relying on a single source of documentation. Standing alone, very few agency financial statements, whether prepared internally or externally, or the agency’s tax returns tell the subject company’s story with sufficient detail to support a full and proper valuation analysis.  Furthermore, most of these sources cannot be reconciled easily with each other.

• Relying on the principal person’s explanation: As surprising as it may seem, many agency owners cannot provide accurate answers to many questions about the agency, its finances and even its most significant customers.

• Obtaining only limited information about external issues: What are the opportunities in the agency’s marketplace? What is the competitive environment like?  Is there evidence of acquisition activity in the area?  What are the agency’s insurance company relationships and underwriting results?  These, among other external factors, usually have a substantial impact on value.

The Breadth and Quality of Information Relied Upon

Independent insurance agency owners regularly describe the value of their agency in terms of a multiple of commissions.  Such a simple methodology is unacceptable for calculating value. The number of factors that affect valuation are too many and too complex.

• What financial information was the basis of the opinion? All financial systems and the resulting financial statements are not the same.  Compiled statements are shallow at best and rely entirely on internally generated information.  Seldom can internal statements and tax returns, which themselves are woefully inadequate for valuation purposes, be reconciled without a considerable effort.

• What was considered regarding the agency’s operations? To whom and how are new sales generated?  Does the agency rely on a single target market or a “specialty” product? How experienced are staff members? These and a wealth of other issues must be assessed.

Common Errors:

• Insufficient understanding of the accounting system: Few agencies, even among those using the same agency-specific, commercial accounting systems, keep their books the same way.  Differences in how, when and where items are booked can result in significant differences in valuation results.  For example, what is booked to an account called “Auto Expense” – does it include: Depreciation of owned vehicles; Insurance; Maintenance; Travel related expenses?  The answers can affect the determination of cash flow projections, appropriate pro forma adjustments and can provide insights into the owner’s management philosophy.

• Failure to identify and distinguish details: “Commission Income” has several distinct components each of which has a substantially different impact on the agency’s value. Similarly, a failure to identify to whom “Commissions Paid Out” are remitted can affect the degree of “ownership” of the expirations.  All “Salaries” are not alike and only detailed analysis can indicate how this item indicates an agency’s strengths and weaknesses or what pro forma adjustments may be required.

• Inadequate assessment of insurance company relationships: An agency’s relationship with its insurance companies is critical.  Too often the simple fact of representing one or more “significant” insurance companies is given inappropriate weight while failing to see the risks associated with a reliance on some insurance companies.     Companies having underwriting problems in local markets often change their underwriting emphasis or selection standards unilaterally and quickly to the detriment of its agents.  Thus, an understanding of the agency’s largest placements, loss ratios and loss ratio trends and premium remittance history are important.

• “Control” issues: How did the evaluator determine and respond to such issues as:  The existence and terms of a Buy/Sell Agreement?  Employment contracts or “formalized” personnel practices?  The lack of covenants with key producers and employees? The volume of business placed by “outside” producers?

The Choice and Weighting of Valuation Methodologies

• Choice of Methodologies: The methodologies of preference for use in valuing an insurance agency or brokerage are: Price to Earnings multiples based on available public and, more importantly, private transactions; Capitalization of Earnings; Discounted Future Earnings and/or Cash Flow.

• Discounts and Premia: Few, if any, valuation opinions result without the application of discounts or occasionally premia.  Independent insurance agencies are by nature subject to a Discount for Marketability.  When Price-to-Earnings multiples are used, data related to the value of public brokers, and occasionally private transactions, requires that a Discount for Comparability be considered.  In some situations a Discount for Minority Interest may be necessary.  The Capitalization of Earnings methodology usually requires consideration of a risk factor adjustment.  Each of these can have a substantial impact on the final valuation calculation.

• Weighting of results: When multiple methodologies are employed, one can expect a range of results.  In most instances one or more of the methodologies will be more closely aligned with the data used, the nature of the agency and any compelling issues. Accordingly, the results are usually weighted,

• “Local” Law:  Most states and federal jurisdictions have case law for valuing closely-held companies and especially minority interests.  How has the valuation opinion incorporated, or distinguished itself from, any such cases?

Common Errors:

• Use of inappropriate methodologies: Methodologies such as Return on Assets, and Multiple of Book Value are almost always inappropriate.  Multiple of Sales or Revenue while useful as means for testing the reasonableness of a result is unsuitable as a method for calculating the value of an independent insurance agency.

• Shortcuts: The most common is relying on arithmetic averages to establish such important financial barometers as sustainable revenues and earnings.  This ignores trends and the precise impact of significant pro forma adjustments.

• Failure to respect special circumstances: Valuation methodologies must fit the circumstances of each situation.  Thus, should the subject agency be valued as a going concern or in run-off?  In what way should the methodologies and assumptions used to value the agency of a deceased sole proprietor / shareholder for estate tax purposes be different?

• Reliance on “rules of thumb.” Lacking an understanding of the insurance agency business or of sufficient applicable data, many analysts resort to general data, or worse, “rules of thumb.”

• Inadequate adjustment for intangible assets: Lacking an understanding of an insurance agency’s intangible assets can result in a failure to make appropriate adjustments to the Balance Sheet and affect pro forma adjustments to earnings.

• Inadequate citations: Too often, reference to source data is absent.  Not only does this suggest that it may not exist, but it deprives one of the opportunity of reviewing it for credibility and applicability.

• Local law: Valuation of a minority interest is often guided by state law.  Similarly, many jurisdictions express a preference for certain methodologies in marital cases or in calculating the tax effects in cases involving a claim for lost earnings.

• Acquisition-related Data: Failure to distinguish value, price and terms in applying multiples derived from the acquisition of a comparable agency.

The Opinion – Reasonable, Credible, Legal

Each methodology employed will render an “arithmetic” result.  To arrive at a final opinion requires that these separate results be reconciled and tested for reasonableness.

• Weighting. In arriving at a single economic result, have the various methodologies been appropriately weighted?  Is the weighting adequately explained?

• Range of Opinion: Few, if any, valuators would be willing to express their opinion as a specific dollar amount.  Thus, it is reasonable to expect that the value will be expressed within a range.  Is the range reasonable?  Has the reason for selecting this specific range been given?

• Test for Reasonableness:The final opinion should be tested for reasonableness.  How is the value distinguished from accepted “rules of thumb?”   Does the stated value make “economic” sense?

• Legality: Do the methodologies meet local legal requirements and standards?

Common Errors:

• Range of Opinion: Failure to support the reason for the breadth of the range selected – or choosing a range of values so wide as to be meaningless.

• Suggesting a value that is patently unreasonable in business terms.

The “Readability” of the Report

One should recognize that the visual appearance, the organization, the thoroughness, the accuracy and the clarity of style each have a substantial effect upon its credibility with the reader.

• Appearance:   While appearance is important, one should recognize that form must not prevail over substance.

• Organization: Is there an effective summary at the beginning to give the reader an overview?  Is there an index? Does the presentation follow a logical order with adequate and appropriate tables, charts and graphs? Does the report deal with all the factors suggested by Revenue Ruling 59-60?  If not why not?

• “Readability.” If you find yourself reading technical financial terms or mathematical formulae that you don’t understand and that are not explained then the report is deficient.

Common Errors:

• Showing off: Often, in an effort to evidence their expertise and erudition (i.e. “to show off”) some experts overstep common sense.  If every aspect of a report is not readable and understandable, if technical data and assumptions are not explained and referenced one should be cautious.
• Failure to date and sign the report: While a foundation for admitting the expert’s work product can always be made, the existence of a signed and dated document often provides insights into who completed the report and when, sometimes useful information is assessing credibility.

• Updates and amendments: If the report has been amended subsequent to its initial distribution, are the amendments noted, dated and the reasons therefore fully explained?

• Accuracy: Failure to get the legal names(s) and legal form(s) of the subject agency correct. This can open the door either to what was actually valued or to the quality of the analysis or both.

Please see our selected list of  most recent insurance cases completed by Moat Associates.

Bibliography

Handbook of Business Valuations, 2nd Edition, Edited by Thomas L. West & Jeffrey D. Jones; published by John Wiley & Sons, Inc. NY

Valuing Small Businesses and Professional Practices, published by Irwin Professional Publishing, Chicago, Illinois.
Business Valuations – Discounts and Premiums, Shannon Pratt, published by John Wiley & Sons, NY.

Guide to Business Valuations, published by Practitioners Publishing Company, Fort Worth, Texas.

The Handbook of Small Business Valuation Formulas, Third Edition, by Glenn Desmon and John Marcello, published by Valuation Press, Los Angeles, California.