Value Disguises
- Apr 2, 2004
- 4 min read
While discussing the profitability of an agency’s producers, the agency owner made an interesting comment about losing money. The producers we were discussing obviously were not profitable, “But,” the owner said, “every commission dollar they generate, even if it is unprofitable, increases my agency’s value.”
My first thought, which I almost blurted out, was “I don’t think soooo!” Because if I owned a restaurant, for example, and 25% of the meals served were served at a loss (excluding any extra profits made on the sale of “loss leader” items because our industry cannot strategically use loss leaders), would the restaurant’s value increase? Not likely.
After I caught myself before blurting out that first thought, I responded that the owner might have a point. And, the more I thought about it, the owner’s statement became even more interesting. “Can unprofitable producers making unprofitable sales increase an agency’s value? And if so, how?” Well, one advantage of being in the financial service businesses is financial results can be distorted for a long time in many ways. For example, insurance companies can easily achieve this phenomenon by placing a lot of unprofitable premiums on their books. This works because many potential buyers, very often including stock markets, will not recognize this until the losses finally gush in years later. Some people might even suggest this is what has already occurred since all rating agencies are advising the industry underestimated losses by $30 to $60 billion (year-end 2003).
The disguises companies use for hiding their financial results are pretty good. One might think that insurance companies buying other insurance companies would know all the tricks. However, judging by the littered path of failed P&C acquisitions, the purchasing insurance companies apparently are not too good at recognizing poor-performing business on the sellers’ books.
I recently read a Wall Street analysis about the success of an insurance company’s acquisition. While Wall Street and the buyer obviously thought the acquisition was a success, I have discussed this acquisition with people I know in the industry, many with very intimate knowledge of the seller’s book, and no one considered the acquisition to be successful for the buyer. (On the other hand, the sale was unanimously considered to be very successful from the seller’s perspective because they got out before their disguise was foiled.) Some get fooled and some don’t, and even Wall Street analysts are sometimes fooled by the many disguises.
P&C insurance agencies can do the same thing. For example, if I wanted to sell an agency for a big price, I might build a big book of poor business and then sell it in a period of no more than three years. Poor business is always easy to find. The benefit would be my loss ratios and contingencies would not suffer until after the sale and yet I would gain extra value from showing fast growth, more revenue, and larger contingencies. Poor business can often be easily hidden because it is too small to draw attention during the due diligence process but is still significant enough to earn sellers a higher sales price.
Another benefit is that since poor business is easy to find, I wouldn’t even need to hire good producers. Poor producers would do just fine. Poor producers are easier to identify than poor business, so some buyers might assume they can make the purchase more profitable by eliminating unprofitable producers after the acquisition. This is certainly an option, but does it make the book any more profitable? Any gain is probably limited by the poor business that either has poor loss ratios and/or poor retention.
When the buyer plans to fire unprofitable producers, the buyer must also make an adjustment to future growth expectations. Higher profits vs. low growth, or vice versa, will offset each other to some extent when determining agency value. However, I believe many buyers are overlooking this adjustment to future growth.
Perhaps some buyers are not fooled at all, but they are not adequately considering profitability because they see an arbitrage opportunity. This requires them to have a market, alas the stock market, where buyers do not recognize the disguised financials either. This is quite obviously the strategy of at least one, if not several, serial agency acquirers.
Opportunity therefore abounds to increase agencies’ and insurance companies’ values by making unprofitable sales! What a great industry we are in!
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