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We are often asked to speak on the subject of alliances between banks and insurance agencies. What kinds of relationships exist? What are the advantages and disadvantages of each? And, specifically, what are some of the considerations for banks and agencies entering into a merger situation?
The Manhattan Group is a consulting firm specializing in insurance. Our practice involves agencies, brokerages, companies and related financial organizations. We are called on annually to value 30 to 50 insurance businesses of all kinds and to help negotiate and structure about 15 mergers/acquisitions. Additionally we undertake a broad range of consulting assignments generally related to financial planning and management and marketing.
In recent years, we have been involved in about a dozen consulting assignments involving banks and insurance. Why are banks interested in insurance at this time? Fifteen years ago, as a member of several bar association committees, we listened to bankers debating the merits of concentrating their efforts on expanding their powers related to interstate banking versus participation in financial services. The decision apparently was to seek expanded interstate banking powers. Having achieved success in this area, the banking industry is now concentrating on expanding its regulatory authority to engage in financial services - particularly insurance. As result of their recent successes and current determination, we believe you will see a continued expansion in this area.
In our view, however, most banks will meet with only limited success in their insurance activities. Interestingly, we believe that insurance professionals can greatly affect how much success individual banks will experience. If insurance agents see banks as one more competitive segment against which they are going to bring their best sales and technical skills, and if agents will strive to improve their management skills and the internal efficiency and success of their agencies, then the influence of local banks will be no more than that of other agencies or the impact of large national houses which, to a great degree because of agents competitive ability, have generally failed to penetrate the mercantile and personal lines marketplace.
Put simply, a successful independent insurance agency is built on its sales skills and its technical capability. Banks need those sales skills and that technical capability. In short, banks will need agents.
If a bank is to enter the insurance agency business successfully, it needs to make a number of interrelated strategic decisions. These can be summed up as: Why does it want to sell insurance? To whom does it want to sell insurance? What products does it want to sell to these target prospects? How does it want to sell these products to these target prospects?
It is our experience that most banks fail to realize how closely entwined these issues are. The answer to each question reverberates to each of the others. Surprisingly, many banks haven't really determined why they are interested in insurance. Obviously every bank expects to increase it earnings, however, on more than one occasion we have found banks motivated simply by a 'me too' mentality, ready to get into insurance because other banks are doing it. Many banks perceive insurance as a way to protect or retain their customer base. This motivation found expression in the number and volume of annuities sold over the past decade. Although large sums of commissions were earned by banks during this period, it would appear that the economic motivation has diminished and banks currently trying to sell annuities are finding the results far less than expected.
Similarly, customer demographics often vary greatly from one bank to another and even from one product or service segment to another within the same bank. Though it is obvious, the products chosen must fit the target customer and the marketing method to be implemented must reflect both the target customer and the competitive features of the chosen products. Too often a lack of insurance experience has led banks and their generalist consultants to arrive at an incompatible combination.
Interestingly, most agents are unable to respond to a bank's needs in all of these areas. Few property/casualty agents understand life insurance. Few life agents understand property/casualty insurance. Agents which have developed an effective servicing organization are often unable or unwilling to become aggressive salesmen. And aggressive salesman familiar with face-to-face selling have few of the skills and experience necessary to mount a successful direct marketing program. The result again can be mutual disappointment.
To enter the distribution or agency side of the insurance business banks have three broad options: they can start de novo, they can enter into some type of third party relationship or, they can buy into the business.
It is our experience that only the largest money center banks can begin de novo. The financial uncertainty, the inability to attract adequate markets and the lack of skilled personnel combine to restrict all but the largest banks. Thus, for most banks and most independent insurance agents, the opportunities lie in developing either a third party arrangement or in a merger/acquisition.
Third party arrangements typically take one of three forms: a purchase or rental of the bank's customer list; working with or through the bank and its staff in the sale or servicing of insurance sales; and, creating a new joint venture entity to perform some or all of the sales or service functions. There are too many variables in what each of the parties wants to accomplish and in how the regulatory requirements are fulfilled to offer any single 'how to' formula. There are, however, some basic observations which may be useful.
Banks and agents generally are overly optimistic about the potential income to be derived from their mutual efforts. Neither party should be misled by the potential suggested by the total number of bank customers. Seldom is a bank's prospect base for insurance sales as large as it initially appears. The diversity of the bank's present products and services creates diverse customer demographics. Each requires different insurance product considerations or different marketing considerations or both. The result is that the prospect list for specific insurance is much smaller than it initially appears. In one bank, even with the offer of the proverbial toaster to encourage the customer to stop by its insurance center, less than 10% of the target audience did so and the actual closing ratio for insurance turned out to be less than one percent. This is not to deny the potential of marketing with or through the bank to its customers, but rather to emphasize the need for a careful analysis of the strategies options and the creation of realistic expectations.
Banks and insurance agents looking to structure a third party relationship most typically create one of three arrangements. The independent agent might serve as an independent sales and servicing arm of the bank providing an entire marketing program including staffing, products, solicitation, closing and servicing. The agent may position its personnel within the bank to solicit customers or it may simply be the marketing arm of the bank conducting solicitations under the bank's auspices from its own premises. These arrangements are beneficial to banks because they have immediate access to an experienced staff, services and markets while keeping there costs at a minimum. The third party provider sees the new source of prospects, often large in numbers to be attractive.
The independent agent might work with the bank to help license, train, motivate and often supervise selected bank personnel in the sale of insurance. Business written is processed through the agency. Banks see this approach as having the benefits as dealing with a third party provider but with the additional benefit of knowing that it is moving closer to the day when it will be in the business on its own. One large money center bank for example is funding the growth of a dedicated insurance sales force which is trained and managed by an independent agent. The established agent provides back office services for a fee. Important to this arrangement is a provision in their agreement whereby the bank can buy back its expirations and the support staff servicing its accounts. Agencies obviously perceive increased income, greater volume for their markets and the prestige of the relationship.
The independent agent merely accepts referrals from the bank. Though such arrangements are of little value to either party unless they are backed up by some formal, continuing solicitation program it is surprising how many local agents and local banks are working together in this casual way. Unless their is an unusual level of commitment by the bank's management, it is our experience, which is supported by several studies, that these arrangements generally result in only minimal and sporadic sales.
Arrangements between banks and third party organizations providing entire 'turn key' marketing programs tend to interest banks because such arrangements have proved to be highly successful with respect to single premium deferred annuity (SPDA) sales. The annuity sale was relatively easy because the prospect was immediately identifiable, often had large sums available, was encouraged to listen because of the fall in CD interest rates and attracted to the tax benefits of annuities. That bankers saw the two products as somewhat similar helped allay any reservations they may have had about 'their' customers making a bad move. As a result, a number of significant third party providers and programs exist in this area. Though a model for other life and health sales and for property/casualty insurance sales few such examples have as yet developed in these areas. The reasons offered are many. There is no obvious customer. There is no obvious buying motivation. Sales are not as large and rewarding either to the salesman or the bank. Single premium annuities require little to no underwriting or servicing. Finally, 'insurance' as distinct from annuities and 'insurance salesmen' as distinct from financial advisors or counselors seems to create an image of concern to many bankers.
Although we are familiar with several situations in which a local bank turned to a local agent for assistance in product and sales training of their platform personnel, the actual sales results have so far been disappointing. The reason seems to be that many independent agents are more skilled in maintenance and referral selling than creative selling, lack experience at creating sales programs in support of any basic training and find the compensation for these efforts to be inadequate compared to a similar investment of time and energy in their own agency activities.
The number of joint venture relationships seems to be increasing. As the number increases, so too does their form and purpose. A study in which we participated recently indicated a number of 'agencies' that had been created by banks, or their owners, and local agents. Typically, business written from the bank's customer base or initiated by the bank was placed in the joint venture agency which in turn purchased 'back-office' services from the established agency.
If a general comment were to be made about third party arrangements it would be that few are the same. As you might expect, each arrangement tends to reflect the needs and goals of the individual parties. Noticeably, most arrangements involve life insurance, especially annuities. To date, few property/casualty arrangements have achieved either the success or the sophistication of those applicable to the sale of annuities.
Because these third party relationships are increasing in number and size, it might be appropriate to take a moment to comment on a couple of 'potholes' that have arisen and that should be considered in any written agreement between the parties.
The first involves what we call companion sales. What happens if the agreement between the parties is for the purpose of selling a specific product and having done so the third party subsequently sells something else? For example the agreement is for the sale of annuities and the sales organization also sell a homeowners policy. What happens when the agreement says the bank shares in all sales to its customers and the customer is already a customer of the agency for one or more products? Or the agency customer subsequently becomes a bank customer? Or the agent makes a general sales call on a bank customer? Such questions must be answered for these and similar situations and the answers must be clear both during the effective period of the contract as well as after its termination.
Another issue that is arising concerns the ownership of the property/casualty expirations and the life insurance renewals. Too often, both the agent and the bank are more interested in the commission income derived from the sale and renewal. Too seldom does either party take the time to appreciate that in a successful arrangement the real value ultimately lies in the value of the expirations or renewal stream.
The fairness of the compensation arrangement is another area which is causing difficulty in third party relationships. Some times the difficulty arises from an honest mistake based on a lack of initial analysis. Though correctable, compensation or cost sharing arrangements shouldn't be guesswork. Alas, too often banks learn, or are informed, after the relationship has been active that their fair share of commissions excludes participation in, or consideration of, contingent or bonus commissions.
Finally, although termination clauses can be found in all agreements between the agent third party provider and the bank they regularly fail to address many of the 'insurance' issues which can spring up upon the dissolution or termination of a relationship. To whom do the expirations, renewals and business records belong? As the typical insurance company agency agreement recognizes these issues between it and the agent is the third party agreement clear and how will the insurance company be expected to comply? What about the extra staff which were added to sell or service the joint venture business. Who is responsible for their termination? And what of the loss of business between the agent and his market? Will a sudden and possibly large reduction put his very agency in jeopardy with one or more markets?
The area of greatest interest is the opportunity for a true acquisition/merger of the bank and the insurance agency. This approach makes sense from the bank's position because it knows what its costs will be, it has a sense for the cash flows and profits it can expect, it gets a known, turnkey operation and often most importantly, its gets the management control that allows it to feel comfortable about how insurance will fit into its banking operations. For the agent, s/he obviously gains the value of the agency, while at the same time creating increased opportunities for himself/herself and the agency's staff.
Having spent almost as much time helping insurance agents and banks unwind poor transactions as getting into good ones, I would advise both to go slowly and to do it right. What does this mean? An agent contemplating approaching a bank or entering into negotiations with a bank should put together a comprehensive profile that presents a complete picture of his/her agency including its strengths and weaknesses, financial history and biographies of each of its personnel, or at least key personnel. Such a profile should be sufficiently comprehensive to answer almost all the questions a bank might want to ask. It should also support in its quality, content and facts the price the agent wants. From the bank's perspective, a comprehensive analysis is the basis for its due diligence as well as pricing. Though it may be taken by some as self serving, such documents should be prepared by people with proven knowledge and experience in agency valuation, mergers and acquisitions.
A critical part of any profile is the presentation of the agency's financials. As most agencies are privately-held, the owners are less interested in reporting earnings as they are in holding taxes to a minimum. As a result, the agency's reported financials seldom reflect the true earning power of the agency. Accordingly, it is necessary to construct a pro forma financial presentation that accurately portrays the agency's sustainable earnings capacity and, to the extent appropriate, anticipates benefits that might accrue from the expected relationship. Most significant in compiling pro forma financials is the identification and documentation of all discretionary expenditures. Along with owner compensation, these expenditures generally represent the heart of the agency's value. On a pro forma basis, most agencies run at a profit margin from the high teens to the low twenties. Significantly, it is our experience that banks can conduct the same agency business at margins approaching thirty percent. The difference almost always is in the amount paid to producers. With a target prospect base and alternatives to cold call solicitation, a bank will find success with a different type of 'sales' person. In the bank environment, product and underwriting experience may prove as important to calling on the prospect as 'sales' skills. Experience indicates that such people can be recruited for much less than the current amounts being paid to an agency's dedicated sales staff.
One of the hardest facts for many agency owners to accept is that the value of their agency will be based on the amount of their pro forma, pretax earnings. Banks, like any other experienced buyer, will be most interested in the amount and quality of earnings. Here again the importance of a quality profile or presentation cannot be exaggerated. A typical, reasonably managed retail agency should expect to be valued at no less than five times, and occasionally up to six times, its pro forma pretax earnings plus any tangible values on the balance sheet after some allowance for minimum working capital. As the challenge is to determine a multiple that reflects the risks involved, both sides are encouraged to seek consultants or counsel familiar with the insurance agency business and insurance agency transactions.
Two facts are significant about this valuation process. First, it assumes the value is cash equivalent. Thus, if the buyer structures an offer based on a payout period or a substantial retention formula the seller should be compensated therefor. Second, whereas many agency values turn out to be less than one times commissions, many turn out to be closer to two times. Rules of thumb can be very, very wrong! It is important for both parties that the right value be established in every case.
As an aside, for those few agencies with the size, financial success and product specialization or diversification to be attractive to a public buyer, the multiples are even higher. The lessons here are several. If you are one of the few, find the right buyer. If you are not one of the few, it is worth the time, effort and even cost to analyze your situation and seek those strategies which can help to enhance your performance, attractiveness and value.
Some of the things which we have found to make an agency more valuable and of greater interest to a merger or acquisition partner are: a balanced capability between property casualty and life and benefits; a staff with strong technical skills; a 'clean' balance sheet, availability of markets and a record of sales and financial success.
On the other hand there are three significant stumbling blocks which impede bank/agency negotiations and subsequent success. First and foremost is the level of owner compensation. The owner of a successful independent insurance agency often makes more money than the bank president. Successfully negotiating a going forward compensation package is seldom easy for either party. Second is the fact of moving from that of an independent entrepreneur to that of an employee. Finally, there is the significant cultural difference that seems to exist between a successful insurance agency and a bank.
In any transaction, it is extremely important for both sides to obtain competent tax counsel. An improper deal structure can reduce the after-tax value to the seller by as much as 40%. Similarly, the cash flows of the buyer can be diminished and the transaction itself jeopardized by inexperienced advisors.
In conclusion, we believe in the independent agent and the independent agency system. We also believe that an increasing number of banks will enter the insurance sales business and obviously, in aggregate, will enjoy increasing success. We are also firmly convinced that the independent agent who truly and effectively manages his/her agency will be in a position to compete effectively whether with banks or others and, as a result, will open options not presently apparent.
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