Defining a Purchase Agreement
As with any real estate asset, the sale, purchase, and ownership of the insurance book of business of an agency begins with a purchase agreement. A purchase agreement is the contract that establishes the deal between the buyer and seller. While you may be comfortable debating the terms and conditions over lunch or a golf game, it is the agreement — the terms — that defines the deal. As indeed is the case with any real estate transaction, any deal to buy a book of business in which the purchase price is in excess of five figures should be documented in a purchase agreement.
Just as a real estate purchase agreement goes beyond the purchase price and breakdown of the deposit installments, the purchase agreement for any transaction for the purchase of a book of business generally includes the purchase price, adjustment provisions, representations and warranties, indemnification provisions, covenants, conditions precedent to closing, conditions of closing, post-closing obligations, escrows and hold-backs if any, and the conditions under which the parties can terminate, usually referred to as a "termination right" provision.
The purchase agreement in a book of business transaction will also address the use of the seller’s name and its results after the change in ownership, the terms for the employment and compensation of seller staff, the closing process, the assignment of book debt, the cooperation obligations of the buyer and seller after the closing, and the notification requirements for policies being transferred and the buyers’ obligations with regard to the transfer of premium refund and direct bill commissions.
The purchase agreement for the purchase of an insurance book typically includes a list of the policies being transferred, whether at the time of the purchase agreement or by a schedule that is attached to the purchase agreement at the closing. The schedule will generally identify the insureds by name, the lines of coverage, the expiration dates, the covered property, and the amount of premium. This provision and its multi-page list give the buyer an opportunity to inspect the list during the interim period prior to closing and to evaluate the reasonableness of all the terms used in the agreement.
The purchase agreement will typically refer to a termination right provision that will permit the seller to terminate the agreement if certain events occur, such as the closing not taking place by a date certain (usually three to six months) after the execution and delivery of the purchase agreement . The right to terminate may be triggered by the failure to receive the permission required from the State Insurance Department or by the failure to receive the buyer’s lender financing approval.
There may be a right to terminate in the event of certain contingencies that are within the control of the buyer, such as in the event the purchase agreement is not submitted to the carrier for change of ownership approval within a designated time period or the failure or refusal to obtain certain consents. In some instances, a buyer may want the option to terminate the deal, regardless of its own actions, in the event that the carrier denies the acquisition of the book of business. Finally, in some circumstances, there are actions that would allow the seller to terminate the agreement. These could include the buyer’s failure to notify the seller of change in financing or the buyer’s assignment of the purchase agreement without the seller’s consent.
The purchase agreement may also include a right to extend the closing date. Such rights permit the buyer or seller to unilaterally extend the closing date on less than two weeks’ notice. While this gives the buyer some level of control, it offers the seller limited leverage to resolve issues that arise close to the closing date. Buyers who need time to secure a letter of credit in order to pay off the book of debt could find it difficult to do so if the letter of credit provider required over two weeks notice for the amount of the letter of credit.
The purchase agreement sets forth the process for determining whether and when the conditions and representations required for closing have been satisfied. The buyer and seller customarily agree to cooperate in determining the timing and content of any notice to the parties after a closing event occurs or if a closing condition has not been satisfied. Further, each party has a right to ask the other to suspend certain pre-closing activities until the closing conditions are resolved. For example, the buyer may not be entitled to assign the purchase agreement or notify the carrier of a change in ownership until the closing conditions are satisfied. This might include a revision of the closing date or an amendment to the schedule of policies if the seller receives notice from a carrier that a policy is not eligible for a change in ownership.
The Insurance Book of Business Defined
Insurance books of business are typically comprised of the particular lines of insurance coverage (e.g., property & casualty, health/life/disability, workers compensation, etc.) for which an insurance agency produces revenues. The two major types of insurance agents (or, more accurately-stated, their agencies) are: independent agents and captive (or "captive) agents, with the latter being further sub-divided into either exclusive captive or independent captive agents (there is also a relatively new category of Agent-Brokerage hybrids). As reflected in the name, an independent agent is not bound to work with any one particular carrier, but rather has the ability to place business with any number of different carriers. An exclusive captive agent, on the other hand, has entered into an agreement with a particular carrier by which the agent is prohibited from placing coverage with any other carrier, requiring the agent to sell the insurance products of that particular carrier. Although such agents are not technically employees of the carrier, their relationship to the carrier is such that they are often referred to as employee-agents. An independent captive agent, on the other hand, is someone with an independent agency that has agreed to tie-in with a particular carrier. These agents are similar to exclusive captive agents but are not required to exclusively sell the insurance products of the carrier. Finally, Agent-Brokerage hybrids are often teams that consist of one or more producers directed by a senior producer who manages and provides oversight for a team of typical independent producers. In this last scenario, the senior producer (and sometimes team members) will have a separate contract in place with a carrier. However, unlike an exclusive captive agent, the agent/brokerage hybrid may sell insurance products of other carriers as well.
The importance of a book of business derives from the fact that it includes all clients (and their accounts) that have been entrusted into the insurance agency’s care and for which revenues and commission dollars are being generated and derived. Accordingly, regardless of whether an insurance agency is a captive or independent, its book of business is comprised of clients that are tied to both: (i) the particular agent; and/or (ii) the insurance agency (which often owns the book, even when the agent leaves the employment of the agency). Thus, for example, an independent captive insurance agent has a book of business that is tied to him or her as an agent, in the sense that that book generally can be taken with that agent when he or she no longer produces on behalf of the insurance carrier in question. By contrast, an independent insurance agency has a book of business that is tied to the insurance agency, since the book is owned by the agency.
Components of a Purchase Agreement for Insurance Books of Business
In the insurance industry, purchase agreements address specific concerns unique to the transfer of an insurance practice. Although not all-inclusive, the following is an overview of key elements in an insurance purchase agreement:
Client Retention Clause
It is common to include a provision in the agreement that makes the purchase price contingent upon a specified percentage retention of clients for a specified period of time against a base rate of retention. In order to give sellers some incentive to remain available to be considered a "retained client," the loss of a client due to a failure to renew should not result in a loss of consideration. Additionally, in order to provide some protection to the buyer for an unusual event which causes a loss of more than a specified percentage of the accounts, there should be a force majeure clause.
Indemnities
Indemnities are a critical part of purchase agreements in the insurance industry. Seller often agree to indemnify a buyer from disclosures made by the seller. Seller should also indemnify the buyer for claims related to insurance coverage sold to the practice by the seller which have not been contested or paid. The parties should review and make the appropriate adjustments to standard indemnity provisions.
Valuation
Purchase agreements for insurance practices are usually based on a multiple of revenues. Although buyers and sellers will likely have different approaches to determining the multiple (based on their individual perspectives and financial situations), the resulting valuation is usually expressed as a current worksheet, an annualized figure for the first full year after purchase, and a value for the second full year.
Structure of the Agreement
The purchase agreement may also provide for the purchase to be structured as either an asset or stock deal, and may be structured as a current or installment sale of the business assets.
Valuation Approaches in the Insurance Industry
Several methods are available to value an insurance book of business and, typically, the more effort put into this process will lead to more accurate results. All other terms being equal, a superior effort will also produce valuations that are more easily reconciled to the purchase price.
Valuation of an insurance agency should include discussion of three multiple-based methods: revenue multiple, EBITDA multiple, and client retention. Circumstances usually dictate one or more modifications among the methods and valuation experts often use formulas in place of the exact multiples. Furthermore, formulas often vary based on the mix of commercial and personal lines business included in the agency or by geographic area. For example, in personal lines business in a highly sought after area, the valuation may be a premium multiple of 1.25 to 3.5 times the 1-year average of the most recent P&L. An agency with a high proportion of commercial lines business may be valued using an EBITDA multiple of 3 to 10 times the EBITDA of the most recent P&L. In regard to client retention, the average of the best performing 50 percent of retained premium can be applied to the most recent 12 month period. The maximum average of the best performing 10 percent of retained premium can be used for premium retention. This retention-based premium is then recombined with the several multiple-based valuations. The retention-based premium is adjusted to reflect the premium of a policy, if a higher one is in force, as a result of a new premium. An adjustment should also reflect the higher premium that might have been written as a new policy in the absence of the existing policy. Premium adjustments should exclude the lost premium of policies which reduced their premium after a coverage check. Remove such policies with greater fee that that policy premium paid by a competitor. Large brokerages typically have different acquisition metrics. Moreover, they likely do not buy insurance books of business for the sole purpose of increasing their premium volume. Thus, the typical revenue multiple applied to an insurance book of business is inappropriately low relative to the EBITDA or net revenues valuation method. And, it follows that the valuation of an insurance book of business used within larger corporations will likely be much higher than a similar insurance book of business focused on the purchase of underlying companies, in addition to the insurance base. Book values are another form of accounting that presumes the risk of expirations, loss of clients, and errors and omissions have been substantially accounted for. This is not an appropriate basis for valuing an insurance book of business and can distort the actual equity value of an insurance book of business.
Legal Aspects and Due Diligence
The legal aspects of a purchase agreement for the sale of an insurance book of business typically focus on a number of key areas. First, the purchase agreement itself must be properly drafted to reflect the intent of the parties, to assign the purchase price and make adjustments to the purchase price based on assumptions pertaining to the books of business. For instance, the book may be valued without the retroactive collection of the earned premiums which were in fact necessary to process the policies. This is often the case because the accounts may not be collectible as they are often very old, and balancing the risks of collection against a greater near term purchase price must be considered. The purchase agreement must also reflect defects in policies that are being conveyed, a recognition of known claims , and an understanding of the additional costs that may be incurred in collecting the accounts that are represented in any purchase price.
Understanding the book of business at issue is perhaps the single most important factor in minimizing long term risks and in making the decision to purchase a book of business. Due diligence must be thoroughly undertaken. This focuses not only on the physical and human elements, but must identify and quantify underwriting and legal risks. These are often hidden in general assessments or aggregate reports, but are critical to evaluating and assessing the true value of the purchase. In our experience the areas that need to be examined in detail not only include the claims process (in the case of claims made polices), but also include a review of multiple year underwriting and retention processes if the business remains with the original agency. A historical view of the book is ultimately essential to managing the purchase, but the seller should not be rewarded for prior improper business practices. If it is discovered that as an individual or agency changes affiliation they may be converting their book to merit which is ripe for an E&O claim.
How to Effectively Negotiate a Purchase Agreement
Negotiating a Purchase Agreement that Works for Both Parties
Now that you have a general understanding of purchase agreements and some of the provisions that may be included, let’s look at how to go about negotiating a purchase agreement that works for both the purchaser and seller. Be aware of your leverage A Buyer must always be aware of leverage. If there are other Brokers you are dealing with, be careful. No one wants to pay for more than the market will bear. Therefore Mrs. Seller, if you have 6 Brokers in the sale process, then the probability of achieving market value is greatly diminished. However, if you have only one party involved, then you may very well be above market value if that party wants the agency so bad that he is willing to access his equity and pay you on terms that you want. We have seen this quite frequently in internal transfers. The Buyer wants a stock position in the Agency to gain control. But for a Seller, control is everything. The Seller may have plans to do a minority recap or simply step aside while the Buyer grows the Agency. It really does not matter. Mr. Buyer, when you are negotiating be careful not to push a Seller too far. He may withhold the customer list if he can. Or he may simply change his mind about selling. In this Agency sale, the Seller has all the leverage. In a typical One Employee Agency Sale, a Seller does not have the leverage because he has no ability to withhold the customer list without putting the Agency value at risk. Remember the rule of thumb here is that the customer list is sacred and cannot be sacrificed. Purchase Price The basic rule of thumb here is that the lower the multiple for the Seller the better for the Buyer. The more the multiple the less the risk. It is a trade-off. Using a word and example we just taught our 9 year old granddaughter, multiply this by this = this. Call your attorney for exact numbers. When you multiply all of the numbers, you arrive at the multiple. You basically have two choices. Adjust the commission rate up or down according to the net amount to be paid to the Seller. Many Sellers want the multiple as a buyer wants a low multiple. What should you do? Number crunch until you see where the break-even point is between the two parties. Use several scenarios. The lower the commission rate the higher the net sale price to the Seller. The higher the commission rate the lower the net sale price to the Seller. Most Sellers would prefer a slightly inflated multiple with a lower commission rate. This way the keys are not given to the Buyer too soon. Also remember not to focus on commission rates alone. Focus on the net revenue from the sale. Understand that the number crunching is the hardest job you have as Seller and requires the most thoughtful attention. It is also the easiest job to place on the back burner while family and career take center stage. We will next discuss the Sale of a Small Agency versus the Sale of an Agency with Employees.
Typical Traps and How to Steer Clear
The acquisition by purchase of another agent’s book of business may involve various risks, which the parties should address in the purchase agreement (such as a stock purchase agreement or asset purchase agreement). The following is a non-exhaustive survey of "pitfalls" to be avoided when purchasing an insurance book of business:
PITFALLS TO BE AVOIDED
1. Do not assume coverage for any errors committed by the seller.
To protect against acquisition of the seller’s exposure for professional liability, the purchase agreement should provide that the buyer shall not be liable for any errors or omissions committed by the seller, only those which are committed after the date of closing (the date the buyer takes over the seller’s book). If the seller does not have any professional liability insurance or its professional liability insurance will terminate on the date of sale, consider personally indemnifying the buyer for any professional liability errors or omissions which are committed prior to the date of sale.
2. Do not assume the seller has clean or sufficient records.
To avoid unpleasant surprises, the purchase agreement should specify what records the seller is to turn over to the buyer and in what format. For example, the purchase agreement may require that the book of business be transferred through the agency management system and only in a format that is mutually agreeable. Also , the purchase agreement should state whether the purchase is to include the seller’s computer hardware and software, and the buyer should do its due diligence by inspecting the hardware and software, and conducting a search of the U.S. Copyright Office to verify that the seller owns the copyright or license to the software.
3. Do not rely solely on the seller’s representations and warranties.
In addition to the representations and warranties that are stated in the purchase agreement, the buyer should be prepared to ask e.g., the seller’s employees, former employees and/or existing clients whether they were dismissed or dropped from the seller’s book of business. Similar questions should be posed to anyone the buyer believes may have knowledge concerning the seller’s past or present relationships with any of the producer’s clients.
4. Do not fail to conduct background checks of the seller’s producers and staff.
Ask questions of the staff, such as: Have any lawsuits been threatened by the seller’s clients? Have any lawsuits been threatened by any type of claimant, e.g., vendors, providers, etc.? And so on. It may also be prudent to conduct due diligence searches against your individual’s names to check for any lawsuits, liens, judgments, convictions, sexual harassment complaints, and other past legal infractions.