Whether an agency owner is looking to streamline their operation to do their an
nual budget, make more profit, or ascertain agency value for an internal valuation or potential sale, creation of a pro forma income statement is important.
Budget Creation
Many agencies do not have budgets—but they should. It does not work to just show certain percentage increases for most expen
ses and compensation. Each line item should be evaluated with managerial and financial staff to determine what is really needed.
Accounting can take a first crack at this process and should remove non-recurring or discretionary items and leave in the expenses t
hat are necessary and ongoing for the department heads and owners to then take a look at. It is best to do a budget by departm
ent, which could include personal versus commercial lines, e
mployee benefits, and individual health versus life insurance. Any niche pro
grams can also have their own budget, such as programs. If an agency has created a separate small commercial department, those expenses should be segregated to see if any p
rofit is being made. Making profit on small accounts is hard, especially if producers are also being paid for writing these accounts.
Profit Center Accounting
As described above, if possible, segregate the revenues by department an
d the related expenses. If there are expenses for the whole agency, such as owner management salaries, postage, repairs, and maintenance, then often using the revenues to the total per
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centage to separate these expenses can be used. Or if the expense is related to the number of people, like rent, then the number of pe
ople and producers in that department to the total personnel percentage can be used to assign these expenses.
Internal Valuation
Once the pro forma income statement is created and management has signed off on the necessary expenses for the agency, the true agency profit can then be used for valuation purposes.
For internal valuation purposes, we use the profit and then do two or three valuation methods. First, we use the Capitalization of Earnings method that establishes the price a buyer coul
d pay in order to yield a specific required rate of return on investment. This method of determining value is widely used in the financ
ial industry. It is also widely utilized by knowledgeable buyers and sellers of independent insurance agencies.
The methodology first determines a risk-free rate, ordinarily U.S. Treasury bonds of 20 to 30 years maturity. A separate risk premium rate, based on the inherent risk of the agency, is then added to the risk-free rate to determine the total rate of return a buyer would require if he/she invested in the agency. The additional return required is usually in the range of 5% to 15%. The greater the perceived risk in an investment, the higher its return should be.
