Chapter 9

Question 1

Define “profit maximization.”

Answer 1

Brokerages strive to build profits, therefore the more profit the better.

Question 2

What are the leading causes that distract from profit maximization?

Answer 2

Brokerages are often distracted from implementing strategies to maximize profits because of the day to day practicalities of running brokerages. The primary distracters: fulfilling client’s needs; information requests; and insurer obligations.

Question 3

Explain how the Multiple of Commissions method works and identify a shortcoming when using this evaluation method.

Answer 3

Valuing brokerages using multiple of commission method bases value on annual commission income multiplied by a certain number (eg. two times annual commission). One major shortcoming of this valuation method is that profitability of brokerage is not considered.

Question 4

Briefly explain how items in balance sheets will affect brokerage value.

Answer 4

Assets: Cash, accounts receivable and other assets will influence value when these pass from seller to buyer.

Liabilities: Current and long term liabilities will influence value when these pass from seller to buyer.

Shareholders’ Equity: As all assets and liabilities have all ready been considered, shareholder’s equity will not influence brokerage value.

Question 5

Identify two main items on Income Statements.

Answer 5

i) Revenues
ii) Expenses

Question 6

Indicate how “cash flow projections” may affect brokerage value.

Answer 6

To ensure adequate funds are available during transition periods the more available cash the better. Accounts receivable will be a strong indicator of pending cash flow. Attention must be paid to aged receivables over sixty days old as they may result in bad debts and not contribute to cash flow.

Question 7

Describe how “billings” may affect brokerage value.

Answer 7

As the cost to bill an account is the same, regardless of size of the account, the fewer the billings the better.

Question 8

Explain how “business mix” may affect brokerage value.

Answer 8

When purchasers are considering brokerages to purchase they will desire brokerages with a business mix that is appealing to them. Brokerages who prefer personal lines will be willing to pay more for brokerages with strong personal lines rather than primarily a business mix. There is no perfect mix, buyer’s preference will prevail.

Question 9

Indicate how “loss ratio” may affect brokerage value.

Answer 9

The Loss ratio of a brokerage’s business indicates the strength of its relations with insurers and affects the contingent profit payments from insurers.

Question 10

Briefly explain seven other factors affecting brokerage value.

Answer 10

i) Geographic Representation – Brokerages wishing presence in certain markets may well pay more for brokerages in which they have no representation.

ii) Companies Represented – Brokerage with contracts with insurers important to purchasers may have an enhanced value.

iii) Type of Billings – Purchasers that have strong direct billing type business will be more interested in brokerages that have a significant amount of personal lines direct billed.

iv) Relationships With Clients – Brokerages with strong retention rates and solid client relationships will have enhanced value.

v) Quality of Employees – Well trained, professional and well compensated staff will enhance brokerage value.

vi) New Business Potential – Potential purchasers will look at the opportunities for growth within existing clients.

vii) Errors and Omission Claims – History of repetitive E&O losses will indicate problems within brokerage operations and will influence value.

Question 11

Identify the three components of the financial management cycle.

Answer 11

i) Budgeting
ii) Classifying financial information
iii) Making comparisons

Question 12

Identify revenue budget considerations that must be considered by brokerages when developing their budgets.

Answer 12

Brokerages must consider: commission income which includes retention; changing insurance rates; up-selling and cross selling; new clients obtained. Other revenue items to be considered are investment income and other income sources.

Question 13

Why must financial information contained in budgets be classified?

Answer 13

Classifying financial information allows brokerages a consistent basis from which to develop comparisons.

Question 14

Financial management should be proactive not reactive. Explain.

Answer 14

Constant measurement of performance will identify positive variances to be maintained and negative variances to be corrected. Simply recognizing variances is not enough. Strong managers recognize that making corrective actions throughout the year is a proactive response to comparisons.

Question 15

Identify the four areas that must be examined by management prior to establishing proper procedures for handling brokerage funds . . . ie) income management.

Answer 15

i) Trust fund Regulations
ii) Commission reserve accounts
iii) Internal cash controls
iv) Account receivables

Question 16

Identify the five factors to consider when determining cost of accounts receivables.

Answer 16

i) Surrendered opportunity cost of funds
ii) Increased cost of collection activities
iii) Cost of borrowing
iv) Reduced bad debt expense
v) Commission losses from failure to extend credit

Question 17

Briefly explain four topics contained in accounts receivable policies.

Answer 17

i) Payment Arrangements – When sales are made, acceptable payment methods must be known by brokers and customers.
ii) Credit Checks – Brokerages may wish to establish contracts with credit bureaus to determine eligibility of clients to receive credit.
iii) Payment Methods – Payment methods acceptable to a brokerage must be clearly established with accounts receivable policies.
iv) Responsibility for Follow-Up – One individual within a brokerage must be identified as being responsible for the execution and enforcement of accounts receivable policies.

Question 18

Identify six ways to finance premiums and, where possible, identify an advantage or disadvantage to each method.

Answer 18

i) Brokerage Financing – An advantage may include additional service charge income for brokerage and disadvantage may include training of clients to pay their bills slowly.
ii) Financial Institution Financing – An advantage may include client’s satisfaction with regular payment schedules and disadvantages may include making a brokerage responsibility for bad debts.
iii) Insurance Company Financing – Advantages may again include regular payments for clients and disadvantages may include minimum premiums required and the need for annual policies.
iv) Premium Finance Companies – Advantages include prompt commission payments to brokerages.
v) Captive Finance Companies – Advantages include financing company controlled by brokerage and disadvantages may include a requirement for competent management and the corresponding expense.
vi) Cash Only Financing – Advantages include less work for brokerage staff and disadvantages include a decrease in sales.

Question 19

While increases in income help to ensure brokerage profitability, expense control can have the same effect. Identify and briefly explain four ways available to the brokerage for controlling expenses.

Answer 19

i) Communicating – Expense control programs must be communicated to all brokerage staff to ensure success.
ii) Identifying Areas for Cost Control – Brokerages should consider employing modern technology, convert to upload and download of personal lines accounts, covert to direct billing of personal lines business and increased productivity.
iii) Classifying Costs – Brokerages must classify costs into categories. This allows brokerage management to focus on matching expenses with products and departments.
iv) Analyzing Expenses – Brokerage management must develop expense standards that represent good performance then make comparisons to these standards to remain proactive in expense management.

Question 20

Identify two methods of indirect income used to maximize personal income.

Answer 20

i) Employee incentive plans
ii) Lease arrangements

Question 21

Explain six reasons why leasing equipment is advantageous to brokerages.

Answer 21

i) Leasing companies may finance 100% of the value of equipment and not require down payment.
ii) Rapid equipment replacement is possible reducing chances of obsolete equipment.
iii) Full value of lease payments may be deducted from income.
iv) Accelerated lease payments may reduce taxable income.
v) Lease arrangements are less restrictive than purchase arrangements.
vi) Brokerages enjoy improved borrowing ability because leases do not add to brokerage’s debt.

Question 22

Explain two types of tests of financial condition.

Answer 22

i) Acid Test – This test of financial condition measures a brokerage’s liquidity and safety margin of cash. Formula simply divides cash and accounts receivable by current liabilities. Consideration of old accounts receivables and amounts of cash verses accounts receivable will influence results.

ii) Equity–to-Debt Test – This test of financial condition compares what you own to what you owe. This test is special importance to long term creditors. Formula simply divides equity by assets.

Question 23

Explain five tests of efficiency used by brokerages.

Answer 23

i) Cost Per Account – This test of efficiency provides insights into improving productivity within brokerages. Formula simply divides costs of operation by number of accounts. Costs may be segregated into all office costs or simply sale costs.

ii) Revenue Per Employee – This test of efficiency provides insights into improving productivity of brokerages. Formula simply divides revenues by number of personnel.

iii) Lapse Ratio – This test of efficiency provides insights into improving retention levels and speaks to existence of client relationships. Formula simply divides commission volume lapsed divided by commission volume of renewals. This may be converted to policy count basis.

iv) Expense Ratio – This test of efficiency provides insights into brokerage expenses compared to commissions. Formula simply divides brokerage expenses by commissions. Many brokerages believe this provides the most meaningful measure of brokerage efficiency.

v) Close Ratio – This test of efficiency measures the success of sales staff. Formula simply divides number of policies sold divided by number of quotes provided.

Question 24

Which test of efficiency is most meaningful to brokerages?

Answer 24

Expense Ratio