Chapter 9: Brokerage Financial Management

Question 1

What is the ethos of profit maximization?

Answer 1

The more profit the better.

Question 2

What is a multiple of commission?

Answer 2

A simple approach that does not take into consideration the profitability of a brokerage in the value calculation.

Question 3

What are the components included on a balance sheet? (2)

Answer 3

1. Assets - cash, short-term investments, account receivables, other assets (facilities, softwares, equipment, etc.).
2. Liabilities - current liabilities, long-term liabilities.

Question 4

What is included on an income statement? (2)

Answer 4

1. Revenues - commissions and possibly contingent commissions/profit sharing (though, due to the inherent unpredictability around any contingent incomes, they are not used in the valuation of the brokerage), investment income, all other incomes (fees-for-service, rental income, real estate commissions, etc.).
2. Expenses

Question 5

What are included in other financial items (brokerage valuation)? (3)

Answer 5

1. Cash flow - large amounts of cash are naturally preferable, and receivables that are over 60 days old will have a reduced value due to the increased risk of bad debts.
2. Billings - fewer billings based on premium volumes is considered to be better.
3. Tax impact

Question 6

When it comes to brokerage valuation, how could a brokerage’s location be important?

Answer 6

Larger brokerage organizations may pay high prices for brokerages in geographic areas where they are looking for representation.

Question 7

What would be evaluated about the nature of a brokerage’s business operation? (4)

Answer 7

1. Companies represented - good brokerage relationships with insurers that the buyer is keen on.
2. Type of billings - a preference of the potential buyers, whether it be predominantly direct bill or agency bill.
3. Relationships with clients - strong client relationships and a correlating rate of retention are sought after intangibles.
4. Business mix - purchaser may have preferences as to the lines of business they are familiar/comfortable with, predominantly personal-lines or commercial-lines.

Question 8

What are some other factors that go into the value of a brokerage? (5)

Answer 8

1. Quality of employees
2. New business potential - single-policy clients represent potential cross-selling of other products, and developing areas that are to see population growth in the near future.
3. Loss ratio - affects relations with insurers as well as the potential/size of contingent profits received by the brokerage.
4. Errors & omissions claims - E&O claims as a percentage of commission income.
5. Market conditions

Question 9

What are the components of the financial management cycle? (3)

Answer 9

1. Budgeting
2. Classifying financial information
3. Making comparisons

Question 10

When evaluating revenue/income, what information should be considered about commissions? (4)

Answer 10

1. Retention rate
2. Changing insurance rates
3. Up-selling & cross-selling
4. New business obtained

Question 11

What does it mean to classify financial information? Why is this important?

Answer 11

Segmenting income and expenses by type. For example, commission income vs fee income, or personal-lines vs commercial-lines.

This allows for a consistent basis to compare financial results between quarters/years.

Question 12

In the event of a variance in actual operations, what should take place, and why?

Answer 12

A variance, whether positive or negative, should trigger an investigation. Negative variances should be rectified with changes in operations, while positive variances would be investigated with an objective to replicate the success.

Question 13

What is involved in income management? (4)

Answer 13

1. Trust fund regulations
2. Commission reserve accounts
3. Internal cash controls
4. Accounts receivable

Question 14

What are trust fund regulations?

Answer 14

Manner in which monies from premiums are handled. Typically, funds are required to be deposited into a trust account, pending transfer to the insurance companies. Agreements allow for commission balances to then be moved in to an operating account.

Question 15

What is a commission reserve account?

Answer 15

A separate account from the operating account, where the probable amounts of commissions that may have to be refunded are held.

Question 16

What factors contribute to the amount of reserve that should be maintained? (3)

Answer 16

1. Total of unearned commissions indicates maximum exposure.
2. Ratio of returned commissions to total commissions over time demonstrates what the average returned commission experience has been.
3. Commissions on large premiums/accounts should be considered, as they are susceptible to competition and represent a greater exposure as far as unearned commission is concerned.

Question 17

Why is it important to pay attention to internal cash controls?

Answer 17

Controlling and handling of cash, cash equivalents, and other securities aids in the mitigation of employee dishonesty.

Question 18

What factors contribute to increased costs of accounts receivable costs? (5)

Answer 18

1. Surrendered opportunity cost of funds
2. Increased cost of collection activities
3. Cost of borrowing
4. Reduced bad debt expense
5. Commission losses from failure to extend credit

Question 19

What are the factors important in an accounts receivable policy? (4)

Answer 19

1. Payment arrangements
2. Credit checks
3. Payment methods
4. Responsibility for follow-up

Question 20

What is brokerage financing?

Answer 20

A brokerage’s own system of premium financing. If service charges are not applied, the brokerage will be overlooking the time value of money due to having less cash on hand for investment opportunities.

Some brokerages push these financing options because they see such service fees as a significant source of income.

Question 21

What are the premium financing options available to brokerages? (6)

Answer 21

1. Brokerage financing (in-house)
2. Financial institution financing
3. Insurance company financing
4. Premium finance companies
5. Captive finance companies
6. Cash only financing

Question 22

What are the means for controlling expenses? (4)

Answer 22

1. Communicating
2. Identifying areas for cost control
3. Classifying costs
4. Analyzing expenses - developing expense standards and making comparisons

Question 23

What are the employee incentive plans employed by brokerages? (5)

Answer 23

1. Bonus plan
2. Stock option plan
3. Performance plans - profit sharing, stock purchase
4. Deferred compensation
5. Pension plans

Question 24

How do lease arrangements come into play when a brokerage is making income tax considerations?

Answer 24

If the firm were to lease equipment rather than purchasing they would accrue a number of tax benefits.

1. Lease agreements often do not require a significant down payment, or do not require a down payment, allowing the firm to utilize cash elsewhere.
2. Mitigates obsolescence risk as equipment is to be returned at or before expiry.
3. Deduction of full lease payments from taxable income.
4. Acceleration of lease payments (if permitted) can increase deductions.
5. Flexibility; lease agreements are less restrictive than debt/financing agreements.
6. Leasing does not add debt to brokerage’s balance sheet, increasing brokerage’s borrowing capacity.

Question 25

What tests can be done to evaluate financial condition? (2)

Answer 25

1. Acid test = (cash+A/R)/current liabilities
   Measures a brokerage’s liquidity position.
2. Equity-to-debt test = shareholder’s equity/total assets
   How much we owe vs how much we own.

Question 26

What are the tests of efficiency a brokerage could employ? (2)

Answer 26

1. Cost per account ratio = office costs/# of accounts
2. Revenue per employee ratio = net revenues/# of personnel

Question 27

What are lapse ratios?

Answer 27

Key measures for analyzing a brokerage’s effectiveness at creating and maintaining client relationships; rate at which business is renewed.

Question 28

What is the commission lapse ratio?

Answer 28

Lapse ratio = commission volume lapsed/commission volume of renewals

Question 29

What is the expense ratio?

Answer 29

Expense ratio = total brokerage expense/commission income