CAIB 4 Brokerage Financial Management PDF

CAIB 4: Chapter 9 Brokerage Financial Management CAIB 4  CAIB 4 Section 1 Value of a Brokerage  The Prime Goal of a Brokerage The ultimate goal of a brokerage: profit maximization. Short-term vs. long-term profitabili...

CAIB 4: Chapter 9 Brokerage Financial Management CAIB 4  CAIB 4 Section 1 Value of a Brokerage  The Prime Goal of a Brokerage The ultimate goal of a brokerage: profit maximization. Short-term vs. long-term profitability. Challenges in maintaining focus on profitability. Profitability in both soft and hard markets. CAIB 4 Valuation of Brokerages Key valuation methods: 1.Multiple of commissions. 2.Multiple of earnings. Other factors impacting value. CAIB 4 Method 1 – Multiple of Commissions Definition of the multiple of commissions method. Equal valuation regardless of profitability. The importance of sale terms and conditions. CAIB 4 Method 2 – Multiple of Earnings Definition of the multiple of earnings method. Focus on the brokerage’s income-producing ability. Other factors to be considered in pricing. CAIB 4  Financial information to consider in valuation: Key Financial Information 1. Balance sheet items. for Valuation 2. Income statement items. 3. Other financial factors. CAIB 4 Balance Sheet – Assets Key asset categories: Cash and short-term investments. Accounts receivable. Other assets (office, technology, etc.). CAIB 4 Balance Sheet – Liabilities Liabilities impact on brokerage value. Both current and long-term liabilities decrease value. Accounts payable and offsetting assets. CAIB 4 Balance Sheet – Shareholders’ Equity Shareholders' equity as a balance sheet item. Universal accounting equation: Assets = Liabilities + Owners' Equity. Effect on value. CAIB 4 Income Statement – Revenue Importance of revenue in determining value. Main revenue sources: Commissions. Investment income. Other income (fees, rentals). CAIB 4 Commissions – Largest Revenue Source Commission percentage vs. premiums written. Trends in commissions. Contingent profit sharing considerations. CAIB 4 Income Statement – Expenses Expense considerations. Impact of controllable vs. uncontrollable expenses. CAIB 4 Other Financial Considerations Additional financial factors impacting value: Cash flow. Billings. Tax impact. CAIB 4 Efficient Business Operations Importance of operational efficiency. Impact on brokerage value. CAIB 4 Organizational Structure Legal and operational organization. Impact on compatibility with the buyer’s goals. CAIB 4 Geographic Representation Geographic expansion’s effect on valuation. Premiums paid for desired locations. CAIB 4 Relationships with Insurers Importance of relationships with insurance companies. Direct vs. brokerage-billed business. CAIB 4 Client Relationships and Retention Client retention and relationship importance. Retention ratio's effect on value. CAIB 4 Business Mix The mix between personal and commercial lines. Importance of buyer preference. CAIB 4 Employee Quality and Turnover Impact of employee quality and turnover on value. Education, training, and productivity factors. CAIB 4  Potential for New Business Single-policy clients vs. multi-policy clients. Growth potential based on location and reputation. CAIB 4 Loss Ratios Impact of historical loss ratios Correlation with contingent on value. profits and insurer relations. CAIB 4 Errors and Omissions Claims Impact of errors and omissions claims on value. Higher claims = lower value. CAIB 4  CAIB 4 Section 2 Financial Management Tasks Financial Management Overview Effective management of: Assets Liabilities Capital structure Income Expenses Key information source: Brokerage's accounting system Financial management extends beyond accounting records CAIB 4 Financial Management Cycle Key Components of Financial Management Budgeting Classifying Financial Information Making Comparisons CAIB 4 Budgeting Overview Importance of Budgeting Forces management to assess income and expenses Facilitates prediction of profitability Budgets serve as control mechanisms for performance evaluation CAIB 4 Revenue/Income Components Types of Revenue/Income Commissions (Largest income item) Investment income Other income (e.g., rental fees, service fees) CAIB 4 Commissions Breakdown Key Commission Variables Retention rate of existing clients Changes in insurance premium rates Up-selling and cross-selling opportunities Acquiring new clients CAIB 4 Expenses Overview Types of Operating Expenses Selling expenses Occupancy costs Salaries and benefits Administrative expenses CAIB 4  Classifying Financial Information Purpose of Financial Classification Segment income and expenses by type and source Identifies patterns for analysis Enables meaningful comparison CAIB 4 Classifying Income & Expenses Key Financial Segmentation Commission income vs. fee income Personal lines vs. commercial lines CAIB 4  Making Comparisons Comparative Analysis Compare actual operations to standards Investigate variances (positive and negative) CAIB 4 Taking Corrective Action Corrective Measures Address negative deviations quickly Reinforce positive deviations for long-term success CAIB 4 Importance of Internal Communication Role of Communication Employees must understand and support corrective actions Promotes alignment within the brokerage CAIB 4 Financial Management Cycle in Action Proactive Financial Management Not just reactive Continuous and proactive monitoring CAIB 4  CAIB 2 Section 3 Income and Expense Management Income and Expense Management in Insurance Brokerages Income and expenses: critical components of financial management Key areas include: Trust Fund Regulations Commission Reserve Accounts Internal Cash Controls Accounts Receivable CAIB 4  Income Management: Trust Fund Regulations PREMIUMS ARE SPLIT BETWEEN MISUSE OF FUNDS POSES RISKS, SOLUTION: SEPARATE TRUST AND COMMISSION (BROKER'S SHARE) AND ESPECIALLY WHEN USING INSURER'S OPERATING ACCOUNTS NET PREMIUM (INSURER'S SHARE) SHARE CAIB 4  Mismanagement could lead to inability to pay insurers Legally compliant practices Trust Fund Risks reduce operational risks and Best Practices Establishing two separate accounts is essential CAIB 4  Income Management: Commission Reserve Accounts Reserves address the risk of cancelled policies requiring commission refunds Key factors: Unearned commissions Historical trends Large premiums CAIB 4 Calculating and Managing Commission Reserves Conservative accounting: maintain a reserve for probable refunds Asset liquidity is crucial for handling unearned commissions Agreements with producers should include return of refunded commissions CAIB 4 Internal Cash Controls: Risk Mitigation Personnel selection and training are key risk control measures Fidelity bonds and surprise audits can help detect fraud early Implement a no-tolerance policy for theft CAIB 4 Accounting Controls: Ensuring Financial Integrity Annual audits by professional firms are crucial Surprise audits for internal checks and balances Focus on verifying assets, liabilities, and income/expense accounts CAIB 4  Accounts receivable (A/R) are Income significant assets, but pose risks if not managed properly Management: Accounts Long collection periods strain Receivable cash flow and increase financial exposure CAIB 4 Costs Associated with Accounts Receivable Bad debts Collection costs Opportunity cost increase with increase with of tied-up funds longer collection slow payers periods CAIB 4 Accounts Receivable Policies Clear policies on payment arrangements, credit checks, and payment methods Specific responsibility for follow- up and enforcement is necessary Aged receivable schedules for prioritizing collections CAIB 4 Alternate Methods of Financing Premiums Brokerage financing: instalments without service charge Financial institution and insurance company financing Premium finance companies and captive finance companies CAIB 4 Premium Financing Models Recourse vs. non-recourse Captive finance companies: Cash-only financing: benefits financial institution financing owned by brokerages and drawbacks CAIB 4 Expense Management: Increasing Profitability Expense management complements income management Reducing costs equals direct gains in pre-tax income Means of controlling expenses include communication, cost identification, and classification CAIB 4 Identifying Areas for Cost Control Employ modern technology and process automation Increase productivity through work organization and elimination of unnecessary steps Focus on administrative efficiency and technology solutions CAIB 4 Classifying and Analyzing Costs Cost accounting helps match expenses with insurance lines Use technology to track and analyze costs Compare expenses regularly against industry standards CAIB 4 Conclusion: Best Practices for Income and Expense Management Focus on trust fund regulations Strengthen internal cash controls Implement robust expense and commission reserves and accounts receivable policies management strategies for long- term financial success CAIB 4  CAIB 2 Section 4 Income Tax Considerations Income Tax Considerations for Brokerages Maximizing income/wealth is key for businesses In closely held businesses, strategies can minimize taxable profits Methods to increase personal income include direct (salary/commissions) and indirect (incentive plans, leases) CAIB 4 Maximizing Personal and Focus on personal income as well Employee Income as employee compensation Income maximization can be done directly or indirectly Incentive plans and lease arrangements offer strategic advantages CAIB 4 Employee Incentive Plans Reward employees for performance and loyalty Incentive plans vary by complexity and tax implications Common plans: bonus, stock option, performance, deferred compensation, and pension plans CAIB 4 Bonus Plans & Stock Option Plans Bonus Plans: Discretionary, not always linked to performance Stock Option Plans: Rewards employees based on brokerage's stock value, mostly for senior management CAIB 4 Performance Plans (Profit Sharing & Stock Purchase) Profit Sharing: Select employees receive payouts based on business profits, widely used in insurance Stock Purchase: Requires purchase at grant time, unlike options that allow time for stock acquisition CAIB 4  Deferred Compensation & Pension Plans Deferred Compensation: Defers a portion of salary or bonuses for later, tax-advantaged periods Pension Plans: Designed to provide income at retirement, making the brokerage more attractive to employees CAIB 4 Lease Arrangements as a Tax Strategy Leasing equipment can reduce taxable income Conserves cash by avoiding large down payments Avoids obsolescence risk by leasing modern equipment CAIB 4  Benefits of Leasing for Brokerages LEASE PAYMENTS ARE TAX- FLEXIBLE TERMS: POTENTIAL DOES NOT ADD DEBT TO THE DEDUCTIBLE UPGRADES DURING LEASE BALANCE SHEET, INCREASING PERIOD BORROWING CAPACITY CAIB 4 Financial and Tax Advantages of Leasing ACCELERATED LEASE PAYMENTS MORE FLEXIBLE THAN DEBT HELPS PRESERVE BORROWING CAN INCREASE DEDUCTIONS AGREEMENTS CAPACITY WITHOUT AFFECTING FINANCIAL RATIOS CAIB 4  CAIB 2 Section 5 Financial Analysis Measuring Financial Performance in Brokerages Two main approaches: Financial condition & operational efficiency Financial condition tests: Focus on liquidity and creditor interest Efficiency tests: Analyze operational effectiveness CAIB 4 Acid Test: Measuring Liquidity Compares assets to liabilities to assess liquidity Measures safety margin of cash and near-cash assets Brokerage's liquidity depends on the composition of current assets (cash vs. receivables) CAIB 4 Equity-to-Debt Test Indicates the amount owed versus the amount owned A higher ratio suggests financial strength and security Important for long-term creditors and overall stability CAIB 4 Working Capital Defence Interval Indicates how long working capital can cover daily expenses Formula: Working capital divided by average daily expense Critical for covering cash flow gaps due to slow premium/commission inflows CAIB 4 Cost Per Account Ratio Measures office/sales costs per account Reflects fixed cost structure, additional accounts may lower average costs Key question: Is the account profitable relative to handling costs? CAIB 4 Revenue Per Employee Ratio Estimates efficiency by calculating revenue per employee Formula: Net revenues divided by total personnel Higher ratio reflects greater efficiency and productivity CAIB 4 Lapse Ratios Measure brokerage effectiveness in renewing client relationships Commission lapse ratio: Measures lost commissions compared to renewals Policy count ratio: Compares number of lapsed accounts to total accounts subject to renewal CAIB 4 Expense Ratio: Efficiency Measure Measures brokerage efficiency by comparing expenses to income Formula: Total brokerage expenses divided by commission income Lowering the expense ratio requires increasing income or reducing costs CAIB 4 Close Ratio: Sales Efficiency Measures sales effectiveness by comparing policies sold to quotes provided Formula: Number of policies sold divided by number of quotes provided Low close ratio indicates need for better sales training or prospect qualification CAIB 4