Caib 4 Chapter 9

Front 1

What is profit maximization and what is the main reason this concept is not put into practice by brokerages?

Back 1

Profit maximization means the more profit the better. Very few put this into practice because the practicalities of operating the brokerage on a day-to-day basis distract attention from a focus on pure profitability

Front 2

What is a major shortcoming of the multiple commission method of valuing brokerages?

Back 2

Does not consider the profitability of the brokerage. A highly profitable brokerage, and an unprofitable brokerage with the same commission income, will have the same value using this method.

Front 3

How does each item on the balance sheet impact the value of the brokerage?

Back 3

A) Assets: in some cases book value of the assets is a valid measure. Cash & Short-term investments cash is the most liquid asset, followed by short-term investments, which can easily be liquidated. Accounts receivable The value of AR depends on their age as well as how quickly and how likely they are to be collected. Other Assets: many other aspects may affect the value of the brokerage (well furnished, modern technology etc. )

B) Liabilities: if the liabilities are to be assumed by the purchaser, both current and long-term liabilities decrease the value of the brokerage.

C) Shareholders’ Equity: the owners equity represents the ‘balancing’ item in the balance sheet. If the sale of a brokerage includes all properly valued assets and an assumption of liabilities, the book value of owners equity has no effect on value.

Front 4

How does each item on the income statement impact the value of the brokerage?

Back 4

A) Revenue: the sources and quality of income or revenue is critical. Sources include: commissions, investment income and other revenue.

B) Expenses: expenses are a factor to the extent that they are considered uncontrollable by the purchaser. The ability to control expenses, and therefore increase profit, is important.

C) Other financial items: cash flow, billing’s, tax impact.

Front 5

What are other factors which might be important to a buyer?

Back 5

1) Quality of Employees: a well-compensated, motivated, highly productive group of employees is invaluable. If key employees are not strong performers, the value of the brokerage may be lowered.

2) New Business Potential: single policy holders could be more likely to take their business elsewhere, at the same time, they are a great opportunity to generate new business by the sale of additional insurance. If brokerage is located in a growing area and has a good reputation with the community, the potential for NBS is enhanced.

3) Loss ratio: if loss ratios are high, brokerage is less value than one with a low ratio. Level of the loss ratio affects the size of the contingent profits and relations with insurers.

4) Errors & Omissions claims: number of E&O claims is an indicator of the quality of a brokerage.

5) Market conditions: soft market means pricing is low and may be an attractive time to buy. Hard market means pricing is high and might be a good time to sell.

Front 6

3 components of the financial management cycle:

Back 6

1) Budgeting: the objective is to anticipate income flows and expense outlays, resulting in prediction or forecast of profitability. The budget items are classified under 2 headings a) revenue/income: money coming into the brokerage- commissions, investment income, other income (rental, service fees, management fees) b) Expenses: operating expenses of the brokerage including: selling, occupancy, salaries, benefits and administration

2) Classifying Financial Information: involves segmenting income and expenses by type. This enables patterns to be identified.

3) Making Comparisons: once standards have been adopted, a comparison of actual operations can be made to determine the level of effectiveness.

Front 7

Four production variables to be considered when budgeting for commissions:

Back 7

1) Retention: this refers to the percentage of clients who will renew. Rate of retention is the result of how effectivef the brokerage has been at developing client relationships. Better relationships means higher retention rates.

2) Changing insurance rates: premium rates vary from year to year depending on whether the market is soft or hard. In soft premium levels may fall, producing lower premium income. In hard uw standards tighten and premium levels may increase.

3) Up-selling and Cross-selling: this curable is directly under brokerage control as it involves such activities as increasing liability limits, increasing property values and selling broader coverages.

4) New Clients obtained: this will be a function of the business building strategies. It’s inevitable that some client relationships will lapse, as a result of relocations, deaths and for other reasons, therefore the brokerage must have a NBS development strategy.

Front 8

Why classifying financial information is valuable:

Back 8

It involves segmenting income and expenses by type. It is valuable because it provides a consistent basis to compare financial results.

Front 9

4 areas of Income management:

Back 9

1) Trust fund regulations: there are 2 parts to the premium charged - The commission (brokerage earnings) and The Net Premium (due to the insurance company for providing protection). It is mandatory in Ontario that these two parts be kept separate. Trust fund holds the income to the insurance company. Operating account holds brokerage commission to pay for expenses.

2) Commission Reserve Accounts: commission is usually treated as income when policy is written or paid. This can overstate income as some policies will be cancelled or reduced prior to expiration and commissions may need to be refunded. The brokerage will create a reserve account to hold a probably amount of commission that may need to be refunded to the insurance company. Have producers sign an agreement to return refunded commissions. Three factors to consider when establishing the reserve amount: 1) Total of unearned commissions indicates maximum exposure. 2) ratio of returned commission to total commissions indicates the average. 3) commissions on large premiums, represents larger exposure.

3) Internal Cash Controls: cash, cash equivalents and negotiable securities constitute a large part of any brokerages assets. There are 2 categories of control devices to protect against “white collar crime” a) Personal Selection: employees need to be trained and compensated properly to help prevent turnover and to discourage employee theft. A fidelity bond application should be completed, surprise audits of records, and a no-tolerance theft policy. b) Accounting controls: annual audits conducted by an accounting firm should be conducted

4) Accounts Receivable: accounts receivable will be the dominant part of current assets. Control of accounts receivable is vital to their financial health. Factors that contribute to the cost of accounts receivable are: surrendered opportunity cost of funds, increased cost of collection activities, cost of borrowing, reduced bad debt expense, commission losses from failure to extend credit.

Front 10

What are the factors that should be evaluated before establishing a realistic accounts receivable policy?

Back 10

1) Payments and arrangements: arrangement of premium should be done at the time the business is written. Expectations of the client and broker should be clear.

2) Credit Checks brokerage may want to enter a contract with a credit bureau to enable them to check the credit rating for clients requesting credit terms.

3) Payment methods it is the duty of the brokerage to determine which payment methods will be used.

4) responsibility for follow-up responsibility for executing and enforcing the credit policy should be clearly defined.

5) schedule for aged accounts receivable highlights the accounts that are past due, enabling collection efforts to be concentrated on the most important areas.

Front 11

What are the advantages and disadvantages of the six different ways available to finance premiums?

Back 11

1) Brokerage Financing advantage: clients do not have to pay the whole premium up front. disadvantage: ignores time value of money, additional work created, trains the clients to pay slowly.

2) Financial institution financing advantage: client - easy payments to financial institution, brokerage - receive the premium in advance. disadvantage: if done on a recourse basis the brokerage remains responsible for a borrowers bad debt.

3) Insurance company financing: many companies offer their own finance plans. nothing in the text about advantage/ disadvantage

4) Premium finance companies advantages: prompt commission payments, reduced billing expense, reduced collection expense, lower accounts receivable, use of money until due to the insurance company, financial risk passed to the insured. Nothing about disadvantage in the text book.

5) Captive Finance companies advantage: can greatly increase the overall profits of a brokerage if it is well managed.

6) Cash only financing advantage: less work and more income for the brokerage early in the policy term. disadvantage: decrease in sales.

Front 12

What are 4 means of controlling expenses?

Back 12

1) Communicating: effectively communicate the need to control expenses to all employees. Individual areas of expense control cannot be reduced unless all employees put forth the effort.

2) Identifying areas for cost control: 3 areas for cost control potentially leading to increased productivity include - employing modern technology, direct policy issuance from insurance company, direct billing.

3) Classifying Costs: cost accounting focuses strictly on costs, matching expenses with products and departments

4) Analyzing expenses: there are 2 components necessary to analyze expenses - a) developing expense standards (based on total income to expenses) b) making comparisons (why is it this way?)

Front 13

What are two indirect methods by which employees may maximize income?

Back 13

1) Employee incentive plans: bonus plans, stock option plans, performance plans (profit sharing, stock purchases), deferred compensation, pension plans.

2) Lease Agreements: leasing certain equipment can help decrease income tax liabilities. Advantages: leasing companies do not require a down payment - conserving brokerages cash and working capital, reduced risk of obsolescence, providing tax advantages, lease agreements are more flexible than debt agreements, may add to brokerages’ borrowing capacity but does not add to debt.

Front 14

2 types of tests used to analyze the financial results of a brokerage:

Back 14

1) examining finances: testing of financial condition (important to creditors)

2) Examining your operations: Tests of efficiency (only meaning if compared to an internal and external standard)

Front 15

What are two key items of information gained when measuring brokerages liquidity?

Back 15

The safety margin of cash to allow for the fluctuations that occur in cash flow

Front 16

How does cash and receivables impact liquidity?

Back 16

A brokerage with a large percentage of its current assets in cash has higher liquidity than one with a large percentage of its current assets in accounts receivable.

Front 17

Tests of efficiency:

Back 17

1) Cost per account ratio: determined by dividing the number of accounts handled by the brokerage into the royal office and general expenses.

2) Revenue by Employee Ratio: divide net revenues by number of personnel. The higher the average is, the greater the efficiency.

3) Lapse Ratios: commission lapse ratio, policy count ratio, expense ratio. (Look on review slides)

Front 18

Which test of efficiency is most meaningful?

Back 18

Expense ratio: profit is the result of commission income received less administration and sales expenses incurred on the production of that commission income.

Total brokerage expense divided by commission income.