Going through the process of buying an agency requires a large amount of effort in a stable market. However, preparing to make an offer to buy a business in the hard market changes how you perform due diligence and other aspects of the process.

Many agencies are trying to manage threats to their operations, such as client retention, staff retention and even carrier retention. Although these risks are a normal part of evaluating the agency, many agency owners are struggling to manage one—if not multiple—of these important factors of their business. The hard market places a unique lens on the things you should consider when performing due diligence before an agency acquisition.

Here are three areas where the hard market has increased the need for additional investigation:

1) Client and Revenue Retention

Insurance routinely goes through hard market cycles where carriers adjust rates as they try to find a balance between competing for business and adjusting for market conditions. But because independent agents are paid a commission on written premiums, agency income is directly affected by these cycles.

A soft market can present opportunities for agencies to increase their client count as the market competition is high for carriers. The primary way to increase written premiums is by earning new policyholders. As rates decrease and carriers are more competitive, agencies can thrive on writing new clients to increase revenue. However, agency commission on renewals can decrease correlated to the rate decreasing on renewal policies.

Currently, the hard market is requiring agencies to pivot their strategy to defense and focus on retaining clients. This is influenced by less competition among carriers to write new clients and increases in premiums that are causing clients to shop, which is forcing agencies to procure more quotes. Many carriers routinely try to adjust rates in line with the consumer price index (CPI) to keep up with claims costs and adjustment expenses. As CPI and other cost factors that contribute to claims continue to inflate, it has presented extremely harsh market conditions for agents.

How does this affect retention? Retention has three major measurements: Client retention, policies in force (PIF) and revenue retention. Client retention and policies in force are often the most common ways that carriers represent retention on a production report. However, the revenue retention measurement is equally important for the agency to track. Why? Because commission revenue is what shows up on the agency's profit and loss sheet and is the largest factor for valuing an agency.

The current hard market poses a unique situation. Many agencies are experiencing decreasing client retention and PIF. But, if they are retaining enough clients, revenue retention is the same, if not higher than normal. Some agencies' PIF or client retention count is in the mid 80 percentage points, but their premium retention was 95% or greater because the rate increases on retained clients outpaced lost business.

Here are some questions to ask about retention during due diligence:

• How is the agency measuring and presenting retention?
• In due diligence, are you able to analyze client retention, PIF and revenue retention?
• Are there any current retention issues with the agency's top markets? If so, what is causing business to be moved or lost?
• Does your agency have comparable alternatives to offer clients that would boost retention?
• What communications or efforts are planned to maintain client retention through a transition?

Having a strategy to secure client and revenue retention is oftentimes an oversight for many new buyers. If available, seek to work with the current owner on a formal plan to communicate with clients and ensure their confidence.

2) Employee Retention

Since 2020, the impacts of the Great Resignation have been widespread. Although the wave of job turnover has slowed—with job quits dropping 12% from 2022 to 2023, according to the U.S. Bureau of Labor Statistics—agency owners across the country still say one of the top issues they face is recruiting and retaining talent.

A key factor that contributes to an agency's value is the staff. Good people attract and retain clients. However, wages and employment terms have shifted in favor of employees, which means employers have had to become more selective of whom and when they hire.

Additionally, many employees are expressing the sentiment of wanting more from their workplace, as well as an openness to consider other employment opportunities. Gallup's “State of The Global Workplace 2023" report found that nearly 6 in 10 employees feel disconnected from coworkers, their supervisor or the company they work for.

Crucially, the uncertainty that can be present through an acquisition escalates the risk that employees would consider leaving the agency. If employees are already considering other employment opportunities, then the news of an acquisition could trigger them to pursue those further or become more disengaged if there is little to no communication for a transition plan.

Most negotiations include confidentiality and nondisclosure terms until a certain stage is achieved. However, it's important to understand employee sentiment to assist with staff planning for the new owner.

Questions to ask that can help with staff planning include:

• What has the current owner shared with staff about their plans to sell the agency?
• At what stage of negotiations could the potential buyer meet and interview staff?
• Does the agency utilize employment agreements? If so, what are the terms?
• Are there employment terms in this agency that are considerably different from your current staffing mode, such as remote work, flexible hours and paid time off?
• Other than salary, what benefits are employees offered and utilizing? Will the agency incur or offer different benefits than your current program?
• If a staffing change is planned, are you planning a severance benefit or support resources for those affected?

Navigating this process can often be challenging, because there are a lot of unknowns to be solved in a short period. If you can, make efforts to have a staffing plan on how to communicate and support employees through the transition process.

3) Carrier Retention

Another top value driver—or risk factor—for an agency is the list of carriers from which they earn commission. However, any carrier that the agency earns more revenue than its profitability is an elevated risk. If one carrier changes its underwriting appetite or contract status, the agency's financial performance could be jeopardized. This is a real risk for many agencies during this hard market with carriers ceasing new business or in some cases canceling contracts.

I recently spoke with an agency owner who was losing their largest personal lines carrier. The carrier was one of the first appointments the agency received when it started seven years ago. After years of successful partnership, this carrier's business represented 25% of the agency's revenue.

In a few months, the agency's client retention rates plummeted because this carrier's rate increases were not proportionate with the local market. It was losing business to competitors as the agency was rewriting customer policies with their other carriers that were open to new business. The agency quickly moved to a retention program to escalate underwriting requests to maintain policies. However, after one month, many of those efforts were unsuccessful.

All carrier contracts typically contain terms that the carrier is to be notified of a major change in ownership by the agency. This is usually to allow the carrier to plan for book consolidations if the new owner is already appointed with them or to build rapport and develop a relationship with the new owner. In some cases, there could be reasons the carrier would not extend a contract to the new owner and terminate the appointment. This is why purchase terms often include contingencies for carrier contracts to be maintained to preserve the value of the agency.

In this hard market, these risks have shifted. Carriers are actively reassessing agency appointments to optimize their distribution strategy. So, when purchasing a book of business, it's crucial to understand the current appointment status and the carrier's relationship with the agency. In some cases, this risk can pose an opportunity if that agency's appointment is threatened and the buyer maintains a good relationship with the carrier.

This is another area that is typically covered under confidentiality. However, buyers must have a plan to effectively perform due diligence around carrier relationships to formulate a transition plan.

Here are some questions to ask that can assist with carrier contracts:

• What are the terms of ownership change contained in the carrier contracts?
  
• What is the current appointment status of the agency's top markets?
• Is the agency on a performance or retention plan with any carriers?
• Does the agency maintain a current list of carrier representative contacts?
• What carriers on the list have ceased writing new business in the area?
• Have any carriers significantly changed their underwriting appetite within the agency's book of business that would cause non-renewals or remarketing efforts?

Although top-line revenue is the primary driver of agency value, it's important to understand the operational components that support the revenue. Hard market conditions coupled with dramatic shifts in the labor market pose elevated risks for anyone who is trying to acquire an insurance agency. It's important to ask probing questions to understand these risks during the due diligence process and how they could impact the agency's performance during and after the transition.

Colby Allen is consultant and financial analyst at Agency Focus.