Insurance agency acquisitions and deal values are near an all-time high and all expectations are that deal flow in 2019 will match or exceed last year’s numbers. And while reported numbers tend to skew towards larger agency transactions there are many agency deals that involve small, local firms that do not appear in industry reports.
The purchase and sale of insurance agencies, brokerages and producer firms pose unique risks and challenges not necessarily applicable to other industries, or even other types of insurance entities. While insurance agencies are not subject to all of the same standards applicable to the acquisition of control of insurance companies, there are nevertheless many important diligence, drafting and even regulatory challenges to consider when contemplating the purchase of an insurance agency. This article will summarize a few of the many wrinkles that should be considered when consummating an insurance agency acquisition.
As an initial matter, while the purchase or sale of an insurance company is subject to a robust regulatory review and approval process under the laws of the insurance company’s home state, the process of acquiring an insurance agency is generally subject to less regulatory scrutiny. Nevertheless, a few jurisdictions expect, through informal positions, to be notified of the acquisition. At least one state — Texas — requires pre-closing notification and exercises approval authority over the deal, or will otherwise allow the parties to consider the approval “deemed” when no notice of disapproval has been sent within a prescribed timeframe. Even an indirect change of control of an insurance agency can be subject to these regulatory requirements, particularly if the agency is licensed in all states. A change of the officers and/or directors of the agency usually requires enhanced regulatory disclosures as well.
A number of states require agencies to make annual cybersecurity filings and a proper review of an agency’s practices should determine whether it has satisfied these fairly new requirements. For example, New York enacted in 2017 a set of insurance regulations applicable to “Covered Entities” (including insurance agencies) requiring them to submit annual certifications each year as to the maintenance of a cybersecurity program in compliance with New York’s standards.
Any potential buyer of an insurance agency probably suspects that the agency needs to hold certain licenses — both resident and non-resident. But what licenses exactly need to be held and who must hold them? An agency generally must hold an insurance agency, broker or producer firm license where such agency sells, solicits and/or negotiates insurance (a few states do not have entity licensing requirements). This requirement applies even if the agency acts in a wholesale capacity in a state by intermediating the insurance placement between a consumer’s retail insurance broker and an insurance company.
Moreover, the agency must hold the correct “lines” under its agency license. For example, many states do not allow a property/casualty insurance agent to place lines of insurance coverage such as life, health or title without obtaining authorization of such lines for their licenses as well. As such, a potential purchaser should confirm that its target holds all the requisite licenses based on where it transacts its business. And, such licenses should not have expired and contain all the proper lines of insurance both to continue to do its current business as well as write the lines of insurance that the buyer ultimately desires for the agency. Fortunately, even if a buyer wishes to convert the target company from a corporation into a limited liability company subsequent to purchase, this can be accomplished under applicable corporate conversion laws without having to re-apply for agency licenses.
Insurance agencies may also need to hold “managing general agent” licenses or registrations depending on the nature and volume of their activities. While such term is loosely used as a business term in the insurance industry, it has a highly technical definition under the managing general agent laws of those states. They relate to the total amount of annual premiums produced by the agency for a particular insurance company and whether the agency performs certain material, outsourced tasks for the insurance carrier, such as binding ceded reinsurance or adjusting insurance claims. In addition, managing general agent agreements are highly regulated under state law and must contain a variety of specific statutorily mandated provisions.
What if the agency is placing coverage with unauthorized insurers? Generally, this will require a “surplus lines” broker license to be held by the insurance agency as well, which brings up an additional host of diligence considerations. Does the agency adequately conduct a “diligent search” of the admitted insurance market before placing coverage with unauthorized insurers? Is it appropriately paying the applicable surplus lines premium tax to the “home state” of the insured? Is the agency advertising surplus lines products, where such activities are heavily regulated under applicable state law? These are just some of the myriad issues that can arise from a review of the licenses of an insurance agency.
Finally, what if the agency has affiliates that also are being purchased, such as claims adjuster firms and third-party administrators? Depending on the jurisdiction, these entities may be subject to their own licensing requirements and must be reviewed independently to determine compliance with the laws of the states where they do business.
Individual Licensing and Activities
What about individual employees or independent contractors of agencies? These individuals also must hold individual insurance producer licenses; they cannot simply “borrow” the licenses of their co-workers or officers or directors of the agency. Additionally, each agency must have an individual “designated responsible producer” that is personally responsible for the agency’s actions and holds the same licenses and lines of insurance as held by the agency.
While most states provide exceptions from insurance producer licensing requirements for individuals who only engage in administrative tasks and are not compensated based on insurance sales, many agencies employ or contract with “customer representatives.” It is important for a potential buyer to conduct the appropriate due diligence to determine whether such individuals should, and do, hold appropriate licensure depending on the scope of their activities. Any review of such activities must necessarily take into account applicable telemarketing laws, particularly with respect to call centers that conduct outbound telemarketing.
Moreover, some agencies take aggressive positions by characterizing their agents as independent contractors for payroll, benefits, tax and other accounting purposes. It is important to carefully examine whether the activities of an individual agent for the agency require the agent to be treated as an employee or as an independent contractor.
Appointments, Foreign Qualifications and DBA Names
On top of confirming satisfaction of agency licensure requirements, the majority of states require that an insurance agency (and any individual producing on the agency’s behalf) be appointed by each and every insurance carrier with which the agency places insurance products.
The task of confirming that an agency and its applicable employee insurance producers hold all required appointments is time-consuming when compared to confirming that an agency holds its required licenses. This is why many due diligence investigations will confirm a sampling of insurance carrier appointments, usually based on insurance carriers for which the agency has its highest annual insurance sales and/or commission payments. This may also require that the seller affirmatively represent in the purchase agreement that all required appointments are held.
In addition, an insurance agency may not be in compliance with the corporate laws of a particular state if it has not properly obtained its foreign qualification to do business from the applicable secretary of state or equivalent state governmental agency. Simply holding a non-resident agency license in a state is not always sufficient, and we have on occasion seen states impose back-taxes and fines in connection with the failure of an agency to have properly obtained its foreign qualification.
Insurance agencies also frequently use fictitious or trade names, commonly referred to as “DBA” names. DBA names will often need to be registered with the applicable departments of insurance and often cannot contain specific words or verbiage that may be misleading or insinuate affiliation with other entities or governmental units. As such, a proper diligence undertaking will analyze any potential DBA issues as well.
Ownership of Insurance Customer Accounts and Policy Expirations, and Exclusivity Provisions
Insurance agencies face dual competition concerns. They must be able to obtain and maintain relationships in the face of competition with other agencies, but they also must combat the potential of losing customers directly to the insurance companies and/or wholesale general agencies with which they do business.
As such, in order to adequately protect the fruit of the agency’s blood, sweat and tears, it is customary to see producer agreements contain “policy ownership of expirations or renewal” provisions that grant the agency the right to renew its client accounts upon policy expiration provided that the agency is not in default under the applicable agency agreement.
In other words, once a policy expires, the insurance company is usually prohibited from actively soliciting or utilizing its other agents to solicit renewal business of the agency’s customers, unless otherwise required to renew under applicable law.
While it is the norm for an agency to retain the right to its customer accounts and expirations, if an agency agreement grants account ownership rights to any other entity, the results can severely impact a potential purchaser.
Even if the principals of the selling agency are bound by non-solicit and non-competition provisions under the purchase agreement, insurance customers are not widgets, but rather people who can choose to work with whomever they would like. Insurance companies and their agents are not going to be bound by the non-compete. Therefore, if the agency does not have the right to its account expirations, attrition to other agents or directly to insurance carriers may skyrocket.
At the extreme, it is possible that an agency is bound by an exclusivity obligation to produce business only for particular insurance companies or general agencies, which could substantially restrict future business opportunities. Thus, it is crucial to carefully diligence any carrier agreements in order to identify such provisions.
Compensation, Contingent Commissions and Profit-Share Arrangements
Insurance agencies survive and thrive off their commissions. As insurance players get more sophisticated, the trend is to move away from traditional “flat” commissions based solely on a percentage of premium generated and instead to “contingent commissions” based on other metrics. This might include the amount of business placed with an insurer, policy persistency results and the “loss ratio” or performance of the risks placed.
While contingent commission structures are not necessarily a cause for concern, they should be carefully analyzed prior to entering into a definitive transaction agreement. Of interest to the potential liability of a purchaser are “clawback” and “loss carryforward” provisions. Simply put, many insurance carriers do not want agencies to get the upside without sharing in the downside as well, so they will sometimes require agencies to return commissions when books of business perform inadequately. What this can mean for a buyer at first blush are endless opportunities for growth and expansion when, in reality, poor performance could require that the buyer dip into its own pockets to return commissions already paid to the seller.
While appropriately drafted representations, warranties and indemnification rights may help limit this exposure, a thorough understanding of an agency’s performance and its potential clawback liabilities can impact the valuation of the agency, as well.
Besides commissions, agencies continue to look for other ways to receive revenue and/or business and often turn to charging insureds “policy fees” or other fees in connection with the placement of insurance. Many states substantially regulate and, in some cases, prohibit such practices, often depending on whether the fee is charged with respect to a surplus lines product.
Agencies also have increasingly been entering into “marketing agreements” with insurance carriers to provide agencies with additional compensation for engaging in the marketing of insurance products. While not impermissible per se, agencies are restricted as to the amount of commissions they may receive under some lines of insurance (typically in the Medicare and title insurance spaces). A marketing agreement that serves only to circumvent such rules and regulations may be found to be in contravention of certain state and federal laws.
Many agencies also enter into referral arrangements with non-licensed entities that can trigger applicable state law where violations are often contingent on whether the non-licensed entity is compensated based upon a successful referral.
Premium Trust Accounts, Fiduciary Obligations and Successor Liability
Unless premium payments are directly remitted by insureds to insurance carriers, agencies are generally required to hold premiums collected from their customers in “premium trust accounts” as a fiduciary for their customers and the respective insurance companies. Any commingling of personal funds in the premium trust account is strictly prohibited. In some cases, an insurance carrier may require an agency to maintain a premium trust account dedicated solely to that insurance carrier.
When an agency has violated its fiduciary duties with respect to a premium trust account, the headaches for a buyer can turn into full-blown migraines. As an initial matter, a buyer may have insurance consumers as well as insurance companies demanding premium (or return premium) owed to them when the seller has absconded with trust funds. The purchase agreement will need to carefully consider successor liability concerns as states often differ as to what parties will be responsible.
But careful drafting may only serve as mild painkiller to the arguably greater concern that insurance agencies are heavily reliant on their ability to do business with insurance companies. Agency appointments can often be rescinded with relative ease even if appointments have been properly assigned to the buyer. Therefore, even if a buyer has only purchased the assets of an agency and has left all liabilities behind, an insurance carrier may demand that the buyer “do right” by the insurance carrier or otherwise face having its appointment rescinded and business flow cut off.
Even if the buyer genuinely had nothing to do with the improper maintenance of the seller’s trust account before closing, it may be left in the unfortunate position of having to fork over considerable funds to insurance companies simply for the right to continue doing business while hoping that the seller didn’t decide to let the trust funds ride in Vegas when it comes time for indemnification.
Earn-Out Mechanisms and Indemnification
Earn-outs and other deferred purchase price mechanisms are particularly popular in insurance agency transactions due to the very nature of the business. If customers don’t like new management, they may simply find a new agency. Therefore, it is not uncommon to see the purchase price bifurcated into numerous components, particularly as to smaller transactions with greater risk of consumer attrition.
For example, we have seen some agency deals where the overall purchase price is heavily contingent upon the occurrence of future renewals of the policies comprising the purchased book of business. Moreover, and particularly with respect to agency transactions where the principals of the seller continue servicing the purchased book of business, earn-outs often will include payments in connection with the growth and expansion of such books as well. A risk-conscious buyer often will demand the right to set off any earn-out payments due to the seller against any indemnification payments owed to the buyer, particularly if due diligence efforts uncover any risks as discussed in the preceding sections above.
We hope this article helps any potential buyer or seller of an insurance agency understand what’s involved in the acquisition of an insurance agency. While not substantially different or necessarily more challenging than the purchase of any other kind of entity, agency acquisitions present a number of unique challenges and issues to consider. This article has sampled just a few considerations that parties should take into account during the diligence and drafting process when consummating an insurance agency deal.
This article was first published on April 1, 2019. Copyright Insurance Journal 2019.