by Kevin Stipe, July 1999

National Underwriter

Here's a quick investment quiz:

Which of the following investments will provide a better financial return over the next five years?
A. Microsoft stock
B. Coca-Cola stock
C. Citigroup stock
D. A newly hired property & casualty producer

The answer is D.  No kidding.

Assuming their price/earnings multiples remain at the current level, the three stocks listed above are projected to generate annual returns over the next five years of approximately 25%, 16% and 15%, respectively.  Certainly these are healthy returns.  But they are pretty meager compared to that of a newly hired producer who, even if he is mediocre, should generate a compound annual return exceeding 50%!

The truth is, most agency principals underestimate the economics of producer hires.  Let's look at a pretty typical example.  You are evaluating whether or not to hire Jeff, a young person who is interested in P&C production and clearly possesses the personality for it.  You sit down to evaluate how much he is going to cost.  You come up with the following estimates.  (Note:  Depending on the size of your agency and the type of business you write, the figures shown here and expected annual performance may need to be increased or decreased.  As long as the expense percentages are the same, it won't materially alter the results.)

As you are looking over the numbers, you realize that the only way you are going to break even the first year is if Jeff somehow writes $82,000 in new business.  You know you'll be lucky if he writes half that amount.  But you hire him anyway, since you know deep down you've got to grow your agency to survive.

Jeff accepts the offer and goes to work.  Nice kid, but not the world's greatest producer.  Rather than home runs, he hits singles and doubles.  The first year, he produces a total of $35,000 in new business.  The second year he grows that by $35,000.  The third year, he does it again.  In fact, for five years, he grows his book by exactly $35,000 per year so that by the end of five years, he controls a book totaling $175,000.

During this five-year period, you have not fared all that well.  You lost $47,000 pretax (which equates to $30,550 after tax) on Jeff the first year, $21,250 the second year, barely broke even the third year, and so on.  By the end of five years, you finally were able to recoup your early-year losses to the point where you now have gotten back your investment and earned an aggregate return of $5,762.  Below is a chart showing your five-year results. 

Table 2:  Five Year Earnings Performance
 

While Jeff's a nice kid, Microsoft appears to have been a better use of your money.

For many agency principals evaluating a producer hire, this is where the story ends.  And that's a shame, because there's a huge element missing.  It is true that on a cash flow basis, Jeff has generated a negligible return.  But every account that Jeff has written also has an asset value, which needs to be factored into our analysis.

Assuming that when you hired Jeff you required him to sign a non-piracy agreement, you are now the proud owner of an asset with a value of $262,589 (which has been computed by multiplying the 5th year pretax profit by a capitalization factor of 6.0).  This $262,589 needs to be included in our computations, regardless of whether or not Jeff's book is actually sold at the end of five years.

Now the complete and radically different picture emerges.  When the $262,589 asset value is added to the five-year cumulative earnings of $5,762, the total five-year return jumps to $268,351.  If this is compared with the $44,363 in after-tax losses incurred in the first two years (which represents your "investment"), the net result is a five-year internal compound annual rate of return of 71%!

There are two basic reasons why the return is so high.  The first reason, which is the inclusion of the asset value, is obvious.  But there's also another reason almost as compelling: the investment in Jeff was made on an entirely pretax basis.  We are fortunate to be in an industry where investments in growth are primarily people-related, and are thus immediately tax-deductible.  One way of looking at this is that, in essence, you can force Uncle Sam to subsidize roughly one-third of your investment in the growth of your agency.  (Uncle Sam won't do that on your investment in Microsoft.) 

There are, of course, some important caveats to this analysis.  First, with a great many firms competing for a limited universe of sales talent, finding producers can be a real challenge, and the search can be costly, whether you conduct the search yourself or pay someone to do it for you.

Additionally, your hired producer  "success rates" (defined as the percentage of producers who succeed for you long-term) will be the single most important factor impacting your economic returns for producer hires.  The wisdom to know when to "cut your losses" on a bad hire is extremely valuable, given that most firms have a success rate of less than 50%.

Conclusion

When you look at the complete picture of the economics of investing in producers, they can be startlingly attractive.  We have encountered numerous agency principals who have avoided hiring producers because they focused on only the short-term cash flow implications of the producer investment, rather than both the cash flow and the asset value. 

So next time some stock broker calls with a "hot" investment tip, you can (politely) hang up the phone knowing that your best investment opportunity (one where you've got insider information!) is reinvesting your profits back into your agency.

Kevin M. Stipe, CPCU, is senior vice president and principal of Reagan Consulting, an independent Atlanta-based management consulting firm working with insurance agents, brokers and companies, as well as financial institutions.