According to OPTIS Partners’ latest quarterly report, following a slowdown in the second quarter of 2020, by the third quarter the mergers and acquisitions market for insurance agencies had returned to pre-pandemic levels.1https://optisins.com/wp/2020/10/sept-2020-ma-report/ The number of acquisitions in the third quarter of this year (170 reported transactions) was virtually identical to the 171 recorded transactions for the same period last year. Private-equity backed/hybrid groups of buyers continued to play a significant role in these acquisitions; they were involved in 71% of announced transactions in the past 12 months and 69% during the third quarter.
Because the mergers and acquisitions market for insurance agencies is likely to remain active for the foreseeable future, we highlight below certain operational issues with respect to insurance agencies of significance in the due diligence process, as well as a regulatory hurdle with respect to an acquisition that potential acquirors should be aware of when attempting to acquire an insurance producer. These areas include the following:
- Ownership of policy renewal rights;
- Disputes relating to fiduciary funds;
- Issues associated with closely-held insurance producers;
- Overreliance on principals in the operation of an insurance producer;
- Inter-affiliate arrangements; and Required disclosures of information by direct and indirect owners of an
- acquiror (and to the extent they are entities, their officers and directors) that seeks to obtain “control” of an insurance producer with a resident or non-resident license in Texas.
II. Types of Insurance Producers
Many insurance statutes do not fully distinguish between an insurance agency (which typically represents insurance companies and may have the authority to bind policies on behalf of such companies) and insurance brokerages (which typically represent policyholders or prospective policyholders), and simply refer to these individuals or entities as insurance producers. Insurance producers engage in the sale, solicitation and negotiation of insurance policies directly with the policyholders and sometimes do so through intermediaries known as subagents.
A managing general agency (MGA), on the other hand, is a specialized type of insurance producer that often is delegated functions typically performed by the appointing insurance company, including underwriting, claims handling, administration, and appointment and management of subagents. The NAIC2The (NAIC) is the U.S. standard-setting and regulatory support organization created and governed by the chief insurance regulators from the 50 states, the District of Columbia and five U.S. territories. Through the NAIC, state insurance regulators establish standards and best practices, conduct peer review, and coordinate their regulatory oversight. Managing General Agents Act contains a narrower definition and includes quantitative thresholds for an insurance producer to qualify as a MGA:
Any person who:
(1) Manages all or part of the insurance business of an insurer (including the management of a separate division, department or underwriting office); and
(2) Acts as an agent for such insurer, whether known as a managing general agent, manager or other similar term, who… produces, directly or indirectly, and underwrites an amount of gross direct written premium equal to or greater than five percent (5%) of the policyholder surplus as reported in the last annual statement of the insurer in any one quarter or year together with the following activity related to the business produced: (i) adjusts or pays claims in excess of $10,000 per claim (or some other amount determined by the commissioner of insurance) or (ii) negotiates reinsurance on behalf of the insurer.
Despite the distinctions set forth in many state insurance statutes and regulations, various issues raised in this article are for the most part pertinent to both insurance producers and MGAs. Except as otherwise set forth below, in this article we will refer to MGAs and insurance brokerages and agencies as “insurance producers”.
III. Ownership of Policy Renewal Rights
Potential acquirors of insurance producers often attribute significant value to ownership of policy renewal rights, which afford the producer ownership of policyholder lists and the right to offer, quote and solicit the renewals of in-force policies produced by the insurance producer and to solicit replacement insurance coverage upon the expiration of such policies. On occasion, insurance producers mistakenly believe that they own such rights given that they maintain policyholder records and are the parties that interact directly with policyholders – soliciting and selling the policies, collecting premiums, and/or making claims payments directly to the policyholders. Unfortunately, insurance producers sometimes discover, particularly upon termination of an arrangement with an insurance company, that they do not own the renewal rights for the policies that they produce, or that there are significant confidentiality restrictions with respect to policyholder lists or other data pertinent to the renewal process. Sometimes, it is ambiguous as to which party – the producer or the insurance company on whose forms the policies are issued – owns such rights, which may create a risk of future disputes.
Ownership of policy renewal rights for an insurance program should be documented in legal agreements (such agreements include MGA, agency or program agreements and will be referred to in this article as “agency agreements”) between the insurance producer and the insurance company that underwrites the risks of the insurance program. A potential acquiror should review the insurance producer’s existing agency agreements to ensure that the producer it intends to acquire owns renewal rights for any policy that it places, and will continue to own such rights following any termination of the agreement. Representative contractual provisions granting the insurance producer such rights are set forth below:
- In the event of termination of the agency agreement, the insurance producer’s (i) customer/client lists for the insurance program, and (ii) the use and control of policy expirations, policy renewals and the exclusive right to market to such customers shall remain the sole property of the insurance producer.
- In the event of termination of the agency agreement, the insurance producer’s records, use and control of expirations shall remain the property of the insurance producer and left in its undisputed possession.
Agency agreements may also have other variations of these provisions that could, for example, potentially grant the issuing insurance company ownership of policy renewal rights upon a failure by the insurance producer to remit premium owed to the insurance company, including the following:
In the event (i) the agency agreement is terminated for material breach for failure by the insurance producer to remit premium as required under the agency agreement, or (ii) the insurance producer fails to account for and remit all premium required under the agency agreement on a timely basis in full within sixty (60) days following the effective date of any termination, all renewal ownership shall be the sole property of the insurance company.
Even though MGAs typically own the policy renewal rights for the insurance business they place, ownership would not be ubiquitous for insurance agencies and brokers. To the extent the target insurance producer does not own the renewal rights for some or all of the policies it places or if such ownership is conditional, as under the provision set forth above, a potential acquiror should be aware that certain types of insurance producers could lose all or a portion of the policyholders (or lose the right to solicit or sell renewal policies to such policyholders) associated with a specific insurance program upon termination or expiration of the agency agreement. Depending on the relative size of the insurance program, this could have an impact on the “persistency” of the producer’s business and its revenue following such termination or expiration, and consequently on the ultimate accuracy of any valuation of such insurance producer.
IV. Disputes relating to Fiduciary Funds
An issue that often arises during the legal due diligence process relates to the fact that an insurance agency, including a MGA, is generally responsible in a fiduciary capacity for all funds received or collected from policyholders. Neither a MGA nor any other insurance agency should commingle any such funds with its own funds absent express consent from the insurance company that writes the business and on whose behalf the MGA or other insurance agency holds such funds. Further, agency agreements are generally quite clear as to the duties of an insurance agency, including a MGA, with respect to fiduciary funds and may include some or all of the following provisions:
- all premiums collected by the insurance producer under the insurance program are collected on behalf of the insurance company and shall be held in a fiduciary capacity by the insurance producer;
- the insurance producer is required to remit all premiums collected to a segregated premium trust account;
- the insurance producer is required to remit to the insurance company (or provide instructions to the trustee to such effect) all fiduciary funds held in the premium trust account on a regular basis (and/or at the request of the insurance company), even if all or a portion of such funds are in dispute; and
- the fiduciary funds cannot be commingled with funds relating to other insurance programs, other insurance companies, the insurance producer’s general/operating funds or capital funds, or funds for any other purpose.3Certain state insurance laws and regulations preclude insurance producers from commingling fiduciary funds with the producer’s own funds. For example, see N.Y. Comp. Codes Rules and Regs. tit. 11, § 20.3 (2006) (Regulation 29) ("Fiduciary responsibility of insurance agents and brokers; premium accounts") and N.H. Code Admin. R. Ins 4301.05.
Despite the unambiguous nature of this language, disputes sometimes do arise between insurance companies and insurance producers as a of the result of the multi-faceted nature of premium trust accounts. For example, in certain producer arrangements, the premium trust account is not only used as an account where collected premiums are deposited, but also used to fund claims payments as a result of various internal net settlement procedures at the producer. Further, sometimes commissions owed to the insurance producer are deducted either before or after premiums are deposited in the account; certain amounts in the account are refunded to policyholders as a result of policy cancellations; and any interest or other income generated from the fiduciary funds typically belongs to the insurance producer.
Although an insurance producer may sometimes withhold fiduciary funds owed to insurance companies in the event the insurance producer is in distress and/or is facing solvency issues, more often than not insurance producers do so because they reasonably believe that such withheld funds are necessary to satisfy other obligations set forth in the agency agreement – pay claims to policyholders, refund premium to policyholders as a result of policy cancellations, pay agency commissions, etc. As a result, insurance companies may initiate lawsuits against the insurance producer to recover unremitted funds.
In addition, we have also seen circumstances where insurance producers improperly commingle fiduciary funds that they hold for different insurance companies or insurance programs or commingle such funds with their own funds. When questioned about these infractions, insurance producers have argued that it may be impractical or inconvenient to transfer fiduciary funds directly into a separate account. This is a red flag in the due diligence process.
In addition to potential litigation that an insurance producer may face as a result of improperly withholding or commingling of fiduciary funds, the insurance producer may also be subject to disciplinary actions from state insurance regulators over improper handling of fiduciary funds and breach of fiduciary duties, which in either case could create significant adverse exposure for the insurance producer. Potential acquirors should confirm that fiduciary funds are properly segregated and that dividends or any other payments made to the insurance producer’s direct owners do not include any such funds.
V. Closely-Held Insurance Producers
Another issue pertinent to both due diligence and the structure of any acquisition of an insurance producer relates to the fact that some insurance producers may be closely held businesses (i.e., owned and run by a family or small number of individuals). It is not uncommon for small and medium sized insurance producers to be founded by a single person or a small group of family members or friends, who have developed and maintained relationships with many of the producer’s contractual counterparties such as insurance companies, subagents, policyholders, etc. The parties with whom an owner has valuable relationships may attempt either to terminate an existing agreement with the insurance producer, renegotiate current terms, or choose not to renew a contract upon expiration as a result of the sale of the producer, particularly if the owner will not remain employed by or associated with the producer thereafter.
This risk is further exacerbated by the fact that many such agreements, especially agency agreements, include termination provisions which allow any party to terminate the contract without cause upon thirty or sixty days’ prior notice (or immediately with cause) and often such short termination periods derive from state insurance laws and regulations.4For example, the Connecticut Insurance Law provides that “[n]o insurance agency contract entered into in this state, by a licensed insurer with an insurance producer licensed under section 38a-769, shall be terminated by the licensed insurer appointing such producer unless the licensed insurer upon terminating such contract shall give not less than ninety days' written notice in advance to the other party” (emphasis added). We have also seen agency agreements allowing a party to terminate the agreement immediately or upon short notice to the extent the existing owner no longer owns the insurance producer. The issue is particularly acute if the insurance business the insurance producer places is concentrated among a small group of insurance carriers or policyholders or if a narrow group of subagents sells a disproportionate amount of such business. A similar issue may arise with respect to the departure of one or more of the principals of the insurance producer, which is discussed in Section VI below.
A potential acquiror could mitigate this risk by maintaining the selling owner’s association with the producer post-acquisition and conditioning the sale upon execution of an employment agreement by the owner with the acquiror or insurance producer. Additionally, through an earn-out a potential acquiror could tie a portion of the purchase price to the performance of the insurance producer post-acquisition so that the acquiror and the owner would share the risk of counterparties terminating existing contracts with the insurance producer en masse following the acquisition. An earn-out also incentivizes the owner to serve as an ambassador to existing counterparties and encourage them to retain business ties with the insurance producer going forward.
An earn-out is of course a useful tool to bridge any gap between a founder’s asking price and an acquiror’s valuation. Founders often have strong emotional ties to their companies and may have very rosy projections of their insurance producers’ future performance and, accordingly, may value their companies higher than potential acquirors. This may make it difficult for potential acquirors to reach an agreement on purchase price with the existing owners. Further, an individual performance-based earn-out in which the former owner is entitled to additional compensation to the extent the insurance agency meets certain financial metrics (e.g., revenue, EBITDA, net income, etc.) for a fixed period following the acquisition could potentially be a tool to resolve any impasse between the parties and mitigate persistency risk discussed above. The earn-out could also be conditioned upon the owner and/or founder remaining employed by or associated with the insurance producer until the end of the earn-out period.
To the extent the potential target insurance producer is intended to serve as a platform for future producer acquisitions, certain adjustments can be made to an earn-out formula to encourage such acquisitions while not creating risk for the earn-out beneficiary of diminished net income or return on equity, after giving effect to subsequent acquisitions, or other financial metrics that could be adversely affected by a roll-up program the amount of the earn-out payment. For example, if the earn-out payment is determined based on the change in the insurance producer’s EBITDA between the closing date of the acquisition and the end of the earn-out period, the EBITDA could be calculated to include EBITDA of any subsequently acquired insurance producer during the earn-out period and discounted by an agreed-upon percentage of the purchase price for such subsequently acquired insurance producer.
Further, even if the parties reach an agreement on price, an existing owner(s) may make various demands with respect to the operation of the insurance producer following the sale, for example, retaining substantially all employees for a specified number of years, maintaining headquarters or offices at existing locations, providing employees with the same or substantially similar salary and benefits as prior to the sale, continuing arrangements with other entities owned by the owners following the sale (i.e., inter-affiliate arrangements; see Section VII below for further discussions on this topic) or agreeing not to divest any portions of the business for a fixed number of years.
VI. Principals of Insurance Producers
Some insurance producers are managed by an individual or small group of individuals (often, the founder(s) or a couple key officers) who play an outsized role in the operations of the producer (i.e., principals). Acquiring an insurance producer that relies heavily on certain principals could be problematic if such principals are no longer employed or associated with the insurance producer (e.g., death, disability, resignation, termination, etc.) following the sale of the producer. Following a principal’s departure, an insurance producer’s performance may suffer if the remaining employees of the insurance producer lack the same or similar levels of skill, knowledge and experience as the departing principal. Further, as noted in Section V above, principals may have developed relationships with many of the producer’s counterparties (e.g., insurance companies and subagents), and these persons and entities may either attempt to terminate the existing arrangements with the insurance producer or choose not to renew a contract upon its expiration following the departure of such principals. This issue is of particular concern if the insurance business the insurance producer places is concentrated among a small group of insurance carriers or policyholders or if a small group of subagents sells a disproportionate amount of such business.
To minimize the potential pitfalls associated with an overreliance on certain principals of an insurance producer and the risks associated with any departure of such principals, we would recommend the following:
- Confirm that the insurance producer is diversified with respect to its policyholders, subagents and insurance companies (i.e., no single (or small group of) policyholder, subagent or insurance company is responsible for an outsized portion of the premium generated by the insurance producer);
- Condition the transaction upon execution of employment agreements with key employees of the insurance producer and establish performance targets for such employees or an management incentive plan;
- Engage in discussions with material counterparties (either directly, if permissible, or indirectly through current employees of the insurance agency) regarding the potential sale of the insurance agency and gauge whether such counterparties express any hesitancy or concern with the change of control; and
- Review existing agency agreements to ensure that there are no principal or “key man” triggers or short termination provisions, including any change of control provisions, and if there are any such provisions, consider conditioning the closing of any sale upon the re-negotiation and amendments to these existing contracts to include more robust protections for the insurance producer (e.g., longer contract term or notice period for termination or narrower termination rights, etc.).5Note, however, that many states have insurance laws and regulations that dictate which contractual terms and conditions must be present in an MGA agreement including, without limitation, inclusion of a termination provision, provisions setting forth the party performing each insurance function, provisions granting or prohibiting the MGA from appointing subagents, and an assignment provision. Potential acquirors should be mindful of these requirements when attempting to renegotiate the terms of an MGA Agreement.
VII. Existing Inter-Affiliate Arrangements
Although not unique to insurance producer acquisitions, potential acquirors should pay close attention to whether the insurance producer has entered into arrangements with affiliates, such as third party claims administrators or captive reinsurers, that will not be acquired as part of any insurance producer acquisition. A potential acquiror should review all inter-affiliate agreements to ensure the following:
- that no agreements provide “sweet heart” deals, i.e., provide the affiliate with favorable terms that are not on an arm’s-length basis (it may be necessary to require that such agreements be re-negotiated on an arm’s length basis prior to closing to reflect customary market terms); and
- that these agreements, unless they are essential for the long-term operation of the insurance producer, continue only for a limited period of time post-closing.
We have seen circumstances under which an insurance producer is a sister affiliate of a third-party administrator6According to the NAIC Third Party Administrator Act (Version 1), a “Third party administrator” or “TPA” is defined as “a person who directly or indirectly underwrites, collects charges, collateral or premiums from, or adjusts or settles claims on residents of this state, in connection with life, annuity, health, stop-loss or workers’ compensation coverage…” that handles claims and other administrative functions associated with the insurance producer’s business. A potential acquiror should conduct proper due diligence on any affiliated third party administrator to ensure that, among other things, there have not been any significant or recurring issues with any of the services provided by the third-party administrator (including any potential regulatory issues and/or policyholder complaints), and that the fees paid to such administrator are fair and reflect market terms.
MGAs are also sometimes involved in captive and/or fronting arrangements in which all or a portion of the underwriting risk associated with the insurance business placed by the MGA is ceded by the insurance company to a reinsurer affiliated with the MGA. In these types of arrangements, it is not unusual for the insurance company to act as little more than a service provider and retain no underwriting risk; all such risks are ultimately borne by the reinsurer(s) and/or the MGA. These types of structures are particularly attractive to the extent the affiliate is not licensed as an insurance company in the U.S.
In such captive and/or fronting arrangements, one area of potential concern is if the existing agency agreement contains a cross-default trigger which allows an insurance company to terminate the agency arrangement with the insurance producer if an affiliated reinsurer defaults on any of its obligations under a reinsurance agreement or if the reinsurance agreement is otherwise terminated. Furthermore, indemnification provisions under the agency agreement which require the insurance producer to indemnify the insurance company for any breaches by the reinsurer may raise additional concerns about unfunded contingent liabilities.
VIII. Producer Change of Control Filing with Texas Department of Insurance
Section 4001.253 of the Texas Insurance Code prohibits an individual or entity from acquiring “an ownership interest in an entity licensed as an agent…if such [entity or] person is, or after the acquisition would be, directly or indirectly in control of the license holder, or otherwise acquire control of or exercise any control over the license holder” unless a filing is made with the Texas Department of Insurance (TDI) (contents of such filing are detailed below). Under the Texas Insurance Code, "control" means the power to direct or cause the direction of the management and policies of a licensed insurance producer, whether directly or indirectly, and there is a presumption of control if such person holds 10% or more of the voting stock or rights of the producer. In other words, an investor may be required to make such filing even if it acquires a small minority interest in an insurance producer licensed in Texas.
To the extent a filing is required, a potential acquiror would have to file with the TDI the following:
- A biographical form for each person by whom or on whose behalf the acquisition of control is to be effected;7This form can be found here.
- A statement certifying that no person who is acquiring an ownership interest in or control of the licensed insurance producer has been the subject to a disciplinary action taken by a financial or insurance regulator of Texas, another state or the United States;
- A statement certifying that, immediately upon the change of control, the insurance producer will be able to satisfy the requirements for the issuance of the license to solicit each line of insurance for which it is licensed; and
- Any additional information that the Texas commissioner of insurance by rule may prescribe as necessary or appropriate for the protection of the insurance consumers of Texas or as in the public interest.
Further, to the extent the acquiror is an entity, disclosure of the foregoing information may be required with respect to the entity’s owners, directors and officers. Specifically, the Texas Insurance Code provides that to the extent the acquiror is a partnership, syndicate, or other group, the TDI may require each partner of the partnership, each member of the syndicate or group, and each person who controls the partner or member to make a filing. If the acquiror or any such partner or member is a corporation, the TDI may require information pertaining to the corporation, each individual who is an executive officer or director of such corporation and each person who is directly or indirectly the beneficial owner of more than 10% of the outstanding voting securities of such corporation, be provided.
Private equity acquirors should be aware that owners (including limited partners of a fund), directors and officers of an acquisition vehicle or of any controlling entity of such acquisition vehicle, and any owner that exercises “control” (directly or indirectly) over such vehicle may have to make the disclosures required under the Texas Insurance Code. Where a private equity fund is acquiring control, it may be a negotiated point with the TDI regarding whether limited partners providing more than 10% of the capital commitments of the fund are deemed to be controlling persons but who are arguably passive from a governance standpoint.
Specifically, the Texas biographical form requires such individuals and entities to disclose their name, mailing addresses and to the extent they are individuals certain personally identifiable information (e.g., address, date of birth, social security number, etc.). Individuals are also required to submit fingerprint cards to the TDI.
After receipt of the necessary information, the TDI may disapprove an acquisition of control of an insurance producer if the Texas commissioner of insurance determines that:
- Immediately on the change of control, the insurance producer would not be able to satisfy the requirements for the issuance of the license to solicit each line of insurance for which is presently licensed;
- The competence, trustworthiness, experience and integrity of the persons who would control the operation of the insurance producer are such that it would not be in the interest of the insurance consumers of Texas to permit the acquisition of control; or
- The acquisition of control would violate any state or federal laws.
The TDI may affirmatively approve a change of control, but to the extent it does not, a change in control is considered approved if the TDI has not proposed to deny the requested change within 60 days following the TDI’s receipt of all required information and documentation.