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The "How-to" Book:
A Practice Management Guide
Developing a Business Plan Human Resource Management Facilities & Equipment Financial Management Business Continuity
Business Continuity
Contents
Professional practice continuation
Defining the problem
Protecting & improving the value of your practice
How to provide for continuity
Impact of professional practice continuation plans
Company endorsed arrangements
Planning for successor management in an established life insurance practice
After you - who?
Guidelines for forming an agreeement
Valuation of existing business
Why value a life insurance practice?
Existing business
Valuation methods
Establishment of valuation assumptions
Collection problems
Deductions from value
Product peculiarities
Renewal account trends
Conclusion
Life agents and business valuation
Contents of the life agents contract
The MDRT contract checklist
Building a saleable business
A word of caution
The business plan
The valuation process
Potential markets
Summary
Sample documents
Home > Business Continuity Untitled

Guidelines for forming an agreement

There are two approaches to take in planning for succession. You will have to decide whether to have a death-only buy-out in place, or a full-blown succession arrangement covering retirement and disability. Here are some guidelines you should follow in forming either type of concession agreement.

First are SERVICE FEES. They should be immediately transferable to your successor in the event of death, disability or retirement. The service fees should be valued at some multiple of a year’s earnings of concession agreement.

The second item is GOODWILL. Many agreements derive that value from a multiple of the agency’s prior year’s first-year annualized commissions. This process recognizes the value of a large producer and allows the seller to cash in on years of outstanding production.

Example: Assume that 1992 first year commissions are $50,000. The purchaser of your agency would pay some percentage of $50,000 as goodwill simply because it’s spelled out in the agreement. This shows that you need a successor who recognizes the value of large, first year commissions to the future success of an agent.

The third item is APPLICATIONS IN PROCESS. For many, this amount is determined by the commission value of pending applications currently in underwriting. Carriers may be able to provide a microcomputer-based “app tracking” feature that can be downloaded from the home office mainframe system to your office management system, giving you instantaneous information on the status of all cases.

The fourth item is what is called the GOING CONCERN VALUE of the “well-oiled machine.” How often does it occur to you that your office can run without you? All your employees know their jobs so well that illustrations get run, applications get processed, and policies get issued, all without your direct involvement. When someone else takes over your agency, it is extremely valuable to the successor to have the agency operating at full efficiency, or like a well-oiled machine. This operating efficiency has a value all to itself and is sometimes call the GOING CONCERN VALUE of a business enterprise.

When you factor all of these items together — SERVICE FEES, GOODWILL, APPLICATIONS IN PROCESS, GOING CONCERN VALUE, plus an agreed value for the fixed assets — you have a calculated value of your agency that, if properly documented, will be a valuable asset to your family. Without such prior planning, the only thing available may be renewal commissions.

If you want a death-only succession agreement, you’re looking for someone to step in, work your files, and preserve your business. You’d be lucky to identify someone who would pay any money to your spouse to “work your files.” At least, if you do find someone to step in, you help out your clients because someone can be there to service them.

Therefore, you need to ask yourself the following questions:

• What kind of deal should be acceptable to your spouse and family?

• How do you identify a quality individual who would serve your clients well?

As to an acceptable arrangement, perhaps it’s a percentage of new commissions generated from the existing clients for a set period. Perhaps it’s a commission-splitting arrangement with the newly licensed surviving spouse? In one actual case, an agent’s widow was guaranteed a small amount of money plus one-third of new commissions generated from existing clients for two years, if she stayed on to service them. Identifying the right individual means examining those features of a successor that you think are important: integrity, hard work, intelligence, financial strength, and an existing practice that would fit in well with your clients. You probably know many agents from local industry associations, clubs and organizations. Take the time to examine who you would like to take over your business.

Since this deal is not to take effect until death, it may be difficult to make it enforceable. But it can be done. In many cases, all that is needed is an undated letter on file, announcing your successor, to be sent to all existing clients at your death, AND a letter of agreement between the two of you spelling out the terms of the succession.

On the other hand, by developing a successor to work with you during your lifetime, you protect your asset base and increase the value of your assets for your heirs. The transition is smoother and clients more readily accept the succession. Here are a few points about a specific legal agreement you could develop if you and your successor want to form a lifetime association.

You should arrange the succession as a partnership so that both parties can contribute business and capital on a tax-free basis. Plan to devote full time to the business so that you can learn to work together.

Determine how you want to divide the profit and losses. Do your renewals go into the pot and get divided up between you? Or, are the renewals yours? I suggest that renewals be assigned to the partnership. This assignment is especially important if the successor is younger and need the financial incentive of having the renewals as recurring cash flow.

This gets the partnership off to a good start.

How about new business? A staggered earnings table is suggested as follows:

For the first year of the partnership, the partner who writes the new business keeps 75 percent of the commission. In the second year, the percentage is reduced to 65-35 percent, shares 25 percent with the other 55-45 percent in the third year, and 50-50 percent in the fourth year.

The agreement should contain a contingency in the event it doesn’t work out for the two of you. Each can take back old files and divide the fixed assets proportionately based on their depreciated value.

The agreement should set forth the purchase price of the agency according to the guidelines we looked at before: service, fees, goodwill, applications in process, going concern value, plus and agreed value for the fixed assets.

Finally, the agreement should cover renewal commissions. Let’s look at renewals from a tax viewpoint in the U.S. Renewals are a measurable asset and are includible in your estate. In addition, they are considered to be income in respect of a decedent (IRD), which means they are income taxable to the recipient of the renewal commissions.

Consequently, proper income and estate tax planning is imperative.

The standard example of IRD is compensation earned but not received by a person before death. Consequently, renewal commissions on prior year business is considered IRD and whoever actually receives the commissions will be taxed on it. Internal Revenue Regulation 1.691(a)-1(b) (2) makes a specific reference to contingent payments such as renewal commissions.

Four tax cases have held that renewal commissions are IRD and subject to tax:

Latendresse v. Comr., 243 F. 2d 577 (7th Cir. 1957), cert. denied, 355 U. S. 380 (1957); Remington Est. v. Comr., 9 T.C. 99 91947); Carr Est. v. Comr., 37 T.X. 1173 (1962); Birmingham Trust Nat’l Bank v. U.S., 80-2 USTC par. 9682 (N.D. Ala. 1980), rev’d, 655 F.2d 68 (5th Cir. 1981).

In addition, the present value of the vested renewals will be included in the agent’s gross estate for estate tax purposes, and future receipts unless payable to the surviving spouse could be subject to estate tax. This shows the necessity of planning for the renewals.

For example, there are differences in treatment between a sole proprietor and a partner or shareholder in an insurance agency. If you write business as an individual agent, the renewals are deemed earned by you and payable to you while alive, and to your estate after your death. If you write business through a corporation or partnership agency, then renewals may be payable to the business. Herein lies a dilemma.

If you write business as an individual, all of the renewals are yours to dispose of as you wish through your will if the policies stay on the books. If you write the business through a partnership or corporate structure, the renewals are payable to the company and you must structure your agreement with your successors to make sure the company gets paid for your business.

Some insurance companies allow you to designate a beneficiary to receive the renewals after your death. Thus, if you are a sole proprietor, you should handle the renewals through your will and carry enough personal life insurance to create instant liquidity. If your agency is structured as a partnership or corporation and you have a designated successor, the renewals should be payable to the company.

Let’s look at levelizing renewal commissions. Normally, renewal commissions decline gradually over a number of years. Some carriers offer a level commission over a greater number of years. Level commissions are calculated by computing the full value of the renewals, applying a persistency factor, discounting these commissions to a present value and then dividing by the number of monthly installments desired.

The tax consequences of level renewals are settled in the law. Two cases, Commr. v. Oates, (207 F.2d 711, 1953) and Olmsted Life Agency (304 F.2d 16, 1962) have held that level commissions will be taxable to the recipient only when the money is received. However, this result is possible only if the levelized arrangement cannot be amended or modified after it is placed into effect.

An important issue here is the valuation of renewal commissions as part of the purchase price of the agency paid by the successor. The different types of policies you write — disability income, individual life, annuities, pension life — generate different types of renewal percentages. The number of lives you annually write can have a drastic impact on renewals if you focus on large face amounts with relatively few cases written each year. One or two lapses can destroy the value of your renewals. Do you sell in the business market, in contrast to the personal market? Studies show that corporate-owned policies tend to stay on the books longer than individually-owned policies, but competition has narrowed this difference considerably.

Here are some interesting statistics about renewals. One carrier reports that a life agent with 25 years in the business receives on average about $25,000 per year in renewals while he continues to service them. Once the procuring agent is no longer involved, persistency drops to between 35 percent and 50 percent. Consequently, if you plan for renewals to be a major financial factor in your retirement income, you must also plan to protect them. Another good reason to get your successor involved ahead of time.

These are just some of the issues involving renewals. Obviously, it’s worth the time to re- examine the treatment of one of your most important financial assets.

What about deferred compensation plans offered by certain carriers? Since these can include both company contributions and your own voluntary deferrals, it is important to know how each component is payable in the event of your death or disability. Without proper planning, your money can be trapped inside the agency and the agency’s value increased at the expense of your family. Take the time to understand your deferred compensation plan.

If you would like more information on these subjects, the MDRT has prepared two extremely helpful booklets, In Search of Profitability… Agent’s Business Plan, and Estate Planning for the Agent.

The first publication has a section pertaining to business continuation planning that coordinates well with the second publication on estate planning. A reprint entitled What Will Happen When It Happens To You, from a presentation by Leonard Neiman and Al Brodbeck at the 1989 Round Table meeting, is a guide to employment agreements and valuing a business. The publications and reprint can be ordered directly from the MDRT.

One other excellent source of information on this subject is the Journal of the American Society of CLU & ChFC. An excellent article is “The Valuation of Existing Business in a Life Insurance Practice,” by John Moyse, published in the July 1990 issue and reprinted in this section on page 16.

Successor planning is essentially the same message you give your insurance clients — fail to plan, and plan to fail. Good luck and good planning.

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