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A Fresh Look at Valuing Reinsurance Cash Streams

Finance and insurance (F&I), and associated reinsurance programs, have long played an important role in the profitability of the dealership model.  These service lines provide a consistent flow of gross margin (often routed outside of the dealership P&L statement, or “off-statement”) and deferred income in the case of earned reinsurance premiums.  These profit centers are being more actively assessed in the buy/sell process, and sellers are increasingly gaining value for these cash flows.

A Look Back

Historically, when buy/sells were most commonly transacted between relatively small dealer groups, or individual operators, the profits associated with reinsurance programs were largely ignored.

That is not to say the profits were not real, or not material.  Dealers have long known the earnings potential of successfully managed reinsurance programs.  But, in the context of the buy/sell, these off-statement earnings were often not calculated into dealership profits.  Sellers generally retained these entities and allowed the reinsurance programs to "run off", and collecting the cash flows as the programs wound down.

I suspect the reason that reinsurance was treated in this manner was the heterogeneity of the marketplace.  Buyers and sellers were rarely using the same types of programs, so buyers viewed the opportunity through their own lens, and did not seriously evaluate the programs put in place by the seller.  And, many sellers may have reasoned that they would receive cash flows as their program wound down, so there was no need to include this in the buy/sell negotiation.

Additionally, there is also the time lag associated with seeding a reinsurance program before it starts to produce meaningful cash flow.
Finally, this treatment of reinsurance cash flows may have reflected the historic market power of buyers versus sellers.  Sellers of individual stores represented one of many stores available to strategic buyers, and buyers could choose to pursue the deals that were perceived to be the most attractive.  

Whole New World

These dynamics, however, are changing.  And, today, this industry convention is being reevaluated.

Buyers and sellers alike recognize the value of these ancillary cash flow streams, providing yet another way to diversify the auto retail profit model and take advantage of additional revenue in a world of increasingly transparent pricing of new and used cars.  

How does reinsurance affect transaction valuations

Much of F&I gross profit flows directly through the dealership statement, and is very clearly a component of dealership profitability.  F&I is clearly an important leg of the stool in evaluating dealership profitability.  In advising our sell-side clients, we find that buyers are very keen to assess F&I gross profit per unit, looking for potentially easy ways to increase dealership performance if they find deficiencies there.  In the fierce world of new car pricing, this represents a very attractive alternative source of gross margin.

To this point, the six publicly traded retailers, for example, have all commented in recent quarters on the importance of F&I to their enterprises’ profitability.  And, each of them have emphasized in past earnings calls their efforts to improve F&I gross profit per unit as a way to offset the margin pressure in the new car department.

Public’s Gross Profit Per New Vehicle

However, often significant revenue and gross profit tied to F&I does not run through the dealer statement.  And, that is where there is an opportunity for sellers to more clearly delineate the profit potential associated with their programs.

The easiest component of any off-statement income to monetize in a buy/sell transaction is any type of pack or over-remit that is flowing to dealers outside of the dealership financials.  This represents real-time gross margin to the dealership, but simply does not appear on the P&L.

Some dealers use these packs to maintain margin in their vehicle service contracts, while others do so to manage sales compensation expense.  Regardless of the reason, we often see these funds flowing to management companies, other dealer-owned entities, and at times even directly to dealers’ home mailbox.  In these cases, we add these funds back to dealership profitability, specifically to F&I gross margin.

The more complex questions around valuation occur in the event of dealer-owned reinsurance entities, which provide a combination of deferred income and investment income.

In this case, there is more uncertainty around timing and cash flows. Funds are set aside for future claims, invested, and claims are paid out as they are incurred.  After seeding a successful reinsurance program over multiple years, we often see dealership groups generating very consistent, and sometimes large, annualized cash flows stemming from the combination of reinsurance profits and investment income.  We have seen cash flows from this kind of arrangement as high as $2 to $3 million per year.

In a traditional buy/sell, the seller retains the reinsurance program and receives multiple years of cash flow as the program runs out.  After the closing, buyers can put in place the same program and anticipate the same cash flows from their newly established reinsurance program; however, the earnings will not begin for several years, since the insurance premiums are earned over time.

In other words, in purchasing a given dealership, a buyer has gained the opportunity to replicate the seller’s historical cash flows from reinsurance.  But, because of the lag associated with the reinsurance income stream, a seller cannot simply add those earned premiums to its dealership earnings to determine their valuation.  However, this stream of cash flow available to the buyer should not be ignored.

The New Deal

As in all elements of the buy/sell world, successful transactions result when buyers’ and sellers’ expectations overlap.  We are finding it increasingly necessary to find common ground as it relates to valuing reinsurance programs, including their projected profitability and the value of this cash stream.

While each program is unique, we can generate common assumptions of unit sales, penetration rates, and performance that enable us to generate cash flow projections over 5 and 10 years.  It is then possible to use these projections to determine the discounted cash flow value of these profits.  This approach recognizes the value of reinsurance earnings to the dealership operations in today’s dollars, and appropriately discounts the cash flows for timing, uncertainty and risk.

Another way to tackle the valuation of reinsurance programs is to explore the possibility of actually selling the existing reinsurance entity, along with the dealership assets.  This approach allows the buyer to experience earnings in year one, and reduces the uncertainty tied to reseeding a new program.  While this is not the way these transactions have typically been structured, the numbers are large enough now that new approaches merit consideration.

Conclusion

As the average size of auto retail transactions continues to climb, financial sophistication on the part of both buyers and sellers is increasing, placing increased interest on this previously over-looked profit stream tied to auto retailing.  Reinsurance profits are now commonly discussed in the context of valuation.  While there are valid reasons as to why reinsurance profits are not a simple addition to dealership profitability, they can be fairly assessed as creating real value and worthy of consideration in the valuation process.

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