Budgeting Insurance in Your Acquisition Model

Do not copy the seller's insurance expense into your model. Build it from five lines instead: the base premium for the program you will carry, the expected change at each renewal, audit adjustments, the losses you pay yourself through deductibles, and growth. Audit adjustments are the bill or refund after the policy year, based on actual payroll or sales. Growth matters because premiums tied to payroll, revenue and vehicles rise as you do. Add fees, taxes and any finance charges, and keep one-time items, such as a tail policy, below the run-rate line. This guide is for buyers building the operating model they show their lender, board and investors.

What insurance lines belong in an acquisition model?

One line called "insurance" hides the parts that move. Break it out so you can see what drives the number and explain changes to your board.

Fees and one-time items sit alongside the five core lines: fees belong in run-rate cost, one-time items below it. Ask your accountant how each component should be classified in your financial statements. The model's job is to show the true cost and its timing.

How should you set the base premium?

The seller's insurance expense is a weak starting point. It may include personal policies, exclude coverage paid by the owner directly, or reflect a business that was underinsured. If you suspect the last one, your earnings before interest, taxes, depreciation and amortization (EBITDA) may be overstated. Read what an underinsured seller does to true EBITDA before you set the number.

Instead, build the base from quotes or indications for the program you intend to carry, line by line: general liability, property, auto, workers' compensation, umbrella and whatever else the business needs. A quote is not bound coverage and can change in underwriting, so label early numbers as estimates and update them when policies are bound.

Model cash timing separately from expense. Many policies are paid annually up front, in installments, or through a premium finance agreement that adds interest. Your accountant will usually spread the expense over the policy term, but the cash leaves on the payment schedule, and in a tight first year that difference matters for the revolver. See premium financing for new owners and pay-as-you-go workers' comp for the payment options.

How should you model changes at renewal?

No one can tell you next year's price. Avoid hard-coding a single percentage you found online. Build three scenarios and let the model show the range.

• Base case. Your broker's read of the market for your industry and lines, applied to the current program.
• Adverse case. A firmer market, a large claim in year one, or a carrier that declines to renew. This is the case to test against your covenants.
• Favorable case. Clean claims, documented safety improvements and a remarketed program.

Treat the first renewal after closing as its own assumption. Carriers often re-underwrite an account after a change in ownership, so model year 2 separately rather than copying the seller's last renewal. See what underwriters want from new owners.

Four things usually drive renewal pricing for a small business. They are the market for each line, your own claims, changes in exposure (payroll, revenue, vehicles, values) and, for workers' compensation, the experience modification factor (mod), a score that compares your claims with similar businesses. Under National Council on Compensation Insurance (NCCI) rules the seller's workers' comp history usually transfers to you, even in an asset deal; rules differ in some independent bureau states and in the monopolistic state fund states (North Dakota, Ohio, Washington and Wyoming). Smaller businesses below their state's premium threshold do not get a mod at all and are rated at 1.00. See the new owner's workers' comp review. For the market backdrop, see the small business market update.

Why can you owe more premium after the policy year ends?

Workers' compensation premium is an estimate. The standard NCCI policy sets the final premium after the policy ends, using actual payroll and the correct class codes, and the insurer can audit your records during the policy and for up to three years after. Many general liability policies work the same way on sales or payroll. See premium audit.

For a growing business this creates a predictable bill. If the policy was written on last year's payroll and you grow payroll by a fifth, expect additional premium after the year ends, roughly in proportion to the growth in the audited exposure. Two habits keep it under control:

• Update estimates mid-term when payroll or revenue moves meaningfully, so the deposit premium tracks reality.
• Reserve for the true-up as the extra payroll is earned, and show the cash leaving a few months after the policy expires, when the audit usually lands.

The true-up is not an extra cost on top of the premium for your actual payroll. It is the part of that premium the deposit did not bill. If you update payroll estimates mid-term, move that amount into the premium line and shrink the reserve, so the same growth is not counted twice.

Audit bills for the seller's policy periods are a separate, one-time question that depends on the deal structure and the purchase agreement. See payroll estimates and surprise audit bills.

How do you budget for deductibles and retained losses?

A deductible is the part of a covered loss you pay. Losses below the deductible, and losses that are not insured at all, are still insurance costs; they just do not show up on an invoice from the carrier. Estimate them from the loss runs:

1. For each line, count the claims per year and note which ones fell partly or fully inside the deductible.
2. Multiply the expected claim count by the amount you would keep per claim.
3. Add small losses the seller paid without filing a claim, if the seller or the managers can tell you about them.
4. Stress test: take the worst year in the history, add one more claim at the full deductible, and check the result against your debt service covenant.

If you plan to raise deductibles to lower premium, model both sides of the trade. See raising deductibles the smart way, and for the full picture of what risk costs across several companies, total cost of risk for small holding companies.

How does growth change your insurance costs?

Most commercial premiums are priced on an exposure base. As the business grows, the premium grows with it, even if rates do not change. Tie each line in the model to the driver it actually follows.

What does a sample insurance budget look like?

A hypothetical example. A buyer acquires a field services business with $1,000,000 of EBITDA and plans to grow payroll by about 20 percent a year. Quotes for the go-forward program total $150,000, and about half of that premium is rated on payroll and revenue. The base case assumes a modest renewal increase. Each renewal is written on the prior year's actual payroll, so the growth row shows growth that has moved into the deposit, and the audit row shows the current year's growth that the deposit has not yet billed.

Every figure here is illustrative. The audit reserve is shown in the year the extra payroll is earned; the cash usually leaves a few months after each policy year ends, so shift it in your cash forecast. The structure is the point: $150,000 of quoted premium becomes $182,000 of run-rate cost in year one, and more as the business grows, once audits, retained losses, fees and growth are counted. The adverse row tells you whether a bad year breaks a covenant. Adjust the lines for your own program and update them at each renewal.

Add-on acquisitions are the biggest step changes; budget each one as its own program until it is consolidated. See consolidating insurance across add-ons. A Morrow review can request quotes on the program you plan to carry and lay out premium by line, so the base of your budget rests on real numbers. Any terms depend on carrier underwriting.

Keep reading

• How Much Should Insurance Cost for the Business I Just Bought?
• The Seller Was Underinsured, So True EBITDA Is Lower
• Payroll Estimates and Surprise Workers' Comp Audit Bills
• Raising Deductibles the Smart Way After You Buy a Business
• How to Report on Insurance to Your Investors and Board
• All guides for new business owners

Frequently asked questions

Can I just use the seller's insurance expense in my model?

It is a weak starting point. The seller's number reflects the seller's limits, claims history, choices and sometimes personal policies run through the business. Build the base from quotes for the program you will carry and treat the seller's figure as a cross-check.

What renewal increase should I assume?

There is no reliable single number. Ask your broker for a read on your industry and lines, then model a base, adverse and favorable case. Test the adverse case against your loan covenants.

Why did I get a workers' comp bill after the policy ended?

Workers' compensation premium starts as an estimate and is trued up by audit using actual payroll and class codes. If payroll grew, additional premium is due. Update estimates mid-term and reserve for the true-up in your model.

Should deductibles be in the insurance budget?

Yes. Losses you pay inside deductibles, and small uninsured losses, are part of what risk costs the business. Estimate them from the loss runs and keep them on their own line so you can see the effect of changing deductibles.

Where do one-time items like tail coverage go?

Keep them separate from run-rate insurance cost so they do not distort ongoing earnings. Who pays for a tail is often a deal term, so check the purchase agreement, and ask your accountant how to present it.

References

• NCCI: Workers Compensation and Employers Liability Insurance Policy WC 00 00 00 C (carrier-hosted copy)
• NCCI: ABCs of Experience Rating
• NCCI: Experience Rating Plan Manual, Item E-1411 (Texas filing)

This article is general information, not legal, tax or financial advice, and not a coverage determination. Coverage depends on the actual policy wording, carrier underwriting, your purchase agreement and your contracts. Ask your attorney and accountant about deal and legal questions.