In the midst of ongoing challenges, insurance agency owners are also facing financial uncertainties that could affect their business. You can help mitigate the impact of these unknowns by stress testing your agency’s balance sheet under an economic shock scenario.
What is Balance Sheet Stress Testing?
In other recent articles, we’ve discussed multiple aspects of assessing, improving, and maintaining the financial health of your insurance agency. Stress testing your balance sheet goes beyond traditional budgeting and forecasting by creating model scenarios to determine the impact of various circumstances.
When the economy shifts, insurance agencies can feel the effects quickly and with great significance. An economic shock is defined as an unexpected change to fundamental macroeconomic variables.
Here are four of the common factors that can lead to economic shock, along with how each of them can affect your business:
- Higher borrowing costs (increased debt payments and reduced cash flow)
- Increased unemployment (significant drop in premium receipts)
- Growing inflation (cancelled policies or reduction in coverage)
- Industry changes (carrier exits, rate adjustments, or underwriting tightening)
How to Crisis-Proof Your Agency
Even though you can’t completely insulate your balance sheet and agency health from economic shocks, you can create models that include liquidity buffers, covenant triggers, and debt flexibility. This will strengthen the foundation of your business and prepare you for unexpected changes in our economy.
While budgeting focuses on your income and outflow, stress testing your balance sheets involves creating a model based on one or more of the previously listed economic shocks and how it will impact your cash flow, cash reserves, and need for additional financing. Here’s a stress test example based on a 20% reduction in premiums received:
Identify the Scenario(s): Build a model showing how a 20% premium reduction would impact your cash flow. Whether the premium revenue drop is the result of inflation, unemployment, or natural disasters leading to unrenewable policies, the financial impact is the same.
Review Liquidity Buffers: Based on the 20% reduction, determine what expenses you could adjust to match the revenue reduction. Or if you need to maintain the same level of spending, identify how much cash you need to support your expense load. Assess your cash reserves and short-term credit to determine how long those funds can provide enough cash flow to sustain your business after a 20% premium reduction. Start with 90-day and 180-day benchmarks. Then, identify which funds you’ll use first, before tapping into other financial resources.
Review Covenant Triggers: Revisit loan agreements for leverage or coverage ratios that could be tripped in an economic shock. Create a model showing how a 20% premium drop will affect your budget and identify early warning signals of a potential covenant trigger.
Assess Debt Flexibility: Look at your existing credit lines, refinancing options, and other ways to restructure or access new working capital to mitigate the impact of a significant premium reduction.
As you wrap up this stress test, you should be able to answer the following questions:
- How long can my liquid assets be able to absorb an economic shock?
- Do I have other assets that could be liquidated for current use?
- Do I have access to working capital through my lender? (Or another lender, such as First Mid.)
- Where can I reduce costs without affecting the quality of customer service and growth needs?
After going through this process with a presumed premium reduction, repeat the steps creating a model for economic shocks such as a weakened global economy, uptick in unemployment, continued inflation, interest rate hikes, widespread changes in underwriting requirements, and other factors.
Putting Your Stress Test to Work
Although you can’t prevent national or global economic events, you can prepare for them. At First Mid, our seasoned lenders have the insights and experience needed to provide guidance on how to most effectively manage your debt.
Please reach out today with any questions or to schedule a complimentary loan review with one of our specialized agency lenders. Our team is committed to supporting insurance agencies and their owners through the ups and downs of the economy. We can be reached at 877-894-2785 or by email at agencyfinance@firstmid.com.
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