Companies operating in the insurance industry, like many other industries, place a high value on client relationships and goodwill. These companies often require key employees to enter into employment contracts with various restrictive covenants to protect the company's client base and goodwill.
The acquiring business in most, if not all, acquisitions of insurance brokers and agencies seek to protect the target business' goodwill and customer relationships by institutionalizing those relationships using various tools. These tools often include restrictive covenants such as noncompetition and/or nonsolicitation agreements. This article expands on my June 2017 article, "Breaches of Noncompetition and Nonsolicitation Agreements," which discussed the risks and potential economic damages associated with breaches of noncompetition and nonsolicitation agreements.
The information in this article is provided to assist those operating in the insurance industry with evaluating the issues relating to acquisitions where such agreements are included and when alleged wrongful conduct relating to breaches of such agreements could be relevant. Specifically, I will discuss general methods used in estimating economic damages associated with breaches of restrictive covenants and similar causes of action. This article will hopefully aid various constituents in better understanding the complex issues that can arise when acquiring or divesting an insurance brokerage or agency and/or dealing with situations involving possible breaches of noncompetition and nonsolicitation agreements.
As a reminder, the enforcement of noncompetition and nonsolicitation agreements varies by state and depends on the facts and circumstances of each case. The intent of this article is not to address the complex legal aspects of estimating economic damages in noncompetition and nonsolicitation agreements but, rather, to provide a brief overview of lost profit considerations and how economic damages may be calculated utilizing a lost profits methodology.1
Lost Profits Considerations
An initial step before calculating lost profits related to the breach of noncompetition and/or nonsolicitation agreements to consider is if a causal connection exists between the alleged wrongful act (the breach) and the injury (damages). Assuming the causation standard is met, the court will then consider damages such as lost profits. One of the most common approaches for measuring lost profits involves the estimation of the revenue that would have been realized but for the alleged wrongful conduct and incremental (or avoided) costs. The difference between the two represents lost profits.2 This is commonly shown as the following formula.
Lost Profits = (But-for Revenues – Actual Revenues) – (But-for Costs – Actual Costs)
Alternatively, this equation can be presented in fewer terms as the following.
Lost Profits = Incremental (Lost) Revenues – Incremental (Avoided) Costs
Incremental (Lost) Revenues
The first component of the lost profits calculation involves estimating the level of revenues that would have been achieved by the injured party but for the alleged wrongful conduct of the opposing party. In the modern era, risk and insurance service providers offer a wide range of solutions that can either be sold separately or as part of a comprehensive solution. Depending on the nature of the relationship lost, a breach may impact some or all of a provider's service lines, including, but not limited to, insurance brokerage, claims consulting, risk management information systems advisory, actuarial consulting, and safety and engineering consulting. While the facts, circumstances, and documentation will likely differ among each service line, common methodologies exist to estimate lost revenues. As introduced in my June 2017 article, common approaches to calculate lost revenues include the following.
Before-and-after approach—This approach compares the performance of the injured party's service line(s) before the event to the performance achieved after the alleged wrongful conduct occurred.3 The lost revenues are the difference between revenues before the alleged wrongful act and the revenues after the alleged wrongful act.
Forecast approach—This approach utilizes sales forecasts of expected performance for the service line, business, and/or industry to estimate the probable effects of the harmful acts.4
Yardstick approach—This approach compares the harmed business or service line(s) of the injured party to a comparable, yet unharmed, service line(s), business(es), client(s), or location(s).5
Market share approach—This approach compares the injured party's market share during the period prior to the alleged wrongful act to the market share of the injured party after the alleged wrongful act.6
By way of example, assume that a producer with postemployment covenants relating to noncompetition and nonsolicitation leaves an insurance brokerage for a competitor. Shortly after the departure, many of the producer's former clients have discontinued business with the original company. The insurance brokerage makes the decision to enforce a noncompete agreed to by the former producer and files suit against the producer and his or her new employer. One part of the brokerage's suit will likely focus on the damages it sustained due to the alleged breach of the noncompete by the former producer. In this scenario, an estimate of lost profits could utilize a variety of information depending on the approach utilized.
For example, the before-and-after approach may utilize the brokerage's records for the former producer to determine what revenues the producer generated prior to his or her departure and compare that to the revenues after his or her departure. This approach may focus on the overall performance of the former producer or could focus on the individual clients of the producer depending on the level of granularity in the data. This amount could then be used as a starting point in determining the lost revenues. Some helpful documentation when utilizing the before-and-after approach in this situation may include, but not be limited to, historical financial results, producer commission schedules, summaries of income by client, and broker of record letters.
An alternative method, the yardstick approach, may utilize the results of a similar set of clients as a proxy for determining the revenues of the former producer. Alternatively, the overall results in the industry or the specific service line may serve as a yardstick to estimate how revenues would have been impacted but for the departure of the producer. In this scenario, helpful documentation may include historical financial results, data on the results of other producers in the same service line as the former producer, and information on the results achieved by the industry.
Under any method of estimating the revenue that would have occurred but for the alleged wrongful conduct, another component will consider how long such revenue would have continued. This is referred to as the damage period. The damage period in many matters involving insurance brokerages and agencies will focus on the life expectancy of a client account. I addressed the issues relating to estimating the life expectancy of client accounts in an earlier article (see "The Value of Insurance Customer Relationships or Policies").
Incremental (Avoided) Costs
Another component of the lost profits calculation is determining avoided costs. Avoided costs are typically described as those costs that would have been incurred in generating the estimated lost revenues.7 Depending on the facts and circumstances of the matter, avoided costs may include only variable costs (e.g., costs that vary in direct relation to revenues) such as commissions on sales or it may include semivariable and/or fixed costs (e.g., costs that do not vary in direct relation to revenues) such as employee licenses, rent, and utilities.
Like lost revenues, data and documentation for avoided costs can take many forms depending on the facts and circumstances of the matter. In the example discussed previously regarding the producer who left a brokerage firm and joined a competitor, the avoided costs may include items such as the commissions paid to the producer, any marketing and sales expenses incurred by the producer such as travel, lodging, meals, and entertainment expenses, any office space leased specifically for the producer that was no longer required after his or her departure, and administrative costs for support personnel. Useful documentation in estimating the avoided costs associated with the lost revenues may include service line financial statements, producer commission schedules, producer expense reports, lease agreements, and employee listings.
It should be noted that costs are not always deductive in nature when estimating lost profits. For example, assume that the former producer as discussed in the earlier scenario also solicited former coworkers to depart for the competitor in an attempt to induce clients to follow. In this scenario, the injured party may have taken actions to retain employees and clients. These actions could have resulted in certain costs such as retention bonuses and compensation increases that would be considered components of damages. Additionally, to the extent that a former employee successfully solicited talent in breach of their employment agreement, any training, recruitment, and employment incentive costs may be considered an additional form of damages.
Another factor that may need to be addressed in a lost profits calculation is mitigation. "In general, the law requires that plaintiffs take reasonable steps to mitigate losses resulting from wrongful conduct."8 This is often interpreted to mean that a plaintiff needs to take some form of action to reduce their damages. This action may include searching for or hiring a replacement for a former producer or developing and implementing a retention plan to retain clients. While the burden of proof of failure to mitigate falls on the party allegedly in breach, the injured party should still make a reasonable effort to avoid damages.
Understanding the general framework of a lost profits calculation can be beneficial in determining what exposure may exist related to an acquisition or divesture of an insurance brokerage or agency that has noncompetition and/or nonsolicitation agreements.
Opinions expressed in Expert Commentary articles are those of the author and are not necessarily held by the author's employer or IRMI. Expert Commentary articles and other IRMI Online content do not purport to provide legal, accounting, or other professional advice or opinion. If such advice is needed, consult with your attorney, accountant, or other qualified adviser.
1 Other forms of economic damages besides lost profits associated with noncompetition and nonsolicitation agreements include, but are not limited to, unjust enrichment and liquidated damages.
2 James R. Hitchner, Financial Valuation Applications and Models Fourth Edition (John Wiley & Sons, 2017), p. 1017.
3 Scott M. Bouchner, Craig M. Enos, Colin A. Johns, John D. Moyl, and Richard A. Pollack, Business Valuation and Forensic & Litigation Services Section Practice Aid 06-4, Calculating Lost Profits (American Institute of Certified Public Accountants, 2006), p. 25.
4 Financial Valuation Applications and Models, p. 1018.
5 AICPA Practice Aid 06-4, Calculating Lost Profits, p. 26.
6 Financial Valuation Applications and Models, p. 1018.
7 Financial Valuation Applications and Models, p. 1014.
8 Financial Valuation Applications and Models, p. 1015.