Brokerage. Management. (Risk) What you don t know and some things you didn t know that you don t know (but think you did or were afraid to ask)

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12 March/April 2009 12 March/April 2009




by Chris Ryan

What you don’t know …

and some things you didn’t

know that you don’t know

(but think you did or


14 March/April 2009 14 March/April 2009

As a broker, owner or manager — especially a new one — you have just a few things to worry about.

Things like business planning around income, expenses, production and recruiting; processes and systems your brokerage will employ; agreements with contractors, vendors and employees.

There are also plenty of lurking risk-management* considerations: errors and omission, property and casualty, personal liability, personal property, disability, overhead, succession and continuity, information security, directors and officers insurance — the list goes on.

So which of these should a new broker, owner or manager pay the most attention to? Whether starting an entirely new brokerage or purchasing an existing one, it’s a critical question to address.

“I break risk into two groups: business risk and liability risk,” says real estate broker and financial planner Rich Arzaga, CRB, CRS, GRI, founder and CEO of Cornerstone Wealth Management, Inc., in San Ramon, Calif. “Business risk is one of those things where people have much bigger eyes than they have skills.” Being undercapitalized is the No. 1 reason small businesses go under, Arzaga says. “They think they can maintain their production level and managing the shop, so their income goes down,” he says. “They thought their cash flow would carry them or market conditions change, so they have to shut down.”

Incorrect business planning assumptions are another source of risk exposure for brokers, owners and managers, according to Arzaga.

“Most entrepreneurs who start a business don’t create a business plan,” he explains. “They create a spreadsheet with sales and costs — that’s not a business plan. They’re riding on one leg of a three-legged stool.”

Compounding matters is the fact that in the one area where they have created metrics, new brokers, owners

and managers can often overestimate production and underestimate expenses.

“They’re in more trouble than they think, which goes back to capitalization,” he says. “Because they estimated poorly, they still might be undercapitalized.” Simply put, new brokers need to write a business plan, one that realistically considers processes, relationships, recruiting and marketing.

On the recruiting side, it’s a classic case of counting chickens before they hatch — or in this case, agents. “In real estate, when you see somebody, it’s, ‘We’ve been friends for 12 years, Mary. Come join me. I’m going to start a shop.’” The optimistic friend and entrepreneur, Arzaga explains, often takes that agent’s positive reaction as a definite “yes” and builds their plan around the assumption that all the Marys they know will come aboard.

“It’s hard to make people leave their current relationship,” he says. “When someone believes they can bring in X number of agents who can achieve Y level of production, and they don’t bring X agents, the next thing they know, of the 20 people they’re counting on, only six show.”

S, C, LLC or LLP?

For current and new owners, one of the biggest risks is that many fail to create a business entity like a C or S corporation, LLC or LLP.

“It protects that business’s worst day from the owner’s other assets,” Arzaga says. “If you opened a shop, it’s under your name and the lawsuit can go after your other assets, everything. Small shops with one to five or one to 10 agents still have big-office liability.”

It’s so easy to overlook that many don’t bother, which he considers a mistake.

“It doesn’t really cost that much to do,” Arzaga says, explaining that it typically requires $3,000 to $4,000 to set up and about $1,000 per year to maintain. “But many small

— Rich Arzaga, CRB, CRS, GRI

Most entrepreneurs

who start a business


create a

business plan

. They create a spreadsheet with sales and

costs —

that’s not a business plan

. They’re

riding on


brokers don’t set them up, and a lot of them are the ones with the least amount of processes and the highest risk.” He warns, however, that establishing an entity can create a false sense of security. Protecting yourself and your business is a two-way street. It’s not enough to protect your personal assets from your business. Conversely, not having enough coverage on your personal assets can endanger the business, too. For that reason, Arzaga says, property and casualty insurance is equally as important as establishing an entity. “You want to be properly insured so that if a claim from an auto accident or at home surfaces, you have enough coverage to pay that claim and the claimant doesn’t come after the business,” he says. “An entity protects the business, but it’s still the individual who owns that entity. Most people are underinsured around their homeowners and auto policies.”

Having a personal liability, or “umbrella,” policy is also important to consider because if someone sues you for more than your coverage amount, the umbrella policy can protect you.

“These are very cheap and rarely used,” Arzaga says. “For $2 million of additional coverage, it might cost $400 to $500 on the higher side per year.” He adds that when personal liability policies do kick in, they can prevent significant financial chaos within a business or family already struck by tragedy.

Life and Depth

When brokers, owners and managers find themselves in partnership agreements, Arzaga says, they should plan for what he calls “The Four Ds”: death of a business partner, divorce, disability or debt. Directors and officers insurance and other strategies such as drafting operating and buy/ sell agreements or securing life and disability insurances can help manage some of these risks, too — or reduce them entirely.

Arzaga has outlined a whole list of things every broker, owner and manager should know about life insurance. “First, it should protect the family’s needs should the owner die,” Arzaga said, adding that the next most-important item would be protecting any business partners through a buy/ sell agreement.

“If one partner dies, if properly funded with life insurance, the surviving partner will get a death benefit to pay the deceased’s family for his or her part of the business,” he explains. The deceased’s family gets the benefit of her hard work, while the surviving business partner can keep running the business.

Next, Arzaga recommends brokers, owners and managers create a secondary retirement plan using life insurance. “You can take a cash value life insurance policy, overfund it and grow the dollars on a tax-deferred basis and pull money out on a tax-free basis,” he explains. “After 15 years, you can pull out a bunch more than you put in for 20 years — tax-free. By pulling money out and not paying taxes when in retirement, it increases the yield of that money. It’s better than pulling out of an IRA or 401(k) and makes for a very nice second pension.”

He also recommends creating golden handcuff agreements to hang on to key employees, which can be especially helpful in a small business where key employees are truly irreplaceable. Brokers, owners and managers can do that by creating an arrangement called a supplemental executive retirement plan (SERP). For every year the employee remains at the brokerage, the owner agrees to overfund an insurance policy by a specific amount.

“Even if you [the key employee] happen to pass away during that time, the death benefit kicks in and I’ll give it to your spouse and family,” Arzaga says. “The intention

Having a personal liability, or “



policy is

also important

to consider because if

someone sues

you for more than your coverage amount,

the umbrella policy can

protect you



16 March/April 2009 16 March/April 2009

is to keep them, and this is a cheap way to do it. They will be very loyal.”

Life insurance can also be used as an alternative to college savings plans because in reality, Arzaga says, not every child ends up going to college.

“Most people think, ‘Let’s go with a 529,” he says. Instead, by funding relatively cheap variable universal life insurance policies when children are very young — from newborn to 2 years old, for example — you get more utility and flexibility than you would from a 529, plus a

guaranteed return.

“The universal life policies are fixed at a 4% to 5% return,” he explains. “A whole life policy is also fixed at a 3% to 4% return guaranteed by the carrier.” Arzaga concedes that whole life insurance is very expensive because of its guaranteed return, but argues that it still makes great financial sense.

“Here’s why it’s making a comeback: The business owner can use life insurance to secure a long-term care and disability rider,” he says. “You can handle all of those risks elegantly and save money.”

Life insurance can help with business continuity and succession planning. If you want to transfer the business to someone over, say, a five-year period, you can use life insurance to fund that process and hedge against getting hurt, sick or dying using a reduced death benefit.

“If he dies, I’m covered; I’m the beneficiary,” he says. “Over time, the benefit is lower and lower.” If the owner lives? “In five years, you’re done and you can get rid of the policy.”

Ensuring and Insuring

Next, he recommends reducing liability through securing an insurance policy and employing practices that protect clients’ privacy, data and information by creating a documentation system, knowing what is in the files and investing in the right kind of encryption software and electronic backups and storage.

“One, you protect yourself from releasing information, but if someone were to take the computers, where are the files?” he says.

The insurance works two ways: On one hand, it’s proactive and reduces risk. On the other, it can replace things. “If your stolen stuff is not protected, you’re exposed twice,” Arzaga says. “A business insurance carrier will replace your computers and the files that they can, but if someone gets a hold of those files, you don’t just want them replaced, you also don’t want the thief to be able to do anything with the data they have.”

He recounts the story of a friend who worked at a mortgage company that closed down. He went back to his old office to see what had been left behind and was amazed to see client files sitting there in boxes.

“The office was abandoned,” he says. “They were there for someone to take as they please — very scary.” Bill Farran, who serves as practice leader, real estate professional for the Bond & Financial Products division at Travelers Insurance in St. Paul, Minn., agrees.

“You have to make sure you have proper policies for document marking and retention for a certain period of time,” he says, recommending that brokers make sure agents use standard contracts and that they properly train and supervise new agents in this area. Not having a formal process for noting the date, time and subject matter can spell disaster for a broker, owner or manager.

“If a claim results, there is no documentation to help legal counsel defend against whatever claim is being made,” Farran says. Further complicating the document process is the mass migration to the Internet over the past few years to transact business and advertise properties.

“That, I believe, creates additional exposure to our insureds from a risk-management perspective,” he says. Many insurers, including Travelers, offer coverage to protect against information security breaches or errors.

— Bill Farran,

Travelers Insurance in St. Paul, Minn.

Without tail coverage,

a broker, owner or manager can


find himself

in an insurance

no-man’s land


Whether looking at information security, building security, physical safety, personal liability or any other risk-management issue, deciding what to change or not to change when a brokerage changes hands is critically important.

“It’s always appropriate to review everything, and if you can do the same job more efficiently, fine,” says Dennis O’Connell, a risk management and insurance attorney and partner at St. Louis-based law firm Bryan Cave LLP. “If you make a decision with respect to changing either equipment, manpower, hours of operation or whatever else, you need to hopefully do it in a way that is not just so that we can save a buck here or there, but so that we can save a buck here or there and maintain the same level of security.”

New Heads Use Tails

When buying or selling a brokerage, one of the most important risk-management considerations is to protect oneself from events that have already occurred or that could occur once the entity changes hands.

This coverage, often called “tail” insurance but more formally known as an “extended reporting period” is a critical risk-management tool for any sized brokerage. Because liability claims are often made long after the event that caused the injury, many liability policies are written on a “claims-made basis,” meaning the insurer pays only for claims it receives during the policy period. Because of this potential gap, a seller will often need tail coverage to protect him- or herself against potential claims that aren’t known of when the policy ends.

“The sales agreement should outline if the buyer is taking responsibility for the assets and liabilities or just the assets,” Farran says. “In most cases where the seller is buying the assets only but not the liabilities, the seller will purchase that extended reporting period endorsement.

“This allows the selling broker to report future claims against the broker, agency or agents contracted at that time,” he continues. “If the seller says, ‘I will assume those past liabilities with the transaction; I’m going to buy a policy at the transaction date,’ that’s going to provide full prior acts coverage on a go-forward basis.”

It’s important to note, too, Farran says, that if the buyer purchases a policy covering the seller’s past acts, the seller

should be somewhat concerned in the event the buyer cancels his or her policy in the future.

“If they cancel or do not structure the coverage correctly and have the old agency name, that coverage will be lost,” he says. The seller, though, can protect himself during this delicate transitional period.

“Say there’s an existing agency that we insure that buys another agency,” Farran says. “We can provide coverage for 90 days for any acts, errors and omissions that occur after the purchase date of the agency under our policy. It’s automatic coverage that provides time for the insured to notify the carrier of their acquisition and for us to underwrite our exposure.”

Without tail coverage, a broker, owner or manager can suddenly find himself in an insurance no-man’s land — the worst possible place to be.

“Let’s say the seller is responsible for past acts and they do not buy an extended reporting period,” Farran says. “The buyer doesn’t care because they’re covered going forward and only care about assets; the seller is responsible for liabilities.” The nightmare comes in when six months down the road, there’s a claim made against the broker or his agents for errors and omissions that occurred prior to that acquisition. Even if there is no merit to the claim, there are still defense costs that need to be incurred.

“Personal assets could be utilized to defend and to pay damages, if awarded,” he says. The challenge with finding good tail coverage, Arzaga says, is that most people don’t read the fine print.

“They go with pricing or a name they’re comfortable with,” he says. “The value of the policy is in what it covers, not the cost or brand. You can hedge that by having an attorney review a specimen policy, which will give you a really clear idea what the policy is.

“When there’s a claim,” he says, “many business owners look at the agreement and say, ‘What does it say again?’ That’s too late.”

*Information regarding risk management can be found in the CRB Council’s course, Brokerage Liability: Develop a Comprehensive Risk Management Plan. Log on to the Education section of to see upcoming course dates.




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