Is Your Book Big or is it PROFITABLE? The Numbers that Matter for Financial & Insurance Advisors!

by Jonathan Bega

This is part two of our series on startup metrics and why financial advisors need to care. In part one, I discuss why financial service professionals, including insurance agents, wealth managers, and financial planners, should be savvy to their cost of acquiring a customer across their channels. In part two, we delved a little deeper into metrics and learnt about customer lifetime value and churn. In part three, we put it all together with a case study and discussed the two most important metrics to understand the health of your book. 

As I discussed last week, this blog was inspired by an employee benefits advisor who had fired a handful of clients while growing his profit immensely. I referred to him as a “quantitative advisor,” a term I use to denote financial services professionals who are focused on the right metrics. These metrics are the unit economics of a client – that is, what does a client cost and what is a client worth? In the previous blog, we discussed the first part of that equation. I demonstrated how you would go about figuring out what a client costs. The value of this was primarily in regards to different channel strategies. For example, imagine a channel where a client was acquired for $500 versus a channel where a client was acquired for $5000. However, comparing these two channels on costs ONLY makes sense if you understand and can compare what the clients they produce are worth.

Let’s go back to the $500 versus $5000 channel. This seems pretty cut and dry, right? One channel is literally ten times as expensive as the other, so you should absolutely spend more money to acquire more clients in the $500 channel. Right? Not so fast! This is based on a key assumption that the lifetime value of a client in each channel is the same. That is, clients produced by the $5000 channel versus the $500 channel are worth the same number of dollars to you over the lifetime of the client. But imagine if the $5000 channel clients are regularly worth $15,000, while the $500 channel clients are worth $1250. All of a sudden, the $5000 channel may be worth much more.

In next week’s blog, I will discuss this ratio between your acquisition cost and your client’s lifetime value a little bit further. However, to get there, we need to first discuss two very important concepts. The first is client churn and the second is your client lifetime value (LTV). Both of these are bread and butter concepts in software-as-a-service companies such as Finaeo and are similarly important for financial planners, insurance advisors, et al.  Understanding your LTV and combining it with your cost of acquiring a customer will give you a very healthy understanding of your business as a financial advisor. This will allow you to diagnose problems ahead of time, better understand the value of your time, and understand the key question – do you have a BIG book or a PROFITABLE book?

Churn, baby, churn!
Let’s first start with client churn. Now, for my investment advisors in the audience, please know that I am not talking about excessive trading on behalf of the client to generate commissions (“churning”). That’s a totally different concept. Client churn is the number of clients you lose in a given time period. It is the opposite of retention. That is, let’s say you start the year with 100 clients and you lose 10 by the end of the year. You have an annual retention rate of 90% and an annual churn rate of 10%. That is:

Churn and retention equation for financial advisors

Okay, that’s pretty straight forward. If you’re an insurance agent, you have churn when a client moves his or her policies to a different agent on record. All of a sudden, your renewal revenue vanishes. If you’re a wealth manager, you have churn when a client moves their AUM to a different wealth manager (or robo-advisor). Calculating churn is fairly easy as well:

Financial advisor churn calculation

So, as above, if you had 100 customers at the beginning of the year, and lost ten of those by the end of year, you have an annual churn rate of 10% (10 / 100). Pretty simple, right? And, thankfully, keeping track of churn is not too complicated either. Simply go through your clients at the beginning of the year (say, October 1st, 2015) and see how many of them were retained by the end of the year (October 1st, 2016). Now, repeat the process for 2014, 2013, 2012, and 2011. Take the average of those five numbers and you have an annual churn number you should feel comfortable with for your book.

Churn Moves the Needle
So why is churn so important? Well, because churn means the loss of not only a part of next year’s revenue, but also the income stream the year after that and the year after that. That is, you have lost the client for life. Imagine a single client that pays you $10,000 in revenue per year every year. Assuming that client stays with you for 30 years, you expect to generate $300,000 in revenue. However, if the client leaves after ten years, you will only generate $100,000. This is irretrievable revenue – once the client has left, he or she is gone forever. And small changes in churn (or retention) can make incredibly large differences over time.

To demonstrate this, I actually built out a really simple churn Google spreadsheet you can play with on your own here. Just download a copy for yourself and edit any of the values in blue. You can see what different churn rates will do for your cash flow over 20 years. For example, I compared three different churn rates on a book that is earning $500,000 annual revenue in year zero. If you had a retention rate of 100%, every year this book would generate a further $500,000 annually. Over 20 years, that would be $10-million. However, when you add in a churn rate, you start seeing a decrease. Now, take a look at the effect three different churn rates have over time:

Churn Matters for Financial Advisors

By year 10, this book has produced $4.7-million with a 3% churn, but only $3.1-million with a 12% churn. That’s a $1.6-million difference! By year 20, it has compounded. The 3% churn rate means the book has generated $7.9-million in revenue over time. The 12% churn rate book, however, has only produced $3.9-million. That’s a $4-million difference over twenty years on $500,000 worth of renewable business. I know which book I’d rather have! But, seriously, the power of churn is often not well understood. So take a few minutes, download this spreadsheet and play with the numbers a bit. Input your own churn rate and book size. See what reducing your churn will effectively do for your lifetime client income streams. Watch how small changes in churn can cause immense shifts in your cash flow. And understand that if you can decrease your annual churn rate, even by a percentage point or two, it could be worth millions of dollars over the lifetime of your business.

A high churn rate also implicitly tells you that you are failing at servicing your customers. If your churn rate is above 7% annually, bells should be ringing and red flags should be waving in your head. You are failing to do something. Whether that’s answering your clients’ questions, being responsive, maintaining enough touch points and rapport, or otherwise, it tells you that something is amiss.

Likewise, if you have juniors working for you, churn rates can tell you a lot about their strengths and weaknesses. Imagine two junior advisors under your care. The first is amazing at closing deals and is constantly bringing in new clients. The second brings in far fewer. At a quick glance, you may decide that the first junior advisor is much better than the second. However, when you investigate, you realize that the first advisor has a brutal 15% churn rate, while his or her colleague has a phenomenal churn rate of 3%. Now the story looks a little bit different. Now it becomes clear that the first junior advisor is an amazing salesperson, while the second is amazing at client relationships after the fact. In more sales-y terms, the former is a hunter, the latter is a farmer. This may mean that you spend more time coaching your hunter on farming. Or it may mean that you specialize their roles, having your farmer spend more time with the clients brought in by your hunter. Regardless of how you deal with it, understanding churn gives you a great framework to better understand what’s going on.

Now, a quick caveat. Not all churn is necessarily equal. Sometimes you may want to fire a client or subset of clients that are no longer profitable. This will increase your churn but may be worth doing.

Client Lifetime Value and Churn
Let’s now turn to client lifetime value (LTV), which is what a client is worth to you over their lifetime as a customer. It is an incredibly important metric, as it tells you how much money a client will generate for you over time. It also helps you better understand how much money you can spend on acquiring the client, but we’ll talk about that more next week.

Now, the beauty of the situation is that a simple LTV is easily calculated by knowing your churn:

Simple LTV formula for financial advisors
A more complex LTV is calculated using gross margins, but let’s set that aside for now. What that equation basically says is that if you know the annual revenue of your a client, and you know the average annual churn of your book, you divide revenue by churn and have a lifetime value. This is an incredibly powerful tool. Let’s try a quick example:

Annual Revenue versus Churn for Financial Advisors

So, in the situation above, a client who will pay you $10,000 / year is worth $333,333 if your annual churn has been 3% ($10,000 / 3%), but only $100,000 if your annual churn is 10% ($10,000 / 10%). Likewise, if the client is worth an annual $50,000 / year, he or she may be worth an expected $1.67-million with a 3% churn, and only $500,000 with a 10% churn over the life of your relationship.

Now, it needs to be understood that this is an expected value. That is, you cannot say with certainty that a $50,000 client with a 3% average churn rate will be worth exactly $1.67-million. They may only stay with you for two or three years, or they may be with you for the next 40. Over your entire book, however, the aggregate LTV should be correct. That is, if you do this calculation over 30 clients and add it all up, you should expect the results to match reality over time. As such, a simple LTV is a great tool to estimate how much a client is worth to you.

Not All Churn and Not All Clients Are Created Equal
However, this brings up an interesting issue: churn can differ between different types of clients. That is, imagine that, as a employee benefits insurance advisor, you cater to both medium-sized companies and mom-and-pop shops. You may want to calculate your churn rate separately for your medium-sized companies and your mom-and-pop shops. This is because the impact on your business by each segment is going to be much different. Likewise, the amount of time you devote to each client type likely differs and will potentially lead to different levels of churn. Let me show you an example. Imagine that you have a medium-sized client about to sign up. This client will be worth an estimated $60,000 in annual revenue. Moreover, while the book started with 200 clients at the beginning of the year, it ended with 180 (i.e., it lost 20 clients):

Financial Advisors Should Calculate their LTV

Based on these numbers, the account is worth an expected $600,000. Now, let’s see what happens in two different scenarios when we split out medium-sized firms and mom-and-pop shops appropriately:

Financial Service Professionals Can Add Granularity to Their LTV Calculations

In scenario 1, we see that of the 20 clients lost, only two out of 50 were for medium businesses. That means that if we bring on another medium business, we can expect an annual churn rate closer to 4% than 10%. Therefore, the LTV of a $60,000 annual account is $1.5-million ($60,000 / 4%).

Now, let’s look at scenario 2:

Financial advisors, insurance agents, and wealth managers can be more granular on calculating LTV

In scenario 2, we have a situation where eight out of the total 50 medium-sized customers were lost. The churn rate here was 16%. This means adding another medium-sized client with an annual revenue of $60,000 is expected to be worth around $375,000 ($60,000 / 16%) rather than the $600,000 of the base case.

Now, this was a clear-cut example of why you may want to differentiate churn a little more granularly based on different business demographics. But make sure you’re not majoring in the minors. That is, there is an infinite number of ways you can cut a business apart. Generally, you don’t want to calculate a different churn rate for every small difference between clients, because then you’ll have as many average annual churn rates as you do clients. Focus on large differences in client profile, product bought, amount spent, or treatment received by you. And if you don’t have at least 30+ customers in the demographic that you’re trying to differentiate churn on, don’t bother doing so – you’ll just measure random noise instead. Generally, the demographics that may be worth focusing on will be based on the range of annual revenues (big ticket clients versus smaller ones) or product type. I’d avoid overcomplicating your calculations by looking at any other variables to calculate churn on.

#Challenger
Challenge for financial advisorsYou know what it is. Calculate your churn. Calculate your simple LTV. And subscribe so that you remember to read next week’s blog post which will elaborate on LTV and tie it into your CAC. Also share it because pretty please?