The impact of contingent commissions on independent agencies

March 12, 2007

Debate continues in the insurance industry regarding the future of contingent income. Any drastic changes in the current compensation structure would have far-reaching effects throughout the industry and would impact independent agencies and brokers disproportionately.

Contingent payments have been a mainstay within the industry since they first evolved in the 1960s. Brokers and agencies alike have come to rely on contingent payments to bolster earnings and increase owner compensation, while insulating them from the unpredictability of premium rate growth in the market. The following will examine the key role that contingents play in agency profitability.

For many independent agencies and brokers, contingents account for a substantial portion of top-line revenues and are integral in supporting pre-tax profits and owners’ compensation. The chart below, based on data from our proprietary Perspectives for High Performance (PHP) Database, compares the impact that contingents have on agencies of various revenue sizes.

Any change to the way contingents are paid would dramatically alter the profitability of most agencies and seriously hinder the ability of many to survive. Some rationalize that agency owners take home most of the pre-tax profit at year-end through dividends or distributions and, therefore, most agencies are not as dependent upon contingents as the numbers suggest. That may be the case for some, but for the majority, the elimination of such revenue would have a profound personal impact on the average agency owner.

If this group includes you, you need to ask yourself, “Could you still run your agency and support your lifestyle without contingents?” If not, what steps are you taking to ensure your viability should you lose this revenue stream?

Dependent on contingencies

In addition to the contribution to top-line revenue and profitability, our PHP Data indicates that regardless of revenue size, most agencies are highly dependent upon contingent income to help cover daily operating expenses, including a substantial portion of payroll and benefits expenses. The following looks at the integral role that contingents play in agency operations by illustrating the percentage of line items that contingent income represents for the average agency.

It is obvious that the impact of eliminating contingents would have ramifications beyond reduced owner compensation. The very ability of an agency to service and support itself hinges on the fact that contingents are considered a legitimate revenue stream. Without contingents, the short-term debt servicing ability and coverage of daily expenses would be hampered as displayed in the chart to the right, which shows that contingents represent in excess of 90 percent of working capital.

Eliminating contingents altogether could have disastrous consequences not only for the independent agency, but also for carriers and ultimately for consumers. Carriers rely on the independent insurance distribution system to create a presence in markets, both large and small, throughout the country. This efficient network is within reach of nearly every consumer and serves to offer competitive pricing to the end consumer. If a large number of agents and brokers failed because contingents were eliminated, the alternative would be cost prohibitive for the carriers to replicate.

In this scenario, consumers would ultimately pay the price — higher premium rates. At the same time, contingents encourage agents and brokers to design risk reduction programs for insureds, thereby reducing the long-term frequency and severity of insured claims — and ultimately premium price. While we cannot speculate as to what will definitively happen to contingents, we have to question whether legislators really want to jeopardize the jobs, benefits and financial stability of thousands of small businesses and their employees.

Having said this, many carriers have moved to replace contingent income with excess commission or surplus commission. While this will mitigate any effects due to the entire removal of contingent income, the question still remains whether the excess or surplus commission will achieve historical contingent income levels. If not, agency profits will be squeezed and in many cases losses will be incurred.

What can you do to protect your agency from these potential issues? We challenge you, the agency owner, to proactively benchmark and review your financial statements. You are all in the risk mitigation business for your clients — now you need to make sure you are mitigating the contingent risks within your own agency. The less you rely on contingents, the less of an impact this issue will have on you. The best agencies do not need contingents, but rather view them for what they are — bonuses.

Albert Lloyd is executive vice president and Craig Niess is a consultant with Marsh, Berry & Co., a Concord, Ohio-based management consulting firm for insurance agencies and brokers. They can be reached at 440-354-3230.

Topics Agencies Profit Loss Excess Surplus

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