Wharton Study Finds Agents, Brokers Play Critical Role in Buying Process

By Andrea Ortega-Wells
June 8, 2005

Profit-based contingent commissions align the interests of independent agents and brokers and the insurer so that correct pricing of policies is achieved, thereby alleviating adverse selection, reports a new study by two Wharton School of Business scholars. (Click here to download the full study [PDF Format]). The research was conducted in response to recent investigations into brokering practices that allege contingent commissions are anti-competitive and detrimental to insurance buyers.

In "The Economics of Insurance Intermediaries" study, Professors J. David Cummins and Neal A. Doherty examine the commercial property-casualty insurance market, and the functions performed by brokers and agents, market competitiveness, compensation arrangements and the process by which policies are placed with insurance companies. The study was financed by the American Insurance Association, an insurance company trade association.

The study concludes that "although contingent commissions, like most business practices, can be misused by the unscrupulous, in general this type of incentive compensation plays an important role in aligning incentives between buyers and insurers and thus facilitates the efficient operation of insurance markets."

According to the study, intermediaries are usually better informed about the risks of their clients than insurers and when such risk information is accurately transmitted to the insurer, carriers compete more vigorously for business and price more competitively and fairly. In this way, the study reports, agents and brokers "assist the flow of information in the insurance market and enhance the efficiency of the market to the benefit of all players."

Cummins and Doherty argue that if risk information about the buyer is not shared with sellers/insurers, low-risk buyers will be penalized by having to pay higher prices than their risk level warrants; i.e., they would end up unfairly subsidizing higher-risk buyers. The authors explain how intermediaries can reduce market inefficiencies and alleviate the cross-subsidization problem for low-risk buyers by assessing the risk level of the buyer and providing that information to the insurer.

The authors noted that intermediaries match buyers with insurers "who have the skill, capacity, risk appetite, and financial strength to underwrite the risk, and then help their clients select from competing offers."

The study finds that contingent commissions also play a role in facilitating the entry of new insurers in the commercial property-casualty insurance market. "Profit-based contingent commissions can be used to align incentives between intermediaries and new insurers, ensuring that new firms receive a flow of business with favorable underwriting characteristics," the authors said.

The authors said that the role of the intermediary is "to increase competitiveness, by providing the buyer access to a wider range of possible insurers and by helping the buyer to compare these bids on the basis of price, coverage, service and the financial strength of the insurer." The authors conclude that "contingent commissions, particularly those based on profit, may further stimulate competitive bidding. By aligning its interest with that of the intermediary, the insurer will have more confidence in the selection of risks and in the information provided by the intermediary. This will help break the 'winner's curse' and encourage insurers to bid more aggressively."

"The question being asked by media and some public policymakers in various investigations over the past several months has been 'Does the mere existence of contingent commissions interfere with brokers' or agents' ability to put the best interests of the insurance buyer first?'" noted Debra Ballen, AIA executive vice president, public policy management, in a statement. "This is an important question, and it lies at the very heart of this critical, objective research."

The authors also found that premium-based commissions constitute the vast majority of intermediary revenues, and contingent commissions account for about 4 to 5 percent of brokers' overall revenues.

Cummins and Doherty noted that most of the contingent commissions are passed on to policyholders in the premium, however, whether this harms or benefits policyholders is a matter of debate. The study stated, "Despite recent allegations that contingent commissions are a 'kickback' from the insurer that compromises the intermediary's obligations to its clients, we show that these commissions can be beneficial to clients."

Cummins and Doherty found that "the bulk of compensation is awarded to those intermediaries who earn the confidence and trust of their clients by making good placements." As a result, according to the authors, any short-term gain resulting from a contingent commission for an inferior placement would not make economic sense, particularly because it could come at the cost of long-term market reputation and resulting loss of their primary compensation source (premium-based commission).