Companies today are pushing, requesting, cajoling, and demanding that their agents produce bigger and bigger books of business. Several companies dramatically increased their minimum qualifying volumes for contingency bonuses recently as a means of achieving their goal. Others are simply pulling contracts for low volumes and raising minimum requirements to maintain all contracts, not just contingency contracts. Big national stock companies are leading this race, but nearly all firms are headed in the same direction. Does this strategy make sense?
AVOID THE SMALL
In many ways, this strategy is smart and long overdue. Profit margins on small books are minimal or, more often, negative. For example, the following actual results are typical for one large national stock company:
- $3.7 billion direct written premium
- 17% noncommission expense ratio
- 14.5% commission ratio
- 5% growth
- 70% average loss ratio
- 15% LAE
- 5,000 independent agents
- $740,000 average direct written premium per agency
This company, like most, isn't growing fast, so a large part of its noncommission expenses is related to renewals and maintaining their agency force (i.e., distribution of manuals, rates, and underwriting guidelines; agency visits; licensing; and a normal distribution of agency overhead). These expenses are fixed, because up to a point they don't vary by book size. If 25% of these noncommission expenses are attributable to maintaining the agency, then fixed annual expenses per agency equals $31,450.
Using the company's average results, the following expenses will be incurred on a small book of $250,000 written and earned premium:
- 70% loss ratio ($175,000)
- 14% commission rate (commissions for smaller agencies are lower due to lower contingencies) ($35,000)
- 15% LAE ($37,500)
- 12.75% (75% of 17%) noncommission variable expense ($31,875)
Excluding the 25% of fixed noncommission expense per agency, total expenses equal $279,375 for a combined ratio of 111.8%. Including fixed expenses per agency, total expenses equal $310,825 for a combined ratio of 124%! As a percentage of written premium, fixed expense equals 12.58% of expense!
Compare these results to the company's average book of $740,000 direct written premium per agency:
- 70% loss ratio ($525,000)
- 14.5% commission ($108,750)
- 15% LAE ($112,500)
- 12.75% (75% of 17%) noncommission variable expense ($95,625)
Excluding the 25% of fixed noncommission expense per agency, the total equals $841,875, for a combined ratio of 112.25%. Add the fixed expenses per agency, and the total equals $873,325 for a combined ratio of 118%, compared with a small book's combined ratio of 124%.
As a percentage of the company's average written premium, fixed expense equals 4.25% of expense. On a $2 million book, fixed expense is a measly 1.57% of expense. So, while most expenses are variable, the small amount of fixed expense incurred makes doing business with agencies with small books - all else being equal - very unprofitable.
Several years ago, I completed a study for a national carrier and found that the average loss ratio on small books was much higher than the company's overall loss ratio. This company was fairly typical, so I doubt its results were an industry anomaly. Higher loss ratios on small books further exaggerate the monetary losses companies suffer on small books.
DON'T GO TOO FAR THE OTHER WAY
While avoiding small books and driving agencies to grow bigger books makes sense, too many organizations, especially large national stock companies, are prone to pushing the pendulum too far the other way. Companies shouldn't press too hard for huge books for two reasons.
First, in an industry that grew by 1.8% in 1998 and 1.9% in 1999, companies are so desperate for growth they're far too willing to pay agencies extra, just to get and keep large books. Their combined ratio in these situations can easily exceed a company's overall combined ratio.
Second, by propelling agencies to grow much larger, companies are in danger of eliminating too many agencies. It's a classic case of being careful of what you wish for, because you might get it. The trend is already evident. Larry Marsh of Marsh-Berry thinks that only 15,000 independent agencies will exist by the mid-2000s. Venture capitalists and the like have set aside at least $5 billion to buy all types of agencies before then. Marsh-Berry estimates the total funds available for consolidating agencies to be $20 billion. Yet $5 billion, and most certainly $20 billion, can eliminate most agencies.
During the 20th century, companies have wielded overwhelming control over both prices and expenses. With fewer but larger agencies and the industry's significant surplus, agencies will gain more pricing and expense power. Large agencies will demand more commissions and better pricing (and they're already successfully doing so). Large agencies get their demands met because so many companies are reluctant to lose large books, and will do whatever they can, even if profits suffer, to keep their big agencies/brokers happy. We're already seeing companies make seemingly ludicrous deals with large agencies/brokers. Many companies don't willingly agree to these agencies' demands (and would normally pull a contract immediately if a smaller agency made some of the more exorbitant demands we've seen), but they're so desperate to maintain their market share that they give in.
Some companies have recognized the shift in the power structure and the potential for an even greater change. The real wake-up call was Marsh & McLennon's acquisition of J & H. Now AON and Marsh, Mac write 67% of all large national accounts' direct written premiums. To counter this swing in power, a few companies have invested heavily in insurance agencies and brokers. Willis, the Hub Group, Talbot, and USI are prime examples. They each have significant backing by insurance companies.
Many analysts have attributed insurance companies' investments in agencies as a survival strategy to maintain the agency system, because without it, these companies would fail. Its questionable whether such an acquisition can outperform an investment in much safer bonds, especially when 60% to 80% of all acquisitions lose money for the buyer, which makes this survival strategy dubious at best. Other companies are developing proprietary distribution methods (i.e., their own sales forces) to counteract the power of big agencies. But the potential for success by this route is doubtful, too. As Adam Smith taught 225 years ago - and has yet to be refuted - the most profitable endeavor is to spend your time, energy, and resources doing only what you do best.
FIND A HAPPY MEDIUM
The alternative to investing heavily in agencies or creating your own sales force - and the safest, simplest, and cheapest way to improve profits - is to find a happy middle ground between large and small books and to pay good agencies more money. Companies must find their optimal book sizes, and to do this they must calculate their break-even points by agency results. As complex as most company financial systems are, few companies know their break-even points for policies, accounts, policies by line of business, or book sizes. The break-even point, or the cost of a sale, isn't simply the company's expense ratio plus loss ratio. An activity-based expense allocation method is much more nearly accurate. The results of such information would show that large books with very large agents and brokers are quite unprofitable, just like very small books. Companies are simply giving too much away in their desperate attempt to gain market share.
Knowing their break-even points, companies can determine what and how much they can offer for any size and type of book. Companies can also focus on maximizing their profits by working with agencies and books of the optimum size rather than blindly pushing for bigger, bigger, and bigger. Likewise, agencies with books below the break-even point that aren't growing and show no signs of potential growth should definitely be eliminated.
Companies can also improve their profitability by developing contingency contracts that pay very well for profitable books and by no longer subsidizing unprofitable books with profitable ones. Paying good agencies well will keep them from moving business to captives, help them stay in business, and strengthen them financially without harming the company.
Every day, many companies are digging themselves into a deeper and deeper pit. Companies in all industries today are feeling the need to get big to survive, but bigness without profits is a losing strategy. If companies continue to focus on BIG, their profits will continue to suffer, and they'll be left in a poor bargaining position with their remaining agencies.