Agency Compensation: Finding Alternatives

AGENCY COMPENSATION: FINDING ALTERNATIVES

Some independent agents, depending on the part of the country they're in and the type of risks they write, are beginning to see a change in the commercial marketplace. Premiums are stabilizing, and in some areas they're actually increasing. Stories are even surfacing about accounts that can't be written through the standard markets at any price.

During the long soft market, most insurance buyers and corporate risk managers became more astute about pricing and more critical of the traditional role played by the agent in the risk transfer equation. The agent who simply wants to sell insurance policies will be bypassed, particularly if those policies now bear a higher premium. The product that buyers want is knowledge - and the professional service that goes along with it. Because they have a number of places to turn for insurance coverages, as well as the ability to retain their own risk, corporate clients now demand professionalism and quality from the agents with which they do business.

The story isn't much different in Personal or Small Commercial Lines. Customers who are strictly looking at price often can buy policies more economically on the Internet, directly from an insurance company, or through a captive agency company. They're also expecting something more than an insurance policy from an independent agent.

To be successful in this new environment, it's essential to find new and better products, improve accuracy and service levels, and develop risk management assistance programs for all types of business written by the agency. Whether it's putting together a complex retro, finding alternative risk transfer mechanisms, or simply conducting an annual review of Personal Lines accounts, an agency must focus on providing the value-added elements that customers have come to expect. Agents must be willing and able to be more than distributors. They must become consultants in a variety of areas and structure their compensation accordingly.

Today's independent agent is more professional and better educated than ever before. Their services have become even more valuable as the number and complexity of risk transfer options increase. And yet the current method of compensating insurance agents isn't based on the exercise of their risk management expertise, but almost solely on the price that the insured pays for the resulting insurance coverage.

Thirty years ago the commission method of payment may have been an accurate reflection of the time and effort expended to sell and service an insurance policy, but not today. Before automation brought such things as computerized rating, automated policy issuance, and direct billing, the producers and support personnel in an agency had to spend a lot more time on policies with multiple units, higher payrolls, and other factors related to increased exposure. The more complex and time-consuming the transactions, the higher the premiums. In that environment it made sense to pay the agent based on a percentage of the premiums.

Today it's not as clear-cut. In order to provide the value-added service that customers are demanding, agents must put in many hours doing things that don't directly generate higher premiums and commissions. In fact, during the recent soft market, the harder agents worked to get the best pricing deal for the insured, the less money they made. How many other industries have such a reverse reward system for their top performers?

It's time for a change. The future of this industry will depend on the development of a system of compensation that rewards the sales force for the quality of performance, rather than the quantity of premium dollars associated with the account.

Ideally, the new system would pay agents well for their dedicated performance in areas where they're crucial to the success of the risk transfer mechanism and pay them less if their efforts have little or no bearing on the success of the transaction. When a buyer can surf the Net and get a number of renewal quotes, there's little need for an agent to be handsomely paid for contacting insurance companies and getting competitive pricing. Agents who go the extra mile and help the insured evaluate the products offered in light of their risk transfer needs or who help them set up risk retention programs deserve more money than those who simply pass along the prices. The commission form of payment doesn't recognize that distinction.

With the sophisticated level of automation available today, it would seem that insurance companies could develop a flat-rate approach to paying for the services rendered by a particular agent for that company on a certain piece of business. The goal would be to pay the agent a portion of the net income from the business written, taking into consideration reasonable labor costs for performing those functions. An interim step towards this goal is the practice of negotiating commissions on large accounts or even quoting premiums net of any commissions. In these scenarios the balance of the agent's income comes directly from the insured for value received in terms of professional advice and service. Sometimes the fees are in lieu of any commissions and sometimes they're based on providing specific loss control or other risk management services that go beyond the traditional sales and servicing functions.

The decision to charge fees should be part of the overall agency business plan. It may be tempting to consider fees when most of the commission has been given up on an account, but that decision will come back to haunt you if it hasn't been well thought out. Unless the change to charging fees is based on solid cost accounting and a determination of the insured's needs, the fees charged may be either too much for the client to accept or not enough to cover agency costs. And the agency may ultimately jeopardize the relationship with the account if the services received aren't perceived to have been worth the fee paid.

Before deciding to implement a fee-based system of charges for your agency's clients, be sure to consider the following questions:

• What services are the agency and its personnel capable of providing, and at what expense?
• What do your clients and prospects need?
• What will the market bear? Is your competition charging fees, or are they performing these same services for free?
• What will the law allow in your state and in the states in which your clients operate?
• Take a look at the contracts with your major insurance companies. How will they respond to this move on your part?
• Does your E&O policy cover such activities?

Once you've made the initial determination that switching at least partially to a fee-based compensation system makes sense for your agency, it's time to look for existing accounts and prospects that would qualify. There's no one set of criteria that makes an account eligible for fee-based risk management and loss control services, but usually the business will have sophisticated exposures that require careful analysis. Also, the annual premiums probably will be more than $100,000 per year. One impact of the turn in the market will be to weed out the very good risks from the average and below-average business. A good candidate for consulting activities right now is the account that has had questionable loss experience that didn't seem to matter to insurance companies in soft market conditions, but will become a serious problem as these same companies become pickier about what they write.

The consulting activities performed can range from simple risk analysis to the creation of complex loss control/cost control programs with educational and inspection components. Setting up retros and self-insurance programs might also be included. Sometimes the primary fee activity is administrative, with the agency taking the responsibility for tracing loss severity and frequency. In other cases it involves conducting hands-on inspections and training sessions with the insured's employees. The decision about the level of involvement should be based on the agency's ability to provide the services that are being sold and the client's receptivity to paying a fee for that assistance.

A prospective account doesn't have to be particularly large or complex, however, to qualify for some kind of fee arrangement. It may be that they really only need an initial risk management analysis that can be handled by a technically qualified service person or account executive. An agency providing this service can generate some decent fee income while getting the opportunity to know an account that isn't yet an insurance client. If the practice is allowed by your state insurance department and insurance carriers, it's possible to waive the initial fee if the prospect subsequently places their insurance with the agency.

One of the biggest hurdles agents face in trying to go to a fee-based compensation system is the question of what to charge. Fees can either be set up on a fixed basis, that is per account or per service rendered, or the charges can be made on an hourly time and materials approach. The big consulting firms now bill at between $150 and $250 per hour for risk management consultants and up to $400 for actuaries, but that isn't necessarily what your agency should do. Whether you decide to go with a flat rate or one based on time, agency management must first determine the appropriate pricing structure by creating a separate profit center for the anticipated activities.

The starting point is profit. What profit margin do the owners want to see as a return on this investment? How much it will cost to provide the services? As part of this analysis be sure to take into account the opportunity cost: If the same people who'll be spending time on these fee-based services were to spend that time generating commissions, how much money would the agency make? If you can't demonstrate that the fee-based profit will be at least as great as the profit that the agency is making from commissions, it's time to reevaluate the original decision.

To determine your agency's pricing structure and break-even level, start with last year's financial statement, and relate each expense item to the revenues generated from commissions. Remove the contingent and investment income from this calculation, because these types of revenues won't be generated from the fee income and they generally have little or no associated expenses.

The following example is for a commercially oriented agency that receives 90% of its total income from direct commissions. It should only be used as a guideline, with your agency's actual expense ratios applied in your own analysis. To determine the expense percentages, first find the percentage of revenues from direct commissions (in this case 90%) and divide all of the total revenue expense ratios by that percentage. For example, if office payroll is 23.8% of revenues, when divided by .9 it becomes 26.4% of commissions. Remove owners' bonuses from the compensation before making the calculations.

This chart indicates that the break-even level for this average agency would be an 11.5% profit margin on direct commissions before owners' bonuses. (Remember, the overall agency profit also includes the 10 points from contingents and investments.) What this process tells us is that the agency can make an 11.5% profit from direct commissions received from traditional production efforts. This should then be the minimum target profit for fee-based consulting. Because insurance expirations generally have more value than a stream of fee income, a good argument can be made for increasing this target to make up for the lower relative value of an agency that receives income from fees. On that basis, a 25% increase in the target would result in a required profit from fee-related activities of 14.4%.

Next, determine the direct cost of providing the consulting service. Let's say that you initially want to provide 100 hours of consulting services using an Account Executive who's making $60,000 per year. With 1,880 working hours in a year, the hourly rate for the salary would be $31.90. Employee benefits for this person would add another $5.10 or so to that, for a total hourly cost of $37. Clerical assistance for preparing reports would be $15 per hour, including benefits, and it will be assumed that this person would also spend 100 hours on the project. Total personnel costs for the 100 hours would be $5,200. Travel expenses and supplies might add another $500. To the direct cost of $5,700 we would then add the target profit of 14.4%, or $820. Without charging any general agency overhead, the cost would be $6,520, or $65.20 per hour.

In this situation, the agency overhead is 19.1%, which would add $12.45 per hour, leaving a total of close to $78 per hour that should be charged. If a producer is getting commission for having sold the consulting job, that cost would also have to be added. In general, based on all of these expense factors, we find that most agencies charge at least $100 per hour for risk management and loss control consulting time. After your agency has done a couple of consulting jobs, you'll be better able to determine the amount of time it'll take to perform the services, and the charge can then be quoted on a lump-sum basis. Until you've had that experience, however, you'll probably lose money if you try to guarantee a price upfront. And no matter how you structure the assignment, put the specific services that you've agreed to provide and the associated fees and payment schedule in writing.