Many agencies split contingency income among owners, producers, offices, cluster partners, VIA (Virtual Insurance Agency) partners, etc.  Most do so solely based on volume.  While this is simple (def. easy), it could also be simple (def. not very intelligent) because it is often over-simplified and does an injustice to one or more people or entities while benefitting others beyond their deserved share.

Most agents will say, simply, “We’ll take our chances if the combination results in greater overall bonus income to the group.”  But I assure you that the agency experiencing the following scenario had serious second thoughts once he realized what was lost as the result of the oversimplification of contingent division by volume alone.

We’re using earned premium (EP) in our examples because all contingency income is based on loss ratios using earned premium as the basis.  But even if written premiums are used as the basis of the sharing of contingencies, the results would be the same.

Actual Scenario: 

# 1 has $2,000,000 with Company (EP); #2 has $1,000,000 with Company (EP).  Contingency income is $52,500.

#1 gets 66% of $52,500 = $34,650; #2 gets 33% of $52,500 = $17,850

 

The combined loss ratio that earned the $52,500 contingency was 40%.  However, #1’s loss ratio was 28% = $560,000 in losses and #2’s loss ratio was 66% = $660,000.  The result was a 40% loss ratio and still generated $52,500.

BUT, if #1’s contingency was generated on his production alone, he would have actually received much MORE contingency than the $34,650 that he received, but the losses of #2 acted to limit his share of the contingency to $34,650.  SHOULD #2 HAVE THE SAME 33% SHARE OF CONTINGENCY THAT WAS SPONSORED BY VOLUME ALONE?

In this scenario, #2 would have received no contingency based on a 66% LR, yet commands $17,850 as a simple percentage of premium.  #1 could have received $60,000 or more (by most contingency contracts) had he NOT had the dilution of #2’s LR and, as a result, lost at least $26,000 as the result of the combination in this year.

Of course, the conditions could have been reversed as easily as in the example above, hurting #2 and benefitting #1.

The answer is to consider both LR AND Premium Volume in your calculation of contingency distribution of a number of members in a common contingency program (i.e. partners, agency’s in a Virtual Insurance Agency, clusters, etc).

 

 

THE SOLUTION:

The primary calculation should be the ratio of the higher agency’s loss ratio vs. the combined loss ratio (in this case 66% divided by 40%) yielding the penalty for loss ratios higher than the combined (in this case 1.65).  When the contingency division is made based on volumes, those total dollars for the participant experiencing higher than average loss ratios are diminished by dividing that amount by the penalty ratio (in this case 1.65) to yield the net amount due to the individuals or entities, whose loss ratios actually negatively affected the net contingency earned.

SCENARIO TWO: As in the Actual Scenario, a $2,000,000 EP agent and a $1,000,000 EP agent enjoys a joint 40% LR based on the larger with a 28% LR and the smaller with a 66% LR.  Agent #2’s LR was 55% above the combined LR.  On a volume percentage alone, Agent 1 would earn $34,650 (as above) and Agent 2 would earn $17,850.  However, when contingency relativity is calculated, (1.65 as the ratio of 66% loss ratio against the 40% average combined loss ratio) Agency 2 would actually get $10,818 (the $17,850 divided by 1.65) and Agency 1 gets the higher amount of $41,682, a 20% benefit over the calculation by revenue alone.

One unusual aspect that would have yielded #1 even greater contingency income was that the proper contingency splitting agreement will ALWAYS identify the loss ratio above which the agency would not have received any contingency income and will eliminate all contingency income if either agency’s loss ratio exceeds that level.

In this case study, Agency #1 would have received 100% of the contingency income of $52,000.  While it is still not an adequate return for a 28% loss ratio (for the contingency program of the carrier in question) on $2,000,000 of Earned Premium, it provides a maximum return (and a minimum loss) to the successful agency while not negatively affecting the higher loss ratio agency (who would have received NO contingency anyway, but still maintains a good relationship with the carrier because of the acceptable combined loss ratio).

Background:

In our scenario, we became involved when #1 realized that over a five year period, he had “lost” well over $100,000 of potential contingency income because, whether through poor risk selection, weather related events or several once-in-a-lifetime losses, #2’s results impacted #1 severely over the long term.  #1 actually enjoyed $80,000 in contingency income during the period when his loss ratios, on their own, would have yielded him nothing but the potential loss of the carrier when analyzed on his own over five years.  As a result, he continued to write the same type of business under the correct assumption that as long as #1 or the other participants loss ratios balanced his own, he would enjoy the market availability AND an undeserved bonus based on growth of a relatively high loss ratio business.

Case Study Result:

The end result was the split-up of the participants in this contingency-sharing arrangement.  I won’t disclose the form of the agreement they had because some are perfectly legitimate and accepted by carriers. Remember, they only pay out on the net loss ratio, so the carriers actually saved money on the arrangement, although they didn’t ever realize that they had a losing agent building a book of business on their behalf.  In fact, the carrier continued a relationship with each of the participants until they realized the actual loss ratio potential of each.  Other forms of agreements, like the many clusters we see, whose ONLY purpose is the combination of volume for contingency maximization, are detrimental to the carriers because they simply cost them more money for the potential of no overall premium growth.  Those cluster partners don’t realize it, but the greed that prompts them to join with other agents for whose underwriting they can’t vouch, may cost them dearly in situations like those shown above.

Combining in a merger, cluster or Virtual Insurance Agency may yield a more active contingency arrangement for the participants – as a side benefit.  But entering into those arrangements ONLY for purposes of contingency splitting is gambling that the other parties involved will have as high quality business and will grow the business as well as you.  Some work – for a time.  But, insurance companies, like casinos in Las Vegas or Atlantic City, are not built by giving away more than they can afford over the long term.  The casinos don’t pay out over 100% of the take on every machine and every table and make it up in their rooms and restaurants.  Otherwise they would be hotels and meal services.  Those advertised returns are meant to lure you into putting more money into the machines.  Insurance companies do the same with Contingency Agreements.  They don’t mind giving agents a piece of the excess profits generated from a combination of growth and loss ratio profitability.  But they wouldn’t last long if, profitable as they are, their premium volume shrunk every year.  Or, grow as they might, the loss ratios were high enough to cause severe combined loss ratios for the company every year.  They are enticing you to place more business and to underwrite that business carefully enough to warrant the “profit sharing” represented by contingency contracts.

So go ahead and find ways of splitting some or all of the contingency income generated each year.  But do so in ways, like the case study above, in which the more profitable agent is not negatively affected by his partners.  Agency Consulting Group, Inc. can assist you with defining a Contingency Calculation that is tailored to your specific situation.  This case study involved two entities or individuals.  However, similar programs can be created regardless of the number of participants adding another nuance for multiple profitable agencies into the calculation.  Call us at 800-779-2430 for more information or e-mail to info@agencyconsulting.com or see our website for information about all of our services (www.agencyconsulting.com ).

An Aside to Our Carrier Friends:

Over the past 15 years, we have been working on behalf of independent agents trying to convince insurance companies that strong agents are worthwhile because they can, in fact, both grow the companies, something they can do themselves with sufficient advertising, and underwrite the client base, something that the direct writers try to do through rigid qualification guidelines and rate manipulation at the point of contact.  If the companies believe that, they would consider the elimination of contingency contracts in favor of different commission rates based on long-term (3-5 year) agency loss ratios.  In this way start-up or marginal agencies will be compensated based on base commission rates and more profitable agents would enjoy both the underwriting latitude that would bring them quicker and more business at less cost to the carriers because of the limited underwriting oversight needed and the commission income that is justified for those bring the carriers both growth and profit. Commission rates would change, over time, if agencies deteriorated or improved and truly unprofitable agencies would depart on their own (instead of through emotional and long-term, and often futile rehabilitation programs because they would only be paid the commissions that were justified by their volume and loss ratio experience.  The agencies would finally receive their compensation on a regular schedule, permitting them to pay for their own growth initiatives instead of hoping for a once-a-year payment that are often split up, as in the scenario above, instead of being used to sponsor the agency’s development. 

This is an attempt to once again professionalize and underwrite the agencies and give the agencies more latitude to underwrite individual business.  When this experiment is done properly as it has over the years by a variety of companies, such as INA and its COMPAR program, both the company and its agents are very successful.  Only when the company relaxes its standards of agency appointment have these experiments gone awry.