Risk Managers' Forum
Contingent commission agreements: Commonplace yet controversial
When it is transparent and not subject to abuse, the contingent commission concept can benefit both companies and clients
By Roger Wade, ACAD, MAAA
Critics claim … (contingent commissions) create a conflict of interest for brokers; that they are anti-consumer. Defenders say they provide a mutually agreeable arrangement that is ethical; it is only the way some people have used them that is unethical.
Historically, the insurance brokerage business has been based on commissions, and contingent commissions have been a standard compensation method for decades—not just in the United States, but worldwide. Critics claim they create a conflict of interest for brokers; that they are anti-consumer. Defenders say they provide a mutually agreeable arrangement that is ethical; it is only the way some people have used them that is unethical. Has participating in contingent commissions become a too-high-stakes game for today’s agent? Is this a case of a few bad apples forever spoiling the way insurance brokers traditionally make their money?
Many businesses pay producers incentives for meeting production quotas and providing profitable business. The concept of contingent commission, or profit-sharing, agreements, has been used to compensate agents for more than 40 years. As an actuary, I can recall designing such an agreement for a major property/casualty company in the 1960s. The initial concept was to reward independent agents, who are under contract to produce business for an insurer, for meeting their sales objectives and to allow them to share in the profitability of the business they generated.
Because independent agents represent multiple companies, the payment of contingent commissions was considered necessary to prevent adverse selection in the applications submitted to the company. Many of these programs were implemented in a time of reduced fixed commissions to agents. If a company reduced its fixed commission from 15% to 10%, a contingent commission would be introduced to allow the agent to maintain his prior income levels if he produced a sufficient volume of profitable business. This in turn led to independent agents representing fewer companies so that they would qualify for the additional commissions. Since an agent legally represents the company, and not the insured, this was an appropriate compensation mechanism.
Brokers join in
Once this concept was in place, insurance brokers, who could receive the same base commission as independent agents, believed that they also could benefit from such arrangements. In particular, profit-sharing arrangements were put in place for larger brokers on small commercial accounts and personal lines accounts. Given these brokers’ administrative expense profiles, these smaller accounts were generally unprofitable. The contingent commission arrangements helped to preserve broker profitability while permitting the insurer to gain access to a large volume of business. In these cases, the concept of a broker representing the client began to be eroded. If you wanted a personal lines coverage from a large national broker, you were generally restricted to a few markets. This, however, did not prevent the client from seeking alternative quotes. In some cases, the brokers also negotiated discounted rates, or broader endorsements, for their clients, resulting in better pricing than could be obtained somewhere else.
The next step in the evolution of contingent commission agreements was their application to larger commercial accounts. The same principles were now being applied to accounts that were not subject to filed rates. In these cases, the broker was usually relied upon to obtain a variety of quotes from the marketplace, which would be presented to the client, who would then select the best program in consultation with the broker. Generally, the individual brokers who handled the accounts did not know the details of these arrangements. This insulated the process from causing bias in the selection of a carrier.
What went wrong
What followed next was insurers informing the local offices of a national broker as to which markets they should prefer from a contingent commission standpoint. It was at this point that the integrity of the system began to erode. By removing the local broker from the placement process, and centralizing marketing activities in a national unit with full knowledge of the contingent commission arrangements, the system was further corrupted. This in turn led to the alleged use of false bids to convince clients that the quote from a preferred market was the best obtainable quote in the marketplace.
Based on the history of these agreements, what started as a reasonable arrangement has evolved into an arrangement that is not in the best interest of the client. While some brokerage firms disclose these agreements, such disclosure is rarely done at the time the decision is being made by the buyer. Many brokerage clients are on a fee basis, such that commissions received are applied against the annual fee. The difficulty with such arrangements is that in the case of a contingent commission, it is difficult to assign the profitability impact to an individual client. Therefore, contingent commissions are not always considered in the fee adjustment process.
While the perception may be otherwise, contingent commissions are not necessarily anti-consumer arrangements. They can be used by an insurance carrier to ensure that the business they receive is profitable. Problems and controversy arise when abuses enter the system. This typically occurs in three ways:
1. The client is not informed of the arrangement.
2. The arrangement causes bias in the advice given by a broker.
3. False bids are obtained.
So what’s an agent to do?
If an agent does participate in a contingent commission program, it would be advisable to include a declaration of compensation in marketing material, stating that the agent is compensated by insurance companies based on a commission that may also include incentives to produce more profitable business for the company.
Whatever the terms of the compensation system, disclosure is the best way to avoid conflicts or any hints of conflict of interest. Always put the clients’ interests first, and honestly answer any questions about compensation. Clients recognize that agents need to be compensated fairly for their work and expertise.
Some insurers are responding to the current publicity by eliminating contingent commission programs. If the companies are not eliminating the programs as a way to cut total commissions, the base commissions should be correspondingly increased. *
Notes from the Agent Compensation/Disclosure Study:
In a November 2004 survey, commercial and public entity respondents expressed concern that agents and brokers may not always submit the client’s business to the “best insurers” and may not always recommend the best insurer to meet their needs.
• Only 65% of commercial enterprises and 76% of public entity respondents agreed or strongly agreed that agents/brokers always submit a client’s business to the “best insurer.”
Associated with the “bid rigging” problem is the “placement service agreement” offered by a few insurers/reinsurers that paid the broker a form of incentive compensation for the placement of a large quantity of business with an insurer. This form of compensation must be contrasted with the long-standing practice of paying brokers and agents contingent commissions from a combination of factors including profitability, mix of business, and premium volume. To earn bonus compensation, many “placement service agreements” only required the broker to place a quantity of premium with the insurer. On the other hand, contingent commissions are earned only when all factors are favorably aligned.
• More than 75% of commercial and public entity respondents agreed or strongly agreed that bonus or loyalty compensation paid to agents or brokers for volumes of business represents a conflict of interest that can adversely affect the choice of insurer by the agency or broker.
• More than half of commercial entities and a third of public entity respondents did not believe that their agent or broker fully disclosed compensation paid to service their accounts.
In short, the survey concluded that customers, agents/brokers, and insurers need to effectively communicate the process of choosing an insurer, fashion compensation schemes that do not pose a conflict of interest in the choice of an insurer for a client, and better disclose the compensation the agent/broker receives for services performed for both the insurer and the client.
Roger C. Wade, ACAD, MAAA, is a senior manager in KPMG’s Financial Services Practice. He primarily provides casualty actuarial and risk management consulting services to self-insured corporations, governmental institutions, and associations. He graduated from Brown University with a Bachelor of Science degree in Applied Mathematics and holds an MBA degree from Drexel University with a concentration in finance. Wade is also a faculty member for Certified Risk Managers International (CRM). For more information on CRM, call (800) 633-2165 or visit www.TheNationalAlliance.com.