If you answer "hard times," you get second prize. If, on the other hand, you answer "fee-based compensation," you get first prize.
By Juan Hovey
Here's an exercise in free association for you: What comes to mind when you think of 1) your typical insurance agency, 2) declining commissions, 3) the soft market, and 4) Apple Computer, Inc.?
If you answer "hard times," you get second prize. If, on the other hand, you answer "fee-based compensation," you get first prize.
Why? The first three items on the list indeed do spell trouble. Insurance agencies face declining commissions and, adding insult to injury, a soft market--with the result being that your typical agency generates less and less commission income each year on less and less premium, all the while working harder and harder.
The same troubles characterize the computer industry. Apple Computer fell on hard times when computers became commodities, not specialty items. Prices and profits plunged in a market so competitive that it forced manufacturers to sell yesterday's production at today's prices before tomorrow's wiped them out.
Apple's competitors--IBM and Compaq, for example,--adjusted. Apple didn't, and today it struggles against high odds.
Insurance agencies face a similar struggle in selling personal lines and cookie-cutter commercial lines coverages. Some see niche marketing as an answer to the adjust-or-disappear conundrum. Others turn to fee-based compensation, charging their customers fees for specific, unbundled services--for example, for marketing an account, for underwriting, for handling claims.
In the long run, fee-based compensation looks promising. It does indeed address the essential problem facing the typical insurance agency--the fact that as commissions and pricing both decline, income drops very fast. It allows the agency to earn a profit irrespective of the ups and downs in commissions or insurance pricing. It arms the client with information reflecting the value of the agency's services. It arms the agency, too, with new and detailed information profiling its own operations.
But fee-based compensation doesn't work for all lines--personal lines and cookie-cutter commercial lines coverages--commodity insurance, in particular. What's more, fee-based compensation forces many agencies to sail new seas; insurance professionals have always earned commissions, and many find the idea of billing for their time discomfiting. Another factor: Few agencies really know what their time is worth.
"The problem is that agencies generally don't know what it costs to do specific transactions," says Stan Loar, CEO of Woodruff Sawyer & Co., a San Francisco brokerage founded in 1918. The agency sells risk management and employee benefits consulting services. It specializes in directors and officers coverages and insurance packages for construction companies, the bio and high tech industries, and large wholesale and retail chains. The firm does about $14 million in commissions, plus another $1 million in fees, on $150 million in gross premiums.
"The challenge is to determine what it actually costs the agency to market an account or issue a certificate of insurance or handle a claim with or without litigation," Loar adds.
"If you don't know what your costs are, it's very difficult to determine what fees you need to charge."
Much of Woodruff Sawyer's fee-based compensation comes from its employee benefits consulting.
"These clients want to know that their employee benefits are tailored to their own objectives--and we get paid based on our function or based on a specific project we undertake, not on whether rates go up or down," Loar says.
"I like fee-based compensation because it makes us accountable for what we do and what we charge. With commissions, there's no advantage to the client with respect to what the agency does or whether it gets paid to do it.
"With commissions, you just say, 'Here's your insurance and here's your premium, and we'll be there to handle your claims.'
"That's ambiguous. With fee-based compensation, we get concrete. We say, 'We're going to allocate 40 hours to market your account, and if you don't want us to market it, you can save this much money--our fee for that time. And here's what it will cost for us to handle claims, and if you don't have many claims, you will save some more money.'"
The process requires that Loar manage his agency's operations in a way wholly different from that of a traditional agency manager. With fee-based compensation, service drives costs; and billings reflect service--so the manager strives to increase service. In a traditional agency, income derives from commissions, which reflect sales. Service, on the other hand, is a cost item, not a source of revenue. So the manager strives to increase sales and hold down service.
"We try to determine what the project is, what services will apply, what the client wants and expects," Loar says. "Then we develop a team to perform those services whose members come with different price tags. We estimate the number of hours it takes to perform a specific service and take that team member's rates and multiply them out.
"Generally we come up with a flat fee and not bill hourly as we go along," Loar adds. "We did try to act like a law firm and bill every transaction, but it was almost impossible for us to do; we don't have the setup to track the time. We found that we had to reconstruct our activity after the fact, and when there was some doubt, we left things out and didn't get paid.
"We do track the time and energy that go into a specific project so that we will know if we have the right numbers to use next year.
"And we do validate what we're doing by comparing our fees to commissions--because that's the historic benchmark. Sometimes our fees are more than the commission and sometimes less, depending on what the client wants from us in terms of service."
Fees work best with large clients employing risk managers, according to another California broker, Roy Taylor, a partner at Goldware & Taylor Insurance Services in Riverside, east of Los Angeles. The agency markets its services to government agencies, manufacturers, contractors, and service accounts such as architects and engineers.
"We prefer to be compensated with fees," Taylor says, "so when we see a client who's potentially a good fit for it, we encourage it. Fee-based compensation takes away lots of questions as to the motivations for our recommendations. Once we establish that our economic gain isn't part of that motivation, it becomes easier for us to do our job in consulting with our clients to get the appropriate risk transfer mechanism in place.
"If the client has the impression that we're trying to sell something all the time, we're just not credible."
Risk managers understand that they have alternatives to insurance, Taylor says, so they want to analyze both the pure cost of insurance and the cost of the broker's services.
Fee-based compensation permits the agency and the client to make very clear exactly what the agency will do and at what point the clock ticks into overtime, Taylor says. The arrangement also permits the agency to remain viable despite the soft market and declining commissions--a benefit to both agency and client. Without fees, the agency ends up striving to give its client the same service with fewer and fewer resources--a recipe for extinction.
"We're very selective," Taylor says. "We use fees with the creme de la creme.
"If we have a troubled relationship with a client or we're entering into a new relationship that looks like it might become difficult, the last thing we want is to go in on a fee basis--because we could run into problems collecting our fees.
"Fee-based compensation overcomes that old bugaboo about commissioned salespeople," Taylor says. "Eliminate that from the equation and you elevate the service of the insurance professional to a new level."
Across the country, Jerry Hargrove, a principal of Northside Insurance Services in Roswell, Georgia, a suburb of Atlanta, took to fee-based compensation naturally. Northside Insurance Services is a multi-line retail agency with a large book of commercial accounts. Hargrove holds a law degree, and he does a lot of consulting with insurance litigators.
"We have an hourly rate based on 15-minute increments," Hargrove says. "I had experience with that type of billing, and we wanted to operate based on what we really do.
"We conduct expert witness pre-trial prep for attorneys with insurance-related litigation," Hargrove adds. "We also do coverage interpretations and position papers, and we design insurance specifications for commercial customers. We're always looking for ways to unbundle our services and package them for a fee.
"We tell our clients that we will find out what the cost of pure insurance is and what the cost of our service is.
"If you don't figure your costs on an hourly basis, you're just tossing numbers around. Somebody somewhere once decided that the broker's services were worth 25% of the premium. Then the number dropped to 20%, and now the paradigm is 15 to 20%.
"Now you have to know that the sales process is worth this much and that issuing a certificate of insurance is worth that much. When you're dealing with a large account and you have the expense of designing sophisticated specifications and the research and the professional exposure, the traditional market just doesn't allow you a sufficient income from commissions.
"And the more sophisticated you get, the more you have to go to fees."
Like his peers Roy Taylor and Stan Loar, Hargrove considers fee-based compensation appropriate for big accounts only; and he's not sure that his agency's fee income--no more than 10% of total commission income--will increase substantially over the next five years.
"I don't see it as the wave of the future," Hargrove says. "I see it as a ripple, and whether it will ever become a whitecap, I don't know--and it will be a long time before it becomes a tunnel to surf in."
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Fourteen years ago he began prospecting for property/casualty business among employers facing big workers comp bills. He came to know a lot about workers comp. Five years ago his expertise had become so valuable that it enabled him to stop selling insurance altogether and begin deriving all of his income from fees paid to his consulting firm, Compaudit Services in New York, which specializes in streamlining workers comp programs.
Moll controls his own income now. He doesn't sell insurance at all anymore. He sells his own ability to find savings in an employer's workers comp bill.
"I used to prospect workers comp because everybody else was prospecting property/casualty coverages and the rates were all the same," says Moll. "I used to ask my prospects whether, if I found errors in their workers comp that resulted in refunds, they would give me their P-C business.
"I got lots of P-C business."
Moll bases his consulting fees on the savings he realizes for his clients. He analyzes experience mods, classification data, and other elements of workers comp packages looking for savings, and when he finds unnecessary expenses, he shares in the savings. His income doesn't depend on any insurer's willingness to pay commissions. He makes money because he understands workers comp and because he adds value to an employer's operations.
"I have a very specialized niche," says Moll, who also writes for insurance-industry publications. "I work with clients on an ongoing basis. When I was strictly a producer, I worked on commission only. I never did fee-based work, but now as a consultant, I don't do any placement of insurance.
"Workers comp is a labor intensive cover. It pays low commissions and generates lots of claims, and most insurance professionals aren't equipped to analyze it. Insurance companies make a big mistake by not paying agents enough to get them involved in workers comp. Their results would be far better if they had agents involved with their clients day to day, trying to control costs."
Despite those obstacles, Moll saw opportunity and capitalized on it.
"And as I look at the insurance marketplace now, I don't understand it," Moll says. "In order for the average agent to survive, he or she is going to have to concentrate on a niche. The agent who tries to depend on being a generalist isn't going to cut it. Companies are going to continue to reduce commissions.
"It will be impossible to survive unless you grab a niche and ride it."
As Moll did himself.
Art Moll knows what comes from expertise--fee-based income.