Contingent Commissions, Insurance Intermediaries, and Insurer Performance

• DOI: http://doi.org/10.1111/rmir.12004
• Date: 01 March 2014
• Author: Nat Pope,Xiaoying Xie,Yu‐Luen Ma
• Published date: 01 March 2014

Risk Management and Insurance Review

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Risk Management and Insurance Review, 2013, Vol.17, No. 1, 61-81

DOI: 10.1111/rmir.12004

CONTINGENT COMMISSIONS,INSURANCE

INTERMEDIARIES,AND INSURER PERFORMANCE

Yu- Lu en M a

Nat Pope

Xiaoying Xie

ABSTRACT

This research investigates the relationship shared by contingent commission

usage and insurer performance. We assess performance using both frontier ef-

ficiency and financial performance measures. Our findings reveal that the rela-

tionship is complex and varies across differing insurerbusiness models. We find

that nonusers of contingent commissions are more cost and revenue efficient

than are users of contingents. However, among insurers that use contingents,

relatively higher levels of use are associated with more efficient operations and

also better financial performance. Additionally, these findings are conditioned

on the type of distribution system the insurer employs.

INTRODUCTION

Contingents are retrospectively paid commissions used in the insurance industry to

help align the production goals of intermediaries and insurers. A unique feature of

the insurance transaction is that the actual value of the account to the insurer cannot

be known until all future claims have been made. However, traditional compensation

to the intermediary is paid on an up-front basis, that is, as a premium volume-based

commission or a fee-based remuneration.1Therefore, the insurer is at a disadvantage in

that it can never know the “true” value of an account when it first accepts the risk and

thus, cannot accurately compensate the intermediary.The use of contingents is designed

to encourage the intermediary to use its presumed superior knowledge of the risk in

Yu-Luen Ma, Ph.D., is a Professor at Katie School of Insurance and Financial Services, Illinois

State University,Normal, IL 61790-5490; phone: 309-438-7081; e-mail: yma@ilstu.edu. Nat Pope,

Ph.D., is an Associate Professor at Illinois State University, IL; e-mail: npope@ilstu.edu. Xiaoy-

ing Xie, Ph.D., is an Associate Professor at California State University, Fullerton, CA; e-mail:

xxie@fullerton.edu. This article was subject to double-blind peer review.

1There are two traditional measures of intermediary performance that trigger the payment of

contingents: premium volume and book-of-business profitability, with the latter being more

commonly employed by larger intermediaries (Cummins and Doherty, 2006). Other potential

triggers used by some insurers include: growth, retention, and business renewal rates (Ju and

Browne, 2007). This article was subject to double-blind peer review.

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62 RISK MANAGEMENT AND INSURANCE REVIEW

better complying with the insurer’s desired risk profile and present the insurer with a

book of business that will better meet the insurer’s goals (D’Arcy and Doherty, 1990;

Regan and Tennyson, 1996; Regan, 1997; Cumminsand Doherty, 2006; Hoyt et al., 2006).

The theory of the firm literature suggests that an insurer’s decision to use contingents is

associated with corresponding expectations of enhanced performance.2In light of the

potential negative backlash associated with the use of the practice, this research exam-

ines the strength of the relationship contingent usage shares with insurer performance.

Up to now, the empirical nature of the relationship has received only scant attention

in the academic literature. This research contributes to that limited body of literature

and makes three specific contributions. First, it examines the relationship between con-

tingent commission usage and four measures of insurer performance: two measures

of efficiency and two measures using financial ratios. Insurer efficiency is assessed us-

ing both cost and revenue efficiency variables derived from data envelopment analysis

(DEA). Financial performance is assessed in terms of an insurer’s return on assets and

return on equity. Second, given the significance the choice of distribution channel shares

with insurer performance (Mayers and Smith, 1981; Barrese and Nelson, 1992; Berger

et al., 1997; Regan, 1997; Elango et al., 2008), we perform segmented analyses on the pool

of insurers based on the distribution system employed: independent agency, broker, or

direct writers. Last, our sample period spans 1993–2008, a time period significantly

longer than the ones used in previous studies and encompasses the post-2004 period

when the issue of contingent usage first found itself in the media headlines. How the

use of contingents is related to insurer performance is an important topic on multiple

fronts, including insurers and their intermediaries as well as state insurance regulators.

Anomalous findings would be of particular interest to state attorney general offices that

have been scrutinizing the practice.

The next section of the article describes the background and associated literature on

the subject. Wesubsequently present our research methodologies, including hypotheses

and data collection details, followed by the empirical results and implications of those

findings. We close the article with a summary of the significant findings.

BACKGROUND AND LITERATURE REVIEW

Unique aspects of the insurance procurement transaction create challenges for an in-

surer in the compensation of its intermediaries. Given the traditional front-loaded

compensation system, intermediaries are (arguably) only weakly incentivized to fully

disclose pertinent information they may possess related to losses that may arise at

some point in the future. Even worse, the commission-based remuneration mecha-

nism may even provide disincentives for intermediaries to provide full disclosure fear-

ing that the insurer may decline the business altogether. The development of con-

tingent commissions addressed these principal–agent problems by assessing the true

2The theory of the firm is one of two traditional branches of microeconomic theory (the other being

the theory of the consumer) and examines the supply of goods by profit-maximizing agents, for

example, firms. For associated discussion, please see, for example, Williamson (1964).