Contingent Commissions and the Management of the Independent Agency

• DOI: http://doi.org/10.1111/rmir.12060
• Published date: 01 September 2016
• Date: 01 September 2016
• Author: Robert Puelz

Risk Management and Insurance Review

C

Risk Management and Insurance Review, 2016, Vol.19, No. 2, 225-248

DOI: 10.1111/rmir.12060

FEATURE ARTICLE

CONTINGENT COMMISSIONS AND THE MANAGEMENT

OF THE INDEPENDENT AGENCY

Robert Puelz

ABSTRACT

Insurance agencies continue to exist as an important distribution mechanism

because they give their contracting insurers advantages in risk selection and en-

able insurance applicants to transfer complex risks. While independent agencies

are compensated by upfront commissions, a key component of their profitabil-

ity is tied to contingent commissions. A contingency arrangement represents

ex post compensation normally tied to underwriting profitability, volume, and

annual growth. We report two actual contingency contracts in the context of

a decision process for choosing among contingency offerings by insurers. We

incorporate both uncertainty and correlation among key variables to arrive at

values for competing contracts, then use a downside risk approach that helps

agency owners select the better contract. The approach offered in this article is

scalable to a selection problem for any number of contingency arrangements.

INTRODUCTION

Commissions are at the core of insurance sales compensation schemes and such

production-based incentives assist in aligning the interests of insurers with their sales

forces. In the property–casualty market, producers are paid after they go through ex-

tensive search, prospecting, and the closing of a new sale, and through effective service

of existing clients who subsequently renew their business with the agency. For larger

independent agencies, there can be a disconnection between the agency owner-manager

and producers who do not hold an ownership interest because second-tier commissions

may supplement total agency revenue yet be of little consequence to producers who do

not have a direct stake in the reward. Such commissions, normally referred to as contin-

gent commissions, remain important to insurers as well as agency owners.1Contingent

Robert Puelz is a Dexter Professor of Risk Management and Insurance, Edwin L. Cox School of

Business, Southern Methodist University.The author can be reached via e-mail: rpuelz@smu.edu.

1While Cummins and Doherty answered many questions, some remain mostly because inde-

pendent agencies tend to be smaller businesses that are generally not publicly traded and data

are limited. Thus, findings have been ascertained from the insurers themselves. For instance,

Colquitt et al. (2011) are able to attribute prevalent contingent commission use to mutual in-

surers, insurers with an array of business lines, and insurers that distribute via an independent

agency, while Ma et al. (2014) associate contingent commission use with insurer financial per-

formance metrics. Little empirical analysis from the agency side has been undertaken, however.

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226 RISK MANAGEMENT AND INSURANCE REVIEW

commissions may help serve a risk selection function as well as help an insurer receive

a volume of business that enhances the benefits from risk pooling.2

The contingency contracting relationship stems from an agency agreement that autho-

rizes the agency owner(s) to place business with a carrier. While the commission by line

of business is part of this insurer–agency relationship and paid with a placement, contin-

gencies or bonuses are additional performance-based incentives paid ex post placement.

Given that contingencies are important to total agency revenue, the characteristics of

contingency agreements and how the agreements are valued is important to the agency

owner. Indeed, when the value of the contingency agreement links loss history, volume,

premium growth, and other factors, which are inherently uncertain at the time of con-

tracting, the agency owner’s decision about contract value is complicated. In this article,

we capture the uncertainties in a model that an agency owner can use as a decision tool

to select among candidate contingency contracts. Contractual details are shown to be

very important as contractual values and preferred contractual choice differ depending

on answers to such questions such as “what is an agency’s likely loss ratio range,” and

“what level of premium growth can an agency be expected to deliver?” In other words,

it would be reasonable to assume that insurers’ attempt to promote certain business out-

comes (risk selection, quantity of business, etc.) through their contracts and the results

reported in this article confirm that premise.

After a brief review of the literature, we put contingency arrangements into a very spe-

cific context in the “Agency Choice of Contingency Contracts” section by comparing

and contrasting two such arrangements so that the institutional structure behind a con-

tingency or bonus is better understood. While there are a number of academic papers

on compensation systems in insurance, there is a very little market information about

these structures. In the “A Model to Choose Among Contracts” section, we propose

how agency owner-managers can evaluate contingency contracts prospectively through

a probabilistic model, which captures the uncertainties inherent in these compensation

arrangements. The two actual arrangements presented in the “Agency Choice of Contin-

gency Contracts” section are evaluated to determine the circumstances under which one

contract is preferred to another. The “Concluding Remarks” section offers concluding

remarks.

BACKGROUND

The choice of insurance distribution system and compensation structure has been

grounded through an agency-theoretic lens to help explain a variety of circumstances

that arise in the nexus between insurance applicant and insurer including whether an

independent or exclusive agency channel is adopted.3Kim et al. (1996, p. 207) take this

tack in their empirical analysis of distribution channel choice that associates certain

2Cummins and Doherty (2006) provide an extensive review and analysis of insurer mar-

ket channels in a paper that appears, at least in part, to be motivated by Spitzer’s

2004 lawsuit filing that focused on broker compensation. For background on Spitzer, see

http://www.insurancejournal.com/magazines/features/2004/10/25/48447.htm.

3The starting point for research that looked at the costs and benefits of different market channels

is Joskow (1973), which is extended by Cummins and VanDerhei(1979) and Barrese and Nelson

(1992).