A Better Method for Measuring Distributor Value

Carrier management teams are under intense pressure to cut expenses, but to make smart cuts, the right measures must be taken first. This is especially true when the cuts affect the distributors that generate all the carrier’s sales.

For most agent-reliant carriers today, distributor costs are often near, or more than, 50% of their total underwriting expenses. The reasons for this high percentage rate vary. Sometimes this is because they manage their administrative expenses well and can afford to pay a higher portion of their expenses to agencies (a higher portion of their expenses, but not necessarily a higher portion of their premiums — two totally different measures).

Some carriers pay higher percentages of both premiums and expenses to distributors because they do not have any other value to offer. Their products are modest to poor, their claims servicing is modest to poor, their underwriting is usually poor and their staff turnover is generally high.

Regardless of any given carrier’s situation, when one single expense constitutes the largest underwriting expense by a large margin, it becomes a juicy target for budget cuts. A small cut in commissions might yield 10 times greater savings than all the postage stamp cuts for 10 carriers combined.

However, carriers that are looking for distributor expense savings are usually measuring the numbers incorrectly. It is the same mistake almost everyone in the industry and virtually 100% of consumers make regarding insurance. Consumers only see insurance as an expense while carriers only see commissions as an expense.

Consumers and most finance professors with whom I have interacted with in regard to insurance fail to recognize the balance sheet value gained. Insurance is designed 100% for the balance sheet, so measuring it solely by expense is a complete mistake.

Carriers that measure commissions only by expense make the same mistake. A distributor force in finance/insurance is like a machine in manufacturing. When a manufacturer buys an expensive machine, it is considered an investment and the value of that machine or new plant, for that matter, is measured on an ROI basis.

The smartest carriers will measure their distributors by ROI, not expense. Today, very few carriers, perhaps six, measure distributors by ROI. As someone said to me the other day, some carriers still have abacuses in their offices. Bear in mind that 150 years ago correct measures were difficult and often impossible to make. The results were simplified out of necessity. Therefore, commissions were counted and measured as a percentage of premiums.

One of my first large projects in this industry, around 1990, proved to a large national carrier that it was possible to accurately measure the ROI of each individual distributor. Breaking old habits when urgency does not yet exist is extremely difficult and the concept proved beyond their ability to accept. So, the measures from the pre-slide rule days continue.

Compensation Buckets

Three major compensation buckets generally exist for carriers. Commissions are the largest. Contingencies are usually budgeted at 2% of net premiums written, plus or minus about two tenths of a percent. The third bucket is generically known as the excess compensation bucket paid in response to negotiations with distributors that fall outside of the first two buckets. This bucket has increased materially over the last 10 years.

These compensation factors are measured by carriers as a percentage of net written premium (NWP) in their financials, which made sense in the old world of straight up reinsurance with little geographic variance or machinations. In today’s more complex world, measuring as a percentage of direct written premium (DWP) is a better starting point because agencies are paid on DWP basis, not NWP.

Correct measures are always related to function. Commissions are a function of DWP, not NWP. For some carriers it is a moot point because they buy relatively little reinsurance and what they retain is extremely consistent. Other carriers, however, buy a lot of reinsurance and are anything but consistent in how much business they retain. That inconsistency itself makes measuring on an NWP basis oxymoronic.

Next there is the question of, “Who cares how much commission is paid if the ROI is adequately positive?” Many companies generate a negative ROI at 13% commission and others may generate a positive ROI at 20%. The problem is that carriers do not distinguish in their commission rates between the good, the bad, and the ugly distributors. It is socialism. Everyone is paid the same.

If the goal of a carrier is to generate a 15% ROI and their largest cash expense (other than claims — which is not an underwriting expense) is distributor compensation, it makes sense to measure input versus output. Furthermore, 13% commission is 550% more than 2% contingencies.

One can leverage outcomes much more effectively by affecting the 13% instead of the 2%. The 2% contingency is the only material distinction between satisfactory results and poor results that carriers have made in their compensation to distributors for the last 50 years.

Distributors to carriers are a lot like agency producers to agencies when graphed. The resulting curve is a Pareto curve (colloquially known as the 80/20 rule), whereby a few make the vast majority of sales. For carriers, unlike agencies, such production concentration has resulted in significant pressure to pay higher compensation to the large distributors. However, for a carrier that manages its distributor compensation and its distributors well, the curve, i.e. concentration, will be less extreme. The relationships will result in a more even line, which shows reduced expenses and less reliance on specific distributors who apply hard negotiating leverage.

The benefit of a good ROI measurement for distributors is that it acknowledges the value the best distributors bring. For example, why set a minimum book size requirement? What is the value of $500,000 DWP with a 40% loss ratio versus $2 million at a 65% loss ratio? It is not a straight trade off because loss ratios in the real world also affect expenses, surplus, growth capacities, and staff resources. A carrier can go broke, albeit slowly, at a 65% loss ratio. Simply pull the contract of the distributor that is not a fit with the carrier (and do not reappoint them when they join a network). One particularly successful carrier has zero volume requirements. Might they know better how to measure results?

Let’s say that all insurance companies have the same value formula of 10 times earnings. Let’s also assume two different carriers with that valuation have an expense ratio of 30% and an investment income of 5%. Let’s further assume the expense and investment ratios apply evenly for all their distributors. At a 40% loss ratio and $500,000 premium, earnings are $175,000. At 10X, the value of that premium is $1.75 million. At a 65% loss ratio on $2 million, earnings are $200,000 or a value of $2 million. That is a tiny increase in value for four times more revenue and it is a realistic example. Different entities bring different values, and the smartest carriers will improve their compensation plans to reward the winners more than the losers.

Carriers really do not have a choice because less than one half of 1% of carriers have such good loss and expense ratios that they do not need to improve if they are to thrive, and maybe survive. The other 99.5% must improve to compete with the 0.5% that already possess serious competitive advantages. For most, this means that if they do not change the behavior of their distributors, the carrier will be put out of business, albeit probably slowly. Only so many surplus notes and unrealized investment gains can be booked to hide the massive profitability differences.

The third compensation bucket is what carriers are calling excess compensation. This is the compensation that the Spitzer probes seemed to target years ago (though the focus on the surface was contingencies, the actual target was excess compensation) and inadvertently made the issue larger rather than eliminating it. Carriers are mismanaging this expense horribly, mainly because they are mismeasuring it horribly. Carrier management and number crunchers are not even measuring it as a percentage of premiums, but as a percentage of total excess commissions.

Clearly those with the measuring tape don’t know what they should be measuring. Their perspective is, “I’ve allocated X% to excess compensation and no one should get more than Y% of the X% no matter how much value, or even premium, they generate.”

I cannot think of a good analogy of how bad that thought process is because even without considering the overall value generated, it should at least be measured as a percentage of premiums generated.Mismeasuring creates a phenomenal leverage point for distributors who bring an ROI of 0% or less because they know their negative value is being ignored. It’s money for nothing for them.

Carriers that want to measure ROI correctly for distributors and avoid throwing the baby out with the bathwater when they surgically improve their expense ratios, will find their measures begin to align with the desired outcomes.

The best place to begin improving expense ratios is by aligning profit share contracts with the correct measures. Profit sharing, historically and still mostly today, is based on the profitability and additional profitable growth of a book. The premiums used are DWP and sometimes earned premium. Yet it is measured and budgeted as a percentage of NWP without regard to growth rates or loss ratios. That is a complete breakdown between the measure and function. No commonality exists between the two.

One way some carriers re-connect the two is with a stability clause — one of the greatest disincentives ever created in any industry. In one way or another, a stability clause states that if the carrier makes too much money, every agency’s contingency will be cut (because the carrier needs to stay within budget as a percentage of NWP). That clause is completely illogical, and every intelligent carrier should be sure to eliminate it from their contracts.

Profit sharing is profit sharing in its purest sense. Just as a CEO is paid a bonus based on profits, not on NWP, so should agents. As I proved to a carrier more than 30 years ago, using ROI correctly to measure individual distributor contributions will deliver the best of all worlds. The net result is alignment with distributors that are delivering the best ROI while eliminating those with negative ROIs.