INSURANCE companies have a terrific opportunity to increase profits and improve agency relationships by designing great contingency contracts. Such contracts are fair and create incentives for agencies to produce results beneficial to the carrier, agencies and consumers. In my experience, companies with the fairest contracts also achieve the best operational results. This correlation should give all insurers a powerful incentive to examine their contingency contracts.

While insurance companies and agencies are in daily contact, their worlds are often far apart. The best contracts bridge this chasm. Therefore, the first step in creating a good contingency contract is to understand how it looks from an agent's point of view. Often, however, insurers fail to do so. Let's consider five aspects of contingency contracts in which carriers often come up short.

Stop losses: Giving finance people the sole power to create contingency contracts is like letting computer geeks design a car without input from the sales force. No doubt the car would boast a lot of cool gadgets, but it probably would be way off target in regard to what consumers value and would pay for.

Such misguided efforts often can be seen in the setting of stop losses in contingency contracts. A stop loss is the largest loss a carrier will hold against an agency when calculating contingency bonuses. I've heard company people talk about the importance of incremental differences on this point. The notion is that by giving agents an extra 0.1% contingency bonus, they'll accept an increase in a stop loss to, say, $500,000 from $300,000.

In reality, however, a 0.1% difference in these circumstances generally does not make any difference to agents at all. The reason is simple. Most agencies have average books of business per carrier of less than $2 million. On a $2 million book with a 45% average loss ratio, an agency incurring a loss in excess of a $300,000 stop loss will end up with a 60% loss ratio. Consequently, it will earn a minimal bonus at best. If the stop loss is $500,000 and a claim hits it, the agency won't earn anything at all. So most of the time, it really doesn't matter whether the stop loss is $300,000 or $500,000.

But that's just for average agencies. If an insurer has agencies with books of business much larger than average or very good loss ratios, a contingency contract giving agencies an extra 0.1% for a $500,000 stop loss could be a real winner. Otherwise, an insurer should set the stop loss at a flat amount or flat percentage, with a cap for very large books. That saves the company time and effort, and the simplicity and consistency improves the insurer's image with its agencies.

Reinsurance: A company employee once complained to me that agents did not understand how reinsurance affected the stop loss in that insurer's contingency contract. I readily agreed. In fact, I told him, except for a handful of people in his company, no one else did either. Since so few people understand the impact of reinsurance on stop losses, why make it a driver at all? Effective contingency contracts encourage agencies to place profitable business with the company in accordance with factors that both parties understand.

Contract revisions: Redesigning a contingency contract every year is a sure-fire way to lower a company's credibility. The market does not change enough to justify a new contract every year, so agents begin to view repetitive contract revisions suspiciously and wonder if the company is simply trying to minimize their bonuses.

Some of the most successful insurance companies haven't changed their contingency contracts materially in 10 years-through markets hard and soft. When agents rank their companies, these carriers are always at the top, and their underwriting profits are superb. So an insurer should create a contract that's fair for both sides-and then let it alone. The company will earn its agents' trust and save a ton of money that otherwise would be spent on paying attorneys, actuaries, consultants, underwriting managers, marketing managers and maybe others to redesign the contract each year.

Growth requirements: Contingency contracts can help build trust and credibility, but companies destroy both when they set unrealistic growth requirements. From an agent's point of view, what incentive is there to build a strong relationship with a company that imposes tough growth requirements in a soft market and doesn't consider a book's profitability-especially if the company's pricing is not competitive? Given the recent investigations of brokers who were paid contingencies strictly for volume, is it even wise to demand so much growth rather than profitability?

When agents are working hard to build profitable agencies, contingency contracts that reward profits and accept reasonable growth simply make sense. From a carrier's standpoint, excellent profit margins also should be preferable to enormous growth without regard to loss ratio. To be effective, growth requirements also should reflect the state of the market.

Stability clause: The stability clause states, in essence, that if a company makes too much money, it will cut all their agencies' bonuses. Where is the fairness in that? Many of the most respected and successful carriers do not include any caps. If a company is going to use one, it should be based on underwriting profits, not on written premium, which is usually the case. Then, if through some odd set of circumstances the agencies achieve good loss ratios but the company's loss ratio is poor, it will be protected from paying too much in bonuses.

Fair contingency contracts benefit companies, agencies and consumers. The worst contracts are written by companies that have lost touch with their agents and the market. Smart companies listen to the market, and they understand the factors that are important to successful contingency contracts. These factors do not change significantly from year to year. Does your company understand this?

(Note: Burand & Associates LLC advocates that agencies constructively manage and improve their contingency contracts by learning how to negotiate and use them more effectively. We maintain that agents can achieve better results without ever taking actions that are detrimental or disadvantageous to insureds. We have never recommended, nor ever would, that an agent or agency implement a policy intended to increase its contingency income at the expense of its insureds' interests.

None of the materials in this article should be construed as offering legal advice, and the specific advice of legal counsel is recommended before acting on any matter discussed in this article. Regulated individuals/entities should also ensure that they comply with all applicable laws, rules and regulations.)

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For The Manager: Where contingency contracts often come up short

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