As we all know, contingent commissions have come under attack in the wake of investigations by former New York Attorney General Eliot Spitzer and other state attorneys general. Among other things, those investigations focused on whether such incentives prompted agents and brokers to improperly steer clients to carriers that gave them the best contingency bonuses, rather than offered clients the best coverage or price.

Some insurers have responded to the allegations by doing away with contingency contracts and replacing them with supplemental compensation contracts. When I recently reviewed some of these contracts, I found they were quite different from the descriptions of them that I'd read in various trade magazines. I'd like to point out some important issues these contracts raise and also dispel a number of myths. Not all of what follows applies equally to all these new contracts, so readers are advised to check the particulars of any contracts they have.
Important issues
In how they determine a performance bonus, the new supplemental contracts differ from the old contingency contracts in two main ways:
–They use different years of agency results to determine the bonus factor. Under the supplemental compensation contracts, an agency's bonus is based on its results for the previous one to three years. Thus, they use an agency's 2006 results (and possibly 2004's and 2005's results) to determine the bonus percentage that will apply to the agency's 2007 production. Under traditional contingency contracts, the bonus factor is based on the current year's results and often the results of prior years. For example, a contingency contract might use an agency's results from 2005, 2006 and 2007 to calculate the bonus percentage that will apply to its 2007 production.
–In addition to basing an agency's bonus percentage on such objective criteria as loss ratios and volume, a carrier may apply additional subjective factors that are determined solely by the company. A supplemental commission contract also may permit a carrier to adjust the total amount of bonus payments it makes to all agencies in a given year.
Traditionally, an agency's loss ratio has been the most important factor in determining the size of an agency's contingency bonus. (In contrast, written premium has been a less important factor.) Therefore, under a traditional contingency contract, agencies can influence their bonuses significantly via prudent front-line underwriting. However, to the degree that a supplemental bonus is subject to carrier modification, an agency's ability to have meaningful influence over that bonus percentage is significantly lessened. Such arrangements do, however, enable carriers to manage bonus payments more effectively.
Under these contracts, if a bonus percentage really is considered “guaranteed” or “fixed” (see Myth No. 1 below), an agency may have to pay taxes on the bonus in the year it is earned, not in the subsequent year in which it is received. Also, after an agency switches from a traditional contingency contract to a supplemental compensation contract, it could, from a tax perspective, initially earn bonuses twice in the first year of the supplemental contract–once from the traditional contingency contract and again from the supplemental commission contract, although the agent will not receive the supplemental bonus until the following year. I'm not an accountant, but I think agencies with these contracts should seek professional tax advice about this matter.
Dispelling the myths
Now let's consider some myths about supplemental compensation contracts.
–Myth No. 1: The bonus percentage is fixed. Some accounts have described supplemental compensation bonuses as if they were fixed, guaranteed percentages–as if the carrier were simply eliminating contingencies and, in essence, increasing its standard commission to make up for the difference. This is a reckless assumption. The bonus is fixed only because the agency knows at the beginning of a year the percentage that will apply to the business it produces over the next 12 months. However, because the contracts contain significant “wiggle room” for companies to change a bonus amount, the bonuses are even less guaranteed than they are under standard contingency contracts. Consider an agency with a 40% loss ratio on $2 million written premium in 2007. Let's assume that under a contingency contract, such results would produce a 1% contingent bonus, payable in 2008. Under a supplemental compensation contract, the agency might be notified that it will receive a 1% bonus on its 2007 production, with the bonus percentage based on its 2006 performance, payable in 2008. However, that 1% may be subject to the company's adjustments. That means an agency may not learn its true bonus percentage until the end of 2007 or the beginning of 2008.
A related myth is that the switch to supplemental commission contracts enables agents and brokers to accurately disclose their compensation to clients. In my opinion, however, the use of any subjective adjustment factor makes true disclosure impossible.
–Myth No. 2: The new contracts “eliminate the incentive to manipulate business.” I've seen this quote and similar ones attributed to both insurance company executives and insurance agency representatives. I believe such statements are misleading. First, they imply that traditional contingency contracts gave agents an incentive to manipulate business placement. Many people in the industry disagree. Second, the new contracts use the same factors as the old ones–i.e., volume and loss ratio–to determine bonuses. So if the old contracts provide an incentive to manipulate business, so do the new ones.
In my opinion, agents never really had an incentive under contingency contracts to manipulate business to the detriment of their clients. After all, the bonuses paid under such contracts are determined retrospectively and based mainly on the performance of an agency's book of business with a carrier. The brokers who Spitzer and others accused of manipulating business profited from compensation agreements that paid them upfront volume-based bonuses, not from standard contingency agreements.
–Myth No. 3: Supplemental compensation contracts are fairer than traditional contingency contracts because agents will know exactly how much they are going to earn. In my opinion, these contracts are significantly less fair. The old contracts spelled out what an agency could expect to earn. If it achieved X results, it knew it would earn $Y bonus. The new contracts, however, are not necessarily as straightforward. Again, there is a lot of wiggle room for the carrier to adjust the effective bonus percentage. If a carrier takes a dislike to an agency (which, as we know, does happen), it could lower its bonus by application of subjective factors. The agency could even receive a smaller bonus than another agency posting worse results, as measured solely by objective criteria. While that may be unlikely, it is possible. I believe a bonus contract loses its fairness when even part of the bonus is subject to carrier subjectivity.
–Myth No. 4: Each company has only one contract and everyone gets the same deal. This is not necessarily so. If anything, under at least one new contract I've seen, the possible deals vary now more than ever.
It is critical for agents to understand the implications of the new contracts, even those agents whose carriers are not using them. If you represent a carrier that does, understanding your new contracts is essential. Otherwise, I expect a scenario similar to one that arose several years ago, when a company introduced a new and substantially worse contingency contract. One of the company's marketing reps was scared to death to present the new contract to agents. But to his pleasant surprise, not one agent called him about it–until the following year when the agents got their contingency checks. Don't be on the receiving end of an unpleasant surprise. Carefully read and understand all your new contingency and supplemental compensation contracts.
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 considerably better results without ever taking actions that are detrimental or disadvantageous to the insureds. We have never and would not ever recommend that an agent or agency try to increase its contingency income at the expense of insureds' interests. Regulated individuals and entities should also ensure that they comply with all applicable laws, rules and regulations.
Chris Burand is president of Burand & Associates LLC, an agency consulting firm. Readers may contact Chris at (719) 485-3868 or by e-mail at Chris@burand-associates.com.

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For The Manager: Subjectivity in supplemental compensation contracts

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