During our annual valuation work for agencies and brokeragesacross the country, one alarming trend we're noticing is that mostare forecasting significant declines in contingent income thisyear, even though commission revenues are holding or increasingslightly. This could have sizable consequences for agencyprofitability.

Contingent income is a powerful asset. It comes in as revenue,but because there is typically no producer compensation associatedwith it, such revenue flows directly to the bottom line asprofit.

Therefore, any change in contingent income, up or down, can havea dramatic effect on profitability.

In fact, as the accompanying bar graph shows, agencies in the“2008 Best Practices Study”–prepared by Reagan Consulting for theIndependent Insurance Agents and Brokers of America–receivedbetween 36.8 percent and 51.0 percent of profits from contingentincome.

Because agencies are relying on contingent income for largeportions of their profits, any reduction would have significantramifications on agency cash flow.

Why is this happening?

The first driver of lower contingent income is the combinationof the soft property-casualty market and the declining economy.These two factors are driving down premiums and driving up lossratios.

Agencies are finding it harder to hit the growth, retention andprofitability requirements in their contingent agreements, and as aresult more agencies are falling into lower bands of contingentincome payouts or are failing to qualify altogether.

Most carriers we've spoken with indicate that the lowercontingents paid out in 2009 (based on 2008 results) aren't theresult of less attractive contingent arrangements but of lessattractive industry performance.

Therefore, the second source of pressure on contingent incomecould come from carriers themselves, as insurer profitability andreturn on equity declined substantially last year, with no sign ofa quick turnaround in sight.

The Insurance Information Institute reported that the p-cindustry's combined ratio climbed to 105.1 in 2008, up nearly 10points from 95.5 in 2007. While a combined ratio over 100 isn'tunusual, it is an indication the industry is not making anunderwriting profit, as it has in three of the last four years.

However, insurers have often made sizable profits from theirinvestment portfolios even in times where they have experiencedunderwriting losses. But due to the downturn in the financialmarkets in 2008, carriers are also finding it difficult to earnincome on their investment portfolios.

With both underwriting profit and investment profit declining,data from the Insurance Information Institute indicates that in2008 the industry recorded its lowest return on equity since2001.

Where will carriers turn to increase profitability and togenerate higher returns? Pricing is certainly the most obviousanswer, but it is also possible they'll re-examine and “tweak”their contingent income contracts.

Several carriers have already implemented payout caps and/orraised the minimum premium volume requirement for contingenteligibility.

For example, agents placing $500,000 in premium with an insurermay now need to place $750,000 to be eligible for that carrier'scontingent income plan. In addition, some carriers are lowering theloss ratio threshold to require a more profitable book to gainaccess to contingent income.

The factors pressuring contingent income aren't likely to relentany time soon. A hard market has yet to materialize–indeed, thequarterly pricing survey by the Council of Insurance Agents andBrokers reported rate declines of 5.1 percent in the firstquarter of 2009–and the prospect of economic recovery remainsuncertain.

Further, it isn't certain we've seen the full reaction ofcarriers to their declining financial performance. With difficultcontingent conditions likely to persist, agencies should beginplanning for reduced contingents and reduced profitability.

We examined the “Best Practices” agencies between $10-and-$25million in revenue for the last 12 years, and discovered aninteresting shift in contingent income that occurred approximatelysix years ago (see accompanying graph). Contingent income went fromaveraging 6 percent of revenues for the six years from1997-to-2002, to averaging 10 percent of revenues from2003-to-2008.

This shift of four percentage points in revenues may not seemthat significant, but the corresponding shift in profits can bedramatic. For an agency with a profit margin of 20 percent, thatfour-point revenue shift represents one-fifth of the firm'sprofit!

We don't believe there will be a major structural change in theway contingent and supplemental income programs are run. Theseprograms are important for agencies and brokerages but are alsoimportant to carriers.

Contingent income allows carriers to ensure that the interestsof agents and brokers are aligned with their own, and gives them away to reward high-performing agents. However, even small changesto contingent income plans can mean big changes to agencyprofitability.

It is difficult to judge the magnitude of the coming contingentincome decline, but it doesn't take much to meaningfully alter anagency's bottom line.

Shirley Lukens and Brian Deitzare partners with Reagan Consulting Inc. (www.reaganconsulting.com),an Atlanta-based consulting firm that developed and produces the“Independent Insurance Agents and Brokers of America Best PracticesStudy.” Ms. Lukens may be reached at [email protected],while Mr. Deitz is available at [email protected].