Are Performance-Based Incentives Ethical?

First is the broad-based nature of the question. It applies not only to the company employee adjuster (the subject of the original question) but also to public adjusters, plaintiffs attorneys, agents, brokers, underwriters, premium auditors, loss control representatives, and any other individual within the insurance business who can increase income or decrease expenses.

Second is the focus of the performance-based system. Does the system reward individuals specifically for achievement of individual goals and objectives, or is the individual primarily rewarded for corporate or business-unit achievement of goals and objectives?

Third is the type of performance-based goals and objectives. Are the goals truly performance-based (for example: reduce average claim payments for auto physical damage to $855 per claim) or are they more accurately "activity" based (contact each auto physical damage claimant every four days until the claim is settled)?

Fourth is the nature of the reward or bonus. Is the reward immediate cash, prizes or other compensation, or is the reward deferred–such as stock options?

Because of these four challenges, I have limited the discussion in this column to corporate, non-production employees of insurance companies. However, future columns will continue to examine the issue, zeroing in on specific job functions within the insurance company and on those non-insurance company professionals subject to the same ethical challenges.

There are four general comments on bonuses based on corporate or business-unit results.

First, they are common, with reportedly more than 60 percent of all U.S. corporations offering incentive rewards. While "common practice" does not justify illegal or unethical practices, such a significant percentage would preliminarily indicate that such rewards systems have passed many tests of ethical behavior and legality.

Second, such compensation systems are inherent in any enterprise. If an organization is losing money, chances of a pay raise are remote, let alone a bonus. On the other hand, if the enterprise has a great year, raises for all may be higher than usual. Few people have raised ethical issues based on normal compensation increases.

Third, almost all organizations have some form of "merit" based compensation. Employees with outstanding results usually receive a greater pay raise, increased recognition, promotion and other forms of compensation.

Fourth, corporate or business unit-based rewards are distant from individual goal-based rewards and, hence, the employee has less incentive to act unethically to increase his or her chance of a greater reward.

Performance standards are either results- or activity-based. Generally, newer employees are given activity-based goals simply because a person new to a job more easily understands what he or she is supposed to do rather than how what they do generates results.

Performance standards are more common among middle and upper-management. These employees usually understand that activity leads to results. They are also less able to influence results such as increased premium income by reducing underwriting standards or closing more claim files by simply overpaying the claim.

There is always the potential for unethical behavior with either type of standard. There is greater potential at the execution level (underwriter, premium auditor, producer, adjuster) than at the management level.

Also, actual performance standards, if incorrectly stated or implemented, offer a greater potential. The potential should not matter to the ethical employee. In discussing compensation based on goals and objectives, the nature of the goal and the level to which they apply within the organizational structure should be considered.

The final general consideration is the nature of the reward. Immediate cash for performance is a bigger carrot on a shorter stick. Deferred types of compensation, such as stock options, force individual employees to look to the longer term for their reward. This added time-distance reduces any potential for unethical behavior.

Readers replies tended to fall into general responses and responses specific to a specialty within the insurance business. Most specialty responses were from a production point of view and discussion of it is deferred for a later article.

Almost all responses indicted that, as in all human activities, there was always a "potential" for abuse no matter what issue is being considered.

The more general responses indicated ethical ways to have such a compensation system. These responses focus on the long-term success of the insurance company, agency or individual activity within the insurance business.

"Any ethical system of performance incentives should only provide rewards for performers if the customers interests are well served. Compensation adjustments of any form must be aligned with the customers interests," said one respondent.

Similarly, another respondent wrote: "Any time efforts or actions are taken to achieve incentives and those actions are not in the best interest of the customer, it would be unethical. Disclosing those incentives would not necessarily make it ethical."

One respondent made a recommendation to those employees ethically troubled by such a system: "Anyone who sees his or her ethics compromised should simply get out if he or she cannot reconcile the potential problem."

It was performance standards at the individual level that troubled the most people. The person who raised this issue wrote: "The practice of performance-based compensation is growing and we are hearing everybodys doing it as a defense. I believe the adjuster has to be free of financial interest in the outcome of a claim or there can be no confidence in the fairness of the system. Punitive damage awards do not seem to deter anyone."

Clearly this comment must be focused on the company claims representative. Otherwise there are some problems with this belief, as it would seem to make all public adjusters, or at least those who receive a percentage of the paid claim, unethical. Further, it would add plaintiffs attorneys to the unethical list as they typically are paid based on their specific performance in the final adjustment of a claim.

Both public adjusters and plaintiffs attorneys do disclose their financial interest in the ultimate settlement, but it still leaves the predicate ethical question of whether these professionals should be subject to such performance-based compensation.

Another view of individual performance compensation from an outstanding executive in adjusting was: "As a field claim representative, if I am paid based on performance of personal goals, such as the number of files I open and close, I could open as many as possible (and look good because of my case load) and simply close them by overpaying and not paying what is fair. There is no incentive to me to pay less because I would only enrich the plaintiffs bar with that choice.

"On the surface I look good with a large number of files opened and closed. In the long run I have adversely affected all insureds with higher premiums, and the insurer and agency with a higher loss ratio," the respondent continued.

"The same is true for an underwriter using cash register underwriting. If my compensation is based on premium increase performance, I can greatly increase premium by ignoring underwriting standards but only at a long-term disservice to my insureds, fellow employees, agents and owners," the respondent concluded.

Rewards based on company or business-unit level were not perceived as an ethical problem. A typical response was: "If the company were to make a profit, why not share it with those that generated it, the employees, just as the insurer would share the profit with its agents, insureds (through future rate stability) and owners."

In summary, most readers, as always, recognize the potential for unethical behavior and agree that an ethical employee should not have a problem.

As to the potential to encourage unethical behavior directly because of performance-based compensation of insurance company personnel, most respondents agreed that such compensation has the least potential for abuse if it is based on corporate or business-unit goals and longer-term results of the insurers operations. The potential for unethical behavior is increased for performance-based goals of individuals with immediate rewards.

To continue this discussion, the question for the first column of 2002, which is scheduled to appear on Jan. 7, isolates the claim representative within an insurance company: "Given that adjusters (as all other company employees) will be rewarded for excellent performance, how should an ethically-based, performance measured compensation or reward system be structured so claimants may be assured of fairness in the adjusting system?"

Those of you who are underwriters, agents, brokers, premium auditors, and loss control specialists should feel free to answer the same question as it applies to your job.

The next "A Question Of Ethics" column, to appear here on Oct. 22 in conjunction with the annual meeting of the CPCU Society, will offer some suggestions on developing a "Statement of Ethical Behavior" for your organization. Any ideas you have on that subject will be appreciated.

Please forward your responses to Dr. Peter R. Kensicki at ethics@eku.edu, or Eastern Kentucky University, Coates Box 25A, 108 Miller Hall, Richmond, Ky. 40475-3101. All responses will be kept confidential.

Peter R. Kensicki is a professor of insurance at Eastern Kentucky University in Richmond, Ky., as well as a member of the Ethics Committee of the CPCU Society in Malvern, Pa.

Reproduced from National Underwriter Property & Casualty/Risk & Benefits Management Edition, September 10, 2001. Copyright 2001 by The National Underwriter Company in the serial publication. All rights reserved.Copyright in this article as an independent work may be held by the author.

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