Are reduced commissions the wave of the future?

For the years that we've represented Travelers our written premium with them has grown every year but two. That uncommon consistency has been the backbone of my agency.

We've seen dozens of other companies come and go; agencies often lose access to carriers for what appear to be whimsical reasons. One national carrier cancelled my agency's contract because we grew too big with them. They had gone through a merger that left them overexposed in the states where we did business. Despite being named their national agent of the year a few years prior, they decided to part with us. Their stated reason for the cancellation was, "We can either cancel you or cancel the next 20 largest agencies." They did give us a $100,000 check for our trouble on the way out the door.

Our growth with Travelers has largely been due to their constant innovation and marketing support. Without a doubt, their marketing department's output is far beyond many other companies' efforts. It is a challenge for us to keep our member agents informed about the vast number of Travelers sales aids. They also have sent some of the best field representatives in the industry to help us.

The Coming of Quantum

When I first heard about Quantum 2.0, I described it as, "exactly what is needed." The Travelers product provides good coverage at a price that usually is either the lowest-priced or second lowest-priced on our comparative rater.

Our member agents sell value. They're located in small towns where delivering a cost-efficient, quality product is expected and demanded. It isn't good enough just to provide the cheapest insurance, because when a loss occurs the wagging tongues in the local coffee shop will click if coverage isn't adequate.

Even though they sell value, our member agents are typical in that they often place the insured with the company that provides the lowest quote; these producers consider this the ethical thing to do. Travelers has said that the average agent places the insured with the lowest price option 83% of the time. When companies see that kind of agent behavior, can you blame them for making low pricing a priority?

Over the years, Progressive developed a corporate mantra based on providing the lowest price possible. In my view, they've also led our industry in commission cutting. Still, it's hard to argue with Progressive's success. By most measurements, they've posted enviable results in growth and profitability. Agents complain about their commission schedule, but continue to place huge amounts of premium with Progressive. About half of Progressive's premium volume is produced through independent agents.

However, the question now becomes: With two industry leaders finding success through reduced commissions, is our industry on the verge of killing the independent agency goose-that-lays-the-golden-egg?

The 2013 Best Practices Study published by Reagan Consulting and IIABA indicated that agencies with revenues under $1,250,000 have an average operating pre-tax profit of 17.4% of revenue. That same study indicated an operating pre-tax profit of close to 10% for larger agencies. The Quantum 2.0 product reduced commission in our state from 15% to 13% on new business and from 14% to 12% on renewal.

At that level the commission is still higher than that paid by the largest writer of private passenger auto for independent agents in Minnesota. However, if all the other companies create reduced commission products, the advantages will be lost, and profits could sink below sustainability for agents—especially if they don't take the additional steps Travelers has.

Agencies Can Endure a Commission Cut, If Roles Change

Commission percentages haven't changed much in the last five decades, nor have the roles of companies and agencies. Historically, insurance companies have provided market-attractive pricing combined with consumer-desired coverage. Agencies have been relied upon to provide an equal value of marketing and expertise to explain contracts to their clients.

The industry has recently changed from this historic equitable balance. Although the majority of consumers still want an agent available to explain things to them, companies are communicating more directly with their insureds through websites and mobile phone apps.

The IIABA's Project CAP and Trusted Choice initiatives have shifted some of the marketing costs to the insurance companies. About 40 companies have supported Project CAP and about 60 companies back Trusted Choice. The PIA has backed smaller but similar initiatives to spread the word of independent agents' intrinsic worth to insurance consumers.

It would be fundamentally wrong for agents to expect insurance companies to pay for advertising without a direct return. Money is not an unlimited resource, and any increase in company expense impacts the company's competitive posture for providing low rates. In the independent agency world, the nexus between the more dollars companies spend on marketing and the direct new premium result for them is quite tenuous. When pricing becomes a key factor to obtaining new business, it behooves insurance companies to cut expenses as much as possible. For the five decades I've been in this business, this dichotomy has set up a value proposition that has been self-defeating for independent agents and their contracted companies.

Under this historic model, agents who can't compete with GEICO and esurance advertising budgets on their own cannot rely on companies to help them. Companies who can't justify advertising expense that don't tie directly to increased production watch almost helplessly as the market share for independent agent carriers is threatened.

Retention Will Continue to Be Key, to Agents AND Companies

In my agency, our fixed expenses are substantial, compared to those that are variable. An increase in written premium is almost always tied to an increase in profit. The majority of the new business we've been placing with Travelers has been new to our agency. The prior carriers listed on the applications for this new Travelers business in our agency have been largely companies that aren't contracted with our agency, like GEICO. However, since the business is coming to us from a "GEICO" it may have risk attributes that would indicate low retention. Travelers has taken what I believe are the right internal steps to increase retention and are monitoring the risk attributes of the new business.

Many people believe that an independent agent must keep a private passenger auto client for at least 4.5 years in order to start to make a profit from the relationship. On average a 4.5 year retention would indicate an agency retention ratio in the high 80s. If Travelers can help boost retention by two to three points, an agency would keep their customers one to two years longer on average. Keeping a customer longer after the "break even" point makes a tremendous difference to the bottom line.

Under reduced pricing, loss ratios will naturally go up since the premium charged for the same exposure is going down. Companies will look to reduced expense ratios to keep their combined ratios at about the same levels. Travelers spent a considerable amount of time developing Quantum 2.0 and no doubt looked at the total commission reduction, including what we expect could be a reduction in contingent commission paid to our agency—due to higher loss ratios.

If our retention improves to projected levels, we will more than make up the decrease in commission with longevity, including any lost contingent commission. Retention goes up when an insurance product sale is made within the guidelines of basic human nature: Before any other consideration, the majority of people want to feel they can trust you. Second, they want to know that the coverage they're buying is suitable to their needs. Then, they want assurance that you, as their agent, will communicate effectively. Lastly, they want a price that is fair.

I've felt that using a comparative rater for the last two decades has decreased trust rather than build it. An agent does her comparisons and then shows the premium comparisons to a prospective customer. Often, her recommendation would be that they buy something other than the lowest cost product based on her analysis of the contract features. That places the agent in the position of a salesperson selling accessories at the last moment, when the customer knows that she works on commission.

Under the Quantum 2.0 sales approach, she would show the customer that the lowest priced product is offered by Travelers. Then she would tell them that Travelers is the company she would recommend. That is followed by a discussion with the prospective customer about additional coverage they might want to consider. Through this new process, she's built trust by recommending the lowest cost company. She's also showed concern about product suitability, and demonstrated her ability to communicate with the customer. It's a subtle nuance, but seems to make a huge amount of difference with the right customer.

The "shopper" is often impervious to the trust process and simply wants pricing. Although we caution our member agents to be courteous to the shopper, we also tell them that a shopper will rarely create profit for their agency and should not be a target customer.

Closing Ratios Have Improved

Using Quantum 2.0 our ratio of sales to quotes has gone from approximately 6% to around 14%. These ratios might sound a little low, but in many instances they include multiple quotes for the same insured in many instances. We're probably three to four points higher on sales to individual customers quoted.

I felt an uneasiness when we first started selling Quantum 2.0 and realized that in addition to pricing and commission changes Travelers had broadened their appetite. In the past they had targeted about 30% of the market and now seemingly target about 35%. I was able to sit down with Travelers product experts and discuss their internal vigilance regarding these changes. They convinced me that they were acutely aware of the potential for disaster. Protocol is in place to quickly react to market conditions that would cause adverse selection. 

While I agree with A.M. Best that Travelers is an A++ company, and we're happy with Quantum 2.0 results to date, I am an independent agent and constantly compare company products. Safeco has a program that is similar to Travelers in that it has minimal coverage in the basic product, which can (and often should) be upgraded. With Safeco, the reduced commission is paid on their basic product, but reverts to the standard commission when an upgrade is sold.

This commission payment method tells us, as their agent, that Safeco will pay us more when we're doing our job as a trusted advisor and less when it appears we're simply taking an order. I assume their actuaries have adjusted the pricing with the upgrades to support the full commission we've earned.

We've not had the success with the Safeco product so far that we've enjoyed with Quantum 2.0.

Reports of Our Demise Are Greatly Exaggerated

McKinsey and Company stated during 2013, "the economics of the traditional agent model are beginning to unravel." It seems to me that the success agents are having with Quantum 2.0 would suggest that, given the right products, the American Agency System is still a force in the market.

Earlier in 2013 McKinsey stated that more than half of auto insurance quotes come from price-sensitive customers, but their subset accounts for less than 30% of policyholders. "If the other 70%—the "silent majority" of policyholders—appears to be difficult to reach, this is likely because they are unresponsive to marketing messages based solely around price."

It seems somewhat perverse that, at a time when agents' ability to make "trust" sales are needed most to attain customers who are the least price-sensitive and more loyal, commissions are being reduced. "Trust" sales require a lot more agency resources than passive "price" sales. We're told that Travelers intends to be more creative with marketing assistance in the future and so far this year we've seen evidence that is true. The marketing assistance dollars we received for the first half of the year exceeded any other six-month period.

Products like Quantum 2.0 allow agents to excel with the 23-30% of the market who will quote their auto insurance this year. The loyal/high retention customers will only be attracted if insurance companies combine "increased involvement in marketing" with "low priced products."

The fact that millennials mainly trust their friends and are somewhat immune to advertising makes increased corporate marketing somewhat tricky. The methods of advertising corporations should employ must be as innovative as Quantum 2.0.    

Conclusions

Hopefully other companies will read this or complete due diligence before making the erroneous assumption that Quantum 2.0 is a success solely because of commission reduction. It is an integrated approach that includes commission reduction as one of many factors.

The industry has been well served by the American Agency System. Consumers want agents, so they think they're also well served by them. Pricing will become more and more sensitive as online quotes are available in "seven and a half minutes." Roles need adjustment. Agents need to be as efficient as possible in how they perform as an advisor. Companies need to involve themselves in marketing more as agents find their budgets squeezed and marketing resources no longer available.

We're only one agency group, but our YTD loss ratio with Travelers personal lines is 44%, which might be an indication of actuarial integrity for the product. It's innovative and well-conceived, but assumes the above-described changes will happen quickly in a world that moves at glacial speed.  

These changes will happen because they must, in order for independent agents and their companies to survive. The Quantum 2.0 approach is obviously compelling, and economic realities rarely bend. However, in today's world those adjustments need to be made in weeks, not years. I'm still smiling, but only because I have faith that positive adjustments are on the way.

Jim Holm, a five-decade insurance industry veteran, is the CEO of Enhancedinsurance.com.