Every year around springtime, many of us are mildly surprised by two anti-climactic events, tax ‘refunds’ and the arrival of contingency checks.
The naïve among us consider both the tax refunds and the contingency checks as ‘bonuses,’ one from our kindly Uncle Sam and the other from our ‘generous’ insurance companies. The competent business owners among us understand that the tax refund is a return to us of our own money for overpayments we made to the government and that they were able to use our money, interest free, for as much as a year before returning it to us. The astute businessperson will try to estimate and pay the tax obligation as closely as they can so they, not the government, have the use of our hard-earned money during the year.
Similarly, contingency income, sometimes incorrectly defined as ‘bonuses’ from our carriers are, in fact, a share of profits generated by our own performance above and beyond the average for the carriers in terms of loss ratio and, sometimes, of growth. The insurance companies estimate their average loss ratio in order to accommodate the profit target that would satisfy their Boards of Directors and/or their stakeholders (stockholders, members, insured). Those agents who generate profitability in excess of the expectation of the carriers should certainly be rewarded for helping the carriers achieve their profit targets.
Traditionally, the carriers define the ‘Flavor of the Year’ for their contingency calculations and reward the agents accordingly after any claim reserve adjustments determined at the end of the year. Sometimes the calculations are simple enough that they can be tracked and managed by the agents to estimate the contingencies that will be earned. Other times the calculations are so obtuse that only the actuaries, with help from a crystal ball, can identify the result. As a consulting firm accustomed to reading hundreds of carrier Production & Loss Documents and analyzing Contingency Agreements, we are often assigned the task of calculating and estimating the annual contingency for our client agencies that they should expect from their carriers. We do this on an on-going, rolling 12-mo basis, so you know exactly what a loss, the loss or gain of premium will do to your loss ratio. Call us (856-779-2430) if you would like to discuss this service.
In any event, the contingency income arrives with a flourish (or a whimper) at the end of the first quarter of every year. The question is, “What do you do with it?”
For some, the contingency income forms the owners’ bonus. You own the business, so the contingency is unexpected income that is not used for daily agency expenses and can be taken home. For multiple owner agencies this bonus is distributed by ownership interest or by the whim of the majority owner. For other agencies that have multiple owning entities that have their own sub-producer codes (i.e. clusters, Virtual Insurance Agencies, etc.), the contingency income is split between the owning entities. For far too many agents, the annual expenses of the agency cannot be managed without a healthy dose of contingency income and they must use it to pay Lines of Credit or to save for monthly expenditure toward normal agency costs.
I’d like to explore each of these and suggest the most effective use of contingency income to grow your agency and make it progressively more prosperous every year.
1. Take the money and run (to Europe, Asia, or to warmer weather or to buy that next, well earned, car or property) – Many agency owners treat their agencies like piggy banks. Anything that isn’t used to pay for operating expenses is available to take home. If we run out of money, the owner is expected to lend money to the agency and get paid back when money is available (at least in theory).
This can work. But if you spent every dollar of excess cash you personally earned during your constructive life, how much would you have saved to support your retirement or your declining years? Similarly, your agency is a living, breathing entity. If you spend every dollar on running costs or for the owner’s pleasure, how could you ever have the surplus to spend money on expansion and growth opportunities (like acquisitions, new producers, marketing campaigns, opening offices, building successors, etc.)? Every time an opportunity arises, the stock answer is that we don’t have the money to do it! In reality, you HAD the money but you chose to use it personally instead of investing in your own company’s growth.
This concept, regardless of the size of the agency, is titled the Mom & Pop Shop. It supports the owner and his (or their) family and pays using the minimum cost to operate. It’s not wrong, but it will never permit the business to grow as well as if it were able to use all or part of its contingency every year on growth initiatives.
A Professional Insurance business reserves all or part of its contingent income specifically for growth initiatives. It uses it to sponsor the down payment on acquisitions (making funding the rest of the acquisition so much easier). It uses it to hire revenue-generating employees. It uses the excess cash to sponsor the acquisition and training of successor over the term needed to make the candidate productive and profitable in the entity. It uses its contingency income to sponsor marketing plans to grow the agency
2. Distribution of Contingency among owners/entities — Whether a Mom & Pop Shop or a Professional Insurance business, sometimes it is appropriate to distribute some or all of the contingency to several profit centers/owners/entities. When this is done in a Mom & Pop Shop, the monies disappear into private hands. In a Professional business, some or all the contingency is allocated to growth or expenses and the balance (if any) is personal bonuses to owners and to employees. However, when you have sub-producer codes with a carrier it means that your growth and loss ratios are split and can be utilized for the proper distribution of contingency. What sense does it make to split contingency income on volume alone when it is just as challenging to underwrite the book of business to profitable levels? What message do we send to our owner/manager/producers who underwrite their business carefully enough to generate loss ratio profits when we just reward on volume?
Shouldn’t there be a Profitability Relativity to the amount of contingency allocated to each entity? Agency Consulting Group, Inc. has a program, the Fair Share Contingency Distribution Program (click here for more information or call us at 856 779 2430), that does this exact thing. It adjusts contingency received by carrier by both volume AND loss ratio relativity. It provides a great deal more information about an agency’s book of business, carrier trending, loss ratio by line across all carriers and by entity, etc. but its primary function is to reward sub-entities for both growth AND loss ratio profitability.
3. Contingency income isn’t “excess.” It is required to offset normal agency expenses – What happens when a storm or unusual losses hit and there is no contingency income in a year when an agency needs thousands or tens of thousands of dollars in contingency to pay its staff and operating expenses for the year?
We can certainly borrow money through Lines of Credit to tide us over until the bonuses hit. But if no contingency is earned or if the contingency contracts are reduced, what happens to our debt?
We must either learn how to operate exclusive of contingency income or we must, somehow, guarantee, that income every year.
a) Option One – Wean yourselves off contingency income – as the agency grows, reserve an amount of commission growth equivalent to 15% of your average annual contingency income each year to pay expenses instead of to your compensation. Within five years you will have enough revenue through normal monthly commissions to sponsor the normal operating expenses of the agency. Use the annual contingency income to reward yourself if you must or to sponsor those new producers, marketing efforts and acquisitions that you could never afford previously.
b) Option Two — Convert contingency income into commissions – This doesn’t apply to agencies whose contingency income is spotty (very high one year and zero the next) or for those that don’t generate a Contingency Percentage of more than 5% of prior year P&C Commissions (dividing your contingency income paid in one year by the total P&C Commission income in the prior year is the proper way to measure contingency income each year in benchmarking your agency’s performance). But if you have a consistent average contingency with a carrier in the 5%+ arena, you should open conversations about eliminating contingency income in favor of 75% of the average contingency percentage (at least five year average as a percent of prior year’s carrier total premium for your agency) as a commission increase guarantee.
If you continue to be profitable, the carrier will make more money on your agency. But you will receive the higher commission every month (as you spend your income) instead of once a year. In this model, if the average contingency percentage goes up or down over time, so does your commission rate. But you are no longer subject to the quirks of insurance company decision-making regarding profitability, it ties a carriers principal agencies (those that create most of its profitable income) to the carrier with commission rates higher than the competitor carriers can pay, and you can better control your spending according to known revenues.
Most agents aren’t aware that carriers have created non-standard compensation models where it makes sense to them. This is one way of doing it in a manner that helps them AND the agency, as well. Warning, you must have a substantial premium volume with a carrier for this to be considered.
We strongly urge all of our readers and clients to use some or all their contingency to grow their agencies. That growth will reward the owners both in more annual income and in more asset value. If you have the wherewithal (agency size and profitability) to convert your contingency contracts into more proper commission arrangements, that is your best position since carriers’ general contingency contracts are still expected to change.