Within the next month many agencies will receive visits from their carrier representatives with contingency checks. Some agents will be ready and waiting, having calculated and insured their contingency income from one or more carriers. Others will be surprised – pleasantly or not – with the check and the gratitude or rationale of the field representative when they present the bonus to the agency. Many agents will only get a letter, e-mail or other electronic transmission informing them that they did not get contingency because of volume or loss ratio shortfalls.
In the short term (in any given year for any given carrier) we know that contingencies for any carrier may be high, low or disappear. But if you have been in business for many years, you have a CONTINGENCY RATIO for the agency that you can calculate with relative confidence that can be trended to project and even budget contingency income in total for your agency.
We all know that contingency calculation is purposely a moving target for the carriers. It is supposed to be a profit sharing device for agents who are more profitable than the carrier average. But, over the years, it has become a device for insurance companies to MANIPULATE agency concentration by stressing growth in some years and profits in others. We recently returned from an agency who was consistently profitable and the largest agency in the state for a regional carrier. But severe rate increases caused a loss of business to other carriers in order for the agency to retain the customers within the agency. The loss ratio was still excellent but even this, the largest agency in the region, was penalized by losing 50% of their contingency with that carrier because they did not grow. This is very short-sighted for the carrier in the long run.
Even with horror stories like this, the loss of contingency from the one company was almost fully funded by the growth in several others. Overall, the agency only lost a small percentage of the contingency it would have earned from that carrier.
The calculation of CONTINGENCY RATIO is done by dividing the contingency income RECEIVED in the current year by the total P&C commission of the agency in the prior year. This is done because contingency is earned from the results of prior year premium generation and loss ratio.
If you calculate the Contingency Ratio for each of the last five or ten years, you will evolve a trend. For instance if an agency’s P&C Commission income stream and contingency stream follows a pattern similar to Table A, below, the average of Contingency Ratios is a good measure for projecting future overall contingency for an agency. If contingency income has ranged widely because of an unusual condition, you can either omit that one year or construct a weighted average by eliminating both the highest and lowest ratio over a ten year period and averaging the rest of the ratios.
Remember, use loss ratios after loss ‘caps’ and don’t include cat code losses that do not accrue to your contingency calculations.
If you have had years that were substantially higher than the norm and/or substantially lower than the norm, you can eliminate them to achieve a ‘weighted’ average for budgeting purposes.
The other issue in budgeting contingency is the often “preached” concept of budgeting your agency excluding Contingency Income and dropping that line of revenue below the Profit line.
In theory, the actions that can be taken by carriers or can result from one or a few major losses makes contingency income inconsistent for budgeting purposes. We have seen agencies have to borrow money to operate in a year after a poor contingency showing because they counted on those contingencies to operate their agencies.
We strongly recommend that you wean yourself off contingency income as an integral requirement for you to make payroll or pay your running expenses. That income stream, generated because of your good loss control and selection habits for your carriers, should provide you with excess income with which to acquire agencies and/or producers, market your agency better and even provide the owners a cushion of earnings. It should not be counted upon to keep the doors open.
Even if you take 10% of projected (budgeted as above) contingency out of your top line revenue each year and drop it to below the profit line, you will be acting responsibly to operate your agency based on Operating Income only (Commissions and Fees), the only income that you should consider regularly recurring. If you do this every year, by the end of a decade, you will operate your agency on your regular income and have the excess income generated by Contingency Income to help grow your agency.