Broker monitoring of premium adequacy: the role of contingent commissions

Abstract

Contingent commissions, which are payments made by an insurer to brokers based on the volume and profitability of insurance placed with the insurer, have been criticized as damaging to the relationship between the insured and its broker. The argument is made that contingent commission payments encourage brokers to select insurers for their clients based on the potential to earn contingent commissions, rather than on the needs of the insured. We argue that contingent commission payments, which while directly paid by the insurer are ultimately paid by the insured through higher premiums, are beneficial to insureds because they provide an incentive for the broker to place their coverage with an insurer that is charging an adequate premium. We contend that although inadequate premiums are perhaps good for the insured in the short term, in the longer term, inadequate premiums will result in price hikes or coverage restrictions that are harmful to the insureds. Our empirical analysis demonstrates that insurers who pay contingent commissions experience less price fluctuation over the underwriting cycle than insurers who do not pay contingent commissions in the US property and casualty insurance industry.

Keywords:

• contingent commission
• insurance underwriting cycle

JEL Classification:

• G22
• N22

Notes

¹ Cohick and Bartz (2005) report that insurance companies have paid contingent commissions for at least the last 50 years.

² These data are reported in, ‘Contingent Insurance Commissions: Implications for Consumers,’ by J. Robert Hunter, published by the Consumer Federation of America, 26 January 2005.

³ Table 2 summarizes three series of combined ratios for the whole property and casualty (P/C) insurance industry and two composites that consist of brokered P/C lines and P/C lines associated with positive contingent commissions respectively. Combined ratios are calculated using the NAIC (National Association of Insurance Commissioners) data. The combined ratio is the sum of the loss ratio and the expense ratio. The loss ratio is calculated by dividing an insurer’s incurred losses plus loss adjustment expenses (LAE) by the insurer’s earned premiums. The expense ratio is calculated by dividing an insurer’s administrative expenses by the insurer’s written premiums. The loss ratio and the combined ratio are commonly used measures of profitability in the insurance industry.

⁴ There exists a fair degree of variation among the contingent commission arrangements offered by different insurers. In addition, some insurers consider other factors beyond volume and profitability – such as growth, retention, business renewal rates, or a combination of these – in calculating contingent commission payments.

⁵ This practice first appeared in the 1990s when it was incorporated in placement service agreements (PSAs) and marketing service agreements (MSAs). Large brokers use these plans more frequently than small or regional brokers (Source: ‘Placement Service Agreements: Big Brokers under Fire’ Advisen Briefing, 26 April 2004).

⁶ The information is from CNA 2006 Addendum to Agency Agreement.

⁷ Meier and Outreville (2006, 2010) provide a comprehensive survey of the literature on the underwriting cycle.

⁸ Since prior studies suggest that a typical underwriting cycle is 6-year, we choose this length to calculate the SD of loss ratios and combined ratios.

⁹ The lines of insurance are fire, allied lines, farmowners multiple peril, homeowners multiple peril, commercial multiple peril, mortgage guaranty, ocean marine, inland marine, financial guaranty, medical malpractice-occurrence, medical malpractice-claims made, earthquake, group accident and health, credit accident and health (group and individual), other accident and health, workers’ compensation, other liability-occurrence, other liability-claims made, products liability-occurrence, products liability-claims made, private passenger auto liability, commercial auto liability, auto physical damage, aircraft (all perils), fidelity, surety, burglary and theft, boiler and machinery, credit, international and reinsurance lines. We choose aggregate write-ins for other lines business as the reference line in our empirical models.

¹⁰ Limited loss ratio includes a stop loss adjustment, the purpose of which is to reduce upward pressure on the loss ratio imposed by a potential single large-value loss event.

¹¹ Two-year loss ratio = (Incurred losses during the current calendar year t + Incurred losses during the prior year t – 1)/(Earned premiums in t + Earned premiums in t – 1)