Pay for Results
June 2007
Supplemental commissions … yes or no? The
debate seems to be generating mixed results. Joe Plumeri of Willis has rejected
supplemental commissions. Pat Gallagher of Arthur J. Gallagher has stated that
supplemental commissions are fine as long as there is full disclosure to clients.1 As of the writing of this article, Marsh and Aon seem to be studying the issue.
by Gary
J. Bausom
Bausom & Associates,
Inc.
Insurance companies willing to pay supplemental commissions are looking to
increase their written premium volumes and therefore are willing to pay an incentive.
However, some large insurers are learning that risk selection (quality) is more
important than volume in terms of bottom line results. Any business needs positive
margins (sales less cost of goods or services sold); otherwise, volume is just
"red" ink.
From the risk manager's perspective, what value is derived from these transactional
payments?
Cost or Value?
What are the overall goals and duties of a risk manager? Risk managers need
to more closely examine the components of their insurance transactions and the
simple criteria by which they judge value received. It seems the series of transactions
in which risk managers may engage should go back to the fundamental principles.
The following are illustrative:
In a traditional sense … risk management consists of identifying, measuring
and financing fortuitous risk in the most economic manner over any 3-5 year
time period.
In the broader enterprise sense … it consists of managing the unforeseen and
having both a pre-disaster and post-disaster recovery plan and actions in
place to help reinstate operations and the business. Additionally, a few
risk managers are asked by senior management to look at upside opportunities.
So, what are risk managers asking for and receiving? When insurance is being
purchased, the loud question is, "How much did we pay?" The muted question is
what was actually received as a result of the payment, and/or may be received
in the future? Insurance is a contingent financing tool that may respond when
a loss occurs. It will not reinstate any business, but it might help to pay
for at least part of the recovery process.
The Costs
Perhaps it is opportune for risk managers to dissect all of their insurance
transactions and the related cash flows. In no particular order, expected losses
need to be valued at their ultimate valuation, at least twice a year. Then the
gross costs of risk transfer, including float, and all other services from the
insurers and brokers, should be identified and analyzed. Without this information,
it is not possible to manage the value received. Alternatively, risk managers
can still buy insurance with the thought it is a commodity and the transaction
becomes simply a matter of the price paid.
Let's step back and look at the major components: services, net risk transfer
costs (including float), and ultimate losses.
-
The services are a critical aspect of not only what the costs are today,
but thoughtful services can influence cost trend lines, prospectively, by
making the right decisions (strategy, structure, markets, etc.) in a timely
manner. (This component could account for 20 percent of the total cost of
risk.)
-
The net risk transfer costs, above expected losses, becomes a market
parameter of the capacity available (insurance capital being invested) and
the demand for insurance. The balance or lack thereof produces buyers or
sellers pricing advantages. (This component could account for 25 percent
of the total cost of risk, including float.)
-
Over any 3-5 year period, how can these expected ultimate losses be economically
managed? (This component could account for 55 percent of total cost of risk.)
The portion of the total cost of risk, for these three major components,
will vary depending on the industry, the risk retention level, and services
performed by the risk management department versus outsourcing. The decision
for a risk manager to outsource depends on the opportunity cost of his or her
time. If there are other functions the risk manager could perform that are highly
valued by management, it is probably a good idea to outsource.
Perhaps it is time to take charge! Given the business's tolerance for assuming
risk, retain expected ultimate losses and manage them efficiently. Expected
losses are more of an accrual/cash flow issue as opposed to a risk issue. Buy
the insurance deemed reasonable on a net basis, and then figure out the required
service component. It may look something like this:
TOC = UL + Net Insurance Costs + Float + Services
Where TOC is total cost of risk, UL is ultimate losses, Net Insurance Cost
is pure risk transfer, Float is the time value of money: time (amount of funds
at some interest rate), and Services are either provided internally or purchased
to manage the various processes. Therefore, to maintain a similar TOC, if the
losses, net insurance transfer costs, and float are subtracted, the balance
is what is available for services. Without determining the right quality/quantity
of resources, the entire process may be managing the risk manager.
Determining the service cost component helps to focus on three key issues:
(1) what specific services are required, (2) what value is being received, and
(3) what is the best way to pay for these services? If risk managers are to
manage, then they need to specify the services needed, who individually will
perform them, the expected results/timeframes, and then pay for those services
directly.
Will this approach cost your company more money? It's unlikely. However,
if for some reason it does cost more, the risk manager will be in an excellent
position to articulate the value received. If this is unimportant to a particular
risk manager, their reply is simply like our friends from down under, "No worries,
mate!"
The Value
Value can be viewed as receiving more than you paid an asset or resource
(including the risk manager's opportunity cost of time). It is not about this
commission or that commission. It may be about compensation paid to brokers.
What services are needed to manage risk, who should provide them, at what cost,
and what is the value to the client?
The major challenge for brokers in delivering the right services, is in acquiring
the best types of talent and keeping these persons motivated. Brokers need technicians
for sure, but they also need individuals to challenge the status quo for the
benefit of clients. The largest brokers generally do not have sufficient talent
for all of the clients they attempt to serve. Conversely, brokers' training
programs may lack the correct content and sufficient resources to develop top
talent. Risk managers who have top talent working on their accounts are fortunate
and should be willing to pay adequately to keep the team in place.
Let's Be Clear
The other aspect of service compensation points to the issue of who your
intermediaries represent. A broker, as defined by most insurance regulations,
represents the buyer-client and not the insurance company-seller. Agents, on
the other hand, represent the various insurance companies with whom they have
signed a contract, which also allows them to be paid commissions. Some simple
questions risk managers need to answer are: Who do your intermediary(s) represent?
Who pays them? And the broker's total take is how much?
The risk manager should be able to obtain a written agreement from the broker
detailing the scope of work and measurable deliverables. He or she should also
be able to obtain a written detailed statement, itemizing each type and amount
of compensation (fees and/or commissions) paid to the broker, and the broker
should sign a statement that this is a full and complete disclosure. In summary,
what services were delivered and what was the total compensation received?
Full disclosure of how much an intermediary is receiving and from whom is
important; however, it is more important for the intermediary to clearly state
who they are representing and act accordingly. It is nearly impossible to avoid
conflicts of interest, represent opposite sides of a transaction, and receive
income from both.
For example, the insurance code in California states, "The Broker-Agent license
issued by the Department is used to distinguish two distinct types of producers."
"The holder of a Broker-Agent license can act either as a broker or an agent."
In practice, intermediaries, in some cases, identify themselves as brokers who
represent the client or insured. The same brokers, in numerous accounts, are
paid a fee by their clients. Additionally, these "brokers" have accepted commissions
of various sorts from the insurance companies on the same client and transactions.
Next Steps
Risk managers need to be willing to pay for solid strategy, market knowledge,
and trusted relationships. They need to determine their service requirements,
and the costs, and pay for them directly. The core service is advice on risk
management strategies and marketplace knowledge/relationships. It is not always
possible to achieve "one stop shopping" when seeking talent. If risk managers
are not willing to pay for quality services, the talent will likely move on.
Risk managers can and perhaps should argue with large brokers that they are
not willing to pay for large overhead charges that support their vertical integration
business models. This overhead is accounted for by numerous services (people),
some of which are infrequently used by risk managers, while these costs are
being, directly or indirectly, passed back to clients.
So, risk managers, decide what you want. Define it, set forth a "road map"/timeline,
and obtain it! It is important for risk
managers to have adequate information to add value and mitigate unnecessary expenses relative to realizing their goals. No worries!
Business Insurance
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