Expert Commentary

Pay for Results

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.

June 2007

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!

1As quoted in Business Insurance articles on April 30, 2007, and May 7, 2007.

Opinions expressed in Expert Commentary articles are those of the author and are not necessarily held by the author's employer or IRMI. Expert Commentary articles and other IRMI Online content do not purport to provide legal, accounting, or other professional advice or opinion. If such advice is needed, consult with your attorney, accountant, or other qualified adviser.

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