Leading both ways: a well-written and well-explained contingency contract benefits agencies and insurers.

A very effective tool for improving profit margins is available to insurance companies: the contingency contract. When a company's contingency contract is written well, it can strengthen the company's relationships with its agency force while simultaneously motivating agency performance. The result is improved profit margins for the company.

Only a few companies are taking advantage of their contingency contract's power to obtain better underwriting results from their agencies. A few companies, for example, have contingency contracts that pay extremely well for low, but reasonable, loss ratios. A loss ratio is the percentage of each premium dollar an insurer spends on claims. These companies tend to achieve better loss ratios than their more numerous brethren who pay poorly for good loss ratios. Many companies simply pay a little more for low loss ratios. A little more is not enough. The incentive for achieving low loss ratios must be significant to motivate agents to give a company their most profitable business.

Many people believe agents cannot pro-actively achieve consistently low loss ratios. Agents can indeed control loss ratios if they desire to do so. Two agents writing within exactly the same set of demographic risks can continually achieve loss ratios 30 percentage points apart. Some agents do not know how and some do not care, but if educated and given reason to care, they can and will control loss ratios.

Some agents continually achieve excellent loss ratios, and they achieve those loss ratios not because they are in a particular geographic area or because they write only low loss ratio business. They achieve low loss ratios through excellent upfront underwriting. Many companies are missing a significant opportunity by not writing contingency contracts that adequately encourage agents to send their best business to them.

What else would a company desire from its agencies? Growth, volume, business in certain lines, consistency, retention? A well designed contingency contract can help a company achieve its desired results.

Building Trust

Contingency contracts can do more than offer hefty incentives for getting the best business. They also can be an important aspect in building the trust that is so imperative to strong company/agency relationships. Companies wishing to build trust take the time to write a fair contract. They also do not change their contingency contracts every year. Just like Wall Street, agencies value consistency.

Unfortunately though, many contingency contracts contain damaging clauses that nibble away at that tenuous bond of trust. For example, the very common clause which effectively states that the company's records are always correct (even if they are wrong) has a purpose. Such clauses, though, do not build much of the trust that inevitably enhances profit margins. Two other trust breakers are stability clauses and incurred-but-not-reported claims policies.

Stability clause: The stability clause gives companies permission to set a maximum amount they will pay in contingencies in any given year. The company caps its contingency expense at some percentage of revenues (which makes little sense because contingencies vary primarily with profits and not revenues). If the clause is invoked, agents find their contingencies cut through no fault of their own. A few companies actually invoked their clauses in 2003 (for 2002 calculations) and a few others threatened to do so (or bluffed they would). Essentially this clause is saying: Our agencies made us too much money this year, so instead of giving the agencies their full contingency bonuses we are going to invoke the stability clause to cut their contingencies. Such actions breed mistrust.

Will agents give their best business to companies they do not trust? No. Will agents give a company good business if the company is going to cut their bonuses lot being too profitable? No.

Incurred-but-not-reported claims policies: Another much more common example is IBNRs. IBNRs are valid if used appropriately, but they can be self-defeating because many agents really do not trust companies' reserving practices. Many agents believe companies manipulate reserves, and particularly IBNRs, in an effort to minimize their contingency checks. While many legitimate reasons do exist for reserves to spike unexpectedly in November and December, most agents do not trust companies. They suspect companies use these reasons as excuses or disguises to cut contingencies. This is especially true when reserves are increased late in the year.

A few major companies, however, have eliminated IBNR charges from their contingencies. This strategic move builds trust rather than destroying it because agents know these companies are less likely to manipulate their loss ratios. These smart companies have eliminated this significant element of distrust. These companies could leverage this advantage even more by publicizing and explaining the benefits (an effective loss ratio, on average, two percentage points lower). In fact, agency/company relationships would benefit if all companies did a better job explaining the causes of loss reserves spiking at year-end.

Explaining the Contract

Writing a great contingency contract is only one aspect of this strategy's success, though. Companies must follow up their great contracts by providing agencies with a detailed explanation about how the contract works. The unfortunate fact is many agents do not read their contracts. They do not know how they work. So if a company wants to motivate agents in a certain direction, even if it has the perfect contract to do so, extra effort is required to explain the contract to agents. At the same time, agents should read their own contracts to ensure they can maximize their contingency bonuses.

A fair correlation exists between the quality of a company's contingency contract and the way it approaches its business. Companies trying to get something for nothing often have poor paying, poorly written and/or unfair contracts. On the other hand, many of the most successful companies continually have good, fair contracts that greatly reward top results.

Insurance is a people business, first and foremost. Many of the companies with perpetually high trust ratios are realizing unparalleled results. On an academic level, several recent research studies have concluded that operational risks, which definitely include agency/company relationships, are more important than financial risks.

Contingency contracts can be very effective tools for motivating agents to excel in upfront underwriting. Contingency contracts can be very effective tools for building trust, and trust enhances profits. Agents definitely have a tendency to give their less desirable business to those companies they trust less. In other words, contingencies can be extremely effective tools for increasing a company's profits. Moreover, the expense associated with doing so is minor relative to the return. Even better, contingents expenses are variable with profits so the company takes no risk.

In other words, no better tool exists, for the price, to increase a company's profit margin.

Chris Burand is president of Burand & Associates LLC, an insurance agency consulting firm.