Performance Review: A distribution channel is an asset that may grow in value if its performance is continuously evaluated. (Distribution: Industry Strategies).

For many general agents and for captive agency managers, measuring distribution channel performance is sometimes as simple as saying, "This quarter's sales are up; we must be doing a good job." However, current quarter's sales tell only part of the story when evaluating the health of a distribution channel. The problem is that a distribution channel's value should be evaluated by its ability to sell policies over the next five to 10 years, not by current quarter's sales results.

For example, sales can increase in the short term by overextending sales agents without hiring replacements. However, unrealistic sales goals and agent burnout could result in increased resignations or terminations, effectively reducing the capacity to sell over a five-year time horizon. Sales also can increase in the short term as a result of aggressive sales practices that create large growth in first-year commissions, but these practices may ultimately create dissatisfied customers who may terminate their policies.

Captive agency managers and general agents should view their distribution channel as a valuable asset, and view their job as maximizing the long-term value of this asset. There are different techniques management groups can use to evaluate the long-term performance of their distribution asset. There is no one-size-fits-all solution to value a distribution channel. Each situation requires careful analysis of the company's objectives and what actions will cause the distribution channel's asset value to rise.

Value Proposition

While specific techniques for each management group are different, there are five general principles that both general agents and captive agency managers should incorporate when valuing their distribution channel.

Focus on Objectives: Any performance measurement must focus on the core elements driving performance. These elements differ from organization to organization. Management must ask themselves key questions about their markets, including: How important is selling new business vs. retaining existing business? Does the sales activity or the number of agents performing the sales activity drive the value? What is the job description of the managers of the asset, and what should they be doing?

Look Forward: The distribution channel's value is based on expected future performance. The expectation of future production is based on assumptions about the future.

Establish Comparable Values Across Time: The value of the distribution channel asset should be comparable across time periods to make the value measure a useful management tool. Care must be taken that any changes in assumptions or mechanics do not distort the value over time. It is very difficult to explain that an agency's value dropped, not because of management decisions, but because of a change in the mechanics or assumptions that underlie the value calculation.

Design Valuations That React Quickly: If designed properly, the distribution channel value should react quickly to success or failure. The value should move rapidly downward when a problem occurs and rapidly upward when success occurs.

Develop Valuations That Are Simple, Fair, and Transparent: The effect of rapid movements in valuations in either direction as a result of management decisions can have a significant impact upon the motivation of the captive agency managers or general agents. The risk with having a highly reactive and volatile measure is that the value may appear to move randomly, creating a perception of unfairness. Therefore, the mechanics of the value measure should be transparent and simple to implement. When a decreasing value indicates a problem, the source of the problem and its solution should be easy to understand and relate to management decisions that can be acted upon. The value measure also must move in ways that correspond to a fair view of the market. For example, if an agency hires many high-quality agents and improves the production of its existing agents, the value should increase. Conversely, if the agency falls into disrepair by losing its top producers and hiring low-quality agents, the distribution channe l value should decrease.

These principles are both a process and a theoretical framework for creating a measure of value. These guidelines are used to look at specific methods for evaluating a distribution channel in the following two hypothetical cases. These case studies reflect two potential ways of evaluating performance and reflect the distribution channel objectives stated in the case studies.

Case Study: Captive Agency

In this case study, the captive agency manager s objective is to recruit, train and motivate the company's captive agents. The manager must hire agents who will grow to become assets to the organization. Once hired, these agents must be trained in order to realize their potential. Agents who have achieved their potential must be motivated to increase their production and stay with the organization. The asset-value measure for these key performance drivers is called future production capacity (FPC).

The FPC calculation starts with the individual agent. Each agent will have a number of productive years with the company. Each agent's index value equals his or her current sales activity multiplied by the agent's expected years of service.

Current sales activity is measured by product neutral production (PNP), a measure that equates products with differing commission rates or patterns. A PNP measure can be as simple as the sum of the first five or 10 commission rates or as complex as a measure that considers the profitability of each product. However, as the complexity of the PNP calculation increases, the transparency of the FPC decreases. For example, consider two life insurance products, one with a large first-year commission and the other with level commissions. If current sales activity is measured on first-year commissions, the large first-year commission will move the value more than the level commissions, even though both products may have the same profitability over 10 years. The PNP measure overcomes this potential limitation.

The number of years an agent is expected to produce for the company can extend to a predetermined retirement date, the minimum age of retirement, or a predetermined number such as 10 or 20 years of service.

The following numerical example tracks the progress of a sample captive agency over a two-year period. The agency has 100 agents each with production of 50,000 PNP and an estimated 20 years of future service with the company. At year-end the agency loses 10 experienced agents and replaces them with 20 new agents. The new agents have a first-year production of 15,000 PNPs. Additionally, the agency has implemented productivity bonuses that result in increases in production of the experienced agents by 10% in year two. (See Table 1, page 43.)

Each year the FPC index decreases because the sales force has one less year of service with the company. For the FPC to remain level the agency must hire additional agents to offset the continual loss of years of productive service by the agents.

In this numerical example, the agency hired at a healthy rate of 20% of headcount and only increased its FPC index by .05%. If the FPC growth target is 5%, then the agency manager is required to hire 30% more headcount and increase the productivity of the agents 12% and train new agents to increase overall production.

If the agency manager's performance is evaluated based on the FPC metric, the manager does not have the option to do otherwise. None of these actions is required if the manager's performance is measured solely on first-year commissions.

The agency's FPC value reacts very quickly to bad management decisions. Losing a productive agent immediately reduces the FPC index by the agent's PNP multiplied by his or her assumed years of service. To remain even, the agency has to replace the agent who is leaving with an agent of equal production and expected service. In reality, it is usually not possible to instantaneously replace a productive agent, so three or four agents must be hired and trained to replace the one productive agent. Decreases in the FPC will also occur if the productivity of the experienced agents drop.

Another way of looking at the FPC for management-reporting purposes is to break the FPC into its component pieces. An FPC management report clearly shows how the agency is gaining FPCs, losing FPCs and what management actions are required to grow them. There are two ways to lose FPCs: one occurs because the agents have one less year of production with the company and the other occurs because agents leave the company. There are two ways to increase FPCs: increase the productivity of existing agents and hire new agents. Table 2 shows a sample management information report based on this example.

Case Study: General Agency

In this case study, the general agent's objective is to maximize revenues over the agency's lifetime. The owner of an agency receives first-year and renewal overrides for selling financial products. An override is a commission paid to an agency manager. It's based on the business produced by the agent. Current sales add to the inventory of renewal overrides while cash payments and lapsed policies reduce that inventory. If the agency is measuring current performance based solely on current first-year commissions, the agency could fail on two fronts: the cash received during the year could be greater than the additional renewals added to the inventory during the year, and the persistency of existing business could deteriorate during the year, reducing expected future renewals.

Measuring the present value of future cash flows overcomes these limitations and forces the agency to look at the long-term value of the business. This valuation should include an assumption for the discount rate used for the present value calculations and a lapse assumption for the commissions. The discount rate should be the cost of capital for the agency. The lapse rate should be a realistic estimate of lapses on the block of business. The lapse rate can vary by product and the manufacturing company.

A simplified example is an agency that is planning to sell the same number of policies each year. The agency receives overrides for four years after the sale. It is important to note that the projected cash flows use an assumption about the expected lapses for the block. Table 3 displays how the agency would be valued in the first year of operations. The value of the agency equals the present value, using a 5% discount rate, of projected cash flows. Projected cash flows include an assumption about the lapse experience of the business.

Table 4 displays how the business develops in the second year of operations. In the second year the renewal overrides from the first year's sales are paid as expected. In addition the agency sells new business, which adds to both the cash flow of the agency and the asset value of the agency. If sales remain level, the value will stabilize after year four as the increase in value by selling new business will exactly offset the cash received. When the value levels off, the agency has the option of increasing the value by either selling more business or decreasing lapsation to grow the asset value.

In the third year (Table 5), all the business written the previous year lapses. The expected revenue from year-two sales that was previously included in the valuation does not materialize, which results in a drop in the year-three asset value.

Like the FPC calculation, the general agency valuation can be turned into a management report, displaying its component pieces (Table 6). The management report follows a chronological progression. First, the agency receives the cash payment of overrides at the beginning of the year, which reduces the agency value. Then at the end of the year the agency is one year closer to receiving the projected cash flows, so an adjustment must be made to unwind the discount calculation. Also at the end of year two, lapse experience materializes, leading to a gain or loss from lapse experience. Finally, new business is written in at the beginning of year three, adding to the agency's value.

It is clear from this example that the general agent must act. The value dropped rapidly because the lapse experience was significantly worse than expected. The general agent can increase the agency value by either selling new business or working hard to retain existing business. In this situation the general agent's best option would be to focus efforts on increasing new sales and meeting the lapse expectation.

These two case studies demonstrated how to apply the guiding principles to two specific examples and build a measure for distribution chain performance that would satisfy those principles. For the general agency, the objective was to maximize renewal overrides, and for the captive agency the objective was to build a large, productive agency force. Both measures are forward looking, react quickly, are transparent, and create values that are comparable across time.

Table 1:

Captive Agency Example

In this example, the agency loses 10 experienced agents in year two and
replaces them with 20 new agents. Also, productivity bonuses result in
increases in production by the experienced agents in year two.

                                Number   Product Neutral       Estimated
                             of agents  Production Units  Future Service

Year One                           100            50,000        20 Years
Year Two Experienced Agents         90            55,000        19 Years
Year Two New Agents                 20            15,000        20 Years
Year Two Total                     110

                             Future Production
                                Capacity Units

Year One                           100,000,000
Year Two Experienced Agents         94,050,000
Year Two New Agents                  6,000,000
Year Two Total                     100,050,000

Table 2

Captive Agency Management Report

Future productivity capacity units are lost each year because agents
either leave or have one less year of expected service. FPCs are
increased by hiring new agents and increasing the productivity of
existing agents.

                                         Calculations

Year One
Loss Due to Aging               100 x 1 year x 50,000
Loss Due to Terminations       10 x 19 Years x 50,000
Gain From Productivity    90 x 19 x (55,000 - 50,000)
Gain From Hiring                     20 x 20 x 15,000
Year Two

                          Future Production Capacity Units

Year One                                       100,000,000
Loss Due to Aging                              - 5,000,000
Loss Due to Terminations                       - 9,500,000
Gain From Productivity                         + 8,550,000
Gain From Hiring                               + 6,000,000
Year Two                                       100,050,000

Table 3:

General Agency Operations Projections, Year 1

In this example, the agency plans to sell the same number of policies
each year. Measuring the present value of future cash flows forces the
agency to look at the long-term value of the business.

                              Present Value *  Year 1  Year 2  Year 3

Override Commission Schedule
 (Assuming no lapses)                   N/A       $50     $30     $30
Projected Cash Flows
 (Includes assumed lapses)             $107       $50     $24     $20
Loss to Lapsation                                   0    ($6)   ($10)

                              Year 4

Override Commission Schedule
 (Assuming no lapses)            $30
Projected Cash Flows
 (Includes assumed lapses)       $18
Loss to Lapsation              ($12)

* Present value is the value today of future cash flows, assuming that
the agency could earn 5% on its money each year.

Table 4:

General Agency Continuing Operations, Year 2

In the second year, the renewal overrides from the first year sales are
paid as expected.

Projected Overrides  Present Value *  Year 2  Year 3  Year 4  Year 5

From Year One                    $60     $24     $20     $18       0
From Year Two                   $107     $50     $24     $20     $18

Total                           $167     $74     $44     $38     $18

* Present value is the value today of future cash flows, assuming that
the agency could earn 5% on its money each year.

Table 5:

General Agency Lapse Problem, Year 3

The decrease in present value between year two and year three indicates
a serious problem for the agency.

Projected Overrides                 Present Value *  Year 3  Year 4

From Year One                                   $37     $20     $18
From Year Two (All policies lapse)                0       0       0
From Year Three                                $107     $50     $24

Total                                          $144     $74     $44

Projected Overrides                 Year 5  Year 6

From Year One                            0       0
From Year Two (All policies lapse)       0       0
From Year Three                        $20     $18

Total                                  $38     $18

* Present value is the value today of future cash flows, assuming that
the agency could earn 5% on its money each year.

Table 6:

General Agency Management Reporting

The management report follows a chronological progression showing how
lapses and the passage of time create adjustments to the present value
of the agency.

                                           Date  Adjustment

Year Two Value               Beginning Year Two
Cash Received in Year Two    Beginning Year Two        -$74
Unwinding of Discount           End of Year Two         +$4
Gain or Loss to Lapses          End of Year Two        -$60
Gain from New Business     Beginning Year Three       +$107
Year Three Value           Beginning Year Three

                           Present Value *

Year Two Value                        $167
Cash Received in Year Two              $93
Unwinding of Discount                  $97
Gain or Loss to Lapses                 $37
Gain from New Business                $144
Year Three Value                      $144

* Present value is the value today of future cash flows, assuming that
the agency could earn 5% on its money each year.

Adrian Pask is an associate actuary in the Hartford, Conn., office of Milliman USA.