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Commission vs. fee for service: rethinking brokers' incomes.

Commission vs. Fee for Service: Rethinking Brokers' Incomes

Brokers' incomes are being closely scrutinized by clients. Instead of being compensated for their efforts with a percentage of the premium, brokers are now faced with the prospect of getting a fee for service provided. Why has this situation developed? Today, brokerage services are considered comparable, so the price paid for them is up for grabs.

Competition in a marketplace fraught with similar products and the cyclical nature of underwriting, which creates yearly price disparities, has led some clients and brokers to opt for a fee system in an attempt to quantify and make constant a broker's worth. Clients who favor fees say that brokers' services are equal and therefore subject to competitive bidding just as underwriters' products. In addition, they consider these services institutionalized and objective. This is the case notwithstanding such intangibles as personnel quality, management's commitment to solve client problems, marketplace reputation, new product development costs and industry representation in lobbying efforts to protect clients.

A problem arises when the basis of remuneration is reduced to a justification of existence, because a broker's intrinsic value to his client is intangible. This theory implies that a client may ask a broker to reduce his worth to produce or retain a piece of business. Moreover, fees for service require a broker to spread other clients' commissions, which make up a broker's capital base, to cover fee clients who pay less than the standard commission on their coverages. From a purely competitive standpoint, fees allow brokers to acquire new accounts without selling their worth and value-added to clients. Fueled by an insatiable appetite for income to feed a capital-starved base, some brokers have created new competition cloaked in the fee-for-service guise of professionalism.

The Broker as Mercenary

In the insurance marketplace the broker is subservient to market conditions and the client's wishes. His competitive instincts parallel the client's needs and the market's ability to satisfy them. He is truly his client's mercenary in a system that rewards his efforts with a commission paid by his client. He accepts the fact that his efforts may not reward him fairly at the moment, but in the long run the market cycle will remunerate him. Thus, it is a self-correcting system.

By focusing on an expense that is minuscule compared to the total cost of risk or corporate revenues, brokers and clients are tampering with a system that has served well for nearly 300 years. For example, an $800 million revenue company with a $10 million cost of risk and an insurance premium, or transfer of risk cost, of $4.2 million might pay $250,000 to $300,000 in commission, depending on market conditions. The key element in the cost of risk is not the commission expenditure but the variable soft cost of the $5.8 million in losses. Reducing these frequent losses can boost a company's earnings, because every $1 in contained losses creates $3 in profits.

The low commission clients pay a broker can have pertinent value-added results when dealing with the cost of risk. The broker's expertise, personnel and reputation lend credibility to a company's risk management function. The partnership between the broker and risk manager is the prime ingredient that maintains the integrity and discipline necessary to contain risk cost. Reduce the broker's commission and place a fee on his service and you trade quality and entrepreneurial acumen for bureaucratic indifference to the client's problems and needs.

Well-run companies do not overpay for products and services, including those provided by brokers. Over time client needs and brokerage services have a way of meeting each other. Take away a broker's incentive and service deteriorates. In addition, symptoms develop within the company that cause the cost of risk to increase until the client cannot afford to correct its problems.

In good or bad times, the fee vs. commission controversy is not the underwriter's concern. The price of his product is based on the exposures insured, the company's risk experience and the cost of handling the account. The premium charged for the product includes commission even if the price is quoted on a net brokerage commission basis. Therefore, commission is built into the insurance business.

Reinsurers pay ceding commissions, overrides and contingent commissions, and if the underwriter knows the broker is charging a fee for service, he still evaluates the risk on a gross premium basis. The broker nets the premium to the fee-paying client, which in most instances is illegal. Subconsciously, the broker knows the client has undermined the fair rate of compensation. As a result, service is affected because the broker knows the premium is not flexible based on service, so he weighs the fair commission rate against the fee to justify the service.

Following the Money

Publicly held insurance brokerages are more likely to accept fees than privately held brokerages. Publicly held brokerages spend approximately 45 percent of the fee-for-service dollar on compensation and benefits for personnel, while private brokers spend 70 percent to 83 percent of commission income on personnel. If 55 percent of a client's fee is not spent on personnel -- the broker's key asset -- what level of professionalism can a firm provide compared to the services of private brokers? For example, at privately held brokerage firms most employees have been on staff more than five years, while brokerage partners have served on average 15 to 20 years. In addition, partners deal directly with their clients every day.

Conversely, most fee-for-service brokers remove their key personnel from daily brokerage activities and place them in management where they direct other employees to deal with clients. Hands-on account management by key executives is an anomaly in these companies because their manager's compensation does not warrant the time-consuming task of dealing with daily, mundane service issues. They are not concerned with client issues such as mergers and acquisitions or with investor-related concerns such as underwriting divestitures and investment mistakes.

Due to a need for value-added service, clients are placing their brokers under close watch. More and more clients are evaluating the quality of personnel in brokerage firms. Furthermore, they want the value-added services included in the commission. These services include property conservation engineering, loss control and safety engineering, claim and loss adjustment services, risk management reports, claim reserve analysis, retrospective rating adjustments and marketing expertise.

Not all brokers provide the same quality of service. Publicly held firms tend to institutionalize the value-added services for clients, while privately held brokers commit their capital and resources to probe and customize their clients' services. In addition, the team you observe during a presentation may not be the one that services your account. Moreover, it is well-known among national public brokerage firms that promotions remove personnel from the primary function of the business: client service. This situation does not occur at private firms where top executives maintain close daily contact with their clients.

Just Deserts

In the final analysis clients get what they pay for. It is difficult to evaluate a broker's real batting average when it comes to service, but clients can evaluate their cost of risk. It stands to reason that excellence cannot be institutionalized when it comes to value-added brokerage services. Reducing a broker's worth to a fee is self-defeating and undermines the complex mechanism geared to serve the client. Take away the incentive and eventually the cost of risk will increase in the one area where costs are controllable: uninsured losses. Eventually, the controllable variable cost of risk escalates due to a management system that allows incidents and hazards to go unchecked. Correcting this situation then becomes a time-consuming risk control problem requiring the efforts of a broker, underwriter and management.

Fee for service may temporarily cut costs, but it is the long-term relationship between a broker and a client that should stand the test. The broker's value over time is directly related to what he or she is paid. Reducing compensation to a fee undermines the service brokers provide, and eventually those services included in the commission will be unbundled by the broker and charged for separately.

Clients in this day and age should realize that they cannot run their risk management programs without a fairly compensated broker. Taking away commissions and replacing them with fees will only reduce the cost benefit to the corporate cost of risk.

Peter T. Clark, ARM, is an account executive at John L. Wortham & Son, a privately owned insurance brokerage in Houston.
COPYRIGHT 1990 Risk Management Society Publishing, Inc.
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Author:Clark, Peter T.
Publication:Risk Management
Article Type:column
Date:Sep 1, 1990
Words:1408
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