1 ACTUARIAL CONSIDERATIONS IN THE DEVELOPMENT OF AGENT CONTINGENT COMPENSATION PROGRAMS Contingent compensation plans are developed by insurers as a tool to provide incentives to agents to obtain certain goals. These programs often target the profitability and/or growth goals of the company. Generally, compensation plans provide incentive payments or bonuses to agents whose loss ratios fall below certain levels and premium growth is above certain targets. More recently, insurance companies are adding other factors into their contingent compensation programs. Examples are business retention and cross-selling. By introducing some fairly standard methods and techniques, actuaries can assist companies in the design of agent compensation plans. In this paper, we will describe some of the general characteristics, actuarial considerations, and flaws found in agent compensation plans. This paper uses homeowners insurance as an example, but the concepts can be extended to other lines of business. In addition, one of the authors of this paper has had the opportunity to implement a plan similar to the one outlined in the paper. This paper will include information about agents reactions to various elements of the plan and a section on educating an agency force about this type of contingent compensation program.
2 -2- RATIONALE FOR CONTINGENT COMPENSATION PLANS Agent compensation programs are designed to provide insurance agents with an incentive to produce the amount and type of business the insurer desires. The plans need to be properly designed to appropriately motivate agents. Over the years, many different compensation plans have been designed. Unfortunately, many of these plans do not properly motivate agents because of flaws in their designs. For example, loss ratio incentives are designed partially to encourage agents to perform proper up-front underwriting. If the agent compensation plan is based on loss ratios without adjustment, the true result can be distorted and not produce the proper incentives. For example, a large loss can dramatically increase an agent s loss ratio. The result could be a loss ratio so high as to effectively deny the agent any possibility of an incentive payment. Therefore, the agent will no longer have any incentive to maximize profitability in his book. Hence, without proper adjustment, use of loss ratios as an incentive measure is flawed. LOSS RATIO INCENTIVE THE NEED FOR CAREFUL DESIGN The loss ratio incentive is the most frequently used element of a contingent compensation program. It is also one element likely to provide erroneous or inappropriate incentives. Loss ratio incentives are used to motivate agents to do everything they can to help the insurer maximize profitability. This includes:
3 -3- Marketing consistent with the company s goals and target markets; Quality up-front underwriting and risk selection; Thorough and appropriate procedures to maximize rating integrity; and Quality service to retain good risks. The book of business from an agent who performs these functions well should have loss ratios low enough to receive a significant contingent compensation bonus. The book of business from an agent who does not perform these functions well should have loss ratios that result in little, if any, incentive payment. Many factors affect the loss ratio incentive element including: Accident year versus calendar year data; IBNR losses; Large losses; Catastrophes; Changes in mix by line of business; and Expense Flattening. These elements are all candidates for actuarial assistance in the development of agent compensation programs. However, none of these elements involves complex or difficult
4 -4- analyses. Further, most insurers have the necessary data to develop the required factors to incorporate into a loss ratio compensation calculation. LOSS RATIO INCENTIVE LOSS RATIO CALCULATION Exhibit 1 shows the calculation of the agency loss ratio for homeowners insurance. This calculation is straightforward and most of the concepts will apply to other lines of business. Accident Year Losses Line 6 of Exhibit 1, displays the term Accident year case incurred losses. Utilizing accident year data instead of calendar year data promptly rewards agents for positive behavioral changes. With accident year data, claims are limited to accidents that occurred during the latest year. Changes in reserves from prior losses (increases or decreases) do not reflect the agent s current book of business and will not affect the accident year loss ratio indication. To properly use accident year data, agent compensation plans must include an adjustment for incurred but not yet reported (IBNR) losses. In the plans, the calculations are usually performed at the end of the accident year. For most short and medium tailed lines (auto and home), in a stable company environment, calculating the incentive payments with losses evaluated as of 12 months (or 15 months) is appropriate. Exhibit 2 shows the calculation of an IBNR load as of twelve months. The data on Exhibit 2 could be obtained from Schedule P of a company s Statutory Annual Statement. Of course, it is
5 -5- necessary to make sure that Schedule P is the best source for this information. In many cases, a reserve or ratemaking analysis may provide a better source of this information. Agent compensation plans can recognize the IBNR load in one of three ways. First, an IBNR load as a percent of premium can be added to the case incurred loss ratio in order to produce an ultimate loss ratio for the agent. (This is shown on Exhibit 1, Line 12). Second, an IBNR factor can be multiplied by earned premium to develop IBNR losses. These losses can then be added to the agent s case incurred losses to determine ultimate losses. Finally, the IBNR provision can be incorporated into the target loss ratio. Then one can base the compensation calculation on the reported loss ratios. For example, if the IBNR factor is 3% of premium, instead of paying a bonus to an agent for an ultimate loss ratio below 60%, the company can use a reported loss ratio of 57% as the target. It should be noted that in some cases, especially for companies with very conservative case reserves, the IBNR factor may be negative. This is entirely appropriate as the goal is to estimate ultimate losses appropriately. Since the IBNR load is calculated based on current premium volume, changes in agency volume over the years do not affect the calculation of the ultimate loss ratio and do not distort the agent s results. In the plan that was implemented, IBNR losses were calculated as a percent of premium. Some agents understood the purpose of the load and most agents accepted it as an equitable allocation. However, in other cases, agents questioned the IBNR load and suggested it was too large,
6 -6- especially if they noticed individual case reserve reductions. These concerns were easily allayed by showing the agents their accident year losses as of 24 months. Invariably, the losses at 24 months showed positive development and supported the IBNR load. Incorporating the IBNR provision in the target loss ratio (the third way described above) would go a long way toward making the plan more palatable to an agency force. Large Loss Adjustments The presence or absence of large losses can cause significant distortion on an agent s loss ratio. The occurrence or lack of one large loss is generally not an indication of the marketing, underwriting or service provided by the agent. Therefore, one large loss should not have an inordinately large effect on the loss ratio. Adjustments must be made to the compensation plan to reflect the random occurrence of large losses. Generally, the adjustment for large losses is accomplished by limiting the amount of each claim entering the compensation calculation. A common adjustment is to establish a loss limit based on an agent s premium volume for the coverage. For example, if an agent s total homeowners premium is $500,000 and the loss limits is 5% of premium, then all losses would be capped at $25,000. Another option is to apply a fixed dollar limit per agent (e.g., a $20,000 loss limit per loss applied to each agent, no matter what the premium volume of the agency). A limit based on percent of premium is preferable because this method insures that the maximum impact of any large loss on the loss ratio is the same for all agents.
7 -7- Selection of an appropriate loss limit percentage is especially important. A common practice in contingent plans is to utilize a loss limit of 10% of premium. However a loss limit of 10% of premium means that a single claim can impact the loss ratio of an agent significantly. A loss limit of 5% of premium may be more appropriate. At 5%, the impact of one loss on an agent s loss ratio is much smaller. The premium included in the loss ratio is calculated (or should be calculated) to cover all losses whether large or small. Therefore, the loss ratio target must include an adjustment for the limiting of large claims. The adjustment can be made by: 1. Reducing premium to a level commensurate with limited losses; or 2. Increasing the losses to a level commensurate with the premium. The latter method is easier to calculate and easier to explain. In essence, actual excess losses are replaced by expected loss amounts in excess of the loss limit. The methodology for this adjustment is similar to an increased limits analysis, with some minor differences. Generally, in an agent compensation plan analysis, risk load is not considered. Also, in compensation plans, the agent s losses often include indemnity amounts only. If this is the case, then loss adjustment expenses are excluded from the analysis. Finally, the losses that
8 -8- are used in the determination of the large loss charge should be evaluated at the same point in time as the case incurred losses. If the compensation plan evaluates losses as of 12 months, the large loss calculation should also be performed as of 12 months. Exhibit 3 shows the calculation of the loss limit charges. Two things should be noted about the calculation. First, five accident years of data were utilized. Second, trend was applied to all accident years. (Discussion of trend is beyond the scope of this paper.) Based on the accident year experience, the actuary can select the percentage of losses in excess of selected loss limits. These selected ratios can then be multiplied by the expected loss ratio to obtain factors as a percentage of premium (on Exhibit 3 we have used a 60% expected loss ratio). These factors are then multiplied by the agent s earned premium to derive expected losses in excess of the loss limit. For loss limits other than those calculated, factors can be obtained through interpolation. As might be expected, the introduction of large loss adjustments did require some explanation to the agency force. The most effective explanation was to describe it as an insurance policy that the agent purchases to protect his or her loss ratio (and contingent compensation) from large losses. In fact, the experience, with the plan that was implemented, was that agents were unhappy when they had a large loss and it blew their loss ratio. This was true even though there was a 10 percent loss limitation built into the plan. It was clear that anything that limited the impact of large losses was ultimately appreciated.
9 -9- Catastrophe Adjustments Especially for property coverage, adjustments for catastrophe losses are extremely important. Catastrophes will generally include hurricanes, earthquakes, tornadoes, hail and other large storms. A severe storm occurring early in the accident year can have a devastating effect on the results of an agent s book of business and destroy any incentive value of the compensation plan for the agent. However, even a small storm can be devastating to an individual agent s loss experience. Therefore it is essential to define and adjust for all catastrophes, regardless of the impact on the company s loss ratio. The best way to adjust for the catastrophe impact is to replace all actual wind and hail losses with expected wind and hail losses, regardless of the size of loss. This will avoid the difficult issue of deciding which losses are catastrophes and subject to elimination and which are not. (Special adjustments may be necessary for other types of catastrophes such as brushfires or earthquakes.) Note that the wind and hail losses should be excluded from the large loss adjustment calculation. There are several methods that can be used to calculate expected wind and hail losses. One procedure is shown on Exhibit 4. In many areas of the country, where there is hurricane exposure, special procedures based on catastrophe modeling should be used. In the method displayed on Exhibit 4, the ratio of wind losses to total losses is calculated for the last twenty years. The average ratio is then multiplied by the expected loss ratio in order to
10 -10- obtain the wind and hail factor as a percentage of earned premium. This ratio is then multiplied by earned premium to obtain expected wind and hail losses. The loss ratio calculation substitutes the expected wind and hail losses for the agent s actual wind and hail losses. Generally agents readily accepted the catastrophe procedure. In fact, by utilizing a fixed wind and hail factor, the number of complaints and requests for exceptional adjustments to agents loss ratios (instances where specific loss ratios would be individually adjusted) was dramatically lower than what might be expected. Expense Flattening In many states, it is common to apply an expense flattening procedure in the formulation of rates by territory or classification. Expense flattening can occur in a number of forms including expense fees or constants and flattened territorial relativities. Expense flattening may affect the agent s expected loss ratio. For example, if expenses are flattened by territory, then the expected loss ratio will differ by territory. To illustrate, as displayed in Table 1, Agent A operates in Territory 1 and Agent B operates in Territory 2 where the rate is half territory 1, and both have a loss ratio of 70 percent: Table 1 Agent Territory Actual Loss Ratio Expected Loss Ratio Is Agent Profitable A 1 70% 73% Yes B 2 70% 65% No
11 -11-70% 70% Even though both agents have the same loss ratio, Agent A is profitable while Agent B is not. This phenomenon occurs because a significant portion of expenses is allocated to territory (or class) on a flat dollar basis rather than a percentage basis. Tables 2 and 3 show an example of how expense flattening affect the expected loss ratio: Without expense flattening: Table 2 Expected Variable Flat Expected Territory Loss Cost Expense Expense Rate Loss Ratio % % With expense flattening: Table 3 Expected Variable Flat Expected Territory Loss Cost Expense Expense Rate Loss Ratio % % There are several potential solutions to this problem. One is effective in situations where the company utilizes an expense fee procedure. In this instance, the plan can utilize premium net of the expense fees. Another is that the premium can be increased by a flat percentage to account for fixed expense. Third, the target loss ratio can be adjusted to the appropriate level. Finally, a
12 -12- compensation plan can be based on the combined loss and expense ratio rather than simply the loss ratio. This will permit any necessary expense flattening adjustments. Exhibit 5 shows an adjustment calculation for expense flattening by territory. The adjustment produces factors that can be used to restate earned premium by territory to the levels they would have been had expenses not been flattened or to adjust an agent s target loss ratio. These premiums can then be utilized to calculate the agent s loss ratio. No matter how it is done, an expense flattening adjustment is very difficult to explain to an agency force. Generally, it is probably best to avoid the expense flattening adjustment if at all possible. However, there are situations where it is clearly necessary. These may include: Companies with large portions of their business with different expected loss ratios because of expense flattening; or States where regulatory requirements may necessitate an adjustment. COMBINING MULTIPLE LINES Traditionally, agent compensation plan loss ratios have been combined for all lines of insurance. Combining lines of business creates a myriad of difficulties. Agents have different mixes of business by line that often change over time. In addition, lines of business have different
13 -13- expected loss ratios. Therefore, a better approach is to calculate loss ratios separately and provide separate incentives by line of business. OTHER INCENTIVES So far the discussion has revolved around the loss ratio incentive. However, there are a number of other important incentives that should be considered in the development of an agent compensation plan. These incentives should tie to the company s long-term goals. One long-term goal for many companies is premium growth. Therefore, companies may wish to motivate agents to grow their book of business. This measure must be calculated with care. To the extent possible, the change in exposure should be utilized rather than the change is premium volume. If it is not possible to use exposures, then premiums should be adjusted to remove the effects of rate revisions. Most companies have goals for both profitability and growth. Achieving both of these goals simultaneously is a challenge for both the company and its agents. As a company grows, underwriting results often deteriorate since new business usually has poorer results than renewal business. One tool to improve growth and profitability is to improve a company s retention ratio. The retention ratio is the percentage of policies in-force at the beginning of the year that are still in-
14 -14- force at the end of the year. Every policy that is retained implies one less new business policy is needed to meet the growth goal. The renewal policy should also have a lower loss ratio and lower expense ratio. This is not to imply that growth can occur without the inclusion of new business. Rather, the agent with a higher retention ratio can grow with less new business than an agent with a lower retention ratio. Therefore, providing an incentive for high retention ratios can be valuable for the insurer. It encourages the agent to provide quality service, perform up-front underwriting and participate in other activities that the company desires. Retention ratios should be a part of most contingent compensation plans. Besides retention ratios, the following elements have been used in some compensation plans: Penetration of homeowner policies in households of auto insureds; Rating integrity (the ability of the agent to properly rate policies); Life insurance penetration in insured households. Other measures to reflect company goals can also be incorporated into the compensation plan. ESTABLISHING CONTINGENT COMMISSION PAYOUTS Once the elements of a contingent commission plan have been selected, the insurer needs to determine a commission payout schedule. This is a difficult exercise for two reasons:
15 -15- The company needs to establish a scale of incentive payments for each incentive element (e.g. a 55% loss ratio is worth an incentive of 2% of premium); and The company can overall have poor performance in an element and still need to make incentive payments to some agents. Incentive compensation programs are similar to workers compensation dividend plans in the sense that the agent gains if he/she produces good results, but does not lose if he/she produces poor results. Therefore, unless payout amounts and ranges are carefully selected, the company may find total contingent commission payouts to be much different than expected. In order to have total contingent commission payouts be close to expected, the insurer should take several steps. The first is to establish goals for each incentive that reflect the level of performance that a company: Needs to achieve its long-term objective; Can reasonably expect its agent to achieve; and Is willing to make an incentive payment.
16 -16- For example, Company A wishes to achieve a 15% return on equity (ROE) for each line of business. It determines that a 60% pure loss ratio is necessary to achieve that ROE. Further, its rates are targeted to produce that loss ratio. Therefore, the loss ratio goal is established at 60%. The company needs to select two other numbers. The first is the minimum performance level. This is the level that below which (or for loss ratio above) no incentive payment is deserved. At this point, the incentive payment will be zero. As the agent s performance improves above this minimum, the incentive payment will increase. Using the example cited above, Company A may choose a 65% loss ratio as its minimum performance level. The company also must pick a maximum performance level beyond which incentive payments will not increase. Agents should have the ability to excel and exceed the goal; however, there is a limit to the amount of additional compensation that can be paid. While this level can be chosen judgmentally, many companies select a maximum that is a similar distance from the goal as the minimum. Using our example, the maximum payment would be at a 55% loss ratio. Table 4 summarizes the results of this decision making process:
17 -17- Table 4 Minimum level for payment 65% Goal 60% Maximum payment level 55% The next step for the company is to select payments for each of these levels. This involves modeling the results to determine: The expected payment at various payout levels; and The variability of possible total payments at different payout levels. The process begins by calculating the incentive element value for each agent subject to the plan based on the formula that will be used in the plan. For example, each agent s loss ratio should be calculated using the formula in the plan. Then those loss ratios should be fit to a distribution that can be modeled by computer simulation. While the distribution will depend on the individual company, often a normal distribution will provide an adequate fit in the ranges over which contingent payouts are made. After a distribution is selected, the company should select tentative payout levels for the goal, minimum and maximum. Using our example, the selections as displayed in Table 5 may be as follows: Table 5
18 -18- Loss Ratio Payout Minimum 65% 0% Goal 60% 1% Maximum 55% 2% Payout levels for interim points can be calculated through interpolation. At this point, the actuary can model the expected payout using computer simulation reflecting the following information: The loss ratio distribution; Each agent s premium volume; and Payout at each loss ratio level (distribution of payouts). The output of the model would be: The expected payout level; and Payout levels at different percentiles (confidence levels). Exhibit 6 provides the output for one hypothetical insurer. Sheet 1 displays the output from the model utilizing 2,000 simulations. The expected payout amount and percent of premium is displayed for various confidence levels. Sheets 2 and 3 display the results for different ultimate loss ratios, 55% and 65% respectively. Note that if the company achieves an average loss ratio
19 -19- of 65%, payments do not fully disappear. This is because some agents will generate loss ratios that qualify for incentive payment. Important considerations relative to the above include: At each loss ratio level, does the expected payout seem appropriate? At each loss ratio level, is the 95 th percentile payout acceptable to the company? Based on the results of the simulation, the company can change the: Maximum; Minimum; or Payout levels in order to develop a more acceptable range of payouts. Then, the simulation can be rerun. This procedure can be repeated until an acceptable range of outcomes is achieved. The simulation is shown for the loss ratio plan element for homeowners insurance. Similar simulations should be completed for each plan element and each coverage. In the course of evaluation, the combined payout for all of the elements should be considered. LEGAL ISSUES
20 -20- It is uncommon for states to have specific regulatory constraints on agent compensation plans. (This paper does not address other legal issues such as contractual issues). However, the statutory language in two states, Michigan and New Jersey, does have an impact on agent compensation plans. These laws (a copy of the Michigan statute is shown as Exhibit 7) prohibit the reduction of normal compensation because of the loss experience of an agent s business. In both of these states, two important elements in the insurance environment are: A take-all-comers provision that restricts underwriting freedom; and Michigan had, at the time and New Jersey still has, territorial rate suppression resulting in inadequate rates in some territories. The purpose of the prohibition on the reduction of normal compensation is to prevent insurers from discouraging agents to write business in territories with suppressed rates or to otherwise restrict the availability of insurance. Normal commission is not defined by statute. However, some of the criteria that have been used in Michigan to define this term include: Frequency of payment (monthly or bi-weekly payments are more likely to be considered normal compensation than annual or semi-annual payments).
21 -21- Coverages included (a plan that applies to only one insurance line is perceived as normal compensation ). Proportion of total compensation include in contingent compensation program (the greater the proportion of total compensation, the more likely to be considered normal compensation ). Finally, regulators may still have the concern that these programs will encourage discriminatory behavior in violation of the take-all-comers requirements. One company actually restated its premium for purposes of calculating the loss ratio incentive to the level that would have occurred had territorial rate suppression not occurred. AGENT EDUCATION For most insurance agents, many of the compensation plan elements described in this paper are new. As with anything that is new, agents will be concerned and will need significant education in order to understand their compensation plan and how to thrive under the plan. Agents will also be concerned about the perceived complexity of a new plan. In essence, the education program needs to do several things. These include: Clearly explain each element of the compensation plan;
22 -22- Describe how the plan motivates the desired behavior; and Make clear to agents how they can win under the new plan. For example, agents need to understand the difference between accident year and calendar year losses. It needs to be made clear that reserve changes on old accidents will not affect their loss ratios; however, their current loss ratio will be adjusted to account for reserves changes expected in the future. They also need to understand that in this new plan, their results will be related directly to business written in the last year rather than business written years ago. Finally, the agent gains under this plan with good up-front underwriting and rating integrity. By contacting insureds before renewal and using that time to obtain up-to-date rating and underwriting information, agents can improve their loss ratio. This improved loss ratio will be seen in the agents results the next year.
23 -23- The educational effort with these programs is significant. An insurer implementing this type of agent compensation program should expect an intensive educational process that will take about two years to be fully effective. The actuary needs to be prepared to work directly with agents and agency management in this educational effort. INFORMATION REPORTING Any contingent compensation program of this type will require significant additional reporting to agents. Reports will need to be generated showing the calculation of all of the contingent commission elements. This reporting needs to be done frequently not just in conjunction with plan payouts. For example, in the plan implemented by one of the authors, loss ratios were reported monthly on a 12 month moving basis even though contingent commissions were paid semi-annually. Hence, agents could track their results. The level of detail that needs to be reported can be significant. In the beginning, it may be appropriate to report individual claim detail so agents can calculate their own accident year losses. Clearly an important aspect of the success of any compensation plan is adequate reporting of detailed information to the agents. CONCLUSION Insurers have traditionally developed contingent compensation plans as tools to motivate agents. However, the motivational value of these plans will backfire without careful design. Using
24 -24- simple actuarial and statistical techniques, the actuary can assist his or her employer to design a plan that will benefit insurers and agents by providing the appropriate incentives. H:\BILLVS\FEB.98\PAPER\CONSIDER.DOC