When retention is used as a precondition to profit sharing, neither policies that are short-term (trip transit, builder's risk, etc.) nor policies which are cancelled by the company should be included in determining the retention percentage. If retention is based on premium instead of policy count, the loss of any one policy might keep the agent from meeting the company's retention goals. To prevent this, there should be a limit to the amount of premium loss per policy which is calculated in the retention ratio. The limit should be either a set amount or a percentage of the previous year's premiums.
Most, though not all of the lines of business excluded from the calculation of profit sharing eligibility and commissions are listed in the excluded lines provision. Some of these exclusions are based on company interpretation of the listed item: war risks excluded under pool business. Many companies' agreements do not specifically exclude accident and health insurance since those companies do not define such insurance as property and casualty business.
As to excluded business which is not listed, lines may be excluded under the income clause or the outgo provision. For some companies, business with premiums of $100,000 or greater is excluded. Additional lines may be excluded by company bulletin. If a company is not writing a line of business, that company probably would not list that particular line as excluded from profit sharing. When special or specialty accounts business is excluded, agents should determine how the companies define this business.
An agency should review its book of business during the year to determine whether the minimum is being met, since excluded lines are not considered when minimum required volumes are computed. A large book of excluded lines could give an agency the misimpression that it qualifies for profit sharing, when it does not, or qualifies only for reduced payout.
We believe only the following lines should be excluded under profit sharing agreements: assigned risks, underwriting associations/pools, agency-placed reinsurance, and lines excluded by law. All other lines of business written by the carrier should be included.
If the agency gives the company a significant volume of profitable excluded business, the agency should negotiate for some other benefit from the company.
Income, outgo and any other factors in the agreement should have one basis throughout the agreement, preferably net written premiums, to avoid inequities. "Income" is usually defined in profit-sharing agreements as net written premiums less policyholder dividends. Note: If the definition of income is based on net written premiums, plus or minus unearned premium reserves, this is actually a type of earned premium basis, rather than net written premium.
Outgo, Including Losses
Outgo usually includes the following: incurred losses, loss adjustment expenses, company expenses, commissions and policyholder dividend.
Losses are usually based on incurred losses: generally defined as all losses paid during the year, plus all losses remaining unpaid at the end of the year. Agencies should be credited for losses outstanding at the end of the preceding year and recoveries.
Agencies usually keep logs of losses to check the agency's loss experience and to verify the accuracy of the company deductions for losses under the profit sharing agreement. The company should supply a detailed list of the losses charged since the information is vital for the agency to reconcile its profit-sharing commission and determine its loss ratio for the year.
We have long been opposed to a charge for IBNR (Incurred But Not Reported) reserves because the amount cannot be reconciled, and because the loss will eventually be reflected as an incurred loss. The charge for IBNR is estimated by companies in several different ways. Whatever method is used, if the charge is not reversed before or when the loss is reported, the agency is charged twice for the same loss. A credit should be given each year to "back out" that portion of the IBNR reserve which corresponds to the period of time within which claims would usually be reported. Agents who are being charged IBNR should be sure they are given credit for last year's IBNR before being charged an IBNR percentage for the current year.
The "stop loss" provision eliminates from the profit-sharing calculations certain losses above a given dollar amount. A number of companies now base the amount of the stop loss on the agency's net written premiums, those with greater volumes having stop losses higher than those with lower volumes.
There is always a charge for the stop loss: a decrease in the participation percentage; an increase in the company expense factor; or a separate stop loss expense line item.
The stop loss provision should be carefully reviewed. If it does not have a catastrophe stop loss, the agency might find that a windstorm or other catastrophe produced a great many individual losses lower than the stop loss limit, which added up to a large overall loss. This could seriously affect the agency's profit sharing for one or more years. Some provisions also limit the amount of loss that will be included in the current year's calculations only, and will carry the amount over the stop loss limitation to following years. Other, more favorable provisions, will limit the loss to a maximum dollar amount with no loss carry over.
Loss carryovers, whether stop loss related or not, can have a serious impact on the amount of the profit sharing commission. Loss carry over provisions specify that a deficit existing at the end of the year will be carried forward a certain number of years. The same effect is obtained by making the profit sharing calculation subject to averaging over a three-year period. In some cases, a loss can be carried forward indefinitely if additional reserves are set up or if additional payments are made on a claim which has already caused a loss carry over. If, for example, each of these new deficits is subject to a three-year carry over, a deficit could be created every year.
Loss Adjustment Expense
"Allocated loss adjustment expenses" are usually defined as those expenses that are chargeable to a particular claim. Unallocated loss adjustment expenses include those expenses which are not clearly chargeable to a particular claim, such as the cost of maintaining the company's claims service. Costs which are already in the company operating expense column should not be charged as unallocated adjustment expenses.
While sometimes credited under the income section, salvage, subrogation and reinsurance adjustments are usually made under the outgo clause. Most agreements include these adjustments, but some do not include one or two of them, and several do not credit recoveries from any of these sources. A few agreements give the company the option of whether or not to provide a credit.
Some companies will recalculate the figures for the year in which the loss occurred rather than add the recovery to the current year's calculations. A number of contracts stipulate that recoveries will be applied first to reduce losses above the stop loss, and then to reduce the amount included in incurred losses.
Outgo other than losses and loss expenses can include acquisition costs, company profit, commissions, operating expenses, policyholder dividends, reinsurance costs, residual market costs, stop loss charge, taxes and fees, uncollectibles and other miscellaneous costs. The most common are agency commissions, company operating expenses and dividends.
While commissions are logically deducted from income, profit sharing commissions should not be handled in this manner since they are actually a share of last year's profit, not a part of this year's expenses. Special bonus arrangements should not be deducted from income. As has been previously pointed out, commissions should be figured on the same basis as the rest of the calculation, preferably on net written premiums.
The deduction for company operating expenses is sometimes figured as a flat percentage of net written premiums, and sometimes as a percentage of premiums varying by line or class of business. Some companies impose a percentage charge which decreases as volume increases. In agreements where a percentage was stated, the percentage charged ranged from 15.5% to 19.5% depending on the company.
Companies vary on what they consider operating expenses. While some may include premium taxes and residual market costs in the company overhead, others break those costs out into a separate charge.
Those agents located in states with large residual markets can have their profit share eroded if the company's costs of participation are included as part of the company's operating expenses or as a separate charge. It is an unfair penalty because residual market business is usually excluded from the profit sharing calculation. The charge also unfairly penalizes the company's profitable agents who probably do not place the bulk of the residual market business.
We also feel the charge for a company profit factor is unfair. A profit-sharing agreement should encompass all profit, not just the amount of profit left after the company has taken a certain percentage out for business expenses.
Profit Sharing Calculation
The method of calculating the agency's profit-sharing payment used to be as simple as multiplying the net underwriting profit, i.e., the difference between income and outgo, by a sliding scale percentage based on volume. Today, many of the agreements reviewed are exceedingly complex, incorporating growth, retention and other factors into the calculations.
For example, one company's formula is as follows:
Determine the performance ratio by adding the commission ratio plus the loss ratio. (The commission ratio equals the commissions payable divided by written premium.) Use this performance ratio to determine the profit bonus percentage from the tables, which are an addendum to the agreement. Then multiply the profit bonus percentage by the "growth adjustment factor." ("Growth adjustment factor" means the ratio of written premium for the current calendar year to the written premium for the immediately preceding calendar year. This ratio may not exceed 2.) Multiply the written premium by the adjusted profit bonus percentage to determine the profit bonus. Determine the renewal retention index and the renewal bonus from the tables. Multiply the renewal bonus percentage by renewal premium to determine the renewal bonus. Apply the stabilization ratio by dividing the sum of all bonuses for all agents/brokers who have a profit sharing agreement in force by the total written premium of all such agents/brokers. If the stabilization ratio is less than 1%, the renewal and profit bonuses are modified by the ratio of 1% divided by the stabilization ratio. If the stabilization ratio is greater than 2%, the renewal and profit bonuses are modified by the ratio of 2% divided by the stabilization ratio.
Equal numbers of companies in our study apply three-year or one-year calculations. One-year agreements might have advantages for some agencies. Many companies now use growth and retention factors in addition to profitability and volume to determine the agency's bonus. Some companies separately reward the agent for growth and/or retention, while others actually penalize the otherwise profitable agency which does not grow and/or retain business at a certain level. As discussed earlier, under some contracts a profitable agency would not qualify for any profit sharing payment if growth/retention objectives were not achieved.
Three companies now have minimum and maximum profit sharing payouts. Their formulas are expressed in terms of a minimum of 1% and a maximum of 2% of all profit-sharing bonuses divided by premiums written (in two of the agreements) or earned (in one of the agreements) by all agencies with profit-sharing agreements.
Called "stabilization ratios" or "guaranteed payment pools," these formulas have worked to the benefit of some of the companies in the hard market by reducing the amount of profit sharing they had to pay. Theoretically, the stabilization ratios and guaranteed payment pools should benefit agencies in a soft market when volume and profitability may suffer and the minimum would be invoked.
Most agreements provide that payment will be made within a reasonable time. Some commit to a specific time (e.g., on or before April 1st) in which the profit-sharing bonus, if any, will be paid. One agreement provides that the company will pay the agency interest on the amount if it does not render payment by a given date.
A contract should specify how amendments will be affected. It is important that the agency be given notice of the amendment prior to the beginning of the profit sharing year. Provisions which allow a company to amend the agreement midyear do not give the agency a fair opportunity to plan according to the change.
The majority of contracts provide that the profit-sharing agreement will be terminated either upon termination of the agency contract or with written notice. Several give the agency advance notice, although none give the 180-day notice which we recommend.
There should be a final calculation of the run-off business following termination. A majority of the agreements reviewed provide that there will be a calculation for the year of termination. A few, however, provide that there will be no profit sharing paid for that final year.
We recommend that the agency receive a profit-sharing payment (if otherwise eligible) for the year of termination and the following year.
Only five of the agreements reviewed contained an arbitration provision. These agreements were with Atlantic, Commercial Union (personal lines), Great American, Home and Zurich-American.
We continued to advocate the inclusion of an arbitration provision in profit sharing agreements. Without the costs of litigation, arbitration provides a fair and objective method of settling disputes that arise under the agreement.
Profit-sharing agreements have changed considerably over the last several years. We have attempted to explain and comment on these changes as well as provide an analysis of the 26 profit-sharing agreements reviewed.
There is no doubt that profit-sharing agreements will continue to evolve as the companies continue to experiment with their profit-sharing agreements to provide the agency with additional income while furthering the companies' marketing objectives.
Each independent agency owes it to itself and its bottom line to study and compare profit-sharing agreements to ascertain which agreements fit the agency's business plans and financial objectives.