Leader's Edge Magazine, January/February 2005
Author:  Steven S. Wevodau

New York Attorney General Eliot Spitzer is clearly a man on mission, but what is it? Just how far has he really gone into a stalwart industry that is now reeling from his criminal probe and accusations of collusion? By wielding press releases and subpoenas, his investigators have uncovered limited criminal acts while attacking the sanctity of contingent commissions and the potential conflicts they may present.   So has the industry overreacted or does Spitzer aspire to revolutionize the insurance brokerage industry by bringing about the demise of a long-standing compensation structure?

Spitzer has focused on the large, publicly traded firms. Several of these megabrokers reacted swiftly to the allegations by abandoning contingent commission income. Feeding client suspicions that brokers had done something wrong, their unquestioning response may have set into motion an irreversible trend. And that leads to two fundamental questions: Where does this leave everybody else in the industry? And can the issue of contingent commissions be resolved without disrupting the economics—and potentially threatening the viability—of the commercial insurance brokerage industry?

Impact on Public Brokers

If a broker loses its contingent income stream, there are really no direct expenses that can be reduced or matched against the revenues, even though expenses have been incurred. Consequently, the presumed reduction in revenues all goes directly to reduce bottom line income of the broker.

A look at the 2003 pro forma results for seven of the industry’s top brokerages, which are publicly available, shows the astounding impact that the elimination of contingent commissions would have had on tax-affected net income, erasing more than 25% of the composite bottom line.

This underscores the vital nature of contingent commissions and the presumed impact to the industry’s leading segment. At a time when falling insurance prices decrease a firm’s organic revenue growth, eliminating this significant revenue stream will strike a “double” blow against the economic welfare of both public and private brokers.

Public brokers must contend with shareholder demands that press the need for continued growth and enhancement of earnings per share. A lack of consistent earnings growth can place the market capitalization of the company at risk.

If everyone opts to forego contingent commissions, the industry faces a steep climb during the next 12 months. If product rates do not increase to boost organic growth among existing clients, these leading firms face an exponential freefall. The investment community will quickly erode their market capitalization, drive down share value and potentially limit access to capital and debt facilities.

Ultimately, this will severely restrict the strategic initiatives brokers may wish to deploy to countermand their lost revenue.

Some brokers have publicly acknowledged that their long-term strategy is to regain lost revenue by charging clients higher fees for the services they offer. However, they have not fully assessed the missing qualitative piece of the equation: lost client confidence. The message they are sending their clients is that they were wrong for accepting contingents and they are asking their clients’ forgiveness as well as asking them to pay their broker more to replace lost contingent commission income. This wrong-headed approach has the makings of a disaster.

Smaller Brokers

The ultimate fate may lie with carriers, which historically have rewarded brokers for growth and underwriting profit. They are at a crossroads, trying to balance political pressures against financial goals. Many carriers will contend that contingents represent a reward for producing profitable business—nothing more than profit-sharing based on the quality of the business. Lower risk exposure and loss ratios not only create greater profits for the carrier, they benefit the client, too. A client with a sound risk management program reduces its loss exposure and ultimately pays lower rates based on its good loss experience.

All of this brings us to the middle market segment, where midsized and smaller privately held brokers patiently await the outcome of the current situation. Depending on your point of view, smaller brokers may find themselves at either the brink of a major catastrophe or facing the opportunity of a lifetime.

Potential risks to the smaller broker lie in the industry’s reaction to Spitzer’s accusations of collusion and conflict of interest. Large brokers with a substantial financial cushion have the luxury of foregoing contingents in favor of higher fees from clients. However, a sweeping call among carriers to abandon contingent commissions will, without a doubt, put the squeeze on many smaller brokers.

Small to midsized brokers are as dependent on contingent commissions as the very largest brokers, if not more so. An analysis of the large brokerage firms, excluding the largest seven, finds that during 2003, 5.5% of all revenues were derived from contingent commissions, compared with 4.8% for the seven largest. Eliminating contingent commissions will create an enormous gap in the economic food chain.

To put this into perspective, look at a midsized broker currently generating $15 million in revenues and sustaining a 20% pre-tax profit margin after normalizing adjustments. Eliminating contingent commissions severely limits the broker’s ability to generate free cash flow, creating a 25% reduction in pre-tax earnings. Essentially, contingents flow right to the bottom line of any firm. Getting rid of them would make it difficult for many small to midsized firms to meet market demands and battle competition. Any time a broker cuts 25% out of the profit margin of a business, it greatly impairs its ability to reinvest in growth and infrastructure and to weather the most challenging times of the brokerage business cycle.

Ultimately, the livelihood of smaller to midsized firms lies in the hands of the carriers and other brokerage firms and how they react to this crisis. The successful brokerage firms will be the ones that not only articulate the value proposition that contingent commissions create for clients, but vigorously pursue opportunities created by clients’ lack of confidence in the larger firms that have abandoned the concept.

Outlook

Contingents may ultimately be reshaped to reward only underwriting profitability, rather than the traditional combination of growth and profit. However, the immediate issue demands that all firms comply with full disclosure and adopt a transparent approach to compensation.

Even if the investigations by Spitzer and others results in changes to the compensation structure, the overall financial economics created between carriers, distributors and clients cannot be drastically changed or many honest, innocent brokerage owners and their firms will face dire financial strains. Shifts in compensation will ultimately be borne by the client, the carrier, or both. The value of quality business is critical to carriers, and the navigation through complex risk management needs is critical to clients.

Wevodau is a contributing writer and managing partner of WFG Capital Advisors.  The opinions expressed are his and do not necessarily reflect the position of Leader’s Edge magazine. swevodau@wfgca.com