Wharton Study Finds Contingent Commissions Necessary, Agents Essential to Industry

Scholars Conclude Profit Sharing Helps Ensure Fair Insurance Pricing

A new study by two Wharton School of Business scholars concludes that profit based contingent commissions are a necessity in the marketplace. The study, "The Economics of Insurance Intermediaries," by Professors J. David Cummins and Neal A. Doherty concludes that "although contingent commissions, like most business practices, can be misused by the unscrupulous, in general this type of incentive compensation plays an important role in aligning incentives between buyers and insurers and thus facilitates the efficient operation of insurance markets." The study was financed by the American Insurance Association (AIA).

According to the study, intermediaries are usually better informed about the risks of their clients than insurers and when such risk information is accurately transmitted to the insurer, carriers compete more vigorously for business and price more competitively and fairly. In this way, the study reports, agents and brokers "assist the flow of information in the insurance market and enhance the efficiency of the market to the benefit of all players."

The authors noted that intermediaries match buyers with insurers "who have the skill, capacity, risk appetite, and financial strength to underwrite the risk, and then help their clients select from competing offers." The authors said that the role of the intermediary is "to increase competitiveness, by providing the buyer access to a wider range of possible insurers and by helping the buyer to compare these bids on the basis of price, coverage, service and the financial strength of the insurer."

"Our research provides empirical evidence that most of the contingent commissions are passed on to policyholders in the premium," notes the study. "However, whether this harms or benefits policyholders is a matter of debate. Despite recent allegations that contingent commissions are a 'kickback' from the insurer that compromises the intermediary's obligations to its clients, such commissions can actually be beneficial to clients."

Among other core aspects/findings of the Cummins-Doherty study:

• The conventional economic-legal role of agents in other industries is contrasted with the role of intermediaries in the insurance buying process, where information must be shared with both sides in order to come up with a product for the buyer. Their analysis argues that if risk information about the buyer is not shared with sellers/insurers, low-risk buyers will be penalized by having to pay higher prices than their risk level warrants; i.e., they would end up unfairly subsidizing higher-risk buyers.
• The authors explain how intermediaries can reduce market inefficiencies and alleviate the cross-subsidization problem for low-risk buyers by assessing the risk level of the buyer and providing that information to the insurer.
• Because the intermediary is, in effect, performing a critical underwriting function for the insurer (conducting comprehensive risk assessments of individual/organizational buyers to establish precisely the risk level represented by those buyers), some form of financial incentive (e.g., a contingent commission) from insurer to intermediary is appropriate.

The study concludes that "although contingent commissions, like most business practices, can be misused by the unscrupulous, in general this type of incentive compensation plays an important role in aligning incentives between buyers and insurers and thus facilitates the efficient operation of insurance markets."

The authors also found that premium-based commissions constitute the vast majority of intermediary revenues, contingent commissions account for about 4 to 5 percent of brokers' overall revenues, and that contingent fees help new insurers break into the property-casualty market.

"Absent contingent commissions," the professors said, "new insurers might find it difficult to obtain high quality placements from intermediaries, who would naturally prefer dealing with established insurers with whom they have developed relationships."

Professors Cummins and Doherty found that "the bulk of compensation is awarded to those intermediaries who earn the confidence and trust of their clients by making good placements." As a result, they conclude any short-term gain resulting from a contingent commission for an inferior placement would not make economic sense, particularly because it could come at the cost of long-term market reputation and resulting loss of their primary compensation source, premium-based commission.

Wharton Scholars Defend Contingent Fees (National Underwriter 6/8/05) 

Wharton Study Finds Agents, Brokers Play Critical Role (Insurance Journal 6/8/05) 

"The Economics of Insurance Intermediaries" (Full report - Professors Cummins & Doherty) 

This article originally appeared in the June 2005 PIA Connection.