What it means
Brokers earn a base commission on every policy, usually a fixed percentage of premium paid at the time the policy is written. The contingent commission is separate and is calculated after the year ends, once the insurer knows how many claims that agency's customers actually made.
The measure at the centre of it is the loss ratio, which is claims paid and reserved divided by premium earned. A low loss ratio means the agency sent profitable customers, and the contingent schedule pays a higher rate the lower that ratio goes.
Insurers use these arrangements because they change behaviour cheaply. An agency that knows a profitable book earns an extra few percentage points will screen risks more carefully at the point of sale, which costs the insurer far less than doing that underwriting work itself.
The conflict of interest is obvious once stated plainly. A broker with a large contingent agreement at one insurer has a financial reason to steer clients there and to avoid clients likely to claim, which is why disclosure rules in many markets require the arrangement to be revealed to commercial buyers.
For a buyer of insurance the practical step is simply to ask. Knowing whether your broker holds a contingent agreement with the insurer being recommended does not make the recommendation wrong, but it tells you what to test in the alternatives presented alongside it.
Accounting treatment catches agencies out as well. Contingent commission is uncertain until the loss ratio is known, so it should be accrued conservatively rather than booked in full through the year, and an agency budgeting on the optimistic figure can lose a large slice of expected income to one bad quarter.
In practice
Real-world examples.
Example
A commercial insurance agency reviews its December pipeline and declines two haulage accounts with poor claims histories. Placing them would have added $140,000 of premium and about $16,800 of base commission, but would likely have pushed the book's loss ratio past the 50% threshold and cost far more in lost contingent commission.
Example
A manufacturer buying employers' liability cover asks its broker directly whether a contingent agreement exists with the recommended insurer. The broker discloses one, and the manufacturer asks for two additional quotes from insurers where no such arrangement applies.
Example
A regional agency budgets $500,000 of contingent income and books it evenly across the year. A large fire claim in the fourth quarter pushes the loss ratio above the threshold, the payment falls to zero, and the agency has to reverse the accrual and cancel its year end bonus pool.
Formula
Calculation
Loss ratio = incurred losses / earned premium
Contingent commission = eligible premium x the rate from the schedule for that loss ratio
An agency places $8,000,000 of earned premium with one insurer during the year. Incurred losses on that book come to $3,600,000, so the loss ratio is $3,600,000 / $8,000,000 = 45%.
The insurer's schedule pays 4% of premium where the loss ratio is below 50%, 2% between 50% and 60%, and nothing above 60%. At 45% the agency qualifies for the top band, so the contingent commission is $8,000,000 x 4% = $320,000.
Base commission on the same book was 12%, or $8,000,000 x 12% = $960,000, so total income from that insurer is $960,000 + $320,000 = $1,280,000 and the contingent element accounts for $320,000 / $1,280,000 = 25% of it.
The sensitivity is what makes this risky income. Had losses come in at $4,400,000 the loss ratio would be $4,400,000 / $8,000,000 = 55%, dropping the agency into the 2% band and halving the contingent payment to $8,000,000 x 2% = $160,000, on a book only $800,000 worse.Case study
Seen in the real world.
This illustrative and fictional example follows Pennifold Brokers, an invented commercial insurance agency placing $22,000,000 of premium a year across four insurers. Roughly $14,000,000 of that sat with a single carrier paying 11% base commission plus a contingent schedule reaching 5% for a loss ratio under 45%.
In a good year Pennifold's loss ratio on that book was 41%, earning base commission of $14,000,000 x 11% = $1,540,000 and contingent commission of $14,000,000 x 5% = $700,000, a total of $2,240,000. Contingent income was therefore $700,000 / $2,240,000 = 31% of what the firm earned from its largest carrier, and the partners had come to treat it as ordinary income.
Two large storm claims the following year lifted the loss ratio to 58%, which fell outside the schedule entirely and reduced the contingent payment to nil. Income from that carrier dropped to $1,540,000, a fall of 31%, while the firm's own costs were unchanged. The fictional lesson was that Pennifold had built a fixed cost base on income that was, by design, entirely variable and outside its control in any single year.
Watch out
Common mistakes.
- Confusing contingent commission with the base commission paid on each policy, when the contingent payment depends on how the whole book performs after the year has ended.
- Booking the expected payment as certain income during the year, when a single large claim in the final quarter can remove it entirely.
- Assuming a contingent agreement is improper in itself, when in most markets it is legal and common provided it is disclosed to commercial clients.
Questions
People also ask.
What is a typical contingent commission rate?
Commonly somewhere between 1% and 6% of premium, layered so the rate rises as the loss ratio falls, and often with a minimum volume or growth condition attached.
Does a contingent commission cost the policyholder more?
Not directly on the individual policy, since it is paid out of the insurer's own margin, but it can influence which insurer a broker recommends.
Are contingent commissions the same as profit sharing agreements?
In practice the terms are used interchangeably, with profit sharing usually describing the same loss ratio based bonus under a different name.
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