ACG - Agency Consulting Group

The PIPELINE

A national monthly newsletter for agency principals dedicated to agency management topic

Tiering Compensation To Incent Producers

What attracts and keeps high energy producers active in the insurance business?

The answer is “MONEY” and the promise of greater income as they grow the agency’s book of business. But our independent agency force appears to be constructed of two types of owners, those who are willing to share the wealth as long as they are properly compensated for taking the risks of ownership and those who strive to generate the most profit by spending the least money on any agency expense.

What this second type of agent has never realized is that the economies of scale work so well for our business that “sharing the wealth” with the producers who can grow the agency actually enriches the owner by three to four times what they pay their producers if they properly analyze their agency operations and financials.

Do you know that if you are an average small agency ($750,000 of commissions) last year you spent an average of $240,082 in commission expense for your 2 producers/owners and $484,000 for all other personnel and operating expenses, and that you earned only 3% profit? More importantly, are you aware that if you grew by $200,000 your expenses would only increase by a maximum of $139,000 ($70,000 to producer commissions and one additional person), increasing your profit from 3% to 9% (tripling the profit percentage and increasing the real dollar profits by almost four times -- from $20,000 to $80,000) (source 2008 Agency Consulting Group, Inc. Composite Group Study, Group 1 Agencies <$1,000,000 Revenue)?

You’ve just been given an example of economies of scale. Even though you may be paying producer commission on the sold business, you won’t have as much additional expense involved in growth as you benefit from the revenue, thereby yielding both greater profit margins as well as much more profit dollars to the owners.

Over 15 years ago we introduced tiered compensation to the agency industry as a way of incenting producers to continuously grow, thereby enriching themselves and enriching the agency even more. At that time we noted producers “hustling” to generate new business, usually at higher commission rates than renewals, to replace lost clients or clients renewing at lower rates in soft markets. It was a vicious circle. Producers were earning more income from new business than they lost from departed renewals. We used to think that keeping renewals was easier than getting new business. Today we know that we are at risk on every account every year unless we have a deep and value-laden relationship with the client. That takes time. Time is the only asset we have as producers and most of us don’t know how to spend it wisely.

Tiered compensation (an important ingredient in the Asset Protection Model of Relationship Sales) answers the question of how producers should be spending their time by associating compensation with the most important thing producers do for agencies, building new and maintaining existing client relationships. Tiering commissions makes sense as an incentive for agencies desiring to grow. It is growing commission rates paid to producers as their volume of production reaches specific profit levels for the agency. Tiered commissions differ from bonus commissions in that they truly incent producers to generate growth - not just new business - by rewarding them based on BOTH growing and maintaining the total book of business for which they are responsible above levels that profit the agency. Since the economies of scale (illustrated above) operate in every agency, a producer who generates $600,000 of commissions not only brings more revenue to the table, but his book of business is much more profitable to an agency than a producer who generates $300,000 and certainly more profitable than producers generating $100,000 or $200,000.

Tiered compensation reflects the value of both the total commissions for which the producer is responsible AND the profitability enhancement of that book of business. So while a bonus program or a new business commission program rewards producers for specific activities like new business generation, a tiered compensation program recognizes greater productivity by giving a producer a higher commission from the first dollar for generating sufficient business to warrant that higher compensation by generating both more commissions AND higher percentage profitability to the agency than that of lower level producers.

Typically the Tier breaks reward producers 5% more commission for every dollar produced than they had been previously earning. However, we have seen agencies who want to keep producer’s reaching for the next tier quicker, so enhance compensation at 2.5% breaks.

If a producer was to earn 33% commission on his book of business – the current industry average (regardless of how you pay – new/renewal, base/growth, straight draw, or salary – or any combination of these methods) up to $300,000, wouldn’t it give a significant incentive to the producer if he knew that once he breaks the $300,000 barrier, he will earn 38%, even for the first $300,000 generated (an immediate $15,000 bonus)? We have seen many tiered compensation programs that paid a producer 33% on every dollar produced up to $300,000, then 38% on every dollar for producers generating from $300,000 to $500,000. Another Tier Break at $500,000 permitted the agency to pay the producer 43% for every dollar produced if he generated more than $500,000 in gross commissions in the agency.

While the average profit margin on producers under $300,000 has been 9%, the average profitability for producers between $300,000 and $500,000 has grown to 15% to 20% (even after paying them an additional 5% commission on every dollar). Producers generating over $500,000 can easily generate the agency a profit of 30% to 35% because of the economies of scale (again after paying the producers another 5% on all production).

Our studies showed that a $250,000 producer generated an average of $22,500 in profit to the agency. At $400,000 (a 60% production growth), profits grew by 311% to $70,000. At $700,000 of produced commission (75% above the $400k level), the producer was generating 324% more profit to the agency ($227,000). This is due to the economies of scale that limit the growth of expenses while the growth of revenues drop to the profit line. AND THIS PROFIT GROWTH INCLUDED ADDITIONAL COMMISSION EXPENSE TO THE PRODUCERS AT 5% HIGHER INCREMENTAL COMPENSATION (Compensation growth at $300,000 and $500,000 from 33% to 38%, then to 43%).

The difference between stable commission rates and tiered commission for someone going from $275,000 to $350,000 in a growth year is the difference between $118,000 and $133,000 in compensation, a 12.7% difference ($15,000) in direct compensation since tiered compensation affects FIRST DOLLAR FORWARD.

When is it appropriate for an agency to increase compensation to one or more producers through a tiered compensation program?

WHEN PROFITABILITY ON THE BOOK OF BUSINESS RISES THREE TIMES THE RATE OF COMPENSATION CHANGE, AN AGENCY SHOULD CONSIDER TIERING ITS PRODUCER COMPENSATION PROGRAM.

This makes it appropriate to tier compensation by 5% for every 25% net increase in profitability (net after the change of compensation and any additional expenses that will be incurred from the growth in the client base). Of course, the larger the client average commission, the less additional expense will be necessary to the agency. But even when average commissions are $1,000 per client or less (normally $7,500 to $10,000 premium accounts), economies of scale will be reached relatively quickly by strong growth producers.

How do you know what your base profit is before a tier break is appropriate?

An agency should do a financial analysis of agency operations to determine the appropriate tier breaks for a given agency performed by a professional firm such as Agency Consulting Group, Inc. Profitability depends on the agency’s spending habits. For instance, if an agent generally distributes all profits every year, you must eliminate the discretionary spending to determine what the “real” profits are for the agency. Then the agency must determine what the minimum profit should be for the agency as a closely held business. For instance, if the actual agency profit is reported close to zero, but the “real” profit (before discretionary spending) is 7.5%, you may determine that the required profit before establishing tiers for commission enhancement is 15%-20% - this is your discretionary minimum. You do this by projecting both additional producer compensation AND any other additional expenses that would be incurred for every level of growth calculated.

This process will tell an agency at what level of overall commission income tiering is warranted. The producer force must achieve that targeted growth, that which will yield the Tier-Break Profit before discretionary distribution, in order to achieve the first tier of compensation. Each producer will be given the same target commission level to achieve to enter the second tier of compensation. Those closer to that level already will certainly achieve it sooner.

For instance if you have $1 Million in gross commissions (we do not use anything but commissions and fees in this calculation) and generate 10% profit you may need $1.3 Million in order to reach your Tier Break (a profitability growth from 10% to over 20%) you have three producers ($150,000, $250,000, $400,000) and another $200,000 of “house business”, you may tell your producers that you will provide them a second tier of compensation at $300,000 of commission generation that will automatically add 5% to their compensation from the first dollar beginning in the year after the agency reaches $1.3 Million in commissions. This may take a few years to reach if your producers are all in a growth mode, or it could require the addition of one or more new producers to achieve that level of growth for the agency. But if you can handle an additional $300,000 of income with no additional staff and would only incur a 5% additional expense on the two best producers, you would be spending $30,000 of additional expense to generate $300,000 of additional profit. Even if you add a marketing load for advertising and marketing of $25,000 and an additional service employee at $50,000, your profitability grows from the current position by almost $200,000!

Since every agency operates somewhat differently, we cannot provide you with an automatic commission income level that defines the tier break points for your agency. However, if you are interested in motivating your producers to continuously generate growth for the agency, you are welcome to contact us at (800) 779-2430 to help you re-design your producer compensation program and create an Incentive Based Comp program for your employees that pay them for productivity instead of for longevity.