During our annual valuation work for agencies and brokerages across the country, one alarming trend we're noticing is that most are forecasting significant declines in contingent income this year, even though commission revenues are holding or increasing slightly. This could have sizable consequences for agency profitability.

Contingent income is a powerful asset. It comes in as revenue, but because there is typically no producer compensation associated with it, such revenue flows directly to the bottom line as profit.

Therefore, any change in contingent income, up or down, can have a dramatic effect on profitability.

In fact, as the accompanying bar graph shows, agencies in the “2008 Best Practices Study”–prepared by Reagan Consulting for the Independent Insurance Agents and Brokers of America–received between 36.8 percent and 51.0 percent of profits from contingent income.

Because agencies are relying on contingent income for large portions of their profits, any reduction would have significant ramifications on agency cash flow.

Why is this happening?

The first driver of lower contingent income is the combination of the soft property-casualty market and the declining economy. These two factors are driving down premiums and driving up loss ratios.

Agencies are finding it harder to hit the growth, retention and profitability requirements in their contingent agreements, and as a result more agencies are falling into lower bands of contingent income payouts or are failing to qualify altogether.

Most carriers we've spoken with indicate that the lower contingents paid out in 2009 (based on 2008 results) aren't the result of less attractive contingent arrangements but of less attractive industry performance.

Therefore, the second source of pressure on contingent income could come from carriers themselves, as insurer profitability and return on equity declined substantially last year, with no sign of a quick turnaround in sight.

The Insurance Information Institute reported that the p-c industry's combined ratio climbed to 105.1 in 2008, up nearly 10 points from 95.5 in 2007. While a combined ratio over 100 isn't unusual, it is an indication the industry is not making an underwriting profit, as it has in three of the last four years.

However, insurers have often made sizable profits from their investment portfolios even in times where they have experienced underwriting losses. But due to the downturn in the financial markets in 2008, carriers are also finding it difficult to earn income on their investment portfolios.

With both underwriting profit and investment profit declining, data from the Insurance Information Institute indicates that in 2008 the industry recorded its lowest return on equity since 2001.

Where will carriers turn to increase profitability and to generate higher returns? Pricing is certainly the most obvious answer, but it is also possible they'll re-examine and “tweak” their contingent income contracts.

Several carriers have already implemented payout caps and/or raised the minimum premium volume requirement for contingent eligibility.

For example, agents placing $500,000 in premium with an insurer may now need to place $750,000 to be eligible for that carrier's contingent income plan. In addition, some carriers are lowering the loss ratio threshold to require a more profitable book to gain access to contingent income.

The factors pressuring contingent income aren't likely to relent any time soon. A hard market has yet to materialize–indeed, the quarterly pricing survey by the Council of Insurance Agents and Brokers reported rate declines of 5.1 percent in the first quarter of 2009–and the prospect of economic recovery remains uncertain.

Further, it isn't certain we've seen the full reaction of carriers to their declining financial performance. With difficult contingent conditions likely to persist, agencies should begin planning for reduced contingents and reduced profitability.

We examined the “Best Practices” agencies between $10-and-$25 million in revenue for the last 12 years, and discovered an interesting shift in contingent income that occurred approximately six years ago (see accompanying graph). Contingent income went from averaging 6 percent of revenues for the six years from 1997-to-2002, to averaging 10 percent of revenues from 2003-to-2008.

This shift of four percentage points in revenues may not seem that significant, but the corresponding shift in profits can be dramatic. For an agency with a profit margin of 20 percent, that four-point revenue shift represents one-fifth of the firm's profit!

We don't believe there will be a major structural change in the way contingent and supplemental income programs are run. These programs are important for agencies and brokerages but are also important to carriers.

Contingent income allows carriers to ensure that the interests of agents and brokers are aligned with their own, and gives them a way to reward high-performing agents. However, even small changes to contingent income plans can mean big changes to agency profitability.

It is difficult to judge the magnitude of the coming contingent income decline, but it doesn't take much to meaningfully alter an agency's bottom line.

Shirley Lukens and Brian Deitz are partners with Reagan Consulting Inc. (www.reaganconsulting.com), an Atlanta-based consulting firm that developed and produces the “Independent Insurance Agents and Brokers of America Best Practices Study.” Ms. Lukens may be reached at [email protected], while Mr. Deitz is available at [email protected].