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Contingent Commissions and Market Cycles. Lan Ju Mark Browne University of Wisconsin-Madison. Question. Do profit-based contingent commissions dampen the underwriting cycle?. Simple Illustration. Underwriting Margin. NC. C. Soft Mkt. Hard Mkt. Time.

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Contingent Commissions and Market Cycles

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Contingent commissions and market cycles l.jpg

Contingent Commissions and Market Cycles

Lan Ju

Mark Browne

University of Wisconsin-Madison

2007 ARIA Meeting, Quebec City


Question l.jpg

Question

  • Do profit-based contingent commissions dampen the underwriting cycle?

2007 ARIA Meeting, Quebec City


Simple illustration l.jpg

Simple Illustration

Underwriting

Margin

NC

C

Soft Mkt

Hard Mkt

Time

2007 ARIA Meeting, Quebec City


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Background on Contingent Commission

  • Compensation Structure to Brokers

    - Direct Commissions (Traditionally)

    - Contingent Commissions

    Profit-based

    Volume-based ( PSA )

  • Current Issue:

    - RIMS against supplemental commissions

Focus !

2007 ARIA Meeting, Quebec City


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A Portion of Contingent Commission Bonus Matrix

Source: CNA 2006 Addendum to Agency Agreement

2007 ARIA Meeting, Quebec City


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Example

  • $2,500,000 premiums written

    Current year limited loss ratio is 30%

  • Contingent commission

    = $2,500,000 * 0.0192 = $48,000

2007 ARIA Meeting, Quebec City


Relevant literature market cycles l.jpg

Relevant Literature – Market Cycles

  • Rational Expectation Theory: Perfect market

    - Cummins and Outreville (1987)

  • Capacity Constraint Theory: Not perfect market

    - Winter(1988, 1991a, 1994)

    - Gron (1994)

    - Cummins and Danzon(1992)

    - Doherty and Garven(1995)

  • Risky Debt Theory: Insurer’s default risk

    - Harrington et. al. (1988,1994, 2004, 2005)

    - Cummins and Danzon(1997)

2007 ARIA Meeting, Quebec City


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Harrington (2004 & 2005)

  • Proxy:

    Loss ratio development = Developed loss ratios - Originally reported loss ratios

  • Argument:

    - Premium growth in the soft market is positively correlated with loss ratio development

    - Excessive price cuts in the preceding soft market are associated with upward claims costs development in the subsequent hard market Trigger the formation of hard market !

2007 ARIA Meeting, Quebec City


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Monitoring by Motivated Brokers

Long-Term

Relation

Clients

Insurer

Contingent

Comm.

Identify

Insurer

Good

Business

Brokers

2007 ARIA Meeting, Quebec City


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Another Description

SC’

SC

SNC

SNC’

P

D

PNC’

SLC

PC’

PC

PNC

SLNC

Q

2007 ARIA Meeting, Quebec City


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Hypothesis and Data

  • Data:

    - NAIC 1997-2005

    - 5-year loss development

    - Focus on latter part of soft market 97-00

  • Hypothesis:

    - Insurers who pay greater contingent

    commissions are associated with smaller loss

    ratio development

    Cycles are dampened !

2007 ARIA Meeting, Quebec City


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Modeling (Firm-Specific Approach)

LRDi,t = α + β1LnGrowthi,t + β2CONCOMi,t

+ β3ROAi,t + β4RBCi,t

+ β5Herfindahli,t + β6Longtaili,t

+ β7Sizei,t + β8Stocki,t+ β9Groupi,t + εi,t

Problem: Endogeneity

2007 ARIA Meeting, Quebec City


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Two-Stage Regression

  • First-Stage: Tobit Regression

    CONCOMi,t = α + β1ROAi,t + β2 RBCi,t + β3 Herfindahli,t + β4Longtaili,t + β5Sizei,t + β6 Stocki,t + β7Groupi,t + εi,t

  • Second-Stage: IV Regression (Primary Interest)

    LRDi,t = α + β1LnGrowthi,t + β2 PredCONCOMi,t+ β3ROAi,t + β4RBCi,t + β5 Herfindahli,t + β6 Longtaili,t + β7 Sizei,t + β8Stocki,t + β9Groupi,t + εi,t

2007 ARIA Meeting, Quebec City


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IV Regression (97-00, N=3,043)

2007 ARIA Meeting, Quebec City


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Conclusion

  • Consistent with Prior Literature:

    Stronger Premium Growth Greater LRD

  • New Findings:

    Greater contingent commission payments

    Less severe upward loss development

  • Further Research:

    - Longer period of data

    - Incorporate multi-period theoretical model

2007 ARIA Meeting, Quebec City


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Thank You !

2007 ARIA Meeting, Quebec City


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