Contingent Commissions and Market Cycles

1. Contingent Commissions and Market Cycles Lan Ju Mark Browne University of Wisconsin-Madison 2007 ARIA Meeting, Quebec City

2. Question • Do profit-based contingent commissions dampen the underwriting cycle? 2007 ARIA Meeting, Quebec City

3. Simple Illustration Underwriting Margin NC C Soft Mkt Hard Mkt Time 2007 ARIA Meeting, Quebec City

4. 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

5. A Portion of Contingent Commission Bonus Matrix Source: CNA 2006 Addendum to Agency Agreement 2007 ARIA Meeting, Quebec City

6. 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

7. 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

8. 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

9. Monitoring by Motivated Brokers Long-Term Relation Clients Insurer Contingent Comm. Identify Insurer Good Business Brokers 2007 ARIA Meeting, Quebec City

10. Another Description SC’ SC SNC SNC’ P D PNC’ SLC PC’ PC PNC SLNC Q 2007 ARIA Meeting, Quebec City

11. 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

12. 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

13. 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

14. IV Regression (97-00, N=3,043) 2007 ARIA Meeting, Quebec City

15. 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

16. Thank You ! 2007 ARIA Meeting, Quebec City