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FEE VS. COMMISSION-DOES IT MAKE A DIFFERENCE? The following article focuses on the insured's perspective of fee and commission based broker remuneration. Understanding the philosophies of both can better prepare you in developing your own income strategies. How does the risk manager determine whether to pay the broker on a fee or commission basis? Does one method have any advantage over the other? How does a broker determine a fee? Often the answers to these questions reveal little. Some brokers are guarded about their remuneration. Some are reluctant to work on a fee basis. A few are adamant about working on commission and are unwilling to reveal their income to a client. Some brokers say it makes no difference to them whether they are paid by commission or fee-as long as they are adequately compensated. The insured usually should be indifferent to the compensation method, provided the amount is fair in relation to the services provided. However, where insurance coverage is with a nonadmitted carrier, taxes may be paid on net premiums only. Here, a negotiated fee paid separately will save the insured money. MANAGEMENT PHILOSOPHY INFLUENCES DECISION Determining how to pay the broker is often influenced by the insured's management philosophy. Some insureds require a separation of premiums and costs of services. Others want to see only a gross figure. We have talked to risk managers who lump premiums and service costs, saying that separation would only "confuse" management. There might be an element of insecurity here: fear of criticism of the cost of brokerage services. One might wonder if a broker who does not want to reveal commissions to the client has the same motivation. We see no good reason why an insured shouldn't be on a fee basis with the broker. Obviously, the fee must be commensurate with the services performed. As long as the fee is subject to periodic review and adjustment, we see no significant disadvantages to this approach. Knowing the cost of services in advance allows the risk manager to budget more accurately. He or she will be able to respond to the inevitable question, "How much does our broker make?" If the fee calculation is properly presented, it will give the risk manager a more complete understanding of services the company is receiving. Some of these services may not be needed or desired, in which case they can be eliminated and the fee reduced accordingly. The ability to make an intelligent explanation of the cost of services is probably the ultimate benefit. HOW BROKERS DETERMINE FEES Let's presume for this discussion that the insured has made the decision to ask the broker to work on a fee basis. Is there any mystery or science to determining a fee? There shouldn't be any mystery. In our observation, there isn't a whole lot of science either, in most instances. Even if a fee formula requires some assumptions, there can still be clear, understandable components. Brokers generally determine fees in the following ways: 1. They back into the fee, based on their expected remuneration on a commission basis. There is not much science in this approach. Brokers look at the historical commissions on their book of business and adjust the given account fee accordingly, based on whether or not the client is likely to require more or less service than the norm. In explaining the fee, the broker may tell the client what his average commission was in a given year. The broker may or may not reveal profit margin. The figure may exclude "extra" revenue such as contingent or profit-sharing commissions. 2. The fee is a guess (educated or otherwise) based on what the client will bear. With this approach, the broker offers little or no explanation other than "based on experience, this is what we think we need to handle your account." The client can work the number back to a rate of commission, but this is still a meaningless figure. A broker told us recently about a seminar attended almost entirely by insurance brokers. One of the speakers was a senior executive of a "big eight" accounting firm who informed his audience that the "bottom line" on fees was to extract as large a fee as the broker thought the client would pay short of moving the account. He went on to admonish the listeners that "if they believed any differently (about fee determination) they were just kidding themselves." We have seen instances where brokers were receiving large commissions, often undiscovered until the account moved. One instance in particular stands out. The incumbent broker had received close to $1 million per year in commission. The competing broker moved the account when a $250,000 fee for offering the same service was quoted. Subsequent performance showed the quality of service was comparable. 3. The fee is calculated by a formula based on costs plus profit expectation. There is more science here, although subjective elements are in the most sophisticated formulas. Unlike attorneys and consultants, few brokers keep accurate time records on a given account. The broker usually will estimate a percentage of time spent by the office or by various individuals. The percentage is then applied to payroll to reach a starting point. Overhead and profit are added to reach the end result. We have seen complicated formulas breaking the components of overhead into many parts as well as simple calculations where one factor was applied to direct payroll. Both use the same starting point. Assuming the percentage of time spent by brokerage personnel handling the client's account is reasonably accurate, a broker can calculate a fee that makes sense to a client. Further, there is no problem explaining overhead, if the broker is willing to fully disclose it. Some will; most will not. Our observation is that they usually are not asked. CONCLUSION For a risk manager and client to accept the broker's remuneration without question is to invite over-charge. Sometimes a client feels uncomfortable probing too deeply, particularly when there is a long-standing relationship with a broker. Still, there are some questions which may be asked without embarrassing anyone, such as: 1. Do you have some method of determining how much we pay as a client for your services? (The answer will open discussions that could be enlightening.) 2. What do you estimate your payroll is as a percentage of total income? (The same question can be asked casually or directly to competing brokers.) 3. What is your profit as a percentage of total income and how does that percentage compare with your profit objective now? (This is another question for comparative reply.) 4. Is any of our business placed through managing general agents, surplus lines brokers, or other intermediaries? Does that benefit or work to our detriment? (If there is not sufficient justification, the extra commission expended may be an additional cost to the client without benefit.) Delving into the remuneration question is not only possible, but some brokers even encourage the client to review fee formulas with them in detail. One highly respected broker told us, "Fee calculation is an art, not a science." We would like to see it less of an art and more of a science even if not an exact one. |