Background — Agency-Wide Profit
Preliminary note: The expense ratios cited below refer to an expense item’s percentage of sales revenue (regular commissions). In our computation of those ratios, contingent and profit-sharing income was not in the math.
To meet reasonable profit targets, most independent agencies will need to maintain a “6-handle” (a percentage in the 60s) on their personnel-expense ratio. By that I mean that as a percentage of sales revenue, the sum of cash compensation, benefits, and payroll taxes will have to be in the 60s. With all other cash operating expenses totaling about 20% to 25% of sales revenue, this will allow most agencies to generate a Core Profit in the low-to-mid teens. Adding contingent commissions and miscellaneous income to the Core Profit allows an EBITDA margin in the mid-20s. Some of our clients do better, some worse, but these overall profit numbers should lay the groundwork for what’s below.
To keep the total personnel-expense ratio in the 60s, the cash-comp piece will have to have a 5-handle (a percentage in the 50s) because the benefits line is likely to be at least 10%. These numbers assume that discretionary owner compensation has been corrected from the actual reported number to a normalized number, sometimes called a replacement level. And, because most agency owners are producers (at least part-time), some of that normalized owner pay should be included in the sales-comp line.
When reviewing agency compensation ratios, we like to break the total cash-compensation expense into four pieces: executive management, sales, service, and admin. In our scheme, salaries for department management/supervision are included in the service and admin lines, not in the executive-management line.
The Sales-Comp Piece. Of the total cash-comp target of, say, 55%, what part should come from sales? That depends on the agency’s mix of business, with the sales-comp ratio being higher for agencies with a higher mix of mid-market and larger accounts. For an agency that gets, say, half to two thirds of its revenue from mid-market and larger accounts (in p/c and employee benefits), a reasonable sales-compensation ratio is from the upper-teens to the mid-20s. A simple example: If an agency pays its producers an average of 32% of their coded commissions (a blend of new and renewal) and half the agency’s accounts have a producer-comp expense (with the remainder being house accounts), the agency-wide expense ratio for sales comp will be 16%.
If the agencies with a preponderance of larger accounts are well managed, however, their higher sales-comp ratio will be offset by lower compensation ratios in the service and admin lines, allowing them to maintain a cash-comp ratio in the 50s and a total-personnel-expense ratio in the 60s. A CSR managing the inside service of a book of small accounts might find it a real challenge to handle annual commissions of more than three times her/his pay (a service-salary expense ratio of 33%), whereas an account manager on large accounts might be able to deal effectively with a book of eight or ten times her/his pay (an expense ratio of 10%-12%). When we find agencies struggling to achieve a 5-handle on agency-wide cash-compensation expense (after adjustment for owner-discretion items), the cause, more often than not, is that they are paying both service people and sales people on small accounts.
Commission Splits. Larger agencies focusing on larger accounts tend to use a new/renewal split of 40/25 or 40/20. For the mature producer, that blends in the mid-20s, and for the newer people, with a higher ratio of new, it blends in the 30s. We find mid-sized agencies typically with splits of 40/30, or 50/30, or 50/25. Some take a salary approach, for administrative ease, trying to reach a ratio in the low 30s — for example, a salary equal to 30% of the previous year’s gross commissions, with quarterly or semi-annual true-ups as needed. A good way to average down the sales-comp expense is to assign certain accounts to a salaried account exec, at a ratio of 20% or lower. This works well at the time of a senior producer’s retirement and in agencies that have an ongoing plan for producers to shed accounts. By “account exec,” we mean someone who “looks” like a producer but does not have a significant new-business bogie.
A few related nuggets on the cash-comp piece:
The splits above are for employee-producers, not independent contractors. Thus, added to the cash-comp piece are payroll taxes, benefits, and usually an allowance or reimbursement for auto and promotion expenses.
Most well-managed agencies eliminate renewal splits (or any splits) for small accounts. The definition of “small” is all over the lot, depending on the region and the agency’s business focus.
Commission splitting on personal lines varies widely too from agency to agency. We think high-end personal- lines accounts, and the personal insurance directly connected with a commercial account, warrant the same splits as mid-market commercial business.
We used to see splits on employee-benefits business higher than on commercial p/c, but not so much anymore.
Equity Plans. Plans that give producers an economic interest in their accounts are often referred to as “producer equity” plans. We use that shorthand too sometimes but try to avoid it in our documents because the producer’s interest is usually in the form of unfunded deferred comp and not really account ownership. This is a big subject in which we have a lot of experience, and it goes beyond the scope of this Burke Ink piece. But we will leave you with two observations:
These plans can be very helpful to you in attracting and retaining good people, they can be an excellent tool for perpetuation planning, and they can serve as strong legal reinforcement for restrictive covenants.
But they have to be designed carefully, with the right thresholds and with the true cost integrated with the cash-comp piece. As with all investments, agency owners’ economic returns come in two forms: income and growth in agency value. A well-compensated producer with a so-called equity plan is tapping into both. A big and important subject.