Cost Recovery - Redux


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Cost Recovery - Redux

  1. 1. THE MARSHBERRY LETTER Volume XXV, Number 12 December, 2009Cost Recovery Redux the effort expended in acquiring Cost recovery version 1.0 - recap new business should be matchedWhen we wrote the July 2007 is- The cost recovery period mea- or exceeded by efforts focused onsue of The MarshBerry Letter on sures how long it takes an agency retaining customers.Cost Recovery and Retention, we to offset the cost of selling anddid so in an economic climate that servicing a dollar of new business In the years since we pennedscarcely resembles the tumultuous and recognize a profit. The original that article, we have witnessed abusiness environment that we are cost recovery equation consisted of steep decline in the U.S. econo-now experiencing. At the time that the following three components: my. Government bailouts, failingarticle was written, agencies were banks, and sagging consumerdriving average organic growth ♦ Acquisition Cost – includes confidence describe the newrates in the 4% to 6% range. The commissions paid to producers normal. Meanwhile, stagnatinginflux of would-be agency buyers as well as selling expenses spending levels have brought the such as travel & entertainment,continued, preserving the seller’s economy to a virtual standstill andmarket and buoying the multiples advertising, and promotion economic growth measures indi-that sellers commanded. Overall, cate that the overall economy has ♦ Servicing Cost – includesthe economy appeared strong contracted. And while this is bad customer service payroll andas reflected by various economic operating expenses news for every economic actor, itindicators, including the Dow Jones is especially painful for insurance ♦ Account Commission – theIndustrial Average which crossed agents whose economic fortunes agency revenue dollars that willthe 14,000 point threshold for the march lockstep with the ebb and be generated by this piece offirst time on July 19, 2007. flow of the overall economy. The business overall growth of net written pre-Despite those halcyon economic The original formula is depicted mium in the U.S. has been nega-times, we maintained that most below: tive since year-end 2007 and isagencies were still overlooking an projected to be -2% for 2009. Cost Customer Acquisition Costobvious way to bolster their growth Recovery --------------------------------------numbers: increasing customer re- This certainly paints a bleak pic- Period = (Commission per Customer -tention. Our article posited that the ture for insurance agencies and (Years) Servicing Cost per Customer)key to understanding growth and has spurred us to revisit, re-eval-profitability came from first measur- Based on this equation, there are uate, and retool the cost recoverying how long it took an account to three ways to decrease the cost formula. This new, more robustbecome profitable (cost recovery recovery period: formula better reflects the reali-period), and then retaining the ties of doing business in the cur-customer past that break-even 1. Reduce your Customer rent market and accounts for the Acquisition Costthreshold. The longer the account increased costs of acquiring andwas retained into the future, the retaining new customers. Before 2. Increase your Commissions permore profitable it would be for the we delve into the new formula, Customeragency. And, since it is cheaper we will quickly re-examine the old(and usually more profitable) to 3. Reduce your Servicing Cost per formula to demonstrate how and Customerkeep a current customer than to why we made the new a new one, we concluded that The MarshBerry Letter Page 1 December, 2009
  2. 2. While all of these are viable op- The new formula is depicted which may be controlled by thetions, most are not practicable. below: agency. As this ratio decreases,First, reducing your customer the potential profit per customer Cost Cost of Sellingacquisition cost would work, but Recovery --------------------------------- and total profit should increase.most agencies are running lean Period = (1- (Cost of Retention + This version includes both ser-and most of the fat has already (Years) Allocated Overhead)) vice staff and value-added staffbeen trimmed away. Secondly, components to account for suchincreasing your commissions As much of the underlying data things as maintaining value-add-per customer is dependent on in the formula has changed, I ed service timelines and stew-too many factors outside of your will briefly describe how each ardship reports and the requisitecontrol. Thirdly, reducing ser- component of the formula is communication with the insured.vicing costs per customer is a derived below. Please refer tostrategy replete with pitfalls. If Chart 1 to see how the various Allocated Overheadyou are sophisticated enough to formula components fit together. Also, please note this example This provides a tracking methodstrip away some of these costs is based on commercial lines for overhead expenses suchwithout negatively impacting accounts. The formula will work as benefits expense and sup-retention, then it is a plausible with other lines of business, but port personnel. Our formulasolution. However, in today’s some may not have value-added assumes that this stays fixedmarket, many customers are service costs associated with over the life of the account, butnow reviewing their policies them. if things change in your agency,and trading on the value-added please make the necessaryservices that are delivered by the Cost of Selling adjustment to your formula. Seeagency. Chart 1 on Page 3. This allows the agency toSo, based on the fact that most monitor and analyze the cost of The Case for Measuring theof these components are, in producing new commercial lines Cost Recovery Periodeffect, “fixed,” the best course business. As the cost per com-of action is to retain customers When we first undertook this mission dollar decreases, thelong enough to reap the profit- project, we were interested in profit potential increases. In anability on the account. But, as gauging the overall industry av- effort to more accurately capturewe will demonstrate, increasing erages for both the cost recovery the true cost of selling, we haveyour retention rates has costs period and the average reten- added both service staff andassociated with it as well. And tion period. Using data from value-added staff components.acquisition costs are, if anything, our proprietary Perspectives for Value-added services includeincreasing in this ultra-competi- High Performance database, we such things as loss preventiontive market. Thus the unveiling pulled commercial lines data for engineers and risk managementof cost recovery version 2.0. every agency over the past few consultants who work with the producer and the insured prior to years and were startled by theCost recovery version 2.0 results. Please refer to Chart 2 the account being put to market. on Page 4.In order to better reflect the truecost of acquiring and retain- Cost of Retention In 2007, the average cost recov-ing customers, we made some In the previous article, we ery period was 5.41 years, whiletweaks to the cost recovery for- stressed the importance of in- the average rate of retentionmula. By using data that is read- creasing retention rates, but the was 7.14 years. So on average,ily available to every agency, this formula did not account for the agencies kept accounts on theformula gives a better picture of associated costs. This section books for nearly two years afterthe true cost recovery period. provides a tracking method for they became profitable. costs associated with retain- ing commercial lines business The MarshBerry Letter Page 2 December, 2009
  3. 3. Fast forward to 2009 and we will see that Chart 1 - Cost Recovery Period - Revised Formulathis spread has diminished considerably. Producer ShareOur most recent data shows that the aver- CL Production Payroll - New Business $300,000age cost recovery period is 6.74 years, + CL Selling Expenses - New Business $40,000while the industry average retention rate = CL Production Cost - New Business $340,000is 6.86 years. In effect, this means that as Divided by: New Business CL Comm $ $200,000soon as an account becomes profitable = Producer Share of CL Prod Cost per NB CL Comm $ 1.70for an agency, it walks out the door. Service Staff Share CL Service Payroll - New Business $50,000The reduction in the spread between cost + CL Operating Expenses - New Business $35,000recovery period and the retention rate in = CL Servicing Cost - New Business $85,000years can be attributed to the fact that Divided by: New Business CL Comm $ $200,000growth has been very hard to achieve in = Service Staff Share of CL Prod Cost per NB CL Comm $ 0.43the past few years, and the costs of doing VAS Staff Share CL VAS Payroll - New Business $5,000business have increased. These facts + CL VAS Operating Expenses - New Business $2,000should compel every agency to measure = CL VAS Cost - New Business $7,000its cost recovery periods and determine Divided by: New Business CL Comm $ $200,000how they will decrease them and/or retain = VAS Staff Share of CL Prod Cost per NB CL Comm $ 0.04their customers for longer periods of time. TOTAL COST OF SELLING - CL: 2.16 The Options – Reducing the Cost Re- Producer Sharecovery Period CL Production Payroll - Service $200,000As mentioned above, the options for + CL Selling Expenses - Service $20,000reducing the cost recovery period are = CL Production Cost - Service $220,0000somewhat limited. Reducing payroll for Divided by: CL Comm $ $1,500,000production, service and value-added ser- = Producer Share of CL Retention Cost per CL Comm $ 0.15vice staff is an option, but in the current Service Staff Sharemarket environment, you need the best CL Service Payroll - Service $250,000 + CL Operating Expenses - Service $240,000talent to win and you need to pay the best = CL Servicing Cost - Service $490,000talent. Additionally, large cuts would have Divided by: CL Comm $ $1,500,000a negative impact on agency morale. = Service Staff Share of CL Retention Cost per CL Comm $ 0.33 VAS Staff ShareBecause retaining customers is the key CL VAS Payroll - Service $3,500to account profitability, dramatic cuts in + CL VAS Operating Expenses - Service $5,500the area of cost of retention will serve to = CL VAS Cost - Service $9,000erode retention periods and decrease ac- Divided by: CL Comm $ $1,500,000count profitability. One thing to consider = VAS Staff Share of CL Retention Cost per CL Comm $ 0.01is having producers trade down the bot- TOTAL COST OF RETENTION - CL: 0.48tom 20% of their book to house accountsso they can focus on selling, not servic- Allocated Overheading, small low-margin accounts. Support Payroll - CL $80,000 + Benefits Expense - CL $160,000 = Overhead Expense - CL $240,000Our data shows that the best way to Divided by: CL Comm $ $1,500,000decrease the cost recovery period is to in- = Allocated Overhead per CL Comm $ 0.16crease new business production. In fact, TOTAL ALLOCATED OVERHEAD - CL: 0.16an increase in new business production of2 percentage points has the biggest effect COST RECOVERY PERIOD - YEARSof reducing the cost recovery period than 2.16a similar improvement in any of the other (1-(0.48+0.16)) = 5.99components. Our study showed a two The MarshBerry Letter Page 3 December, 2009
  4. 4. Chart 2 Industry Average Cost Recovery and Retention Periods for Commercial Lines Accounts 2.00 1.50 New Business Dollars 1.00 0.50 0.00 -0.50 -1.00 -1.50 6.74 Years -2.00 1 2 3 4 5 6 7 8 9 10 Years Cumulative Profitability Income from Average Account over a ten-year period (Comm less Svc. Cost)percentage point increase in new ness practice throughout the Summarybusiness production can reduce industry.the cost recovery period by as In these challenging times whenmuch as one year. If managed effectively, value- customers are hard to find and hard added services can engender to keep, knowing your cost recoveryThe Options – Increasing loyalty to your agency and period is essential to the health ofRetention Rates increase the costs to switch your agency. By better understand- to another agency. In these ing what affects your account profit-One of the most effective ways ability, you will be able to make the tough economic times, in-to increase retention is to deliver organizational changes necessary sureds are increasingly scruti-a value-added service platform. to reduce your cost recovery period nizing their policies. Even theWhile this used to be something and increase your retention rates. most loyal clients are willingthat only the most sophisticated to shop their policy if theyagencies employed to differenti- Craig Niess is a Consultant at feel that you are not offeringate themselves in a crowded MarshBerry and can be reached value-added services or not at ormarketplace, it continues to delivering them as promised. 440-392-6584.evolve into a standard busi- The MarshBerry Letter © 2009 Marsh, Berry & Company, Inc. (440) 354-3230 / (800) 426-2774 4420 Sherwin Road / Willoughby, OH 44094