THE MARSHBERRY LETTERVolume XXV, Number 12 December, 2009

The MarshBerry Letter Page 1 December, 2009

Cost Recovery ReduxWhen we wrote the July 2007 is-sue of The MarshBerry Letter on Cost Recovery and Retention, we did so in an economic climate that scarcely resembles the tumultuous business environment that we are now experiencing. At the time that article was written, agencies were driving average organic growth rates in the 4% to 6% range. The influx of would-be agency buyers continued, preserving the seller’s market and buoying the multiples that sellers commanded. Overall, the economy appeared strong as reflected by various economic indicators, including the Dow Jones Industrial Average which crossed the 14,000 point threshold for the first time on July 19, 2007.

Despite those halcyon economic times, we maintained that most agencies were still overlooking an obvious way to bolster their growth numbers: increasing customer re-tention. Our article posited that the key to understanding growth and profitability came from first measur-ing how long it took an account to become profitable (cost recovery period), and then retaining the customer past that break-even threshold. The longer the account was retained into the future, the more profitable it would be for the agency. And, since it is cheaper (and usually more profitable) to keep a current customer than to win a new one, we concluded that

the effort expended in acquiring new business should be matched or exceeded by efforts focused on retaining customers.

In the years since we penned that article, we have witnessed a steep decline in the U.S. econo-my. Government bailouts, failing banks, and sagging consumer confidence describe the new normal. Meanwhile, stagnating spending levels have brought the economy to a virtual standstill and economic growth measures indi-cate that the overall economy has contracted. And while this is bad news for every economic actor, it is especially painful for insurance agents whose economic fortunes march lockstep with the ebb and flow of the overall economy. The overall growth of net written pre-mium in the U.S. has been nega-tive since year-end 2007 and is projected to be -2% for 2009.

This certainly paints a bleak pic-ture for insurance agencies and has spurred us to revisit, re-eval-uate, and retool the cost recovery formula. This new, more robust formula better reflects the reali-ties of doing business in the cur-rent market and accounts for the increased costs of acquiring and retaining new customers. Before we delve into the new formula, we will quickly re-examine the old formula to demonstrate how and why we made the new changes.

Cost recovery version 1.0 - recap

The cost recovery period mea-sures how long it takes an agency to offset the cost of selling and servicing a dollar of new business and recognize a profit. The original cost recovery equation consisted of the following three components:

♦ Acquisition Cost – includes commissions paid to producers as well as selling expenses such as travel & entertainment, advertising, and promotion

♦ Servicing Cost – includes customer service payroll and operating expenses

♦ Account Commission – the agency revenue dollars that will be generated by this piece of business

The original formula is depicted below:

Cost Recovery

Period (Years)

=

Customer Acquisition Cost--------------------------------------(Commission per Customer - Servicing Cost per Customer)

Based on this equation, there are three ways to decrease the cost recovery period:

1. Reduce your Customer Acquisition Cost

2. Increase your Commissions per Customer

3. Reduce your Servicing Cost per Customer

which may be controlled by the agency. As this ratio decreases, the potential profit per customer and total profit should increase. This version includes both ser-vice staff and value-added staff components to account for such things as maintaining value-add-ed service timelines and stew-ardship reports and the requisite communication with the insured.

Allocated Overhead

This provides a tracking method for overhead expenses such as benefits expense and sup-port personnel. Our formula assumes that this stays fixed over the life of the account, but if things change in your agency, please make the necessary adjustment to your formula. See Chart 1 on Page 3.

The Case for Measuring the Cost Recovery Period

When we first undertook this project, we were interested in gauging the overall industry av-erages for both the cost recovery period and the average reten-tion period. Using data from our proprietary Perspectives for High Performance database, we pulled commercial lines data for every agency over the past few years and were startled by the results. Please refer to Chart 2 on Page 4.

In 2007, the average cost recov-ery period was 5.41 years, while the average rate of retention was 7.14 years. So on average, agencies kept accounts on the books for nearly two years after they became profitable.

The MarshBerry Letter Page 2 December, 2009

While all of these are viable op-tions, most are not practicable. First, reducing your customer acquisition cost would work, but most agencies are running lean and most of the fat has already been trimmed away. Secondly, increasing your commissions per customer is dependent on too many factors outside of your control. Thirdly, reducing ser-vicing costs per customer is a strategy replete with pitfalls. If you are sophisticated enough to strip away some of these costs without negatively impacting retention, then it is a plausible solution. However, in today’s market, many customers are now reviewing their policies and trading on the value-added services that are delivered by the agency.

So, based on the fact that most of these components are, in effect, “fixed,” the best course of action is to retain customers long enough to reap the profit-ability on the account. But, as we will demonstrate, increasing your retention rates has costs associated with it as well. And acquisition costs are, if anything, increasing in this ultra-competi-tive market. Thus the unveiling of cost recovery version 2.0.

Cost recovery version 2.0

In order to better reflect the true cost of acquiring and retain-ing customers, we made some tweaks to the cost recovery for-mula. By using data that is read-ily available to every agency, this formula gives a better picture of the true cost recovery period.

The new formula is depicted below:

Cost Recovery

Period (Years)

=

Cost of Selling---------------------------------(1- (Cost of Retention + Allocated Overhead))

As much of the underlying data in the formula has changed, I will briefly describe how each component of the formula is derived below. Please refer to Chart 1 to see how the various formula components fit together. Also, please note this example is based on commercial lines accounts. The formula will work with other lines of business, but some may not have value-added service costs associated with them.

Cost of Selling

This allows the agency to monitor and analyze the cost of producing new commercial lines business. As the cost per com-mission dollar decreases, the profit potential increases. In an effort to more accurately capture the true cost of selling, we have added both service staff and value-added staff components. Value-added services include such things as loss prevention engineers and risk management consultants who work with the producer and the insured prior to the account being put to market.

Cost of Retention

In the previous article, we stressed the importance of in-creasing retention rates, but the formula did not account for the associated costs. This section provides a tracking method for costs associated with retain-ing commercial lines business

The MarshBerry Letter Page 3 December, 2009

Fast forward to 2009 and we will see that this spread has diminished considerably. Our most recent data shows that the aver-age cost recovery period is 6.74 years, while the industry average retention rate is 6.86 years. In effect, this means that as soon as an account becomes profitable for an agency, it walks out the door.

The reduction in the spread between cost recovery period and the retention rate in years can be attributed to the fact that growth has been very hard to achieve in the past few years, and the costs of doing business have increased. These facts should compel every agency to measure its cost recovery periods and determine how they will decrease them and/or retain their customers for longer periods of time.

The Options – Reducing the Cost Re-covery PeriodAs mentioned above, the options for reducing the cost recovery period are somewhat limited. Reducing payroll for production, service and value-added ser-vice staff is an option, but in the current market environment, you need the best talent to win and you need to pay the best talent. Additionally, large cuts would have a negative impact on agency morale.

Because retaining customers is the key to account profitability, dramatic cuts in the area of cost of retention will serve to erode retention periods and decrease ac-count profitability. One thing to consider is having producers trade down the bot-tom 20% of their book to house accounts so they can focus on selling, not servic-ing, small low-margin accounts.

Our data shows that the best way to decrease the cost recovery period is to in-crease new business production. In fact, an increase in new business production of 2 percentage points has the biggest effect of reducing the cost recovery period than a similar improvement in any of the other components. Our study showed a two

Chart 1 - Cost Recovery Period - Revised FormulaProducer Share

CL Production Payroll - New Business $300,000+ CL Selling Expenses - New Business $40,000= CL Production Cost - New Business $340,000

Divided by: New Business CL Comm $ $200,000= Producer Share of CL Prod Cost per NB CL Comm $ 1.70

Service Staff ShareCL Service Payroll - New Business $50,000

+ CL Operating Expenses - New Business $35,000= CL Servicing Cost - New Business $85,000

Divided by: New Business CL Comm $ $200,000= Service Staff Share of CL Prod Cost per NB CL Comm $ 0.43

VAS Staff ShareCL VAS Payroll - New Business $5,000

+ CL VAS Operating Expenses - New Business $2,000= CL VAS Cost - New Business $7,000

Divided by: New Business CL Comm $ $200,000= VAS Staff Share of CL Prod Cost per NB CL Comm $ 0.04

TOTAL COST OF SELLING - CL: 2.16

Producer ShareCL Production Payroll - Service $200,000

+ CL Selling Expenses - Service $20,000= CL Production Cost - Service $220,0000

Divided by: CL Comm $ $1,500,000= Producer Share of CL Retention Cost per CL Comm $ 0.15

Service Staff ShareCL Service Payroll - Service $250,000

+ CL Operating Expenses - Service $240,000= CL Servicing Cost - Service $490,000

Divided by: CL Comm $ $1,500,000= Service Staff Share of CL Retention Cost per CL Comm $ 0.33

VAS Staff ShareCL VAS Payroll - Service $3,500

+ CL VAS Operating Expenses - Service $5,500= CL VAS Cost - Service $9,000

Divided by: CL Comm $ $1,500,000= VAS Staff Share of CL Retention Cost per CL Comm $ 0.01

TOTAL COST OF RETENTION - CL: 0.48

Allocated OverheadSupport Payroll - CL $80,000

+ Benefits Expense - CL $160,000= Overhead Expense - CL $240,000

Divided by: CL Comm $ $1,500,000= Allocated Overhead per CL Comm $ 0.16

TOTAL ALLOCATED OVERHEAD - CL: 0.16

COST RECOVERY PERIOD - YEARS2.16

= 5.99(1-(0.48+0.16))

percentage point increase in new business production can reduce the cost recovery period by as much as one year.

The Options – Increasing Retention Rates

One of the most effective ways to increase retention is to deliver a value-added service platform. While this used to be something that only the most sophisticated agencies employed to differenti-ate themselves in a crowded marketplace, it continues to evolve into a standard busi-

ness practice throughout the industry.

If managed effectively, value-added services can engender loyalty to your agency and increase the costs to switch to another agency. In these tough economic times, in-sureds are increasingly scruti-nizing their policies. Even the most loyal clients are willing to shop their policy if they feel that you are not offering value-added services or not delivering them as promised.

The MarshBerry Letter © 2009Marsh, Berry & Company, Inc.(440) 354-3230 / (800) 426-27744420 Sherwin Road / Willoughby, OH 44094MarshBerry@MarshBerry.comwww.MarshBerry.com

Summary

In these challenging times when customers are hard to find and hard to keep, knowing your cost recovery period is essential to the health of your agency. By better understand-ing what affects your account profit-ability, you will be able to make the organizational changes necessary to reduce your cost recovery period and increase your retention rates.

Craig Niess is a Consultant at MarshBerry and can be reached at Craig@MarshBerry.com or 440-392-6584.

-2.00

1.50

1.00

0.50

0.00

-0.50

-1.00

-1.50

2.00

1 2 3 4 5 6 7 8 9 10

6.74 Years

Cumulative Profitability over a ten-year period

Income from Average Account (Comm less Svc. Cost)

Years

Chart 2Industry Average Cost Recovery and Retention Periods for Commercial Lines Accounts

New

Bus

ines

s D

olla

rs