Question

Life Insurance salespeople are frequently paid a combination of salary and commission (i.e., a percentage of the value of the policies they sell). Explain how this compensation scheme is the solution to a principal-agent problem. In your answer, be sure to discuss the objectives and tradeoffs faced by both the principal and agent as it relates to this specific example (the sale of life insurance).

Answer 1

Principal Agent problem occurs when goals of the principal (Company’s higher management officials) and the actions of the agents (Sales People) are not aligned. This problem occurs because principal has an expectation that the agent will perform his duties with the best interests of the principal in mind, but this is not always true as agents tend to work, to increase their own self being. Problem arises because of asymmetric information. In this case the sales people are dealing with the client on day to day basis, thus have more information than the higher management. Management cannot always ensure that agent is acting in the principal’s best interest. Thus leading to conflict of interest and unnecessary hindrance in the work flow. It can be solved by agency cost either by hiring an immediate reviewer, keeping a close eye by management or benefiting the agent from the principal’s interest. The first two involves extra cost and time that not necessary solves the problem as higher management doesn’t always have time for micromanagement or immediate reviewer tend to align his interests with the agents. The best solution in this case is providing commission ( i.e percentage of the value of policies) along with the fixed salary. This will serve agents’ self-interest of earning more money by selling more policies. This will give them pride and sense of authority to do more work, fulfilling their job objectives. While the principal objective is to have more sales thus more profits, this aligns with the interests of agents. Principal takes his decisions by taking it effect on the whole company while agent takes decision specific to the situation. Even after aligning the same interest, management has to keep an eye by time to time review so that agents doesn’t act rash to sell policies unethically or illegally.