“I think the concept of contingent commissions is dead in the water and agents, to survive, will have re-define their model for compensation.”
—Steven J. Dreyer
Managing Director
Standard & Poor’s
SPECIAL REPORT
AGENTS BEING SWEPT INTO THE SCANDAL
Contingent commissions may very well be a casualty of the investigation
By Phil Zinkewicz
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“I think the concept of contingent commissions is dead in the water and agents, to survive, will have re-define their model for compensation.” —Steven J. Dreyer |
Some years ago, a young journalism trainee on a New York daily newspaper, anxious to move ahead, asked her editor if she could cover a particular panel discussion at an insurance industry annual meeting taking place in Manhattan. The editor felt that the young reporter was not yet ready for such an assignment, but she persisted and finally he agreed, but on one condition. “Cover the panel discussion, then come back and report on what they said,” ordered the editor. “But, if the audience is invited to ask questions, don’t get up and ask anything. Just listen to what others ask and make notes.” The young reporter promised.
When the young reporter returned, she was visibly upset. Her editor asked her what was wrong. “Well,” she answered, “the panel discussion was on the soft insurance market. The insurers on the panel all agreed that excessive competition in the marketplace had driven rates too low for them to make a profit. I know you said not to ask a question, but I couldn’t help myself. I got up, went to the microphone and asked why, if they all agreed rates were too low, didn’t they get together and agree on the proper prices to charge?” Rolling his eyes to the ceiling, the editor asked what happened next, knowing all too well what the answer would be. “The audience began to laugh,” she said. “Small titters at first, but it grew until the entire ballroom was in hysterics.”
Obviously, in her haste to demonstrate her newfound self-importance, this young trainee had forgotten for the moment that there were such things as antitrust laws and that price fixing was illegal. A funny story at the time, albeit not for the embarrassed editor.
However, probably very few in the insurance industry would find that story funny today.
The fear and panic that engulfed the entire insurance industry in October when New York Attorney General Eliot Spitzer filed a lawsuit against Marsh & McLennan alleging price-fixing in its business dealings with corporate insurance clients is not going to go away any time soon. Also named in the lawsuit as participants in the alleged price-fixing activities were American International Group, the Bermuda-based ACE Ltd. and The Hartford—industry giants all. In announcing the lawsuit, Spitzer promised that more brokers and insurers would be dragged into his price-fixing scenario, which he called bid-rigging. Basically, Spitzer charged that employees at Marsh would take a corporate account to a “favored” insurer and get an insurance quote. Then, they would go to another insurer and intentionally ask for a quote that was higher than that being offered by the favored insurer to assure that the favored insurer would get the business, with the promise that they would return the favor in the future, according to Spitzer. This would make the client believe that they were enjoying a competitive bid when, in fact, the cost of the coverage had been pre-determined.
Immediately following these allegations, hysteria mounted and industry uncertainty prevailed. Four employees of American Home, a subsidiary of AIG, resigned and pled guilty to “misdemeanors” with the promise that they would become witnesses for Spitzer in the future. Some employees at Marsh were ousted, including the head of its brokerage unit; then Marsh CEO Jeffrey W. Greenberg resigned.
Insurance stock prices dropped and Marsh & McLennan Companies itself suffered a one-day stock decline of 25%. Speculation began to grow that if Spitzer was able to prove his price-fixing allegations, it would be the end of the insurance industry’s long-cherished McCarran-Ferguson antitrust exemption, limited though it is. But allegations of price-fixing were only part of the worries that were facing the insurance brokerage industry.
According to Spitzer, in addition to the price-fixing scheme, another alleged broker-insurer abuse was the industry’s contingent commission system, a long-held tradition of insurers and brokers, where insurers paid brokers a special commission based on either volume and/or profitability of the brokers’ book of business.
It is important to make a clear distinction between bid-rigging and contingent commissions, according to Standard & Poor’s, one of the rating organizations that is keeping a close eye on the matter. Said Thomas S. Upton, property/casualty ratings team leader at S&P: “It is possible that our current review will reveal that these issues—contingent commissions and bid-rigging—were indeed linked, however loosely, in the operations of some of the affected companies. But, in the first instance, it is essential that they be recognized as distinct issues with entirely different implications.”
Upton pointed out that contingent commissions is a practice that has been criticized as compromising a broker’s obligation to deliver the best value in insurance to the customer. However, it is not illegal, as is bid-rigging, says Upton. “Indeed, it is well established in insurance broking as a means of rewarding brokers for the quality—and not just the quantity—of the business they bring in. This practice is also known as a placement service agreement (PSA) or market service agreement (MSA).”
Nevertheless, in the face of the allegations in Spitzer’s complaint regarding contingent commissions, Marsh announced shortly after Spitzer’s lawsuit was filed that that it would cease this practice with immediate effect. Willis Group Holdings Ltd. announced that it was abolishing the practice, as did AIG and ACE. Upton said that the impact on brokerages could be greater than expected because, according to information that some brokerages disclosed in late October, contingent commissions are more of their business than they had revealed previously. Marsh reported that contingent commissions contributed $845 million in cash income annually. Willis estimated its 2004 global MSAs at $160 million, $35 million of which the company said was related to North American revenue.
“In an extreme scenario, the loss of contingent commissions could reduce brokerages’ cash flow and hurt the credit ratings on these companies,” said Upton. “If contingent commissions were suspended, this could result in a material decline in the cash flow of insurance brokerages in the short run, and that will be a key driver in any rating adjustments. But we believe that insurers, for the most part, will not be seriously hurt by the contingent commissions issue.”
The question is: Where do the smaller independent agents fit into this morass of developments? Spitzer’s initial investigation involved the largest broker in the world, Marsh. The companies he named were also among the giant players. But the concept of contingent commissions reaches from the top down to the Main Street agents. These smaller agents have, for years, depended upon contingent commissions to keep afloat when their companies arbitrarily decided to cut agents’ upfront commissions. Now, because of Spitzer’s investigation, the concept has come into question and there are speculations that contingent commissions may become a thing of the past.
S&P Managing Director Steven J. Dreyer said that, in Spitzer’s initial announcement, the attorney general was only referring to the brokers’ role in contingent commissions. “But then, when California’s Garamendi announced his own investigation into the contingent commissions concept, he made no distinction between brokers and agents, and he said he was investigating the concept right down into the personal lines area,” according to Dreyer. “So agents immediately began being swept up into the entire question of compensation within the insurance industry. Now agents will be asked to defend why they should be entitled to contingent commissions. I think the concept of contingent commissions is dead in the water and agents, to survive, will have re-define their model for compensation.”
The concept of contingent compensation may indeed be on the way out as Dreyer suggests. With Marsh, Willis, AIG and ACE no longer working on a contingent commissions basis, can the smaller agent hope to defend it?
“I think that agents and brokers are going to have to come face-to-face with the notion that buyers of insurance will now be spending a lot more time attempting to understand how everybody is being compensated in the insurance transaction,” said Andy Barile, president of the Rancho, Santa Fe-based Andrew Edwards Consulting. “And, I think buyers will be a lot more skeptical about how the compensation system works.”
David Wood, partner of Wood & Bender LLP, one of the nation’s leading firms in the fast-growing legal specialty area of insurance policy enforcement, said that the contingent commission system sends the wrong message to clients. “Basically, the agent or broker is saying to the client, ‘I have a financial interest in taking you to a carrier that pays me to bring in business.’ So then, the client has to ask, ‘Is my agent or broker taking me to the right carrier for me?’ That’s a question that wouldn’t be asked if the contingent commission system didn’t exist.”
Wood emphasized that the contingent commission system is really a problem that has been brought on by carriers. “Carriers have always dangled the contingent commission in front of the agent and broker to get the best business. Look at Marsh. By its own admission, its contingent commissions reached $845 million. That’s a lot of money, and difficult for brokers to resist.”
Difficult indeed, and for the smaller broker, almost a matter of survival. At press time, most of the independent agent and broker representatives were holding back on talking to the press on this issue. The Independent Insurance Agents & Brokers of America (IIABA) issued a canned statement, saying that the association decried bid-rigging and called for those involved in the matter to be called to justice. However, the IIABA noted that “legal sales incentives” should not be impeded, meaning that the contingent commissions concept should be upheld. Yet, by press time, the IIABA had not come up with someone at the association to be interviewed on the subject. The National Association of Professional Insurance agents (PIA) refused to provide a spokesperson on contingent commissions before press time. It too issued a canned statement saying that PIA will continue to stand behind and defend legal compensation agreements, including profit-sharing between independent agents and their appointed carriers.” The Council of Insurance Agents and Brokers Association (CIAB) refused to speak with Rough Notes at all and didn’t have even a canned statement.
Perhaps the reluctance on the part of these associations to discuss the contingent commission system as it applies to agents and brokers is due to the fact that they see the concept as a disappearing method of compensation. Wood, Barile and Dreyer all said that agents and brokers may have to look to a new model of producer compensation—one that is more open and much more transparent that contingent commissions.
The author
Phil Zinkewicz is an insurance journalist with some 25 years’ experience covering the international insurance and reinsurance arenas. He was the insurance editor of the Journal of Commerce for a number of years, handling all their domestic and international supplements. In addition, he regularly writes for a number of London publications.