Are placement service fees an acceptable market practice or little more than a bribe? Ronald Gift Mullins looks at the contribution that such fees make to brokers' income and the pending US legal confrontations

The contingency fees paid by some insurance companies to entice brokers to place the 'appropriate' business with them culminated in New York attorney general Eliot Spitzer suing Marsh Inc, the brokerage unit of Marsh & McLennan Cos (MMC), for illegally steering clients to insurers paying it the highest contingency fees, as well as conspiring with insurers to rig quotes on client programmes. Major insurance companies - ACE, American International Group (AIG), The Hartford and Munich American Risk Partners - are named in the complaint as participants in steering and bid rigging, but are not part of the lawsuit. The suit seeks restitution and punitive damages from Marsh Inc and to bar it from collecting contingent fees, also called placement service agreements (PSAs) and market service agreements.

Responding on 15 October 2004, the day after the lawsuit was filed, MMC announced that Marsh Inc "will immediately suspend its practice of market services agreements with insurance carriers. Today's decision was made in light of the serious allegations and questions that have been raised about this long-standing industry practice."

Jeffrey W Greenberg, chairman and chief executive officer of MMC, said, "We are greatly disturbed by the allegations of wrongdoing. We take them very seriously, and we are conducting a thorough investigation of these allegations. As the facts are being reviewed, we believe it is in the best interest of our clients to suspend MSAs immediately."

AIG said it is cooperating with the investigation and had asked the New York Insurance Department twice since 2002 for advice on placement service agreements.

The attorney general's office also said two executives from an AIG excess insurance unit, American Home Assurance Co, pleaded guilty to criminal fraud charges for their involvement in alleged manipulation of insurance bids. AIG issued a statement saying the company is "saddened" by the two employees' guilty pleas "because we hold ourselves to the highest ethical standards". It was not clear from the attorney general's complaint if the two officers from the AIG affiliate were rogue employees or following company policy.

Further legal actions from the attorney general are expected as he vowed at a press conference: "This investigation is broad and deep and it is disappointing. It demonstrates again the craven disregard for ethics and the law among some of our largest corporations."

The investigations into contingency fees began following a letter in February 2004 from the Washington Legal Foundation, a public interest law and policy group in Washington, DC, to the insurance commissioners of New York and California. The Foundation described the PSAs as "potentially damaging", and said that they encourage "brokers to steer customers to insurers that will profit the broker but not necessarily benefit that customer ... PSAs compromise a broker's duty to the client's best interests by encouraging brokers to refer business only to companies that pay them handsome contingency fees. As a result, customers run the risk of paying more for coverage they do not need, and receiving less in terms of overall policy benefits."

Within months, the little-known contingency fees became the hard focus of state attorneys general, insurance commissioners and risk managers, and spawned lawsuits by advocacy groups.

Subpoenas served

Over the next few months, New York state attorney general Elliot Spitzer issued subpoenas to major brokerages - Marsh & McLennan, Aon, Willis Group Holdings, Arthur J Gallagher and Kaye Insurance Associates; insurance companies - Chubb, Hartford Financial Services, Aetna, CIGNA, UnumProvident Corp and MetLife, and also National Financial Partners Corporation, a diversified financial services firm. These subpoenas requested a number of documents relating to contingent fees. In October 2004, AXIS, a Bermuda-based insurance company, said its US affiliate had been subpoenaed by Mr Spitzer.

Not one to pass up a chance for confrontation with the re/insurance industry, California Insurance Commissioner John Garamendi began an examination of these fees. In addition, Connecticut state attorney general Richard Blumenthal announced his office had begun looking into the issue. Besides the regulatory probes, Marsh, Willis and Aon were named in California lawsuits filed by United Policyholders, a consumer activist group in San Francisco, which said the brokers were defrauding California policyholders by not adequately disclosing contingent fee agreements. In addition, class action certification was granted by a Illinois circuit court judge to policyholders suing Aon for engaging in "unfair and fraudulent business conduct" by accepting commissions from insurers based on the profitability, growth and volume of business placed with individual companies. A similar lawsuit is reported to be pending in the Illinois Cook county circuit court against broker Arthur J Gallagher. The suits ask for monetary relief and a requirement that brokers more openly disclose the extent of contingent fees.

The bottom line

To benefit from contingency fees, the broker has to meet certain premium volume levels and sometimes loss margins set by individual insurance companies.

The fees are paid by insurers periodically following an accounting of the business the broker has brought to the insurance company. Since the fees are earned with little material expense, they contribute significantly to a broker's bottom line. These fees may also be reflected in individual employee bonuses.

There are no reliable statistics as to how much these contingency fees add to a brokers' annual revenue or profits. Some estimates put the figure as high as 20% of revenue, others have it from 2% to 5%. Advisen Ltd, an insurance research and consultancy firm in New York, estimates Marsh's 2003 income from contingent commissions at $306m, Aon's at $208m and Willis' at $36m.

A research report by JPMorgan in January 2004 estimated the brokers' average contingency commission of revenue in 2002 at 4.3%, with a range of 2.1% to 6.0%. As a per cent of earnings, however, the average surged to 11.0% with a range of 8.3% to 20.0%.

The complaint from Mr Spitzer said Marsh received $800m in contingency fees in 2003, which is 8.5% of its $9.38bn in brokerage revenues and more than half of the $1.5bn in net income that MMC reported that year.

The examination of contingency fees was visited earlier in a 25 August 1998 circular letter from the New York Insurance Department to all licensed brokers and property/casualty insurers. The letter said an allegation had been received about "undisclosed compensation, in addition to commissions", being paid to brokers by insurers as additional compensation for the placing of business "without such information being furnished to insureds ... It is the position of the Department that the undisclosed receipt of additional compensation is sufficient to create the perception that brokers are conflicted in their loyalties and that such conduct may constitute a violation of Section 2110 as a dishonest or untrustworthy practice". The department said this payment of additional commissions "appears to warrant scrutiny" but apparently let scrutiny tarry. Six years later, the practice is receiving intense and broad interrogation and exposure.

No complaints

The Council of Insurance Agents & Brokers (CIAB), a trade group funded by agents and brokers, located in Washington, DC, issued a statement: "PSAs are not linked to placement of a specific policy but are paid to brokers by carriers based on their overall relationship and the services provided by the broker for the carrier. It is the industry standard to disclose these arrangements to commercial customers." The CIAB said it has been on record for nearly six years as favouring disclosure of PSAs.

Commercial property/casualty customers are sophisticated buyers of insurance, the statement noted and "the Council has confidence that they are aware of these arrangements and understand their purpose." The CIAB said it was not aware of any customer complaints relating to the existence or use of PSAs.

A survey by the Risk and Insurance Management Society Inc (RIMS) revealed its 8,000 members were in favour of brokers reporting the commissions they are getting paid by insurers. A statement from RIMS said: "RIMS strongly supports the position that broker compensation and placement agreements should be transparent, with all sources of compensation, direct and indirect, disclosed without client request. Failure to disclose such arrangements runs counter to the spirit of partnership that risk managers seek to achieve with their brokers, vendors, and insurers." Most risk managers are responsible for buying insurance for their corporation.

The brokers and insurance companies have disclosed little about the official inquiries or lawsuits, other than announcing they have been subpoenaed and that they do not discuss on-going litigation. The attorneys general also remain close-mouthed about their actions.

Marsh & McLennan senior advisor John Sinnott gave a general endorsement of contingency fees as the keynote speaker at an insurance forum in Bermuda in June 2004. He said he saw no conflict in brokers being compensated by the insurers with which they place business.

In September 2004, Marsh launched a new internet site
Aon Corp, one of the first brokers to receive a subpoena from the New York attorney general, in a statement said: "Such compensation agreements between insurance companies and brokers are a longstanding and common practice within the insurance industry. Aon discloses such arrangements in fee agreements with clients, invoices to clients, and its web site." Its web site has a dense paragraph entitled "Fee/Commission Disclosure", whose prime aim seems to be to obfuscate any understanding of its policy on contingency fees.

Willis Group said that brokers have had such agreements with insurance companies for many years to compensate the brokers for services they provide to the carriers. It said a web site devoted to this issue was being developed and would be operational in mid October. In reference to the lawsuits in California, Willis declared: "We intend to defend ourselves against these allegations vigorously". A Willis spokesperson said that the complaint, which states that a "significant portion" of the brokerage's $665m first-quarter revenues were derived from California business, was in error.

"Less than 3% of Willis' total global revenues emanate from California, so only a very small portion of that can be attributed to contingent fees," the spokesperson reported.

"Win-win-win"

"Properly structured contingent commissions produce a 'win-win-win' scenario for the broker, the insurer and the insurance buyer," said Claire Wilkinson, director - global issues, Insurance Information Institute, a New York City-based trade group funded by (re)insurers and brokers. She said the commissions generate additional income from the insurer and the insurer knows that the broker is motivated to place profitable business with it.

"And, the buyer of insurance that performs well under the terms of an insurance contract ... is likely to be quite attractive to the insurer," she continued, "and enjoy favourable pricing, terms and conditions."

Andy Barile, Andrew Barile Consulting Corp, Inc, California, thinks broker's fees must be revealed to the insurance buyer, just like the reinsurance brokerage commission is now known to the buyer of reinsurance. "Buyers of insurance must manage the process better and be aware of the broker's inducements to do business with a carrier," he said. "Risk managers must be better informed as the broker has its own agenda/profit margins. Carrier selection is also becoming more limited with the disappearance of P/C insurers such as The Home, Continental, Reliance, Kemper, INA and Aetna."

Studying the effect contingency fees have on placement of insurance business has been almost impossible due to the proprietary nature of the data.

With the power of the subpoena as exercised by attorneys general, the extent of the contingency fees will eventually become more transparent.

One of the few serious studies of contingency fees has been published by Jeffrey M Wilder, PhD, who researched and wrote his doctoral dissertation at the Massachusetts Institute of Technology on contingency fees in commercial insurance. He used data on sales made by individual insurance agents working for a privately-held insurance agency in Arizona from 1994 through 2000.

Fees distort behaviour

He identified two types of agents working at the agency: agents with a share of ownership (equity) in the agency and those without equity.

He was able to identify the effects of contingency fees, which reward the agency for attaining sales and profitability targets with an insurer, because only equity agents have incentives to respond to this compensation.

Using non-equity agents as a control group, he found evidence that contingency fees distort behaviour on several fronts. "Equity agents are more likely than non-equity agents to place new coverage with insurers offering contingency fees," he said. "Moreover, upon renewal, they are less inclined to move coverage from insurers offering contingency fees to insurers that pay only commissions. In addition, equity agents are found to be more likely than non-equity agents to write coverage with contingency fee insurers with greater sales volume and more profitable sales, both of which increase the contingency fee paid to the agency." The paper can be found at www.ssrn.com
Mr Wilder is now an economist with the US Department of Justice - antitrust division, Washington, DC.

Lewis Hassett, an attorney specialising in brokerage insurance and reinsurance matters, Morris, Manning & Martin, LLP, Atlanta, Georgia, does not think that courts, attorneys general or even insurance commissioners are equipped to handle "meaningful disclosure" of contingency fees. Brokers, like attorneys, accountants, actuaries, consultants, physicians, are professionals. "Professionals simply have a duty to give advice divorced from their own financial interests," he maintains. "The professional who puts his or her interests first will not be in business for long, particularly in the commercial context." Rather he reasons that if any action concerning contingency fees needs to be taken at all, it should be addressed through "a deliberate legislative or quasi-legislative process, or leave it alone".

Not "unduly" influencing

William Graham, CEO, The Graham Company, a broker in Philadelphia, does not believe brokers' contingent fees to be unfair, unjust, illegal or unethical, and considers that brokers should not be ordered to stop the practice. "The Graham Company does use these fees," he said. "They are a part of doing business in the insurance industry. Although contingent fees only represent 3% to 4% of our gross revenue, we use 100% of this money to fund 30% to 40% of our total bill for education, training, and quality assurance."

"I don't believe that contingent fees 'unduly' influence the placement of coverage," he said. "However, if two companies have identical pricing, identical coverage, identical service, and one pays profit sharing and the other doesn't, I believe a broker would place business with the company paying the contingent fees."

Mr Graham mentioned that American International Group is the only major insurance company that he knows of that doesn't pay some form of contingency fee. "Interestingly, we do 25% to 30% of our total written premiums with AIG, and AIG has never paid us a nickel of contingent income," he said.

"We use AIG frequently because they offer coverage in areas where other companies would not be willing to write coverage, they have excellent claims service, they have a very good loss control service, and they do a lot of other good things. If contingent fees influenced our thinking at all, we certainly wouldn't be doing 25% to 30% of our business with AIG."

Apparently, AIG has been paying contingency fees, as 'Hank' Greenberg, CEO of AIG, revealed in a conference call a day after the lawsuit against Marsh Inc that AIG would probably stop making incentive-type payments to brokers.

With the heightened attention on contingency fees from the New York attorney general, insurance commissioners, consumer groups, risk managers and lawsuits, this revenue-producing mechanism may be disallowed, or undergo a transformation sometime in the future. But if the outcome means a defeat for brokers, there seems little reason to worry. With their agility and resourcefulness, they will soon create a shrewd scheme to replace the lost income.