Bruce Ballentine of Moody’s on new agreements between brokers and US regulators.

The world’s three largest insurance brokers - Marsh, Aon and Willis - announced last week that they have entered into amended and restated agreements with state regulators regarding brokerage compensation practices and related disclosure requirements, writes Bruce Ballentine, an analyst at Moody’s.

Among other changes, the top brokers may once again accept contingent commissions from insurance carriers, a common practice among smaller brokers, but one that was prohibited for the top brokers over the past five years. The new equal treatment is credit-positive for the top brokers, opening the door to incremental revenues (although Willis says that it will continue to forgo contingents) and facilitating acquisitions of smaller brokers that already accept contingents. Moreover, the amended agreements indicate that the top brokers have achieved the business reforms called for in their regulatory settlements/agreements of 2005.

Insurance brokerage compensation and disclosure practices became a hot topic because of a series of regulatory investigations spearheaded by the New York Attorney General in 2004-2005. Regulators alleged that certain brokers were engaged in improper and anti-competitive business practices (such as bid-rigging and tying) and that contingent commissions, where commission levels are based on premium volumes placed with insurance carriers, can create improper incentives for brokers to steer business to such carriers. In early 2005, the top three brokers entered into agreements with regulators to eliminate contingent commissions, reimburse certain clients and adopt other business reforms and controls.

The investigations and agreements of five years ago led to significant business reforms among the top brokers, including increased transparency regarding compensation arrangements and enhanced internal training and compliance programs. These reforms paved the way for the amended agreements announced last week. The simultaneous announcements were triggered by a new compensation disclosure rule (Regulation 194) adopted by the New York State Insurance Department as of 10 February 2010. This rule applies to all brokers active in New York, including the top three. While allowing for contingent commissions, the new rule calls for brokers to disclose general compensation information to virtually all insurance purchasers and to disclose more specific information upon request by the purchaser.

One other leading broker caught up in the regulatory investigations of five years ago was Arthur J. Gallagher & Co. In 2005, Gallagher entered into settlement agreements with Illinois regulators that imposed similar restrictions to those in the original New York agreements, including a prohibition of contingent commissions. The Gallagher agreements were amended last year, permitting Gallagher to accept retail contingent commissions across all lines of business starting in October 2009.

In connection with last week’s announcements, Willis reiterated its refusal to accept contingent commissions, believing that this approach is in the best interest of retail clients. The top three brokers have all made comments about the importance of serving clients’ interests and informing clients about compensation arrangements, but Marsh and Aon do seem open to the possibility of accepting contingent commissions. For Marsh and Aon, the acceptance of such commissions could boost revenues somewhat and could facilitate acquisitions of smaller brokers that also accept contingents. Still, we expect that contingents will remain a modest component of revenues for the top brokers—well below the levels of 2004 and prior years—given the firms’ increased awareness of potential conflicts of interest and the heightened scrutiny on the part of clients and regulators.