Risk Management Reports

June, 2004
Volume 31, No. 6
Fatalism and Conflicts of Interest

I’m becoming a fatalist in my old age. Late in April several readers asked for my thoughts on the recent disclosure that the Attorneys General in New York and Connecticut and the Insurance Commissioner in California are investigating alleged conflicts of interest surrounding contingency commissions received by several major insurance brokerage firms. I suppose I should have replied, like the good Inspector in Casablanca, “I’m shocked, shocked!” These revelations, however, are old and stale: several of us have railed against the patent misrepresentations and egregious interest conflicts inherent in the global “system” of insurance sales for more than thirty years, to little effect. My cynical comment is that matters won’t change this time around.

The problem lies in how an insurance broker presents its services to the public. It claims, for example, that it is the “representative” of its client, offering experience, judgment and expertise in selecting and placing the most appropriate insurance for that client. Yet who pays the broker? The insurance company awards the broker a commission, one that is negotiated almost entirely by the broker and the company. Does this distort the placement process, when one company offers a commission higher than another, or when one (a mutual) offers no commission? No, say the brokers: we are entirely and completely objective! Then consider what the Attorneys General are studying: most brokers also arrange additional commissions, euphemistically known as “placement service agreements,” should a piece of business be especially coveted by a company or if an entire book of business placed by that broker delivers a profit in excess of agree margins. Do these “contingency commissions” affect placement decisions? “Of course not,” protest the brokers. They are merely an “age-old and common practice” (from an Aon spokesman – New York Times), “a long-standing, common industry practice” (the CEO of Marsh – also New York Times) or a “reward system when the job is done right” (a letter to Business Insurance by the CEO of a New York brokerage firm). If we’ve been doing it for years, how can it be unethical or even illegal?

But the list of under-the-counter payments hardly ends with the upfront and contingency commissions. Brokers conventionally collect the premiums due insurers and may hold these fiduciary funds for from several days to as long as several months, earning interest for the broker’s account, not for the insured or insurer. If they hold a strong negotiating position, they can demand the right to place any facultative reinsurance for a particular client’s insurance program, thus generating more commissions. Some brokers receive lowinterest loans from insurers. One major insurer took a major stock position in a publiclyheld broker. And brokers have invested in the creation of new insurers with which they then place business.

The problem today isn´t that most buyers don´t know what is going on. They know but they don´t care. "Our members appreciate what the broker is doing. They don´t care where the payments are coming from as long as they are disclosed," protested the executive director of the Risk & Insurance Management Society (RIMS), the representative organization of insurance buyers, as quoted in the New York Times. Are these buyers therefore complicit in supporting this system of conflicts by not raising the hue and cry for change? Yes, even though RIMS some five years ago gently slapped the brokers´ wrists and asked them, please, to disclose these arrangements when asked!

Admittedly, the "system" that countenances these manifest conflicts has been working well for more than 150 years, so why change it? Most insurance brokers that I know display a remarkable level of objectivity, given these multiple payments generated from their vendors, not their clients. Is there really any need for change now? Yes, because these payments add to the cost of insurance. Some, perhaps, go to valuable work on behalf of either the insurance company or the insured, but financial analysts allege that most of these extra payments drop directly to the brokers’ bottom lines. Another roadblock is the size and clout of the few major brokerage firms: a buyer trying to attack this system may find his organization without access to needed insurance. My hope is that, just possibly, the change in current attitudes toward conflicts of interest may stimulate some systemic change.

In 1971, in Best’s Review, I wrote the following words: “Many of the national brokerage houses operate as both brokers and agents, depending on the circumstances. Under certain agreements, they have negotiated additional contingency commission arrangements in which they will share with the insurance company the ‘profit,’ if any, accruing from a favorable overall loss ratio. If a broker is representing himself as serving his client, there is no moral or economic reason for him to collect a contingency commission from an insurance company. The risk manager can insist that his broker eliminate all contingency commission arrangements with the insurance companies with which he places business.”

I also suggested, away back in 1971, that insureds should pay their brokers fees for the work they do and remit premiums directly to insurers. Thirteen years later, in 1984, I tried once more to stimulate change. I published a picture of the grin of the Cheshire Cat, each tooth representing a broker’s source of income, most from insurers. In 1998, I again rose to the bait. In “Yogi Berra, All Over Again?” August 1998, I argued that simple disclosure and transparency could and would not change a system corrupted by conflicts. The critical issue is that conventional insurance carries an overhead cost of from 20% to as high as 40% of premiums, the bulk of which are payments to those who “produce” and sell the insurance! That alone should indicate to buyers that the system is not working! When less than 60% of premiums are allocated to the payment of losses, it is no wonder that financial officers look at other risk financing options.

Times have changed. Now stockbrokers are guilty of unethical behavior in touting the stocks of companies that reward their firms with other fees and commissions. Mutual funds are guilty of unethical behavior for permitting favored investors to practice market timing. So why aren’t insurance brokers equally guilty of unethical behavior for accepting extra payments from insurance companies, disclosed or not? Will the phrase “independent broker” join “independent agent” as an oxymoron as hilarious as “airline food?” Do not these additional payments create the perception that the buyer’s interests are not paramount to a broker?

These system participants, buyers, brokers and insurers alike, have too long tolerated a system that creaks with conflicts, anachronisms, and inefficiencies. I don’t see anything “illegal” in these machinations, other than, perhaps, false advertising, but isn’t it time we cleaned up the act? Today, financial services industries are forced to become more open and transparent. Even a perception of conflict of interest is not tolerated. So perhaps Eliot Spitzer of New York, Richard Blumenthal of Connecticut and John Garamendi of California will be the catalysts for a long-overdue change, one that has clients paying brokers directly and solely, buyers remitting premiums directly to insurers, and expenses dropping as a result. Is this too much to hope for? Probably! My fatalism caught the persistent grin of that Cheshire Cat. I hope I won’t be echoing these same comments ten years from now.

If a risk manager desires a relationship of utmost good faith with an advisory organization, then the compensation paid by the client should be only in the form of a mutually agreeable fee. No other forms of remuneration, including contingency and reinsurance commissions, are acceptable.

Felix Kloman, "Yogi Berra, All Over Again?" , Risk Management Reports, August, 1998

Copyright 2004, by H. Felix Kloman and Seawrack Press, Inc.

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