Commission Controversy Calling for Clarity on Broker Compensation

Money can get in the way of all types of relationships. And the subject of money – specifically, compensation agreements between insurers and brokers – has been front and center in recent negotiations between larger insurance brokerages and buyers. In some instances, this process has become adversarial, entering the legal sphere through several class action lawsuits filed in U.S. courts, most notably in separate actions against Aon Corp, Marsh & McLennan Cos. and Willis Group Holdings.

In other cases, groups like the Risk and Insurance Management Society (RIMS) have carefully set out their position, not overtly disagreeing with the practice of various compensation agreements between insurers and brokers, but insisting on transparency and improved disclosure. Concern about compensation agreements is certainly not a new issue in the insurance and risk management sectors. Arrangements such as contingent profit commissions have been around for at least the last 50 years. In 1999, RIMS issued a policy statement that held contingent commissions were acceptable – with full disclosure. However, the issue has taken on a timely spin because of several key developments.

Last April, several U.S. state officials announced investigations into compensation agreements that exist between insurance brokers and companies. New York Attorney General Eliot Spitzer, California Insurance Commissioner John Garamendi, and regulators in Connecticut are all currently looking into fee arrangements, alternatively known as broker contingent agreements, placement service or market service agreements. In New York, Marsh, Aon, Willis, Arthur J. Gallagher and Hub International subsidiary Kaye Insurance Associates have received subpoenas, in addition to several large insurance companies, such as Chubb.

Marc Violette, a spokesman for the New York Attorney General’s Office, says, “we have a direct interest in this subject and the investigation is ongoing. We plan to make an announcement by the end of October.” The stakes were raised in July when a state court in Chicago granted class-action status to a lawsuit originally filed in 1999 against Aon Corp. Two Aon clients allege that the broker “devised, implemented, supervised and enforced” a scheme to conceal commission from its clients. Aon said in a statement that it will appeal the lawsuit, which it believes is “completely without merit”. In August, a group called “United Policyholders” filed lawsuits in California against Marsh & McLenann Cos. and Willis Group Holdings Ltd. related to special commissions. The policyholder-rights organization is represented by several law firms, including class-action giant Milberg Weiss Bershad & Schulman LLP.

FULL DISCLOSURE

In late August this year, RIMS issued a revised policy statement on industry compensation and placement practices. In particular, the risk organization broadened its definition of “compensation agreements” from contingent commission to include “fees related to the broker’s overall book of business, as well as those fees related to specific offices, to individual primary and excess coverage, and to reinsurance placements.” RIMS now holds that “broker compensation and placement agreements should be transparent, with all sources of compensation, direct and indirect, disclosed without client request.”

The risk association updated its position statement because its members were increasingly vocal on the subject through online discussion groups and other arenas, according to RIMS president Nancy Chambers. “We did this to provide information to our members and allow them to make the best decision for their individual situation,” Chambers says. “We have a diverse membership; some are very knowledgeable about compensation agreements, while others don’t know as much about them.”

Susan Meltzer, a former president of RIMS and assistant vice president of insurance and risk management at Sun Life Financial, says “what we did in 1999 with the original policy statement was really dip our toes in the water. I think the revised statement is stronger, especially in expanding compensation agreements and insisting on full disclosure. The one area that still puzzles me is why risk managers aren’t more aggressively demanding full disclosure.”

NICE MARGIN

For their part, major brokers have stated that they are fully cooperating with any state investigations, but generally defend contingent agreements as a “long standing and common practice within the insurance industry,” according to an April 23 statement from Willis (Willis and Marsh both declined to comment specifically for this article).

David Pegues, executive vice president with Aon Reed Stenhouse Inc., says, “there is a vocal group in the risk management community who obviously has concerns about contingent commissions, there are others who seem indifferent to it. It is an issue that flares up. About ten years ago, it was prominent, now it has become an issue again.”

“I accept contingent commissions as a reality of the marketplace, but the question immediately follows, what then is the big problem with brokers issuing full disclosure?” asks John Rislahti, director of insurance and risk management for the government of Manitoba and co-chair of the 2004 Canadian RIMS Conference in Winnipeg, where broker commissions will be one of the topics in a plenary session. “Why don’t they put it out in the open?”

In a January 2004 report, J.P Morgan estimated that contingent commissions accounted for over 5% of brokerage revenues and nearly 20% of earnings year-to-date for publicly traded U.S. brokers. It also estimated Marsh’s 2003 income from contingent commissions at $306 million, Aon’s at $208 million and Willis’ at $36 million. Hub International reported contingent commissions and volume overrides of approximately 6.5% of revenue in 2003, or $18.5 million (all figures U.S).

DIFFERENT AGREEMENTS

While there is a great deal of activity around brokerage compensation agreements in the U.S., what about Canada? With the strong influence of foreign carriers in the domestic property and casualty insurance marketplace, several sources say there are nearly identical kinds of contingent arrangements in Canada. “Because our market is heavily influenced by U.S. and Europe, you see similar kinds of compensation structures for brokers here,” says Pegues. “It is a standard practice in our industry and has been for at least the last 50 years,” he adds.

It is important to define the terms associated with compensation agreements. There is a spectrum of financial arrangements with insurance companies that reward brokers according to various criteria, such as profitability, volume of business and loss experience. There is more emphasis in Canada on terms like “contingent profit commission” in which insurance companies, on an annual or semi-annual basis, share profit with brokers based on the underwriting profitability of a book of business. This seems less of an issue because brokers cannot predict or control exactly how much profit an insurance company will derive from their book.

In fact, the U.S.-based Insurance Information Institute (III) says “properly structured contingent commissions produce a ‘win-win-win’ scenario for the broker, the insurer and the insurance buyer…The broker generates additional income from the insurer. 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 enjoy…favorable pricing, terms and conditions.”

Other terms for broker compensation, such as market service agreements (MSAs) or placement service agreements (PSAs) are not as familiar in Canada. However, these are similar in nature to “market” or “volume” overrides, a long-standing practice for insurance companies in Canada to pay commission to brokers for moving a book of business. Overrides were especially common in the soft insurance market of the late 1990s.

CONFLICTING INTERESTS

The Washington Legal Foundation (WLF), a non-profit law and policy center that prompted the state inves
tigations in New York and California with a news release last February, singled out PSAs, or overrides, as a particularly “troubling trend” in the insurance industry. “Insurance brokers are paid to advocate for their customers, not themselves,” said Daniel Popeo, WLF chairman and general counsel.

Yet another compensation-related arrangement the WLF calls into question is “leveraging” or “tying” selling. According to the WLF, “this practice coerces insurance companies into handing over their reinsurance needs in exchange for future referral for the primary insurance business.” This practice could not be verified in Canada.

While at least some of these compensation agreements exist in Canada, they are not an immediate concern of provincial regulators. Grant Swanson, executive director of the licensing and market conduct division at the Financial Services Commission of Ontario (FSCO), says there are no plans to investigate insurance company and broker commission arrangements. He points to a FSCO consultation paper released last spring that, among other things, calls for a specific conflict of interest standard for insurance agents modeled after the standard for lawyers. The amendment, if adopted, would apply mainly to life insurance and general insurance agents.

The Registered Insurance Brokers of Ontario (RIBO) is the self-regulating body for independent p&c brokers in Ontario. The only part of its regulations that deals with disclosure of compensation relates to situations where brokers charge both fees and commission, says chief executive officer Jeff Bear. In these cases, brokers must fully disclose to buyers the commission, fee and complete remuneration. Bear adds there is nothing in RIBO regulations dealing with contingent commissions or individual compensation agreements between insurance companies and brokers.

BROKER VIEW

The two main issues in brokerage compensation schemes are disclosure and potential conflict of interest. The definition of “disclosure” largely depends on whom you ask. Brokers argue they have made visible efforts in this area. “I believe that broker revenues should be disclosed to the client, and there are already rules to that effect in Ontario as governed by RIBO,” says Jeff Brandham, president of the Markham-based CG&B Group. “We are required to disclose how we charge fees or commissions and these rules are being followed. If a client requests information about contingent fees specifically, we will disclose that. However, we don’t have contingent agreements with every market and these tend to be done on a three-year average.”

Several of the larger brokers, prompted by the state investigation in the U.S, according to Meltzer, have put compensation agreements, disclosure practices and related information on their websites and on the back of all invoices to clients. For example, both Aon and Marsh have extensive sections on their websites, which include information on how risk managers can roughly calculate the effect of contingent commission on their individual accounts.

Pegues says he has responded on this issue to several individual risk managers who have requested more specific information. However, he says, “at Aon, we do not make reference to it specifically without a client requesting it. We think that risk managers are generally aware of contingent commissions.”

NEW ATTITUDE

On the public position of RIMS that compensation agreements should be disclosed “without client request,” there is less progress, according to Meltzer. “I think that is a very important point and I don’t see it happening,” she says. “It was facetious for brokers to initially say that because they show contingent fees online of their annual financial statements, then that is disclosure. I have also had a broker say to me that contingent commissions were too complicated for risk managers to understand. It is these attitudes that I think should start to change.”

There is also disagreement among risk managers and brokers as to what precisely constitutes “conflict of interest” when it comes to compensation agreements. “I don’t believe there is a conflict of interest in contingent commission,” says Brandham. “There could be a potential conflict when it comes to overrides for moving a book of business. The professional broker must first and foremost serve the interests of his/her clients. If a broker moves a book of business strictly for commission, he/she will not have those clients for long.”

“We are an agent of the insured not the company,” says Pegues. “It is the broker’s job to find the best balance for the buyer in terms of coverage and price. Contingent commissions don’t change that.”

As a risk manager, Rislahti says he sees the potential for conflict of interest in the bigger marketing picture. “We may deal with a broker in Winnipeg who is honestly unaware of any contingent commissions or other market arrangements,” he says. “Yet when the risk goes back to the head-office, it could be a different story. There may be agreements that influence where the business is placed.” And, Meltzer observes, I don’t believe that risk management accounts are compromised by contingent commission and conflict of interest – if the risk manager is doing his or her job. And by that I mean pressing for full disclosure, getting information about fees and services and making the right decisions based on that information.

BROADER SERVICES

The whole issue of compensation agreements between insurers and brokers highlights an evolving trend in how intermediaries get paid for their work. Traditionally, the majority of insurance brokerage revenues have been commission-based, but that is changing. The soft market environment of the 1990s, coupled with growing consolidation, led brokers to provide a wide range of new services, such as risk management, research and consulting. More and more brokerage revenues, often as much as one-quarter to one-third, are based on fees for services, rather than commissions.

Acknowledging the reality of fee-based services, Meltzer argues, however, that such fees should be directed more evenly to the buyers of insurance.” I don’t think brokers are charging risk managers properly for their services,” she comments. “I know of smaller and mid-sized accounts that use a lot of broker services. Instead of charging them, brokers have to make up the revenue somewhere else, so they do it through contingent commissions and other arrangements. I think that is pretty dysfunctional.”

As for the issue of regulatory investigations and high-profile lawsuits, many will be watching developments in the U.S. with close interest. With imminent announcements from aggressive consumer watchdog agencies, such as the New York Attorney General’s Office, there may be some fallout to the compensation schemes that brokers have comfortably adopted as additional sources of revenue. There are also those who see a great deal of smoke, but little fire in the U.S. investigations into and legal actions against insurer-broker financial arrangements.

“I don’t think the lawsuits in the U.S. are going anywhere, nor do I expect any to emerge in Canada,” says Meltzer. “I also don’t see any regulatory investigation here, because who would pick up the ball? With Spitzer’s investigation in New York, I think he will be happy with a full disclosure environment. He has bigger fish to fry.”