S&P asks “how will brokers replace contingent commission revenue?”

In light of the investigations spurred by New York Attorney General Eliot Spitzer into broker compensation practices, and the resulting decision by most large brokers to discontinue receiving contingent commissions, the “million dollar question” is how this revenue will be replaced, says rating agency Standard & Poor’s in a new report.
S&P notes that the global broking business has operated as an oligopoly, with the three top brokers Marsh, Willis and Aon accounting for 60% of the market. Brokerages over the past two decades have borrowed at low interest rates to finance the acquisitions which brought about this high level of consolidation. During this period, brokerages have operated at high rates of return, often in the 20% range, while their insurance company counterparts have reaped much lower rewards despite being subject to the actual risk of paying claims.
But with the massive changes taking place in the market since mid-October, when Eliot Spitzer announced the filing of civil charges against Marsh for alleged bid-rigging and conflict of interest in accepting contingent commissions, the broking industry has been in utter turmoil. The controversy “is unraveling the delicate fabric of an industry that was financed by phenomenally wide spreads between high rates of return and low borrowing rates,” the report notes. “Most at risk are the highest leveraged players in an industry that was always steeped in debt to start with.”
In fact, given the absence of contingent commission revenue at a time when interest rates are beginning to rise and soft market pricing is starting to creep into the marketplace, the weakness of broker balancesheets becomes apparent.
S&P suggests two possible outcomes of the commission scandal the potential that contingent commissions based on “quality of business” rather than “volume of business” could remain, or insurers could begin to deal more directly with the insured.
The rater notes that contingent commissions based on the quality of business placed with an insurer can be seen to be to the benefit of all parties the broker receives the commission, the insurer gets a better risk, and the customer gets better rates. However, some brokers are more reliant on volume-based contingent commissions which, the rater notes, “are dead”.
In the second possible outcome, insurers could take the risk management services they have been paying brokers to perform and bring those in-house. “Prospectively, companies could staff up their risk-management capabilities, taking a much more active role in identifying their risk requirements and, more significantly, playing a more active role in placing the business with multiple brokers or perhaps even directly to the insurance carriers,” speculates S&P credit analyst Steve Ader. “The industry could become more commodity-based, like Wal-Mart. In effect, revenue normally paid to brokers could end up as salaries in the company’s risk-management department.”