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The contingent-commission scandal has called into question long-standing insurance practices. But corporate risk managers share the blame.
Russ Banham, CFO Magazine
September 1, 2005
Like many risk managers, Dave Hennes eagerly awaited notification about his company's financial slice of the $850 million settlement that insurance broker Marsh reached last January 31 with New York Attorney General Eliot Spitzer. When Hennes, director of risk management at The Toro Co., learned the amount in late May, his jaw dropped. "The number astonished me," he says.
Marsh offered Toro, a Minneapolis-based manufacturer of landscape products with $1.7 billion in 2004 revenue, several hundred thousand dollars. While Hennes declined to divulge the exact amount, the offer far exceeded his expectations. "It tells me that the contingent commissions Marsh received from our insurers had a much bigger influence on how business was being done than we'd ever imagined," he explains.
Other risk managers opening correspondence from Marsh in late May had similar reactions. Janice Chamberlain, senior director of risk management at Costco Wholesale Corp., says she was "pleasantly surprised" to learn that the Issaquah, Washington-based superstore chain with $47.1 billion in 2004 sales, had received a $661,000 offer from Marsh.
But risk managers shouldn't be too happy about refunds of contingent commissions. These are the additional commissions that Marsh, Aon, Willis North America, and other insurance brokers received from insurance companies based on the amount or the profitability of the business the brokers referred to them. Risk managers like to portray themselves as skillful architects who shape coverage based on their organization's appetite for risk. When insurance is too dear or unavailable, they take pride in helping their companies do quite well without it, thank you, by means of self-insurance or captive-insurance subsidiaries.
However, it appears that a fair number of risk managers weren't as independent of the insurance industry — of insurance brokers, in particular — as they should have been. Given the opportunity to have their brokers disclose contingency-fee arrangements with insurers, many risk managers failed to do so.
Unwittingly or not, at least some corporate insurance buyers enabled abuse of their employers by brokers. Risk managers' lack of vigilance gave their brokers a free pass to steer corporate business to insurers who were guided by the fees insurers paid rather than by their clients' needs. At the very least, some risk managers lacked important knowledge of how the coverage they bought for their companies was being priced. All this means CFOs, particularly those of small and midsize companies, may have to review their charges' performance with additional rigor.
The contingency-fee controversy came to a head last October, when Eliot Spitzer sued Marsh, the biggest insurance brokerage in the industry, for bid rigging. While contingency fees aren't illegal in themselves, in his complaint Spitzer charged that they "created an improper incentive" for Marsh to maximize profits, sometimes moving brokers to get "fictitious high quotes from insurance companies in order to deceive its clients into believing that true competition had taken place." Without admitting guilt, Marsh settled, issued an apology, and undertook governance changes. Later, Spitzer reached similar settlements with the other two largest brokers, Aon and Willis, for $190 million and $50 million, respectively. In May, another big broker, Arthur J. Gallagher & Co., settled a contingency-fee case with the Illinois Attorney General and the state's director of insurance for $27 million.
Long before the Spitzer investigation, leaders of the Risk and Insurance Management Society (RIMS) had warned members about the fees. In 1998, the prominent trade group already worried about the effect of fees on a broker's motivation for recommending or placing business with particular insurers. It supported the disclosure of all broker compensation arrangements before insurance is bought. In 1999, RIMS struck a deal with Marsh in which the broker would identify — at the client company's request — the client's insurers with which the broker had contingency deals. The risk manager could then estimate the contingency revenue generated by those agreements.
But the risk managers did very little requesting, so they were left in the dark. "Marsh explained to me five years ago what contingent commissions were, and said that they were fairly insignificant," says Toro's Hennes. "So I wasn't too concerned. I figured maybe they were getting less than 5 percent of my premium from insurers as a contingency. I was stunned to find out that in some cases it was nearly as much as full compensation."
Dick Schmidt, director of risk management at Illinois Tool Works, a Glenview, Illinois-based diversified manufacturer of industrial products with $11.7 billion in 2004 revenues, was also taken aback by the number of contingent commissions Marsh received. Its $200,000 settlement offer covered 253 items dating from 2001 through 2004. Says Schmidt, "This was much deeper than I'd imagined, in amounts more than I expected." Adds Costco's Chamberlain: "I never had the feeling we'd been duped, and yet apparently we were."
What's more, the offers to brokers' clients do not eliminate the potential abuse arising from such conflicts of interest (see "More Conflicts," below). True, risk managers for large corporate buyers ultimately have been able to wield their clout to negotiate fees with some brokers on certain lines of insurance. But as a result, the present compensatory scheme for many brokers is a mix of fees paid by insurance buyers and commissions paid by insurance sellers. The larger the corporation, the greater the likelihood their brokers will receive fees rather than commissions.
But this lopsided arrangement leaves risk managers at smaller companies with more need to negotiate fees. "Brokers prefer commissions, which provide higher margins, which is one reason they target midsize companies," says William J. Kelly, a former risk manager at Chase Manhattan, Merrill Lynch, and J.P. Morgan, and currently a director of the insurance risk solutions practice at PricewaterhouseCoopers.
Yet many risk managers are content with this mixed bag of compensation methodologies, as well as the additional revenue brokers receive from insurance companies. "As long as my broker tells me where he is getting his income from and how much it is, I'm OK with it," says Schmidt. "If I'm not paying the total income the broker is receiving, then I have to judge if he is worth the income I am paying him. Disclosure gives me a negotiating tool when it comes to discussing fees."
But Schmidt, for one, says brokers must improve their disclosure. He wants them to break down the income they receive to as granular a level as law firms do. The firm used by Illinois Tool Works keeps a time sheet that shows what it is billing in tenths of an hour. But, says Schmidt, "I once asked Marsh if it could tell me how much it was spending on my account, and it either couldn't or wouldn't. I'm still not sure how the company came up with its numbers." (Marsh recently said it would soon start providing breakdowns of services provided and related fees.)
Kelly says such disclosure can't come soon enough. "For most of my career, brokerage arrangements were not even written down," he points out. "There has been no historic discipline around brokerage services and hourly rates. Brokers would say they would do this and that for free because of the opaque compensation structure. The old joke is that you can't get a conference room big enough to meet with the brokers for the first time, then after that you do business only with the youngest guy in the room."
Yet disclosure is unlikely to improve much unless risk managers demand it. "If we were asleep at the switch, then shame on us," says Lance Ewing, vice president of risk management at Las Vegas–based Caesars Entertainment Inc. "The spotlight may be on the brokers, but we need to do more heavy lifting ourselves."
Russ Banham is a contributing editor of CFO. David M. Katz, deputy editor of CFO.com, contributed additional reporting.
Can insurance brokers serve two masters?
While Marsh, Aon, and Willis North America no longer accept contingency fees, smaller regional brokers still do. All brokers continue to receive basic commissions from insurance companies, as well as income for providing various consulting services. Brokers also are paid commissions from insurers for brokering reinsurance. In short, brokers still get paid by both insurers and clients.
This doesn't sit well with Felix Kloman, a former principal at risk-management consultancy Towers Perrin and publisher and editor of Risk Management Reports. "If someone purports to serve your best interests, they should be paid by no one but you," argues Kloman. "If I were a CFO, I'd ask some hard questions of my risk manager about whether or not the company has received the best balance of coverage, financial security, and cost available in the [insurance] market. If the company is using a broker who receives income of any sort from an insurer, this should give pause."
Brokers have a different view. Says Joe Plumeri, chairman and CEO of Willis Group: "As long as you do business properly, have the right Chinese walls, and don't depend on one business to engage in another business, it's no different than a bank taking money and lending money at the same time."
In fact, the firms have no intention of paring services to brokerage firms on behalf of clients or restricting their own income to client fees alone. Instead, the brokers promise transparency and disclosure in their dealings with risk managers, filling them in on who they are doing business with and at what cost. As part of its settlement with New York Attorney General Eliot Spitzer, Marsh committed to disclosing the range of premium quotes received from insurers and to revealing the "contractual agreements with any of the prospective insurers, and all compensation to be received by Marsh for each quote," according to the agreement. Adds a spokesman: "Our intent is to be as transparent as possible."
But Kloman says disclosure is "no remedy," explaining that brokers "will always be tempted to steer business to insurers that give them the most money. When that happens, corporate clients are denied the benefits of competition. Why should a broker receive a commission from an insurance company when the broker is in business to represent your interests?" — R.B.