Risk Management

Managing the Risk Manager

Challenged to ask brokers about contingency-fee payments, corporate insurance buyers dropped the ball. Finance chiefs would be wise to take a fresh...
David KatzApril 28, 2005

CFOs should look very closely at their corporate insurance buyers — and at how hard-nosed they are when it comes to negotiating cheaper, better-quality coverage — if the evidence heard at last week’s yearly conclave of risk managers is any indication.

Risk managers like to portray themselves as skillful architects who shape coverage based on their organizations’ appetites for risk. When insurance is too dear or isn’t on the market, they take pride in helping their companies do quite well without it, thank you, by means of self-insurance or captive insurance subsidiaries.

But a fair number of risk managers don’t appear to have been as independent of the insurance industry — of insurance brokers, in particular — as they’ve portrayed themselves to be. Given the opportunity to have their brokers disclose contingency-fee arrangements with insurers, for instance, many risk managers fell asleep at the wheel.

In the worst case, some corporate buyers might have been unwitting enablers of serious broker conflicts of interest, according to leaders of the Risk and Insurance Management Society, the prominent association of corporate risk managers that met last week in Philadelphia. Over more than five years, despite warnings from leaders of RIMS, 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 arguably lacked crucial knowledge of how the coverage they bought for their companies was being priced.

To many, the contingency-fee controversy was spawned last October, when New York State Attorney General Eliot Spitzer sued Marsh, the biggest insurance brokerage, for bid-rigging. Under contingency arrangements, insurers typically agree to pay fees to brokers based on the amount or the profitability of the business the broker places with the insurer.

The fees aren’t illegal in themselves. But 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 for $850 million, issued an apology, and undertook governance changes. Later, Spitzer reached similar settlements with the other two largest brokers, Aon and Willis North America, for $190 million and $50 million, respectively.

Long before the Spitzer investigation, however, RIMS had warned its members about the fees. In 1998, the society was already worrying about their effect on “a broker’s motivation for recommending or placing business with particular insurers” and supporting the disclosure of all broker compensation arrangements before insurance is bought. In 1999, RIMS struck a deal with Marsh (then called J&H Marsh & McLennan) in which the broker would identify — at the client company’s request — the clients’ insurers with which the broker had contingency deals. The risk manager could then estimate the contingency revenue generated by those agreements.

The problem was that the risk managers did very little requesting. To their credit, RIMS leaders who spoke in Philadelphia excoriated their peers for dropping the ball. “In 1998 and 1999, we challenged everybody [to press brokers for] transparency, and most of you did not insist on it,” said incoming RIMS president Ellen Vinck in a speech. Vinck, the vice president of risk management and benefits at United States Marine Repair, wondered if contingency fees would have become such a problem “if we had been more vocal.”

Following the Money

Indeed, according to Spitzer’s complaint, Marsh’s appetite for the fees began to mushroom in the late 1990s. In 1998, a J&H Marsh & McLennan executive claimed that only about 5 percent of the brokers’ total global revenue stemmed from contingency fees, according to a report at the time in the National Underwriter. By 2003, however, about $800 million of Marsh’s $1.5 billion in earnings came from the arrangements, Spitzer noted in his complaint.

Last August, after the current scandal landed in the headlines, RIMS updated its policy to a demand that brokers disclose all sources of their compensation “without client request.” Marsh, Aon, and Willis have since gone that policy one better, dropping their acceptance of the fees entirely.

On its own, the half-decade failure of many risk managers to press brokers about contingency fees might not have had much effect on companies’ financials or the protection they might have obtained. More serious, from a finance chief’s point of view, is what the lapse has to say about the longstanding relationship between risk managers and brokers and its effect on overall corporate risk management.

Although risk managers have been trying to declare independence from the insurance industry in the 30 or so years since risk management began to emerge as a profession, they’ve been bound hand and foot to the brokers. The relationship has “worked for us for generation upon generation,” Vinck told reporters at the RIMS conference, not only providing access to the marketplace and knowledge of the variety of products but also acting “as my advocate.”

If brokers are supposed to act as their advocates, however, why did so many risk managers fail to hold them accountable for their separate pay schemes with insurers — schemes that could distort broker loyalties and cloud risk managers’ views of how much competition was actually taking place in the marketplace?

Truth be told, many risk managers have too much invested in their relationships with brokers to question their compensation closely. Although the buyers present themselves as the consumerists of the insurance world, they simply don’t want to offend their intermediaries. Part of the timidity might have to do with the industry’s revolving door: Risk managers often end up in more highly paid broker jobs. What’s more, the brokers do a lot of the policy-scrutinizing work that risk managers might have to do themselves if they dealt directly with insurers.

The result has been that risk management departments often constitute little insurance “shops” within corporations, institutionalizing the buying of insurance and the attendant shelling out of broker commissions as if they were givens. In such a situation, the advice of the broker seems to have held sway, and the contingency-fee scandal suggests that said advice might have been less than objective.

To make sure that the balance between buyer and seller tilts back toward corporate purchasers, CFOs would do well to take a fresh look at the jobs their risk managers are doing — especially in light of their relationships with brokers. Finance chiefs, who must sign off on their companies’ financials under the Sarbanes-Oxley Act, need their risk managers to have an unobstructed view of the coverage they’re buying and the terms on which it’s bought in order to know how well corporate assets are being protected. “Does my risk manager have a view of the market that’s independent of the information the broker provides?” is a question a prudent senior executive might well ask.

Apparently anticipating such questions, the three top executives of the big brokers were selling transparency at the RIMS conference as if it were a hot new product. Acknowledging that brokers would have to prove their worth anew, Michael Cherkasky, president and chief executive officer of Marsh, offered to provide “real-time information that will help you make decisions.” Joe Plumeri, chairman and CEO of Willis Group Holdings, the brokerage’s parent company, spoke of going beyond disclosure of brokers’ compensation to reveal details about their role and how they plan to make good on what they’ve promised.

For his part, Patrick Ryan, Aon’s chairman and CEO, suggested that buyers would be held accountable for the information they get from brokers and insurers. “You, as risk managers, should never put yourself in a position,” he said, “that you can’t answer [questions about] what it is you’re paying for.”