Recently, insurers and brokers in several states have come under regulatory scrutiny for their joint participation in contingency fee arrangements. In these arrangements, a broker receives increased profit commissions from an insurer based on the volume of policies placed with an insurer, or on the low incidence of risk of the business placed. This practice, common in the insurance industry overall, is being attacked on two fronts: first, that these types of contingency fee arrangements create an inherent and impermissible conflict of interest for a broker, who by legal definition represents the consumer and his best interests in a transaction with an insurer; and second, that when a contingency fee arrangement does exist between an insurer and a broker, disclosure to the consumer of the arrangement is non-existent or at the best, weak and insufficient. Private causes of action, though currently limited, have also been initiated challenging contigency fee arrangements as inherently unfair business practices.
New York Attorney General Eliot Spitzer and regulatory officials in Connecticut and California are currently investigating contingency fees paid to brokers by insurers, based on profit. In April, 2004, Aon, Marsh & Mclennan, Willis Group, and Chubb all confirmed receiving subpoenas from the NY Attorney General’s office. Hartford, Cigna, Aetna and Metlife, Inc. confirmed in late May that instructions were received from the New York Department of Insurance ordering the company not to destroy any documents relating to their dealing with brokers. In addition, another half-dozen insurers also may have received subpoenas. The subpoenas issued have stimulated a windstorm of anxious activity. Following the subpoena, Aon Corp. shares dropped 8%.
Spitzer has attained notoriety for his Wall Street investigations of similar mutual fund industry agreements, allegations of improper trading in variable annuities, and conflicts of interest between investment bankers and stock analysts. Known for upstaging the Securities and Exchange Commission, Spitzer spearheads new investigations, with the SEC following up with their own inquiries.
The NY, CA and CT investigations of broker contingency agreements were pushed to the forefront by a few different factors. A letter addressed to New York Attorney General Eliot Spitzer, New York Superintendent of Insurance Gregory V. Serio, California Attorney General Bill Lockyer and California Insurance Commissioner John Garamendi, written by the Washington Legal Foundation (WLF), a non-profit public policy think tank, discussed the conflicts of interest that exist within the insurance brokerage industry. Two industry practices were cited for inquiry: Placement Service Agreements, also referred to as “revenue sharing” or “contingency agreements”; along with “leveraging” or “tying”.
Placement Service Agreements (PSAs) or Market Service Agreements (MSAs) are contingent profit commissions paid annually to brokers based on volume of policies placed with an insurer, and the low incidence of risk of the business placed. “Leveraging” or “tying” refers to a related practice involving reinsurance contracts. Brokers will threaten to withhold referrals to an insurance company unless the insurer agrees to address reinsurance needs with that broker.
Non-Profits and consumer advocacy groups allege that contingency commissions are kickbacks for brokers, and that the consumer’s best interests cannot be primary in a broker’s profit incentive program. In the event a broker was closing in on their volume target for an insurer, they might be enticed to place their next policy there, despite the consumer’s needs. Brokers often help their clients file and collect on insurance losses, and a PSA arrangement based on assessed risk might discourage a broker from reporting claims.
Insurance Brokers argue that when they perform well under contingent commission arrangements, the increase of low risk business placed with an insurer leverages better pricing conditions. “Brokers have had such agreements with insurance companies for many years to compensate the brokers for services they provide to the carriers and many of the major carriers have these agreements with brokers,” Willis Group stated in an April 23, 2004 press release. Compensating brokers does seem to be a long-standing industry custom: an Aon spokesman described the arrangements as an “age-old common practice”. A letter to Business Insurance by the CEO of a New York brokerage firm described commissions as “a reward system when a job is done right”.
Disclosure
Five years ago, the Risk & Insurance Management Society (RIMS) criticized the practice of contingent commissions – particularly brokers’ failure to disclose their financial involvement with insurers. According to the Executive Director of RIMS, “Our members appreciate what the broker is doing. They don’t care where the payments are coming from as long as they are disclosed.” RIMS eventually compromised by jointly developing with super-brokerage Marsh & McLennan a disclosure policy that notified a client of the broker’s contingency fees upon the client’s request.
Concurrently, in 1998 the New York Insurance Department issued a bulletin warning that undisclosed compensation is “sufficient to create the perception that brokers are conflicted in their loyalties and that such conflict may constitute a violation of Section 2110 (New York Insurance Code) as a dishonest or untrustworthy practice.” The Bulletin further described the methods of disclosure with which brokers and insurers must comply. A Wall Street Journal article concluded that the New York Insurance Department’s interest in the contingency fee issue stemmed from the brokerage industry consolidation of the period.
At this point, all brokers are engaging in disclosure practices. However, the practice is not specifically directed toward the client in many cases.
In a recent lawsuit in Illinois against brokerage Arthur J. Gallagher & Co, the appellate court said that the firm’s disclosure statement in their 10-K SEC filing was not sufficient. The plaintiff argued that a client should not have to rely upon a disclosure statement contained within a lengthy financial statement such as a SEC filing. The court supported this view, stating that although the 10K filing on public record might be considered disclosure, that the question was whether disclosure was “complete, full, clear and candid.”
In January, 2004, J.P. Morgan issued a summary regarding contingent commissions within a semi-forecast of the future of the P&C sector, and supported the idea that current disclosure practices are weak and incomplete. The securities firm believed that an active debate over the issue of contingent commissions would be launched in 2004, and those contingent commission fees would be negatively impacted. “Although the often-undisclosed contingent arrangements are legal, recent trends within the regulation of financial institutions suggest that such arrangements could well be prohibited, or significantly modified in the future. We believe the most likely outcome is greater disclosure requirements and an outcry for reform from insureds.”
Litigation
In 2001, a Monterey, California attorney with Anderson Kill & Olick filed a lawsuit against the insurers in The Hartford group. This suit has gained in momentum and scale over the past few years – over 40 individual insurers have been named as defendants ( Allianz, American International Group (AIG), Continental, Chubb, The Hartford and all California-licensed subsidiaries) and a precursory examination of the listed court documents, orders, motions, and stipulations provide approximately 250 separate documents. The lawsuit is still in pre-trial discovery stage.
Anderson Kill previously targeted the major brokerages – Aon, Willis and Marsh – in a similar contingency fee suit, and settled out-of-court and off public record. The current San Francisco lawsuit names no brokerages as defendants, and specifically refers to the aforementioned brokerage firms as “excepted brokers”.
The Plaintiff’s Causes of Action under California Business & Professional Code (Subsection 17200 et seq.) demonstrate the Insurance Companies’ inherent unfair business practices involved with the payment of contingent commissions. Specific points include:
- Commissions paid to brokers constitute a conflict of interest on behalf of the policyholder and unfairly negate the policyholder’s right to coverage;
- Commissions paid to brokers provide incentives to unfairly conduct business with policyholders, such as failing to make claims on behalf of the consumer.
- Policyholders pay premiums for specific, requested insurance coverages. The commissions paid to brokers by insurers come indirectly from the consumers’ premium payments. The cost of these commissions has been passed to the consumer. The restitution sought is a repayment of these premiums to policyholders.
- The fees and commissions produced for brokers as a result of undisclosed contracts constitute undisclosed kickbacks to brokers of premiums paid to insurers by policyholders.
The remedies sought include restitution in the form of a refund to all policyholders. In addition, the “Plaintiff also seeks to enjoin the Hartford Defendants from selling any more insurance through certain brokers unless and until they fully inform all past and prospective policyholders of the kickback agreements.”
Limiting Risk
JP Morgan’s report of the broker commission issue stated that tighter protocol for disclosure would be in the future. Where would a disclosure statement to the consumer fall? The Illinois appellate courts in the Arthur J. Gallagher suit found that disclosure statements in SEC filings are inadequate. If we began the practice of including a disclosure statement in an insured’s application or policy, these would come under the scrutiny of Insurance Regulatory officials who review consumer documents prior to issue.
The New York Insurance Department regulated disclosure of broker’s compensation in the past, and issued an advisory bulletin. Enclosed in the 1998 NY bulletin are the following recommendations for disclosure. Italicized language has been added, offering suggestions and notes for each state-mandated suggestion:
- All compensation arrangements between an insurer and a broker should be reduced to writing and agreed to by both parties;
- All such compensation arrangements should be disclosed to insureds prior to the purchase so as to enable insureds to understand the costs of the coverage and the motivation of their broker in placing the business;
- All fees paid to brokers should be included as factors in the establishment of an insurer’s premium rates;
- All fees paid to brokers (and reasons for such fee payments) should be included in a broker file maintained by the insurer; and
- The insurer’s internal auditing procedures should include verification that all fees paid to brokers are proper and within the parameters of the New York Insurance Law and Department regulations.
Research may need to be conducted into the short term risks involved with XXXX Corporation’s brokers. Willis Group, one of the mega-brokerage holding companies involved in the New York regulatory investigation, has a small San Diego subsidiary that brokers Property & Casualty insurance.
Long term, a great risk would be a private action brought forth in civil trial. The subpoenas issued by the New York Attorney General for insurers (Aetna, Cigna, and Hartford) may only be information gathering with the purpose of attacking brokers’ disclosure practices. However, a recent national news agency article surmised that the subpoenas are part of a broad investigation “whether the fees that insurers pay brokers as an incentive to sell their products constitute a fair business practice or pose a conflict of interest.” Risk also includes further litigation such as that in the San Francisco Anderson Kill suit, which has demonstrated the legal avenues the Plaintiff’s Bar might approach in their pursuit of insurers.
Reference Guide:
(1) “Aetna, Cigna Subpoenaed in Broker Probe”
Associated Press – 6/11/04
http://biz.yahoo.com/ap/040611/insurance_probe_3.html
(2) “UPDATE – Hartford receives subpoena on broker compensation”
Reuters – 6/10/04
http://biz.yahoo.com/rc/040610/finanical_hartford_2.html
(3) “Birth of a Crusade: Spitzer Turns to Insurance Brokers”
By Matthew Goldstein
TheStreet.com 4/23/04
http://www.thestreet.com/pf/markets/matthewgoldstein/10156237.html
(4) “Now, insurance comes under regulatory fire”
The Economic Times – 5/2/04
http://economictimes.indiatimes.com/articleshow/msid-657839,prtpage-1.cms
(5) “Payments to insurance brokers draw scrutiny”
By Theo Francis
The Wall Street Journal 5/17/04
http://www.ajc.com/money/content/money/0504/17insure.html
(6) “Contingent Compensation and Service Agreements Between Insurance
Brokers and Insurers”
Insurance Information Institute May 2004
http://server.iii.org/yy_obj_data/binary/736589_1_0/BrokerCompensation.pdf
(7) “June 2: Commentary – Fatalism and Conflicts of Interest”
By H. Felix Kloman 6/2/04
Global Association of Risk Professionals (GARP) – Todays Risk eNews
http://www.garp.com/risknews/newsfeed.asp?Category=16&MyFile=2004-
06-02-8757.html
(8) “RIMS and J&H Marsh & McLennan Agree to Contingency Disclosure
Policy”
RIMS News Release 1/25/99
http://www.rims.org/Content/NavigationMenu/Home/99release.doc
(9) “RE: Disclosure of Brokers’ Compensation”
State of New York Insurance Department
Circular Letter No. 22 (1998)
8/25/98
http://www.ins.stat.ny.us/c198_22.htm
(10) “Marsh & McLennan Agrees to Disclose Contingency Fees It Gets From
Insurers”
Wall Street Journal – 1/26/99
http://www/siver.com/SiverScan/May99_Risk_Man.htm
(11) “Payments to insurance brokers draw scrutiny”
By Theo Francis 5/17/04
The Wall Street Journal
http://www.ajc.com/money/content/money/0504/17insure.html
(12) “Contingents May Be Smaller, But More Prominent in 2004”
Insurance – Non-life
US Equity Research
JP Morgan Securities Inc.
1/13/04
http://www.rims.org/Content/NavigationMenu/Home/JPMorgan.pdf
(13) “UPDATE – Hartford receives subpoena on broker compensation”
Reuters – 6/10/04
http://biz.yahoo.com/rc/040610/finanical_hartford_2.html
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