Contingent Commissions: Letting the Truth Get in the Way

Let’s get one thing straight right off the top: If what he alleges is true, Eliot Ness – I mean Spitzer – is right on the money with some of the accusations he has made against a few of the major players in the insurance brokerage industry. Again, if true, what these companies did was, without question, wrong.

As Dan Danyluk, CEO of the Insurance Brokers Association of Canada (IBAC) is quoted as saying in an Insurance Brokers Association of Ontario (IBAO) release October 26: “The allegations of fraud and bid-rigging described in New York are repugnant to insurance brokers because they would represent a betrayal of their clients. These acts are illegal in both the United States and Canada and if proven, should be prosecuted to the full extent of the law. The allegations allude to unethical and illegal acts of those accused. These allegations should not be construed as representing industry-wide practice.”

Neither Danyluk, nor IBAO CEO Robert Carter (also quoted in the release) are talking about the contingent commissions paid to brokers by insurers when they speak of the illegality, immorality and impropriety. What they are speaking of, I suspect, is the alleged bid-rigging.

According to Spitzer’s civil complaint (and I stress civil, not criminal) against broker Marsh & McLennan, “Marsh has repeatedly provided clients with false and inflated quotes. It frequently designates a winner, and then solicits inflated bids from other insurance companies, who provide such bids, knowing that later they themselves will have a turn to get business without meaningful competition. A choice made by a client under these circumstances has been made under false pretenses created by both Marsh and the complicit insurance companies.”

Contingent commissions (placement service agreements or, for Marsh, market service agreements, MSAs) in and of themselves are not evil. In fact, according to The Wall Street Journal, November 2, Spitzer is allowing Marsh to collect US$275 million in contingent commissions which may be used to pay penalties or victims in any settlement with the Attorney General. (Boy, contingent commissions must be downright diabolical if Spitzer is allowing Marsh to continue to collect, and pay a pending fine, with them – kind of like allowing a thief to sell a stolen car so he can make bail).

No, they are not evil. Nor are they secret (and if they were meant to be, they are the worst-kept secret ever, well, aside from the one that there are no WMD in Iraq). Consider the fact that both The Globe and Mail and The Toronto Star recently carried stories on contingent commissions, complete with numbers provided by the Insurance Bureau of Canada (IBC) and the Office of the Superintendent of Financial Institutions (OSFI), both public sources. About 33,000 independent brokers and their employees, plus the insurers who work with them and the regulators that oversee them, are aware of these commissions. What kind of secret is that?

Really, a 1% or 2% commission is not even worthy of discussion, let alone investigation. The issue is (or should be) whether some of the big U.S. brokers rigged bids in order to make some more attractive than others. The two matters must be bifurcated and considered individually.

The fact is, the practice of paying brokers an additional commission based on services rendered, volume, retention, and/or profitability of the business is neither illegal nor immoral, and companies should not be bullied into abandoning their use.

George Cooke, CEO of The Dominion of Canada, stated in The Globe and Mail, October 22: “I’m very comfortable with our plan.” He said his company’s setup, which effectively works as a profit-sharing arrangement with brokers, is aimed at ensuring that “we get the business we want, not the business we don’t want.” He also said the agreements contain clauses stipulating that the brokers must act in the best interests of clients.

As Carter put it: “Brokers have nothing to hide. Member brokers freely declare that they are compensated on both a fixed and contingent commission basis. This is standard contractual practice in the industry that rewards, as in any business, elite performance enhancing competition and service to the ultimate benefit of the consumer. Brokers must maintain above average business relationships with insurance markets in order to maintain the market and be in a position to negotiate the best possible terms for their clients… While terms vary from insurer to insurer, in the aggregate, total commissions are similar enough that there is absolutely no advantage to a broker placing business with one company over another based on commission. Most insurance companies are regulated federally, and brokers are regulated provincially. Regulators are fully aware of the commission arrangements including contingent commission that in no way is excessive or unusual.”

The problem with the contingent commission issue is that press coverage on the subject has largely been one-sided, with unknowledgeable journalists branding the commissions “secret”. It appears that if these insurance neophytes had no prior knowledge of the existence of the commissions, then they must be secret and the insurance industry must, therefore and once again, be hiding something (which, as Trotsky once said, is Bolshevik).

Consider the statement made in The Globe and Mail article entitled “Insurers getting dragged out of disclosure stone age”, October 26: “Deep down, we all knew that insurance brokers received some sort of compensation from the insurers they represented.”

Well thanks for the news flash, Mr. Cronkite. Of course brokers receive compensation from the insurers they represent – it’s how they survive (brokers don’t work on behalf of insureds out of the goodness of their hearts – they do so because they are running for-profit businesses, for Pete’s sake). The unsensationalized truth, if the mainstream press would bother to print it, is that contingent commissions have been around at least since Mackenzie King was a backbencher.

According to The Globe and Mail, October 28, “Property and casualty insurers paid out contingent commissions totaling $290 million last year…” In the October 23rd Toronto Star, the Insurance Bureau of Canada put the figure at $359 million.

The Globe article stated: “While these payouts accounted for only a small slice of a broker’s overall compensation, they had a huge impact on the insurance companies’ overall profitability. For example, ING Insurance Co. of Canada paid out $45.7 million in contingent commissions last year, and posted a profit of $123.6 million. Dominion of Canada General Insurance Co. paid $26.7 million in contingent commissions, a figure that exceeded its profit of $20.3 million.”

There are at least two major flaws with The Globe’s reasoning. First, the paper pits the two companies’ payments of contingent commissions against their respective bottom lines, yet it doesn’t give a break-down of what made up the commissions (i.e. how much was paid to compensate brokers for services rendered, such as underwriting, claims and administration; and how much because of volume, retention and profitability). The article, by implication, supposes that ING and Dominion’s profits would have been much larger had the contingent commissions not been paid. However, if brokers weren’t reimbursed for the cost of providing services, they would cease to perform them, leaving it entirely to insurers to service the client. This would raise insurers’ expense ratios (and thus their combined ratios) and shrink their bottom lines. Alternatively, if brokers continued to service clients but insurers didn’t reimburse them on the back end, they would likely have to do so on the front end through higher base commissions.

Second, the article pits the contingent commissions paid by the two companies against their bottom lines rather than against net premiums written. ING wrote $2.97 billion in net premiums last year; contingent commissions of $45.7 million works out to just 1.54% of that total. For DoC, $26.7 million in contingent commissions against $1. 03 billion works out to just 2.6% of NPW.

The nine largest property and casualty insurers in Canada mentioned in the article paid just over $200 million in contingent commissions in 2003 “…according to industry figures obtained by Report on Business and confirmed by the federal banking and insurance regulator [OSFI].” The article noted that the nine companies had combined profits of $541 million last year. What it failed to mention is that the group had net premiums written of $14.88 billion. Put against that number, the roughly $200 million in contingent commissions represents just 1.34% of the group’s NPW – a pittance.

Placing IBC’s $359 million against the industry’s consolidated 2003 net premiums written of $30.11 billion means that contingent commissions paid out last year made up just 1.19% of the industry’s NPW, certainly not worth pulling the alarm bells over, or getting ones knickers in a knot.

And yet, as reported by The Globe, October 28, provincial opposition members (such as Ontario NDP MPP Peter Kormos, go figure), and the Ontario Trial Lawyers Association are calling on the government to set up an independent public inquiry into the industry’s compensation practices. In other news, Bill Clinton will soon hit the rubber chicken circuit to speak on the finer points of celibacy, and word has it that Osama bin Laden is writing a how-to book on anger management.

The end result is “regulators across Canada yesterday [October 28] launched a wide-ranging probe of all relationships between insurance companies and brokers, including corporate links that are pervasive in the property and casualty sector.” (The Globe and Mail October 29, 2004)

In my view, investigating small independent brokers for something one or two of the big global brokers did is a lot like investigating every mom & pop operation for something the big box stores did, and we all have Eliot Spitzer to thank.

But then again, what do you expect from a guy who is elected to his position and may run for governor in 2006?

Consider this statement found at www.spitzer2006.com and a related quote taken from an editorial in The New York Observer: “In 2003, Eliot’s office recovered US$1.74 billion in penalties, fees and tobacco money — a 34% increase over the record US$1.3 billion collected in 2002.” The Observer: “Mr. Spitzer probably has done more to stabilize the state’s finances in the last few years than any other elected official. By refusing to look the other way as CEOs and financial institutions ripped off New Yorkers, he helped bail out the state during a difficult budget crisis.”

It certainly makes one think about the political angle of Spitzer’s activities, the connection between his actions and the state’s finances (justice is justice, there should be no such connection) and the connection between his present actions and his future career path.

But, as political consultant James Carville once said, “You don’t get elected President by running for dog catcher.”

Woof. Woof.