High Strung

An overwhelmingly 92% of senior management of U.S. property and casualty insurance companies – as sampled by a survey conducted by the Insurance Information Institute (III) of delegates at this year’s Joint Industry Forum – expect that investigations into “certain industry practices” by state regulators and attorneys general will “expand” – presumably in number as well as depth – over the year ahead. Of course, the reference to investigations into “industry practices” applies to the controversy surrounding payment by insurers of broker contingent commissions – fees of over-and-above standard commission arrangements set with intermediaries – which over recent months were brought to public attention by charges made by New York’s attorney general Eliot Spitzer against company and broker individuals relating to alleged business “bid rigging”.

The Spitzer investigation has already tainted several well-known corporate names in the global insurer and broker communities, with many of the corporations in question having inadvertently “plead guilty” (if not by actual admittance) by agreeing to monetary settlements in lieu of possible criminal charges being pressed in certain circumstances (of course, as unfolding events relating to the Spitzer investigation have revealed, the “price of bought innocence” can change before the ink on the contract has dried). While insurers and brokers implicated in the Spitzer investigation have been quick to throw money toward stilling public attention by agreeing to settlements with Spitzer, there remains a great deal of skepticism within the U.S. insurance industry that the stigma of the broker contingency issue and bid rigging will simply go away. Indeed, the analysts and company CEOs speaking at JIF, believe that the public outcome of the Spitzer investigation will be a fundamental change in the way the industry operates – for instance, any form of “financial reward” as an incentive paid by insurers to brokers could be eliminated as a legal practice. It is therefore interesting to note that nearly two-thirds of the attendees surveyed at the JIF event believe that most companies will be able to settle Spitzer-type charges made against them during the course of 2005.

However, the JIF attendee survey presents a less upbeat outlook for the passing this year of much needed federal legislative measures in tort reform and an extension of the Terrorism Risk Insurance Act (TRIA) beyond 2005. In both cases, the view of the attending senior management attendees at JIF were almost split 50/50 to whether such legislative relief would result this year: 53% of those surveyed believe that TRIA will not be extended this year, while 51% do not expect that Congress and the White House will enact meaningful class action reform legislation during 2005.

The majority of the JIF survey respondents also predict rising underwriting costs in the year ahead, with more than half expecting that commercial markets will undergo “significant softening” during 2005. And, the industry’s “changing tide of fortune” over the next 12 months will likely see a new round of consolidation among primary and reinsurance company ranks, at least according to the views of two-thirds of the survey respondents.

OUTSIDE VIEW

A panel consisting of p&c insurance industry analysts, and a member of New York’s Department of Insurance, became embroiled in the controversy caused by the Spitzer investigation. Specifically, the focus of the panel members was on whether there was a legitimate reason for brokers to receive payments from insurers outside of the standard commission arrangement which is perceived to be “paid” by the insured as part of the insurance transaction, whether regulators have any role in dictating reimbursement of brokers in terms of their greater responsibility of serving the best interests of the insuring public, and lastly, whether rating agencies should have established a position toward providing greater transparency on intermediary remuneration.

The panel speakers all agree that the issue of broker contingent commissions and insurer “incentive programs” for brokers has to be the worst kept secret if indeed it were ever meant to be kept “under the table” by the industry. Regulators, rating agencies, analysts and even commercial insureds in terms of risk managers have long known of these practices, they note. The charges made by Spitzer regarding alleged bid rigging has merely highlighted the potential abuse that could result from non-disclosed remuneration paid by insurers to brokers. The issue, therefore, is how will the industry move forward in dealing with broker remuneration and whether this should fall under the ambit of state regulators.

“There simply isn’t any rationale for brokers to be compensated by anyone other than the insured,” observes Vincent “VJ” Dowling, managing partner of Dowling & Partners, Securities, L.L.C. This, however, does not necessarily apply to “agents”, as opposed to “brokers”, where certain profit-incentive rewards can produce valid benefits for insurers, he says.

“No one ever wants interference by regulators. Now, everyone is saying, ‘where was the regulator when all this [the alleged bid rigging and payment by insurers of broker contingent commissions] was happening’,” comments Gregory Serio, superintendent of insurance at New York’s Department of Insurance. “Buyers [insureds] didn’t come to the regulator [with complaints], and they are still not calling to the regulator. We’ve talked to individual buyers, and they seem embarrassed and even fearful for their jobs. They knew what the deal was about,” Serio notes. With everyone, including the so-called “harmed parties” wanting the public attention surrounding contingent commissions to go away, it is difficult for regulators to adopt any defined position in this area, he adds.

The payment by insurers of contingent commissions to brokers is really not the issue that should be examined, says Matt Mosher, group vice president of the p/c rating division of A.M. Best Co. The real issue at hand is disclosure – if insureds are made aware of what remuneration is being received by brokers from insurers, then there is no “underhanded” nature to the transaction, he notes. Dowling concurs with this view, pointing out that, “contingent commission, or profit-share arrangements, are not wrong, as long as they are disclosed”. Ultimately, it comes down to transparency, he adds.

Serio takes a different stand, saying that, “I don’t believe that [regulated requirement for] disclosure can prevent abuses”. Furthermore, he notes, the danger of doing so could result in an “over reaction” to the situation. “The best thing we can do is look for practical, sensible solutions. The buyers have to tell us [regulators] where they want us to go.”

In addition, Serio says that regulators can benefit in dealing with emerging industry issues by working with rating agencies in the sharing of information. He also believes that rating agencies can play a greater role in promoting transparency within the p&c insurance industry, and thereby influence “best practices” in the sector. “Everyone is looking at the regulator to institute a ‘best practices’ policy for the industry [regarding broker contingent commissions].”

Overall, the “cost” associated with contingent commissions will not benefit insurers in the event that the practice is abandoned, observes Dowling. “The 2% contingent commission fee will be eaten up by compliance [costs]. Insurers won’t see it in their profit margins.”

TURNING POINT?

From an underwriting profitability standpoint, as well as overall net profitability, the U.S. p&c insurance industry is facing a fragile environment, says James Schiro, CEO of Zurich Financial Services Group. A softening in key market indicators, combined with the significant natural catastrophe losses experienced last year in terms of the hurricanes that lambasted the U.S. eastcoast and the tsunami disaster in Asia, make reading the future prosperi ty of the industry difficult, he adds.

“I think we are getting into a ‘softer market’,” states Warren Heck, CEO of Greater New York Mutual Insurance Co. However, he notes that there is “still a lot of price adequacy” in rates which should hold the industry in good stead in the year ahead. And, he observes, “the underwriters today are more disciplined”.

Donald Southwell, president of Unitrin Inc., holds a mixed view regarding the industry’s “expertise” at managing the cycle: “I don’t think we’re [now] smarter than the last cycle, but we do have more responsible players. There is no evidence of undisciplined players disrupting the market.” However, he does expect that the industry’s past temptations will lead to future problems. “I expect that we will hurt ourselves [again].”

“I think we’re going to screw it up [cycle management] again,” says Edmund Kelly, CEO of Liberty Mutual Group, in very emphatic terms. “I must agree,” comments John Phelan, CEO of American Re-Insurance Co. “The biggest clich in the industry is ‘it’s going to be different this time’.” Blaming the poor decisions of company management which lead to the onset of undermining price competition on abstracts like “a soft market cycle” is a poor response to dealing with the problem, Phelan notes. “Either we’re going to be tough enough [as insurers] to separate from the pack, or we’re going to continue blaming the [industry’s] problems on a ‘soft market’. Each [company] CEO needs to ask, ‘will we do it again?’.”

LEGAL QUANDARIES

“The tort system [in the U.S.] is completely out of control. Do I see [tort legislative] reform? I think we have more chance of breaking from the industry cycle than gaining tort reform. It’s just way too political,” says Schiro. However, Southwell is more optimistic of progress being made toward tort reform at both the state and federal levels. “I’m encouraged to some extent…and I’m even encouraged that we will get something from Congress [this year].” The problem with tort-related costing within the U.S. system is its unpredictability, observes Phelan. “How do we cost it?” And, the unfortunate truth of the past is that the industry has a history of not passing on tort-related costs except to its shareholders, he adds.

Are insurers more confident of legislative advancement of TRIA? The responses of those partaking in the CEO panel range from outright derision to a small camp of “hopefuls”. Extension of TRIA beyond 2005 will only occur if the issue is regarded as an “economic” necessity and not a solution for the insurance industry, says Heck. But, Kelly believes that the White House ha already placed too much commitment behind TRIA to abandon coverage at this point. “I think the White House will put its shoulder behind an extension of TRIA by mid-summer.”

Kelly agrees, however, that uncertainty surrounding the future of TRIA is causing disruption in the marketplace. “It’s not healthy running a book of business on a temporary basis. We’ve got to get a permanent solution.” Phelan does not believe that traditional insurance solutions are adequate to provide coverage of terrorism risk. And, he notes, “I don’t think that TRIA [resulted from] insurance [industry] lobbying”.

Looking ahead, Kelly notes that insurance is a tough business. “We talk about [the risk of] terrorism, we talk about high cat losses, the lack of progress on tort [reform], the poor investment environment. And all you can say is, ‘what a business!’.” Now, with the controversy caused by the Spitzer investigation having turned up the public heat on the insurance industry, he expects that future performance will very much depend on companies individually rather than broad market trends. “Although, I think that greater transparency and disclosure will ultimately be better for the insurance industry,” he surmises.