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Now that major commercial insurance brokers have scrapped the use of contingent commissions, insurance carriers should have a little extra cash on hand. The question is, Who's going to get their hands on it?

Because they will no longer have to pay those contingent commissions to brokers, carriers will have one less expense, and that may give them the opportunity to lower premiums. They also could decide to pocket some of the extra cash or use it to finance higher base sales commissions to brokers. Commercial insurance buyers hope the extra cash ends up in their pockets, in the form of lower premiums.

"Everything is pretty much in play right now," says Steven Ader, associate director at Standard & Poor's. "It's a developing issue."

Marsh, in particular, generated millions in profits through the use of contingent commissions. Equity analyst Jay Gelb of Prudential Equity Group, believes 2003 contingent commissions provided Marsh with about $845 million in revenue, Aon with about $200 million, Willis with about $80 million and Arthur J. Gallagher with between $45 million and $50 million.

Brokers may try to recoup some of that revenue with new or higher fees for services. But they are unlikely to recover all of the lost revenue. If they are unable to boost revenues sufficiently, that could prompt brokers to cut costs. Marsh, for instance, has already cut 3,000 jobs, for annual savings of $400 million.

Willis, which did not collect anywhere near as much as Marsh in contingent commissions, could benefit by a gain in market share as disgusted customers leave Marsh for competing full-service brokers.

In addition, commercial insurance buyers may find they will have to pay for services from their broker that they once took for granted.

"There were some services done that were not charged for," says Ader. "The brokers will start putting price tags on the other types of services." Insurance buyers and carriers could be charged those new or higher fees, he says.

Brokers also could try to negotiate with insurers to get a higher base sales commission for placing business, but insurers may not agree as the money for those higher commissions would have to come out of the pcokets of either the insurers or theinsurance buyers.

"I think we are going to see changes," says Don Thorpe, senior director at Fitch Ratings in Chicago. "I think, at this point, the different parties are jockeying for position."

Although the payment of contingent commissions has been a longstanding, widespread, and legal practice, those commissions were not always well disclosed to insurance buyers.

A HISTORY OF OPACITY

As far back as 1998, the New York Insurance Department advised that contingent commissions should be disclosed to buyers of commercial insurance to enable them to understand the costs of the coverage and the motivation of the broker in placing the business.

But while regulators advised brokers to disclose the contingent commission structure to commercial buyers, they stopped short of prohibiting contingent commissions.

What are contingent commissions? As in any other sales-driven industry, contingent commissions are a kind of bonus used to reward the best salesmen for a job well done.

"Incentives are used in every sales distribution force in the United States," says Robert A. Rusbuldt, chief executive officer of the Independent Insurance Agents of America. "Whether you're selling computers, refrigerators, automobiles, you name any product out there, there's a sales incentive program. It's part of the sales culture, the more you sell the more you are rewarded."

In the insurance industry, contingent commissions have been paid by insurers to brokers and agents annually based on volume, renewal rates, or even the profitability of a book of business over time.

For years, carriers paid the commissions to agents and brokers as an incentive for reaching volume or profitability targets. But in his civil suit against Marsh Inc., the world's No. 1 broker, New York Attorney General Eliot Spitzer has accused the firm of bid-rigging and failing to look after clients' interests by steering business to the insurers that paid it the heftiest contingent commissions.

Spitzer claims the practice amounts to collusion because commercial buyers are cheated out of the best price. In the wake of Spitzer's complaint, most major brokers have decided to stop accepting contingent commissions.

BROKERS: A CONFLICTED LOT

But because brokers, unlike agents, are supposed to work for and are paid by commercial insurance buyers, whetting a broker's appetite for profit through the use of contingent commissions could create a conflict of interest, if not a huge fiduciary problem.

By giving up contingency commissions brokers are hoping to do away with even the appearance of a conflict of interest and restore public confidence. Brokers are taking steps to improve disclosure to make it clear to buyers how they are compensated.

Broker compensation often includes a retainer paid by large corporate clients as well as a standard base sales commission. The insured pays its premiums to the broker, who takes a commission out of that payment and then sends the remainder on to the insurance company. The commission rate, however, is usually negotiated between the insurer and the broker.

Marsh has said it is seeking consistent standard commission rates from insurers for each transaction and within layers of a program in a transaction so that insureds can better compare the costs of alternative proposals. Standard sales commission rates generally vary not only from one carrier to another but from one line of business to another and by layers within a program.

How will the proposed changes in the broker compensation system affect the insurance company bottom line? "That's the question," Ader says. "That's something we're only going to know over time."

Carriers will no longer have to allocate money to pay for contingent commissions. So, they should be able to pass some of their savings on to the buyers of insurance in the form of lower premiums, he says. "With the loss of contingent commissions, that pool of money, a material part of that will flow to the people that purchase the insurance," Ader says.

If carriers, however, lose revenue because of a decline in sales that were once generated by brokers hungry for contingent commissions, there may not be that much in savings after all.

Then there is the question of the contingent commissions insurance companies pay to agents. Contingent commissions have come under attack as an unethical practice, but they are still an important part of the relationship between insurers and agents. Unlike brokers, however, agents work for the insurers. Contingent commissions, therefore, should pose no conflict of interest for them.

"To say that incentive compensation is inherently bad is just too broad of a statement," says Joseph Annotti, vice president of public affairs at the Property Casualty Insurers Association of America. "If you say that, then you have to say the same thing for incentive systems for car dealerships and other businesses," he says.

Contingent commissions also help to weed out unprofitable business. "If you take away the profit-sharing plans, all the agent then cares about is writing business, not good business," he says.

With all of the concern about potential conflicts, however, agents should disclose to clients their relationships with insurers and how they are being compensated, Rusbuldt says. If agents have contingency deals with insurers, they should disclose them.

As Spitzer's investigation plays out, the industry is taking steps to improve transparency and disclosure. But the system of broker compensation is still undergoing reform and it is still unclear how the changes will affect agents, brokers, insureds and insurers.

PATRICIA VOWINKEL, a former journalist with Reuters, is a regular contributor to Risk & Insurance®.

January 1, 2005

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