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More than two years after a series of allegations surrounding contingent commissions rocked the insurance industry, the industry finds itself in a paradoxical situation with surprisingly little clarity.
Brokers, agents and insurers strive to balance profitability with permissibility as policyholders wonder how they actually benefited from reform efforts. While some brokers and insurers have changed their prior practices, others have merely adopted fortified disclosure.
Clearly, these costly regulatory inquiries caused painful restructurings and layoffs at the major insurance brokerages. It is unclear, however, whether they provided meaningful reform and, if so, whether that reform is being implemented even-handedly.
Contingent commissions comprise additional remuneration paid by insurers to agents, brokers and managing general agencies based on reaching a minimum premium volume or achieving an overall loss ratio below a certain threshold. While contingent commission agreements have been in place for decades, more recent consolidation enabled certain brokers to gain unprecedented market power when negotiating with insurers, due in part to these arrangements.
The top four brokers, who together dominate insurance placements, negotiated comprehensive placement agreements that entitled them to payments directly from insurers based on factors such as business volume, renewal rates and profitability. Smaller brokers continued with less sophisticated contingent commission agreements.
Although agents and MGAs also received contingent commissions, regulators paid extra attention to brokers' contingent commissions because regulators saw brokers as representing policyholders rather than insurers. From the regulators' perspective, contingent commission agreements between brokers and insurers called brokers' loyalties into question.
In early 2005, regulatory pressure mounted to the point where certain large brokers announced they no longer would accept contingent commissions from insurers while, at the same time, a few large insurers said they no longer would pay contingent commissions to brokers. The decision to walk away from these profits represents a major change in the broker compensation structure.
Interestingly, however, many smaller brokers did not make the same commitment, which raises questions as to whether there is now a level playing field.
In addition, regulators lodged allegations that some brokers had colluded with insurers to rig bids, fix prices and steer clients to the insurers with the most lucrative contingent commission programs.
In late 2004, the National Assn. of Insurance Commissioners reacted to industry events by establishing the Broker Activities Executive Committee Task Force. The goals of the "EX" Task Force are to increase the transparency of brokers' compensation and assist in the continued monitoring and analysis of industry events.
The NAIC model act for producers, the Producer Licensing Model Act, provides guidance for intermediaries. Interestingly, the PLMA does not distinguish between agents and brokers. Instead, the model refers to "insurance producers," which it defines as persons required to be licensed under the laws of a state to sell, solicit or negotiate insurance. The original version of the PLMA did not prohibit the payment of contingent commissions to insurance producers.
The EX Task Force amended the PLMA in December 2004 in an effort to increase the transparency of brokers' compensation. The PLMA, as amended, applies to all insurance producers who receive compensation from the customer, but it specifically exempts reinsurance intermediaries, MGAs, sales managers and wholesale brokers who only act as intermediaries between the insurer and other producers.
The amended act requires that disclosure of compensation be made before the purchase of insurance or when a producer is processing a policy renewal. The disclosure needs to convey to the clients the factors that influence compensation paid to producers. Even as amended, however, the PLMA still does not prohibit the payment of contingent commissions to producers.
Today, it appears that brokers are following two different paths when it comes to contingent commissions. Most large brokers have stopped taking contingent commissions, but smaller brokers continue to accept them, with perhaps a bit more disclosure.
The financial impact on the large brokers has been substantial.
In 2005, brokers' consolidated net income, as reported in the Fitch Insurance Broker Index, declined by an average of 22%. While profits of most of the largest brokers improved in 2006, the regulatory hurdles remain large.
These large brokers have been trying to raise commission rates and implement new pricing structures that will help make up the difference. Without such revenue enhancements, these intermediaries will clearly be working at a competitive disadvantage as compared with smaller and midsize brokers.
On the other hand, given the size differential, it is unlikely that these smaller brokers will be able to use this advantage to gain any significant market share on large corporate accounts. Still, there is no question that the growth of large brokers will be constrained going forward.
From an insurance company perspective, the lines are not much clearer. While some companies have been forced to stop paying contingent commissions, others continue.
Another cause of concern is the so-called "65% rule."
At least two large insurers have agreed in settlements with regulators to stop paying contingent commissions on lines of business in which insurers that represent 65% of the gross written premiums for that line either have not been paying such commissions or agree to similar settlements.
Administering and monitoring of the "65% rule" could become quite cumbersome. More important, this particular rule, by definition, would be enforced unequally.
Meanwhile, in spite of the regulatory changes, debate continues about whether contingent commissions are a legitimate form of broker compensation. Many in the insurance industry insist that contingent commissions were never the problem.
Defenders of contingent commission arrangements say allegations of steering and bid-rigging abuses caused the industry to abandon an otherwise acceptable practice. Insurance buyers, on the other hand, wonder if and when the reduced commission structure will result in lower premiums.
Without question, however, the industry has moved in the direction of greater fairness and disclosure. While there is disparity between the large and small brokers, it seems that virtually all brokers now provide more information about practices that might be perceived to sway their loyalties.
At the same time, most insurers have undergone stringent Sarbanes-Oxley Act testing, ensuring that their quoting practices are appropriate and uniform. Finally, corporate risk managers are more sophisticated in their dealings with intermediaries.
It is worth noting that these corporate risk managers still value advice from large brokers. In spite of the allegations hurled at brokers in the past few years, it appears the vast majority of commercial customers have stayed with their original broker since the contingent commission inquiries started.
These corporate insurance buyers seem to be the chief beneficiaries of improved disclosure of broker compensation arrangements. Greater disclosure now enables them to weigh their intermediary's incentive structure against their own objectives and make informed decisions.
Key Coleman is a principal and John Bonaguro is a manager in the Chicago office of PricewaterhouseCoopers L.L.P.