The Insurance Scandal: Just How Rotten?

The insurance industry is the latest financial sector to have its darkest secrets exposed to the light.

The embarrassment felt by the insurance industry is acute. But how did the problems arise? Few people outside the industry understand either its structure or how it has evolved in recent years. Essentially brokers are classic middlemen. They stand between companies that want to buy insurance and the insurers that sell it, taking a commission for services rendered. But the broker’s job is no longer one of simply finding the lowest price. These days brokers help companies to prepare complex evaluations of their insurance needs, often in many different countries. That task requires knowledge of the insurance providers in each local market, but also a good understanding of local risks. Companies’ proposals and risk assessments are used by insurers in making their bids; indeed, without the help of a broker many large companies would be unable to solicit meaningful offers from the big insurers. In effect, brokers serve as corporate advisers and form an important distribution channel for insurers. Since the brokers work for both sides, they have, increasingly, been paid commissions by both.

In their defense, brokers say these arrangements are disclosed to clients, and that, with adequate disclosure, the system can work. Yet disclosure is often vague, at best, and the potential conflicts are glaring. Indeed, Mr. Spitzer has revealed what amounts to gross abuse of the pricing system. Insurers have been offering incentives to brokers in the form of so-called “contingent commissions” — money paid only if the broker places a certain amount of business with a particular insurer.

Contingent Conflicts

Such commissions are generally calculated by the volume of business sent by a broker to an insurer — the more the better, regardless of whether it is in clients’ interests. Less commonly, the commissions are based on the insurer’s profits. But that can also harm customers, because a broker might choose not to push for a legitimate claim that will reduce the insurer’s profits.

In the past some lawsuits have stemmed from these arrangements, notably a big case against Marsh and Aon in 2000. After a settlement, the testimony, evidence and disposition were subjected to a strict gag order, a common outcome in insurance cases. But legal momentum against contingent commissions has been building. The crucial breakthrough in Mr. Spitzer’s investigation appears to have been the emergence during the past month of telling e-mails. According to the complaint, Marsh threatened to “kill” one insurance company if it did not provide sufficient commissions. ACE was told by Marsh that receiving more business would require the payment of “above market” commissions to Marsh (as opposed to lower rates to Marsh’s clients).

Further, Marsh executives were rewarded for moving business to insurers paying high commissions and penalised when they did not. In one of the most egregious moves, Marsh reached a deal that linked the size of its contingent commission to AIG’s ability to maintain prices on policy renewals. “Marsh is secretly raising the price of insurance for its clients and putting at least some of the increase into its own pocket,” says the complaint.

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