WFG - Capital Advisors

by Ben Dyson

Eliot Spitzer's allegations of price-fixing and bid-rigging at Marsh will have a profound impact on the revenues and reputations of almost all brokers. Ben Dyson asks who the winners and losers will be in the ensuing power struggle.

As little as six months ago, insurance brokers were happily defending contingent commissions.

At the World Insurance Forum in June this year, Jack Sinnott, one-time chief executive of Marsh, the insurance broking division of Marsh & McLennan Companies (MMC), denied that contingent commissions create a conflict of interest. These commissions are where insurers pay brokers a fee for the volume of business they get from them, and are also known as placement services agreements (PSAs).

Sinnott said that as part of serving risk managers – brokers' true clients – brokers also provided distribution services to insurers. “This should be paid for by the insurer, not the insured,” he told delegates. “There is absolutely no conflict here. We are acting as an advocate of the client while producing an opportunity for the insurer.”

Sinnott and other broking representatives were standing up for contingent commissions at that time because in mid-April, New York Attorney General Eliot Spitzer had subpoenaed the three largest brokers – Marsh, Aon and Willis – for information about the practice of receiving compensation from insurers.

For a while, nothing happened. The market was left to speculate about what Spitzer was doing with the information he had demanded.

But on October 14, six months after the subpoenas, Spitzer hit the broking industry, and Marsh in particular, with a bombshell. He filed a civil lawsuit against MMC, alleging bid-rigging and price-fixing at Marsh.

Specifically, Spitzer accused the broker of deliberately steering business towards insurers that paid it the most. To do this, he said, the company would ask insurers to make false bids to give the client the impression that competition for the business had taken place.

And, perhaps crucially, Spitzer's complaint turned Sinnott's earlier defence of contingent commissions on its head. “These ‘services' are illusory,” said the complaint, responding to the explanation of contingent commissions on Marsh's website. Spitzer argued that the distribution Marsh is being paid for through contingent commissions is something it has to do anyway and its clients are already paying it for this.

Spitzer has since withdrawn his lawsuit against MMC as a whole, resolving instead to pursue individuals at the firm. But that has not stopped shockwaves spreading throughout the broking industry. Few brokers will be untouched by the after-effects of Spitzer's allegations. “Everyone will get splashed,” says Graham McKean, chairman of London broker BMS Group. “All will suffer.”

Contingent commissions are widespread. This has prompted many, including brokers' own boards, to ask whether these payments influence other brokers to act in the way Spitzer has accused Marsh's employees of doing. A wave of internal investigations is now underway as a result.

The upheaval wrought by Spitzer's attack on Marsh, and his vow to continue investigating broking practices, has led some to predict that the broking industry will never be the same again.

Jon Balkind, analyst at investment bank Fox-Pitt, Kelton, wrote in a recent report: “When we woke up on the morning of October 14, we did not expect that the insurance brokerage industry would change forever, but it has.”

Out of the frying pan

Perhaps the most noticeable change is that the larger brokers are no longer defending contingent commissions. Instead, they seem to have been racing one another to abolish them.

Willis was first past the line. It announced on October 21 that it was dropping volume and profit-based contingent commissions in response to clients' criticism of the practice. Aon followed closely behind on October 22.

Bringing up the rear for the larger brokers were Arthur J Gallagher and Marsh, which both announced they would get rid of the commissions on October 26. Marsh had said on October 15 – the day after Spitzer hit it with the lawsuit – that it was suspending contingent commissions, but had not indicated whether the suspension was permanent.

Even smaller brokers that are far removed from any accusations are starting to give up their contingent commissions. On November 15, South African broker Alexander Forbes announced that it had stopped accepting them.

As well as abolishing contingent commissions, all these brokers disclosed how much they had earned from them (see table).

On the one hand, the decision to ditch contingent commissions is a big plus for the broking industry. The brokers that have agreed to relinquish them are removing what has long been a bone of contention between brokers and risk managers.

Risk managers have often questioned whether brokers were truly acting on their behalf, given that they were also being paid by insurers. But now they have agreed to stop this practice, brokers believe there should no longer be any confusion about who they are working for. This should make for an easier relationship.

But on the other hand, the loss of the revenue provided by contingent commissions could scarcely have come at a worse time for brokers. Prices in the insurance market are softening, which is shrinking brokers' revenues and hitting their profits.

The additional effect of abolishing contingent commissions will cause some brokers to miss their profit targets. Aon, for example, has had to scrap its earnings target of $2.20 a share for 2004 because of the cumulative effect of falling revenues and the loss of contingent commissions.

“The large, listed brokers are suffering from product rate stabilisation, which continues to decrease organic growth,” says Steve Wevodau, managing principal at investment bank WFG Capital Advisors. “The elimination of contingent commissions takes a section of revenue and eradicates it from the financial statement. This creates a struggle to maintain bottom-line growth.”

Others agree. Steven Dreyer, managing director at rating agency Standard & Poor's (S&P) points to the $845m that Marsh made in contingent commissions in 2003, and the company's net income for that year of $1.5bn. “If you consider it all to be profit, contingent commissions made up at least half of the organisation's overall net profit last year,” he says. “If that goes away permanently and completely, it could be devastating.”

The large brokers may not be alone in their suffering. The effects of the Spitzer allegations have not yet filtered down to smaller brokers, according to some, and so they have not yet faced much pressure to abolish contingent commissions.

However, some believe it is only a matter of time before they feel the pinch, and that the days of contingent commissions are numbered.

“As they are I think they're dead,” says Dreyer. “Some brokers are still clinging to them, saying that they do them the right way. But volume-based preferential treatment is eventually going to disappear totally. It has already been forsaken by the major brokers and the others will have to follow suit.”

If contingent commissions are completely banished from the marketplace, the smaller brokers could be hit as hard as the larger ones. Smaller brokers are facing similar pressures to their bigger peers.

“If there is a complete abolition of contingent practices that is going to have a resounding impact on the small-to-mid-sized brokerage market,” says Wevodau. “Contingent commissions represent more than 5% of their overall revenues. They are already struggling with declining property rates and increased competition.”

In contrast to Dreyer, however, Wevodau does not think the commissions will go away completely. “Rumours of their death are greatly exaggerated,” he says.

Shifting the balance of power

Those brokers that have given up contingent commissions, or have had them cut off by their carriers, now face the challenge of making up the revenue they will lose as a result.

Some are likely to find this easier than others, however. Because of the accusations levelled at Marsh, disgruntled clients may turn their backs on the broker and head for those not directly implicated in Spitzer's probe.

Equally, prospective clients may be reluctant to place their trust in a company that has been accused of bid-rigging, price-fixing and client deception. Therefore, Marsh could struggle to hang on to existing clients and win new business, both of which could cause revenues and profitability to slide further.

“Marsh obviously has something of a black mark over its head,” says Adam Klauber, analyst at investment bank Cochran, Caronia Securities. “If Marsh is trying to get new Fortune 2000 business that is going to be a bit tougher than it was before Spitzer.”

In response to dwindling revenues and the loss of its contingent commissions, Marsh has slashed 5% of its workforce – or 3,000 jobs – to cut costs. Some see this as an admission that the company will not be able to make up its revenue shortfall. “Marsh's move to lay off 5% of its workforce seems to indicate that it won't recover 100% [of its lost revenue],” says Dreyer at S&P.

Marsh itself has played down the amount of business it could lose because of the Spitzer probe. Michael Cherkasky, MMC's chief executive officer, told analysts at the company's third-quarter conference call that clients were largely supportive of the broker.

“The disaffection reported by some sources has not been our experience,” Cherkasky told analysts. “We are talking to our clients on a daily basis, at both the executive level and throughout the organization. We are finding hard questions, but again, we're finding steadfastness. Our October retention rate was slightly down from a year ago and our new business rate was up over last year's.”

Some of Marsh's rivals, however, tell a different story. “Relationships with big brokers will undergo some very profound reappraisal. I'd be surprised if they didn't,” says McKean at BMS. “Marsh is saying that it has customer support. We have anecdotal evidence that this is only partially true and that some business has transferred from Marsh. When the numbers come out then we'll see to what extent Marsh's customers have supported it.”

The winners will be Marsh's smaller rivals. Willis, in particular, has been singled out for success by several analysts.

One reason for Willis's expected success is that it was less dependent on contingent commissions than some of its larger rivals. Therefore it will miss them less.

“Willis didn't have the high cost structure that Marsh and Aon had,” says Klauber. Therefore, he says, Willis did not need as much contingent commission revenue to pay for its high cost structure.

And because it is a smaller broker, it will require less revenue to grow. “Willis is in a much better position to grow from a smaller base,” says Klauber.

Willis has also found favour with analysts because, not only has it avoided accusations of bid-rigging, it was also quick to disclose its contingent commissions. Therefore, some expect Willis to be one of the biggest beneficiaries of any business that Marsh loses.

Willis itself seems to be gearing up for this. Its proposed method for dealing with the revenue shortfall caused by abolishing contingent commissions is starkly different to Marsh's. Far from laying off staff, Willis may have to hire more to cope with the influx of new business.

“The company sees significant new opportunities to enhance its global market share, especially with middle-market and large accounts,” Willis said in a statement accompanying its third-quarter results. “Efforts to grow market share will include increased marketing, aggressive targeting of new accounts and continued hiring of new producers.”

Willis is not the only firm that is likely to benefit from the misfortunes of others. Along with Willis, Klauber names brokers such as Palmer & Cay and Arthur J Gallagher as potential beneficiaries of the shakeout.

More business may not be the only bonus for smaller brokers. They could also pick up some of the larger brokers' staff. Many observers are expecting some disgruntled employees and broking teams to defect from the more troubled firms and join those less harmed by Spitzer's probe.

Klauber says there has been a steady shift of people from the larger brokers recently. “Over the past 18 months there has been a lot of movement in the broking industry,” he says. “It has been a hot market. Companies have been trying to build themselves up by hiring people and offering them attractive packages. A lot of the defections have come from Marsh and Aon.” And he believes the Spitzer probe will ensure this trend continues. “It will be more of a continuation than an acceleration,” says Klauber.

Some broking teams may even decide to split off and form their own mini-brokers to capitalize on clients' increasing mistrust of the bigger firms. And if they do, there will be money waiting for them.

“The broking industry has been a profitable area for private equity firms,” says Klauber. “There is definitely capital out there looking for these types of opportunities. We would expect one or several new brokers to pop up.”

As the balance of power shifts towards small and mid-sized brokers, larger companies may try and stand their ground by making acquisitions. If the larger brokers are unable to grow their revenues by attracting new business, they may have to buy it instead.

“What I see is that some of the mega-brokers are going to have to move fairly expediently to acquire mid-sized firms to bolster their position in the market,” says Wevodau at WFG.

The smaller brokers' new found power in the marketplace could also give them the urge to merge, according to some.

“[The effect of the Spitzer probe] has the potential to effectively increase fragmentation in the broker market,” says Todd Bault, analyst at investment bank Sanford C Bernstein. “The bigger brokers may lose some market power and the brokers under them may gain a little power, allowing the smaller brokers to look at more opportunities. In this case, everything becomes more competitive. Against that background, there may be more impetus for the smaller groups to merge.”

New ways to pay

As if all this upheaval were not enough for brokers, the loss of contingent commissions has prompted another big shift in the market. It is forcing brokers to completely rethink how they are paid – not only by insurers, but also by their clients.

Traditionally, clients pay brokers either a commission based on the amount of business they place or, as has become more common recently, a fee for the work they undertake on behalf of the client. They have also been receiving contingent commissions from insurers based on both the volume and profitability of the business they place.

The trouble is, it has not always been clear who was paying for what. Many suspect that contingent commissions were allowing brokers to provide additional services to their clients at either reduced or no cost.

The combination of the loss of contingent commissions and the increased scrutiny caused by the Spitzer probe means this must now change. Brokers will have to be very specific about who they are charging for what service.

“There has to be a costing of the various services brokers provide,” says Nigel Barton, chief executive officer of new London broker Oxygen. “The broking industry has to catch up with other professions in costing out its services. That will be the most significant long-term effect [of the Spitzer probe].”

Brokers will have a lot of explaining to do. They are going to have to spend a lot of time demonstrating to clients the value of each of the services they offer, and asking for appropriate pay in return.

This may be easier said than done, however. Firstly, brokers may have to completely change the way they work. Some brokers will never have had to think about the costs of their services before. “A lot of line brokers have no idea of the cost of each of the services they provide to clients,” says Barton. “They know what their own current annual expense budget is, but many have no idea by activity per sector what their costs are.”

And secondly, brokers – particularly the larger ones – will have to be very careful about how they approach their clients for what could be more money. They are likely to get short shrift from clients if they are seen to be trying to make up for lost contingent commissions.

“There is a level of arrogance among some of the larger brokers in that they have taken the view that they will forgo contingent commissions and, in order to replace them, will extend their services and ask their clients to pay more,” says Wevodau at WFG. “This is overestimating their importance and impact, and underestimating the smaller brokers.”

Arguably the biggest challenge facing brokers, however, is winning back their clients' trust. Although only Marsh has been accused of bid-rigging so far, contingent commissions were the driving force behind this, and almost every broker in the market has been paid them. Even innocent brokers will have their work cut out explaining to clients that all is well.

“I don't think brokers are any higher in the pecking order than used-car salesmen,” says McKean at BMS. He adds that the number of column inches devoted to bid rigging in recent weeks may have turned the general public against brokers. “They have come to the conclusion that brokers are a bunch of crooks, which I regret.”

Brokers are working hard to repair their tattered reputations. Marsh, the hardest hit, has revealed big changes to the way it does business and has created a global compliance organisation to ensure that the company does not step out of line. And Willis has introduced what it calls the Client Bill of Rights to ensure its employees keep clients' best interests at heart.

If they keep their promises, brokers could eventually win back the trust they have lost. McKean says the bad feelings generated by the publicity of the Spitzer probe will pass. He adds: “It is important that we are seen to be working in our clients' best interests, operating transparently and competing fairly. If this is observed, it will go a long way to restoring what little reputation we had.”

The New World Order