Disclosure Rules to Stiffen, But Most Agents Will Keep Contingency Fee Deals - Mega-brokers May Lose Out, But Smaller Firms Should Maintain Revenue Stream

National Underwriter - Property & Casualty Edition
Michael Ha
January 3, 2005

Since New York Attorney General Eliot Spitzer filed a civil suit against Marsh & McLennan three months ago, the four largest public brokers in the country—along with two major carriers—have already made announcements they will eliminate their contingency-commission arrangements.

However, while these four brokers are hard at work trying to find ways to make up the revenue shortfall, it appears that in 2005 most other intermediaries could very well continue to keep their contingent-compensation practices—provided that they offer better disclosure to clients, market observers predict.

To date, the top four brokers—Marsh, Aon Corp., Willis Group and Arthur J Gallagher—have all announced they are eliminating the practice of receiving any form of contingent compensation, while on the carrier side, American International Group and ACE said they are discontinuing such payments to brokers.

For these four major brokers, eliminating contingent-commission arrangements would likely have a material impact on their earnings in 2005. The most glaring example is Marsh & McLennan Companies, which received over 7 percent of its $11.61 billion of gross revenues from contingent commissions during 2003—the latest year for which full-year data is available.

MMC has since announced it would cut some 3,000 positions globally—5 percent of its staff—in cost-saving measures.

For Aon, contingent compensations made up 2 percent of its $9.75 billion of gross revenues in 2003, while Willis' contingents constituted 4 percent of its $2.08 billion in annual gross revenues. Gallagher's contingent commissions made up 3 percent of its $1.3 billion annual revenues.

Contingent compensations are an even bigger factor on a net-profit basis. According to 2004 estimates by New York-based investment banking firm J.P. Morgan Securities, contingent compensations make up nearly one-fifth of earnings for publicly-traded U.S. brokers.

While these brokerage giants declined to comment on how they would try to make up the loss in revenues in 2005, one expert said there may be a few ways they can bridge part of the shortfall.

"The simple answer is that these major brokers will recoup as much of the loss to key revenues as they can through straight commissions," according to Robert P. Hartwig, senior vice president and chief economist at the Insurance Information Institute in New York. However, that effort will likely fall short, Mr. Hartwig predicted, so these brokers will likely try to recoup additional sums through fees for existing client services.

"These brokers will have to demonstrate the value of the services that they were basically giving away or were including as a package of benefits for being a Marsh client or an Aon client or a Willis client," Mr. Hartwig said.

For instance, the mega-brokers produced special reports or brought in experts to talk to clients' risk managers on loss control, claims and a host of other topics, he pointed out. From now on, he noted, these value-added services will either have to be "paid for separately or will have to disappear for risk managers to understand how important they are."

Mega-brokers "will also try to cut expenses, which, for example, Marsh already did by laying off 3,000 people," he added.

Some major brokers will also try to leverage MMC's misfortune to steal the biggest broker’s accounts as well as its key employees. According to Peter Porrino, global director of insurance services at Ernst & Young in New York, there have been discussions about certain brokers being in a good position to pick up additional work in 2005.

For example, since Mr. Spitzer filed his suit against MMC, Willis has announced it has recruited a number of regional Marsh executives, including Arlene Corsetti, who had overseen Marsh's Midwest region, and Brian Morgan, who has lead Marsh's Mid-South sales team. These executive defections could persuade former Marsh clients to jump to Willis, observers note.

Still, Mr. Hartwig forecast, all these measures combined won't make up for the entire loss of revenues for some. Thus, these large brokers will continue to look for a better revenue replacement plan well into 2005. "They don't have that new economic model yet. They are still searching," he said.

However, among brokerage firms with mostly middle-market client lists, as well as smaller brokerage firms and independent agencies, market participants predicted that most such firms will successfully defend contingent compensation but will have to offer greater disclosure to their clients. Some of these changes will be mandated by state law, following the lead of the model developed by the National Association of Insurance Commissioners. (See related story in NU’s upfront breaking news section.)

Indeed, based on what the NAIC recommends, state insurance commissioners will have to decide whether to adopt the national group’s recommendations on broker disclosure—or perhaps go even further, noted Cory Walker, chief financial officer at Brown & Brown Inc., a Daytona Beach, Fla.-based broker with a predominantly middle-market client list.

Rob Lieblein, managing principal of WFG Capital Advisors in Harrisburg, Pa., agreed that most brokers are waiting to see what the NAIC offers in its model law. "You had the top four brokers who have come right out and took a proactive approach," he said. "Pretty much everyone else is taking a wait-and-see attitude to find out where the industry, the NAIC comes out."

"Transparency—that’s ultimately where this is all headed," Mr. Hartwig observed. "Brokers want it and insurance buyers want it. The regulators will force it and will compel it to happen in 2005."

However, some industry experts expect contingent commissions will continue to play a critical compensation role for the majority of brokers and agents for years to come, boosting their bottom lines while giving them a stake in the outcome over the life of policies—as claim-sensitive deals only pay off if a broker’s book stays below a targeted loss ratio.

J. Paul Newsome, insurance analyst at St. Louis-based investment firm A.G. Edwards & Sons Inc., predicted that "the vast majority of contingent fees will remain intact."

"Overwhelmingly," Mr. Newsome forecast, "most brokers will be paid just the way they have always been paid—principally with straight commissions but with a little bit of contingent commissions."

"I believe that contingent commissions will not be pushed over the cliff in the industry," Mr. Hartwig agreed. "There is a general recognition in the industry among brokers and insurers, and even among insurance buyers, that contingent commissions—appropriately structured and appropriately disclosed—have and can play an important role in the business."

Further, proponents of contingent commissions argue that potential conflicts of interest for intermediaries diminish substantially outside the world of mega-brokers, because middle-market brokers and smaller independent agents primarily depend on payments from carriers for their revenues and generally receive very little, if any, fees from insurance buyers—thus preventing what Brown & Brown's Mr. Walker describes as "talking out of both sides of the mouth."

Brokers like Marsh and Aon, Mr. Walker said, had been using a different economic model. "They were getting significant fees from clients. For Marsh and others, a big part of their revenues come from the fee business, but we are primarily commission-based. We are only getting paid by carriers—our clients are not paying us," he noted, disclosing that Brown & Brown had received some $30 million in contingent compensation in 2004.

At mega-brokers, client fees could make up anywhere from 30 percent to half of revenues, according to Ernst & Young's Mr. Porrino.

Additionally, non-mega-broker contingent commissions tend to use more of the traditional profit-based model. Some observers say this has less potential for conflicts when compared to the more recently developed, business-volume-based model that mega-brokers have increasingly been using during the past decade.

"For middle-market [brokers], what we call contingent commissions primarily have a loss-ratio based calculation—it's profit-sharing from carriers if losses are below a certain percentage," Mr. Walker explained. "That's different from the mega-broker model based on volume," also referred to as marketing service agreements, or MSAs, he noted.

David Bradford, executive vice president at Advisen Ltd., a New York-based provider of insurance data resources, agreed that MSAs—a relatively new type of contingent compensation first introduced in the 1990s—have typically been the purview of mega-brokers.

"Deals that got Marsh into trouble were based strictly on the volume of business they placed with insurers—that's the MSA-type, volume-based agreement," Mr. Bradford noted.

Most of what the smaller brokers and independent agents have in terms of compensation schemes, on the other hand, are based on the profitability of the business they place with insurers.

"It's an important distinction," Mr. Bradford said. "Smaller brokers don't see anything [extra] unless the business actually produces profit, and then the brokers share in the profitability with insurers. That's the type of commission that is typical for smaller brokers and the one they are fighting hard to retain."

David Eslick, chief executive officer of Briarcliff Manor, N.Y.-based broker U.S.I. Holdings Corp., is another one of the industry veterans defending the use of contingent compensation. U.S.I. Holdings received about $18 million (4 percent of its revenues) from contingent compensation in 2004—with some 17 percent of that volume-based. In addition, about 95 percent of U.S.I. revenues come from insurer-paid commissions, with the remaining 5 percent coming from various client fees.

Mr. Eslick pointed out that contingent agreements have been around for decades. He said they recognize the importance of the agent/broker-carrier relationship—based on intermediaries offering insurers a complete overview of the risks they are shopping. Some of the services agents and brokers offer insurers include sharing the knowledge of the business to be written as well as the needs and desires of clients, and efforts to provide detailed information to assist in underwriting and smooth submissions.

In addition, properly structured contingent compensation deals aren't linked to any specific policies. Typically, a broker or agent doesn't know whether any contingent commissions will be paid or the amount of that payment until the underwriting year is closed, if the deal is properly structured.

Mr. Eslick agreed that the primary issue in 2005 is embracing a consistent disclosure policy agreed upon by all regulators. He also pointed out that the NAIC has been "working very hard on vetting and approving a consistent disclosure policy that could then be adopted by state regulators."

He predicted that in 2005, most brokers and agents will hold onto their contingent compensation deals—but with more transparency, conforming to the NAIC model law. "I think that's probably where we are all headed this year," Mr. Eslick said.