The Spitzer Factor

Wealth & Retirement Planner
January/February 2005

As the New York Attorney General’s probe into insurance industry compensation practices heat up, how will you avoid fallout?

By Dan Rafter

New York Attorney General Eliot Spitzer has been grabbing more than his share of headlines lately.  From battling the Securities and Exchange Commission to investigating fraud in the mutual fund industry, to announcing his run for governor of New York, he has kept himself busy.

Leaving no stone unturned, in October of last year Spitzer took on the insurance industry, launching a widespread investigation of compensation practices between insurance carriers and the broker/dealer firms that distribute their products.  Spitzer again grabbed headlines when he filed civil lawsuits against Marsh & McLennan Cos., the largest insurance broker in the world, and Universal Life Resources, another large insurance broker.  The lawsuits accuse the brokers of taking kickbacks from insurance companies to recommend their products to corporate customers. 

The question is, how does Spitzer’s latest crusade impact your business as an independent financial advisor?  What effect will the probe and the potential indictments have, if any, on your clients’ planning strategies?  What about public perception about insurance companies?  Will recent negative publicity regarding commissions, alleged bid-rigging and possible kickbacks trickle down to your own firm?  What’s to prevent your clients from wondering if you are facing financial pressure to recommend one insurance or investment option over another?

“The issues surrounding conflict of interest are now being raised to a whole new level of scrutiny,” Rob Lieblein, managing principal with WFG Capital Advisors, says.  “It’s natural for people to wonder if their financial planners, too, have any conflicts of interest.  It’s up to the planners to disclose as much information as possible to ease their clients’ concerns.”

Are you in a position to do this?  A complete understanding of the issues and an ability to address them openly with clients are key, say industry experts.  When it comes to picking up the pieces of hurricane Spitzer, it will be up to the advisors who reach consumers one-on-one to mitigate public perception.

The Issues
On Oct. 14, 2004, Spitzer sued Marsh & McLennan Cos., accusing the brokerage firm of working with insurers to choke off competition by steering clients to those insurance companies that paid Marsh the highest commissions.

Since then, Spitzer’s probe has expanded to include nearly every kind of insurance, from automobile to life to medical malpractice, refueling a long-running debate on how the insurance industry should be regulated.  Congress held a hearing on the issue in November 2004.

Under the McCarran-Ferguson Act of 1945, insurance is controlled by individual states.  The resulting patchwork of state-by-state regulations has created headaches for many companies.  Some large insurers, including Allstate Corp., are calling for a dual regulatory system in which insurers could select either state or federal oversight. 

Spitzer has likened the commissions offered by insurance carriers to the broker/dealers that distribute the product to kickbacks.  In his investigation, he accuses brokers of steering corporate business to the insurers that paid the highest commissions. 

The bad press from the investigation, and the unease generated by the increased attention paid to the state-by-state regulatory system now in place may have a big impact on financial advisors.  Your clients, after all, read the newspapers and watch the network news.  Officials in the insurance industry are already seeing the results of a shaken public faith – not only in the insurance sector, but in the financial services business in general. 

“This does have a big impact.  Trust is the foundation of the brokerage industry and of insurance in general.  The public needs to be able to trust brokers,” Barry Meiners says.  Meiners is director of marketing and communications with the Council of Insurance Agents & Brokers, a national trade group composed of commercial insurance agencies and brokerage firms.  “When you have allegations of fraud, those are very serious allegations, especially in an industry built on the principles of trust.”

Fortunately, there are steps financial advisors can take to protect their business and their clients. 

TIP 1:  ANSWERING THE COMPENSATION QUESTION
Much of Spitzer’s investigation focuses on the way insurance companies compensate brokers.  Spitzer is calling for far greater disclosure of how this process works.  Financial advisors can ease their clients’ concerns by explaining immediately that they are receiving no compensation from anyone by recommending specific investment vehicles.  Planners also should explain to their consumers that they, too, are taking their own steps – by not taking commissions from different investment vehicles or by disclosing them up-front – to root out potential conflicts of interest. 

“This situation has further heightened our diligence regarding disclosure, regarding our efforts in trying to identify serious conflicts of interest,” says Scott Curtis, president of Raymond James’ insurance unit, Planning Corporation of America.  “The Spitzer probe didn’t trigger that activity, it was already underway, but it did heighten it.”

Curtis recommends that financial advisors reassure their clients that they don’t receive special compensation or incentives for selling or recommending one product versus another. 

“At the core of this investigation, that is the issue, Curtis says.  “That’s probably what consumers are looking at.”

TIP 2:  THE WHOLE INDUSTRY IS NOT ROTTEN
Often during a large-scale fraud investigation, an entire industry is painted as corrupt when only a few individuals or companies are actually involved in any wrongdoing.  It happened in the mutual fund industry during Spitzer’s 2003 probe and, because of news stories focusing on predatory lending, it happened to mortgage brokers.  It may be happening now with the insurance industry. 

Financial advisors should reassure their clients that the Spitzer probe doesn’t meant that all insurance companies and brokers are unethical. 

“The Spitzer investigation is very narrowly focused on some large brokers and insurance companies.  The entire industry should not be tarred with the same brush,” Joseph Annotti, vice president of public affairs with the Property Casualty Insurers Association of America, says.  “Mr. Spitzer’s questioning of the entire industry is a bit of an overkill approach.  The implication is that somehow every American consumer is getting damaged because incentive compensation systems exit.  We don’t think that’s the case, and we don’t think consumers should be led to believe that this is the case.”

TIP 3:  COMPENSATION IS THE NORM
Annotti points out that most businesses rely on some form of incentive compensation.  Financial advisors should explain this to their clients, and should add that compensation is only a problem when it is kept hidden.

“Incentive compensation is pretty much the norm in any type of industry that uses a professional sales force – the auto industry, real estate industry, you name it,” Annotti says.  “The focus of this investigation needs to be where the alleged illegal actions took place.  The problem is there, not just on compensation in general, and the focus should be there, too.”

Your best bet?  Explain to your clients in layman’s terms what commissions, if any, you receive and provide a general outline of how you are compensated for your work. 

TIP4:  LITTLE IMPACT ON CONSUMERS
While Spitzer’s insurance probe has generated big headlines, very little of it actually impacts individual consumers.  So far, the investigation has focused on corporate clients – large companies purchasing insurance.  Individuals working with their own independent financial advisors have not been part of the probe. 

Planners should make this clear to clients who are concerned about the investigation.  “This case really has focused on the large companies,” Lieblein says.  “It is still unknown how far this will spread.”

THE TARGET: PROBE AFTERMATH
While industry leaders work on beefing up compensation disclosure requirements, prognosticators are offering theories of how the industry might change as a result of the Spitzer probe.  Here are two recent developments. 

Will Investigation Lead to Industry Consolidation?  A recent study released by financial services industry valuation and consulting firm WFG Capital Advisors analyzed the impact of New York Attorney General Eliot Spitzer’s investigation of the insurance industry.  The study of the top seven brokerage firms, released in November of last year, suggests that many leading insurance brokers have abandoned contingency commissions as a result of Spitzer’s probe.  And this, WFG officials say, could lead to serious financial trouble in the industry. 

By eliminating contingency commissions, the study says, brokers will significantly lessen their earnings.  By taking this step these leading brokerages will reduce their composite earnings by 25 percent. 

To make up for this, insurance brokers will have to grow their revenues by aggressively acquiring other firms, say officials with WFG.

NAIC Responds to Spitzer Probe.  On December 29 of last year, the National Association of Insurance Commissioners adopted model legislation outlining new compensation disclosure requirements designed to help consumers understand how insurance brokers are compensated for the insurance products they sell. 

Based on the new requirements, brokers must disclose the amount of compensation he or she will receive form the insurer.  In addition, the broker must describe how compensation is calculated, including any contingent compensation.  If the amount of contingent commission is unknown, the broker would be required to provide a reasonable estimate of how much contingent commission would be received and the method in which it is calculated. 

Also, according to the model legislation, in certain circumstances, when producers do not receive compensation from clients, they would be required to disclose their relationship with the companies they represent.  Visit www.naic.org for a full draft of the model legislation. 

NAIC is considering additional requirements, which include disclosure of quotes received by brokers, recognition of the producer’s fiduciary responsibility, and disclosures regarding agent-owned reinsurance arrangements.