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INSURANCE BROKERS --  LIKE STOCK BROKERS --
INVESTIGATED BY ATTORNEY GENERAL
Understanding the Dynamics of the Insurance Market

New York Attorney General Eliot Spitzer (famed for his probes of the mutual fund and investment advisory businesses) is now investigating the practices of insurance brokers. The concern is the apparent conflict of interest inherent in their compensation arrangements.

"Regulators and industry analysts say the costs of the bonuses are passed on to customers; there is concern too, that customers may be getting inappropriate insurance" -- New YorkTimes, April 24, 2004

"Critics say the fees amount to kickbacks to the brokers that are in conflict with their duty to get the best deal for clients" -- Wall Street Journal, May 24, 2004

Conflict of interest is at the heart of too many business problems. Stock broker Merrill Lynch was chastised for inflating the prospects (and the stocks) of companies because Merrill received huge investment banking fees from those companies. Now the spotlight shifts to the insurance brokers.

In both cases they were/are dealing with two constituencies with directly opposite interests. One simply cannot serve two masters.

Property/casualty insurance brokers have relationships with insurance companies whereby the broker’s financial prospects are directly and indirectly tied to the fortunes of the insurance companies. Commissions are a percentage of premiums. In addition, "contingent commissions" are paid to the brokers based on both the premium level and the loss experience of their entire book of business. Thus the temptation exists (at least subconsciously) to provide the worst thing from the client’s point of view: a high priced policy that covers little. There are other insurer-provided perks as well such as trips and conferences. For various reasons, the problem is not solved by the broker simply offering to charge fee in lieu of commission.

We don’t believe there is necessarily a problem with this arrangement; it’s simply a matter of awareness. The role of the insurance broker has to be clarified; insurance brokers have themselves muddied the waters by posturing as consultants and advisors. A recent New York court case illustrates:

Chase Scientific Research, Inc. sued insurance broker NIA Group, Inc. alleging the broker was negligent and failed to secure sufficient coverage. The court stated that "brokers and agents … do not have a continuing duty to advise, guide or direct a client based on a special relationship”(Business Insurance 3/26/01).  The point made was that brokers and their customers are engaging in a simple arm’s length buyer/seller relationship. The buyers of insurance need to know that fact.

Many insurance brokers are extremely competent and principled. Any problem that exists exists because of role confusion, clear and simple.  If buyers want insurance, they should go to the source that is selling it.  If they want advice and consultation (professional services) they should arrange for that separately.  The market will operate effectively to eliminate excesses from the system if the buyer creates the structure to allow it to work:

The insurance buyer should unbundle the insurance product and service as follows: 1) Purchase the insurance product and related administrative services from the broker; 2) Purchase advice and consultation from a separate firm that works solely for the buyer on a fee basis. Thus the professional services are separated out from the delivery of the product, where the controversy resides. Periodically, conduct a competition for the insurance product whereby price can be subjected to the rigorous scrutiny of the market (managing this process should be part of the consultant’s services).

The approach vis-a-vis the broker, then, is: we don’t care how you are compensated – the free market will do the adjustment for us. Price will be a major factor (all other things being equal) and the brokers’desire to obtain the business will wring out all excesses from the quote.  Excesses include not only the broker fee, but also the much larger premium.  Absence of competition between brokers for business is what allows brokers to favor one insurer over another for reasons other than the client's interests.  The possibility of a broker losing the business to a competitor is what will keep the system functioning.

This approach recognizes the reality of the broker compensation model and works within it. Keeping the professional services separate allows for freer movement from provider to provider, putting liquidity into the process. It also allows for stability in the professional relationship (advice and consultation).  Bottom line: Professional advice and management separate from the product, and market pressures working to deliver best coverage terms, conditions and price.

Given the inevitability of losses, you'll be judged not by whether you were the victim of an event, but by how well you planned for it.

(C) 2004 Licata Kelleher Risk and Insurance Advisers, Inc. Permission granted for distribution as is (with full attribution).

Contact us for risk management strategy and implementation. We stand ready to be your partner in your business ventures.

Licata Kelleher is a risk management and insurance advisory firm. The firm does not sell insurance, but does counsel clients on the effectiveness of insurance, on reducing the cost of insurance and on the risk management process.

The above is intended to be general information, and should not be construed as specific recommendations.

 For more information, contact Debora Wu, at DWU@LicataRisk.com

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Reports

Fall 2005 INTERNATIONAL RISK MANAGEMENT
 
Spring 2004 EMPLOYMENT LAW MORPHS INTO A MONSTER

Fall 2004 INSURANCE BROKER SUED BY NEW YORK ATTORNEY GENERAL

Summer 2004 UNDERSTANDING THE DYNAMICS OF THE INSURANCE MARKET

Winter 2004 WORLD TRADE CASE UNVEILS INNER WORKINGS OF INSURANCE BROKER

 Fall 2003 A RISK MANAGEMENT APPROACH CFOs (AND THEIR ACCOUNTANTS) CAN LOVE

Summer 2003 PRESERVING COVERAGE FOR INNOCENT INSUREDS

Spring 2003 LEAVING TERRORISM COVERAGE ON THE TABLE

Winter 2003 COMPUTER SECURITY IS NOT A BLACK HOLE

Fall 2002 "LET'S BE CAREFUL OUT THERE

Spring/Summer 2002 WHAT WARREN BUFFET KNOWS ABOUT INSURANCE COMPANY FINANCIALS

Spring 2002 OPPORTUNITIES ABOUND IN DEVELOPMENT OF CONTAMINATED PROPERTIES

Winter 2001 "YOU CAN'T PAY US THIS MONTH? WHAT DO YOU MEAN 'NEW DEVELOPMENTS?"

Fall 2001 WORLD TRADE TERRORISM -- REPERCUSSIONS FOR INSURANCE MARKET

Summer 2001 ENERGY AVAILABILITY: CURRENT REALITY OR FOND MEMORY?

Spring 2001 "HOLD THAT BALLOT UP TO THE LIGHT"