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Hidden Commissions

Should clients be concerned that their broker receives millions of dollars in hidden kickbacks from insurers for bringing business to them, in addition to the upfront commissions charged on the placement?

Regulators on both sides of the Atlantic seem to think not. But as these side agreements become more popular is there a case for greater transparency and disclosure? And do they create an unlevel playing field where some broking firms can effectively subsidise their placement commissions with payments from insurance commissions?

Although most often called overriders, these side deals are known as many things - including volume payments, placement service agreements (PSAs) and even back-handers - although the latter suggests illegality, of which there is no evidence. Nor is there much evidence on how widespread the practice is - although unquestionably it is a highly profitable activity for those brokers who are sufficiently dominant to secure these payments. In essence, insurance companies agree to pay a sum - typically based upon volume, but sometimes on profits or levels of commissions - in return for providing a certain service.

These "services" can be broad ranging. For instance, in MMC's 2002 Report and Accounts, it explains: "These services include new product development, the development and provision of technology, administration, and the delivery of information on developments among broad client segments and the insurance markets."

But ultimately underwriters’ willingness to enter into these agreements depends upon more commercial criteria: the quantity (and quality) of business the broker can guarantee. It is a point recognised by MMC when it explains: "Placement service revenue includes payments or allowances by insurance companies based upon such factors as the overall volume of business placed by the broker with that insurer, the aggregate commissions paid by the insurer for that business during specific periods, or the profitability or loss to the insurer of the risks placed."

Indeed, PSA agreements by brokers are a feature on both sides of the Atlantic, despite the fact that London Market brokers have to bear far higher costs than those operating in North America, Bermuda and Europe. In London it is the brokers who administer and process claims and who help issue policy wordings - an often enormous cost. Yet the overrider commissions charged do not appear to take this additional burden into account - anecdotal evidence suggests PSA commissions in North America are just as high as those in London.

Commitment to fuller disclosure
There is also evidence that as the industry gears up for the 1 January renewals, PSAs have never been more popular - despite a concerted attempt by insurance buyers to inject greater transparency into these agreements some four years ago. In 1999, the UK risk managers association AIRMIC called for an end to hidden commissions. It led to two major London market brokers Aon Ltd and JLT both committing to fuller disclosure, while in the US Marsh agreed to greater transparency with the US risk managers association, RIMS.

Indeed, Aon Ltd's 2001 Client Service Charter commits the firm to reject overriders. "To avoid conflicts of interest we do not accept incentives from insurers to place business with them - these incentives are sometimes called 'overriding commissions' or simply 'overriders'", the Charter explains. Nevertheless, the broker continues, "insurers may also pay Insurer Services Brokerage or other remuneration for the work we do for them. The standard level of this brokerage is 2.5 percent of premium but depending on the services provided, higher levels of brokerage, or fees, could apply".

In contrast, Marsh - the acknowledged leaders in charging PSAs - tends to charge a higher rate. For instance, in the London Market, Marsh has told some clients that it wishes to charge 6 percent of net premium on all UK business and 7.5 percent of net premium on all other business placed next year. “Slip commission (where applicable) will reduce by the same percentage,” Marsh tells its insurers in its recent “Conversion” report. “Conversion”, Marsh explains, is the name being given to a change in the way it wishes to be paid by underwriters. “Crudely put it is recognising the difference between wholesale and retail roles but taking the wholesale commission and converting it into a separate revenue to be paid off-slip [IQ emphasis],” the report continues.

It's a fee which many insurers are happy to pay. As one Lloyd's underwriter told IQ: "I'm uncomfortable when it's not transparent but it takes a brave man to say he will never pay a PSA because there is a fear of losing business. Marsh are supremely powerful but their business is often supremely good."

It is this fear of losing business - or failing to make one’s premium income targets in a declining market - which appears to be driving more and more such agreements. Property, offshore energy and aviation have all seen rate reductions in 2003 and evidence suggests insurers are increasingly willing to enter into side agreements if it means they will meet their income targets.

"It's currently being driven by volume," remarked one London Market broker. "Some of the start-ups are particularly keen on them. In Bermuda it’s not uncommon to hear 'we will give you 5 percent if you give us $20mn of income but we will give you 7.5 percent if you give us, say, $70mn of business'."

However, he also highlighted an issue which is of grave concern to the industry's clients - potential conflict of interest. "I have also heard insurers say they are happy to pay them because it disincentives brokers to negotiate lower rates. If a broker gets a 5 percent kickback on an account that has seen 400 percent rate rises, then it is clearly in the underwriter's interest to continue paying them."

Basic conflict of interest
This is a wholly cynical view but David Gamble, the chief executive of AIRMIC, explains that his members are concerned about the lack of transparency. "There is a basic conflict of interest with overriders. Are brokers advising in the interests of the client or are they acting as a marketing arm for insurers?" he told IQ.

Marsh explains that “one of the principal drivers of conversion is clarity”. In a section entitled “Are clients aware of this revenue stream?”, it explains: “Marsh has established a standard format ‘Client Service Agreement’ making plain to Clients that Marsh may be paid by Underwriters for services rendered in addition to fees they pay or slip commissions they allow us to retain... Specific disclosure requests from clients are answered individually.

For Gamble, AIRMIC is waiting to see the Financial Services Authority’s stance when they take over UK broker regulation in 2005: "We are very interested to see how the FSA will respond to this practice. The situation is very different to when we raised our concerns because we now have an infinitely more powerful regulator," he told IQ.

But current indications are that the FSA is unlikely to go much beyond the current requirements of the General Insurance Standards Council which stipulate that a broker must disclose all commissions - but only if asked by the client.

An FSA consultation paper (CP187) published earlier this year did not propose requiring intermediaries to disclose inducements they receive from insurers. Although an FSA spokeswoman told IQ: “We are, however, consulting on a general 'unfair inducements' rule that would cover things like volume overrides.” She continued by explaining that the consultation process is ongoing. “CP187 proposes that we will not ban any particular sort of inducements as long as they are not used in a way that results in customers being treated unfairly. However, as part of our consultation on the 'unfair inducements' rule we asked about whether there are any features of inducements that should be banned. We are currently considering responses and will be publishing feedback and final rules in January [2004].

In the US, however, regulators say there is little pressure to increase disclosure. Lenita Blasingame, the deputy to Mike Pickens, the Arkansas insurance commissioner and president of the National Association of Insurance Commissioners, commented: "In most States, volume commissions have to be disclosed but only as part of a company's aggregate commissions in their State filings.

It is not a situation that everyone is comfortable with. Susan Metzer is a former president of the US risk managers association RIMS and the current executive vice-president of IFRIMA, the International Federation of Risk & Insurance Management Association. She told IQ: “There is no voluntary disclosure of these arrangements other than in the aggregate in the financial statements of the publicly traded brokers. I do not think that this is adequate as commissions should be subject to transparent reporting.

Metzer points out that many North American risk managers “have moved from a commission to a fee based remuneration of their brokers” and as a consequence are “insisting on quotes from their insurers which are 'net' of commission to ensure that they are not charged twice” - although she acknowledges that these do not include PSAs which are still received by brokers.

She continued: “Those risk managers who pay by commissions do have concerns regarding this.

But how widespread are PSAs? With disclosure voluntary and an understandable reluctance for brokers to reveal their reliance on them, it’s difficult to say. What one can say for certain is that it involves many hundreds of millions of dollars. For instance, Marsh Global - the market facing division of Marsh which deals with these payments - is estimated to generate around a third of all Marsh's revenues, which would suggest annual income of $700mn-$800mn. Many other commercial brokers are also thought to derive a significant proportion of their income from these payments.

The brokers who do charge PSAs also make the valid point that they do a lot of unpaid work, especially in London. But is this all the more reason for greater transparency, especially in the post-Enron era of improved disclosure and corporate governance? Why shouldn't these payments be disclosed and any suspicions of conflicts of interest neutered? After all, even if international regulators are reluctant to intervene, buyers can vote with their feet - as Gamble warns: "Buyers are pretty fed up with the vast price increases. Although some rate rises have been justified, others appear opportunistic. AIRMIC members are generally very happy with the service they have received from their brokers but if they begin to feel they are being ripped off then this goodwill might be lost. If companies decide to self-insure then it would be a problem for the industry."

A cautionary tale then for both brokers and insurers.

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