Felix Kloman gave a suitably provocative speech at the IRM annual lecture in October in London. With the assistance of some humourous references to Bruce, Bruce, Bruce, Brian and a dead parrot (courtesy of Monty Python for those who were not present), Kloman made some hard-hitting comments about the essentially obsolete business model still prevalent - despite the Eliot Spitzer-led attack on industry practice - in the field of remuneration of intermediaries and the transaction of commercial insurance contracts.
He also addressed the issues of fragmentation of risk management practice and the continuation of the narrow definition of risk, which focuses on the downside at the expense of a more balanced view of risk and reward.
Here, I would like to look at the first of these issues - the apparent unwillingness or inability of the insurance industry to eliminate a systemic conflict of interest in the role and remuneration of insurance intermediaries.
Back in November 2004 when the Spitzer investigation first made headline news, I exchanged e-mails with Kloman on the subject of the potential for destructive and undeserved collateral damage to many stakeholders in the insurance markets. I also expressed my sense of the need for a change in the industry's business models and practices - including a review by the national risk and insurance management associations of their commercial relationships with the various market participants - as follows:
'The national and international risk and insurance management associations should consider carefully some of the possible ramifications of the fallout from the Eliot Spitzer investigations (et al). We should not lose sight of the fact that an important part of the risk and insurance manager's role lies with formulating risk financing and risk transfer alternatives for his or her company's top management's consideration. We need a market place within which to create such options. To date, basis risk is best addressed in the commercial insurance market, if it is not retained.
'We all know that the commercial insurance market is in a fragile state, having to confront increasingly complex underwriting challenges; with a potentially fluid capital base; with a legacy of two decades of under-performance in terms of risk adjusted returns; with a legacy of under-reserved liabilities that represent at least 10% of the total market capital base, and in a changing and complex accounting environment that is likely to impose significant asset/liability mismatching volatility to the published financial results of these already weakened insurance companies.
'The insurance buyers need to understand that Marsh's (or Aon's or Willis's etc) problems with Eliot Spitzer and the SEC are only the tip of a potentially destructive iceberg. While the key market players that are implicated in improprieties should be able to work out definitive (but expensive) settlements and business model changes with the market regulators within a reasonably short period of time, the much greater danger lies with the plethora of civil lawsuits that may emerge, driven by a powerful plaintiff bar, on behalf of shareholders who have seen dramatic share price collapses and who allege past mis-statements of financial health at both brokers and carriers. The last thing that the commercial insurance industry needs now is an additional multi-billion dollar, multi-year series of class action lawsuits.
'Further, consider the collateral damage that a politically-driven series of investigations (and the Eliot Spitzer example may spawn progeny) can bring to an industry where 99.99% of the people employed continue to work, diligently, honestly and constructively every working day of the year.
How is the social cost of firing cruise missiles into companies justified when only a handful of well-placed bullets is required?
'Like it or not, corporate insurance buyers have been, for the most part, placid onlookers at the growing leverage of the consolidating insurance brokers. It is also true to say that most of the national risk and insurance management associations' activities are heavily subsidised by the insurance intermediaries and insurance companies. So there is more than a hint of ingratitude - even an element of hypocrisy - in certain current attempts to create a distance between the insurance procurement community and the marketplace in which it has historically derived much comfort and support.
As we review and discuss business model changes, this aspect of association financing and subsidies should also be thrown open to question.'
Kloman responded rapidly and succinctly, and endorsed the fact that the insurance buyers can, and should, play an important role in agitating for change. In fact, he levelled considerable criticism at the insurance buyers.
'That insurance buyers have been 'placid onlookers' (although 'placid' may not be the proper word: I prefer 'complicit', in that few were willing to attack a system that, as you point out, heavily subsidised buyer organisations and entertained the buyers themselves) contributed to the problem and the disease. To have an adviser or intermediary paid by the vendor he selects, rather than by the client (commissions themselves) is essentially corrupting.
'Had buyers earlier had the gumption to push for material changes in the system, we might not have had the current chaotic conditions, some of which could seriously erode the ability of insurers to provide risk financing. Pandora's Box is now open, and I believe the best approach is to push for a radical change in the entire business model. That change will include:
- elimination of ALL commissions and any other income (placement of reinsurance, etc) from insurers to brokers (those who hold themselves out as advisers to buyers)
- substitution of fees, mutually agreed on, and based on time spent and quality of work
- direct contact between buyers and insurers, when desired by buyers (most insurers will have to gear up for this new approach)
- all premium payments to be made directly to insurers
- support by buyers of new and more intelligent regulation of insurance companies (this means federal regulation in the US and the possible application of Basel 2 to insurers globally)
- greater use of capital markets for all forms of risk financing
- push for tax deductibility of properly constructed internal risk financing reserves.'
Lack of progress
Nearly a year has passed since this exchange of e-mails, and the intervening months have been noteworthy for the apparent lack of progress. This was recently summed up in one publication in September in an article entitled 'Chaos reigns - despite promises for greater disclosure, confusion and indecision continue to surround brokers' use of contingent commissions'.
It is clear that market agreements and even contingent commissions are still in use. Some insurance intermediaries are continuing to earn contingent commissions on the basis that, so long as they are disclosed, they are acceptable to both buyer and insurance carrier. Other insurance intermediaries have reversed earlier statements or decisions to stop receiving commissions from insurance carriers on the basis that others are still continuing to do so.
Nor are the national risk and insurance management associations apparently ready to change their ways and wean themselves off the generous financing of conferences, seminars, workshops or educational initiatives. They continue to accept subsidies and donations in the face of the Spitzer storm. That may have been displaced from the newspaper headlines by other more dramatic natural storms, but it still continues to blow.
What has happened to the notion of agency? Why is there not more comment or attention paid to this relatively simple legal principle? It should be axiomatic for a market intermediary that describes itself as a buyer's agent to work exclusively for and be remunerated by its principal - the buyer. No other forms of payment from any other source should be received within the boundaries of the agency agreement.
Nothing of course prevents an insurance intermediary from deciding to play the role of agent to an insurance carrier, but such intermediary can no longer represent the best interests of any party other than its principal - the insurance carrier.
However, with the best will in the world (which cannot always be assumed), insurance intermediaries cannot play both roles within the same management structure, and arguably should not do so within the same equity structure.
It is no longer enough (and probably never should have been enough) for insurance intermediaries to state that, from now on, full and complete disclosure of all avenues and sources of revenue will be made to both buyers and sellers. The global business environment is more complex, and belief and trust in the commercial marketplace much lower than they have been in the past - and much lower than they should be in an industry necessarily underpinned by the principle of utmost good faith.
As Kloman stated in his lecture: 'We have corrupted a system that mandates trust between client and adviser and utmost good faith between buyer and insurer.' There is no place for legacy conflicts of interest in the global insurance markets, even if they may be more perceived than real. If the market participants cannot or will not change their business models, it is inevitable that external stakeholders will force the change sooner or later.
There are basically two reasonable responses to the existing, largely self-imposed agency conundrum.
- Either the insurance intermediaries reorganise their management structures - and preferably their equity structures - so as to separate effectively and credibly their insurance buyer agency teams from their insurance carrier/market agency teams, or:
- Insurance buyers should accept as a fait accompli that the kind of reorganisation entailed in the first suggestion is likely to be sufficiently complicated and costly to discourage all insurance intermediaries other than non-legacy, start-up operations from pursuing such a strategy. As a result, the insurance buyer should assume that insurance intermediaries are agents of the market that they serve - that they work for the insurance carriers and are remunerated only by the insurance carriers.
Personal experience suggests that, since a burst of risk and insurance adviser spin-off activity is not likely in the immediate future, the sophisticated insurance buyer should take pains to separate insurance placement activities (that may or may not involve an insurance intermediary) from risk and insurance management advisory services that may include the design of risk financing structures. It is necessary to keep the different agencies distinct and apart, and for the buyer to pay only for the services of the agency representing unequivocally the buyer's interests.
There is another important stakeholder interest that is directly concerned with the question of insurance intermediary reorganisation/business model evolution. How should employees that work for these insurance intermediaries feel about having their annual bonuses, stock option plans, discounted stock purchase plans, and company-linked savings plans exposed to further regulatory missiles? Who will be willing to invest years of service in a company whose business model has been shown to be vulnerable? How will the best and the brightest be retained in an industry that is not willing or able to sort itself out while it has the chance?
- Chris Lajtha is the founder/owner of ADAGEO, a risk management consulting company, Tel: +33 6 16 32 11 38 08, E-mail: email@example.com.