A house divided: while the four biggest insurance brokers--and several top insurance carriers--shun contingent commissions, many smaller players in the industry defend and rely on them.

Key Points

* The top four global brokers represent about 77% of the total revenue from the top 20 brokers.

* While the top four brokers and several large carriers have stopped the practice of contingent commissions, many smaller companies still rely on them.

* Travelers and Chubb have established a new incentive-based compensation system that's focused on past performance, rather than contingent on future business.

Like many insurance brokers, Alex Soto, president of Miami-based Insource Inc., has some strong opinions about contingent commissions.

"Incentive programs that reward excellence in risk management are right, proper and legal" Soto said. "This brouhaha that we need to eliminate contingent commissions--the decision of Mr. Spitzer that somehow [contingent commissions] create an incentive to place a potential client in a more expensive, less valuable product because I will be compensated--is a fool's argument," Soto said.

He's not alone in his view.

"Contingent fees are legal and part of the American way of doing business," said Robert Rusbuldt, chief executive officer of the Independent Insurance Agents and Brokers of America. "Incentive compensation for sales excellence is used in virtually every sales force in the country. What is baffling to many agents is how incentive compensation, which is legal, got caught up in what were clearly illegal activities that deserved to be prosecuted."

Meanwhile, others in the industry--including Joseph Plumeri, chairman and chief executive officer of Willis Group Holdings, have called for the complete elimination of contingent fees after then-New York State Attorney General Eliot Spitzer put the practice of the commissions in the spotlight when he investigated several companies in the industry for "allegations of fraud and anti-competitive business practices" in 2004.

Several executives pleaded guilty to such practices, including bid rigging. But the guilty pleas echoed above and beyond the wrongdoing of any individual to have a tremendous impact across the entire industry.

When Spitzer announced the $850 million settlement with Marsh & McLennan Cos. to resolve any allegations of wrongdoing, included in the settlement was Marsh's plan to limit its insurance brokerage compensation to a single fee at the time the business is placed, a ban on contingent commissions and a requirement that all compensation be disclosed to and approved by Marsh's clients.

With $11.7 billion in revenue for 2005, Marsh captured a tidy 36% market share of the $32.6 billion in revenue of the top 20 global brokers, according to Best's Review's ranking of top global insurance brokers.

"These landmark reforms will help protect against conflict of interest and help restore the integrity of the entire insurance industry, if followed by other firms," Spitzer said at the time the settlement was announced.

The four largest brokerages in the United States--Marsh, Aon Corp., Willis Group Holdings and Arthur J. Gallagher--swore off contingent commissions soon after the investigations in 2004. Together, those top four brokers represent about 77% of the market share of the top 20 brokers. The top 20 brokers represent about 90% of the total market, according to A.M. Best.

Insurers Ace Ltd. and American International Group followed suit soon after, and were joined by Travelers, Zurich Financial, Chubb, Metropolitan Life and Unum. Many of those companies agreed to give up or limit contingent commissions in settlements with state attorneys.

"The carriers deciding not to offer contingent fees probably had a more profound impact on the market than the brokers not accepting them. Not accepting them was a small corner of the market, but when insurance companies stop paying them, they aren't paying them to the mom-and-pop brokers, said Ed Koral, a senior manager with Deloitte's insurance industry group.

While these giants in the industry are saying no to contingent commissions, smaller national and regional players continue to say yes.

"The unfortunate part is that the agreements entered into by insurance companies and brokers were based on discussions where we weren't at the table," said Soto. "But those agreements have deeply affected us."

Patchwork of Pay

While the dust settles on the investigations and settlements, what remains is a market in transition, with many different ways to compensate brokers--including some new proposals from Travelers and Chubb. (See "New Rules" on page 30.)

"There are multiple ways that people are being compensated. It's always been that way; it's just more pronounced now," said Ken A. Crerar, president of the Council of Insurance Agents and Brokers. "Compensation shouldn't be defined; let the market innovate"

Soto, who is also president of the IIABA, agreed.

"What regulates me is competition. We have intense competition. Not only do I know it, hut so do my clients,' Soto said.

Soto said it is ridiculous to think an agent would risk a relationship with a client for the "little, extra minuscule" contingent commission.

"My client judges me every day on four issues: the quality of the product, the price, the quality of the insurance company and what I do for them as an agent and broker. It's about coverage, price, quality and service. If those things don't translate into value for them, they move on," Soto said.

John Sarich, an insurance industry veteran and executive vice president of RemitPro Inc., said contingent commissions were perceived as a conflict of interest primarily because the insurance industry "didn't handle the public relations aspect well. I don't think they explained it very well."

Fresh Air

The debate over contingent commissions has resulted in a re-examination of the way insurance buyers, brokers and carriers do business.

"It's led to some very productive dialogue between brokers and their clients as to what services are necessary and who should be providing them. Several of them have signed agreements requiring [them] to be transparent," said Koral.

Agents and brokers are having different conversations with clients than they had in the past, said Crerar. "The whole turmoil caused the industry to do a real hard look at themselves."

"I think this review is good, because it causes agents and brokers to be transparent to justify what they are doing. I don't think there's any harm in that," said Jim Henderson, chief operating officer at Brown & Brown, the seventh largest global insurance broker according to Bests Review.

Brown & Brown has not abdicated contingent commissions, Henderson said. "Contingent commissions are really profit sharing. Their history and origin are well-documented, and we continue to receive them," he said.

He said what he expects carriers to do now is offer profit sharing incentives based on a broker's historical performance, not one that is strictly volume based.

Other criteria, including retention of business, profitability of the business, and even the use of electronic transfer of funds to make the business more efficient could be rewarded with additional commissions. "There's a number of performance criteria [the carriers] are asking us to do, and if you do all these things, they are willing to pay you more," Henderson said.

These types of agreements were not those that led to the various state attorneys general investigations, Henderson said.

"There were agreements out there that were in conflict with the existing understanding with the customer. The broker would have a fee-based agreement with the insured, but unknown to the company, there was additional compensation consideration with the carrier," Henderson said. "I don't know of any broker doing that today."

He said the industry agrees that practices such as bid-rigging "are categorically wrong."

Perhaps the biggest change impacting all carriers has been the increased drive to be transparent.

For instance, Brown & Brown reached a settlement with Florida regulators over disclosing to buyers its relationship between its retail and wholesale brokerage.

"They haven't asked us to change the practice, but disclose it," Henderson said. "Disclosure has been good for the industry. It's expensive. It's painful. But I think it's a good procedure."

New Measuring Stick

Brokers are being forced to actually calculate how much it costs them to provide services to clients, Koral said.

"They are assessing the profitability of their accounts and trying to get additional fees or reduce services to deal with the shortfall," Koral said. "What we've seen in the last two years is continued adjustment to a world without contingent commissions, and more movement toward a careful measurement of the cost to deliver services."

He said large brokers did not have a system to measure to the letter what it cost to deliver services to clients. "They have begun time reporting. It's a very basic thing, but if you don't have that information, it's very difficult to know what it costs you on a case-by-case basis."

Crerar agreed. "One of the reasons they had problems determining costs is they didn't know the profit level on their business. They have a much better handle on what their margins are like now. Now, they talk about whether they can do a certain piece of business or not."

All of this has bad a positive impact on the industry, many said.

"The distribution sector has come out of this feeling much stronger about who they are and what they do. I think risk managers are much clearer on what the brokers do. It's forced a dialogue that may not have happened in the past," Crerar said. "If the government stays out of it, the market will continue to innovate."

Koral wondered how long the industry can function as a house divided. "How long can you go without someone trying to force one way of doing business?" he said.

Rusbuldt said it's also the American way to have different ways to compensate people.

"Some pay incentive compensation. Some pay contingent commissions. Some pay supplemental compensation. And some don't pay any. The marketplace will decide whether a company needs to pay an incentive commission or not," Rusbuldt said.

Contingent Commissions

Brokers traditionally have been paid through flat fees and/or by commissions. Contingent commissions, also called override commissions, are a specific type of commission that is triggered by something other than the placing of that specific policy. For instance, contingent commissions can be offered for producing a certain volume of business during a year, or offered as a profit-sharing mechanism to reward brokers if the business they produce reaches certain profitability thresholds.

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