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Brokerage service agreements spell out responsibility.

by David D. Holbrook

David D. Holbrook is president of Marsh & McLennan Inc. in New York.

Imagine the following scenario: At the of a new relationship, a well-established broker arranges to place insurance for the risk manager of a sparkling-water company. Shaking hands on the deal, they both agree on the amount and method of the broker's compensation without putting anything down in writing. Later that year, the client contemplates acquiring a competitor. Believing that it was included in their verbal agreement, the client asks the broker to perform a due diligence analysis from a risk management perspective. This is the first major misunderstanding.

A few months later, the acquisition is completed and the client's business increases 100 percent. Although the insurance risks and the placement requirements double, the client believes the same initial compensation encompasses these additional broker responsibilities. This is the second misunderstanding. Finally, the new company's safety and property protection management systems need to be reviewed and improved. Again, the client believes this activity is covered by the initial agreement, and again, he is mistaken.

As a result, the mutual understanding harmonious relationship between the client and broker is stressed and may deteriorate. One of the curious anomalies of the insurance industry is that brokers and their corporate clients often operate without explicit written agreements. Both parties assume they understand the terms, yet that is often not the case. Too frequently, only individual recollections and the cooperative spirit of the client and broker are relied on when misunderstandings occur.

Despite the trend toward negotiated compensation in the brokerage industry, the give-and-take process seldom defines current arrangements. Yet each year, brokers and clients can, and should, clarify the scope of services and specify the delivery period. They can then incorporate these terms into a written brokerage service agreement.

The agreement eliminates arguments or objections when the client asks the broker to perform services covered-or not covered-by it. From the client's perspective, the agreement helps compare proposals from competing brokers by detailing the services being offered. This may sound like a radical departure from tradition, but the sparkling-water company scenario illustrates how quickly these arrangements become complicated and controversial.

The broker's compensation is obviously a key issue in any service agreement. The amount of compensation, the payment method and contract length should be clearly defined. The agreement should also contain stipulations regarding substantial changes in the scope of the client's business through the addition or elimination of operations. In such cases, the client and broker are expected to negotiate in good faith to revise compensation upward or downward as circumstances warrant.

The agreement could also list terms for a midterm cancellation of the relationship. This can be a sticky issue if the incumbent broker believes he or she has earned the whole year's commission at the inception of the placement. it should also stipulate that insurance intermediaries, such as wholesale brokers, are the broker's subcontractors who are being compensated for their services by the insurers they represent.

The broker's service obligations must also be outlined in an agreement, and would probably begin with a broad philosophical statement on broker representation of risk managers in the international insurance market. The agreement would cite specific responsibilities, including negotiating with insurers for coverage, assisting in the preparation of underwriting information and completion of insurance applications and reviewing the accuracy and conformity of all policies and endorsements delivered by insurers. In addition, it would outline responsibility for checking retrospective rating adjustments and audits and providing loss prevention services.

The agreement should detail circumstances under which the broker is not responsible, such as the solvency or claims-paying ability of insurers or the accuracy of information provided by the client. It should also indicate situations, such as co-brokerage arrangements at the direction of the client, for which the broker has limited liability.

Post-policy servicing responsibilities should also be delineated, as they are probably the most misunderstood aspect of any brokerage engagement. Specifically, such servicing of former clients must be separated from similar duties performed for existing clients.

Marsh & McLennan's general practice is to "put the tail in front." When starting with a new client, the broker is expected to take over the post-policy servicing of the tail. After all, from the client's perspective, doesn't the new broker have a greater interest in the client than the ex-broker? Similarly, if the broker is replaced, the successor should assume responsibility for post-policy servicing.

Many brokers mistakenly believe they are legally required to provide claims services to former clients. However, there are no such legal requirements. Furthermore, in today's litigious society undertaking such work for previous customers has become impractical and too costly for brokers to provide in the name of client service.

From the broker's standpoint, the problem has been compounded by the heavy merger and acquisition activity in the 1980s, which led to a gradual consolidation of the broker's client base and to some extreme situations. For example, Marsh & McLennan was asked to provide post-policy servicing for a former client, but the company had been broken up through a series of acquisitions and mergers. However, its liabilities were still intact.

Brokers cannot price post-policy servicing on an open-ended basis with any degree of confidence. No broker or client can project unknown services into an unknown future. Nor can they price today what the services will cost tomorrow. For example, in an asbestos case, Marsh & McLennan absorbed extra expenses of about $1 million in one year for an existing client. Claim reporting requirements called for copies of about 12 million documents in a hurry, and charges from an outside service totaled almost $400,000. Additional outlays of more than $600,000 were chalked up by Marsh & McLennan's claims department beyond the usual overhead built into compensation for this service. In the name of self-protection and fairness, wouldn't we have to renegotiate our compensation? From the client's vantage point, receiving something for nothing in the short term does not lead to long-term relationships.

Eliminating Body Language

It has been said that brokers are misdeclaring their true profits, dividends and taxes. This happens because they do not take into account the real cost of servicing the long tail and handling incurred but not reported claims. Accounting procedures do not allow brokers to set aside reserves, as insurers are allowed, to reflect the additional and inevitable expense of providing these services.

Brokerage service agreements have generally been used by only a few conservative clients or brokers in unusual circumstances. Today, the client and the broker need these agreements if their relationship is to survive the complexities, pressures and litigious nature of the current environment.

Unless something goes wrong in the relationship, the client and broker may not pay much attention to the existence of an agreement. Indeed, documents remain out of sight and out of mind until problems erupt. But why should these valuable partnerships be pushed to the point where matters can only be settled in court? Why not eliminate uncertainties and worries from the start?

The interests of both parties would be strengthened if the entire industry recognized the necessity of translating the broker-client relationship from body language into written language. Accountants, lawyers and investment bankers have written agreements with their clients. Brokers should have them as well.
COPYRIGHT 1991 Risk Management Society Publishing, Inc.
No portion of this article can be reproduced without the express written permission from the copyright holder.
Copyright 1991 Gale, Cengage Learning. All rights reserved.

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Title Annotation:insurance brokers
Author:Holbrook, David D.
Publication:Risk Management
Date:Jul 1, 1991
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