Having instigated major investigations into various aspects of the financial services industry, Eliot Spitzer, New York State attorney general, has turned his attention to insurance brokers, causing major ripples across the whole insurance sector. On October 14 Spitzer filed a complaint with the New York Supreme Court, accusing executives at insurance broker Marsh & McLennan of colluding with top insurance companies to fix prices and divert business towards favoured accounts, rather than acting in the best interests of their clients.
But Spitzer was not about to stop there. On November 12, he filed a second suit against life and disability insurance broker Universal Life Resources. His next move is widely expected to be a suit against the world’s second largest insurance brokerage, Aon, in the coming weeks.
Spreads for several European insurance names widened quickly on October 15, the day after the complaint was filed. AIG widened from 25bp to 36bp over mid-swaps in a week, while Munich dollar bonds widened from 28bp to 39bp over mid-swaps in a few days. Marsh bonds widened from 80bp to 280bp over mid-swaps.
While Spitzer’s latest crusade against corporate malfeasance is characteristically focused on the middlemen, European insurance companies and their bondholders are understandably skittish about the knock-on effects for the industry, and the possibility that insurers will be implicated in illegal activities. Insurers AIG, ACE, The Hartford, and Munich-American RiskPartners are all accused of participating in bid-rigging schemes. Zurich North America is mentioned but not implicated: Marsh threw some business its way in the hope of landing a contingent commission agreement, but was unsuccessful.
Spitzer alleges that many large insurers have been complicit in Marsh’s schemes. “They have paid hundreds of millions of dollars for Marsh to steer business their way,” he says. At times, says the complaint, “the insurance companies have gone much further, colluding with Marsh to rig bids and submit false quotes to unwitting clients.”
European insurance houses with significant US operations are most exposed to potential investigations: Spitzer has already subpoenaed ING Group, for example. Axa, Allianz, Zurich Financial Services and Munich Re all have large US operations.
Insurance brokers are supposed to act as the agents of insurance buyers, whether companies or individuals. Brokers solicit bids from insurers and then advise their clients to pick the best offer. In return, buyers of insurance pay insurance brokers a commission, on top of the price of the insurance.
So far, so good – except since the late 1990s the brokers have also been receiving commission from the insurers: a clear conflict of interest. Worse still, the scale of these payments will often be linked to the volume or quality of business that the broker steers towards the insurer. These contingent commission arrangements have been known in the industry as either “placement service agreements” or more recently “market service agreements”. Entering into such an agreement obviously gives the broker an incentive to favour some insurers over others, and to neglect its promise to act in the interest of its customers. Spitzer alleges that in 2003, Marsh made $800 million from contingent commission payments; its net income that year was $1.5 billion.
Surprisingly perhaps, this practice is legal, commonplace and was rarely criticised before the Spitzer investigations. The most painful charge for Marsh, however, relates to the alleged practice of bid rigging. The accusation goes like this: driven by the desire to capitalise on its contingent commission agreements, Marsh designates the winner of the bidding process in advance – regardless of how competitive that insurer’s offer is. But in order to make the process look competitive, Marsh convinces other insurers to submit false bids at inflated prices. Other insurers agree to submit these false bids on the understanding that it will be their turn to benefit next time around.
The Spitzer complaint explains in detail how Marsh put pressure on AIG to engage in systematic bid manipulation. Not content to rely on the implicit pressure of the contingent commission relationship, Marsh ran a system of ‘A’, ‘B’ and ‘C’ quotes. Where AIG was the incumbent carrier and a policy was up for renewal, Marsh would dictate to AIG a target premium and policy terms for a quote – an ‘A’ quote. By submitting this quote, AIG would guarantee retention of the business.
Where another insurer was incumbent, Marsh would ask AIG for a ‘B’ quote – also known as a ‘backup’ or ‘protective’ quote – often predetermined by Marsh. AIG would provide this quote on the understanding that it would not receive the business. AIG’s quote would always be slightly less favourable than the incumbent’s.
Finally, Marsh would request a ‘C’ quote when there was the possibility of actual competition for a client’s business – although even here, Marsh would often set price targets. According to Spitzer, the ‘ABC’ quote system was strictly enforced by William Gilman, executive director of marketing at Marsh Global Broking.
Of course, many insurers refused to take part in either contingent commission agreements or bid rigging. But the pressure on them to participate has been strong, given the degree of concentration in the insurance brokerage market. Corinne Cunningham, insurance analyst at RBS, explains: “The brokers have a lot of leverage over the insurers, given that the top three brokers – including Marsh – control the majority of the market.”
Spitzer alleges that Marsh’s Gilman warned that AIG would lose its entire book of business with Marsh if it did not provide ‘B’ quotes: “As he put it, Marsh ‘protected AIG’s ass’ when it was the incumbent carrier, and it expected AIG to help Marsh ‘protect’ other incumbents by providing ‘B’ quotes.”
The effect on Europe
There is no immediate cause for panic. Spreads on European insurance names had largely recovered within a week of the complaint being filed. Analysts claim that the spread reaction was amplified by technical factors. Spreads were already very tight because of CDO issuance going into October, but as the synthetic bid subsided, technicals eased up. “Disquiet over the GM downgrade provided further instability,” says Damien Régent, insurance analyst at UBS, “so when the bad news broke, spreads moved quickly.”
According to Régent, there was no real-money sell-off: the Street was long subordinated insurance debt and some hedge funds may have taken short positions. “In the context of a year of gradual tightening, it’s not a big deal,” he adds.
The market does not seem to expect any major impact on credit quality across the sector, except perhaps for individual names that have been found to be complicit in bid rigging. This could affect their credit ratings, not so much because of the fines they could potentially receive, but because the damage to their reputation could see them lose out on both new and repeat business. That said, the insurance market has also become more concentrated over the last few years, which means that in certain lines of business, it will be difficult to avoid using some of the market leaders, even if they have ripped you off in the past.
Cunningham at RBS argues that the ultimate impact will depend on how widespread the practice has been. “If all insurers have been participating in bid rigging then whilst they will face fines, their market positions could well be maintained as at the end of the day you have to get insurance somewhere,” she says. “But if it’s a few isolated players, they might suffer – even to the point of ratings pressure.”
A more subtle pressure will come from income streams wilting if insurers now have to sell at ‘honest’ prices. But this pressure should be offset by the fact that insurers will no longer be paying large commissions to brokers.
While Régent does not believe that the Spitzer investigations pose an imminent threat to credit quality in the insurance sector, he nevertheless sounds a note of caution. “The spread implications depend on the state of the credit markets generally. We are telling our clients to be cautious about insurance sub debt as we approach year-end. Technicals will become weaker as we approach year-end: no one wants to make strong calls. If the market is nervous about the sector, this could cause problems.” But, he adds, the yield is still great: “The carry on subordinated insurance debt is around 40bp over the overall corporate index.”