First there were Hurricanes Charley, Frances, Ivan and Jeanne to get the insurance industry’s attention. Now, the insurance industry is staggering from a wave of investigations and indictments alleging a variety of abuses. Recent headlines have detailed investigations initiated by New York State Attorney General Eliot Spitzer, but the underlying issues are not new. Consumer advocates in California are waging a five-year battle against insurers in state court.

What are these alleged abuses? The concerns of most investigators center around two main issues: bid-rigging and contingent compensation to agents and brokers. Let’s look at these issues and how best to respond to them.

Bid-Rigging
Bid-rigging is a scheme in which an agent or a broker conspires with a handful of insurers to inflate bids. The insurer that “wins” the bid gets more premium than it would have received in a truly competitive environment. The agent gets a higher commission because of the inflated premium. The insurance buyer is the only loser.

Can you be a victim of bid-rigging? If only one insurance agency or brokerage bids and provides insurance to you, it is possible that your premium is higher than it should be.

Most agencies and brokerages are ethical, and do not practice bid-rigging. However, the economic incentive is always there to abuse the bidding process, so it is best to take some precautions when bidding your insurance.

How can you avoid bid-rigging? You should shop your insurance with two or more agencies or brokerages. Be sure that none of the agencies or brokerages engages in blocking. This is the practice where an agency or brokerage hogs the market by submitting your bid specifications to all the eligible insurers. You can prevent blocking by doing a market allocation. Market allocation is the process of assigning specific insurers to each agency or brokerage for bidding purposes. You may have to sign “agent of record” and/or “broker of record” letters giving each of the parties – depending on their roles as agents or brokers or both in your particular situation – clear authority to bid your insurance with the insurers you have allocated to them. As a bonus, you often get better pricing this way.

Bid rigging is less likely with direct writers. A direct writer is an insurer whose agents are also the insurer’s employees. Most representatives of direct writers are ethical professionals. Still, there have been instances where representatives of competing direct writers have conspired to trade off accounts in order to earn increased commissions. This is particularly hard to detect.

The only defense against this practice with direct writers is to stay in touch not only with the agents, but with the sales managers and underwriters as well. Let the sales manager and underwriter know the price you were quoted by their agent. A simple and discreet way to handle this is to e-mail a short message to the sales managers and underwriters. You may write, “We are considering your bid of $XXX for our insurance.” If the price you send to them doesn’t match the price the underwriter released, you will hear about it shortly.

Contingent Compensation
In addition to commissions and fees, some agents and brokers receive contingent compensation from insurers. Profitability or the volume of premium dollars produced, or both, drives most contingent compensation plans. Regulators are scrutinizing these bonuses because they create an incentive to inflate premium levels. Some regulators are proposing disclosure of contingent compensation to insurance buyers.

It should be noted that there is nothing illegal or immoral about contingent compensation. Contingent compensation is similar to “spiffs” or bonuses paid to other sales professionals and can become a major portion of an agent’s total income. Most of the controversy surrounding contingent compensation comes from the incorrect assumption that insurance agents have an obligation to find the best price for the insurance buyer.

Rules for Agents
By law, an insurance agent is an agent of the principal, which is the insurer. The agent generally has no fiduciary responsibility to the insurance buyer beyond offering appropriate coverage for the insurance buyer’s business. That means that the agent must at least offer the minimally-required coverages; but nothing prevents the agent from selling additional coverages that exceed the needs of the insurance buyer.

This is especially true for direct writers, where the agent is also an employee of the company as described earlier. These agent-employees have a responsibility to their employers to produce profitable business. It is fair and accurate to say that the objective for all agent-employees is to sell as much profitable insurance as they can for as much premium as possible.

Rules for Brokers
The ball game is a bit different for brokers. Technically, brokers work for the insurance buyer and not the insurer. Brokers normally work on a fee basis for the insurance buyer, but there are many possible compensation arrangements. A typical compensation arrangement has the insurance buyer paying the broker a fee that is determined in advance of the engagement; and the broker then obtains insurance quotes on a net basis; that is, with the normal commission that is paid to an agent subtracted from the premium total. In some cases, a broker won’t be able to secure coverage on a net basis, such as when the broker must use a direct writer for coverage.

The basic rule is that the broker acts as an intermediary for the insurance buyer and is paid by the insurance buyer; an agent acts as an intermediary for the insurance company and is paid by the insurance company.

The rules are not always uniform from jurisdiction to jurisdiction. Some jurisdictions require the broker to work solely on a fee basis for the insurance buyer, while others may allow a broker to receive commissions. Because the rules are not standardized, the distinction between agents and brokers is sometimes blurred. You should check with the insurance commission in your state to understand how brokers may operate.

Regulators are concerned that some brokers who do not receive commissions may receive contingent compensation from insurance companies. This creates a clear conflict of interest for the broker, and is potentially harmful to the interests of the insurance buyer. The conflict of interest is in one or both of two areas.

First, if the broker is compensated by the insurance company for the volume of business the broker brings to the company, there is an incentive to produce that business even if the price or coverage is not the best for the insurance buyer. Second, if the broker is compensated by the insurance company for profitable business, - losses that are significantly lower than premiums paid - there is an incentive to inflate prices or decrease coverages for the insurance buyer.

Insurance buyers should first ask brokers if they accept contingent compensation from insurers, and then weigh the implications of the answer before making a decision to do business.

Caveat Emptor
Bid-rigging never touches most businesses, but the precautions needed to avoid big-rigging are simple and can yield better pricing. With direct writers, practice a little extra communication with underwriters and sales managers to ensure you are receiving legitimate pricing. If you use independent agents, be sure to use several agencies for bidding, and do market allocations early in the process to increase your chances of receiving aggressive, competitive pricing.

In contrast to bid-rigging, contingent compensation plans are almost universal in their use. What does this mean to the insurance buyer who works with agents? Not much except, perhaps, to be aware that the insurance transaction is a negotiated process between a buyer who is looking for the best value, and a seller who is looking for the highest profit.

Contingent compensation with brokers is a more complicated issue, and you may do well to use only brokers who refuse to accept contingent compensation from insurers.

About the Author
Scott M. LeMay is the principal consultant in risk management and insurance advisory services for LeMay + Lang, a financial services firm in Memphis, Tennessee that serves a wide range of businesses and specializes in automobile and equipment dealerships. He is a Certified Risk Manager, an Associate in Risk Management, and a Certified Insurance Counselor. Scott can be reached at lemay@lemay-lang.com.