Commentary

Not Spitzer’s Job

This article appeared in The Wall Street Journal on October 22, 2004
When homebuyers buy a house, the realtor is paid a commission by the seller. If buyers view that as “conflict of interest,” they might imagine being steered to the wrong house and paying an inflated price.

Eliot Spitzer divines such a “conflict” in the fact that insurance companies pay “contingent commissions” to brokers who bring them new business or get clients to renew policies. As in previous Spitzer cases, this one began with a press release citing snippets from one company’s e-mails. The initial target is Marsh & McLennan, owner of the world’s largest insurance brokerage. And as with previous Spitzer press releases, the media dutifully described the New York AG’s unproven charges against a few as industry-wide “scandal.” CBS Marketwatch spoke of contingent commissions being “at the center of a growing scandal in the insurance industry.” There’s no crime named “scandal,” so presumptions of innocence can be dispensed with. The press release was titled “Investigation Reveals Widespread Corruption in Insurance Industry,” but “corruption” is just another smear word like “scandal.”

Allegations of inadequate disclosure of the terms of commission agreements could be easily remedied if valid. Yet Mr. Spitzer demands “major corrective action and reform.” He wants insurance brokers to stop collecting fees from sellers, although such an unlegislated “reform” would require larger fees from buyers. A few insurers mentioned in the complaint have said they’ll stop paying such fees. But that may be bad news for those insurers and their clients, since these commissions, like other market arrangements, came into being for a reason. Contingent fees are often based on the profitability of the business, so that brokers who keep bringing high-risk clients to insurers will not be rewarded for doing so. Contingent fees for renewing policies also provide a clear incentive for brokers to keep clients satisfied. Business insurance can be custom-tailored, so policies do not compete on price alone.

Mr. Spitzer’s complaint said that collecting fees from insurance companies is “phenomenally profitable.” “In 2003 alone,” it says, “approximately $800 million of Marsh’s earnings were attributable to contingent commission payments. That year, Marsh overall reported approximately $1.5 billion in net income. Marsh, however, has never disclosed to its shareholders how contingent commissions constitute the lifeblood of its business… . The enormous size of these profits is not happenstance… .” If Marsh described $800 million of revenues as profits, earnings or income, as the complaint suggests they should, they’d be guilty of fraud. And far from being “the lifeblood of the business,” these fees were only 7% of revenues.

The serious charges involve bid-rigging — collusion to make sure a favored company isn’t underbid. This supposedly resulted in “elevating the price of insurance for every policyholder.” Marsh allegedly became the biggest among insurance brokers by systematically overcharging all its clients, nearly all of whom are major corporations. Yet wouldn’t a broker’s reputation for routinely overcharging for insurance become commonly known? Don’t sophisticated corporate purchasing agents know how to shop around?

Some selections from e-mails do appear damaging. But many key accusations are not direct quotes and others cite no specific reference. Sections that may appear to suggest “elevating the price” do not really say that. One underwriter wrote that his company wanted to charge $890,000 but “could get to $850,000 if needed. [A Marsh broker] gave me a song and dance that game plan is for AIG at $850,000.” Since this irritated challenger was clearly unwilling to underbid the incumbent, why should the broker recommend changing insurers?

Companies involved in Mr. Spitzer’s complaint may have run afoul of New York’s 1893 antitrust law, but that remains to be proven. In any event, that wouldn’t demonstrate industrywide “corruption” or “scandal” any more than the overblown complaint about active trading in a few mutual funds involved industrywide scandal. But Mr. Spitzer has the deck stacked his way thanks to the 1921 Martin Act, which allows almost anything to be called fraud.

Mr. Spitzer has no authority to dictate how insurance brokers are paid. Improving disclosure is unobjectionable, but meddling with market-based incentive schemes is risky. If New York’s elected legislators want to ban this variety of sales commissions, that’s their business. It’s not Mr. Spitzer’s job to regulate entire industries through threats of endless litigation.

Alan Reynolds is a senior fellow at the Cato Institute.