Questions of balance

New York attorney general Eliot Spitzer's investigation into alleged bid-rigging and unfair commission arrangements in the US has brought the UK market's practices under scrutiny.

Volume overriders and profit share agreements are common practice within the UK insurance market, but questions are being asked about the future of these deals.

Even corporate days for clients are being questioned.

With statutory regulation of brokers imminent and talk of a further consultation paper on commission disclosure next year, the question has been brought into sharper relief.

Whether these deals are illegal depends on the interpretation of the FSA's rules on unfair inducements (ICOB rule 2.3), which are deliberately couched in broad and high-level terms.

The rule states that: "A firm must take reasonable steps to ensure that it, and any person acting on its behalf, does not: offer, give, solicit or accept an inducement ... if it is likely to conflict to a material extent with any duty that the firm owes to its customers ..."

The definition of an "inducement" is very broad, being: "a benefit offered to a firm, or any person acting on its behalf, with a view to that firm, or that person, adopting a particular course of action. This can include, but is not limited to, cash, cash equivalents, commission, goods, hospitality, or training programmes".

The rule is not all-encompassing, and all reinsurance contracts and contracts defined as "large risks" are exempt. It also has territorial limitations.

So how does this rule apply in practice?

As a general rule, the insurance broker is the agent of the insured. At common law, if it receives no payment from the insured, it may receive an ordinary or reasonable remuneration according to market practice from the insurer.

If a broker receives an extraordinary sum, then it needs the insured's consent to avoid it being a secret profit. A broker can receive payments from both the insured and the insurer only if the insured consents. Payments under these agreements are then subject to the common law.

Placement service agreements

Under the FSA's rule, which supplements the common law, payment by an insurer to a broker under a placement service agreement (PSA) is certainly an inducement. Whether it is unfair will depend in each case on the circumstances.

It follows that an insurer who enters into PSAs is at significant risk of breaching the unfair inducement rule. If insurers still wish to use PSAs, then to protect themselves as far as possible, they should obligate the broker to disclose to the customer the existence of the PSA and how much cash the broker will receive in commission.

Profit share agreements

Critics say profit share arrangements encourage mis-selling, while others say they reward brokers for managing the level of risk. This in turn benefits all parties, including customers who are offered more competitive premiums.

They are, however, a long-standing market practice most commonly associated with line slips and delegated underwriting.

Such agreements are "inducements" according to the rule. Accordingly, they ought only to be entered into if any conflict with duties owed to the customer are properly managed. This is difficult where a broker is agent both of the insured (or client) and of the insurer.

As a minimum, insurers should require the broker to disclose to their client the agreement giving rise to the dual agency role and the commission they will receive under it.

In the long term it may benefit the market more if brokers who are granted delegated underwriting authority act only as agent of the insurer, thus changing the current structure of distribution channels.

Corporate days

Although seemingly harmless, corporate days are inducements because their purpose is to drum up business.

Similarly, gifts may be inducements. The real question is whether they are likely to conflict to a material extent with any duty that the firm owes to its customers.

The guidance notes to the FSA rules state in relation to goods and hospitality that "in particular, such benefits should not be of a kind or value that is likely to impair the ability of a firm to act in compliance with any rule in ICOB ...".

Hence, it is to a large extent a question of size and degree: the more elaborate or expensive the corporate event or gift, the more likely it is that it would be found to be an unfair inducement. This is true also of whether the gift is conditional on any particular event (for example, place this business with us and we will ...).

The guidance given by the FSA requires insurers and brokers to adopt procedures to recognise inducements and to deal with them when they arise.

There remains, however, a large grey area. In relation to corporate days, can an insurer take a broker to watch a game of rugby at Twickenham?

Or what if the broker does not benefit directly, because say, the insurer takes the broker's son to the game at the broker's request?

It is important that these events are kept as separate as possible from any business conducted between the insurer and broker.

Insurers ought to undertake a risk assessment in relation to planned corporate days to ensure that the event is not likely to conflict with any duties owed to the customer.

More guidance

The scope of the unfair inducement rule shows it to be unrestricted, encroaching on all of the practices considered above.

It can only be hoped that the FSA will choose to issue more guidance in relation to specific market practices so that insurers can act with full confidence that their activities are in compliance with the rule, although the FSA has regrettably not adopted this approach in the past.

For those insurers who do not comply with the rule, the potential consequences are stark: the FSA can impose unlimited fines on firms and on approved persons.

The FSA can also withdraw a firm's authorisation or permission and it can make restitution orders.

More important, however, can be the reputational loss to an insurer or broker following the announcement of an investigation by the regulator. This has in the past resulted in the insolvency of the company concerned.

Spitzer will level the UK playing field

New York attorney general Eliot Spitzer's far-reaching, and in some regard zealous, inquiry into contingent commissions has raised the question of transparency in the broker market, writes Elliot Lane. The ripples caused by his allegations, and the criminal charges brought against employees at AIG, Zurich and Ace, have yet to become waves in the UK, but many brokers are already bracing themselves for a full review of commissions in the new year.

But the majority of regional UK brokers do not want transparency. Spitzer's attack on the industry has left them shell-shocked, but the FSA's inertia and reluctance to offer a clear statement on its position before 14 January 2005 (when its statutory powers are finally invoked) has made them more reticient.

Motor broker MCE head of business development Julian Edwards says: "Transparency is a good thing to a certain degree. We publish our charges for add-on policies, a breakdown for what the client pays. But we don't publish our commissions or our overriders or our inducements."

David Curry, a broker at Miller Insurance Services, says: "I would like to see more of a response from the FSA, because that's after all who we are going to be regulated by. They have made it public that Aon, Marsh, and Willis have obtained their 'minded to authorise' letters, which is fine, but I would like more of a stance from the FSA."

Under the FSA's criteria, what are deemed to be "fair" inducements will be tolerated. This is not prescriptive and leaves the interpretation open.

It could be manipulated - does this mean a golf hospitality day or day at the races with clients is a fair inducement?

Heath Lambert Group managing director Adrian Colosso says: "Insurer agreements must only exist in the market where they are based on pre-agreed service levels, clearly identified for actual work undertaken. This can only result in raising the standards of service for clients.

"We have competed for business where our competitor's fee structure is a joke, and where it's impossible, in our opinion, to make any money. This will give us a level playing field."

It is understood Marsh UK's senior executives are already discussing a post-Spitzer business model. The crux of its plan will be to put the emphasis on the premium paid to place the risk. Any commission would be transparent and obvious on the placement. Then all other services, such as administration, marketing risk management, distribution will be calculated on a specific fee for the specific work.

Reinsurance broker Cooper Gay has already created a new entity, CG Global Risk, which will offer its multinational clients' services but on a discretionary basis. Cooper Gay chief executive Toby Esser says this move was taken in response to Spitzer's investigation into tying among the larger brokers concerning reinsurance agreements.

The large brokers, he says, are accused of pressuring their insurers to accept reinsurance agreements from their own in-house divisions under the threat that they will withdraw their clients' business.

Esser adds: "From our perspective, Spitzer saying tying is illegal is terrific news. It gives us the level playing field that we wanted and I imagine the fallout of the inquiry will lead to more consolidation. I personally would rather see consolidation than the market fracturing further."

With City law firm Freshfields exonerating Marsh UK from any evidence of bid-rigging, the ball now falls into the FSA's court. With speculation that the FSA will revisit the commission issue and look at introducing a blanket fee-based structure to the UK insurance industry.

An FSA spokesman says: "We cannot rule out a consultation in the next six months."