The New York Attorney General's Controversial Suit Against the Insurance Industry:
Why Claims Eliot Spitzer Is Overreaching Are Wrong

After taking on the mutual fund industry, New York Attorney General Eliot Spitzer is now setting his sights on the insurance industry. Two weeks ago, at a news conference, he announced he had found wide-spread wrongdoing.

Since then, the stocks of various insurance brokers and companies have dropped. The major CEO of one insurance broker has resigned. The Wall Street Journal has denounced Spitzer on its editorial pages, alleging that he's overreaching, and turning his office into a regulatory agency.

In this column, I will examine Spitzer's civil suit. I will also consider the claim that Spitzer - rather than doing his job, and enforcing the law - is actually, in effect, trying to write new laws without consulting the legislature or the voters. I will argue that this claim is in error: In fact, Spitzer is doing his job. Moreover, if he is overstepping the limits of his office, it is in part because the insurance commissioners of New York and other states are not doing their jobs.

Spitzer's Office's Suit Against Insurance Broker Marsh & McLennan

Spitzer's complaint against the insurance broker Marsh & McLennan alleged statutory claims for fraud, securities fraud, and antitrust violations, and common law claims for fraud and unjust enrichment.

Companies hire insurance brokers to help them choose insurance companies and particular policies. Historically, the broker's commission would be based on a percentage of the total value of the policy. It would be paid by the chosen insurance company, but the company doubtless passed the cost on to the client company.

But March & McLennan used a different (and quite popular) commission system that is at the heart of Spitzer's complaint. I will call it "contingent commissions."

The Contingent Commissions System: How It Works

Here's how the "contingent commissions" system works: The insurance company still pays the broker. But it doesn't just pay the broker a percentage of the policy value. Instead, it pays the broker if the broker achieves some aim that is the in the long-term interest of the insurer.

For example, the insurance company might agree to pay the broker a "success commission" if the broker brings over $10 million of business to that insurer in one year, or if 50% of the clients who buy insurance from the insurer never file a claim.

Do contingent commissions give brokers the incentive to disserve the insurance-buying companies that are their clients? Critics have argued the answer is yes.

But the insurance industry - a united front of brokers and insurance companies -- has responded that contingent commissions are really no different than old-fashioned fixed commissions: In both cases, the broker has an incentive to persuade the insurance-buying client to choose the most expensive policy, not the best policy for the client. And this could be a conflict of interest.

But the potential conflict of interest, the insurance industry claims, is cured by full disclosure. Brokers have the duty to provide clients with multiple, competing bids from different insurers. The client makes the choice. Even if the broker recommends an expensive option, the client can choose another option. Furthermore, as long as the broker discloses that it is receiving contingent commissions, the client can factor that information into its evaluation of the broker's advice

Spitzer's First Argument: Disclosure Is Misleading

Persuaded by the insurance industry's argument, insurance commissioners have held that contingent commissions are permissible as long as the broker discloses their existence to the client, and as long as the client has access multiple bids for similar products.

But Spitzer's suit alleges that the insurance brokers and companies have found a way to get around both these protections, thus ripping off the companies that buy insurance.

First, Spitzer alleges, disclosure is less than complete - or is misleading. For instance, Marsh is alleged to have concealed its contingent commissions under the bland-sounding label "Market Service Agreement" ("MSA") - when, Spitzer alleges, no separate "service" was actually at issue, and the payment was just a reward for giving a particular insurer business.

Spitzer's Second, More Powerful Argument: Collusion Undermines Competition

Second, Spitzer contends, the reality is that clients are not offered genuine price competition. Theoretically, this should happen. But in reality, he alleges, it does not.

In theory, an insurance-buying client is guaranteed the lowest price for insurance as long as its broker faithfully provided a complete set of competing bids. Moreover, in theory, even if the broker provided an incomplete list, the companies that were left off the list could alert the client to their lower prices.

After all, the insurance market is a cutthroat business - with sophisticated corporate customers and a huge amount of money at stake. So, if there was ever a market that should, in theory, be "self-regulating," the commercial insurance market would be it.

But in reality, Spitzer says it's not so simple or efficient. Spitzer alleges that brokers like Marsh undermined fair competition among bidders by allegedly arranging for the major insurers to fake their bids.

Because of such arrangements, Spitzer contends, each time an insurance-buying client received a set of competitive bids, the insurer that Marsh wanted the client to pick always had the "lowest" bid. Thus, the company - thinking it was exercising free choice - chose the lowest bid, unaware that in effect, it wasn't the chooser; Marsh was.

Why Collusion Occurred: The Advantage of Cartelization

On Spitzer's theory, why might insurers like AIG, ACE, or Zurich--huge, powerful companies--have allowed this to happen? Why wouldn't one of them blow the whistle on the fake bids, and demand to submit genuine, lower bids and win even when Marsh didn't pick them? Put another way, why wasn't the system self-regulating after all?

The answer Spitzer can give is simple. All the big insurers had an interest in creating a system where the brokers--and not the market--decided which company the client would pick. That is, they preferred cartelization to competition. And the brokers were more than happy to set up a system to manage the cartel--for a price.

The Harm That Was Caused If Spitzer's Claims Prove True

Some press accounts have asked: Even if Spitzer's right, what's the harm to the insurance-buying companies? Isn't the extra money all coming from the insurers - who are the ones bribing the brokers for policy placement?

The answer is no. In the end, the cost of the "bribes" is paid by the clients--companies like Ford. Second, and most important, the real problem with the contingent commission system is not the commissions themselves. It is the system of price-fixing that the contingent commission seems to inevitably produce. The cost of price-fixing is not really borne by the large corporate customer, but by all of society.

For example, in his complaint, Spitzer describes the case of Greenville, South Carolina. Greenville retained Marsh as a broker to purchase insurance for a school renovation project. The value of the insurance contract was approximately $3 million.

Marsh allegedly steered the contract to one insurer, Zurich, in exchange for a contingent commission. In order to persuade Greenville that Zurich had the best price, it allegedly arranged with another insurer, CNA, that CNA would produce a dummy bid which would be guaranteed to lose, but which would make the Zurich bid look good. Of course, Greenville opted for the lower, Zurich bid.

Who really was hurt by this scheme, if it occurred as alleged? The taxpayers of Greenville - who paid more than they should have to insure their school renovation.

Is Spitzer Using a Few Crimes as a Pretext for Broad Reform?

The Wall Street Journal and other critics have complained that Spitzer has conflated the criminal acts of a few insurance executives--the price fixers who provide the dummy quotes--with the system of contingent commissions itself.

It's true that on the day that Spitzer announced his office's suit against Marsh, he also revealed that AIG employees had pled guilty to criminal charges involving rigging bids. It's also true that -- on the basis of the two criminal cases and the filing of a civil lawsuit that has not even been settled -- the practice of contingent commissions has been temporarily suspended by many companies. The practice is now viewed with great distrust.

Plainly, Spitzer connects the criminal acts with the contingent commission schemes. But that does not mean he wrongly conflates them.

His theory seems to be that for the schemes to work, someone must act like a criminal. Apparently, on Spitzer's view, contingent commissions are like the Devil's Candy: They create an irresistible temptation that leads inevitably to criminal conduct, which harms society. And on this view, it makes perfect sense to connect the crimes with the schemes - and put an end to both.

Is Spitzer Overreaching with His "Devil's Candy" Theory?

But should Spitzer be the one endorsing the "Devil's Candy" theory - or should the option be left for the legislature or an administrative agency?

Only careful empirical analysis can prove or disprove the theory. Typically, a legislature or a regulatory agency would hold hearings, listen to experts, and commission reports to test the theory. Yet there is also another option: The theory can be tested in court.

Sometimes courts--aided by lawyers--can make judgments about whether certain practices offend "public policy." In a sense, that is what Spitzer has done with his investigation and suit, albeit in a very public and crude way. Spitzer is essentially saying that the system of contingent commissions, as currently practiced, is so infected with corruption that any company which employs them should be put on notice that they will be held civilly liable for the practice.

Normally, I would be wary of a state attorney general assuming so much power. The Wall Street Journal has noted that the insurance commissioners of many states have decided that contingent commissions are okay, assuming (as described above) full disclosure and competitive bidding exists.

But perhaps the commissioners' decision not to effectively forbid contingent commission only proves Spitzer's point. His argument is, precisely, that insurance regulation may not be working in this case -- and the regulators got it wrong when they gave a free pass to contingent commissions.

In such a case, Spitzer's decision to step into the breach and act on the public's behalf seems like the right thing for a state attorney general to do.