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Abstract:
Although the traditional economic explanations of insurance underwriting cycles add to our understanding of the phenomenon, as explanations for the cyclical nature of insurance markets they go only so far. While identifiable phenomena such as the "pricing problem" (i.e., the inability of insurers to calculate their cost of goods sold at the time a policy is underwritten) and the "interest rate problem" (i.e., the dependence of insurers on investment income to generate earnings) can be viewed as immediate causes of the unusual volatility of liability insurance markets, other forces are at work at a more basic, behavioral level - forces that are given particular reign by the lack of certainty inherent in pricing a product designed to indemnify unpredictable future losses. First and foremost is competition for revenue and market share, which as a practical matter drives the day-to-day behavior of underwriters to a far greater degree than concerns with ultimate profitability. Underwriters - like everyone else in business - are motivated by (i) the desire for financial reward and (ii) fear of losing employment or opportunities for advancement. And, during all but the absolute peaks of the underwriting cycle, underwriters are evaluated according to the amount of premium they can generate. The second factor is what can best be described as the ebb and flow of bureaucratic influence within an insurer that accompanies shifts in perceived profitability. The third factor is the influence of insurance agents and brokers on the pricing behavior of insurers, and the consequences of that influence.

insurance, underwriting, insurance pricing, torts, medical malpractice, directors and officers, errors and omissions, underwriting cycle, insurance pricing

Abstract:
In 2004, the property-casualty insurance industry was roiled by a scandal unparalleled in its history, with the world's largest insurance broker, Marsh & McLennan, accused of defrauding customers by rigging bids to maximize its own profits. In addition to its sensational bid-rigging charges, New York State Attorney General Eliot Spitzer's October 2004 suit against Marsh challenged insurers' long-established practice of paying insurance brokers and agents (or producers) additional compensation contingent on their sales volume and the profitability of their risks. Spitzer argues that such contingent commissions are not adequately disclosed to insurance buyers and can have anticompetitive effects. Indeed, in Spitzer's view, a broad spectrum of financial arrangements entered into by carriers and independent producers threaten the competitiveness of the P&C insurance market. But I argue that, rather than promoting competition, an industry-wide ban on contingent compensation might instead undermine the financial stability of small insurance agencies in communities throughout America. Ironically, this could well lead to the further consolidation of insurance brokerage business in large global firms like Marsh. Indeed, the state of affairs that first drew Attorney General Spitzer's attention--large commercial insurance brokers allegedly manipulating the market for their own benefit--was the result of nothing so much as the coupling of time-honored sales incentive practices developed on Main Street, USA with an unprecedented level of market power attained by a few global mega-brokers following a consolidation spree in the 1990s. It would be an expensive mistake, however, to jump from that observation to the conclusion that all contingent compensation of all insurance producers is necessarily harmful to insurance consumers. This article (i) traces the history of Attorney General Spitzer's investigation into insurance market practices, (ii) offers an overview of producer compensation practices as they have evolved in the U.S. P&C market, (iii) outlines recent regulatory and legislative responses to the Spitzer investigation, and (iv) suggests a simple, voluntary reform that would increase transparency for insurance consumers while avoiding the pitfalls likely to attend more draconian solutions.

insurance, Spitzer, competition, insurance agent, insurance broker, insurance producer, producer compensation, commissions, contingent commissions, disclosure, bid-rigging