Who is your broker working for?

The Anthology showcases some of our best writing for clients. This piece for MacTavish explores broker conflicts in the commercial insurance market

AUTHOR: Emma Simon

EDITOR: Francis Jay

Most companies use a broker to source and place insurance. This may cover a range of different products from property insurance to business indemnity.

Clients pay brokers a fee for this specialist service. Legally the broker acts on behalf of the client to ensure that they recommend the most appropriate cover.

However many companies may not realise that brokers also collect a range of commissions, service fees and profit share payments from insurers — potentially leading to significant conflicts of interest.

To make matters worse, a distinct lack of transparency surrounds these different fees and charges.  Some will be disclosed to clients via terms of business agreements, although even here there can be a lack of detail over the services being provided for the fee.

Other indirect commissions and charges are far more opaque and are not disclosed to the client at all — a full list of these different fees is provided in the box below.

Mactavish warns that, with insurance premiums rising, this situation is getting much worse. It is creating “extraordinary” conflicts of interest, with brokers potentially earning far more from these “service agreements” than from client fees.

It wants to raise awareness of this problem among corporate clients and is calling on the Financial Conduct Authority (FCA) to investigate more thoroughly.

Broker charges explained

Corporate clients ought to know that the back of their renewal report should contain a breakdown of fees and charges paid to the broker.

First and foremost this should detail the client fee, usually a flat charge. This is the main focus for most clients, as it is what they pay for the broker’s service.

But these documents should also detail other payments, such any commission earned by the broker (known as brokerage) for placing this business. It may also include an insurance brokerage fee (ISB), which relates to any “administration services” the broker carries out for the insurer. This could include a charge for issuing documents or paying the premiums.

Both the commission and ISB are usually charged as a percentage. Together they are typically worth between 3.5 to 5 per cent of the underlying premium. These commissions are paid on top of any client fee — although it may be possible to get a rebate of this commission for some lines of business, effectively reducing the client fee paid.

Clients should also be aware that these are only the tip of the iceberg when it comes to broker earnings.

There may be a host of additional charges, not all of which are disclosed in terms of business arrangements.

These can include:

• Additional commissions from reinsurers
• Commissions paid by third parties, such as finance providers
• Profit-share arrangements – which may relate to this particular business or the brokers’ entire portfolio being placed with this insurer
• Income earned on client funds before they are paid to the insurer

As well as the administrative ISB charge, which relates to a particular client, brokers can charge an “advisory work service fee”. This relates to administrative or information services that the broker provides for the insurer across its portfolio.

Mactavish points out that as these fees don’t relate to specific clients, details are rarely disclosed.

Higher fees ahead

Insurance is a cyclical business, with prices softening and hardening depending on underlying economic conditions.

Low interest rates have led to an unusually long “soft” market, with premiums remaining low for more than 10 years. Conditions are shifting, however, with premiums starting to harden across several classes of insurance business.

Given the structure of these various fees and commissions, it is not hard to see why this will exacerbate conflicts of interest in the broker market.

Clients pay a fixed fee to brokers. These fees have been on a downward trend for the past 10 to 15 years, because of competition in the market. Many might argue that they are now too low, helping to create the current problem.

Over this period, brokers have to some extent been able to subsidise lower client fees with an increased number of “supply side” commissions from insurers and other providers.

Most of these are charged on a percentage basis, which means that the amount brokers earn from the client, as against the insurer, can rapidly move out of kilter as insurance premiums start to rise.

Mactavish gives an example of a client placing corporate insurance business worth £1m.

This might equate to the company paying a flat £40,000 broker fee, plus a 3.5 per cent brokerage charge and a 2 per cent ISB fee. On a £1m book of business this means fees of £35,000 and £20,000 respectively.

However, with prices rising, the business could soon cost £5m to insure. Now the client would still pay the same £40,000 fee, but the commission charges could be earning the broker a further £350,000.

Mactavish points out that this creates huge conflicts of interest. Can the broker be said to represent the client, when most of its earnings come from other commissions and payments? Are these payments influencing broker recommendations?

As Mactavish points out, the size of these payments makes it is difficult to imagine that there is no effect on where business is placed – at least in some circumstances.

What can clients do?

Clients who are proactive and fully understand the complex insurance market may be able to manage elements of their broker’s remuneration.

Clients can request a breakdown of the various direct fees charged – although details of how to do this are usually buried in the small print of terms of business agreements.

This requires proactive management and review across the entire programme of insurance policies. Services such as those provided by Mactavish may be able to help and also ensure that clients request and use commission rebates where appropriate.

Yet even the most proactive clients are likely to be left in the dark when it comes to these various “indirect” payments. Very few clients will be able to get a clear and complete picture on how their broker will benefit financially from being appointed, a clear sign of market failure.

This is not helped by the fact that the terminology used to outline “portfolio” arrangements in terms of business agreements is often deliberately opaque and difficult to decipher.

Brokers may stress that such remuneration is not linked to individual accounts. As a result it may be difficult for them to provide a client-by-client breakdown for the amount earned under such portfolio-level arrangements.

But without a clear sense of how exactly the broker is benefiting from these “supply-side” relationships, it is impossible for buyers of commercial insurance to assess the scale of their broker’s potential conflicts of interest when selecting insurance partners or arrangements for them.

Time for improved regulation

The complexity of current arrangements is making it harder than ever for clients to negotiate a way through the commercial insurance market. This is affecting both larger corporate and smaller businesses.

Broker terms of business agreements assume a level of client sophistication – or disinterest – in agent remuneration, which is not sustainable as the market hardens and seemingly innocuous payment schemes become worth substantially more.

These practices have become embedded in the insurance marketplace over the past decade. But with premiums rising, buyers of commercial insurance should take a closer look at exactly what financial rewards they allow their brokers to claim.

As the balance of broker remuneration tips towards insurer-derived income, questions have to be asked about these additional “service” fees – and whether they accurately reflect the specific work done for insurers.

If they do, the reality is that brokers are mostly working for insurers rather than clients in a hard market, and this does not reflect their legal status as the client’s agent.

However, if these fees do not reflect the work done, then the remuneration model falls way short of any acceptable standard of transparency.

Either way reform is needed. Improved regulation has historically occurred during periods of increased premiums, when these remuneration structures come into focus.

In the 1980s and 1990s as clients moved away from commissions and towards fees, brokers began negotiating “overriders” or “contingent commissions” from insurers, which were paid in addition to client fees.

These ostensibly related to work done by brokers for insurers but were paid in line with the size, profitability and retention performance of their portfolio. Their value became a closely guarded secret, there was no consistency in what was paid and the conflicts created were obvious and damaging. Airmic (the Association of Insurance and Risk Managers in Industry and Commerce) and others campaigned, ultimately successfully, for their removal and the Spitzer scandal — and associated fines for anticompetitive behaviour — finished them off.

ISB was introduced as an alternative to such mechanisms during the hard market of the early-mid 2000s. This was still based on the principle that insurers derived value from administrative services rendered by the broker, but clients did not want to pay for these services within their fee.

However these fees were originally introduced at a much lower level than today (under 2 per cent of premium) and were subject to a low overall cap, to manage the impact on incentives.

While the principle of being paid by both sides of the deal was still breached, it was at least arguable that the conflict was manageable.

Since then, the removal of ISB caps, the huge growth in its value and variability, and the proliferation of other opaque “service related” payments, has eroded any credible argument that these conflicts can be properly managed.

Brokers, like any professional service provider, are perfectly entitled to charge what they choose for the services they provide – and following a long soft market many clients today may be paying too low a core fee relative to the work involved.

But the healthy operation of any market is founded on transparency. The sheer complexity here makes full transparency impossible. Broker contract sections explaining remuneration may tick a compliance box but are impenetrable to anyone without deep inside knowledge.

With drastic premium increases in some parts of the market already driving these misalignments way out of kilter, it is high time the FCA took far more interest in this sector.