The Blog

Reform the Insurance Industry

Only a dramatic change in the way insurance companies and their fee arrangements are structured can bring the reform to which consumers, investors, and capital markets are entitled.

12:00 AM, Oct 27, 2004 • By IRWIN M. STELZER
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JUST WHEN THE FINANCIAL SERVICES INDUSTRY thought it had made its peace with New York's attorney general, Eliot Spitzer showed that his battle with the investment banking industry had whetted, rather than sated, his appetite for combat. Helped by guilty pleas from two executives with American International Group (AIG), he charged Marsh & McLennan, Ace, Ltd., and other companies with bid rigging and the payment of improper fees that undermined insurance brokers' incentives to get the best deal they can for their clients.

Some wags say that Spitzer is trying to show that he can take on a tough Soprano-like "family": industry legend Hank Greenberg is the CEO of AIG, and his two sons hold or held similar positions at Ace (Evan) and Marsh (Jeffrey, until recently). Greenberg denies that the family exchanges any industry gossip.

Spitzer charges that several insurance companies engaged in schemes to rig the bids for the business of major insurance buyers. Companies arranged for competitors not to bid--or to enter phony, still higher bids. And brokers took kickbacks from insurance companies in return for placing their clients' business with the bribers, even if such placement was not in their clients' interests.

I must confess that I read of these developments with mixed emotions. Several decades ago I sold my consultancy to Marsh, and so know some of the older generation of that company's executives, all of whom are now retired. My hope is that they are not personally involved in the shenanigans that Spitzer seems to have uncovered.

On the other hand, I have long argued that it will be impossible to clean up the financial services sector until a major restructuring aligns the incentives of brokers and bankers with the interests of the customers they are supposed to serve. Look at it this way: You want your stockbroker to give you advice that is in your interest. But he lives on commissions, which gives him an incentive to get you to buy and sell shares more often than might be in the interest of maximizing the value of your portfolio. Sure, he has to worry about the reputational consequences of wiping out too many clients. But financial services providers are often dealing in products that their clients are ill-equipped to appraise, making it difficult for them to assign blame when things go wrong--especially since very often clients have nothing to blame except their own greed.

These share analysts also work in investment banks that are desperate to earn fees for doing deals and advising major companies. At a dinner attended by some bankers and corporate CEOs, I asked the company bosses whether they would give business to an investment banker whose analyst-colleague had rubbished his company. Raucous laughter was the response.

Then there are the auditors. They, too, have a structural conflict of interest. If an auditor gets tough with a company's executives, he risks the ire of his partners who are trying to sell lucrative consulting services to that company.

BACK TO THE INSURANCE BUSINESS. Brokers have an incentive to maximize rather than minimize the fees paid by their clients, so that they can maximize their own commissions. And if a bit of collusion can make the client think he is getting the lowest rate that a free market can produce, so much the better.

All of which proves that the financial services industry is one that requires shrewd and tough regulatory oversight. But no regulator, no matter how devoted and how tough-minded, can ever fully offset the incentives that many of the players in the market have to misbehave.

Which is why there is talk of two reforms far more fundamental than fines. The first is to replace commissions with a form of charging that does not create an incentive for brokers to ignore their clients' interests. No one is quite certain how that can be done, although a really competitive, unrigged market in which fixed fees are offered is on some lists.

The second is to restructure the firms that provide financial services. Investment banks can be forbidden to flog shares, leaving those who advise clients as to what shares to buy and sell free from pressure and incentives to be kind to the firm's investment-banking clients or prospects. Accounting firms might be prohibited from selling any consulting services to firms that they audit, leaving auditors free to antagonize their clients without worrying that it will cost the accounting firm consulting assignments.

Lest this sound excessively radical, consider this: First, Spitzer has uncovered practices that have been on-going for years in the investment banking and, it seems, in the insurance businesses. This, despite the existence of myriad regulators in America and in the United Kingdom. A flawed industry structure makes effective regulation virtually impossible.