It Has Begun. Finally.
Over the past several years, virtually every facet of the financial services industry has been hit with scandal. Since 1999, we’ve learned that stock analysts at the nation’s biggest brokerage firms lied to their clients by encouraging them to buy stocks the analysts knew to be losers. Underwriters sold stocks to the public that they knew were bad investments. Corporations falsified earnings reports. Accounting firms helped their corporate clients lie. CEOs and other executives engaged in insider trading, and at least one lied to the FBI. Mutual fund managers looked the other way when some shareholders engaged in market timing and late trading, and even worse, some managers participated themselves, all at the expense of their shareholders. Also implicated in one way or another: retirement consultants, pension benefits firms, 401(k) plan providers, Section 529 college savings plans, and even the regulators themselves, who have been accused of allowing the problems to fester. So far, firms have paid nearly $3 billion in fines, dozens of executives are in prison, some regulators have been forced to resign, and hundreds of lawsuits are underway.
The scandals haven’t been limited to Wall Street: Athletes have been accused of taking performance-enhancing drugs, journalists have been caught lying about their news reports, and religious leaders have been found to be pedophiles.
Yet, the recent financial scandals pale beside the new insurance scandal, for this one will result in bigger changes than the others.
At first glance, the insurance scandal involves insurance policies that are purchased by corporations, not consumers, so it’s easy to dismiss the conversation as just more of the same mumbo jumbo. But as you’ll see, this scandal will have a huge impact on consumers. It will affect how you buy insurance, who you buy it from, and what you pay for it.
The story begins with Marsh, a subsidiary of Marsh and McLennan, the nation’s largest insurance broker. But the story won’t end with Marsh. Virtually every insurance broker, along with most insurance companies, are being investigated, some, like Universal Life Resources, are already being sued because of alleged improper business practices. Before this is over, many more headlines will appear, naming many insurance companies and insurance brokers.
This article will explain how the insurance industry operates, how the alleged offenses were committed, and what changes you can expect from the reforms that are likely to come. So let’s start at the beginning, with Marsh.
Marsh is not an insurance company. Rather, it is an insurance broker. That means it helps companies buy insurance, but doesn’t actually provide the insurance itself. It’s similar to a real estate broker: A Realtor doesn’t own the house you’re buying; she simply helps you find the house you want and then she facilitates the transaction between you and the seller. For her trouble, a Realtor earns a commission, paid by the seller.
Ditto for insurance brokers. Marsh clients are (mostly) big corporations. Corporations buy lots of insurance -- property and liability insurance, and group health and life coverage for their employees. As you can imagine, big companies can spend tens of millions of dollars on insurance premiums every year. Instead of shopping for policies themselves, many companies turn to insurance brokers for assistance. The broker helps the company determine what kind of coverage is needed, and then it gets quotes from many insurance companies. The broker then presents the quotes to its corporate client, and earns the commission when the company chooses a contract.
As you’d expect, companies typically choose policies that offer the best coverage for the lowest cost. That’s the value of working with a broker; he or she does the legwork to find those policies.
But Marsh, apparently, wasn’t always playing fair. In some cases -- exactly how often isn’t known at this writing -- Marsh allegedly engaged in bid-rigging. Here (in a hypothetical example that is a bit oversimplified) is how it works: A corporate client hires a broker to help it find the cheapest insurance. But the cheapest policies often pay the lowest commissions (that’s one reason the policies are cheap). The broker wants to earn the highest commissions, so it conspires with low-cost/low-commission carriers to submit higher bids, so that they are no longer the cheapest (this time). This causes the corporation to pick a different insurer, one it thinks is the lowest bidder, when in fact it is just paying the broker higher commissions. The corporation ends up paying more for insurance than it should have, and the broker earns more in commissions.
About a dozen insurance executives from at least three firms have already lost their jobs over the scandal, and three have pled guilty to criminal fraud; none of the three worked for Marsh. Instead, they worked for two insurance companies, AIG and Ace. But they are not alone: Many other insurance companies have been subpoenaed, too, including Aetna, Prudential, Life Insurance Company of North America, Hartford, Chubb, Met life, Cigna, UNUM Provident, Aon, Munich-American Risk Partners, National Financial Partners, and St. Paul Travelers. Please note that merely receiving a subpeona does not mean there has been any wrongdoing.
And what of Marsh? In just three days, Marsh’s stock lost 42% of its value. More than $9 billion of the company’s equity was wiped out. The stock has since recovered somewhat, but still, you can pity Marsh’s 43,000 employees world-wide. Many of them own Marsh stock in their 401(k) plan. Some also have Marsh stock options and some also own Marsh shares via the Marsh Employee Stock Purchase Plan.
The scandal was uncovered by New York Attorney General Elliot Spitzer. (He’s the fellow who broke the mutual fund scandal.) Following his lead, other regulators have started to act. The California insurance commissioner and the Connecticut Attorney General (more insurance companies are headquartered in Connecticut than any other state), along with regulators in dozens of other states, including Virginia and Maryland, have announced that they have launched investigations.
One entity is silent, however: the federal government. No federal agency has announced that it is examining the insurance industry. Why not? Because the federal government has no jurisdiction. Instead, insurance is regulated by the states. Hence, 51 attorneys general and insurance commissioners are weighing in.
That’s the first change you can expect to see as a result of the scandal: Once Congress returns next year, you can expect legislation creating federal regulation of insurance agents and brokers. Currently, insurance licenses are granted by the states. This has resulted in fragmented oversight, because the states differ in what is permissible. The industry has fought the idea of federal regulation for decades, but this time it might lose the argument.
Also, watch for massive reform regarding compensation. Currently, those who buy insurance -- companies and consumers alike -- have no idea how much they pay in commissions to their agents and brokers. Expect regulators to require commission disclosure, so that you will know how much your agent earns when selling you a policy. This will apply to your auto, homeowner’s, life, disability, long-term care and umbrella liability coverage. Once insurance agents are required to disclose how much they earn selling a policy, you can expect commission rates -- and therefore overall policy prices -- to decline. Thus, one outcome of the scandal is that consumers will enjoy lower insurance costs in the future.
It’s an open secret that insurance agents are among the most highly compensated of all those who work in the financial services industry. One reason is that, unlike stock brokers and investment advisors, insurance agents do not have to disclose their commissions. It can lead to a nasty conflict of interest. For example, “term” life insurance policies pay about 10% in commissions. But “variable universal” life policies pay commissions as high as -- ready? -- 120%. So, is your insurance agent or financial planner telling you to buy a VUL contract because it’s better for you, or better for him? Complete commission disclosure can help make this conflict of interest go away, and that’s why I’ve been calling for commission disclosure for years.
And Marsh has taken a strong leadership position in this area. The company has announced that it is introducing full commission disclosure, and it has asked all insurance companies it represents to offer standardized commissions, to eliminate the possibility that Marsh (or any other broker) might have an incentive to sell one policy over another. Marsh’s pronouncements are to be commended. Changes like these are unprecedented in the insurance industry and will alter the way insurance is sold in this country. If Marsh succeeds in getting these changes adapted by the industry, insurance costs will come down and disclosure will improve. And that will be most welcome indeed. Ironic, isn’t it, that a company that is alleged to have acted inappropriately is the one that is bringing about much-needed reforms -- reforms that, for decades, regulators and Congress have never succeeded in doing themselves.