Upheaval in the insurance industry: potential implications for policyholders

Generally, although the law of agency requires fact-specific enquiry, it is regularly contended that an independent broker is the agent of the customer, his principal, for whom he has been instructed to find insurance. The law of agency provides a relatively well-defined set of rights and remedies for agents and principals alike. The starting point is that agency is a form of fiduciary relationship.

The key obligation of a fiduciary is that of loyalty (Bristol & West v Mothew, [1996] 4 All ER 698). Consistent with this obligation of loyalty, an agent cannot, without his principal’s consent, place himself in a position, or enter into a transaction, in which his personal interest, or his duty to another principal, may conflict with his duty to his principal. The principal’s consent is only valid if he has full knowledge of all the material circumstances and of the nature and extent of the agent’s interest.

The duty of good faith implicit in the relationship between principal and agent means that the agent must act at all times in the interest of the principal and must not let his own interests conflict with those of his principal (see Logicrose v Southend United FC [1988] 1 WLR. 1256). In addition: “The principal is entitled to the disinterested advice of his agent free from the potentially corrupting interest of his own. Any such private interest, whether actual or contemplated, which is not known and consented to by his principal, disqualifies” the agent (Logicrose; see also Keith Henry & Co. Pty Ltd v Stuart Walker & Co. Pty Ltd [1958] 100 CLR 342).

In the context of insurance, there is the obvious potential for a conflict of interest to arise between a broker’s duty to find the most suitable insurance policy in the market, and his interest in obtaining the best commission possible.

To the extent a broker is deemed to be the insured's agent, therefore, it is important to note that, under well-established rules of agency, an agent cannot, without the knowledge of his principal, use his position to acquire for himself a benefit (that is, a secret profit) from a third party, other than that contemplated by the principal at the time of entering into the agency relationship (Halsbury's Laws of England, Agency). The agent must account to his principal for any such unauthorised benefit obtained in breach of these rules (Regier v Campbell-Stuart [1939] 3 All ER 235).

From 14 January 2005, the general insurance industry has been subject to a transition from regulation by the General Insurance Standards Council (GISC) to statutory regulation by the FSA.

The FSA has published business conduct rules (ICOB) for insurance intermediaries, the majority of which are in accordance with the GISC’s former regime. Among other things, this new regulation by the FSA, in the form of the ICOB, governs the disclosure of commission for commercial customers (ICOB at 4.6).

Although ICOB does not specifically address contingent commissions it:

These rules include the clear mandate that a broker must not offer, give, solicit or accept an inducement that is likely to cause a conflict of interest with respect to its duties to the policyholder (ICOB at §2.3.2).

In this regard, the FSA has recently outlined situations where it believes contingent commissions and other inducements represent a conflict of interest. In a letter to insurance market trade associations and the Association of Insurance and Risk Managers, the FSA provided two examples of situations where an inducement would be determined to be a conflict:

(Business Insurance, 1 February 2005.)

In addition, the rules require that brokers have an internal procedure in place to determine whether inducements are in violation of the rules: “For example, it should be able to identify situations where the existence of an inducement has caused a course of action to be adopted, that conflicts to a material extent with any duty that the firm owes to its customers, and which would not have been taken in the absence of the inducement. It should also have in place a mechanism for remedying such situations should they occur” (ICOB at §2.3.9).

Finally, ICOB requires that, if requested by the policyholder, a broker “must promptly disclose the commission that he receives” (ICOB at §4.6.2) and, more broadly, requires that a broker must, regardless of whether information is requested, “provide a commercial customer with sufficient information to enable the commercial customer to make an informed decision about the contract being proposed [and] the premium and any fees relating to the [contract]” (ICOB at §5.4.1).

At a minimum, the FSA will require brokers, on request from a policyholder, to disclose commission in cash terms, or to the extent it cannot be indicated in cash terms, the basis of calculation of the commission. The level of detail must be sufficient to enable the customer to verify the amount. This must include all forms of remuneration including profit share, volume overriders and payments from premium finance companies.

Breach of ICOB can, in some circumstances, give rise to a claim for damages under section 150 of the Financial Services and Markets Act 2000 or disciplinary action by the FSA (or both).

If an insurance intermediary has not complied with his obligations, either express or implied, in the terms and conditions of a contract, his client could sue him for breach of contract, the remedy being damages. A broker’s terms of retainer may impose an express obligation on the broker to disclose all commissions received from the insurer. If this obligation has not been properly complied with, a policyholder may be able to bring an action for breach of contract for losses suffered.

The policyholder may be able to join the insurer into court action if it can be shown that there was an element of conspiracy between the broker and the insurer, that is, if it can be proven that the insurer knew the broker was unlawfully failing to disclose to the policyholder all commissions received. Once again, the remedy will be damages.

Potentially available damages include rescission of the broker engagement and disgorgement of commissions, restitution, compensatory damages (trebled in some instances), punitive damages, attorneys’ fees and costs.

Well-known class action plaintiffs’ counsel, Milberg Weiss and Lerach Coughlin, have filed actions against Aon, Marsh, AIG, ACE Ltd and Hartford. Shareholder plaintiffs allege that:

United Policyholders, a US consumer organisation, has filed separate actions against Marsh, Aon, and Willis in California, as well as a class action complaint in the Southern District of New York alleging breach of contract, breach of fiduciary duty, negligent misrepresentation, and civil RICO.

In the past, broker remuneration has not always been adequately disclosed to policyholders. While policyholders might have been aware of the retail commissions they paid and the overall cost of an insurance placement, they were not always aware of other types of commissions their brokers collected (such as wholesale commissions, facultative reinsurance commissions connected with the original insurance placement, and contingent or volume-based override commissions, which refer to the practice of accepting contingent commissions from insurers based, not on the underwriting profitability of the insurer's book of business, but on the volume of business the broker was directing to the insurer).

Spitzer’s investigation has already had a significant impact on the way insurance brokers and insurance companies are conducting business. A number of US brokers, including Marsh and several of its largest competitors, have promised to make their remuneration more “transparent” to clients. In Marsh’s case, for example, this will mean giving clients in the US full disclosure of retail and wholesale commissions, premium finance compensation and other fees charged on their accounts (Business Insurance, 15 November 2004).

As the market, especially corporate policyholders on both sides of the Atlantic, presses for greater transparency and disclosure of monies received by brokers placing their insurance business, it is likely that other insurance brokers in Europe will follow this lead. Indeed, some brokers in the UK, including leading reinsurance brokers, have committed to financial transparency, including full disclosure of contingent commissions (Financial Times, 23 October 2004; Lloyd's List, 17 December 2004).

At a minimum, disclosure by brokers of their total compensation package almost certainly will be required going forward.

Ultimately, the burgeoning investigation into broker compensation practices will change relationships among risk managers, brokers and insurers, and the possible elimination or limiting of contingent commissions (see box, What are contingent commissions?) may benefit smaller brokers who have not in the past been able to compete with volume placements (National Underwriter, 6 December 2004; Business Insurance, 15 November 2004). Although the world’s largest brokers have long exercised their market power in the global brokering business, the curtailment of contingent commissions may create more competition in the marketplace. In addition, independent insurance consultants may gain increased influence and a greater role in the market overseeing the placement process and providing truly independent advice.