World’s Biggest Broker Faces Uncertain Future

The Cycle Turns for Marsh Mac as N.Y. States Strikes $850M Deal for Charges

Life goes in cycles. Everything and everybody from the cosmos down to the lowliest plant follows a certain rhythm–businesses and economies included. Only one stock (General Electric) has remained in Standard & Poor’s industrial index since its inception in the 1890s. The once mighty Marsh & McLennan Companies Inc. (MMC) now faces this reality. (“MMC” refers to the Group; “Marsh” to the brokerage and insurance services companies.)

Marsh is not alone; the entire sector is going through a crisis. A report published by S&P in December, “Oligopoly of Insurance Brokers Gives Way to Pressure to Add Value,” called it “the perfect storm.” S&P examined the current state of the brokerage industry, both generally and in light of the numerous investigations being conducted by government bodies–notably New York’s Attorney General Eliot Spitzer. Its conclusions aren’t pretty. The three largest brokers, who currently control “a 60 percent share of the global market”–Marsh 31 percent; Aon 22 percent and Willis 7 percent–are increasingly threatened. In getting to that position S&P noted that “the brokers created a starkly uncompetitive and distorted market, gaining excessive power in the relationship among the insurer, the customer and the intermediary.” Primary Credit Analyst Thomas Upton noted, “The distribution tail at times wagged the insurance dog.”

That dominant position is now under fire and seems unlikely to survive. As the biggest dog in the game, Marsh, makes the biggest target and has the most to lose. GM’s legendary CEO “Engine” Charlie Wilson once told a Congressional Committee, “What’s good for the country is good for General Motors, and vice versa.” MMC occupies an analogous position. What happens to it in the near and long-term will affect the course of the insurance industry, and vice-versa.

Where it goes, what it does, what changes the future holds are linked, even if all the ramifications are still unclear. MMC’s brokerage business, which includes consulting and risk management services, is currently in the spotlight, but it’s only part of a mammoth organization with a market cap of close to $17 billion. In 2003, gross revenues from MMC’s risk and insurance services businesses totaled $6.9 billion with net income of $1.54 billion. Its Trident II investment trust with $1.4 billion in capitalization was big enough to provide a substantial part of the funding that set up AXIS Specialty in Bermuda following the Sept.11 attacks. MMC was also instrumental in establishing ACE and XL in the 1980s.

What happens to MMC, and its insurance related operations, especially Marsh Inc., which has approximately 40,000 employees and more than 400 offices in over 100 countries, involves two main subsets–the operational and financial consequences for MMC itself and the more fundamental permutations those consequences will have throughout the industry.

The bid rigging charges against Marsh are the logical place to start. Everyone agrees this has to stop. It constitutes fraud and involves criminal penalties. A bulletin from Spitzer’s office relates how Robert Stearns, a Marsh Inc. senior vice president, found this out the hard way. He entered a guilty plea in January admitting that between 2002 and 2004, he instructed insurance companies to submit noncompetitive bids for insurance business and conveyed these bids to Marsh clients “under false and fraudulent pretenses.” According to Spitzer, Stearns’ crime, participating in a scheme to defraud in the first degree, is a felony. It carries a sentence of one and one-third to four years. His plea followed similar admissions of guilt from two executives at AIG, two from Zurich American, and one from ACE.

Two other considerations are people and money. XL’s CEO Brian O’Hara has repeatedly stressed their primary importance in constituting an effective corporate culture and contributing to the fulfillment of a company’s goals. “They [people] are the critical component and fundamental [company] strength,” he said at the European Insurance Summit in Vienna last October. “Products can be reproduced, with people and values it’s not that easy.”

Following Marsh’s indictment, a number of senior people left and many more are growing increasingly restless. First, CEO Jeffery Greenberg, whose position became untenable as the investigations mushroomed, was forced to resign. His successor Michael Cherkasky, is the former CEO of Kroll Inc., an international security and consulting firm that MMC bought in May 2004 for $1.9 billion. His mandate was clear: “Clean house.”

He didn’t wait long. Two weeks after he succeeded Greenberg, Roger Egan, president and COO of Marsh Inc., and Christopher Treanor, Marsh Inc.’s chairman and CEO of Global Placement, were asked to “step down” from their positions. Ten days later on Nov. 18, MMC announced that five members of its board of directors, who were also company executives, had also “stepped down” in keeping with “promises to change the governance of the corporation.”

They included: Mathis Cabiallavetta, vice chairman, MMC; Peter Coster, president, Mercer Inc.; Charles A. Davis, vice chairman, MMC and chairman and CEO, MMC Capital Inc.; Ray J. Groves, senior advisor, Marsh Inc.; and A.J.C. Smith, chairman, Putnam Investments and former chairman of MMC. That left the board with Cherkasky at its head and 10 outside members. MMC’s senior management had been effectively decapitated.

Other people are leaving too. A number of managers have taken positions with other companies. MMC has announced plans to lay off about 3,000 employees to reduce annual expenses by $400 million. About three-quarters of the layoffs will occur in the insurance and risk management sectors. In the meantime MMC’s share price has dropped from close to $70 at the top of the market in 2001 to around $30.

Then there’s the question of money. Marsh announced on Oct. 15 that it would no longer accept contingent commission payments–Market Service Agreements (MSAs) or Placement Service Agreements (PSAs). In 2003 the company made $845 million from them, over half its net income. S&P’s report noted that services were often performed that justified the commissions, but not in all cases. S&P pointed out that a “material portion of the $845 million” was volume-based.

“In return for paying these commissions to brokers, insurers simply received higher volumes of business from customers. Consequently, the individual brokers at Marsh who received contingent commissions were rewarded merely for the volume–not the quality–of the business they brought in.” S&P noted that since the commissions added no value to the customers, and in many cases weren’t even disclosed, those customers might go directly to the insurance companies, and use the money they save to set up in-house risk management, or to lower rates.

The rating agency’s report concluded that whatever direction the future of the industry might take, “the fact is that volume-based contingent commissions as such are dead and brokers must now scramble to find new revenue streams.”

S&P credit analyst Steve Ader observed: “The heightened scrutiny of this sector could change fundamentally how the business is priced and what the revenue stream is. Prospectively, companies could staff up their risk management capabilities, taking a much more active role in identifying their risk requirements and, more significantly, playing a more active role in placing business with multiple brokers or perhaps even directly to the insurance carriers. The industry could become more commodity-based, like Wal-Mart. In effect, revenue normally paid to brokers could end up as salaries in the company’s risk-management department.”

While the demise of contingent commissions might actually be a positive development for the industry over the long-term, for Marsh, as for the other big brokers, it’s extremely negative. Not only does it cut off a good portion of their revenues, but it also increases their customers’ skepticism about their activities, pushes them towards more direct involvement in risk management and comes at a time when premiums are showing signs of decline.

Lost revenue isn’t MMC’s only financial concern, however. It’s also going to have to pay out large amounts of money. Earlier this year it bailed out Putnam following settlement agreements reached last April with the Securities and Exchange Commission and the Office of the Secretary of the Commonwealth of Massachusetts on market timing issues [triggered by an earlier Spitzer-led investigation] for $110 million in penalties and restitution. Civil lawsuits against Putnam are still ongoing and many new ones against MMC have been filed.

Settling the present case will cost even more. On Jan. 31, MMC confirmed an agreement with the New York State Attorney General and the Superintendent of the New York State Insurance Department to establish an $850 million fund to compensate clients. MMC also stated that the agreement resolves the actions that were commenced against MMC and Marsh Inc. over questionable brokerage compensation and account placement practices and that it would enact reforms to lead the industry in transparency and service to clients. Under the terms of the agreement, the company neither admits nor denies the allegations in the complaint filed by the attorney general and the citation issued by the insurance superintendent.

Spitzer remarked that the monies from the $850 million settlement would be used to refund insureds who wish to take advantage of the funds. “Not a penny goes to the state or the lawyers. It all goes back to insureds,” he said in remarks before the National Press Club in Washington, D.C. He noted that there could be additional suits from insureds who choose not to participate in the settlement he has made with Marsh.

But New York is not the only state seeking to recover money from MMC. Connecticut Attorney General Richard Blumenthal filed a lawsuit against it and ACE Financial Solutions Inc., alleging that ACE reportedly paid Marsh a secret $50,000 commission to steer an $80 million state contract to the company.

Florida’s chief financial officer subpoenaed Marsh in November for documents related to an anti-trust probe against several large brokers. He also filed an additional subpoena for documents concerning the purchase of property insurance coverage for state-owned buildings. A number of other states are also investigating Marsh, including Illinois and California.

All of the probes and fines have had a decidedly negative effect on MMC’s ratings, which in turn increases its cost of credit.

Given how big MMC is and how long it’s been around (since 1905) reports of the group’s demise may be premature, but it’s clearly in trouble. The Wall Street Journal reported that MMC Capital might be sold, not only to raise money, but also to avoid lingering suspicions of any conflicts of interest. Some analysts think MMC’s demise is overdue. Jim Peterson, writing in the International Herald Tribune, likened its position to Arthur Anderson after Enron. “Insurance consumers are ready for a post-Marsh world,” Peterson wrote. “They are already questioning the value of large-firm brokerage and eager to regain for themselves part of an arguably misallocated stream of revenue.”

Crises always bring change, but in this case it’s still too early in the game to accurately predict what those changes might be. Hard as it is to imagine a Marshless world, that is one scenario, but only one. It’s more likely that the brokerage industry will face the new challenges and will find new ways of earning revenues, and that Marsh, along with the rest of the industry, will have to carve out a new future in the face of those realities.