The Economics of Insurance Intermediaries

ABSTRACT This article analyzes the economic functions of independent insurance intermediaries (brokers and independent agents), focusing on the commercial property-casualty insurance market. The article investigates the functions performed by intermediaries, the competitiveness of the market, the compensation arrangements for intermediaries, and the process by which policies are placed with insurers. Insurance intermediaries are essentially market makers who match the insurance needs of policyholders with insurers who have the capability of meeting those needs. Intermediary compensation comprises premium-based commissions, expressed as a percentage of the premium paid, and contingent commissions based on the profitability, persistency, and/or volume of the business placed with the insurer. Empirical evidence is provided that premium-based and contingent commissions are passed on to policyholders in the premium. However, contingent commissions can enhance competitive bidding by aligning the insurer's and the intermediary's interests. This alignment of interests gives insurers more confidence in the selection of risks and thus helps to break the "winner's curse" and encourages insurers to bid more aggressively. Independent intermediaries also help markets operate more efficiently by reducing the information asymmetries between insurers and buyers that can cause adverse selection. INTRODUCTION Insurance is a complex product representing a promise to compensate the insured or a third party according to specified terms and conditions should some well-defined contingent event occur. Simply to describe this obligation requires complex language. However, the buyer's decision is made even more difficult because the value of the insurer's promise depends both on the reputation of the insurer for settling claims fairly and on its financial capability to meet these obligations. Thus, the buyer of insurance faces the daunting task of first deciding what sort of insurance protection is needed given the risks faced, and then comparing policies offering alternative coverage at different prices from several insurers with different levels of credit risk and reputations for claims settlement and policyholder services. In most insurance transactions, there is an intermediary, usually an insurance agent or broker, between the buyer and the insurer. In commercial property-casualty (PC) insurance markets, the intermediary plays the role of "market maker," helping buyers to identify their coverage and risk management needs and matching buyers with appropriate insurers. The matching process is complex and multidimensional. The role of the intermediary is to scan the market, match buyers with insurers who have the skill, capacity, risk appetite, and financial strength to underwrite the risk, and then help the client select from competing offers. Price is important but is only one of several criteria that buyers consider in choosing the insurer(s) that provide their coverage. Also important are the breadth of coverage, the risk management services provided, the insurer's reputation for claims settlement and financial strength, and other factors. It is common for the coverage not to be placed with the low bidder. In October of 2004, New York Attorney General Eliot Spitzer filed suit against global broker Marsh & McLennan alleging that the firm engaged in bid-rigging and received kickbacks from insurers for "steering" specific commercial accounts to them. The lawsuit and ensuing actions against other brokers have created controversy about the role of intermediaries in insurance transactions. In particular, it has been alleged that the compensation of agents and brokers through contingent commissions, often related to the underwriting quality or volume of business placed with an insurer, constitutes an anticompetitive practice that is detrimental to buyers (Spitzer, 2004; Hunter, 2004, 2005). The goal of the present article is to provide information that will be useful in evaluating the role of intermediaries by objectively discussing intermediaries and their compensation structures. …