News came this week that the largest publicly traded insurance brokerage organisations--Marsh & McLennan Companies, Aon, and Willis Group--have reached "restated agreements" with various US state regulatory authorities allowing them to take contingent commissions, a practice that had been banned since 2005. This news follows on the heels of Arthur J. Gallagher's 2009 agreement winning over Illinois authorities to that position. We've been expecting some rationalisation of regulatory practice along these lines.
Contingent commissions compensate brokers for the profit and/or volume of business placed with an insurance company. On the face of it, these arrangements can clearly be abused. But they originated as a market incentive for brokers to take a stake in controlling losses facing insurers and can also work to align the interests of clients, intermediaries, and insurance companies.
The 2005 agreements led to a skewed market outcome as the vast majority of the intermediaries in this fragmented market were allowed to keep taking contingents while the larger firms were operating under the bans. Over time, insurance companies developed alternative ways of rewarding (or penalising) firms operating under the ban, including base commission rate changes and "supplemental" commissions.
Contingent commissions still have their critics even at the larger brokers (Willis has stated it will continue to avoid taking them). But we think the recent changes should help promote economic efficiency by allowing the market a greater role in deciding what is or is not acceptable practice. In turn, it should help lift uncertainty and other weights on brokerage revenue and profitability. The new revenue won't simply be a step upward dollar for dollar, as alternative practices helped fill in some of the gap since 2005. But the regulatory headwinds are certainly fading.
The brokers have been shouldering other weights in recent years, to be sure. The slow economy has coupled with soft insurance pricing and the impact of near-zero short-term interest rates on float returns to reduce revenue growth and margins well below historic averages. We anticipated some form of rationalisation of regulatory practices relating to compensation as one element of our thesis on the brokers. This latest news helps cement those earlier expectations--a factor that could boost our fair value estimates as we update our models for 2009 results. Insurance pricing remains persistently weak, but we still don't think falling insurance rates, a contracting economy, and near-zero money market rates will be permanent.
Bill Bergman is a Morningstar equity analyst.
