The Value of Contingent Commissions in the Property-Casualty Insurance Industry: Evidence from Stock Market Returns
Ghosh, Chinmoy, Hilliard, James I., Journal of Risk and Insurance
Insurance producer compensation has incorporated contingent commissions for decades. In 2004, the New York State Attorney General sued insurers and brokers, alleging compensation abuses and calling for elimination of some forms of contingent commissions. Daily stock price return data reveal negative announcement-period portfolio returns for property-casualty carriers, suggesting expected negative cash flow effects. Firm-level losses were related to intensity of contingent commission use, suggesting that the effects of such regulatory changes would be felt most by firms that relied on contingent commissions. Investors believed contingent commissions were valuable not only for producers but also for carriers.
How important are contingent commissions in the insurance industry? Since New York Attorney General Eliot Spitzer announced a landmark lawsuit against Marsh & McClennan Companies and several insurance carriers in 2004, contingent commissions have become a subject of both popular and academic attention. In particular, Cummins and Doherty (2006) and Cummins et al. (2006) explore the impact of regulatory limitations on the use of contingent commissions on agents and brokers (producers). They note that producers, deriving between 2 and 6 percent of their revenues from contingent commissions, would likely experience reduced cash flow. Carson, Dumm, and Hoyt (2007) further examine the importance of contingent commissions for smaller distributors and reach similar conclusions. Cheng, Elyasiani, and Lin (2010) further examine the effect of the threat of regulatory change on producers as well as the spillover effect on carriers. Cooper (2007) analyzes the global effects of local regulatory changes in this case. (1)
The prevailing consensus among academic studies is that contingent commissions are a valuable compensation mechanism for both producers and carriers, and that their elimination or curtailment would reduce cash flow opportunities for firms that used them. This study adds to the literature, measuring the differential effect of the lawsuit on the stock market valuation of carriers that used contingent commissions relative to those that did not, as well as the marginal effect of contingent commission intensity on expectations of future profitability.
Cummins and Doherty (2006) point out that contingent commissions provide significant advantages not only to carriers and producers but also to the entire insurance market. By aligning incentives between carriers and producers, contingent commissions may resolve numerous agency problems that would otherwise plague the industry, especially moral hazard and adverse selection. However, some types of contingent commission can induce anticompetitive behavior and other abuses. Evidence of such abuse was presented to Spitzer in late 2003, and he began a year-long investigation culminating in a lawsuit announcement.
Spitzer's lawsuit announcement attracted national interest for two key reasons. First, although the lawsuit named only four carrier firms and focused on their activities in New York, it had industry-wide, national implications. Since New York enforces an extraterritorial application, requiring carriers writing business in that state to comply with New York regulations in other states where they do business, the effects of the lawsuit were felt more broadly than New York alone. Thus, rulings and settlements resulting from this lawsuit would likely affect producer compensation across the U.S. insurance industry.
Second, during his tenure, Spitzer had become particularly effective at enforcing regulation in new ways, targeting industries such as financial products, liquor, and energy. His office had become so powerful and effective that defendants frequently agreed to fines and stipulation agreements without ever going to court. Hence, when Spitzer filed a lawsuit alleging unlawful compensation practices (following months of public investigation and subpoena) and suggested that the insurance compensation model was flawed and due for change, the industry took note. …