Jeremy Warner's Outlook: Spitzer strictures spell insurance shake-up

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The Independent Online

The insurance team at JP Morgan will be feeling particularly pleased with itself this week.

The insurance team at JP Morgan will be feeling particularly pleased with itself this week. As far back as last January the investment bank's US analysts warned that contingent commissions, or "placement service agreements", were going to become a big issue for the industry in 2004. "Although the often undisclosed contingent commissions are legal, recent trends within the regulation of financial institutions suggest that such arrangements could well be prohibited, or significantly modified", they said in what has turned out to be a remarkably prescient circular.

Yet there was one part of the analysis JP Morgan didn't get quite right. "Current disclosure is weak and incomplete, and likely to be scrutinised in 2004", the circular said, "particularly in the UK where the Financial Services Authority (FSA) is assuming regulatory oversight for insurance brokerages in 2005". In fact, the strong arm of the law has struck first in the US, where Eliot Spitzer, the attorney general for the state of New York, last week filed a formal complaint against Marsh & McLennan, and put the entire industry on notice of further action.

In Britain, where according to JP Morgan, the practice is equally bad, there has by contrast been no movement at all by regulators. The General Insurance Standards Council, the industry's own self-regulatory body, received a number of complaints about placement service agreements earlier this year, but decided not to take them further after the complainants refused to go public with their allegations. The FSA, which takes over responsibility for regulating the insurance industry next year, will say only that it is monitoring the situation. Meanwhile, the Office of Fair Trading, which might be thought the more appropriate regulator as this is an issue more about untoward trading practices than prudential oversight, regards insurance as a matter for the FSA.

Goaded into action by Mr Spitzer's strictures in the US, both organisations will now be cranking themselves up for action. Contingent commissions are, it seems, relatively common practice throughout the insurance industry worldwide. Yet the point is that we have little idea who applies them, how much is made out of them, and what their terms might be. The broker is not obliged to disclose contingent commission arrangements to his clients, though some do, and many won't inform the investment community about them either.

The aim of placement service arrangements is to attract more and better business. The insurer might, for instance, pay the broker an extra commission if the volume of business the broker brings to the party exceeds a particular target. Alternatively, the extra commission is based on the business not exceeding a loss ratio target, encouraging the broker to place better quality business with that particular company.

Some brokers see no particular problem with these practices, as they regard themselves as perfectly capable of managing the potential for conflict of interest the arrangements give rise to. Many clients are unlikely to take that view. Mr Spitzer has been able to cite some truly shocking instances of abuse. A broker is employed to provide unbiased professional advice on where to place business to the client's greatest advantage. If he is being influenced by the size of the commission, he is unlikely always to be acting in the client's best interests.

The fines doled out by Mr Spitzer and others promise to be quite damaging enough. But the bigger question is what might replace these practices if they are judged so bad as to deserve an outright ban. Any system which allows the broker to collect commission both from his client and the insurer he places the business with must be open to question, yet to ban commissions from insurers altogether would turn the industry on its head, undermining large parts of the broking community.

All the same, brokers have to respond in some way or other. That almost certainly means finding ways of earning more of their money directly from the client, which in turn will mean extracting more keenly priced products from the insurers so as to help defray the cost to the client. Though it is the brokers who are in the firing line, the insurers may end up just as badly burned. Either way, it all spells more trouble for the general insurance industry just as it was starting to emerge from its post 9/11 gloom.

Unhelpful analysis

J Sainsbury was too busy preparing for this morning's presentation of its "business review" to be able to answer questions yesterday on the size of its pensions deficit, yet if a new analysis by the pensions consultant John Ralfe is to be believed, then the situation at the beleaguered supermarkets group is even worse than imagined and the company's pensioners should be quaking at their Zimmer frames.

According to Mr Ralfe, Sainsbury self-consciously adopted a much more high-risk investment strategy for its pension funds in March last year as part of an actuarial valuation - moving from holding 100 per cent bonds to back pensions in payment to almost 60 per cent equities and 40 per cent bonds. This allowed the company to assume a greater future rate of return from the scheme's assets, giving lower actuarial liabilities, a lower actuarial deficit and consequently lower deficit funding by the company.

Without the riskier strategy, the deficit would in fact have been £451m, not the £161m reported, and the deficit contribution from the company would have been £53m instead of the recently agreed £20m. Given all the other pressures on the company's profits, it is easy to see why Sainsbury would want to do this. Less easy to see is why the trustees should agree, since the effect of a riskier investment strategy is, according to Mr Ralfe, to increase the risks of a shortfall in the event of insolvency.

In the arcane world of pension accounting, however, not all is as it seems. As it happens, Sainsbury's timing in switching from bonds to equities in March last year could hardly have been better. March was when the stock market hit bottom. If the fund had switched 60 per cent of its pensions in payment assets to equities at that stage, it might well have wiped out the deficit entirely, and that goes for its actuarial, FRS17, or just about any other valuation you care to take.

Sainsbury can perhaps be faulted for its lack of transparency, but it is alarmist analysis of the type produced by Mr Ralfe which is proving the death of private sector, final salary pension provision.

Sainsbury is in a state of crisis, but it is not yet in any danger of becoming insolvent. In such circumstances, it is perfectly entitled to take risks with the pension funds it underwrites. In this case, the extra risk seems to have paid off handsomely.

Early departure

Bernie, the bolt. Or perhaps we should be saying Chris. The chairman of the new Office of Rail Regulation, Chris Bolt, lost no time yesterday in dispatching his chief executive, who has found herself shunted out of the job after only three months of service.

The official reason for Suzanne McCarthy's departure - that Alistair Darling's rail review rendered the job different from the one she had been led to expect - looks about as threadbare as the state of the network itself.

Ms McCarthy joined the ORR only three weeks before publication of the Darling review, so we must assume she knew exactly what she was letting herself in for. On the other hand, it looks as though Mr Bolt and the rest of the ORR board did not.

It has taken them 13 weeks to figure out that a career civil servant whose past expertise included running the Human Fertilisation and Embryology Authority, was not cut out for the railways. This falls into the category of fast and decisive action by the standards of the railway, but given the embryonic status of the ORR itself, it is not the most auspicious of starts.