UK: How Much Are You Paying Your Insurance Broker?

Insurance briefing from Debevoise & Plimpton LLP published in the November 2009 issue of The In-House Lawyer

Contingent commissions were a lucrative feature of the London insurance market for many years, but the enquiries engendered by Eliot Spitzer, then New York State Attorney General, highlighted the methodology of brokerage in London and resulted in their reduced use.

Although the furore arising out of the Spitzer probe into commissions paid by insurers to brokers is now five years old, the fact that the Financial Services Authority has not (then or since) mandated any substantive obligations in this regard means that the issues of broker remuneration and inducement have not gone away. Indeed, European risk managers view a recent US legal ruling as paving the way for all brokers to resume taking contingent commission payments on insurance contracts, and several global brokers have been negotiating with various US state regulators to reinstate the collection of contingent commissions by 2010. The New York State Insurance Department has proposed new regulations that require greater transparency in brokers' disclosure to clients of the compensation they receive in placing a policy.¹ So where does that leave commercial purchasers of insurance in the UK? Is their insurance being placed with insurers as a result of inducements to brokers and are there cost implications?

Going back to basics, in the absence of any intention to the contrary, it is the usual premise of agency within insurance that the broker is the agent of the party seeking the insurance, the insured. A broker must, as a matter of the law of agency:

1) act in the best interests of their principal;

2) not place themselves in a position where their interest may conflict with their duty;

3) act within the scope of their authority;

4) not make a personal profit out of their position without their principal's knowledge and consent; and

5) use reasonable due skill and care.

A broker's closest commercial relationship is frequently with the underwriter with whom they are placing the business, and in some circumstances a broker may act in a dual capacity as agent for both the insurer and the insured, eg where the policy provides for notice of the claim to be given to the broker, who would also owe a duty of care to the insurer to inform them of the claim. Nevertheless, the cardinal rule is that the broker is the agent of the party seeking insurance and they must not allow any other possible duty to conflict with their obligations to their primary principal. If such a conflict is perceived to exist, the broker must obtain the principal's fully informed consent to the broker acting in a dual capacity.

AGENT'S DUTIES TO ACCOUNT

A central tenet of agency law is that the agent must make full disclosure of any personal interest to the principal and must account for all sums received from any other party, unless specifically released from doing so. An insurance broker can, however, benefit from the anomaly that they need not disclose their commission to the insured, unless specifically requested to do so.

SECRET PROFITS²

As payment for their services, the broker will be entitled to receive as payment either an amount agreed with their principal or a reasonable commission. They are not entitled to make any profit above this sum and any additional sums must be disclosed to their principal. Failure to do so will be a breach of their contract of agency.

A secret profit is any sum above the amount they are entitled to receive from their principal, that they are paid as a result of the exercise of their authority. There need be no dishonesty or fraud, merely a financial advantage to the broker that accrues by virtue of their position. It does not matter that the principal would not have been able to obtain the same benefit, or even that the act occasioning the profit was not done strictly within the course of the broker's employment; the broker must account for all benefits or money received, including gifts and any payment that the broker receives as a result of securing insurance, on behalf of their customers.

BRIBES³

A secret profit becomes a bribe and is therefore capable of attracting civil and criminal liabilities, if it:

It has been judicially stated that there is an irrebuttable presumption that the agent is infl uenced by any bribe, and the motive for payment is irrelevant, even where the agent has acted in the best interests of their principal.⁵ More accurately, the recipient is liable because they might have been influenced, not because they were. The principal is entitled to the services of an agent free from all possible influence.

However, it is clearly absurd to suggest that the mere fact that an underwriter is technically liable for the payment of brokerage to the broker to secure the introduction of the principal's business to the underwriter is sufficient to turn the commission into a bribe, although this may be true if the brokerage agreed by the underwriter is so high that it cannot be interpreted as anything else. There are several old cases that indicate that it is perfectly acceptable for brokerage to be paid by the other party to the contract, so that this technicality can be ignored. If, however, the broker receives an agreed fee from the insured and a profit commission from the insurer, they should properly inform the insured. In the absence of the insured's informed consent, the broker is clearly making a secret profit.

WHO PAYS BROKERAGE TO THE BROKER?

It is necessary to determine the source of the broker's remuneration because, if they receive brokerage from the insured and a sum (however characterised) from the insurer, they will be in breach of their duties as agent of the insured. If, however, they receive both payments from the insurer, their position may be better. The concept that the broker is not paid by the party to whom they owe almost all of their duties, the insured, but rather by the insurer for introducing the insurance business to them, is interesting because it is counter intuitive. Nevertheless, although the matter has never been fully argued in court, the proposition that the insurer is responsible to the broker for the payment of their brokerage in the absence of agreement to the contrary is generally accepted judicially.⁶ Lloyd's takes the view that the insurer or reinsurer is liable for brokerage.⁷ What, then, is the position where the broker is faced with the option of two insurers, the business being placed on identical terms and rates of premium, but where one gives 5% and the other gives 15% brokerage?

The insured pays exactly the same and receives exactly the same, whichever insurer is used, but the broker has earned a profit in excess of the usual brokerage. This is a secret profit. The problem is that a fiduciary must not make a profit out of their position without the insured's consent. If they do, the insured can recover. But the principal is not given a remedy solely to compensate them for loss, because they can recover whether or not they have suffered loss. The rule is there to enforce the high standards that equity requires of a fiduciary and it is better that the principal might receive a windfall than that the fiduciary should benefit.⁸ Equity considers that the agent making a secret profit has obtained it for their principal and any bribe is a legitimate payment intended for their principal.

The key must be the lack of conflict between duty and interest. If, in the above example, one insurer gives 5% brokerage and another 7%, the broker would not seem capable of criticism if they agree the latter as long as the 7% is reasonable and in line with market rates, and, crucially, that the quality of the insurance is as good as can be obtained elsewhere. They are presumably entitled to maximise the remuneration payable by the insurer. It is only where this figure exceeds what is reasonable that there is a problem.

Thus, even without the consent of the insured, in the right conditions contingent commissions can be legally justified, which is why they remain available despite the furore. If, however, the broker receives an agreed fee from the insured and a profit commission from the insurer, they should properly inform the insured because they are clearly being paid by both parties, which cannot validly occur without their consent. In the absence of the insured's informed consent, the broker is clearly making a secret profit, with potentially extremely adverse consequences.

WHAT CAN THE INSURED DO IF THE BROKER RECEIVES ADDITIONAL COMMISSION?

Rescission

The principal, on discovering the bribe, could elect to rescind the contract with the third party ab initio.⁹ If it was too late to elect, the principal could terminate it from that point onwards.¹⁰ However, rescission is not confined to cases where a bribe or secret commission is agreed to be paid. It extends to any situation where the agent puts themselves in a position in which their interest and duty may conflict, so that their principal does not necessarily obtain disinterested advice, and the other party to the transaction is aware of this.¹¹ However, the other party must be aware either by actual knowledge or wilful blindness that the agent intended to conceal their conflict of interest from their principal. Constructive notice is insufficient since parties to negotiations do not owe each other a duty to act reasonably, but only to act honestly, and the principal's right to rescind is for fraud, not negligence.¹²

Recovery of bribe from the agent

Whether the principal decides to affirm or rescind, the bribe/secret profit is regarded as a gift to them from the other principal. The bribe belongs to the principal in any event, because such benefits do not constitute benefits under the contract or as part of the consideration but are an independent secret profit.

No recovery of premium or brokerage

If the principal affirms the contract they will not be entitled to recover the premium or brokerage, but they will be entitled to obtain the secret profit made by the broker. Assessing the value of the secret profit will depend upon someone's ability to define the maximum reasonable level of brokerage.

The litigation in Carvill America Inc v Camperdown UK Ltd [2005]achieved no substantive result but merely called into question the identity of the party responsible for paying the broker.¹³ If the broker is paid a fee by the insured and a commission by the insurer, or if the Commercial Court were to decide that it is the insured who is generically liable for brokerage instead of the insurer, then one immediate effect would be that any payment by insurers would be unlawful unless fully disclosed to and agreed by the insured, because:

1) being paid by the insurer it would be a secret profit, ie any sum (that they are paid as a result of the exercise of their authority as agent) above the amount they are entitled to receive from the insured as his principal;

2) a secret profit becomes a bribe if it is paid by a third party to an agent that is secret from their principal (and the insurer is a third party to the contract of agency);

3) there is an irrebuttable presumption of inducement – that the agent has been persuaded by the payment to place the insurance with that insurer;

4) the broker would therefore be in breach of their duties to account, and not to make secret profits, and to act in the best interests of their client; and

5) the insured could recoup payment of the secret profit from either the broker or the insurer and could even avoid the contract (which it might consider doing if the value of claims were less than the premium and the insurance near expiry).

OFFICIAL POSITION

The FSA has not mandated specific rules on contingent commissions but has categorised the voluntary code prepared by various insurance trade bodies for commercial customers as industry guidance.¹⁴ This indicates that intermediaries should consider whether a relationship with a party other than the commercial customer has influenced the advice to the commercial customer in arranging insurance or the selection of the insurer, and that it is the duty of an insurance intermediary to manage conflicts of interest so that the intermediary's interest does not conflict with the interests of commercial customers and of any insurers on whose behalf they may act, either by disclosure or withdrawal from the engagement. An insurance intermediary must decline to act for the commercial customer unless, in the particular circumstances of the case, disclosure and informed consent are sufficient to resolve the conflict.

In its proposed code of conduct to the insurance directorate of HM Treasury in May 1998, initially aimed at Lloyd's brokers, Association of Insurance and Risk Managers (AIRMIC) recommended that prompt payment discounts, long-term agreements and renewal incentive bonuses should not be retained without the policyholder's informed consent, and that brokers should not accept volume overrides, growth incentives or profit commissions. It now broadly supports the industry guidance, but believes that more detail is required, and has prepared standard letters for intermediaries that set out earnings, capacity, services and a disclosure checklist.¹⁵

The short answer as to the broker's remuneration is that a broker should disclose any payment from the insurer in excess of market rates; in the absence of such payment, a purchaser of commercial insurance who wants to know how much the broker is receiving should ask him.

Footnotes

1 NY DOI Proposed Regulation No 194 (11 NYCRR 30) on Broker Compensation.

2 'In our age it is more important than it ever was for the courts to hold the precise and firm line drawn between payments openly, and therefore honestly, received by agents, and undeclared payments received by agents secretly, and therefore justly liable to all the legal consequences flowing from breaches of an agent's fiduciary obligations.' Imageview Management v Jack [2009] EWCA Civ 63.

3 'The courts of law of this country have always strongly condemned and, when they could, punished the bribing of agents, and have taken a strong view as to what constitutes a bribe. I believe that the mercantile community as a whole appreciate and approve of the court's views on the subject. Some persons undoubtedly hold laxer views. Not that these persons like the ugly word "bribe", or would excuse the giving of a bribe if that word be used, but they differ from the courts in their view as to what constitutes a bribe. If a gift be made to a confidential agent with a view of inducing the agent to act in favour of the donor in relation to transactions between the donor and the agent's principal and that gift is secret as between the donor and the agent – that is to say, without the knowledge and consent of the principal, then the gift is a bribe in the eye of the law.' Hovenden v Millhof [1903] All ER 848. See also the Bribery Bill (before Parliament March 2009), which introduces swingeing reform by way of application, new offences and increased penalties.

4 Anangel Atlas Companhia v IHI [1990] 1 Lloyd's Rep 167.

5 Hovenden v Millhoff [1903] All ER 848, 851; Anangel Atlas Companhia v IHI [1990] 1 Lloyd's Rep 167, 171.

6 Pryke v Gibbs Hartley Cooper [1991] 1 Lloyd's Rep 602. There is some case law to the contrary, eg Carvill America Inc & anor v Camperdown UK Ltd & ors [2005] EWCA Civ 645 in which the Court of Appeal refused an application to set aside service of a claim under English law in the US on the basis of certain distinguishing factors and so is not conclusive. The court felt unable to accept that there was no 'serious issue to be tried' and remitted it to the Commercial Court, where it settled.

7 See draft decision paper headed 'Grossing up and Net Equivalent' for Lloyd's Regulatory Board, 25 July 1994, paragraph 2 6(a).

8 Reading v AG [1948] 1KB 268, 275.

9 Logicrose Ltd v Southend United Football Club Ltd [1988] 1 WLR 1256.

10 Armagas Ltd v Mundogas SA [1986] AC717.

11 Anangel Atlas Companhia v IHI [1990] 1 Lloyd's Rep 167.

12 See 9).

13 See 6).

14 FSA regulatory update, issue 16, April 2009, p4.

15 See AIRMIC Guidance, 'Transparency, disclosure and conflicts of interest in the commercial insurance market'.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.