Roasted on the Spitzer

If there weren't already enough risks associated with overseeing a private equity portfolio, it seems now firms may have to be wary of those they pay to help find protection for them: insurance brokers. Recent investigations spearheaded by Eliot Spitzer, the attorney general of the state of New York, have unearthed a litany of what Spitzer charges are behind-the-scenes abuses committed by a number of players in the insurance industry.

At the end of October, Marsh & McLennan Companies, the world's largest broker of insurance, made headlines when chief executive and chairman Jeffrey Greenberg left the company, less than two weeks after his firm was accused of cheating its clients. In the turmoil of the days following that initial announcement, Marsh lost half of its value on the public market.

Though Spitzer said he would not bring criminal charges against Marsh itself, he did indicate he would pursue criminal prosecutions against individuals. According to a New York Times article, five Marsh executives have been suspended, including the head of the company's global brokerage unit.

The departure follows a lawsuit filed October 14th, accusing Marsh of conducting sham bidding – Marsh was allegedly matching corporate clients with the insurance they need, but the firm would arrange coverage based on fees paid to it by insurers.

Of course, the backhand additional compensation – commonly referred to as “contingency fees” and “placement services agreements” – isn't anything new at all, as industry observers are quick to point out, and a number of brokers have long taken commissions above and beyond their officially established fee. But, according to Spitzer, Marsh failed to disclose what the firm was doing to earn those extra fees. He alleges Marsh was misleading clients by arranging coverage based on which insurance carrier paid it the most money.

The regulatory problems go beyond brokers. AIG, a provider of liability insurance for the private equity industry, disclosed last month that it was under investigation by the Securities and Exchange Commission and the Justice Department because of transactions it arranged making financial statements of companies appear better than they were.

These insurance issues also have greater meaning for private equity firms, as coverage rates surged in 2002 and 2003, following a spat of buying after September 11 and the era of Enron and corporate scandal. The private equity insurance market is littered with carriers and brokers to choose from, including AIG, Chubb Group, XL, Hartford Financial Services, ACE, Zurich, and Houston Casualty Company.

“For private equity firms, as for all other commercial company clients that brokers represent, the new developments will help streamline the insurance buying process and make it more transparent to the end purchaser”, says Kim Patlis, a partner at New York–based Corporate Risk Solutions, LLC, which serves as an independent risk management advisor for private equity firms and their portfolio companies.

Although it is the Fortune 500 companies that may be hit the hardest by the alleged wrongdoings of insurance brokers, Patlis says private equity shops are also affected, particularly if they don't have dedicated risk management teams or outside watchdogs in place making sure they are receiving the best insurance coverage, with the right carriers for the best price. “Here you are a private equity firm, and you receive various recommendations from your broker, all of which look fine, but do you really know why the broker is recommending one carrier over the other?”, Patlis says. “A lot of private equity firms don't have a specific understanding of what is happening in the insurance industry every day, because they have their own job to do”.

However, one bad seed doesn't spoil the crop. Spitzer has uncovered certain problem areas which the industry will need to clean up. Indeed, Patlis agrees, “most of the insurance brokers try to achieve the best results for their clients, throughout keeping their interests aligned with those of their clients”.

The Spitzer-driven developments are expected to help create more openness in the insurance industry. Private equity firms, like its other clients, can only benefit.