Yesterday, New York Attorney General Eliot Spitzer dropped a lawsuit on Marsh & McLennan's (NYSE:MMC) insurance brokerage operation, claiming that the firm, in collusion with several other insurance companies, fixed prices and rigged bids to generate larger commissions from big insurers. Spitzer has in hand two guilty pleas from now-former AIG (NYSE:AIG) executives who admitted to scheming to defraud insurance customers in activities that include price-fixing and bid-rigging. Their cooperation in this case not only puts Marsh at risk, it also could potentially spread to the highest level of executives at AIG, the country's largest commercial insurer.

Other companies named in the civil suit were Hartford Financial Services (NYSE:HIG), ACE Ltd. (NYSE:ACE), and Munich-American Risk Partners. The attorney general's complaint (.pdf file) enumerates a long-standing scheme among Marsh and the insurance companies to defraud companies and individuals by overcharging them for insurance. In the bid-rigging scheme, the insurance companies would provide "B quotes," extremely highly priced policy offers that Marsh would use as a comparison to another company's above-market quote, which would then look reasonable in comparison. Each of these companies pays Marsh under a contingent commission basis. These commissions tend to be based on the amount of business the insurer receives from the broker, the renewal rate thereof, and the profitability of the business.

To consider why this is bad, understand what it is that Marsh's clients pay it to do: companies and individuals who need insurance, rather than trying to figure such a complicated market out themselves, go to Marsh to serve as their advocate. Marsh figures out their insurance policy needs and then goes out into the market to negotiate with carriers on clients' behalf to maximize coverage at the lowest possible price. So if Marsh has side deals to steer deals to one insurance company or another -- even if they are disclosed to the customer -- the end result is that it has a built-in conflict of interest. And as the lawsuit spells out in lurid detail, this conflict seems to have become too much of a moral hazard for Marsh. A Marsh executive told the attorney general that these contingent commissions amounted to about $800 million in revenues for Marsh in 2003.

In his news conference yesterday, Spitzer absolutely savaged Marsh, saying that he was "misled at the very highest levels of that company" and that he very possibly might press for criminal charges against Marsh to go along with the civil suit. He also noted that evidence that his office has uncovered thus far suggests that illegal practices extend to every major insurance broker through every line of insurance. Marsh is the largest American insurance broker: Its biggest competitors, Aon (NYSE:AOC) and Willis Group (NYSE:WSH), have also received subpoenas, but have not been implicated in bid-rigging at this point.

Contingent commissions are a long-standing practice in the industry and are not illegal. But Marsh claims that it considers its customers' interests above all when binding insurance, and such blatant conflicts have rightly been questioned for some time. Now it looks like the conflict was even worse than widely perceived. I'll provide more coverage on this in my regular commentary column on Monday.

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Bill Mann owns none of the companies mentioned in this article. Please view his profile for a complete list of holdings.