Marsh & McLennan (NYSE:MMC)? I'd like you to meet Arthur Andersen. Arthur? This is Marsh. No, not Mark, Marsh. You guys have a lot in common. One of you is an irrelevant disgraced former giant; the other one may well soon be the same.
Marsh & McLennan comprises three basic components: the Marsh & McLennan Insurance Brokerage, Putnam Investments, and Mercer Consulting. Last year Putnam was, along with Janus (NYSE:JNS), near the center of the mutual fund scandal in which the funds allowed big money folks to take advantage of their retail investors in various and sundry ways. Putnam fired six fund managers who had market-timed their own funds. I recall at the time thinking: "Wow, Marsh better get in there and clean this up."
Silly me. Almost exactly a year later, Marsh & McLennan is at the center of another scandal that involves big money on one side and smaller customers on the other. But where its customers thought Marsh was searching through the complicated world of insurance policies on their behalves, instead Marsh had allegedly arranged for insurance companies to pay it contingent commissions that actually helped them garner above-market rates for policies, generating more than a billion in revenues for Marsh. So of the three components of Marsh & McLennan Companies, Putnam had its own pillaging of customers last year; Marsh, allegedly, this year. If they hold true to form, watch out for a bombshell out of Mercer Consulting about this time next year. Last year's problems at Putnam, while painful, didn't really put the company at risk. This time around, the scandal at which Marsh sits dead center could conceivably be one of those Arthur Andersen-type blows to a company that has been a central fixture in its business for decades. This is that serious for Marsh & McLennan. What's more, this scandal could conceivably touch every corner of the insurance business.
New York's attorney general, Eliot Spitzer, dropped a lawsuit (.pdf file) on Marsh Thursday, claiming that the firm fixed prices and rigged bids in order to generate larger commissions from big insurers, including AIG (NYSE:AIG), Ace Ltd. (NYSE:ACE), Hartford Financial Services (NYSE:HIG), and Munich-American Risk Partners. Marsh's clients pay it to steer them through the complicated insurance market, to be their advocates in negotiations with insurance carriers. 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.
Got a hand in your pocket yet?
Can you see why a side agreement between Marsh and an insurer might be a wee conflict of interest? Instead of working on the clients' interests, instead Marsh had plenty of incentive to place policies with certain insurers, regardless of whether they were the cheapest or otherwise most appropriate carriers. According to the lawsuit, a Marsh executive informed the attorney general's office that about $800 million of its revenues came from contingent commissions, paid by insurers based on the amount of business Marsh places with them, renewal rates, and the profitability of the policy. So you have Marsh's clients who are ideally paying Marsh to broker the most complete insurance package at the best price on their behalf, and on the other hand you have the insurers who compensate Marsh for steering the most profitable policies possible their way. Moreover, the latter group knows the business cold; the former, by virtue of its coming to a broker in the first place, is likely ignorant of the inner workings of risk management.
By the way, I know what we have here is a suit, not a conviction, so I should probably be saying "alleged." But unless the attorney general's office simply fabricated the evidence it disclosed with the civil suit, I think that we can say with certainty that there was a systemic level of misallocation of trust in Marsh's motivations. The chances of this are slim, given the guilty pleas and concomitant cooperation they've already received from two AIG executives.
Sure, the "kickbacks" went by the more patrician sounding "market service agreements," or MSAs, and they were disclosed to customers and are pervasive in the insurance brokering business. The emails and communications between Marsh and the insurers made it clear that the participants knew exactly what was transpiring: They were rigging bids. The stock market has cut Marsh nearly in half -- it's not awaiting a verdict in the suit to come to its own conclusion. Marsh hastily announced Friday that it was canceling its policy of having service agreements with insurers, which means that about $800 million in extremely profitable revenue has just gone poof! That's more than half of the company's net income. But getting rid of the MSAs after the company has been charged isn't nearly good enough.
Why Marshes tend to smell
What's frightening is that the service agreements that sit at the center of the controversy with Marsh are pervasive throughout the $1.1 trillion insurance industry. They're not illegal, no more so than the commissions that financial planners receive for steering customers to certain mutual funds are.
There are certainly some reasons to think that Marsh & McLennan will come through this, not the least of which is the three-headed nature of its business. I'm not so sure that this isn't a mortal blow to the company, or at least its equity. Marsh now has three big problems facing it.
The first is the suit itself and the necessary changes in business practices. Spitzer has held out the possibility that he will pursue criminal charges at Marsh to go along with the existing civil case. The end result will be that the gravy train of payments from insurance companies -- an extraordinarily profitable one at that -- is heretofore derailed, perhaps permanently. Marsh is not going to be able to replace those revenues, and the scandal that is unfolding has had the effect of shining some disinfecting sunshine on what was a fairly murky part of the process of matching insurance carriers with clients. This much will also impact the other brokers, including Aon (NYSE:AON) and Willis Group (NYSE:WSH), which are as of yet not charged with any wrongdoing. The fines and restrictions, both business and regulatory, could prove extraordinarily expensive and long-lasting.
Second are the inevitable shareholder and, more importantly, the customer class-action lawsuits. These were the true death knell for Arthur Andersen, as its potential liability outstripped many times its capital base. Customers have the type of cases that the plaintiff's bar simply salivates over -- breech of contract and fraud by deep-pocketed companies. The intricacies of insurance pricing are likely to be well beyond the comprehension of most juries. But "Marsh then faked bids to make the process look competitive?" Yeah, they'll get that.
And finally, Marsh, like all participants in the insurance business, provides a commodity service. Why do companies go to the Big 4 accounting firms, the big-name law firms, or the big investment banks, even if they're much more expensive? That's pretty easy -- reputation. You can get insurance, and insurance brokerage services, from anywhere. But insurance coverage by a company unable to pay isn't worth the paper it's written upon. And the claim by a broker that it's working on the client's behalf when it has just been shown to have breached its duty to scores of similar customers isn't worth much. Marsh's clients are in the business of mitigating risk. That's why they come to Marsh, to insure against risks that could run into the billions of dollars. How many corporate boards are going to be less likely to approve a risk manager's decision to retain Marsh in light of the present scandal? How many risk managers are going to eliminate Marsh as an option rather than even try to justify selecting it? Before Arthur Andersen collapsed, hundreds of companies decided that its involvement in the Enron collapse had the effect of putting their own accounting in question, and so they changed auditors.
Andersen hadn't even been convicted of anything -- the hit to its reputation was enough. Marsh & McLennan had the best reputation among clients in the business, which this suit, before anyone spends a second in court, has obliterated. Marsh's biggest hope may perhaps be that Spitzer's next move is to unveil charges against the entire industry, meaning that customers who would otherwise move don't really have options that aren't similarly implicated.
In his remarks, Eliot Spitzer noted that the insurance companies have been quick to blame "everyone else for premium increases," especially trial lawyers. Is anyone likely to believe them the next time around?
Bill Mann wonders how many more reputational blows the U.S. financial industry can take before it actually blushes. He holds shares in none of the companies mentioned in this article. The Motley Fool is investors writing for investors.
