By Dale C. Crawford, MBA, CPCU, ARe
For the potential arbitrator or consulting expert, the phone call always goes in one of two distinct directions. The caller identifies him/herself as an attorney, and the conversation quickly turns to the business at hand:
I represent Honesty Insurance Company. Three years ago, my client entered into an agreement with Reliable Managing General Agency to write business on our behalf. We have found that Reliable violated the agency agreement in multiple ways, failed to disclose required information, and may have fraudulently withheld funds owed to my client. We have filed for arbitration under the terms of the contract for damages and premium funds owed
I represent Reliable Managing General Agency. Two years ago, my client agreed to represent Honesty Insurance Company to produce business. We have carefully followed every term of the contract, made all records available to Honesty, and remitted all premiums, as required. Now Honesty canceled the contract, failed to pay earned commissions and profit sharing, and filed suit.
The dispute resolution process then follows and may result in a lengthy and expensive conflict for both sides. While litigation is a natural and expected result in the insurance industry, these disputes are not over benefits from an insurance policy, but are rather conflicts between two business partners that involve a frequency and repetition of the same issues: violation of contract terms, lack of disclosure, and misapplication of funds. Anyone who has been in the business for a significant time has seen the identical scenario repeated over many years. Why is it not infrequent for the term managing general agency, or MGA, to be inherently associated with downright corruption or fraud, and why do these battles continue to develop among experienced industry executives on both sides?1
First, a caveat is necessary that cannot be overemphasized. There is a wide and successful industry of MGAs that have been in operation for many years and enjoy lucrative symbiotic relationships with specialty carriers operating in this environment. Their business is usually written through insurers with rate and coverage flexibility.
These MGAs are an important and vital part of the property-casualty industry; they are creative, innovative professionals who use specialized skills to locate and work with insurers to fill gaps left by standard carriers.
In contrast to the stable, long-term affiliations with specialty carriers are those MGA relationships that are the typical breeding grounds for disputes. Several characteristics are common in these circumstances:
A contract that applies only to program business. Instead of broad, across-the-board surplus lines business of general liability, property, and auto, these contracts will have narrow restrictions—typically, some singular line of business. It may be some form of professional liability, contractors of a certain type, or some specialized industry. The focus is a relatively small group of homogenous exposures.
A lack of operating history of the program. These are usually new ventures, perhaps with a producer who has access to the prospective group and expectations to expand on what may be a small base of accounts anticipated to grow considerably with an insurance program tailored to the coverage objectives of the members.
A producer, either retail or MGA, that has relatively little or no experience in managing a program. The owners of the MGA may have some experience with the business, but have been operating without underwriting authority, with the business previously written in the traditional system of submission and individual acceptance by the insurers.
The insurance company joining with the MGA has no previous history with the type of business to be written. A personal experience comes to mind involving a large retail jewelry chain that owned an insurance subsidiary whose sole purpose was to provide insurance for merchandise sold and financed. This was low-limit, first-party coverage that the stores required borrowers to carry during the term of finance. A new MGA convinced the insurer to write commercial umbrella liability through a complex web including a reinsurance broker and reinsurer that would, supposedly, fully protect the insurer from ultimate loss. The results were predictably disastrous.
The reinsurers denied coverage and attempted to rescind. This leap from property coverage on financed jewelry to commercial umbrella through an MGA was not all that unusual. For added measure, this took place during a highly competitive era in the industry, when competition was so brutal that rock-bottom terms and pricing were necessary to write business.
Anyone involved in the excess and surplus lines or reinsurance industry has seen these MGA scenarios play out at least since the 1970s. Yet, attorneys, arbitrators, and consulting experts still see these types of MGA arrangements. Because the same issues are at the core of these disputes, there have to be reasons, almost always following a similar pattern. Thirty years of observations within the industry and an additional dozen in dispute resolution provide a viewpoint into the rationality and business dynamics that create these situations.
First, from their standpoint, MGAs are entrepreneurs that are out to create a market niche for themselves and build a thriving business. If properly managed, their ventures can indeed be quite successful, through commission income, contingent bonuses based on underwriting results, and establishment of a business with substantial value. For an insurer, an MGA can be a potentially attractive enterprise as well—a chance to expand into new lines or classes of business and increase profits. Why, then, do so many of these arrangements go so wrong?
The answers are frequently found in the essential nature of the enterprise itself. For the insurer, this is most often an introduction into a new class of business in which it lacks an experience base. Instead of building its own internal institutional knowledge, this is delegated outside the organization to the MGA. Thus, the insurer does not have and is not acquiring the overall comprehension and subtleties of the business; instead it relies on the MGA while remaining responsible for the results.
If properly analyzed, the situation begs the question, what would induce an insurer to enter into such an arrangement? The answer appears to be, for the opportunity: an insurance executive envisions the chance to enter a new line of business and increase volume with projections of significant profits.
The real attraction is the perceived ability to do this with virtually no effort or upfront cost to the insurer. The expansion can be accomplished without adding personnel, office space, and processing facilities; the insurer only has to take the premium, and the MGA performs all the functions, often also processing claims. This attractiveness and ease of entry tends to mask the real danger in transferring underwriting authority outside the building.
The prospective insurer is often provided with the additional sweetener of the MGA obtaining reinsurance to protect the insurer from loss. This can be structured as total security, where all underwriting risk is reinsured, or as partial protection, in which the issuing carrier retains only a small percentage. In the former arrangement, the insurer becomes only a front and receives a fee of a certain percentage of premiums; in the latter, risk is significantly minimized.
These ventures borne of mutual optimism typically begin to lose luster when claims activity is introduced. Then, for example, losses may occur that exceed the anticipated levels. Based on the severity of losses and surrounding circumstances, the insurer may simply terminate the contract and walk away. Often, however, the problems escalate dramatically.
If there is reinsurance, that protection may prove illusory. In some cases, the reinsurance never existed because the MGA simply did not obtain the protection. In others, the reinsurer denied liability based on fraud or misrepresentation, or it became insolvent. Then the insurer finds that, not only are the losses more than projected, but that the protection it relied upon does not exist. Typically, once problems have been identified, the insurer will conduct an underwriting and financial audit. Based on the results, arbitration or a lawsuit may soon follow.
When the dispute escalates to outside resolution, the issues are typically complex and focus on numerous discrete issues, such as violation of the MGA's authority regarding underwriting classifications and pricing, failure to report and disclose premiums, and often misappropriation of funds. An arbitration panel or jury must sort through these issues and decide whether the MGA committed the alleged improprieties or whether it merely experienced underwriting results worse than anticipated—in other words, a business deal gone badly.
Based on numerous observations over the years, this author has found an element of truth both ways. In some instances, the MGA was downright fraudulent, with egregious violations of underwriting authority and guilty of absconding with premiums. Other instances were more benign and appear to reflect little or nothing more than poor underwriting experiences. In the latter instances, instead of acknowledging unsuccessful, albeit costly, business relationships, the related executive or management team responsible for the MGA venture may be perhaps under pressure to place the blame elsewhere; thus, the desire to "make the MGA pay" for its transgressions and recover the underwriting losses.
Because these scenarios have repeated for at least forty years, what is the realistic likelihood that insurers will adopt the necessary vigilance to refrain from granting underwriting authority for classes of business in which they have no experience or that MGAs will universally act with total adherence to all contractual requirements? The answer might, unfortunately, be no different than the high-tech or housing market's response to preventing future financial calamities. Perhaps the most fundamental reason that these scenarios will continue is the inherent conflict of interest in a relationship in which the MGA is charged with providing the vigilance necessary for successful underwriting while being compensated by commission based on the volume of business written.
It bears mention here that this inherent conflict of interest has been addressed by the National Association of Insurance Commissioners in its adoption of the NAIC Model No. 225, known as the Managing General Agents' Act, which sets restrictions on the powers that can be granted to MGAs. Each state has adopted this in some form.2 The extent to which this act will reduce or eliminate MGA-related disputes remains to be seen.
Just as with traditional, long-standing MGA arrangements of writing multiple lines and classes with experienced partners on both sides, there can be legitimate opportunities in new ventures. How can there be potentially successful prospects for both sides, while protecting the insurer and creating a successful enterprise for the MGA? Here are a few basic tenets:
Above all else, understand the business. If an insurer has no internal expertise in a certain class or line of business, consider long and hard before making an entry by delegating underwriting authority to an outside entity. If a decision is made to go forward, examine and evaluate the business just as if it were part of the internal underwriting function.
Audit, audit, audit. Both parties benefit when the insurer visits frequently to review files and financial records. Underwriting audits should include all submissions to show exactly how the contract provisions are being applied. The applications that are declined can provide valuable insight into the operating practices and compliance with contract provisions. At the same time, an open and ongoing dialogue should occur between the MGA management and the responsible executives at the insurer.
Document, document, document. The importance of documentation cannot be exaggerated. First, the MGA agreement should be a comprehensive road map for all aspects of the operation and should be followed. Additionally, any exceptions or side agreements should be immediately written and communicated to the other side and internally within both organizations. Any discussions resulting from visits should likewise be memorialized. In the event of a dispute, it is to the advantage of both sides to have a complete paper trail of all agreements.
Insurance is a microcosm of the increasingly complex global venture of finance, and there will continue to be opportunities for creative entrepreneurs who identify needs, design solutions, and establish long-lasting, effective partnerships. The observations shared in this discussion are intended to aid those who will have the opportunities and desire to participate.
Editor's Note: This article originally appeared in the December 2013 newsletter of the American Association of Insurance Management Consultants. It is has been edited here for use in Insights, a professional journal of the CPCU Society.