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Relying on Disclosure When it is Least Likely to Matter

posted by Daniel Schwarcz

I’ve argued in my posts so far that transparency in property/casualty insurance markets is woefully inadequate.  Transparency, however, is not always a particularly good solution to a regulatory problem. The most visible controversy in the property/casualty insurance industry in the last decade illustrates this point nicely.  

That controversy involved the payment by insurers to independent insurance agents of “contingent commissions.”  These commissions are essentially year-end bonuses to agents based on the volume and/or profitability of the business sent to the insurer.  Such commissions create obvious conflicts of interest for ostensibly independent agents – the carrier who is best for the consumer may not be the carrier who maximizes an agent’s contingent compensation.  In response to this risk, numerous insurance jurisdictions, as well as the National Association of Insurance Commissioners, embraced disclosure requirements for insurance agents.  

Unfortunately, the regulatory problems created by contingent commissions are particularly resistant to disclosure-based responses.  To understand why, it is helpful to realize that contingent commissions are simply a specific example of a general phenomenon in which market intermediaries extract side payments from other professionals for steering business to them.  Yield-spread premiums – whereby lending institutions pay bonuses to mortgage originators depending on the rate of interest paid by the borrower – are another example. 

Such trilateral dilemmas, as Howell Jackson has dubbed them, are generally unresponsive to disclosure-based solutions.  Indeed, it is for this very reason that Dodd-Frank abandons a disclosure-based approach to yield-spread premiums in favor of an outright ban.  

There are at least four reasons why disclosure is not an effective response to trilateral dilemmas.  First, consumers who rely on intermediaries to recommend other service providers generally have a limited capacity to assess the end-service provider's relative strengths and weaknesses.  For instance, an insurance consumer who is told that she may receive biased advice from an independent agent does not have any particularly effective way to respond to this risk – the very reason she is seeking advice from the agent is precisely because she is unable to make detailed, substantive judgments about insurance. 

Second, because intermediaries interact closely with their customers, they can discriminate between sophisticated consumers who may be on guard of tainted advice and unsophisticated customers who are unlikely to identify such advice.  Thus, one study found that contingent commissions had a much larger impact on the advice that agents offered to uninvolved customers than it had on the the advice offered to more informed and active customers. 

Third, consumers often have a relationship of trust with their intermediary that blunts the tendency to scrutinize the advice they receive.  Any disclosure of a financial conflict of interest may consequently be undermined by personal loyalty.  

Finally, trilateral dilemmas often occur in a larger context where consumers are facing multiple decisions.  Consumers thus typically make their initial insurance decisions in conjunction with taking a job, moving, or buying a home or automobile.  In these settings, consumers are particularly unlikely to be able to effectively digest the content and implications of a disclosure.

For those few who have reached the end of this post, I’ve written more extensively on both contingent commissions generally and contingent commissions in personal lines of coverage.  



But insurance agents *always* work on commission, this causes an inherent conflict of interest.

I don't know the solution, but it sucks bad.

Steevo: You are right that ordinary commissions always create a conflict of interest. But contingent commissions create special, particularly difficult, conflict of interest. This is because they create much stronger steering incentives for agents, because the optimal response to them is often for an agent to consolidate all of his or her business with a single carrier. Also, they are much harder to effectively disclose than ordinary commissions, because they don't reflect a fixed number. In any event, though, my view is that insurance agents should be prohibited from referring to themselves as "independent" unless they receive precisely the same, fixed commissions -- with no contingent compensation -- from different carriers offering the same types of coverage.

That's a really great post. Very succinct and full of insights. Thanks very much.

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