The Value of Contingent Commissions in the Property–Casualty Insurance Industry: Evidence From Stock Market Returns

• Author: James I. Hilliard,Chinmoy Ghosh
• Date: 01 March 2012
• DOI: http://doi.org/10.1111/j.1539-6975.2010.01399.x
• Published date: 01 March 2012

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The Journal of Risk and Insurance, 2012, Vol.79, No. 1, 165-191

DOI: 10.1111/j.1539-6975.2010.01399.x

THE VALUE OF CONTINGENT COMMISSIONS IN THE

PROPERTY–CASUALTY INSURANCE INDUSTRY:EVIDENCE

FROM STOCK MARKET RETURNS

Chinmoy Ghosh

James I. Hilliard

ABSTRACT

Insurance producer compensation has incorporated contingent commissions

for decades. In 2004, the New YorkState Attorney General sued insurers and

brokers, alleging compensation abuses and calling for elimination of some

forms of contingent commissions. Daily stock price return data reveal neg-

ative announcement-period portfolio returns for property–casualty carriers,

suggesting expected negative cash flow effects. Firm-level losses wererelated

to intensity of contingent commission use, suggesting that the effects of such

regulatory changes would be felt most by firms that relied on contingent

commissions. Investors believed contingent commissions were valuable not

only for producers but also for carriers.

INTRODUCTION

How important are contingent commissions in the insurance industry? Since New

York Attorney General Eliot Spitzer announced a landmark lawsuit against Marsh &

McClennan Companies and several insurance carriers in 2004, contingent commis-

sions have become a subject of both popular and academic attention. In particular,

Cummins and Doherty (2006) and Cummins et al. (2006) explore the impact of reg-

ulatory limitations on the use of contingent commissions on agents and brokers

(producers). They note that producers, deriving between 2 and 6 percent of their

revenues from contingent commissions, would likely experience reduced cash flow.

Carson, Dumm, and Hoyt (2007) further examine the importance of contingent com-

missions for smaller distributors and reach similar conclusions. Cheng, Elyasiani, and

Chinmoy Ghosh is a Professor of Finance, School of Business, University of Connecticut. James

I. Hilliard is Assistant Professor of Risk Management and Insurance, TerryCollege of Business,

University of Georgia. The authors can be contacted via e-mail: chinmoy@business.uconn.edu

and jih@uga.edu, respectively. The authors thank two anonymous reviewers for helpful com-

ments. This article has also benefited from helpful remarks from Mark Homan, Anne Kleffner,

Lin Klein, Tom Miceli, and Laureen Regan, as well as the participants of the American Risk

and Insurance Association annual conference and seminar participants at the University of

Connecticut and the University of Georgia. Dr. Hilliardacknowledges the financial support of

the Spencer Educational Foundation and the Stephen D. Messner Scholarship Fund.

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166 THE JOURNAL OF RISK AND INSURANCE

Lin (2010) further examine the effect of the threat of regulatory change on producers

as well as the spillover effect on carriers. Cooper (2007) analyzes the global effects of

local regulatory changes in this case.1

The prevailing consensus among academic studies is that contingent commissions

are a valuable compensation mechanism for both producers and carriers, and that

their elimination or curtailment would reduce cash flow opportunities for firms that

used them. This study adds to the literature, measuring the differential effect of the

lawsuit on the stock market valuation of carriers that used contingent commissions

relative to those that did not, as well as the marginal effect of contingent commission

intensity on expectations of future profitability.

Cummins and Doherty (2006) point out that contingent commissions provide signif-

icant advantages not only to carriers and producers but also to the entire insurance

market. By aligning incentives between carriers and producers, contingent commis-

sions may resolve numerous agency problemsthat would otherwise plague the indus-

try,especially moral hazard and adverse selection. However, some types of contingent

commission can induce anticompetitive behavior and other abuses. Evidence of such

abuse was presented to Spitzer in late 2003, and he began a year-long investigation

culminating in a lawsuit announcement.

Spitzer’s lawsuit announcement attracted national interest for two key reasons. First,

although the lawsuit named only four carrier firms and focused on their activities in

New York, it had industry-wide, national implications. Since New York enforces an

extraterritorial application, requiring carriers writing business in that state to comply

with New York regulations in other states where they do business, the effects of the

lawsuit were felt more broadly than New York alone. Thus, rulings and settlements

resulting from this lawsuit would likely affect producer compensation across the U.S.

insurance industry.

Second, during his tenure, Spitzer had become particularly effective at enforcing

regulation in new ways, targeting industries such as financial products, liquor, and

energy. His office had become so powerful and effective that defendants frequently

agreed to fines and stipulation agreements without ever going to court. Hence, when

Spitzer filed a lawsuit alleging unlawful compensation practices (following months of

public investigation and subpoena) and suggested that the insurance compensation

model was flawed and due for change, the industry took note.2

To explorethe effect the lawsuit on the stock prices, this study tests three hypotheses:

first for named firms, second for other contingent-commission-paying firms, and

1To the extent that the threat against contingent commissions reflects a change in regulation,

several other studies provide important insights as well. The most important of these studies

include the seminal theoretical work by Schwert (1981) and empirical methodology by Binder

(1985a, 1985b). Cornett and Tehranian(1990) and Halek and Eckles (2010) have written event

study reports focusing on market reactions to regulatory and ratings changes. An expansion

of the literature is seen in Boyer (2000), Erfle, McMillan, and Grofman (1989), and Stango

(2003), in which the regulatory threat hypothesis is explored—the notion that market prices

respond to threats of new regulation and firm responses to those threats.

2For details of these investigations and other concerns about contingent commissions in 2004,

see J.P.Morgan U.S. Equity Research (2004) and Insurance Information Institute (2005).