Surviving the storm
Marsh's Virginia brokers cope with parent company's scandal

by Jack Milligan
Virginia Business
December 2005

For John L. “Mac” McElroy III and many of his compatriots at Marsh Inc. — the country’s largest insurance brokerage firm — the phrase “10/14” brings back painful memories. A managing director with 20 years of experience at the firm, McElroy oversees client development for Marsh’s Virginia operation, based in Richmond. When he finally arrived home on the evening of Oct. 14, 2004, he read something that made his stomach turn somersaults.

Earlier in the day New York Attorney General Eliot Spitzer — a reform-minded lawman with a touch of Elliott Ness in him — had filed a civil suit against New York-based Marsh & McLennan Cos. (MMC), Marsh’s parent company, alleging that Marsh had run a bid-rigging scam that had cost its corporate clients hundreds of millions of dollars in unnecessary insurance premiums. For a professional services firm, there could hardly be a worse allegation. Someone in the Virginia office had printed a copy of the suit from Spitzer’s Web site, but McElroy didn’t have a chance to look it over carefully until he got home.

“It did not read like a lot of legal jargon,” says McElroy. “It read like a Robert Ludlum novel — in other words, [it was] extremely digestible to the American public and I physically felt sickened by it.” It would later turn out that the scam involved a relatively small number of brokers in Marsh’s New York office and was not representative of how the firm did business. But at that moment, McElroy felt betrayed by people in New York who had dragged his firm’s reputation through the mud.

Marsh has taken steps during the past year to repair the damage caused by the scandal — and save its corporate skin. In February, MMC negotiated an $850 million settlement of civil fraud charges with the New York attorney general’s office — a deal which most likely averted a criminal indictment of the firm. At Spitzer’s insistence, it also issued an apology for the affair.

The scandal has reverberated throughout Marsh’s Virginia operation, which includes West Virginia and generates about $30 million in annual revenue. Its 107 employees have worked hard to retain key clients while competing brokerage firms have tried to lure them away. E. Christopher Schutt, a managing director who became president of Marsh’s Virginia unit last summer, credits Michael G. Cherkasky, MMC’s chairman and chief executive officer, with extricating the firm from its legal predicament. But Schutt saves his highest praise for those he says really saved the firm — the senior brokers and account management personnel in regional offices around the country who work with Marsh clients day-in and day-out, including his people in Virginia.

“They may have been like me, doubled over on the couch at night,” says Schutt. “But when they were [in the office], they were on the phone with their clients, taking care of their clients’ needs. They saved the company. The people on the floor around the country saved the company.”

One of those rank-and-file employees who stood by the firm through its time of trial was Vice President Eric Harley, an account executive who had joined Marsh in its Richmond office just four months before news of the bid rigging broke. Harley previously had spent 15 years as an underwriter at two insurance companies that did business in Virginia. He says that all his dealings with Marsh’s Virginia operation were completely above board, and he has no regrets about joining the firm despite all that has happened. “I’m still glad I came here,” Harley says. “It’s a great place to work.”

Although Marsh was able to dodge a potentially lethal criminal indictment, the firm is by no means out of the woods. In its settlement with Spitzer, Marsh agreed to stop collecting — in addition to its normal fees or commissions — “contingent commissions” from insurance companies in return for directing large volumes of business their way. The payment of contingent commissions played a central role in the bid-rigging scam, and Spitzer wanted the practice banned. But those commissions were a veritable gold mine for Marsh, and it remains unclear whether MMC will ever return to its pre-10/14 profitability.

Schutt says that Marsh will have to make up for any revenue shortfall by working harder and smarter. “We’re going to have to better serve our clients,” he says. “We’re going to have to better articulate our value to clients. We’re going to have to look very hard at clients where we lose money.”

In addition to Marsh, the MMC companies include Mercer Human Resource Consulting, the largest advisory firm in the benefits field; mutual-fund company Putnam Investments; and Kroll Inc., which provides a variety of investigative, security and technology services to large corporations.

Marsh is the largest MMC subsidiary by far, having accounted for 33 percent of the parent company’s $12.2 billion in revenue in 2004. In Virginia, Marsh’s client roster includes a handful of Fortune 500 companies, such as Smithfield Foods Inc. in Smithfield and Owens & Minor Inc., a Glen Allen-based medical supplies distributor. But most of the firm’s clients are middle-market businesses, particularly in the health-care, retail and transportation sectors. Schutt says Marsh also serves a number of municipalities around the state and handles a lot of environmental risks. In addition to Richmond, the Virginia operation has offices in Norfolk and Charleston, W.Va.

In a typical assignment, Marsh would advise a corporate client on the structure of its insurance programs that might include, for example, property, general liability and business interruption coverages. Marsh then would go into the insurance marketplace on the client’s behalf and place these various coverages with the insurance company offering the best combination of price and policy terms. In return for this service, Marsh would normally receive either a fee that it would negotiate with the client, or it would be paid a commission based on an agreed-upon percentage of the client’s insurance premiums.

The bid-rigging scandal involved two separate aspects, beginning with contingent commissions. Although Spitzer characterized them somewhat nefariously as “kickbacks,” the payment of such commissions had been a common practice in the commercial insurance industry for years. Most sophisticated corporate clients knew of the practice, including McGuireWoods LLP, a Richmond-based law firm. “In making the decision to use Marsh, that was the cost of doing business,” says Alexander H. Slaughter, a partner who has been involved in the firm’s insurance program for 25 years.

Spitzer believed that the practice of accepting contingent commissions created a potential conflict of interests for the broker, and here he was on solid ground. The commissions were originally intended to compensate brokers for services they performed on behalf of insurance companies, like keeping records and collecting premiums. But in recent years the arrangements were also used to reward brokers that directed large volumes of business to a particular insurance company, raising the question of whether that underwriter was being selected because it offered the client — or the broker — the best deal.

The second part of the scandal involved an obscure group of Marsh brokers in the firm’s New York office who specialized in excess casualty insurance — coverage intended to apply only in catastrophic situations that result in hundreds of millions of dollars in losses. Unbeknownst to the rest of the company, a small group of these excess casualty brokers had been arranging with various insurance companies to submit phony bids — called “B quotes” — that had been set deliberately high. The intent was to secretly direct business to insurers with which Marsh had contingent agreements in place.

To date, 16 insurance industry executives have pled guilty to criminal charges related to Spitzer’s investigation, including six at Marsh. Eight other Marsh brokers have pled not guilty to criminal fraud charges and are awaiting trial.

In its settlement agreement, Marsh agreed to set up an $850 million restitution fund for its clients. In addition to not accepting contingent commissions, the company agreed to limit its compensation to a single fee or commission paid when a client’s coverage is placed with an insurance company.

Schutt gives high marks to 54-year-old Cherkasky. The former New York prosecutor had been running Kroll, which was sold to Marsh in July 2004, when news of the bid-rigging scandal broke. When Jeffrey W. Greenberg resigned as chairman and CEO of MMC 10 days after Spitzer filed his lawsuit, the company’s board of directors turned to Cherkasky.

The new boss wasted little time hammering out a settlement with Spitzer. The two men had worked together years before in the Man-hattan district attorney’s office, where Cherkasky had been Spitzer’s boss. In recent years Spitzer has become famous — some would say infamous — for pursuing giant financial companies such as Merrill Lynch & Co. and Citigroup for various misdeeds, and there was little doubt he was eager to add Marsh to his collection of scalps. Cherkasky says that an indictment of Marsh — which Spitzer was threatening — could have had disastrous results. “[Marsh] would have been out of business,” Cherkasky says. “We most likely would have had our license suspended pending the outcome of the litigation.”

Schutt says that Cherkasky brought “a very no-nonsense, calming yet realistic approach” to the situation. Not only did he make the key decision not to fight the Spitzer lawsuit, Cherkasky also undertook a damage-control strategy of discussing the bid-rigging scandal and its ramifications in a very open manner. “We had a strategy of getting our dirty laundry out on the table,” Schutt says. “That was the best thing we did under Cherkasky’s leadership.”

The settlement with Spitzer will have a significant financial impact on MMC that goes well beyond the restitution fund. The insurance brokerage unit received contingent commissions of about $845 million in 2003, which was just 7 percent of its $11.6 billion in revenue that year — but over half of its $1.5 billion in net income. The reason for such a sharp disparity, according to securities analyst Cliff Gallant at the investment banking firm of Keefe Bruyette & Woods in New York, is that the profit margins on the contingent commissions were around 90 percent. Gallant believes that MMC’s earning power may have been permanently impaired by the loss of the contingent income. “Over time they will be able to raise their [base commission rate], but I don’t think they’ll ever get to the same level of profitability,” he says. “Their margin has been hurt permanently.”

Through the first nine months of 2005, MMC’s net income declined 57 percent to $365 million — a clear sign that the scandal, including the loss of contingent commissions, has hurt its earning power. Since taking over Cherkasky has sought to lessen the impact by laying off approximately 4,000 Marsh employees, or about 11 percent of its employment worldwide. And he also began the painful process of dropping clients — mostly small companies — that cannot be serviced profitably by the firm. Marsh has axed about 1,000 clients thus far, although the process won’t be completed until next spring. Cherkasky also wants to raise Marsh’s commission rates — “We have to make sure our clients understand our value proposition and pay us for that,” he says — although a highly competitive insurance market may preclude that step for a while.

As devastating as it was to Marsh’s reputation, the Virginia operation was helped by the perception among many of its clients that the bid-rigging scam was a New York problem. None of the contingent commissions generated by the bogus scheme found their way out to the hinterlands; instead, they were credited to another Marsh profit center that was run from New York.

Although some Virginia clients left because of the scandal, the defections were not crippling, says McElroy. “We lost some business for sure, but it could have been a whole lot worse,” he says.

One long-time client that stayed with Marsh is Smithfield Foods. The company’s corporate risk manager, Parul Patel, says the Marsh account executive assigned to Smithfield did a good job of keeping her informed of developments surrounding the bid-rigging scheme by calling her a couple times a month. Although she was surprised by the scandal given Marsh’s reputation, she knew that none of the people she normally dealt with were involved. Smithfield’s senior management asked her to consider moving the company’s business to a different brokerage, but Smithfield ended up staying in part because it trusted Marsh’s Virginia-based brokers, and the firm had helped Smithfield out of a couple of tough scraps in the past. Because Smithfield does business in nine countries outside the United States, Patel also liked the fact that Marsh has a large network of overseas offices. “They are the largest risk consultant in the world, and they are global,” she says.

McGuireWoods also remained a client after receiving assurances that Marsh would have the necessary re-sources to service the law firm’s insurance program despite the broker’s staff cutbacks. As with Smithfield, Marsh also kept the law firm well apprised of developments in the Spitzer case as they unfolded. “They hustled in the good sense of the word,” Slaughter says.

Since the agreement with Spitzer, Marsh has made significant changes in the way it does business. As the agreement requires, clients now receive full disclosure of all compensation the firm receives on their accounts. Marsh must file ongoing compliance reports with the National Association of Insurance Commissioners, a national organization of state insurance departments. And it has established a Global Compliance Group to, in effect, keep an eye on itself. Acting under pressure from Spitzer, Marsh’s two largest competitors in the United States, Aon Corp. in Chicago and London-based Willis Group, signed agreements with Spitzer that they will no longer accept contingent commissions. They have not said whether they will adopt a similar disclosure policy on pricing, although Cherkasky predicts that competitive pressure will force them to follow suit.

Marsh has also changed the way it places various coverages such as excess casualty. Whenever possible placement is now done on a regional basis and overseen by brokers like Schutt and McElroy. Cherkasky says the primary benefit of this new arrangement is that it provides clients with more transparency and removes the incentive for bad behavior. Patel at Smithfield likes the arrangement because the placement of her coverages is now handled by local brokers who know her company better.

And in a strategic shift that might help replace some of the lost revenue, Cherkasky wants all MMC subsidiary companies to aggressively cross-sell each other’s services in those instances where obvious synergies exist. One logical pairing is Marsh and Mercer Human Resource Consulting. Companies large enough to require an insurance broker often need the services of a benefits consultant as well. McElroy says that Marsh’s Richmond staff will soon move from its current downtown location at Riverfront Towers to James Center III, which is just two blocks away. Marsh will share its space there with Mercer’s operation. “Mercer is providing excellent client service and it’s making a larger footprint in Virginia,” says McElroy. “That’s good and we like that.”

A 13-year veteran of Marsh, Schutt says he has seen a big change take place in the company since 10/14. “We’ve had this significant cultural shift relating to the new management and to the business reforms,” he says. “It’s simply a better place to work today than it was before.” Schutt knows that Marsh may end up working harder for less money than when it was still raking in all those contingent commissions, but he also knows that things could be a lot worse.

Schutt recounts a conversation he had within the last year with the corporate risk manager at a Fortune 100 company that fired Marsh on all its insurance programs before the bid-rigging scandal was uncovered. “When she looks at a service provider, she wants someone who’s hungry, humble and smart,” he says. “And she told me, ‘You guys have always been smart, but I wasn’t sure how hungry you were, and you definitely weren’t humble.’” Schutt pauses a moment and then breaks into a smile. “This particular company has hired us back on half its business since 10/14 because we still got the smart, we’ve gotten a lot more humble, and our hunger is back.”