Shaking Hands With Strangers? Producer Agreements NeedRevamping

While most insurance industry executives appropriately examine,negotiate and conduct due diligence prior to entering into a newbusiness arrangement, they almost never think twice about signing aflimsy, one or two page contract with insurance brokerscollectively valued at tens of millions of dollars. In essence,such contracts amount to nothing more than a handshake–with astranger.

Most of todays producer agreements or notices of appointment inthe insurance industry have become so boilerplate and perfunctorythat they have lost their effectiveness. The legal relationship andobligations between insurance companies and brokers is typically sounclear in a producer agreement that both parties are overexposedand underprotected if a dispute arises.

Further, disputes are more likely where the contracts do notthoroughly spell out the rights and obligations of each party.

It is time for carriers and brokers to revamp these contracts toclearly define the relationship and obligations between the twoparties.

The amount of money changing hands in the insurance industry isstaggering– insurance dollars account for a tremendous portion ofour countrys overall economic activity. In fact, the U.S.property-casualty insurance market (including fire, extendedcoverage, liability and similar losses) totaled close to $400billion dollars last year. A significant portion of the moneychanging hands occurs via the independent broker. Thus, much ofthis money is transferred between these two parties with only aproducer agreement.

In addition to the substantial money changing hands in theinsurance industry, insurance laws are in a constant state of flux.The change in laws will have a direct impact on the relationshipbetween the parties. Consequently, it is crucial that the produceragreements address this inevitability. Not to do so is simplyfoolhardy.

For example, early this year, a California case, Krumme v.Mercury Insurance, sent shockwaves throughout the industry asa San Francisco Superior Court judge ruled that producers for aleading writer of auto insurance in California were in fact“agents” rather than “brokers,” as stated in the produceragreements. The Court examined the producer agreements whenadjudicating this case.

This difference in wording automatically altered the legalrelationship between the insurance companies and its brokers–nowagents. The producer agreement did not adequately address therelationship or take into account the potential for change in thelaw.

A properly drafted producer agreement could have protected thecompany in many ways. Such an agreement should clearly define theintention of the two parties to have a broker and carrierrelationship. Also, in the event that the business relationship isdeemed otherwise, the logical consequences of the change inrelationship should be specified.

As a result of the ambiguity and lack of detailed, thoroughdrafting in the producer agreement, this carrier was exposed tosignificant liability that could have easily been avoided.

The liability arose from the fact that a producer may not chargea fee for transacting insurance with an insurer for which theproducer is appointed as an agentor deemed to be an agent, as inthe Mercury case. All fees charged in relation to atransaction of insurance by an agent (or broker deemed an agent)are constructively received by the agents principal, i.e., theinsurer. The constructive receipt of such fees by an insurerresults in the insurer effectively collecting more premium thanpermitted under its premium rate schedule, which must be filed andapproved by the Commissioner.

The automobile industry presents a perfect example of howagreements should be properly drafted. A car manufacturer allows adealer to distribute its product only after a lengthy negotiationof the parties obligations prior to entering into the relevantcontract.

Another example is office space rental. As all executives know,the negotiation that is involved prior to signing the leaseagreements are arduous, but necessary.

If insurance brokers are allowed to distribute a companysproduct (and, in most cases, collect commissions upfront) shouldntthey be subject to certain conditions and restrictions, ifmalfeasance or nonfeasance occurs?

The first step to improve the standard producer agreement is toclearly outline the scope and authority of the distributionprocess. The following factors must be considered when defining thescope and authority of distribution:

What authority does the broker have to offer this product?

What types of statements that a broker might make to a potentialcustomer when referring to the insurance company are unacceptableto the insurance company? Examples of such statements would bemisrepresentations about the insurance policy: that the productcovers items that, in reality, it does not; that coverage isimmediately bound, when it may not be; or that the rate is “lockedin” when often it is not.

Who is entitled to sell an insurance companies products? Forexample, if the broker sells the book of business to a third party,the insurance companies should have a strict approval process ofthe new owners of the book of business. While this generally occursas normal business practice, it is not required in many existingproducer agreements.

Equally important is that an appropriately written produceragreement should outline the consequences if the brokermisrepresents or harms the insurance companies in any way. Theconsequences must be set forth in a manner that is equitable, swiftand clearly defined.

Does the producer agreement set forth the consequences of abreach or default? Does the producer agreement automaticallyterminate the agent if the agent is sanctioned by the Department ofInsurance for a serious act? What if the carrier has to pay costsof any nature (i.e., legal fees, adjusting fees or reimbursement topolicyholders) due to the brokers errors?

These issues, like any other contractual relationship, must beaddressed up front, not after the fact.

Just as important, the insurance companies should have the rightto offset commissions.

Many of todays producer agreements require the insurancecompanies to actually continue paying commissions to brokers whohave, in some way, damaged the insurance companies name bycommitting negligence or even fraud. The insurance company usuallyhas no recourse because the producer agreement they signed isantiquated, thinly worded and does not address this type ofcalamitous situation. Even if the producer agreement does addressthese situations, the drafting is typically inadequate and notgiven much thought.

What about the insurance companies right to audit a brokersbusiness records? For a producer agreement to be effective, itshould include language allowing the insurance companies to auditthe brokers business records on a regular basis.

This is important because the broker is in control and receivesa significant amount of money and information that must have somequality control. As we know, a cursory review of loss ratios doesnot tell the entire story.

This is not to say that producer agreements are always silent onthe issue of audits. In fact, many companies do have a policy ofregularly examining a brokers financial records. However, thelanguage in the producer agreement is usually vague andinadequate.

The producer agreement should address simple issues such as thetypes of audits that are allowed. Other relevant questionsinclude:

What types of records will the insurance companies be permittedto examine?

Who should pay for this audit?

What happens if the audit reveals a breach of the produceragreement?

This one clause alone can provide tremendous protection to aninsurance company. Unfortunately, the auditing language in aproducer agreement is overlooked.

Termination clauses should also be linked to an offset ofcommissions in a producer agreement.

As most insurance companies are aware, they must continue to paycommissions in the event of a termination of a producer for aperiod of time. However, the continued payment is not withoutexception. These exceptions should be clearly defined in theproducers agreement.

What other industry would require you to continue paying anemployees salary long after that worker has been fired for wrongfulacts?

The role of premium financing should be addressed in everyproducer agreement. Brokers often enter into their own contractualarrangements with outside premium financing companies. Knowingthis, insurance companies should address when a broker utilizespremium financing for its clients.

For example, in the event of a cancellation and return ofunearned premium, who is obligated to return the unearnedcommission? The return of net unearned premium (net of commission),in most jurisdictions, can be a violation of the InsuranceCode.

Current producer agreements rarely, if ever, address this issue.Worse, the lack of consideration of this issue within the produceragreement causes insurance companies to expend valuable resourcesdealing with unearned commissions. It is too easy for insurancecompanies to save money by simply having a correctly draftedproducer agreement that addresses this issue.

It is important to realize that brokers are required to followstringent guidelines set up by the State Department of Insurance.While the producer agreements usually address the compliance withstate insurance laws, carriers rarely consider changes in the lawthat impact how its product is distributed. The Mercurycase cited above demonstrates the type of change that can occur.Failing to address this inevitability is dangerous as the companycan be exposed to civil actions and regulatory scrutiny.

In summary, insurance carriers must recognize that anappropriately drafted producer agreement can provide substantialprotections and even address potential legal issues before theyoccur. The working relationship between insurance companies andtheir brokers is a mutually beneficial oneand one that can besubstantially improved when each party understands at the outsetexactly what their role is in providing insurance programs to theircustomers. Finally, it is always important to remember “an ounce ofprevention is worth a pound of cure.”

Sanford Michelman is a partner in the Los Angeles-based lawfirm of Michelman & Robinson LLP, which is a full service lawfirm. He specializes in insurance, business litigation andinsurance transactional matters, and can be reached [email protected].

Reproduced from National Underwriter Property &Casualty/Risk & Benefits Management Edition, June 30, 2003.Copyright 2003 by The National Underwriter Company in the serialpublication. All rights reserved.Copyright in this article as anindependent work may be held by the author.