It is time for carriers and brokers to revamp these contracts to clearly define the relationship and obligations between the two parties.

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

In addition to the substantial money changing hands in the insurance industry, insurance laws are in a constant state of flux. The change in laws will have a direct impact on the relationship between the parties. Consequently, it is crucial that the producer agreements address this inevitability. Not to do so is simply foolhardy.

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

This difference in wording automatically altered the legal relationship between the insurance companies and its brokers–now agents. The producer agreement did not adequately address the relationship or take into account the potential for change in the law.

A properly drafted producer agreement could have protected the company in many ways. Such an agreement should clearly define the intention of the two parties to have a broker and carrier relationship. Also, in the event that the business relationship is deemed otherwise, the logical consequences of the change in relationship should be specified.

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

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

The automobile industry presents a perfect example of how agreements should be properly drafted. A car manufacturer allows a dealer to distribute its product only after a lengthy negotiation of the parties obligations prior to entering into the relevant contract.

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

If insurance brokers are allowed to distribute a companys product (and, in most cases, collect commissions upfront) shouldnt they be subject to certain conditions and restrictions, if malfeasance or nonfeasance occurs?

The first step to improve the standard producer agreement is to clearly outline the scope and authority of the distribution process. The following factors must be considered when defining the scope 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 potential customer when referring to the insurance company are unacceptable to the insurance company? Examples of such statements would be misrepresentations about the insurance policy: that the product covers items that, in reality, it does not; that coverage is immediately bound, when it may not be; or that the rate is “locked in” when often it is not.

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

Equally important is that an appropriately written producer agreement should outline the consequences if the broker misrepresents or harms the insurance companies in any way. The consequences must be set forth in a manner that is equitable, swift and clearly defined.

Does the producer agreement set forth the consequences of a breach or default? Does the producer agreement automatically terminate the agent if the agent is sanctioned by the Department of Insurance for a serious act? What if the carrier has to pay costs of any nature (i.e., legal fees, adjusting fees or reimbursement to policyholders) due to the brokers errors?

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

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

Many of todays producer agreements require the insurance companies to actually continue paying commissions to brokers who have, in some way, damaged the insurance companies name by committing negligence or even fraud. The insurance company usually has no recourse because the producer agreement they signed is antiquated, thinly worded and does not address this type of calamitous situation. Even if the producer agreement does address these situations, the drafting is typically inadequate and not given much thought.

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

This is important because the broker is in control and receives a significant amount of money and information that must have some quality control. As we know, a cursory review of loss ratios does not tell the entire story.

This is not to say that producer agreements are always silent on the issue of audits. In fact, many companies do have a policy of regularly examining a brokers financial records. However, the language in the producer agreement is usually vague and inadequate.

The producer agreement should address simple issues such as the types of audits that are allowed. Other relevant questions include:

What types of records will the insurance companies be permitted to examine?

Who should pay for this audit?

What happens if the audit reveals a breach of the producer agreement?

This one clause alone can provide tremendous protection to an insurance company. Unfortunately, the auditing language in a producer agreement is overlooked.

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

As most insurance companies are aware, they must continue to pay commissions in the event of a termination of a producer for a period of time. However, the continued payment is not without exception. These exceptions should be clearly defined in the producers agreement.

What other industry would require you to continue paying an employees salary long after that worker has been fired for wrongful acts?

The role of premium financing should be addressed in every producer agreement. Brokers often enter into their own contractual arrangements with outside premium financing companies. Knowing this, insurance companies should address when a broker utilizes premium financing for its clients.

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

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

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

In summary, insurance carriers must recognize that an appropriately drafted producer agreement can provide substantial protections and even address potential legal issues before they occur. The working relationship between insurance companies and their brokers is a mutually beneficial oneand one that can be substantially improved when each party understands at the outset exactly what their role is in providing insurance programs to their customers. Finally, it is always important to remember “an ounce of prevention is worth a pound of cure.”

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

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