In choosing how to react to this breakdown, the broker must decide whether the event was one which, in
principle, is insurable and which a reasonable person would be expected to be covered. If the answer is
affirmative, the broker might extract a large reputation toll from the insurer. But, if the policyholder “is
trying it on” — to hold up the insurer to pay for a loss that is not an insurable loss (e.g. poor business
performance) — the broker will not impose a reputation cost on the insurer for refusing to pay.
By acting as a guardian of reputations, the broker can help secure a market for non-contractible losses.
The formal and informal incentive structure for the broker reinforces this value-creating role. There is
some ambiguity as to whether an insurance broker is the agent of the policyholder or of the insurer. The
policyholder chooses whether to seek the services of a broker who will advise on insurance, on the choice
of insurers, and will place contracts with specific insurers. The policyholder also is concerned with the
treatment of its claims and usually expects the broker to become involved. The broker’s involvement can
range from a monitoring of the settlement to exerting pressure on the insurer to go beyond the strict contract
wording. Thus, the ability of the broker to create a market for non-verifiable losses will enhance the demand
for its services. The issue of legal agency is clouded by the payment for the service and by the incentives
this creates. The normal structure is for the broker to receive a commission from the insurer based on
the premium. However, many policyholders, particular large commercial clients, negotiate a fee with the
broker (for which the proportional commission is an offset) related to the perceived value added. Such an
arrangement provides a mechanism for the broker to be directly rewarded for creating insurance coverage
for non-verifiable losses and for disciplining insurers that behave poorly towards their policyholders.
But brokers also act on behalf of insurers. Insurers often have contingent fees for brokers under which
an additional compensation is paid to the broker based on the revenues and/or profitability of the book of
business the broker holds with the insurer. Insurers typically compete amongst each other in the design
of these profit and revenue sharing schemes and there is evidence that brokers do indeed respond to these
incentives in their placement and cancellation decisions, (see Wilder, 2002).
In our formal model below, brokers respond to these bilateral incentives in the following way. Brokers
offer an implicit deal to policyholders that they will use their leverage over insurers when unusual claims
arise. For their part, insurers understand that such leverage will be used and that this adds value for the
policyholder. Thus, insurers price for this effect. When a verifiable loss occurs it is paid according to the
contract. When a non-verifiable loss arises, the broker determines whether the loss is ex post insurable or