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Can He Reinvent Marsh?


In July, when the world's biggest insurance broker, Marsh & McLennan Cos., (MMC) bought Kroll Inc. (MMC), the investigations and crisis management company, it had no idea how smart the purchase would turn out to be. Kroll is the only Marsh Mac division not tainted by scandal. First, Marsh Mac tapped Michael G. Cherkasky, the head of Kroll, to run its insurance-broker division. Then, on Oct. 26, the board made him head of the entire $12 billion financial-services behemoth.

Cherkasky, a former prosecutor, seems to be the right man at the right time. He has already avoided the worst outcome: the possibility of a criminal indictment of Marsh Mac that could have put it out of business. But Cherkasky, 54, still faces a mammoth challenge in restoring the firm's reputation and shoring up its finances. Although the firm is likely to survive, analysts say it could end up a shadow of its former self. Already, investors have wiped out nearly 40%, or about $9 billion, of its market cap since New York Attorney General Eliot Spitzer sprung his trap on Oct. 14 with a civil suit that charges Marsh Mac with rigging bids and accepting payments for directing clients' business to selected insurers. All the major credit-ratings agencies subsequently downgraded its debt, sharply hiking the cost of borrowing the money the firm needs to finance its brokering business.

Marsh Mac may bear the brunt of the insurance scandal, but the entire insurance industry is coming under greater scrutiny from regulators and law enforcers. Spitzer is also investigating other brokers and insurers, including Aon (AOC), ACE (ACE), and Willis Group Holdings (WSH). Meanwhile, American International Group Inc. (AIG), one of the world's biggest insurers, is facing a Justice Dept. investigation into its sale of a product that allegedly enabled cell-phone distributor Brightpoint Inc. to inflate its earnings. Regulators are also looking into deals in which AIG allegedly arranged for client PNC Financial Services Group Inc. to shift loans off its books.

A SERIOUS BLOW

Experts say the insurance industry will be forced to change the way it does business. With many fees under fire and rigged bids taboo, insurers and brokers are likely to suffer a serious financial blow. Says Morgan Stanley (MWD) insurance analyst Vinay Saqi: "[They have] had a difficult time making money when the game is rigged in their favor. We're concerned they won't fare well in a truly competitive environment." Worse yet, the scandals might prompt some major clients to sidestep brokers altogether and set up captive insurers either alone or in groups to handle most of their insurance needs.

Cherkasky was briefly Spitzer's boss in the New York County District Attorney's Office and the two are friends. Indeed Cherkasky has given $14,500 to Spitzer's campaigns since 2002. Spitzer's office said he will not accept any further donations in the future.

Cherkasky moved fast to meet Spitzer's demands. He oversaw the ouster of CEO Jeffrey W. Greenberg and axed contingency fees -- payments from insurance companies for steering business their way. He promised more transparency on fees and a beefed-up effort to ensure that Marsh Mac employees comply fully with laws and regulations.

Those moves may be enough to blast away Marsh Mac's notoriously secretive and allegedly corrupt culture (BW -- Nov. 1). But once Cherkasky has stabilized the company he must focus on stanching its bleeding finances. Some $845 million -- half of the insurance broker's annual profits -- came from contingency fees. That revenue has suddenly evaporated -- and Cherkasky concedes he hasn't worked out how to make it up. On a conference call on Oct. 26, he told reporters: "We haven't determined, dollar for dollar, how we'll replace the revenue." Yet the next day he told analysts that Marsh Mac will still pay a 34 cents quarterly dividend, at a cost of $178 million -- a hefty sum for a company whose profits are under siege. Cherkasky did say Marsh will still charge insurers for certain services it provides, without giving details. But Jay H. Gelb, a Prudential Equity Group LLC analyst, figures Marsh will be able to replace only a quarter of the lost fees by charging higher commissions. (About 20% of revenues come from commissions that aren't in dispute.) Still, Marsh will have to tread gently or risk losing clients to rivals.

Marsh's cash will also be depleted by any settlement money it has to fork over as well as the costs of other lawsuits. Experts say that bill may run as high as $1 billion. Says Adam Klauber, research director at Chicago insurance researcher Cochran, Coronia & Co.: "If Marsh Mac can't pay for it out of cash flow, it will need to stabilize its debt rating and eventually get it raised in order to increase financing options."

That could be tough. This summer, Marsh Mac shelled out $1.9 billion in cash and debt to buy Kroll. Many analysts argued that it had overpaid. They say, Marsh Mac is maxed out on the amount of new debt banks are likely to let it take on. Says Mark Lane, an insurance analyst at William Blair & Co. in Chicago: "Marsh Mac will likely have to raise cash through hybrid equity issues like convertibles."

FIRE SALE?

If Marsh Mac's financial situation gets much worse, Cherkasky might have to consider selling its Putnam Investments (MMC) mutual-fund division, along with pension-consulting and human-resources arm Mercer Consulting Group (MMC), to raise cash. Lane estimates that Putnam is worth $4 billion and Mercer $3.5 billion. In a fire sale, he says, they would fetch far less -- and Marsh Mac would be hit with a substantial tax bill. Besides, Marsh Mac's lenders would probably veto the idea: The firm is worth more as a whole.

Still, Marsh Mac might be tempted to spin off the divisions to shareholders simply to lessen the potential conflicts of interest that arise from selling their products to each other's customers. For example, Mercer is being investigated by regulators for various practices, including pushing Putnam funds to pension clients. Analysts say a spin-off might ease pressure from regulators, but it wouldn't add much to the broker's cash reserves.

Mercer and Putnam seem to be the least of Cherkasky's worries. Right now, Marsh Mac is facing a possible exodus of brokers. Willis and other brokers say they've been inundated with calls from Marsh employees. To stem the outflow, Marsh may have to pay its brokers more to offset suddenly worthless stock options, putting more pressure on its bottom line. Clients could walk, too. Cherkasky shrugged off this threat during his Oct. 26 press conference, saying that by changing its business model and increasing transparency, Marsh will hold onto most of its clients.

The truth is, it's difficult for clients to jump ship to another broker. Even though Aon Corp. has its own Spitzer-related woes, Marsh and Aon, the two largest insurance brokers, are about the only firms that can handle major global risks, say analysts. Clients don't move around a lot. According to Cochran Coronia's Klauber, 93% stay with their broker. The reason: Voluminous and sensitive client information must be provided to bidders, and then the broker must analyze the bids. "It's a very complex process. It's difficult to snap your fingers and say: 'I want to get rid of Marsh,"' he says. In early September -- the renewal deadline to have policies in place by Jan. 1 -- about 40% of clients had renewed their agreements with Marsh. But, analysts say, many corporate risk managers are mulling a change for 2006.

The industry as a whole isn't out of the woods, either. The big risk: Corporate clients will decide to put together their own insurance policies, axing brokers altogether. According to Morgan Stanley, a record number of captive insurers -- subsidiaries that companies set up to handle their own insurance -- were set up last year. Says Morgan Stanley's Saqi: "What risk manager, treasurer, or CFO wouldn't consider alternative sources of risk financing after having the bond of trust with its broker/insurer challenged?" Companies could also decide to bypass brokers and strike up deals with insurance companies directly.

The industry could remain on probation for years as state regulators scrutinize them -- and the rates they charge -- with renewed vigor. The National Association of Insurance Commissioners has said it will try to break the market power of the big brokers. Meanwhile, other brokers and insurers are sure to be hit by lawsuits as Spitzer expands his probes.

Marsh Mac must get through its legal mess and hammer out a settlement that includes restitution to its clients. Sources close to Spitzer's investigation say it's unlikely this will happen as quickly as Marsh Mac would like. This is one crisis that will require all of Cherkasky's skills.

By Marcia Vickers, with Diane Brady, in New York and Joseph Weber in Chicago


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