SPITZER'S CRUSADE
Inside the muckraker-in-chief's campaign against insurance companies and why--surprise, surprise--this investigation is just getting started.
By PETER ELKIND

(FORTUNE Magazine) – WANT TO KNOW THE BIG SURPRISE about Eliot Spitzer's high-profile business-scandal machine? It's not the billions of dollars in settlements he has wrung out of major companies to atone for their wrongdoing. Nor is it the range of powerful industries--from Wall Street to mutual funds to drug manufacturers--that New York State's crusading attorney general has targeted. What's truly stunning is his ability to force reform--to root out institutionalized sleaziness with lightning speed.

In the world of government regulation, what Spitzer has achieved is virtually unprecedented. Congress and federal agencies such as the SEC take years, if they're lucky, to reshape an industry or change its basic practices. (They don't call it burdensome government regulation for nothing.) Yet Spitzer, an elected official from a single state, has turned entire industries upside down.

Now, as we are all aware, we can add to that list the long-entrenched and opaque insurance business. Indeed, Spitzer's latest blitzkrieg--launched with his Oct. 14 civil complaint against the world's largest insurance broker, Marsh & McLennan--offers the clearest window yet into how America's muckraker-in-chief does it. The strategy has been remarkably consistent. Step one: Wade broadly into a gray area of odorous but long-accepted industry practices. Step two: Seize on evidence of black-and-white outrageous conduct--typically in e-mail form--and use it to marshal public outrage. Step three: In the resulting tsunami of scandal, swiftly exact reform of the whole industry, including gray-area behavior.

With his 31-page complaint (and almost 100 pages of exhibits), Spitzer has again exposed the venal underbelly of an entire industry, operating right under regulators' noses. And he did it, as usual, by damning his targets with their own words: e-mails that showed Marsh betraying its clients by steering their insurance business to favored underwriters in exchange for millions in backdoor payoffs. As one Marsh executive put it, "We need to place our business in 2004 with those that have superior financials, broad coverage, and pay us the most." Even worse, Spitzer exposed a broad pattern of brazen bid rigging, orchestrated by Marsh with the collaboration of such insurance giants as AIG, Hartford, and ACE.

The reaction was instantaneous. In four trading days, Marsh's stock price plunged by nearly 50%, whacking $11.5 billion off the company's market value. After 11 days Marsh CEO Jeffrey Greenberg--whose head Spitzer had effectively demanded--was gone. And after 12 days Marsh announced that it would stop accepting all backdoor payments from insurers, which in 2003 had amounted to $845 million, a big chunk of the company's profits. Spitzer hadn't just turned Marsh upside down. With a single lawsuit he had effectively ended this longstanding, highly lucrative practice throughout the corporate insurance-brokerage industry. Aon and Willis Holdings, Marsh's two biggest rivals (the three companies control nearly 80% of the market) quickly announced they would stop accepting such payments from insurers too.

That, of course, does not mean that Spitzer is through. Although the attorney general--in response to the regime change and promised reforms at Marsh--has agreed not to criminally indict the company, he expects to file criminal charges against several Marsh executives, among others in the industry (three insurance executives have already pleaded guilty in connection with bid rigging). His suit also seeks penalties and disgorgement from Marsh for all the contingent fees it has received in recent years--a figure that exceeds $2 billion. Settlement talks are expected to begin later this month with Marsh, even while the industry investigation continues.

The Spitzer Method is hardly without controversy. Why, critics ask, should the attorney general of New York State be allowed to interfere in longstanding insurance practices (or to use earlier examples, demand lower mutual fund fees, or change the structure of Wall Street research, or force drug companies to open up their clinical trials to public scrutiny)? If you define his mission traditionally, perhaps he should not. After the Marsh suit was filed, the Wall Street Journal editorial page pronounced itself troubled "about a public official unilaterally deciding that an industry's business model must change" and harrumphed that Spitzer "increasingly views himself as all three branches of government--legislator, regulator, and judge." But as Spitzer pursues his prey, there's a rough-justice quality about what he accomplishes. He's invariably on the side of the little guy, and the businesses he targets are in no position to argue. It's indisputable that his method works.

The insurance probe--the product of just six months of digging--makes that undeniably clear. Consider that in Spitzer's previous big investigations into Wall Street research and mutual funds, change required negotiated settlements, extracted over a period of months. In the long-entrenched insurance industry, corporate brokers have already unilaterally eliminated the most abusive practices Spitzer targeted.

The entire process took only days.

LIKE MOST OF ELIOT SPITZER'S investigations, the earthquake that rocked the insurance industry began with a tip. In this case it took the form of an anonymous, two-page, single-spaced letter that landed, on April 5, on the desk of David Brown, the Spitzer deputy who runs the office's investment protection bureau.

Brown, a 46-year-old Harvard Law graduate who had left a $500,000-a-year job at Goldman Sachs to work for Spitzer, was still immersed in the mutual fund investigation, finalizing a $225 million settlement with Janus Capital for allowing improper market timing. Also, Brown knew nothing about insurance. But the letter's detailed explanation of "contingent" commissions at Marsh ("Marsh is receiving major income for directing business to preferred providers," the tipster advised-- "i.e., the bigger the incentive [they pay Marsh], the more business they get") grabbed his attention. Spitzer's two previous landmark investigations--into Wall Street research and trading abuses in the mutual fund business--had also focused on conflicts of interest. Another consideration increased the odds of hitting pay dirt: Insurance was a virtually unpoliced realm. There was no federal oversight whatsoever, and the 50 state regulatory agencies were notoriously cozy with the industry. "This is prime Eliot material here," thought Brown.

Unlike many regulators, Spitzer's attorneys don't hesitate to act first and study up later. Two days after reading the letter, Brown sent Marsh a broadly drafted subpoena to make sure that any incriminating documents would be preserved. As Marsh started coughing up e-mails, Brown and his staff began learning about what they had already begun investigating. More subpoenas went out to insurance companies and a few other brokers, large and small. Brown became convinced that the industry was rife with improper inducements for steering business. But it was the bid-rigging evidence, surfacing in the e-mails in early September, that kicked the Marsh investigation into overdrive--and that would provide the outrage factor Spitzer required.

While Marsh and its competitors were hired by corporate clients to find the best insurance at the best price, the brokers, incredibly enough, were also being paid by the insurers. Debated for years in the industry, these "contingent commissions" (also known as "placement services agreements") had long been vaguely disclosed to clients as a benign payment for unspecified "services." Still, Marsh's marketing materials insisted, "our guiding principle is to consider our client's best interest in all placements."

But internal e-mails told a different story. They showed that Marsh directed business to the insurers with which it had struck the most lucrative deals. In fact, Marsh executives actually ranked underwriters by the profitability of the contingent agreements they'd signed. "Some are better than others," a Marsh managing director advised colleagues. "I will give you clear direction on who [we] are steering business to and who we are steering business from." A list of those rankings was later circulated to Marsh brokers, who were instructed to "monitor premium placements" in order to provide "maximum concentration with Tier A&B" companies. Insurance executives were bluntly advised that the way to boost their business was to sign a richer deal with Marsh.

The eureka moment, though, didn't come until early September. That's when staffers stumbled across e-mails showing how Marsh rigged the process to guarantee that no one underbid its chosen underwriter for a piece of business. One such case involved excess casualty coverage for Fortune Brands. E-mails show ACE was prepared to bid $990,000 for the policy but revised its bid upward to $1.1 million at Marsh's direction. "Original quote $990,000...," an ACE executive explained to a colleague. "We were more competitive than AIG in price and terms. [Marsh] requested we increase premium to $1.1M to be less competitive, so AIG does not loose [sic] the business...."

Marsh, the investigators found, routinely demanded that insurers submit phony, inflated bids to give its clients the illusion that they were getting competitive prices. These came to be known as "B quotes." ACE, for example, was told to keep playing ball if it wanted more business from Marsh clients. "I do not want to hear that you are not doing 'B' quotes or we will not bind anything," a Marsh senior vice president e-mailed an ACE VP. When one insurer refused to submit a phony bid, Marsh made one up and submitted it in the insurer's name anyway.

Such bid-rigging practices were "endemic," Spitzer says. His complaint asserts that one Marsh office asked agents for the Hartford insurance company "on virtually a daily basis" for inflated bids (called "throwaway quotes"). Taking the charade a step further, Marsh even asked insurers to show up for client presentations when the outcome had already been determined. When a Marsh broker e-mailed Munich-American Risk Partners to send a "live body ... to introduce competition," a Munich manager bristled in an e-mail emblazoned with large-cap type: "WE DON'T HAVE THE STAFF TO ATTEND MEETINGS JUST FOR THE SAKE OF BEING A 'BODY.' WHILE YOU MAY NEED 'A LIVE BODY,' WE NEED A 'LIVE OPPORTUNITY.'"

Such eye-popping evidence is critical to the Spitzer Doctrine. It had made his case in the Wall Street research scandal, where there had been a longstanding belief that analysts were conflicted, but e-mails then flat-out proved it. The internal messages showed analysts trashing stocks they publicly touted in order to protect their firms' investment-banking business. Such discoveries had made all the difference in the mutual fund scandal, revealing fund executives' tolerance of fee-generating market-timers and late-traders, who were supposed to be banned from their funds. "Without the e-mails, these cases never would have been made," says Spitzer. "They have opened up whole new vistas. And we will not file unless we can prove our case overwhelmingly. If you're making a structural argument [for change in an industry], you've got to be right."

Asked about the issues revealed in its documents, Marsh management sealed its fate when in-house lawyers reacted dismissively in a series of meetings with the attorney general. According to Spitzer and Brown, the broker's lawyers first defended the contingent payments as a time-honored--and fully disclosed--industry practice. They then insisted that Marsh brokers weren't influenced by the incentives. And finally they suggested that Spitzer just didn't really understand the insurance business. "He was right," the attorney general says. "I don't understand the insurance business as well as they do. But I do understand bid rigging."

Marsh's attitude was especially foolish given its troubled recent history. Its subsidiary, Putnam, had paid a $110 million settlement in the mutual fund scandal; Mercer Human Resource Consulting, another Marsh division, had disgorged $440,275 in fees from the New York Stock Exchange after acknowledging that it had provided inaccurate reports to the NYSE board about exchange chief Dick Grasso's $140 million pay package.

In an Oct. 14 press conference after filing his suit against Marsh, Spitzer--who had been attacked for being too willing to cut deals with dirty companies' CEOs--pointedly declared that "the leadership of that company is not a leadership I will talk to." Marsh finally took the hint, removing CEO Greenberg and replacing him with Michael Cherkasky, who had once been Spitzer's boss in the Manhattan district attorney's office. Marsh, along with competitors AON and Willis, soon made their announcement that they would no longer accept any payments from insurers. Marsh executives now pledge to lead the industry in adopting reform.

SO WHO'S THE NEXT TARGET? SPITZER and his war room staff are turning their sights on the rest of the insurance industry. The prosecutor says his aim is to eliminate all financial arrangements that color the duty of brokers and agents to find the best deal for their customers. That will apply to the rest of the big corporate brokers and insurance companies, which are already under investigation.

And Spitzer is widening his inquiry still further. The attorney general told FORTUNE he's also looking into mom-and-pop agencies that sell insurance to small businesses and consumers. He says he's found a similar pattern there of undisclosed inducements. "This affects what you and I are encouraged to buy--and how much we pay," says Spitzer. "That's where everybody gets hurt."

Brown says he's already uncovered a variety of "really bad practices" among insurance operators all the way down to the "strip mall"--slippery incentives for business that insurers pay to small retail agents and brokers. "For them, these types of backdoor payments are very, very important," he says. "They've all grown up on them." Some take the form of cash. In other cases, insurers lend independent insurance agencies money, then forgive the interest if the agents write enough policies with the underwriter. "If you hit a target, you don't pay the interest on a $10 million loan," says Brown. "That's a lot of dough." The goal, he says: "real transparency and price competition where insurance is sold everywhere. None of us knows what a world with insurance price competition would look like, since it's never existed."

While the big companies are moving "like lightning," to change their practices, says Brown, "it'll be interesting to see if the smaller operators reform themselves. If they don't, maybe we'll have a more extended inquiry on our hands."

At the moment, the latter path seems likely. In a statement responding to Spitzer's suit against Marsh, the Independent Insurance Agents & Brokers of America, a trade group that calls itself the Big 'I,' condemned "bid rigging and steering," but then went on to declare that "legal sales incentives should not be impeded." Such "incentive compensation is one form of compensation used to reward sales excellence," added Robert Rusbuldt, CEO of the trade group, and "a commonly understood part of the American sales culture."

In other words: precisely the sort of practice that Eliot Spitzer likes to eliminate.