New York state Attorney General Eliot Spitzer’s investigation into possible client abuses by the insurance industry may prove systemic, damaging industry profitability in the short-term and possibly fundamentally changing the way the industry works says Fitch Ratings.

Last week, Spitzer filed a lawsuit against Marsh Inc. and its parent Marsh & McLennan Companies Inc. alleging that Marsh & McLennan unfairly profited from steering clients to insurers that may not have offered the best price and policy terms, but offered Marsh & McLennan larger fees through lucrative contingent commission arrangements known as placement service agreements (PSAs). Additionally the lawsuit alleges that in several instances, Marsh & McLennan colluded with insurance companies to rig the bidding process for insurance contracts.

Fitch says that while Marsh & McLennan is the only defendant named in the recently filed suit, the ongoing nature of this investigation may lead to the discovery that other brokers participated in similar schemes, and could also face significant litigation. Fitch believes that this situation is partially an outgrowth of the greater market power that vested in the hands of a few large brokers following a wave of consolidation in the late 1990s.

“These matters may have broader implications for the property/casualty, health and life insurance industries as well, all of which utilize broker distribution to varying degrees,” it warns, noting that Spitzer’s suit mentions a number of insurance organizations, including ACE, American International Group, The Hartford, and Munich American Risk Partners.

“At this point it is unclear whether these alleged collusive practices represent an isolated case or a systemic market problem, and whether further investigation will lead to litigation against these previously mentioned insurers or other market participants,” it says, noting, “Fitch would not be surprised if they were systemic. Further, these matters create another public relations setback for the insurance industry, which remains an industry that is generally not well trusted nor held dear by its customer base.”

The rating agency says that the timing of these allegations is unfortunate for property/casualty insurers, as commercial insurance buyers have endured significant price increases since 2001. “Recent more prevalent trends of rate declines and resistance to further increases may accelerate if customers widely believe that previous deceptive practices by their insurer led to higher past premium costs,” it warns. “Any market wide changes in the nature of insurance broker compensation may have a material effect on the industry’s profitability and operating margins.”

That said, Fitch notes that its concerns are tempered somewhat by its view that regardless of how these issues are settled, insurance brokers will remain instrumental in the distribution of property/casualty insurance and continue to receive compensation in some form based on the value of services provided.

Fitch says it believes that the contingent compensation arrangements that are at the center of this probe have not been disclosed to customers as thoroughly or completely as necessary in all instances. However, Fitch also believes that the issues regarding conflicts of interest and lack of disclosure with PSAs are separate issues from the more serious collusion and bid rigging allegations, which could have taken place under other compensation arrangements as well.

“These events will clearly affect the ongoing debate regarding broker compensation, leading to greater disclosure of broker compensation arrangements, and may also lead to a sharp voluntary or involuntary decline in the use of contingent commissions in the insurance market,” it says.

Marsh & McLennan’s ratings were put on Rating Watch Negative by Fitch following the lawsuit’s announcement, “as the company faces significant potential costs related to fines and damages related to settling this matter, as well as potential damage to Marsh & McLennan’s insurance brokerage franchise that may affect future business growth and profitability.”

And, Fitch says it believes that changes in Marsh & McLennan’s management, organizational structure and internal control systems are likely to result in the near term. “This litigation also creates a huge distraction for Marsh & McLennan management in managing day to day operations and follows closely on the heels of recently settled regulatory investigations with Marsh & McLennan’s Putnam investment management operations,” it notes.