THE INVESTIGATION BY

New York Attorney General Eliot Spitzer into the dealings of insurance broker

Marsh & McLennan

The charges are serious. Spitzer alleges that Marsh convinced insurance companies such as ACE and AIG to submit sham bids on insurance deals in order to create the appearance of a competitive market. Marsh had already preordained that certain insurers would get the deals, according to the charges. The insurers allegedly participated in this with the understanding that their turn would come up in due time.

The ramifications for Marsh are enormous, because a major element of this scheme involved commissions the insurers would pay it for steering clients their way. Marsh has said it will suspend these so-called "market services agreements," which represent about $845 million a year in revenues, for the time being. That might not be enough to convince Spitzer not to press criminal charges, however. Marsh also will suffer from the inevitable class-action lawsuits that are already being organized around the country.

SmartMoney.com recently spoke with Morningstar equities analyst Justin Fuller, who covers the insurance industry for the mutual-fund tracking firm, about the widening scandal. Last week, Fuller lowered his fair-value estimate on Marsh & McLennan (often referred to as Marsh Mac) and put a $24.50 "consider-buying" threshold on the company.

SmartMoney.com: You downgraded Marsh Mac's fair-market value earlier this week to $39 from $50, and you put your consider-buying threshold at $24.90. The stock now stands at about $24. Should investors consider buying Marsh & McLennan?

Justin Fuller: We think that at our five-star consider-buying price of $24.90, an investor is paying $21 for the Marsh & McLennan's Kroll, Mercer and Putnam business units and $4 for the Marsh unit. The latest report we pout out shows that if these contingent commissions are not just suspended but permanently eliminated from their business model, the value of the unit is about $4 a share, provided that Marsh is not able to charge higher up-front commissions or levy additional fees. But there still is a fair amount of risk and uncertainly surrounding the company right now.

SM: Is there a chance that this could spread to other business units, such as Putnam, which has had its own problems related to the mutual-fund late-trading scandal?

JF: I think there could be some headline risk from that. If you consider that this is the third problem for Marsh in the last two years along with the Dick Grasso salary uproar at the New York Stock Exchange and the Putnam mutual-fund timing scandal I definitely think there is some headline risk for its other units. But we still think the other business units are worth about $21 in fair value

SM: Marsh Mac cancelled a conference call on Monday, and it hasn't yet scheduled another call. How do you read that?

JF: It did cancel the conference call. Since Thursday, it has replaced the head of the Marsh unit and its directors have launched an internal investigation. They also disclosed that these contingent commissions are about $845 million in revenues, and we think those are almost pure profit. But other than that, there hasn't been a lot of communication from the company to the investment community, which definitely continues to demonstrate uncertainty. Investors aren't really sure what's going on inside the company at this point.

SM: Marsh Mac has lost half its market cap since the news of Spitzer's investigation broke. Is the drop justifiable? Its annual revenues are $11 billion, and as you say it will lose about $845 million a year if it suspends contingent commissions.

JF: In addition to the lost revenue in this case, there are allegations of price-fixing and bid-rigging and a lot of regulatory and litigation uncertainties surrounding the company. I think the stock price is a reflection of that uncertainty. Spitzer has said that this is just the tip of the iceberg, and I think you're seeing some of that in the stock price. From our estimate, that $845 million is north of 90% in pure profit, so that will definitely have a significant impact on profit margins if those are fully eliminated.

SM: Morgan Stanley has said that Marsh Mac could be forced to cut its dividend. What do you think?

JF: I think there certainly is a possibility that it may have to cut its dividend, but the way we've compensated for that is in our above-average risk rating, which basically gives investors a greater margin of safety. At this point in our model, we haven't cut the dividend, but considering that the company might have significant regulatory fines and that Spitzer said he might want all the contingent commissions over the last few years to be paid back, a reduction in dividends is certainly possible.

SM: You say that you "harbor serious doubts about the firm's governance and executive integrity." Spitzer has said he won't talk to the company's leadership. Do you think CEO Jeff Greenberg will eventually have to resign? Will he be fired by the board, which has been long criticized for its lack of backbone?

JF: Since this is the third scandal that Marsh has been implicated in, Spitzer may be saying that this is three strikes and you're out. I think it's certainly possible that the board may be forced to make a change of some kind. When you consider that the directors and officers own about 5% of the outstanding shares, there's certainly a lot at risk for the executive officers and the board, so they may try to resist any type of management change. But it seems that Spitzer has made it clear that there would have to be a management change for him to participate in any negotiations.

SM: This all looks pretty bad, but we're not really looking at an Enron or WorldCom kind of collapse here, are we?

JF: In those cases there was much more accounting fraud. What we've seen here are illegal activities in terms of bid-rigging and price-fixing. The insurance industry isn't going to go away. The insurance-broker industry will still be around as it proves to be a service for risk managers. The question is what type of role Marsh will play in that going forward in light of this lawsuit. At this point there hasn't been any accounting fraud alleged in the complaint. Would Spitzer demand payment back from these commissions? Maybe, but there hasn't been any talk about any restatements.

SM: The specter of the class-action lawsuits will hang over this for a long time. How much of a factor is that in your evaluation of the company?

JF: That certainly is a risk to the company. Already in the last few days we've seen a lot of class-action lawsuits organized. In our fair value, we think that our above-average risk and the corresponding margin of safety to our fair-value estimate compensates for some of this class-action litigation risk.

SM: Spitzer's investigation has spread into the health-care insurance sector, and stocks like Cigna and Aetna have suffered. It looks like the entire insurance sector is under a cloud now. Should investors steer clear of insurers until this thing blows over?

JF: It's really hard to say. I think that all insurers have been hit hard by the headline risk associated from this investigation. Spitzer has said that this is the tip of the iceberg. It has certainly weighed on investors' minds, but so far the only firm that has been charged with any serious wrongdoing [as of Wednesday] has been Marsh. There's certainly an air of uncertainty surrounding the sector, but at this point Marsh has been the only one that's been a target.

SM: How much of a surprise was this to you?

JF: The original investigation began last April. At that point the consensus view was that contingent commissions were an industry practice that's gone on for some time, and most people thought there would be greater disclosure, but that basically these types of payments would continue. Since not only the payments exist, but also the price-fixing and bid-rigging [allegedly], and these payments are being viewed as kickbacks, the investigation has certainly highlighted the seriousness of what's [allegedly] been going on. At this point, it seems that there's a reasonable probability that these commissions will definitely be reduced, if not eliminated entirely.