Perverse Incentives

How brokerage models can lead to bad actors in a game of unbiased advice

I was reminded of perverse incentives, or un-biased guidance at least, while I was reading The Price We Pay by Marty Makary, MD which is a new book about how broken the economic model of American health care has become. Dr. Makary does a wonderful job in his investigative journalism methodologies to uncover the price gouging, back-handedness and downright unethical business practices of some of our renowned health care institutions and health insurance companies. He shows the numerous ways that employers get screwed into paying higher prices for insuring their workforce and ultimately how the costs end up getting pushed down to the employees and ultimately the American taxpayer. One section of the book that made me perk up because it has such a strong parallel to what we see in commercial real estate is how the healthcare consultants or health insurance brokers get paid and how they’re incentivized.

Health insurance “consultants'“ or brokers often own the most valuable trusted relationship, the relationship with the employers. American employers are huge spenders on health insurance for their employees and need guidance, as we all do on our non-core business areas, on health insurance. These health insurance brokers will help a company select a group insurance policy from one of the national or regional insurance providers. They can also help guide them to do a self-insured model but that’s a different story altogether. These brokers are often free for the employer but are paid a commission from one of the providers upon selection. Most insurers will pay a commission to the broker for a newly originated policy of around 4%. That’s considered “market standard.” Some insurers however will sweeten the deal and offer bonuses or additional incentive for bringing employers to them. Naturally this leads to perverse incentives. For example, what happens when an insurance broker is advising a company and they’re presented with two options that are nearly identical in coverage, but one costs more than the other. Surely, you’d expect rationality to say that the broker should nudge or guide the company to select the lower cost option. What happens though if the higher cost plan pays a healthy commission to the broker but the lower cost option refuses to partake in “market standard” practices and will not offer such commissions? .The cost of the commission is baked into the insurance premium the company pays anyway. It would be in the best interest of the company to select the lower cost option but more often than not, it’s the opposite. The broker who generally controls information might choose not to present the lower cost option. The broker might choose to present both but shed a more favorable light and argument toward the higher cost / better incentivized option. They might slight the lower cost option with horror stories or bad mouthing their service. There are numerous variables in the decision of health insurance beyond price & coverage but you can start to see where incentives will lead a seemingly un-biased consultant to push one product over the next, at the behest of their client. As I’ve learned in economics though, there’s no such thing as a free lunch, and when you receive a service free of charge, then it usually means YOU are the product. In this case, the broker is selling the company to the insurance carrier. The broker has the power to be the shepherd of the sheep.

In commercial real estate we see the same dynamic at play with tenant representative brokerage (Tenant Rep). A tenant rep is often retained for free by a company on their behalf to help them make real estate leasing decisions, a significant cost and often confusing process for a company. Similar to health insurance, a healthy 4% commission paid by the landlord is “market standard” to pay a tenant rep broker for a transaction. In an essence, a tenant rep broker is presenting their client to engage in a transaction with a counter-party who is then going to pay the client’s representation a fee for service. Intuitively it makes no sense but this is “market standard".” So what happens when there are two spaces, each offering similar size, price, characteristics but one landlord is willing to pay a commission and the other refuses to play the “game?” Theoretically, the company should make the decision with all the facts on the table and do what’s best for its business. In reality, you might see incentives take hold and watch as a masterful broker gives “unbiased” advice about why one space is more favorable than the other. You can imagine a world where that broker would say, don’t choose to work with landlord XYZ (the one who refuses to pay commission) because they don’t take care of their buildings, they’ll screw you on other things, etc. The broker has the power to be the shepherd of the sheep.

All of this is not to say that every broker gives unbiased guidance. In fact, the BEST brokers play a long-term game and will often guide their clients to making the best decision for their business even at the behest of their own incentives. There are also numerous arguments to say that no two policies, or no two spaces are EXACTLY alike and so there are more factors at play here beyond financial but those are usually a distraction from an underlying market participant theory that actors in a game will play to their best hand. Nonetheless, the brokers that tend to win in the end are the ones that play a long-term game and do what’s best for the client no matter their own transactional benefits. Those are the brokers I like to associate myself with. Word gets around when you do well by your clients, even if it’s not the best financial gain for you in that single transaction. That’s what guidance should look like but market standards can often present perverse incentives.