Updated from Dec. 23

Six years ago,

American International Group

(AIG) - Get Report

had a problem.

Rival insurers were offering brokers sky-high commissions on a type of policy designed to shield corporate officers and directors from business liability, a trend AIG feared was costing it business in California's Silicon Valley. The solution, newly unsealed court papers show, was a system of incentive payments to the brokers that became the basis of New York Attorney General Eliot Spitzer's investigation into insurance industry kickbacks.

"We felt that the gap between what we pay as commission on average and what our competitors pay in commission for essentially the same type of policy was so great that it would cost us a fair amount of business," said Stephen Gold, the AIG executive, in a deposition taken last year in a pending California civil lawsuit. "We needed to narrow the gap somewhat."

The incentive payments, more commonly known in the insurance business as contingent commissions, satisfied the demands of both brokers and AIG. The insurance brokers -- or some of them, anyway -- got fatter paychecks, while AIG got more bang for its buck without having to raise its standard commission rate.

"We did not wish to increase the cost of doing business unilaterally without accomplishing our business goals," said Gold, an executive in AIG's domestic brokerage group in San Francisco, in the deposition. "Our business goal was to prevent the loss of our position in the market. Simply to raise the rate and create a higher cost on all of our business ... would ultimately be a cost that all of our clients would have to bear."

Gold added: "We were only going to make the extra payments if we got the result that we wanted to see between us."

Gold's deposition testimony was unsealed recently in a three-year-old suit filed by a New York firm under a California law that enables lawyers to act as private attorneys general and bring actions in the public's interest. The lawsuit,

previously reported on by

TheStreet.com

, alleges that AIG,

Allianz

(AZ)

,

Chubb

(CB) - Get Report

and

Hartford Financial

(HIG) - Get Report

all made incentive payments to induce the brokers to steer customers to them, even when it was "contrary to the best interests" of their clients.

The suit, filed by

Anderson Kill & Olick,

alleges that the payments, which weren't disclosed to policyholders, amount to "bribes or kickbacks providing a strong monetary incentive to the included brokers." An AIG spokesman had no comment on the Gold deposition.

The allegations in the Anderson Kill lawsuit are similar to the ones lodged against the insurance industry in early October by Spitzer in a civil fraud suit filed against

Marsh & McLennan

(MMC) - Get Report

, the nation's largest insurance broker. The Marsh litigation focused a regulatory spotlight on the entire industry and led to a massive selloff in the sector and the ouster of Jeffery Greenberg, Marsh's former chief executive.

In the wake of the Spitzer investigation, much of the insurance industry has disavowed contingent commissions and incentive payments, with firms such as AIG, Marsh and

Ace

(ACE)

all saying they will no longer make or accept those payments. The investigation, which initially focused on property and casualty policies sold to big corporations, is now looking into similarly shady business practices in a wide spectrum of insurance products.

But most of the brokers on the receiving end of the incentive payments from AIG and the other insurers in the Anderson Kill lawsuit aren't huge firms like Marsh. Rather, the brokers tend to be small, privately owned concerns that peddle policies to small business and consumers. The California litigation is another indication of just how commonplace incentive payments were in the insurance business.

The unsealed court papers also reveal that some of the insurers took great pains to keep these payment agreements secret from the general public. Hartford and AIG, for instance, "contractually prohibited" brokers from disclosing the incentive payments to prospective insurance buyers, the court papers allege.

In fact, the insurers wouldn't unseal the documents in the litigation until Spitzer's investigation shook up the industry. Chubb was the last holdout, agreeing to lift the protective order on its court filings just a few days ago.

"They knew it was improper and they wanted to keep the consumer from knowing about,'' says Finley Harckham, an attorney with Anderson Kill.

The court filings show just how lucrative incentive fees could be for brokers. AIG's standard incentive contract paid a 3.5% bonus on top of a standard 12.5% commission. Chubb paid an added commission of 4.5%. Allianz and Hartford were more generous, paying incentive bonuses of 8% to participating brokers.

Marsh previously said it raked in $845 million in revenue last year from contingent payments, or 11% of the firm's total revenue.

The unsealed court papers also reveal just how mercenary the insurance business is when it came to incentive payments, which have been around in some fashion or other for at least half a century. The documents show that insurers were as much a driving force behind the spread of contingent commissions as were fee-hungry brokers.

David Swanson, a Hartford executive, testified in his deposition that the Connecticut insurer first began making incentive payments "back in the late '50s.'' Swanson, who joined the firm in 1976, said incentive payment deals were not signed with all brokers and were used to maximize profits in specific types of insurance.

"The goals of the program are to retain and grow our business ... but what I would say is it is not all-inclusive of what business Hartford writes,'' Swanson said. "Again, understanding that not all agents receive a contingency agreement.''

A Hartford spokesman declined to comment.

A Chubb internal memo, describing the firm's "contingent commission point program,'' says the goal was to put more money "into the hands of the most profitable Chubb producers and those whose business grows in accordance with our targets.'' Contingent commissions should be used to "better drive desirable producer behavior.''

Gold, meanwhile, testified that AIG only signed special commission deals with a "handful'' of the 5,000 brokers that were doing business with his San Francisco office. The insurer was only interested in inking deals with brokers that specialized in selling director and officer, or "D&O," policies.

At the time, AIG was facing growing competition from insurers paying fat commissions to brokers for selling D&O policies to Silicon Valley start-ups and dot-com darlings.

"Many brokers would ask for such a thing all the time,'' he said. "I think I can say all, all of these brokers are primarily brokers who do business with AIG in the area of management liability to D&O and E&O (executives and officers). There was no point in us putting in place incentive agreements in other lines of insurance where we didn't face that problem.''

In fact, by August 2003, a full year before the insurance scandal broke, AIG had stopped paying incentive bonuses to brokers for selling D&O policies. Gold testified that the insurer no longer needed to make the payments because several competitors were no longer in business. AIG was no longer in danger of losing market in the D&O market, especially after the bursting of the dot-com bubble.

"Many of those companies had gone out of business along with many of the insurance companies that were providing D&O insurance,'' Gold said. "I think what you see now is that there's much more of a demand for an insurance company that is financially stable and has no questions about is solvency is capable of defending directors and officers when they get sued. And I think AIG has been and is the dominant company that meets all of those requirements."