Insurance brokers - who will the winners be?

The Loch Ness Monster. Area 51. The grassy knoll. To the list of the world's great unsolved mysteries can be added a further conundrum - the continued success of the insurance broker.

For years, traditional brokers have laboured under the Sword of Damocles that is dis-intermediation, be it from direct players, comparison sites or even from traditional bank-assurers. And for some parts of the market, those fears have been fully justified. In the UK, for example, direct insurers have risen from nothing to control 41% of the personal lines market (ABI, 2015). And it has been estimated that comparison sites now account for over a third of UK motor policies.

This has had some inevitable consequences, with many smaller / high street brokers giving up the ghost and a wave of (often very poorly executed) consolidation sweeping the lower end of the market, as players have turned to scale benefits to counter-act dramatic falls in income. And this was before Silicon Valley threatened to unleash a tsunami of further disruption onto the industry’s shores. 

And yet the broker survives and in the commercial lines sector in particular, prospers.

Why is this?

Well the cynic might argue that the archaic nature of the insurance industry itself has helped shield the market from the sort of Big Bang type reform that struck the banking industry 30 years ago. Anyone remember open outcry? Wander around Lime Street today and you will still see brokers, collars turned up against the wind, off to pitch their wares armed only with a bulging and brightly coloured Manilla folder wedged hopefully under one arm. Some might say that the industry's biggest single barrier to entry for new entrants is the fact that it remains so stubbornly paper-based!

However, I would argue that the real reason for the broker’s survival lies in a simpler and more prosaic truth.

Trust.

Hardly earth shattering, I know. But in my experience those outside the industry - and even those inside it at times - consistently underestimate the extent of the trust that clients place in their broker and the strength of the relationship that springs from this. In few other industries, for example, can often relatively junior individuals leave one shop for another, reasonably confident in their ability to take a couple of million dollars of brokerage across the street with them.

For a product that is often said to be sold rather than bought and that has become, for the vast majority of businesses, relatively standardised, this sense of loyalty to their broker is somewhat counter-intuitive. But that is to ignore the very different psychology and motivations of the corporate buyer, who sees the value of insurance in insulating against shocks, keeping their management team out of court and de-risking new initiatives rather than a grudge purchase where price is the over-riding factor.  

Because of this, brokers often occupy a privileged position at the corporate top table, alongside a company’s accountants, bankers and lawyers. Accompany a company on a meaningful claim and the strength of that position gets enhanced even further. And with the emergence of new risks such as cyber and the world today ever more complicated, unpredictable and unstable, then the need for a trusted adviser to help you protect your shareholders, employees and clients from whatever might be thrown at them and navigate the complexities of the market, becomes more important than ever. Small wonder, therefore, that commercial lines brokers have proved so resilient. 

This though, exposes the mystery - the classicists amongst you might even say Hamartia - that lies at the heart of the broking model. The value provided by a good broker is almost entirely in the advice they give – diagnosing where your risks are, identifying which risks should be transferred and which retained, designing placement strategies, helping put in place pro-active risk prevention and mitigation strategies, getting claims paid, etc. And yet brokers are typically paid via commission for placing the risk, arguably the least value-added and most transactional part of what they do. Particularly in today’s market, where underwriters are falling over themselves to cut rates to secure market share and where, in the words of one former colleague of mine, “my twelve-year-old son could place an off-shore energy policy right now.” Her words, not mine!

It is the perfect illustration of someone negotiating over the price of the saddle, but giving the horse away for free.

The real problem with commission, of course, is the potential mis-alignment of interests it creates between brokers and their clients. At the most basic level, in any normal intermediary-based industry, the better deal you get for your client, the more you might expect to be paid. In the insurance industry, however, the more the client pays, the more commission the broker makes. Even stranger, it is paid for by the insurer despite the broker supposedly acting on behalf of the client. The risk of perverse incentives abounds.

That's not all. Commission is also a pretty blunt way of linking effort to reward. The work involved in renewing a policy with the same insurer, for example, is a fraction of that required to set it up, and yet the same commission rate applies. Similarly, the effort required to place a $20m policy is not hugely more than that involved in placing a $10m one and yet one will pay double the other. Some clients eat up huge amounts of time pursuing a contentious claim and yet will pay the same commission rate as a far more straightforward client with little claims activity. It is hard to see how this doesn’t create a cross-subsidisation effect between the simpler, less demanding clients and the more complex, challenging ones, to the detriment of the former.

Further complicating the picture is the fact that the economics of this tried and tested model have become increasingly challenged by the precipitous fall in the rating environment over the past few years, particularly outside the more volume based classes. Commission is all well and good for brokers when prices are holding firm, but in a market where rates are falling 20-30% a year, as they have been in the aviation and energy markets for example, they are suddenly faced with having to do the same, if not more, work, for less money and with the prospect of worse to come.

But brokers are nothing if not resourceful. Diversification has allowed some to grow their income by shifting their value proposition to providing a broader risk consultancy offering and cross-selling additional services. Consolidation and automation have taken supply out of the market and released significant efficiency savings. And, perhaps most importantly, ever more elaborate ways have been found to extract value from the market through sophisticated placement strategies, providing analytics and consulting expertise and taking on parts of the insurance value chain in return for a fee. And while brokers have rightly been very careful not to replicate the structures and practices that landed them in hot water with Eliot Spitzer not so long ago, I would speculate that for the larger brokers at least, income generated from the market is proportionally larger than it was pre-Spitzer.

While the broking community's inventiveness is to be lauded, the risk is that they start eroding the very foundations of their continued success. The more that clients feel that their broker is more concerned with selling them additional consulting or software services than worrying about their core programme, the more revenues that they perceive their brokers to be pulling out of the market beyond their core commission, the more blurred the lines become between where brokers end and where insurers begin, then the more clients may start to question the value their broker is adding and whether they are truly acting in their best interests.

But then, perhaps clients have the market they deserve? Certainly few apart from the largest and most sophisticated clients have agitated to move their brokers onto fee based remuneration structures that more clearly link the actual effort involved and value created – as they do for their other professional advisers who largely bill in terms of time and access to relative tiers of expertise. And stories abound of clients not playing fair, rewarding a cut in the premium with a proportionate fee reduction rather than rewarding their broker's efforts - small wonder brokers have been happy to let things lie.

Perhaps these things are simply far too entrenched - the 'custom and practice' too deeply rooted, or as is possibly the case with large scale affinity / programme type business, too impractical, to change? Particularly where all parties feel happy with the relative trade-offs. But I wonder if there isn't potentially a certain mutual convenience in the broker's cost being if not quite invisible to the client, then at least one step removed in that most never have to sign an actual cheque. It must almost feel like it is free...

Besides, you need to be careful what you wish for. There is an interesting read across here to the UK wealth management industry, where recent regulatory reforms have banned advisors from earning commissions from whichever provider they recommended to their client, to eliminate the risk of advisers placing / churning business to the highest fee payer and for earning trail commissions for little ongoing effort. Instead, if clients want discretionary advice they now have to pay their adviser an up-front fee which will typically run into the thousands of pounds and then pay further fees every time they transact. In theory, this makes sense and the money that the providers were paying to the intermediaries by way of commission should have been handed back to client in the form of price reductions, leaving them no worse off once they had paid for advice. In practice, of course, this has created a windfall profit for the providers and left an advice gap at the heart of the British wealth management industry, because many clients have balked at the prospect of cutting a cheque for a couple of grand even though they were happy to pay this, and probably much more, when the adviser's costs were discretely embedded into the cost of the product. No wonder clients, brokers and insurers in the insurance industry have largely preferred to stick with the status quo. The law of unintended consequences looms large.

Where does all this point, therefore, when considering the sustainability of the broking industry in the face of the changing market dynamics they are now facing? I would make a couple of suggestions. 

Firstly there is probably a large swathe of medium-sized commercial lines business where the economics simply do not justify the continued provision of brokerage advice and services on the same basis that this has been supplied in the past. Radically different operating models will be required, probably leveraging some of the learnings from the banking world who have also had to evolve their service model. There is probably an opportunity for AI and robo-advice based models, such as are increasingly being seen in the wealth management world. At one level this will favour those brokers with large retail / affinity / SME customer bases and strong brands who can leverage existing practices and infrastructure up the value chain. But it also potentially suggests a rich seam of opportunity for disruptors armed with weapons-grade analytics and innovative distribution strategies.

Secondly, when it comes to larger, international companies or non-standard, more complex risks, the importance of the trusted broker relationship is not going to change. In fact if anything and as I have argued elsewhere, the world’s greater uncertainty and volatility makes that very simple, human trust based relationship, more important than ever. Insurers will continue to pay for this distribution - they have no choice. And new entrants, who think that a roomful of MIT graduates and a piece of smart tech can dislodge a 20 year relationship forged in the white heat of a ugly claim will find out the hard way how wrong they are. In this part of the market, they are far better served focusing on providing solutions to back-end operational efficiencies and supplying discrete tools and services.

However, what is likely to change is what the client's trust-based relationship with their broker is built on. Being able to navigate your way around a wine list, procuring Centre Court tickets at Wimbledon and being an excellent transactional broker may have been enough to win and retain business in the past, but it just won't cut it in the future. Clients now need a far more holistic, technical and analytically-based approach to helping them understand, manage and mitigate their exposures. The placement will become a hygiene factor for most, if indeed it isn't already.

The challenge for the brokerage community – and by extension for the sustainability of their trusted relationships with their clients - is whether they are equipped to meet their client's rapidly shifting requirements from either a capability, a tools or an organisational perspective.

Many brokers simply don't have enough people with the highly technical, analytical and consultative skills that they need if they are to provide the advice that their clients are increasingly likely to require. This implies the need for a far more strategic and thoughtful approach to long term resource planning to ensure that people with the right sort of qualifications and attributes are being attracted to the organisation and the right sort of skills developed in those that are already there. Some of their people will be able to make the necessary transition to this new world; others sadly won't. And while this may create a short-term opportunity for some players to attract displaced talent and with them, their loyal clients, over the longer term they are likely to end up saddled with the cost but without the income, unless they too can acquire or build these skills.

With this change in capabilities comes a potential change in organisational design, as brokers will need to transition from wearing all sorts of hats as they typically do today - sales rep, relationship manager, programme designer, placement expert, claims fixer etc. - to them acting as a sort of overall risk adviser that then brings in expertise and tools, drawn from specialised teams, as and when it is required. This in turn implies quite a significant cultural shift for many brokers, who often guard their client relationships jealously and are wary of exposing them to a colleague who might screw things up.

I realise that for many this this sounds like absolute heresy and no doubt some players will seek to make a virtue of their brokers continuing to operate across a broad front. But to me it feels like an almost inevitable consequence of the world's increasing complexity and the impossibility of any one person having the depth or range of technical expertise needed if they are to meet their clients' evolving needs. It can surely be no coincidence that almost every single other professional services industry has evolved in this way?

The real complexity is that this will be an evolutionary change, as the technical and analytical demands of clients in different classes and different parts of the world and even within the same classes and parts of the world, will vary. This implies that the successful brokers will be those who can effectively operate two models in parallel, as they mirror their clients’ own evolution.

This would tend to favour the larger brokers, who have both the resources and the scale to develop a more sophisticated relationship-management based service model alongside their existing one, hire and develop people with the right skills mix and develop the analytics they need based on huge amounts of data. 

Smaller, more niche brokers and MGAs too, should be more able to develop their offering because of their narrower focus and ability to target their investments to their advantage. The people who may struggle are those caught somewhere in between, with all the cost of managing this transition (potentially on a global scale) but without the scale to be economic or the investment capital and data to be effective. Further consolidation of those lacking the resources or culture to embrace this new world is inevitable. 

One thing is for sure. If history has proved one thing it is that brokers are remarkably good at morphing their offering to reflect their clients' changing demands and dreaming up new ways to grow their income, whatever obstacles thrown in their way. 

In this I am somewhat reminded of Louis XIV’s Minister of Finances, Jean-Baptiste Colbert, who once described the art of taxation as being “in so plucking the goose as to obtain the largest amount of feathers with the least possible amount of hissing.” 

On that basis, the broking community might want to consider running for office!

? James Twining 2016

Please read my other posts on whether we need insurers anymore, the enduring mystery that is the insurance broker, moving on from the concept of an annual policy, making sense of the various London Market trade associations and the long term threats to Lloyd's future.