|
...market, compensation arrangements for intermediaries, and the process by which policies are placed with insurers. Insurance intermediaries are essentially market makers who match the insurance needs of policyholders with insurers who have the capability of meeting those needs. Intermediary compensation comprises premium-based commissions, expressed as a percentage of the premium paid, and contingent commissions based on the profitability, persistency, and/or volume of the business placed with the insurer. Empirical evidence is provided that premium-based and contingent commissions are passed on to policyholders in the premium. However, contingent commissions can enhance competitive bidding by aligning the insurer's and the intermediary's interests. This alignment of interests gives insurers more confidence in the selection of risks and thus helps to break the "winner's curse" and encourages insurers to bid more aggressively. Independent intermediaries also help markets operate more efficiently by reducing the information asymmetries between insurers and buyers that can cause adverse selection.
INTRODUCTION
Insurance is a complex product representing a promise to compensate the insured or a third party according to specified terms and conditions should some well-defined contingent event occur. Simply to describe this obligation requires complex language. However, the buyer's decision is made even more difficult because the value of the insurer's promise depends both on the reputation of the insurer for settling claims fairly and on its financial capability to meet these obligations. Thus, the buyer of insurance faces the daunting task of first deciding what sort of insurance protection is needed given the risks faced, and then comparing policies offering alternative coverage at different prices from several insurers with different levels of credit risk and reputations for claims settlement and policyholder services.
In most insurance transactions, there is an intermediary, usually an insurance agent or broker, between the buyer and the insurer. In commercial property-casualty (PC) insurance markets, the intermediary plays the role of "market maker," helping buyers to identify their coverage and risk management needs and matching buyers with appropriate insurers. The matching process is complex and multidimensional. The role of the intermediary is to scan the market, match buyers with insurers who have the skill, capacity, risk appetite, and financial strength to underwrite the risk, and then help the client select from competing offers. Price is important but is only one of several criteria that buyers consider in choosing the insurer(s) that provide their coverage. Also important are the breadth of coverage, the risk management services provided, the insurer's reputation for claims settlement and financial strength, and other factors. It is common for the coverage not to be placed with the low bidder.
In October of 2004, New York Attorney General Eliot Spitzer filed suit against global broker Marsh & McLennan alleging that the firm engaged in bid-rigging and received kickbacks from insurers for "steering" specific commercial accounts to them. The lawsuit and ensuing actions against other brokers have created controversy about the role of intermediaries in insurance transactions. In particular, it has been alleged that the compensation of agents and brokers through contingent commissions, often related to the underwriting quality or volume of business placed with an insurer, constitutes an anticompetitive practice that is detrimental to buyers (Spitzer, 2004; Hunter, 2004, 2005).
The goal of the present article is to provide information that will be useful in evaluating the role of intermediaries by objectively discussing intermediaries and their compensation structures. The emphasis is on the market for commercial PC insurance. By way of preview, the analysis shows that intermediaries have a valuable role to play in helping insurance markets to function efficiently, thus benefiting both buyers and insurers. Although contingent commissions, like most business practices, can be misused by the unscrupulous, in general such compensation plans play an important role in aligning incentives between buyers and insurers and thus facilitate the efficient operation of insurance markets.
INSURANCE MARKETING CHANNELS
Insurance is distributed through a variety of marketing channels. Although some insurers market insurance directly to buyers, by mail, telemarketing, or company employees, the vast majority of commercial PC insurance sales involves an intermediary. An intermediary is defined as an individual or business firm, with some degree of independence from the insurer, which stands between the buyer and seller of insurance. (1) The degree of independence of insurance intermediaries varies considerably. Probably the lowest level of independence occurs when insurers use exclusive agents, who usually are independent contractors rather than employees but represent only one company. (2) Next on the scale of independence are independent agents and brokers, who regularly deal with several insurers. The focus of this article is on the latter intermediaries, referred to in this article as independent intermediaries.
The distinction between independent agents and brokers is a subtle one. The usual "textbook" distinction is that insurance agents are "agents" (in the legal sense) of the insurer, whereas brokers are traditionally described as agents of the policyholder. However, the textbook distinction is too simplistic to provide an adequate description of the insurance marketplace because independent agents and brokers perform many of the same functions and provide services to both insurers and policyholders (see also III, 2004). In fact, both independent agents and brokers act in varying degrees as advocates for the policyholder, providing services such as coverage design, loss control, and claims management. In addition, although independent agents do represent several insurers under "agency appointment" contracts, many firms, generally known as brokers, also place a significant proportion of their business under essentially identical contracts. (3)
The primary distinctions between independent agents and brokers relate primarily to size and the range and depth of services provided. Independent agents in general tend to be smaller than brokers and provide services to relatively small businesses and consumers in localized markets, whereas brokers tend to service larger and more complicated business insurance needs. The largest regional, national, and international brokers provide a wide range of sophisticated services, including management of captive insurance companies, loss control services, risk modeling, and risk management consulting. Hence, independent intermediaries are arrayed across a continuum in terms of size, sophistication, and the range of services offered. Thus, while the labels "agent" and "broker" have a disarming legal simplicity, the economic reality is more complex. Independent agents and brokers are best thought of as market makers or matchmakers who match particular needs of policyholders with the products of insurers.
Consider the different ends of the continuum of intermediaries. Most independent agents focus on local or regional commercial and personal lines clients. They compete with each other and with exclusive agents, direct writers, and smaller brokers in the local marketplace. Independent agents provide services to clients, advising them on their insurance needs and then searching for appropriate coverage. Independent agents also provide important underwriting information to insurers because they generally have more information than the insurer about the risk characteristics of smaller clients. This informational function is usually recognized in the agent's compensation. Nevertheless, it also benefits the policyholder to the extent that policyholders matched with appropriate insurers are more likely to be satisfied with post-sale services and less likely to incur costs of switching insurers in the near future.
At the other extreme, large commercial insurance buyers employ brokers to design and place insurance on their behalf. The risks for the largest policyholders are complex and often difficult to place. The broker plays a pivotal role in providing information to prospective insurers to help them in evaluating the risk. In cases where risks are too large or complex to be insured by a single company, the broker often plays a "syndication" role, locating insurers who are willing to take on various "layers" of the coverage being placed. This often involves a complex negotiation process that determines the coverage design, pricing, and ultimate placement of the business.
A significant degree of mutual trust is required in the placement of commercial insurance contracts by independent intermediaries. Thus, the policyholder relies on the relationship between the intermediary and insurer when placing risks. An intermediary needs strong working relationships with insurers to place business on advantageous terms. In the remainder of this article, the term "intermediary" or "independent intermediary" is used to refer to both brokers and independent agents, except in instances where we specifically intend to distinguish between these two types of intermediaries.
COMPETITION AMONG INTERMEDIARIES
It has been argued by some that insurance products are inherently complex and that this restrains competition among insurers (Hunter, 2005). Indeed, such complexity does make it difficult for buyers both to understand fully the coverage they need and to evaluate the service and claims-paying capabilities of insurers. The role of the intermediary is to break through the complexity by helping insurance buyers to understand and purchase insurance. We now discuss competition in the insurance market.
Concentration
In 2004, there were approximately 39,000 independent agencies and brokers in the United States, (4) who controlled 68 percent of commercial lines PC business and 32 percent of personal lines business (Table 4). (5) The dominance of independent distributors in commercial lines reflects the fact that coverages, loss control, claims settlement, and other services in these lines tend to be relatively complex. In personal lines, where coverages and services tend to be simpler and more homogeneous, the exclusive agency and direct writing insurers are dominant due to lower distribution costs and other factors.
The allocation of premium volume by distribution system in the principal PC lines is further explored in Figure 1, which shows market penetration by the principal distribution systems for 2004 based on premiums. (6) Insurers primarily using the independent agency system account for at least 50 percent of premium volume in all commercial lines except fire and allied, medical malpractice, and reinsurance. The highest market shares for companies primarily using brokers are in other liability, products liability, and reinsurance. (7) Thus, brokers are relatively important in the more complex and risky lines.
[FIGURE 1 OMITTED]
The share of both commercial and personal lines business handled by independent distributors in the United States has been in a very shallow decline over the past two decades (Swiss Re, 2004). Accompanying this decline has been a consistent reduction in the number of independent intermediaries averaging about 1.3 percent per year since 1992 (IIABA, 2004). Though this may have a little to do with loss of market share, it is more a reflection of consolidation, a trend that has shown little sign of abating.
The brokerage segment of the industry is highly concentrated. Table 1 shows the brokerage revenues of the world's top ten brokers and the breakdown of their revenues by line of business, while Table 2 shows the 100 largest brokers based on brokerage revenues from U.S.-based clients. The world's top two brokers, Marsh and Aon, have 68.6 percent of the revenues represented by the top ten global brokers. Marsh and Aon account for 47.7 percent of revenues among the top 100 brokers in the United States. The top five brokers account for 64.7 percent of U.S. revenues, the top ten for 79.3 percent, and the top 50 for 98.0 percent.
On average, for the world's top ten brokers, commercial lines retail brokerage accounts for 56.1 percent of total revenues, services account for 12.2 percent, wholesale brokerage for 10.0 percent, and reinsurance brokerage for 7.4 percent. Personal lines are generally not a significant source of revenue for the top brokers and are less important than commercial lines for most independent agents. (8) Thus, the bulk of commercial PC lines for the large and international buyer segment of the market is placed by a small number of large brokers for each of whom it is their biggest source of revenue. However, smaller brokers and independent agents retain a significant market share among local and regional business buyers.
Mergers and Acquisitions
Many of the current leaders in the insurance intermediary industry owe their positions to M&A activity rather than organic growth. For example in 1997 Marsh made major acquisitions of Johnson and Higgins and Sedgwick, almost doubling its size. In 1996-1997, Aon more than doubled in size with acquisitions of Bain Hogg, Alexander and Alexander, Minet, and Jauch and Hubner. Other players also have achieved top ten positions through aggressive M&A activity. For example, between 1997 and 2003, Arthur J. Gallagher completed 59 deals in North America; Accordia, 13; Brown and Brown a staggering 82; and Hill, Rogal and Hobbs 28 (Swiss Re, 2004). Outside the top tier of the brokerage segment of the industry, the M&A activity has been less dramatic.
The merger activity falls into several patterns. Many were broker-broker deals whereas others were bank acquisitions. Indeed banks now own 10 percent of the broker market, with the two big players being BB&T and Wells Fargo. Many of the acquisitions have been driven by the quest for economies of scale and scope. For example, BB&T acquired MSW in 2003 primarily to build a "distribution network to compete with the global public brokers." (9) Other acquisitions were driven by the desire to expand into new product lines or regions. For example, by acquiring Tri-City, BISYS diversified from wholesale life insurance broking into the PC market. Given the need to compete with the global brokers, significant M&A activity among regional and niche brokerages is expected to continue. Similarly, M&As among independent agents and acquisitions of agencies by larger intermediaries are expected to continue, driven by the need to compete with larger intermediaries in commercial lines and with exclusive agents in personal lines.
COMPETITIVE STRUCTURE
Barriers to Entry
The vast number of independent agencies testifies to low barriers to entry. However, the ease of entry into the market is inversely related to size. It seems relatively easy through consolidation to create regional brokers by purchasing smaller regional and local intermediaries. However, entry becomes progressively more difficult further up the size continuum, and entry into the top tier of brokers would be rather difficult. The largest brokers are global in scope and have developed a level of sophistication and range of service capabilities that would be difficult to duplicate. The megabrokers also have unparalleled capability to syndicate large, complex risks that would take years to develop for de novo rivals. Although there have been attempts to match the capabilities of the megabrokers through affiliations of medium-size brokers in various countries, the degree to which such firms can compete internationally with the more fully integrated megabrokers is not clear (Conning & Company, 2005).
Niche and Regional Players
Many of the small to medium-sized intermediaries are niche or regional players. Some of these firms specialize in specific lines of insurance or products or in servicing clients from a particular industry. They play an...
NOTE: All illustrations and photos
have been removed from this article.
More articles from Journal of Risk and Insurance
A comparison of neural network, statistical methods, and variable choi..., September 01, 2006
The pricing of insurer demutualization initial public offerings., September 01, 2006
Pareto-optimal insurance policies in the models with a premium based o..., September 01, 2006
Subjective economic risk to beneficiaries in notional defined contribu..., September 01, 2006
Multi-event bonus-malus scales., September 01, 2006
Looking for additional articles?
Search our database of over 3 million articles.
Looking for more in-depth information on this industry?
Search our complete database of Industry & Market reports by text, subject, publication
name or publication date.
About Goliath
Whether you're looking for sales prospects, competitive information, company
analysis or best practices in managing your organization,
Goliath can help you meet your business needs.
Our extensive business information databases empower business
professionals with both the breadth and depth of credible,
authoritative information they need to support their business
goals. Whether it be strategic planning, sales prospecting,
company research or defining management best practices -
Goliath is your leading source for accurate information.
|
