The weight of disclosure

Fingers at the ready, your starter for ten: what do you get if you cross a soft market with the rise of the super-brokers, the consolidators? Answer: hefty commission levels. Ask any major insurer and you will find that they are paying considerably more commission at the moment to the likes of Jelf or Towergate than they have been previously, with annual hikes of three or four per cent not uncommon. Conditions are soft, yet it seems that the current power of the consolidators is costing underwriters dearly.

"If you look at Norwich Union's last annual report and what it paid out in commission charges across the whole UK business then you can see that it went up from 22.4% commission to 26% commission," says Tony Cornell of Cornell Consulting. "If you translate that into premium income then that's just over £200m. It so happens that NU made an underwriting loss for that year of £200m (£214m), so the extra commission it is paying contributed to its underwriting loss."

Ill prepared

Cornell believes that insurers, by agreeing to hefty commission hikes in the first place, have only made the situation worse by enabling the market to shrink even further: "You have to look at when these commissions were agreed. NU and others agreed these types of commission for the sake of short-term income and gaining business in a soft market, yet now they can't afford to do it.

"The issue is that they have made the financial position of the consolidators so strong that it becomes an increasing problem because it has, in turn, enabled the consolidators to buy more brokers. This means that a smaller broker, which an insurer was dealing with that gave them a couple of million pounds' worth of business at a certain level of commission, now becomes part of a consolidator, which will then charge for that business at higher levels of commission."

The insurers themselves are not so keen to accept all the blame for the current situation. Mike Lawton, broker sales director at RSA, emphasises that commission levels have been driven not only by the consolidation of brokers but also by the consolidation of books of business: "Commission is only one factor in terms of our profit and loss. We also have to look at rates, costs and the loss ratio." He notes also that factors such as the rise of market networks have played their role.

Besides, no insurer worth its salt is really going to accept levels of commission that are economically disadvantageous, Lawson suggests: "I guess that consolidation and the rise of the super-brokers isn't a bad thing in itself; we want to be part of a partnership. A broker realises that a relationship has to work for three parties: the insurer, the broker and the client. If that all works then we're absolutely fine, however, if that triangle starts to change shape because there is a requirement of the insurer that represents an unacceptable return then we will walk away from that opportunity or relationship. RSA is in a slightly different place; we don't simply bow to the pressure of increased commission levels. If we can't make a return then we will walk away."

For Cornell, underwriters have to bear the responsibility for the current situation: "It's the insurers' fault for letting this situation happen. The consolidators appear to be working on the Tesco and Sainsbury's model, which is to increase the power of the distributor. Having said that, I don't think that there's anything wrong with it, it's just the way they operate. It's a battle that is being won by the consolidators."

Digging in

Whether or not insurers really are losing out to the consolidators in the current skirmish is, perhaps, not the real issue here. As Cornell suggests, although it seems that the consolidators have the upper hand at the moment, they are viewing this as a long-term battle: "Insurers are hoping that the Financial Services Authority will solve the situation for them by controlling commissions or insisting on mandatory disclosure. My feeling is that, behind the scenes, insurers are probably all supportive of mandatory disclosure because it solves all of their problems for them. There is more than one side to all of this. Axa, for example, is buying brokers so that, when they reach the appropriate size, they can then say 'sod-off' to the consolidators. Then, the other insurers might follow."

According to Mark Grice, partner and insurance specialist at Mazars, even the purchase strategy of some insurers as a response to the consolidators is risky: "The amount they give away to consolidators is a lot but, then again, you'd like to think that these people know their business and where their profits are.

"In terms of pricing, it will take some of these insurers that have bought these brokers a long time to make their money back. An insurer buying a broker is securing underwriting profit and is effectively buying the profitability of the broker, yet do the numbers add up? I think that they are paying a premium for underwriting profit and the profitability of the broker. However, if you have a critical mass then you can control pricing more easily, and if you have enough volume then you can design the product to suit the clients' needs."

Besides, according to Lawton, the present commission levels are unlikely to last. He says that market hardening could have an effect as reduced capacity gives more power to the insurer. He adds: "Another thing that could affect this is commission transparency. I think it will take the FSA a couple of years to change the laws. If they do then a lot of brokers will start to get their houses in order as there are a lot of lines of business where it's hard to see how brokers actually add value."

"No, the current levels of commission won't survive the test of time," agrees Cornell. "It isn't sustainable. Insurers will either buy brokers or the FSA will regulate, or insurers will look for alternative distribution channels." There is also a precedent, he says: "It happened with the international brokers. Spitzer came along and spoiled it all for them but change in the UK market could take five or ten years."