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November 2, 2004

Wanted. A New Type of Insurance Broker

by William Pitt

"Your problem," Henry Marsh once said to a client, "is not insurance, it is risk." Almost a century after Marsh and Donald McLennan founded Marsh & McLennan in 1905, the brokers' problem is not risk, it is insurance.

A visitor from Mars would doubtless expect an "insurance broker" to focus on insurance. But ever since Henry Marsh, brokers have been seeking to modify that perception and position themselves as risk management advisors first and insurance intermediaries second. They have largely failed to do this because they are powerfully incentivised to focus on insurance, rather than risk. The case for a new type of insurance broker depends on understanding quite how widely these incentives have prised apart the interests of brokers and their clients.

The incentives are both positive, herding brokers towards risk solutions that involve insurance, and negative, deterring them from developing solutions that do not involve insurance.

The positive incentive is brokerage - all brokerage, not just contingent commissions. It remains a far more important and more lucrative revenue stream for brokers than fees (and such fees as are charged are commonly pegged to prevailing insurance rates rather than priced for value). Brokerage, including contingent commissions, drove Marsh's operating margin above 25% in 2003. By comparison, the operating margin at Mercer, Marsh & McLennan's family of consulting businesses, was 13.4%.

But the negative incentive that drives brokers away from non-insurance risk solutions is even more powerful. At large corporate clients, brokers deal mainly with risk managers. Risk managers focus on insurance for two reasons. The first is that the management of insurable risk - sometimes called hazard risk - is their job: they are not paid to manage risks that cannot, at least theoretically, be insured. And the second is that if they buy unbiased risk management advice from a broker, they will have to pay the broker an unbundled fee - and defend and explain that fee to their bosses. If they simply buy insurance, the broker gets paid by underwriters and the risk manager has no explaining to do.

This mix of broker incentives has several negative repercussions for the brokers' clients:

1. Brokers are encouraged to promote the purchase of insurance when insurance is not the answer. For example, the incentives encourage activities like benchmarking, where brokers target companies with less insurance than their peers and try to convince them that they are "underinsured". Having as much insurance as your competitors may be reassuring, but it does not always make good business sense.

2. They exalt negotiating skills over risk analysis skills. Insurance contract wordings often tend to be short on detail: London market slips, which bind cover ahead of policy issuance, are a case in point. They frequently present grey areas in the event of claims. Brokers negotiate these terms and conditions up front with underwriters and then renegotiate them following a major claim.

By contrast, incentives for rigorous risk analysis are lacking because the broker, as an intermediary, shoulders no risk for its own account and because the risk manager is reluctant to pay for such analysis.

3. They exalt knowledge of the insurance industry over knowledge of the client's industry. The brokers' current business model requires detailed insurance industry knowledge but just enough client industry knowledge to talk to risk managers without sounding foolish. Compare the client industry knowledge that a strategy consultant must possess with the knowledge required of an insurance broker. The latter is, relatively speaking, a veneer.

4. They discourage broader corporate understanding of the potential uses and value of insurance. Insurance buying remains a silo-based corporate activity, largely confined to the risk manager's domain. The scope and potential of insurance are generally not well understood by other executives and, often, even by other finance department executives. Brokers sometimes complain that insurance is treated as an afterthought by clients when major strategic issues, such as mergers and acquisitions, are on the table. The lack of dialogue between insurance brokers and senior corporate executives is the reason.

None of the above springs from an instinctive Machiavellian or myopic outlook on the part of brokers. Nor of course do brokers reflexively recommend insurance as the solution to every client exposure: they will often propose captives and other risk retention arrangements as a means to lower their clients' total cost of risk. But the above tendencies are widely observable and are natural consequences of brokers' compensation arrangements, which encourage certain behaviours over others.

If clients' interests are suffering from the current broker business model, insurers' interests are not necessarily faring much better. Commercial lines insurers have abdicated control of their brands in large measure to the brokers and the rating agencies, and witnessed a commoditization of their product as a result. It must be frustrating to an insurer to be told by a broker that contingent commissions are paying for, among other things, intellectual capital to develop new insurance products, when the insurer feels perfectly equipped to do that for itself. Brokers undoubtedly help insurers reduce their fixed distribution costs, but the opportunity costs are high.

How might a new type of insurance broker address all of these problems and align its interests durably with those of its clients? Some characteristics of the broker's current business model would need to change, but not all. The firm would have the following characteristics:

Remuneration would be fee-based and value-priced. The broker would have no incentive to recommend insurance unless it was in the client's best interest.
The broker would continue to offer deep knowledge of the insurance markets. But the transactional component of the broker's role would be subordinate to the risk consulting component.
The broker's primary client relationship would be with the finance director, not the risk manager.
The broker's expertise would be client industry specific and would extend beyond insurable risks.

The realism of this may be questioned. Finance directors have a lot on their plate already. Brokers' action on delivering disinterested risk management advice has fallen short of their rhetoric for so long that they cannot simply profess expertise across the spectrum of risk, insurable and uninsurable, and expect clients to flock to their banner. They will have to hire the right people and establish credibility if they are at last to fulfill the role that Henry Marsh envisaged. But if not now, when?

Printer Version (PDF)

William Pitt is a senior advisor to HawkPartners.


Perspectives: Overview Books Articles Newsletters Presentations Whitepapers November 2, 2004 Wanted. A New Type of Insurance Broker by William Pitt "Your problem," Henry Marsh once said to a client, "is not insurance, it is risk." Almost a century after Marsh and Donald McLennan founded Marsh & McLennan in 1905, the brokers' problem is not risk, it is insurance. A visitor from Mars would doubtless expect an "insurance broker" to focus on insurance. But ever since Henry Marsh, brokers have been seeking to modify that perception and position themselves as risk management advisors first and insurance intermediaries second. They have largely failed to do this because they are powerfully incentivised to focus on insurance, rather than risk. The case for a new type of insurance broker depends on understanding quite how widely these incentives have prised apart the interests of brokers and their clients. The incentives are both positive, herding brokers towards risk solutions that involve insurance, and negative, deterring them from developing solutions that do not involve insurance. The positive incentive is brokerage - all brokerage, not just contingent commissions. It remains a far more important and more lucrative revenue stream for brokers than fees (and such fees as are charged are commonly pegged to prevailing insurance rates rather than priced for value). Brokerage, including contingent commissions, drove Marsh's operating margin above 25% in 2003. By comparison, the operating margin at Mercer, Marsh & McLennan's family of consulting businesses, was 13.4%. But the negative incentive that drives brokers away from non-insurance risk solutions is even more powerful. At large corporate clients, brokers deal mainly with risk managers. Risk managers focus on insurance for two reasons. The first is that the management of insurable risk - sometimes called hazard risk - is their job: they are not paid to manage risks that cannot, at least theoretically, be insured. And the second is that if they buy unbiased risk management advice from a broker, they will have to pay the broker an unbundled fee - and defend and explain that fee to their bosses. If they simply buy insurance, the broker gets paid by underwriters and the risk manager has no explaining to do. This mix of broker incentives has several negative repercussions for the brokers' clients: 1. Brokers are encouraged to promote the purchase of insurance when insurance is not the answer. For example, the incentives encourage activities like benchmarking, where brokers target companies with less insurance than their peers and try to convince them that they are "underinsured". Having as much insurance as your competitors may be reassuring, but it does not always make good business sense. 2. They exalt negotiating skills over risk analysis skills. Insurance contract wordings often tend to be short on detail: London market slips, which bind cover ahead of policy issuance, are a case in point. They frequently present grey areas in the event of claims. Brokers negotiate these terms and conditions up front with underwriters and then renegotiate them following a major claim. By contrast, incentives for rigorous risk analysis are lacking because the broker, as an intermediary, shoulders no risk for its own account and because the risk manager is reluctant to pay for such analysis. 3. They exalt knowledge of the insurance industry over knowledge of the client's industry. The brokers' current business model requires detailed insurance industry knowledge but just enough client industry knowledge to talk to risk managers without sounding foolish. Compare the client industry knowledge that a strategy consultant must possess with the knowledge required of an insurance broker. The latter is, relatively speaking, a veneer. 4. They discourage broader corporate understanding of the potential uses and value of insurance. Insurance buying remains a silo-based corporate activity, largely confined to the risk manager's domain. The scope and potential of insurance are generally not well understood by other executives and, often, even by other finance department executives. Brokers sometimes complain that insurance is treated as an afterthought by clients when major strategic issues, such as mergers and acquisitions, are on the table. The lack of dialogue between insurance brokers and senior corporate executives is the reason. None of the above springs from an instinctive Machiavellian or myopic outlook on the part of brokers. Nor of course do brokers reflexively recommend insurance as the solution to every client exposure: they will often propose captives and other risk retention arrangements as a means to lower their clients' total cost of risk. But the above tendencies are widely observable and are natural consequences of brokers' compensation arrangements, which encourage certain behaviours over others. If clients' interests are suffering from the current broker business model, insurers' interests are not necessarily faring much better. Commercial lines insurers have abdicated control of their brands in large measure to the brokers and the rating agencies, and witnessed a commoditization of their product as a result. It must be frustrating to an insurer to be told by a broker that contingent commissions are paying for, among other things, intellectual capital to develop new insurance products, when the insurer feels perfectly equipped to do that for itself. Brokers undoubtedly help insurers reduce their fixed distribution costs, but the opportunity costs are high. How might a new type of insurance broker address all of these problems and align its interests durably with those of its clients? Some characteristics of the broker's current business model would need to change, but not all. The firm would have the following characteristics: Remuneration would be fee-based and value-priced. The broker would have no incentive to recommend insurance unless it was in the client's best interest. The broker would continue to offer deep knowledge of the insurance markets. But the transactional component of the broker's role would be subordinate to the risk consulting component. The broker's primary client relationship would be with the finance director, not the risk manager. The broker's expertise would be client industry specific and would extend beyond insurable risks. The realism of this may be questioned. Finance directors have a lot on their plate already. Brokers' action on delivering disinterested risk management advice has fallen short of their rhetoric for so long that they cannot simply profess expertise across the spectrum of risk, insurable and uninsurable, and expect clients to flock to their banner. They will have to hire the right people and establish credibility if they are at last to fulfill the role that Henry Marsh envisaged. But if not now, when? Printer Version (PDF) William Pitt is a senior advisor to HawkPartners. Copyright © 2004 Insurance Day Sign up to receive email updates of future Perspectives. home \| marketing services \| litigation services \| about us \| perspectives \| careers \| contact us \| Privacy policy ©2006 Hawk Partners. All rights reserved