The personal lines broker – not the king of price!

With the recent results announcements from short-term insurers, one cannot but wonder what the role of the personal lines broker will be in the not too distant future. The fact is that almost all the traditional insurers made underwriting losses on their intermediated personal lines insurance. Compare that to significant double digit underwriting margins from the established direct insurers (Outsurance had an underwriting margin of 25% for 2013) and you know that the market is changing.

The best way to understand the large variation in performance is to dissect the income statement into its four drivers. Underwriting performance is a function of the premium charged, less the cost of claims, acquisition and administration. To fully understand the challenges facing the intermediated model, we need to look at each of these aspects separately.

Pricing

To some the solution might be quite simple: increase the premium charged and all your problems go away. Unfortunately it is not that simple.

Ours is a highly competitive industry where customers have significant choice and the rate of churn is increasing as the ability to switch insurers has become very simple. With the direct insurers still making good margins, any aggressive ‘across the board’ pricing strategy risks more clients switching to the direct insurers, leaving the traditional insurers with an even worse performing book.

While more discreet price increases for poorer performing risks is no doubt critical, this may not in itself be enough to stem the tide. Add to this the problem that for most of the traditional insurers a very significant portion of their business is written on third party platforms (group schemes). This means that they do not possess sufficient data to effectively apply selective increases.

Pricing accuracy

How do the direct insurers achieve a better loss ratio despite on average charging a lower price? The answer lies in their accuracy of pricing. Direct insurers are better at risk selection and they do not have to accept the good with the bad in a portfolio of risks. The direct insurers, through their direct relationship with the insured, are able to get significantly more data than the traditional insurers and then utilize that data in their underwriting.

Traditional insurers often do not even have the most basic of data about their clients. Under group schemes, the insurers effectively give the broker access to a ‘black box’ underwriting module that in theory generates a technical price for each risk.

This creates two challenges for insurers. Firstly many of these ‘black box’ underwriting
modules are outdated and do not distinguish sufficiently between a good and a bad risk. Secondly, the control over pricing is effectively outsourced to multiple brokers through their ability to discount pricing.

This inelasticity leads to anti-selection when competing in a market where competitors have a far more elastic pricing curve. The inelastic pricing results in the bad risks being under-priced compared to the elastic curve and the good risks being over-priced, which means that a disproportionate amount of bad risk finds its way to traditional insurers compared to the direct insurers.

Add to this the fact that the broker portfolio also requires the insurer to accept the good with the bad risk and one can start to see how the anti-selection starts to mount against traditional insurers.

Get the picture

Let me use a simple example to illustrate the point. One of the most common underwriting criteria is age. The assumption is the younger you are the less experienced you are as a driver and therefore the more likely you are to have an accident. Assuming Insurer A does not have the ability to determine the age of the driver it would charge the same premium for all drivers. Insurer B, on the other hand, can determine age and adds a loading to young drivers and gives some discount to older drivers. The result would be that all young drivers would migrate to Insurer A and all older drivers would migrate to Insurer B.

While age is used as a risk proxy by all insurers, it is nonetheless an assumption based on historical data and in a world where there is no better proxy than age, it is known to be an effective rating criteria. However, telematics have already started to change this. The more granular your data, the greater advantage one has in terms of price elasticity. The more elastic the pricing, the more likely you are to attract the better risks.

Managing claims better

Broker driven insurers pay claims more easily as they look to protect a portfolio of clients, whereas the direct insurers do not have the same pressure from an intermediary.

Should the traditional insurers take a harsher line and repudiate more claims? The long-term effect of such an approach would not be wise if the insurer is intent on remaining in the intermediated space as brokers would be quick to protect their own reputation with their clients. The knock on effect on the insurer’s commercial business, also makes this a very risky strategy indeed.

One area that certainly does warrant focus is claims cost leakage through ineffective procurement practices. Insurers, for example, still pay too muany of their claims in cash, thereby forgoing the opportunity of leveraging claims spend. By improving on procurement processes, traditional insurers can certainly improve on their loss ratios, however, direct insurers often have more control over the claims process and are therefore more likely to benefit the most from improved procurement practices.

Reducing the cost base

Traditional insurers undoubtedly need to look at their operational efficiencies, but with most of them busy with mainframe decommissioning, this is going to be difficult to do without compromising service. There is also a very restricted benefit this offers, which is not sufficient to bridge the performance gap.

Binder regulations are also forcing down administration fees paid to brokers, however, based on current evidence this is not a material saving to insurers. Moreover, binder fees erode the economies of scale of insurers making the model less cost effective.

Acquisition costs

On average, insurers pay around 15% in commission, which compares to approximately 8% acquisition costs direct insurers pay per policy. Will brokers be prepared to cut their commission in half? That will be unlikely, especially in a world where the nominal value of commission has been coming down and operating costs going up.

The solution

While the above picture might sound like doom and gloom for the broker model in personal lines, this need not be the case. However, what is certain is that the current broker model cannot sustain itself and there will have to be a change.

Brokers will have to adapt their models and facilitate in acquiring data for insurers to allow for more accurate pricing. They will need to come to terms with doing business on insurer platforms to leverage economies of scale, while the intermediated insurers will have to build the capability to support the service demands of their brokers, improve their own operational efficiency and procurement practices.

It is safe to say that there will always be a segment of the insured population that wants the convenience and advice that a broker provides. Given that they appreciate the value provided by a broker, they will need to be comfortable with the fact that they will need to pay for the experience, skill and convenience of having a broker. This will require the brokers to be able to have the tough conversation with their clients around price and selling their value proposition to these clients. For too long now, the value proposition of the broker was all about ‘a better price’, whereas current trends point to a world where the broker will seldom be able to achieve this.

The time has come for brokers to take pride in their profession and the immense value they add. That is not to say that in some cases, especially high net worth portfolios, the broker will not be able to get the best price for their client. However, that should not be the basis of what the broker sells to the client. The role of the broker is far more valuable than the marginal premium saving that can be achieved for a client. Consider the value lost by clients who, on their own, have failed to cover themselves adequately and then suffered a loss.

There is place for multiple distribution models in personal lines, but the success of those models will lie in the underlying value proposition that they provide. Just as the direct insurers will battle to position themselves as being the champions of independent and tailored solutions, the broker channel should not be positioning itself as the king of price (excuse the pun!).

The broker should focus on and believe in their core value proposition and have the conviction to charge the client for this privilege.