Massive consolidation has taken place among the distributors of commercial insurance over the past ten years. Three global insurance brokers—Marsh McLennan, Aon, and Willis Corroon—now dominate most of the markets where brokers are active.

Insurance companies are taking the hit, for the clout of the global brokers has helped drive down insurance prices—a development that benefits corporate clients but squeezes insurers. Meanwhile, market deregulation in many markets, such as the European Union and Japan, has increased competition among insurers and thus exerted further downward pressure on prices.

Clearly, the balance of power between brokers and insurers is changing. But if they focus too closely on this competitive dynamic, both insurers and brokers may fail to address their fundamental weaknesses and therefore risk losing out to new entrants, such as investment bankers, Internet companies offering financial services, and specialist risk consultants. These competitors are in a position to exploit the inefficiencies of an insurance industry that is not sufficiently focused on the needs of its clients. Up to 35 percent of premiums are spent on transaction costs—equivalent, on a worldwide basis, to as much as $140 billion that is not invested in growth or returned to shareholders. By contrast, the most efficient companies, which deal directly with individual customers by telephone, spend only a third as much of their revenue on administration.

Brokers and insurers could pay a very high price if they fail to collaborate, to refine their organizations by segmenting their clients and improving their management of knowledge, to develop new products and service models, and to use technology to cut transaction costs. Among other things, this risks putting new entrants like investment bankers, Internet companies, and specialist risk consultants in the driver’s seat.

A changing broker market

The traditional role of brokers has been finding insurance for corporate clients, negotiating the price and scope of coverage, and advising clients on the design of their risk programs. Most brokers make money by taking commissions from insurers on the premiums paid by clients.

In the United States, as well as the United Kingdom and some other European countries, brokers dominate the distribution of commercial insurance, for in these relatively deregulated and competitive environments they can influence the choice and terms of insurers. Brokers have also begun to gain market share in such deregulating markets as Italy, Spain, and Latin America. Japan’s deregulation of insurance in the late 1990s legalized brokering and the entry of global brokers into the local market.

But industry forces are changing the role of brokers. Excess underwriting capacity and falling insurance prices have reduced the value they can add to transactions by matching insurers with customers and negotiating terms. Sophisticated corporations question the need for insurance, preferring instead to develop their own internal risk management operations, which has forced traditional brokers to develop new consulting skills to serve them. Technology is another source of pressure: brokers could find themselves bypassed altogether if they do not respond by devising technology-based service models. All of these developments are depressing brokers’ revenue from traditional sources and turning transactional sales organizations, which receive commissions from insurers, into professional risk advisers receiving fees from clients.

Despite the structural pressure on the income of global brokers, they have performed well in recent years as compared with insurers by combining traditional economies of scale with increased buying power to gain a larger share of the value generated by insurance transactions. In the United States, brokers’ shares have outperformed those of the insurance sector as a whole by more than 65 percent.

The consolidation of the global brokers has been driven by the need for new sources of value as insurance prices fall and more companies insure themselves.¹ Meanwhile, the proportion of revenue generated by the top five brokers grew from about two-thirds of the broker market² in 1989 to almost nine-tenths in 1997, with three firms—Marsh McLennan, Aon, and Willis Corroon—accounting for more than eight-tenths. The largest brokers have truly gone global, building their positions by acquiring significant brokers in hitherto largely nonbroker markets (such as Germany and Italy) and by taking over most of the leading firms in existing broker markets, such as the United Kingdom.

As markets deregulate, insurers will face growing price pressure from global brokers and their international networks, which use their buying power to obtain better terms from insurers. While freezing out less favored suppliers, global brokers can extract lower prices or better terms for their clients and improve their own remuneration through higher commissions (a higher percentage, that is, since the prices on which the commissions are based have dropped) or a greater share of the insurer’s reinsurance business. This buying power in turn generates extra revenue that global brokers can use to finance acquisitions and increase market share.

Enlarged scale also extends opportunities for cross-selling. Local retail divisions of a global broker, for instance, will cooperate with its specialist units in London and New York to help sell specialist coverage as well as standard insurance. Scale has also helped global brokers cut their staffs by as much as 7.5 percent over two years—without, in many cases, involving a significant loss of revenue. In addition, the postmerger concentration of experts in many fields has made it possible for global brokers to create such specialist units as Marsh McLennan’s FinPro, which deals with financial and professional risks; Willis Corroon’s Fine Art and Jewelry Division; and Aon’s Natural Resources Division.

Meanwhile, in response to falling revenue from traditional sources and rapid growth in demand, brokers have developed new fee-based services. These include employee benefits consulting, the management of in-house corporate insurers, and risk assessment and control services. (Brokers—sometimes in alliance with accountants and other professional firms—must often compete against insurers for a share of this growing market.) A number of brokers have even begun to enter the underwriting business in lucrative niches where they have specialist knowledge. One of them is Aon, which owns not only stakes in underwriting businesses that control more than 6 percent of the underwriting capacity of Lloyd’s of London but also some underwriting agencies, such as Aon’s Sports, Leisure, and Entertainment Division. Another broker that has invested significantly in underwriting capacity is Marsh McLennan.³

Some observers believe that brokers may eventually turn into full-fledged insurers. For two reasons, this is unlikely. First, returns on capital will probably be higher from selectively underwriting a few specialist types of insurance than from general business, where insurers have struggled in the past few years. Second, the value of the advice given by brokers is rooted in their independence, which the complete integration of brokering and underwriting would destroy.

Brokers are also becoming involved in the emerging risk securitization market. As an alternative to traditional reinsurance, brokers, like investment bankers, raise pools of capital to guarantee the liabilities of clients or, as fund managers, invest in the bonds that such pools of capital secure.

In many industries, new distribution technology makes it possible to bypass transactional intermediaries (see boxed insert, "Airline industry parallels"). Since insurers and noninsurance companies can be expected to start using the Internet to reach some businesses directly, brokers will have to create their own electronic links, as Willis Corroon’s Adviser and Aon’s AonLine are already doing for some companies.⁴ Other electronic brokering initiatives include INSTRAT (an electronic bulletin board, set up by the broker Sedgwick, for Lloyd’s reinsurance) and CargoInsure (a World Wide Web site set up by the broker Benfield Greig).⁵ In parallel, brokers are trying to build advisory services such as risk assessment and risk control to generate extra revenue and reinforce customer relationships.

Finally, global brokers have started to replace the traditional "one-size-fits-all" service model by segmenting their client bases and aligning their organizations around the new segments. Strategic account managers deal with Aon’s biggest accounts, for example, while Aon Enterprise specifically serves small commercial clients. In the United Kingdom, Willis Corroon has created Willis Risk Solutions for multinational and complex accounts, Willis Corroon Corporate for middle-market and less complex larger accounts, and Willis Corroon Commercial for small accounts. Segmentation has promoted the shift of the brokers to a client-focused rather than transactional approach and a parallel move from commissions to fees.⁶

A changing insurer market

Insurers are responding to the emergence of global brokers by consolidating faster, becoming more focused on clients, pursuing forward integration by acquiring brokers, and, in some cases, undertaking more direct marketing.

The pace of consolidation—already taking place in reaction to overcapacity and slow growth—has accelerated as insurers seek to take a stand against the increased power of brokers, for larger companies have more leverage to negotiate terms of coverage and remuneration. The process has been widespread in the United Kingdom, where mergers among insurers have followed the rapid consolidation of brokers; deals have taken place between Royal and Sun Alliance, Commercial Union and General Accident, Zurich UK and Eagle Star, and Norwich Union and London & Edinburgh.

At the same time, insurers, like global brokers, are aligning their organizations more closely with customers by creating specialist divisions to tailor offers and support to different customer segments. Most large insurers now have separate divisions to deal with global clients, and many also have divisions dedicated to small businesses.

In addition, there is a trend among insurers to forward-integrate by taking stakes in distributors. In the past year, a group of US and UK insurers has bought a piece of Willis Corroon; a consortium of US financial institutions, including insurers, has invested in the broker USI; and XL Capital proposed an investment (eventually not made) in the US wholesale broker Tri-City. None of these moves threatened the brokers’ independence; their chief aim was to maintain or develop access to diverse distribution channels.

Insurers are also building a direct-sales capability, creating specialist divisions, for example, to provide risk solutions for complicated multinational accounts. A few insurers are also reducing their processing costs and their commissions to brokers by selling directly to small commercial customers.

Strategies for insurers

To survive at all, midsize generalist insurers will be forced to specialize or consolidate

To counter the increased power of global brokers, insurers must become either very large (to gain leverage) or very specialized (to be "category killers" in their chosen niche). Large companies will have to develop product-specific underwriting and claims skills in target areas to generate value from scale. To survive at all, midsize generalist insurers will be forced to specialize in a few areas or to consolidate.

For a scale-based strategy to succeed, insurers need critical mass in all their key markets. Consolidation, which has already begun through in-market mergers, is now occurring across national borders. Such mergers have been particularly numerous in Europe as the single market moves closer to reality—for example, the deals between Allianz (Germany) and AGF (France), Generali (Italy) and AMB (Germany), and AXA Group (France) and Guardian Royal Exchange (United Kingdom). This cross-border consolidation should help the participants build truly multinational operations serving their global clients, develop global brands that will help them acquire and retain customers, generate economies and skills in specialist areas, and limit the global brokers’ ability to negotiate competitive terms. If these opportunities are not exploited, the scale players will be left with unwieldy structures that will destroy shareholder value.

In the face of the "commoditization" of standard insurance, insurers lacking global scale must develop a distinctive proposition for general business—which is likely to be difficult—or specialize by building expertise in specific sectors or new products. In the United Kingdom, specialist insurers handle hospitals and musical instruments. One company targets Chinese restaurants, translating the usually incomprehensible language of policies into plain English and Chinese for their benefit. Such specialists must achieve depth and breadth in their areas of focus by acquiring similar interests and shedding dissimilar ones. They may swap assets—an effective way for two midsize operators to create specialized portfolios without running up acquisition and disposal costs.

For insurers that have neither scale nor a distinctive specialization, the future looks uncertain. The most likely outcome for them is to be swallowed by larger insurers as the returns to their shareholders decline. Only by attempting to bypass the global brokers can these players create value in a brokered market. The most attractive markets for such insurers are small and midsize businesses, where high transaction costs provide a price umbrella for entry by insurers who bypass brokers. Direct marketing to customers is also potentially attractive for large insurers in the major corporate segment, where a number of insurers already go direct. Their ability to do so is increasing as the largest insurers build up expensive and sophisticated product and advisory capabilities.

Insurers can reduce their dependence on brokers by creating their own electronic links with clients—for example, obtaining electronic access to client claim and administration data. They could also underwrite business without using brokers by selling standard packages of policies to small businesses through the Internet, say, as some companies are starting to do in the personal insurance area.

Like brokers, insurers should also be expanding into fee-based risk management services, either to reinforce customer loyalty or to replace lost margins in traditional businesses. Brokers, however, will be better placed in this respect because clients see them as independent, disinterested advisers. Finally, in response to multiple pressures, insurers can withdraw from all or part of the market, as CIGNA did recently when it sold its general insurance business to concentrate on health insurance.

Insurers and brokers must be friends

Efficiency and client service have taken a back seat in the insurance business. Often, customers are sold indecipherable policies far more complex than they need. A small manufacturing company with $3 million to $5 million in revenue might have 15 policies with ten insurers, greatly increasing the chance of error. Claims take forever to be paid, and the basis for partial or complete denials is too rarely spelled out. Some clients don’t receive policies until making claims—only to discover that losses aren’t covered.

Insurers and brokers must work together to cut costs and improve service. Standardizing products, automating underwriting and processing, and eliminating duplication of activities between brokers and insurers could not only cut the transaction costs of large businesses by up to 40 percent but also improve service. For small-business customers, reductions of as much as two-thirds are possible. The recent consolidation of three electronic-commerce networks by a group of global insurers and brokers suggests that the industry may at last be getting serious about improving its operations.

The threat of new entrants

Insurers and brokers that fail to follow the strategies described above are greatly increasing the possibility that five years from now their businesses will have destroyed value, leaving outsiders to make the real money in insurance.

Internet companies may well turn many kinds of insurance into commodities

Capital market operators have already entered the high-margin reinsurance field by underwriting bonds that can raise more capital and provide more flexible coverage than traditional insurance markets do. Internet companies may commoditize many types of insurance by vastly improving access to information about pricing and terms of coverage and by capturing the brokers’ and insurers’ margin and passing some of it on to customers. Traditional insurers would then be left as pure capital providers for this business; brokers would be relegated to the more appealing but still limited role of supplying risk services and relationship-based advice to these clients (as opposed to placing actual insurance deals). Although this outcome is not inevitable, insurers and brokers must act now if they are to prevent it.

As risk control becomes more sophisticated, large corporate clients are more and more likely to question the value of traditional insurance and to prefer risk transfer techniques that combine traditionally insurable and uninsurable risks in a single bundled product at a lower price. At the same time, the transaction costs of capital market solutions (such as the securitization of risk) will fall rapidly as liquidity rises, making many of them more attractive than traditional insurance to both insurers seeking reinsurance and corporate clients seeking primary coverage. A small minority of large insurers and brokers will succeed in making the transition. But investment banks and specialist consultants will capture much of the value because they combine large talent pools, expertise, and access to investors.

In the midsize- and small-business segments, electronic commerce will permit clients to shop for the best prices and services through intermediaries that are neither brokers nor insurance companies, much as some customers rely on nontraditional banks and nonfinancial companies for on-line personal financial services. Specialist risk management consultants and service providers will gain share in insurance-related service markets, so many traditional insurers will be forced to become mere providers of capital for the new intermediaries, while traditional brokers may be reduced to servicing a core of clients whose main requirement is a personal relationship with their brokers.

The key issue for brokers and insurers is whether they can reposition themselves quickly enough to counter the erosion in demand for their services and to fend off attacks from new competition. Before they can do so, however, the industry must shed its traditional aversion to radical change.