It has been almost three years since Eliot Spitzer–then New York's attorney general (now governor)–leveled charges against the insurance brokerage industry, beginning in October 2004 with accusations of fraud and antitrust violations against Marsh & McLennan.

The controversy over questionable business practices–especially the use of contingent commissions–rapidly affected large insurance brokers specifically, and the broader insurance industry generally.

A number of individuals confessed to, and were convicted of illegal acts, such as fraud. Several large brokerage firms made commitments to compensate their policyholder clients for their previous actions.

The business practice that drew the most scrutiny was the use of contingent commissions. However, the controversy raised a broader focus on compensation arrangements within the brokerage industry.

Demands for greater transparency came from many fronts. The demand for compensation transparency affected all areas of the brokerage community–including reinsurance intermediaries.

In the three years since the controversy erupted, the reinsurance brokerage community responded by taking proactive steps to develop transparency standards and rules of ethical conduct.

One impact is the heightened awareness by reinsurance intermediary clients of all issues surrounding compensation.

Increasingly, insurance companies are demanding more than just transparency. Reinsurance broker clients want to know more than just how much compensation the intermediary receives. They also want to know why the compensation is appropriate.

In other words, insurance company clients are demanding a better understanding of the underlying economics of the reinsurance intermediary service, such as:

o What is the total revenue earned by the broker?

o What expenses do they incur?

o How much profit is earned, and is it reasonable?

The issues surrounding the pricing of a service–any service–are subtle and complex. In general, it is incorrect to ask what the “right” price or a “fair” profit should be for a given service.

The correct answer is not theoretical but practical. If two parties agree to enter into a service arrangement for a given price, then that price is the right one for that situation.

However, every seller of a service–such as a reinsurance intermediary–must develop a framework for pricing.

Increasingly, buyers of reinsurance intermediary services want to understand not only the cost but the framework in which this cost was developed.

There are three main approaches to the pricing of reinsurance intermediary services: market, cost-plus and value-added.

o Market Pricing:

This is the most common framework for determining the compensation of reinsurance intermediary services. The phrase “standard brokerage” demonstrates how customary this market pricing has been, and continues to be, in the reinsurance broker industry.

Rules of thumb, accepted by many participants in the transaction, predominate. Standard brokerage on treaty pro-rata placements vary between 1 percent and 2.5 percent of gross premiums. For excess-of-loss placements the standard is 5-to-10 percent of contract premium.

The key advantage of market pricing is that it reflects a broad consensus of the “right” price. The rules of thumb were not developed out of thin air. They are the result of many buyers and sellers of reinsurance intermediary services coming to terms over a long period time.

In a broad sense standard brokerage has been field-tested. It provides a common framework that can be used in a variety of situations.

The key disadvantage is that standard brokerage may bear no direct relation to the cost of the services provided, or the value created. An example is the purchase of corporate catastrophe cover by a large global national insurance company.

A limit of $1 billion purchased in the traditional reinsurance market is not unusual for the largest players in the industry. The contract premium for such a limit is often in excess of $100 million (assuming a rate on line greater than 10 percent). Standard brokerage–even at the low end of 5 percent–can easily exceed $5 million for this single transaction.

The cost of providing the service–the salaries and overhead of the brokers and personnel involved in placing and monitoring the transaction–is generally substantially less than the $5 million in revenue.

Increasingly, broker clients are asking if the “standard brokerage” is appropriate, especially where the revenue far exceeds the cost involved.

o Cost-Plus Pricing:

Another approach is cost-plus pricing. Under this framework compensation is based on the time and expense involved in placing and servicing a reinsurance contract–plus an appropriate amount for profit. This approach, though reasonable, has rarely been used in the market.

The business model of a reinsurance broker is not complex. The intermediary receives revenue and incurs expenses. The principal expenses are salaries and other employee compensation costs. Overhead costs–rent, travel, catastrophe model license fees, marketing and prospecting costs, and so on–also need to be covered.

Cost-plus pricing can be used to directly measure the impact of these expenses. The starting point is the amount of time various personnel–brokers, accountants, claims advisors, legal staff, analytic professionals–spend on placing and servicing an account.

A price is determined that pays the salary of the staff for the time involved and includes a provision for other salary-related benefits and overhead costs as well as a reasonable profit.

The key advantage of cost-plus pricing is the direct evaluation of the actual costs involved in providing a service. In this framework the amount of intermediary compensation is tied to actual effort performed.

Transparency is increased. The buyer of the service has more confidence that the compensation paid is directly related to the service provided. It forces the intermediary to make a reasonable estimate of the costs involved, and to explicitly outline the services that will be provided.

A downside to the cost-plus approach is that it may not reflect all the situations that could arise in a client-broker relationship. In many ways this approach to pricing is used in the business consulting industry.

But a reinsurance intermediary is not just a consultant. A consultant customarily has a narrow scope for any engagement–the timing and the deliverables are generally well-determined.

An intermediary, on the other hand, has a broad scope. They must address issues not only known at the start, but also those that develop over time. A client may demand services that were not originally contemplated–and that will be provided by other brokers in a competitive environment.

In using cost-plus pricing, a reinsurance intermediary will need to recognize this broader scope and make a provision for it in determining compensation.

o Value-Added Pricing:

Another framework for the pricing of reinsurance brokerage services is value-added pricing. This approach bases the compensation to the reinsurance intermediary in the economic value created by the transaction to the insurance company buyer.

The greater the economic benefit to the buyer, the greater the compensation should be to the intermediary that helped create it.

The principal advantage to value-added pricing is it puts the emphasis on what matters most–economic value creation. Standard brokerage, as a rule of thumb, does not address this issue.

A cost-plus pricing approach may be counterproductive in this regard as well; a focus on the details of intermediary expense may be of no concern to the insurance company. What will drive them are measurable, beneficial results.

A major drawback to the value-added approach is that measuring economic value created is problematic at best.

The cost of the transaction (the reinsurance premium) must be compared to the benefit provided (the capital that can be freed to be used for more productive uses).

Measuring the amount of capital that can be released is not always straightforward. Insurance companies often purchase reinsurance coverage without directly calculating capital released and the return on that capital.

Other issues–reducing aggregates, increasing market share, strategic goals–are paramount. The benefit is real, yet not readily expressed in hard numbers.

These three approaches–market, cost-plus and value-added pricing–are used in the costing of services.

Within the reinsurance intermediary industry, one has predominated–market pricing based on standard brokerage.

Increasingly, however, sophisticated broker clients want to know if the standard approach is providing the right service at the right price.

In response, intermediaries need to clearly define the services they will provide for given accounts, and more accurately determine the compensation needed to support the delivery of those services.

Brokers will need to determine service standards and required compensation, and then effectively communicate that to their insurance company clients.

Transparency is a key driver of this change. Other factors play a role as well, such as:

o Increased competition.

o Service demands.

o The changing role of the intermediary.

Increased competition is a result of a declining reinsurance market–a study performed by Gallagher Re indicates that U.S. reinsurance premiums have contracted this decade as primary insurers retain more risk.

Reinsurance intermediary services have, in general, a higher profit margin than primary insurance broking. This can be seen in large international insurance brokers with reinsurance subsidiaries.

In terms of people and revenue, the reinsurance subsidiary is a relatively small part of the parent company. In terms of profit, however, it is not unusual to see the reinsurance subsidiary contribute a majority to the bottom line.

In a competitive environment, customers will want to understand the drivers behind the perceived high-margin compensation.

The demand for services beyond the traditional role of placement–such as catastrophe modeling, rating agency advice, enterprise risk management consulting–has grown.

Sophisticated intermediaries know their role is broader than just broker placement. They see themselves as advisers, assisting clients in developing risk management strategies and finding the appropriate risk-transfer vehicles.

A shift to a more consultative and service-provider role–along with increased competition–will put pressure on intermediaries to reassess their approach to compensation.

The emphasis on compensation transparency has allowed insurance companies to gain a better understanding of the drivers of–as well as encouraged them to explore nontraditional approaches to–broker compensation.

More and more, insurance companies want to understand how much it truly costs to service their account (cost-plus pricing) and how much economic benefit is created by the intermediary (value-added pricing).

In a transparent insurance world, standard brokerage may no longer be enough to justify the pricing of reinsurance intermediary services.

Special Reports /

Reinsurance Intermediaries Not Immune To Demands For More Than Transparency

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