The Economics of Insurance Intermediaries

This article analyzes the economic functions of independent insurance intermediaries (brokers and independent agents), focusing on the commercial property–casualty insurance market. The article investigates the functions performed by intermediaries, the competitiveness of the market, the compensation arrangements for intermediaries, and the process by which policies are placed with insurers. Insurance intermediaries are essentially market makers who match the insurance needs of policyholders with insurers who have the capability of meeting those needs. Intermediary compensation comprises premium-based commissions, expressed as a percentage of the premium paid, and contingent commissions based on the profitability, persistency, and/or volume of the business placed with the insurer. Empirical evidence is provided that premium-based and contingent commissions are passed on to policyholders in the premium. However, contingent commissions can enhance competitive bidding by aligning the insurer’s and the intermediary’s interests. This alignment of interests gives insurers more confidence in the selection of risks and thus helps to break the “winner’s curse” and encourages insurers to bid more aggressively. Independent intermediaries also help markets operate more efficiently by reducing the information asymmetries between insurers and buyers that can cause adverse selection. INTRODUCTION Insurance is a complex product representing a promise to compensate the insured or a third party according to specified terms and conditions should some well-defined contingent event occur. Simply to describe this obligation requires complex language. However, the buyer’s decision is made even more difficult because the value of the insurer’s promise depends both on the reputation of the insurer for settling claims fairly and on its financial capability to meet these obligations. Thus, the buyer of insurance faces the daunting task of first deciding what sort of insurance protection is J. David Cummins and Neil A. Doherty are at the Wharton School, University of Pennsylvania, Suite 3000 Steinberg Hall-Dietrich Hall, 3620 Locust Walk, Philadelphia, PA 19104-6302, USA. The authors can be contacted via e-mail: [email protected] and [email protected]. The authors are grateful to Richard MacMinn for insightful comments on an earlier version of this article. The authors acknowledge the financial support of the American Insurance Association for this research. 359 360 THE JOURNAL OF RISK AND INSURANCE needed given the risks faced, and then comparing policies offering alternative coverage at different prices from several insurers with different levels of credit risk and reputations for claims settlement and policyholder services. In most insurance transactions, there is an intermediary, usually an insurance agent or broker, between the buyer and the insurer. In commercial property–casualty (PC) insurance markets, the intermediary plays the role of “market maker,” helping buyers to identify their coverage and risk management needs and matching buyers with appropriate insurers. The matching process is complex and multidimensional. The role of the intermediary is to scan the market, match buyers with insurers who have the skill, capacity, risk appetite, and financial strength to underwrite the risk, and then help the client select from competing offers. Price is important but is only one of several criteria that buyers consider in choosing the insurer(s) that provide their coverage. Also important are the breadth of coverage, the risk management services provided, the insurer’s reputation for claims settlement and financial strength, and other factors. It is common for the coverage not to be placed with the low bidder. In October of 2004, New York Attorney General Eliot Spitzer filed suit against global broker Marsh & McLennan alleging that the firm engaged in bid-rigging and received kickbacks from insurers for “steering” specific commercial accounts to them. The lawsuit and ensuing actions against other brokers have created controversy about the role of intermediaries in insurance transactions. In particular, it has been alleged that the compensation of agents and brokers through contingent commissions, often related to the underwriting quality or volume of business placed with an insurer, constitutes an anticompetitive practice that is detrimental to buyers (Spitzer, 2004; Hunter, 2004, 2005). The goal of the present article is to provide information that will be useful in evaluating the role of intermediaries by objectively discussing intermediaries and their compensation structures. The emphasis is on the market for commercial PC insurance. By way of preview, the analysis shows that intermediaries have a valuable role to play in helping insurance markets to function efficiently, thus benefiting both buyers and insurers. Although contingent commissions, like most business practices, can be misused by the unscrupulous, in general such compensation plans play an important role in aligning incentives between buyers and insurers and thus facilitate the efficient operation of insurance markets. INSURANCE MARKETING CHANNELS Insurance is distributed through a variety of marketing channels. Although some insurers market insurance directly to buyers, by mail, telemarketing, or company employees, the vast majority of commercial PC insurance sales involves an intermediary. An intermediary is defined as an individual or business firm, with some degree of independence from the insurer, which stands between the buyer and seller of insurance.1 The degree of independence of insurance intermediaries varies considerably. Probably the lowest level of independence occurs when insurers use exclusive agents, 1 The focus of this report is primarily on independent agents and retail brokers, i.e., brokers who deal directly with personal and/or commercial insurance buyers. There are also wholesale brokers, who serve as intermediaries between retail insurance brokers and specialized markets ECONOMICS OF INSURANCE INTERMEDIARIES 361 who usually are independent contractors rather than employees but represent only one company.2 Next on the scale of independence are independent agents and brokers, who regularly deal with several insurers. The focus of this article is on the latter intermediaries, referred to in this article as independent intermediaries. The distinction between independent agents and brokers is a subtle one. The usual “textbook” distinction is that insurance agents are “agents” (in the legal sense) of the insurer, whereas brokers are traditionally described as agents of the policyholder. However, the textbook distinction is too simplistic to provide an adequate description of the insurance marketplace because independent agents and brokers perform many of the same functions and provide services to both insurers and policyholders (see also III, 2004). In fact, both independent agents and brokers act in varying degrees as advocates for the policyholder, providing services such as coverage design, loss control, and claims management. In addition, although independent agents do represent several insurers under “agency appointment” contracts, many firms, generally known as brokers, also place a significant proportion of their business under essentially identical contracts.3 The primary distinctions between independent agents and brokers relate primarily to size and the range and depth of services provided. Independent agents in general tend to be smaller than brokers and provide services to relatively small businesses and consumers in localized markets, whereas brokers tend to service larger and more complicated business insurance needs. The largest regional, national, and international brokers provide a wide range of sophisticated services, including management of captive insurance companies, loss control services, risk modeling, and risk management consulting. Hence, independent intermediaries are arrayed across a continuum in terms of size, sophistication, and the range of services offered. Thus, while the labels “agent” and “broker” have a disarming legal simplicity, the economic reality is more complex. Independent agents and brokers are best thought of as market makers or matchmakers who match particular needs of policyholders with the products of insurers. Consider the different ends of the continuum of intermediaries. Most independent agents focus on local or regional commercial and personal lines clients. They compete with each other and with exclusive agents, direct writers, and smaller brokers in the local marketplace. Independent agents provide services to clients, advising them on their insurance needs and then searching for appropriate coverage. Independent agents also provide important underwriting information to insurers because they generally have more information than the insurer about the risk characteristics of smaller clients. This informational function is usually recognized in the agent’s compensation. Nevertheless, it also benefits the policyholder to the extent that policyholders matched such as the surplus lines market and the London market. Reinsurance brokers play an important intermediation role between primary (retail) insurers and reinsurers. 2 The degree of “exclusivity” of exclusive agents varies somewhat. Some exclusive agents are literally exclusive, selling all of their business through a single company. However, others are primarily “exclusive” with one company but place some policies, such as specialty policies, with other insurers. 3 Insurance intermediaries are examples of “two-sided firms.” See for example, Rochet and Tirole (2003). 362 THE JOURNAL OF RISK AND INSURANCE with appropriate insurers are more likely to be satisfied with post-sale services and less likely to incur costs of switching insurers in the near future. At the other extreme, large commercial insurance buyers employ brokers to design and place insurance on their behalf. The risks for the largest policyholders are complex and often difficult to place. The broker plays a pivotal role in providing information to prospective insurers to help them in evaluating the risk. In cases where risks are too large or complex to be insured by a single company, the broker often plays a “syndication” role, locating insurers who are willing to take on various “layers” of the coverage being placed. This often involves a complex negotiation process that determines the coverage design, pricing, and ultimate placement of the business. A significant degree of mutual trust is required in the placement of commercial insurance contracts by independent intermediaries. Thus, the policyholder relies on the relationship between the intermediary and insurer when placing risks. An intermediary needs strong working relationships with insurers to place business on advantageous terms. In the remainder of this article, the term “intermediary” or “independent intermediary” is used to refer to both brokers and independent agents, except in instances where we specifically intend to distinguish between these two types of intermediaries. COMPETITION AMONG INTERMEDIARIES It has been argued by some that insurance products are inherently complex and that this restrains competition among insurers (Hunter, 2005). Indeed, such complexity does make it difficult for buyers both to understand fully the coverage they need and to evaluate the service and claims-paying capabilities of insurers. The role of the intermediary is to break through the complexity by helping insurance buyers to understand and purchase insurance. We now discuss competition in the insurance market. Concentration In 2004, there were approximately 39,000 independent agencies and brokers in the United States,4 who controlled 68 percent of commercial lines PC business and 32 percent of personal lines business (Table 4).5 The dominance of independent distributors in commercial lines reflects the fact that coverages, loss control, claims settlement, and other services in these lines tend to be relatively complex. In personal lines, where coverages and services tend to be simpler and more homogeneous, the exclusive agency and direct writing insurers are dominant due to lower distribution costs and other factors. The allocation of premium volume by distribution system in the principal PC lines is further explored in Figure 1, which shows market penetration by the principal 4 IIABA (2004). In 2000 there were about 42,000 agencies and in 1992 there were 46,000. For an earlier survey, see IIABA (2002). 5 Table 4 is based on A. M. Best Company (2005). The agents’ trade association estimates that independent agents and brokers hold 79.8% of the commercial lines market and 36.6% of the personal lines market. See IIABA (2004). ECONOMICS OF INSURANCE INTERMEDIARIES 363 FIGURE 1 Market Share by Primary Distribution System: 2004 Fi de lit y & S ur et y Fi re & A llie d 0 10 20 30 40 50 60 70 80 CM P CA L CA PD MM AL