Stephen Tacey looks at the future of the reinsurance broking sector in the wake of Spitzer

The future of the reinsurance broking sector worldwide seems increasingly uncertain. The shock waves set up when New York State Attorney General Eliot went after Marsh over issues of bid-rigging and contingent commissions have fanned out across the broking sector. Contingent commissions as such were less of an issue in the reinsurance market than in retail and wholesale sectors, but their sudden demise leaves a sizeable gap in the revenue streams of the world's leading re/insurance brokers.

Marsh and Aon have both settled with Spitzer for $850m and $190m respectively in recent months. Promises of future good behaviour and customer transparency charters followed. Marsh chief Jeffrey Greenberg stepped down. Aon's Pat Ryan remained to apologise and earnestly aver, "we are moving to an even higher level of transparency" and will "ensure that every client transaction is free of even the appearance of conflict of interest."

Opinions differ as to whether Spitzer has permanently and fundamentally changed the reinsurance broking sector. Spitzer and his attorney general counterparts in other states continue to cast their nets ever wider - looking into finite reinsurance for example - promising "many will be implicated by the time we are finished".

One specific effect of heightened sensitivity to perceived conflicts seems to have been that the balance of opinion has tipped against the viability of brokers sponsoring or taking major shareholdings in reinsurance start ups as previously Marsh has done with Ace (1985), XL Capital (1986), Mid Ocean (1992) and Axis (2002), Aon with LaSalle Re (1993) and Endurance (2001), and Benfield with Montpelier Re (2001).

In reality, there is little to suggest that any of the brokers involved derived illicit advantage from their involvement and in most cases this was short-term. But even the suggestion of possible impropriety now seems to be unpalatable. Though Benfield's involvement, in the George Soros-backed Glacier Re, last December might seem contradictory, the likelihood is that major broker holdings in reinsurers will not continue.

LINGERING DOUBTS

There could also now be doubts over the viability of the multi-level model pursued with such vigour by Marsh and Aon throughout their rampant acquisition trails through the 90s. Such doubts gained credence when in February Aon and Willis almost simultaneously announced plans to sell their respective wholesale arms Swett & Crawford and Stewart Smith Group - the latter finding a buyer in American Wholesale Insurance Group.

Though Marsh's new chief executive Michael Cherkasky denied any plans to dispose of its wholesaler Crump, claiming full customer disclosure obviated any suggestion of conflict, speculation was inevitably sparked that the big three might also consider divesting themselves of their reinsurance operations.

"It is an interesting area," comments Toby Esser, chief executive of rapidly growing reinsurance broker Cooper Gay. "On the one hand you can see potential issues arising over joint ownership of leading retail and reinsurance brokers in the current climate.

"But equally it is hard to see Guy Carpenter, for example, being worth the same floated off separately as it is as part of Marsh. In which case it becomes a moot point as to who would want to buy it or back an IPO."

Marsh, and to some extent Aon, appear keen to emphasise some degree of separation between their reinsurance and retail operations. Joe Plumeri's Willis, however, espouses a more integrated "one flag, one team" model.

In reality, attempts at separate branding will carry limited conviction so long as the operations concerned remain within a single corporate structure.

STRUCTURAL CHANGE

Of course the fact that the major brokers' reinsurance operations have historically been significantly more profitable than wholesale arms would suggest their being be less readily cast off. Significant structural changes in the market could well materialise over the coming year, however, as contracting revenue streams from reinsurance broking bring valuations down and encourage thoughts of non-organic growth.

The planned retirement of long-time chief executive Pat Ryan has already prompted speculation that Aon could become a takeover target and Marsh's share price crash in the wake of its Spitzer settlement prompted questions over its future independence. Around the time of last year's Monte Carlo Rendez-Vous rumours of a Willis bid for Aon backed by KKR were circulating, then in October Benfield rejected a bid from Willis that would have valued it at $1.3bn.

Most commentators agree that some further consolidation is almost inevitable in the light of shareholder pressure to meet targets and achieve growth in a shrinking market.

"I think we have already seen the big wave of broker consolidation," says Alastair Speare-Cole, Aon Ltd's head of direct reinsurance business and reinsurance services. "But there could be one more big merger to come, and perhaps some further consolidation slightly further down the field - particularly among Lloyd's brokers. There could also be another big insurance broker merger that could see a reinsurance broker disappear."

Uncertainties persist, but what is clear is that the market has moved into a potentially very fluid and unpredictable phase. Market observers appear primed to expect the unexpected.

PROJECTED DOWNTURN

One of the major drivers of uncertainty is the projected medium to long-term downturn in brokers' financial performance signalled early this year with a series of disappointing fourth quarter results announcements and warnings of challenging market conditions to come.

With most of their revenues deriving from business originating in the US, UK-based brokers like Benfield and JLT have been particularly hard hit by a weak dollar. Following a bumper 2003 in which all 10 leading reinsurance brokers achieved double-digit growth in revenues - and all but four of them more than 20% - the current trend has not impressed financial analysts, leading some to question why anyone would contemplate investing in reinsurance brokers in this phase of the market.

Speare-Cole maintains that "margins on reinsurance broking are still relatively attractive compared with other parts of the insurance industry." But he agrees "reinsurance brokers are going to have to work harder in future to achieve the kind of margins that will make them attractive to investors.

"Part of that is about improving efficiency," he says, "but - from the larger reinsurance broker's perspective in particular - it is also about coordinating our delivery of skills, knowledge, contacts, and technical expertise to meet the increasingly demanding requirements of reinsurance buyers."

Chris Clark, chief executive officer of Willis Re speciality, agrees.

"We are very focused on avoiding the silo mentality you sometimes see in larger broking houses. We can add the greatest value by providing a single client advocate through whom we can live up to the promise of delivering global resources locally."

Improving efficiency will necessarily be a major theme for brokers in the current market climate. Since broking is an archetypal "people business" where salaries typically account for between 50% and 60% per cent of revenues, cost savings normally mean people savings.

Rebounding from the impact of its Spitzer settlement, Marsh has committed itself to a programme of cost cutting that targets annual savings of $375m and is expected to result in the loss of around 2,500 out of 60,000 employees (how many of these might be within Guy Carpenter is unclear).

Analysts have suggested that Aon needs to shed around 1,600 employees worldwide, but widespread job cuts are currently being resisted and cost-efficiencies sought elsewhere. In particular, Aon has invested heavily in its IT infrastructure. There are signs now that electronic trading based around an approach that focuses on connectivity through ACORD XML messages - rather than shared systems - may finally be taking off, opening the way to more efficient working practices across the sector.

EFFICIENCY DRIVES

Efficiency is now a particularly urgent issue in London where payments formerly received from underwriters may have previously offset the cost of inefficient practices.

While the largest players focus on consolidation and cost-efficiency, elsewhere the picture is more varied. Willis, having emerged relatively unscathed from Spitzer's attentions, is looking to take on employees to address opportunities it perceives in the large corporate insurance sector from customer disaffection with its larger rivals.

JLT has announced its intention of restructuring its risk solutions operation, where executive chairman Ken Carter, who took over from former chief executive officer Steve McGill who departed following last November's profits warning, believes the company is underweight in the reinsurance area.

Meanwhile rising players like UK-based Cooper Gay, and Arthur J Gallagher and John B Collins in the US continue to show strong organic growth, attracting new employees and teams, and establishing new offices.

SMALL IS BEAUTIFUL

Cooper Gay's Toby Esser argues that the tide is turning in favour of leaner, hungrier brokers beyond the established top tier. "It is a lot easier for a broker our size to maintain momentum," he says.

"We should always be able to move into a new segment, win a few new accounts, open new offices. What would be a small win for one of the top three is significant for us. As an independent privately-owned company, we attract people with a different mindset - more ambitious, entrepreneurial and aggressive.

"If you are working for one of the majors and you decide you want to participate directly in the profitability of the income you generate, the barriers to setting up on your own from scratch are pretty high these days. In reality there are not that many places you can go, so it is relatively easy for us to pick up highly motivated talented teams and individuals and provide an environment in which they can flourish."

In December last year no less an insurance luminary than Hank Greenburg - at the time still AIG chief executive officer - appeared to lend support to this view, whilst adding a Spitzer-specific spin, suggesting that leading brokers would lose market share to smaller, newer competitors who might be "leaner and more responsive to the fiduciary relationship they have with their clients."

Aon's Speare-Cole however believes that notwithstanding residual legacy and infrastructural issues inherited from their past histories of non-organic growth, larger brokers hold the strategic advantage.

"Outside particular specialist niches," he comments, "I think it is very difficult for smaller brokers to compete with the scale of expertise, and resources we can bring to bear. I don't accept that entrepreneurialism is in any way the preserve of smaller brokers.

ROLE IS BROADENING

"I think it is something all good brokers share - and that spirit of innovation and entrepreneurialism often comes across now through cross-pollination of different approaches, different analytical skills, experience in different sectors - which is where bigger brokers can shine."

The broker's role is increasingly moving towards a much broader capital management consultancy - assessing risk across a client's entire portfolio and evaluating the impact of a variety of reinsurance and other capital management solutions.

"It is about much more than the pure transactional aspect today," says Speare-Cole. "Brokers who cannot offer sophisticated modelling capabilities will increasingly be at an disadvantage."

Willis' Chris Clark also highlights the increasingly technical nature of the reinsurance broker's role. "The whole process has become far more sophisticated over the last 10 years. It is now much more of a science than an art.

"There is a huge amount of analytical work that goes on before the risk reaches the market, both on the part of the broker and the client's ceded reinsurance department - which, again, is something that barely existed ten years ago. Back then I don't believe Willis employed a single person in analytics. Today we have a team of more than 40 just here in London."

The fact remains that fees for services continue to represent only a small percentage of reinsurance brokers' revenues and doubts persist as to brokers' willingness and/or ability to charge separately and realistically for ancillary services that have traditionally been thrown in. The distinctly cool reception accorded to brokers' attempts in London to agree alternative forms of remuneration to make up for abandoned payments from carriers do not bode well in this context. Brokers are under pressure, with more expected of them and less on offer in return.

Brokers report that security was the major concern in the market through the January renewals. This was reflected in protracted and difficult negotiations with carriers over clauses seeking collateralisation in the event of reinsurer downgrades. Security concerns also came vigorously to the fore last summer, when the revelation of Converium's $400m reserve shortfall, subsequent downgrade and share price slump raised wider fears over reinsurers' potential exposure to long-tail US liabilities.

Increased retentions partially reflect systemic misgivings about the value of unsecuritised reinsurance capacity. All of this leaves the longer-term future of the reinsurance sector far from clear. Brokers have little choice but to anticipate, assimilate, and direct the process of change best they can - wherever it may ultimately lead.

Above all, they must identify effective ways of profiting from role(s) that are simultaneously acceptable to clients, capital/capacity providers, regulators and shareholders.

- Stephen Tacey is a consultant and freelance journalist specialising in insurance-related issues.