The era since Eliot Spitzer's bid-rigging allegations has transformed the insurance brokerage market. Steven Ader assesses the impact on its three biggest players.

Over the past three years, the business of insurance brokerage has undergone a sea change. Before 14 October 2004, Marsh & McLennan (MMC) was undisputed market leader, with a well-consolidated position astride the industry. Although Aon's global presence and diversification closely rivalled MMC's, its market share, measured by consolidated revenues, rendered it a distant second. Willis, the number three global broker worldwide, had similar global reach in certain segments, but 7% market share and lack of diversification in non-insurance businesses rendered it a lesser player.

How the mighty have fallen! Since the fateful October day, when then New York attorney general Eliot Spitzer levied his allegations of bid-rigging against MMC - and significant but less damaging charges against Aon and Willis - the industry hasn't been the same. The initial credit damage emerged within days. By 21 October, all three brokers had endured a substantial hit. The counterparty credit rating for Marsh (MMC), at the time "A+", fell three notches to "BBB+", and a month later dropped another notch to "BBB". Aon's rating dropped one notch, from "A-2" to "BBB+2", and outlooks for both became negative. Willis' outlook initially went on creditwatch, then dropped to negative the following April, although its rating remained "BBB-".

By August 2005, the initial damage was contained. All three agreed to pay total settlements of more than $1bn to their customers over three years to close out most of the regulatory and legal allegations against them. They also suspended using contingent commissions as a source of revenue. No small concession this; the commissions are a no-cost income stream for brokers, and for the trio comprised a material slice of pre-tax income. For Aon and Willis, the 2003 share was 20.4% and 13% respectively. Marsh's contingent commissions comprised a whopping 52.6%.

Marsh's heavy reliance on contingent commissions of $845m that same year, against $169m and $70m at Aon and Willis respectively, explains how Aon, despite modest risk and insurance revenue growth ($5.6bn segment revenue in 2006 versus $5.5bn in 2004) has overtaken Marsh ($5.5bn in 2006 versus $6.2bn in 2004). All three essentially gave up the contingent commission income approximating what they earned in 2003, plus the potential to earn such income in future. But fallout from the losses to date has been far greater than was apparent at the time, both for the companies and the overall industry.

What has changed

The allegations and the resulting fallout altered - perhaps permanently - the contours of the industry. Few, if any brokers, still collect volume-based contingent commissions; the market has turned against the practice. However, many continue to collect contingent commissions based on agency profit levels. These comprise a significant portion of their income, and bifurcated the market in ways that puts these global brokers at a competitive disadvantage, requiring them to retool their business models. A major disadvantage, thus far, is that growth by acquisition has come almost completely off the table. The ban on contingent commissions makes buying smaller brokers more problematic for these global players. The principal difficulty is in pricing the enterprise. Sellers can't receive full value from a global broker as they wouldn't pay for a contingent commission stream that would be immediately lost upon closing.

Consequently, global brokers are missing opportunities to acquire some sizable broker properties. These are, instead, pursued by large investment bankers eager to avail themselves of significant cash flow streams at more favourable prices. In January, Goldman Sachs' private equity affiliate GS Capital Partners acquired broker USI Holdings Corp, and in March private equity firm Apax Partners, an arm of Morgan Stanley, announced plans to buy insurance broker HUB International. Both firms derive a portion of income from contingent commissions.

Global brokers have had to change their business models to ones relying almost exclusively on organic growth and expense initiatives, rather than acquisitions. Each has cut costs through carefully allocating resources to small and midsize clients and in some cases, by dropping smaller, unprofitable clients that previously contributed to volume and improved the contingent commission stream. They now place more emphasis on cross-selling and packaging value-added services from their worldwide infrastructures for their clients, thereby justifying charging more than their smaller, contingent commission collecting brethren. The changes improved the financial picture for the trio. Aon's "BBB+" rating now carries a stable outlook, versus a negative outlook in August 2005. Last December, Willis's rating was raised to "BBB" from "BBB-", with a stable outlook. Even Marsh, the most adversely impacted, has a "BBB" with a negative outlook, unchanged from March 2005.

Challenges still ahead

Despite these positives, the overall picture for global brokers isn't all rosy. They have successfully addressed the expense part of the profitability equation, but strong organic growth generation remains a challenge, especially for Marsh and Aon. For these two, losing contingent commissions created pricing disadvantages that caused them to cede market share to smaller competitors. In addition, Marsh, hit hardest by Spitzer's allegations, took the most material reputational hit, and is still recovering. Slower than expected improvements in organic growth are the primary driver in Marsh's negative outlook, despite significant improvements in financial flexibility from refinancing and reduction of debt, to enhance income to a level sufficient to balance its debt load.

Similarly, December's revision in Aon's outlook to stable from positive was driven by lower organic growth and resultant pace of improved profitability than previously incorporated in the outlook. Although Marsh's risk and insurance unit is still losing market share as measured by zero organic growth in a growing market (commercial lines premiums rose 2.3% for the nine months ended 30 September 2006) the decline stabilised in the fourth quarter as evidenced by 5% organic growth. While recognising Marsh's status as a top tier global broker, one shouldn't overlook its other business segments such as Mercer Human Resource Consulting, Mercer Specialty Consulting, Putnam Investments, Guy Carpenter, and Kroll. In 2006, these contributed $918m of operating income, against $677m from the risk and insurance unit. However, in late 2006 MMC opted to sell Putnam, which generated $303m of operating income last year, for $3.9bn. Although the disposal modestly detracts from MMC's earnings profile on a quantitative and qualitative basis, the effects should be offset through prospective debt pay downs and strategic investments funded from the proceeds.

S&P expects MMC's overall operating performance to continue improving in 2007 and 2008, but the permanent loss of contingent commissions will most likely delay the recovery of the Marsh unit's pretax income to historical levels. Meanwhile, management has the task of not only mitigating the competitive and financial damage inflicted on these segments but, more importantly, successfully implementing internal initiatives to safeguard against future adverse developments.

Willis was less impacted by the loss of contingent commissions and didn't have the bid-rigging allegations to cope with. It needed fewer tweaks to its business model and has recovered quicker. S&P expects Willis' market share to benefit in 2007, considering that return on revenue exceeded peer group averages in 2006, with revenue growth at 7% and organic growth a robust 8%. Commitment to improvement is evident in its five-year "Shaping our future" strategic programme, initiated in 2006. Goals include the continued creation of peer-leading organic growth and further containment of operating costs.

Aon, hit less than Marsh but more than Willis, has also recovered from the Spitzer allegations. But it continues to face the challenge of how best to deploy its deep worldwide resources, attract new business and generate industry-leading growth and profitability. Although its risk and insurance segment showed 4.9% growth for 2006, results were hampered by the unit's low 2% organic growth. Whether Aon can continue to improve its operating performance to a level commensurate with its strong competitive position will depend on its organic growth initiatives. Aon is somewhat diversified outside its risk and insurance segment; $120m and $138m in pretax segment income came from continuing operations in its consulting and insurance underwriting segments respectively in 2006, against $842m from risk and insurance.

Organic growth is key

Looking forward, we expect global brokers to continue focusing on improved organic growth, having addressed the cost side of the equation. However, the pricing cycle downturn for both the property and casualty industries is hampering progress.

And legal challenges to the global brokerage industry are nowhere near over. Lawsuits from regulators over contingent commissions and the use of finite reinsurance are still outstanding, and new suits have been emerging. Insureds, particularly in the UK, are more likely to hold their brokers liable when unsuccessful in settling differences with their insurers. Aon and Benfield face a £325m lawsuit from Lloyd's, alleging that risk to their reinsurers was not presented fairly, and they should be held liable for the failure of the reinsurers to pay claims. This suit follows a March 2006 preliminary UK court judgment that found Aon liable for BP's shortfall between its total losses and what it recovered in its settlements with underwriters, plus interest and costs. These disputes aren't unusual. Still, the tendency of insurers to involve brokers more aggressively in insurance recovery disputes adds uncertainty as well as challenges to the sector's recovery.

Steven Ader is director of Standard & Poor's insurance ratings.