Value-added (noun, adjective)

The giveaways incessantly stuck by marketeers to magazine covers prove it without a shadow of a doubt, as do the endless exhortations about bonuses emblazoned on cereal boxes the world over: everyone loves to get something for nothing. The principle that gratis sells is as fundamental to the rules of marketing as the tenet 'there ain't no free lunch' is to economics. Any capitalist worth his salt is promising to give away something for nothing, and the risk transfer business is no different.

In the world of reinsurance, freebies are called value-added. Once they encompassed only the additional offerings of reinsurance brokers, who were attempting 1) to justify the double-digit commissions they earned on relatively simple programme placements, and 2) to show clients some benefit from their massive round of consolidation, which reduced cedants' choices to the minimum. Now reinsurers offer value-added as well (or at least they bray about it much more these days). This value-added revolution among the leading risk warehouses comes as they step-up their efforts to separate the DFA-providing, product-development-assisting, underwriting-supporting wheat from the capacity-only, plain vanilla, commodity chaff.

Array of tools

In truth, the value-added is well worth having. Today's brokers offer a splendid array of tools to assist with the analysis of exposure aggregations, the potential interaction between invested assets and insurance liabilities, and the ROE impact of various reinsurance programmes on real insurance portfolios. They also offer primary buyers a value-added package which (sometimes) includes risk management consulting, and even advice on alternatives to conventional insurance.

Of course as the economists point out, if any of this is worth having, someone is going to have to pay for it. Difficult as it may be to believe, there is no free lunch, even in reinsurance. Recognising this truism, in the mid 1990s brokers tried - and largely failed - to get their clients to pay fees for their value-added services, in exchange for a reduced or eliminated brokerage. While a handful of sophisticated clients saw the benefits of this option, in most cases the suggestion that insurance and reinsurance buyers pay a transparent fee for service was met with steady reluctance followed by outright refusal. Risk carriers had always paid the brokerage, and clients were happy to see this continue. After all, it makes the bookkeeping quite a bit simpler.

Contingency fees

Because of this, brokers had to find another way of covering the cost of their value added. They invented contingency fees (aka Placement Service Agreements, overriders, etc) to cover part of this cost - although when it came to explaining the whys and wherefores of these fees, the added value they covered was claimed to be extra services provided to risk carriers, such as premium collection (itself now a cost-area for brokers, since terms of trade increasingly prevent them from hanging on to client money for ages to earn investment income, and since interest rates make doing so much less rewarding anyway). Contingency fee deals were never intended, it seems, to cover the cost of value-added services offered to brokers' clients, the buyers.

This plan has recently been shown to be flawed, causing much chagrin in the industry. It is in a way surprising that no one became excited about this issue much earlier, considering the constantly invidious position of brokers, who must, perhaps uncomfortably, act as the fiduciary agents of the buyers, while, at the same time, acting as part of the sole distribution network of the sellers (at least in certain lines and territories). Although all parties involved are vigorously seeking ways to develop methods of remuneration more acceptable in a post-Spitzer world, no one has yet even attempted to tackle this conundrum.

At least the brokers (in most cases) no longer own the insurers (although the international markets - Lloyd's in particular - carried along quite happily in this way for many decades). It is ironic that Marsh, the broker at the centre of the insurance-industry battle of the Spitzer crusade against the financial services industry, is potentially set to dismantle an operational structure which, so far, came closest to solving the problem.

Its retail brokers around the world handled client concerns and were paid by clients through commissions, while its placement operation, which dealt with the risk carriers and provided the value-added which they received, was paid by insurers.

The ultimate outcome of the current furore over brokers' contingency fees looks set to achieve one key result: it will show to insurance and reinsurance buyers that added value is not something that should be expected, Crackerjack-like, in every box. Quite to the contrary, euphemisms aside, if it is worth having, it is worth paying for. In the end, even the mighty insurance sector cannot overturn the fundamental laws of economics.