Independent Brokers: Tightening the Belt?

With insurers operating in Canada having increased total direct premium volume by 17% year-on-year to just under $30 billion for 2002 – despite a dramatic reduction in market underwriting capacity during the same period – the obvious assumption is that percentage-based broker commission earnings rose proportionally. Indeed, commissions paid by insurers last year rose by 9.5% to around $2.9 billion compared with the $2.7 billion in commission payments made for 2001 – the annual growth rate far outstripping the performance of the Canadian economy as well as the cost of inflation over the same period.

Yet, brokers say their net earnings have declined, largely as a result of increased overhead expenses brought on by the hard market. While market conditions are showing moderate signs of improvement in terms of coverage availability and a tapering off of price increases, particularly within the beleaguered personal lines arena, brokers fear that the relief may be too late, and too little, to avoid a rush of consolidation next year as independent brokerages tighten their belts to ride out the “costs of the past”. Brokers also point out that, while the market is expected to be less restrictive next year, the return of capacity will be cautious as insurers grapple with their own cost pressures and the political mire of auto product reform introduced by the various provinces in the second half of this year.

Although some insurers used the limited capacity of the hard market to cut broker commission structures, this has yet to develop into a “mainstream trend” brokers say. However, they are cognizant of the “commission cost” built into premiums and a new sense of regulatory attention on insurers’ expenses. Notably, the former Progressive Conservative (PC) government of Ontario put forward legislative cost-reduction initiatives as part of its auto product reform package under Bill-198 which called for insurers to cut their own expenses by $100 million – without any indication to how companies would do so. The fear on the broker front was that this would spark a reduction in commissions on what is not only their bulk of business (auto insurance accounts for about 65% of total premiums in Ontario), but the area where they have incurred the highest cost overhead due to increased customer relations volume.

“The $100 million expense cutback [in Ontario] is probably gone with the previous government,” comments Bob Carter, executive director of the Insurance Brokers Association of Ontario (IBAO). However, he notes, “we just don’t know”. The new Liberal government in its election campaigning called for a 10% reduction in auto premium rates within a 90 day period, Carter observes, which means that the industry will have to look at how it can achieve the necessary cost efficiencies. “We’re as an industry going to have to meet with them [the government] soon to see how we can reduce costs to achieve this [rate reduction] if the government remains committed to it.” He notes that, internally, all company expenses have come under scrutiny, “and no doubt commissions have been looked at”.

While some of the smaller mutual insurers operating in Ontario have cut commission rates, Carter says none of the major companies have moved in that direction. However, the IBAO initiated a commission and cost study among its members earlier this year (the study is in final preparation) to highlight the overhead expenses incurred by brokers. “Our study shows that we [brokers] are losing money on auto business which we have to make up elsewhere.” Much of this expense relates to increased staffing and training of customer service representatives (CSRs) to handle the rising tide of consumer questions and complaints. “We’re [brokers] not making any money on the higher [auto] rates,” he emphasizes.

COMPANY ACTIONS

“Insurers are being squeezed to keep [premium] prices down,” observes Bill Star, president of Kingsway General Insurance Co. In addition to the general pressure that continues to be applied by head-offices on local branch operations to reduce expenses, the “overhead factor” is becoming more high-profile on the regulatory front, he adds.

In this respect, Star points to the $100 million expense cutback proposal of the former PC Ontario government. “I think insurers will have to look at commissions” in reducing their overhead expenses as they move forward, he notes. Plus, insurance regulators do look at expense ratios in rate filing applications, he adds, “which with the current political spotlight on auto [coverage] pricing, this is even more so [the case].”

Kingsway has applied commission rate reductions based on product and region, Star says. The logic he follows is that, with premium rates having risen sharply over the past two years as companies have tried to regain underwriting profitability, the overhead carried by brokers has not risen to the same extent. “With rates having gone up, the question is whether broker [operating] costs have gone up as much as companies’ [operating costs].” He also rebuts the broker argument that the “customer overload” of queries handled as a result of the hard market have driven expenses up to the point that they claim. “Yes, brokers are facing a higher workload today because of consumer queries, but this is also an opportunity for them to increase their business. Who wouldn’t want to have customers phoning them?”

However, Star acknowledges that commission rate structures on general business in Canada are not out of line with broker remuneration trends in the U.S. Where Kingsway has looked at renegotiation of commissions, it is in classes of business where rates have risen steeply due to claim losses. “Specifically, trucking comes to mind, where rates in Canada and the U.S. have risen by more than a 100% over the past three years. Under such circumstances, it’s hard to justify the same commission rate.”

Star expects that market capacity will remain tight in 2004, largely due to the global industry’s shortage of capital. This, combined with uncertainty regarding political interference with auto and the provincial product reforms, will make international companies hesitant to put more money into their Canadian operations. “Companies will be reluctant to put more money into Canada [next year].” As such, independent brokers will remain hard-pressed to find new markets as coverage availability creeps forward slowly, he predicts. “We’re [Kinsgway] still seeing about three times as many broker applications coming into the office than a year ago.”

Whether or not a business percentage-based form of broker remuneration such as the current commission system is the most appropriate method for insurers to operate by is debatable, muses Claude Dussault, president of ING. While broker remuneration based on commission earnings may rise sharply as rates increase, there is an automatic add-on to the overhead running cost of brokerages, he notes. Furthermore, brokers would argue that insurers do not increase commission rates when pricing drops, he adds.

And, with broker base commission rate structures having remained almost static for a number of years, Dussault believes that the more appropriate approach to reducing distribution costs is to look at improving efficiency between broker and insurer. “I think you need to sort this [broker-to-company interaction] out before you can look at issues such as commissions.”

ING has not cut base broker commissions, Dussault says, in fact the insurer has grown its broker distribution base over the past year. A major component of ING’s distribution strategy is “profit incentives”, he explains, which provides the broker added value in the placement of business. “I think a combination of ‘fixed’ and ‘variable’ earnings components are important to insurer distribution strategies.”

However, Dussault does see cost pressures on brokers increasing in the months ahead as a result of the political uncertainty surrounding auto insurance in many provinces. “Auto insurance reforms are taking place, but now we have uncertainty on the political front. This will add cost pr
essures on brokers.” The proposed 20% rate reduction in Nova Scotia and a 12 month rate freeze is a typical example of such uncertainty in the market in terms of companies holding back in extending their commitments to a particular region, he adds. As such, he expects that the next three years will see consolidation at both the company and broker levels.

The year ahead will be a “paced recovery” regarding increased coverage availability, says Rowan Saunders, president of Royal & SunAlliance Canada Group. He also expects that the industry will see renewed consolidation among brokers and companies. “The next few years will likely be similar to the consolidation of the 1990s. Insurers coming out of the hard market will have to refocus their operations.”

Saunders, however, is more optimistic of market conditions returning to a normal state during 2004. “This will depend on insurers’ ‘comfort level’, but I think we could see a mild recovery in early 2004.” But, he cautions, there remain several wild cards in provincial product reform initiatives which could disrupt the market. The biggest concern of insurers is where the Ontario auto market is headed under the new government. “Rate freezes and rollbacks won’t work [in Ontario]. And, Nova Scotia is [currently] really the ‘hotbed’ with its planned 20% rate rollback. [Product reform] in New Brunswick is already seeing depopulation of the FA [Facility Association].”

Royal & SunAlliance has also not cut base broker commissions, but has adopted a more formal approach to “broker management programs”, Saunders says. This involves careful study of how closely aligned brokerage operations are in terms of their books of business as well as strategies relative to the insurer’s own objectives. Royal & SunAlliance has also enhanced its broker profit sharing program, which Saunders expects will become a growing area of remuneration as companies shift business strategies toward specific segments of the marketplace. In the current operating environment, insurers are unlikely to take on new brokers, he notes, with companies more likely to concentrate on developing existing relations. “I don’t think companies are going to be handing out new broker contracts, they’d rather expand capacity for existing brokers [on their books].”

POLITICAL HOTSPOTS

While capacity shortage and consumer ire over price increases is widespread across the provinces, the two main trouble spots causing insurer reluctance to commit additional underwriting resources are Ontario and Atlantic Canada – with New Brunswick and Nova Scotia producing the greatest amount of political uncertainty in that region, brokers say. Ultimately, it comes down to product reform and regulations, observes Doug Grahlman, incoming president of the IBAO.

The new Ontario government’s stance on auto insurance is something of an unknown factor, Grahlman notes. However, the government does appear to be committed to its rate reduction promise, and brokers and insurers need to communicate the reality of the market conditions to the new authorities, as well as consumers, to avoid an extreme conflict situation. “Rate reductions of 10% [as promised by the new government] don’t happen overnight.” Although there remains a great deal of uncertainty over the political direction of auto insurance regulation in Ontario, the product reforms initiated by the former PC government have seen stronger insurer interest in the marketplace, comments Carter. “Some companies are now starting to come back [with capacity] after 18 months.” That said, Carter does not see a dramatic change in market circumstances for next year – pricing is likely to remain tight although improved cover availability will remove some of the pressure on brokers.

Carter points out that much of the media attention focused on auto pricing has blown the issue out of proportion. “The cost of parking your car in downtown Toronto costs more than insuring it. We have to keep it [the cost situation] in perspective.” In his perspective, the biggest challenge for brokers in the year ahead is restoring credibility of the insurance industry in the eyes of the public.

New Brunswick, which formed the “eye of the storm” in the ongoing regional political debate over government-run auto insurance versus private insurance, is beginning to show positive signs in market coverage availability following the product reforms (mostly involving capping of minor bodily injury claims) brought in by the provincial government earlier this year, says Bob Kimball, a former executive of the Insurance Brokers Association of New Brunswick (IBANB) and current vice president of the Insurance Brokers Association of Canada (IBAC), as well as chair of the FA’s operating committee for N.B. “There is cautious optimism that the current system in New Brunswick can work. But, there is also concern that someone else could throw a wrench into the works.”

To illustrate the improved conditions in market availability, Kimball notes that the population growth rate of the FA within the province has declined markedly over recent months. From January to end April this year, the FA had been growing monthly in numbers by about 100%, he notes, which by the month of May the acceleration rate had fallen to 50%, followed by only a 26% increase for June. “I expect that the growth in FA numbers will have fallen to a negative growth situation by the end of the year. Companies are aware that there’s business there [in the FA] that shouldn’t be there.”

However, Kimball acknowledges that there is ongoing market uncertainty regarding the future regulative environment of the province. Although a joint Atlantic Canada regional task force recently produced a report advising the governments against implementing state-run auto insurance systems, the political pressures remain.

Notably, the New Brunswick government has established its own investigative committee under NDP provincial leader Elizabeth Weir which is expected to provide its findings to the government during the course of November. But, Kimball observes, “it’s just a study. Anything she [Weir] comes back with won’t mean that the government will go that way.” Furthermore, he says that insurer/broker relations have improved since the provincial government’s auto product reforms were brought into place in June this year. In this respect, there has been no discussion on reduced commissions or other earnings incentives, he adds. “If anything, companies realize that they need the credibility of brokers [supporting them].”

An insurer CEO panel discussion hosted at the recently held joint conventions of the New Brunswick and Nova Scotia broker associations proved to be “quite an eye-opener for many brokers”, comments Peter Fredericks, president of the Insurance Brokers Association of Nova Scotia (IBANS). The stark reality of the meeting was the fact that the major insurers operating in N.S. were willing to pull out of the province if the government’s plan to implement a 20% auto rate reduction, and freeze prices at this level until the end of 2004, is brought into effect. “We’re one step closer to government-run insurance if the companies pull out.”

Other N.S. government restrictions include a ban on underwriting rating such as age and gender, Fredericks notes. The (minority ruling) government seems to want to “railroad through” the legislative underwriting restrictions in conjunction with its “pain and suffering award” cap on minor injury bodily claims, he adds. However, both brokers and insurers through the Insurance Bureau of Canada (IBC) are attempting to achieve a moderate compromise on the proposed legislation which is supposed to take effect from November this year.

Brokers have proposed that the government only apply the 20% rate reduction to the mandatory portion of auto insurance and to remove the existing rate freeze (which has been in effect for most of this year) as from the beginning of next year. Rate approvals should then be subject to the new rate review board proposed by the government, Fredericks says. “The real stumbling block for companies is the rate freeze for next year a
s rates are already inadequate. Our [broker] concern is customers, because the renewals for next year, and there are literally thousands of them, we won’t be able to place because the markets won’t be there,” he adds.

From a broker perspective, Fredericks says that a move to government-run auto insurance in the province presents two obvious problems: loss of the “ownership of the book of business” by brokers to a state monopoly, and the fact that government-run insurers pay lower rates of commission. And, should the government stick to its guns on underwriting restrictions but not appoint a government insurer, then brokers face the risk of losing additional markets due to the unfavorable underwriting conditions, he adds. With many brokers operating with only two markets, the loss of one insurer could be the end of the family business. Such a move could spark mass unconditional consolidation through mergers and acquisitions. “Which means that members of family-run [brokerages] businesses won’t get the value of a life-long investment.”