End for the London Wholesale Market?

Six long-term gravitational forces are likely to combine to tip the independent London wholesale insurance market into a different orbit. 

In December, NASA’s spacecraft OSIRIS-Rex landed on the surface of Bennu 101955, a large asteroid. Scientists believe that it could one day strike the Earth, should gravitational interaction between the two bodies, during a close approach in 2060, cause it to change its trajectory. The energy released by the impact would be 80 times more powerful than Hiroshima. Is there a parallel, perhaps, to the independent London wholesale market (i.e. excluding business placed into London by the in-house placement teams of the large international brokers), hurtling inexorably to its doom, due to the pull of gravitational forces beyond its control? To answer that question, we perhaps first need to start with some definitions. Historically, the London wholesale insurance market has played a valuable role in matching brokers from (mostly) overseas looking to place large, complex or unusual risks into the London market capacity, in particular Lloyd’s. North America has long been by far the largest source of business into the London wholesale market. Reflecting the size of this market, brokers operating within North American typically access the London market either directly via a London market wholesaler, or indirectly via a U.S. wholesaler intermediary, who will themselves place the risk with a London market wholesaler. The process is, perhaps unsurprisingly for something that involves the words “London” and “insurance,” woefully inefficient, not to mention expensive. Imagine a U.S. corporate, approaching a local broker, who then goes to a U.S. wholesaler, who involves a London wholesaler, who then places the risk into a Lloyd’s syndicate (potentially via an MGA?), with each stage of the chain putting its snout in the fee trough. The process brings to mind the ancient symbol of the Ouroboros – a dragon, eating its own tail. Yet, the London wholesale market has been, and continues to be, very successful. The U.S. surplus lines market, for example, has been growing at 9% per annum, well above the growth rates seen in the normal insurance market in the developed economies. Within that, the Lloyd’s share has grown even more strongly, at around 12%. London is still the largest writer of excess and surplus lines and still the largest delegated authority business in the world. There are several reasons for this strong growth, but prime among them may be the London market’s proven ability to spot trends and emerging opportunities, innovate solutions and then mobilize quickly to write them first. When the market is at its best is when wholesalers are working in close partnership with their producing brokers to develop creative ways of managing not just existing risks but also new and emerging risks, attracting premium to the market that would otherwise have gone elsewhere or perhaps not have been spent at all. This is worth paying for, although that shouldn't disguise the fact that a lot of the sector's income is renewal business that requires little incremental effort. Wholesaling is typically a high-margin business, partly because it remains stubbornly commission-based but also because it benefits from high operational leverage, with a relatively small number of relationships with a relatively small number of placing brokers potentially giving access to a large flow of referred business. The market has also proved very stable, with business flows and retention rates not moving for years, underpinned by strong relationships that are difficult to dislodge once established. And the market - particularly at the larger end - has proved remarkably adept at boosting commission income affected by the soft market conditions, through the use of facilities, captive MGAs, facultative reinsurance and other non-placement services such as advisory or data services. So adept, in fact, that the FCA has launched a market study, concerned that the level of competition and innovation, the barriers to new entrants and the risk of conflicts may leave something to be desired . See also: Top Emerging Risks for Insurers   On the face of it, therefore, the overall health of the London wholesale insurance market would seem quite robust. As Mark Twain might have said, “rumors of its demise have been much exaggerated.” And yet I would argue that six long-term gravitational forces are likely to combine to tip the independent London wholesale insurance market into a different orbit. An orbit that while perhaps not threatening Bennu 101955's fiery end, will inevitably result in the market being much smaller and much changed from today. 1. Broker consolidation strangling supply The critical North American market continues to be consolidated aggressively by the large international brokers (in particular Marsh, Aon and Willis). This inevitably leads to risks that were previously wholesaled being placed directly into the London (and other – see below) markets by these large brokers’ in-house placement teams. With no end in sight to the North American consolidation trend, the amount of premium available to the "indepdendent" London wholesale market will inevitably come under increasing pressure. 2. U.S. wholesalers increasing their buying power  The U.S. wholesale market has essentially consolidated over the past few years into three main entities: AmWINS, Ryan Turner and CRC, each of them controlling around $6 billion to $7 billion of premiums. This has given them vastly improved buying power and the ability to demand better commercial terms. This has been facilitated (some might say accelerated) by moving to preferred supplier lists, to improve their operational efficiency by dealing with fewer counterparties. While ostensibly good news for those who come out on the right side of any supplier selection exercise, from an overall market perspective this inevitably raises the risk of premiums being funneled into the hands of a smaller number of independent London market wholesalers on worse terms than before, shrinking the available profit pool and leaving the “losers” high and dry. 3. U.S. wholesalers vertically integrating  Faced with long-term weak economic growth and soft market conditions, other parts of the insurance market have increasingly sought to vertically integrate to capture margin and drive efficiency. Examples abound but would include Berkshire Hathaway establishing a primary carrier, brokers setting up captive MGAs and insurers and re-insurers (e.g. Axa and Munich Re) investing heavily in insurtech in the hope of developing their direct channels and (presumably?!) circumnavigating brokers in some lines. How long, therefore, until U.S. wholesalers establish or buy a London market wholesaler and place their own business into the market through their own entity, to maximize efficiency and minimize leakage? Indeed, AmWINS has arguably already taken the first step, buying THB in 2012. While to be fair, AmWINS has so far resisted the urge to bring all the business in-house, logic and precedent suggest that at some stage there is a risk this will happen. Once the first move is made, will the rest of the market be able to resist following, potentially marooning the independent London market wholesalers who rely on this huge source of business? 4. Growing local market sophistication and depth The traditional insurance cycle has for years driven an ebb and flow of business between the domestic U.S. markets and London. Typically, the London wholesale market does particularly well in a hard market, when local brokers struggle to find sufficient capacity and risk appetite. However, the relentless pressure of the soft market conditions that the market has been laboring under for the last 15 years has shifted the dynamic. Local U.S. underwriters have been forced to adapt their risk appetite and invest in their own capabilities to write business that would previously have traveled to London, to keep their top and bottom lines moving in the right direction. While a future hard market could favor the London market once again, these type of skills and investment are not easily unlearned or undone. Further, the last few years have seen the establishment of an increasing number of local MGAs – essentially specialized capacity backed by Lloyd’s paper, as the Lloyd’s market has sought to drive its own growth by investing in developing its own on-the-ground distribution muscle. Why involve a London market wholesaler or broker, if you can access Lloyd’s directly in the form of an MGA? The hypothesis must therefore be that if the market hardens and the tide comes back in, it will not go anyway near as far up the beach as it would have previously. Further, I have argued previously that fundamental changes to long-term market trends mean that the traditional concept of a market cycle may well be obsolete and we may have now entered a new paradigm characterized by longer cycles and low volatility. On this basis, local markets will continue to eat away at premiums placed in the London wholesale market over the long term, with no hope of a respite. 5. Emerging centers of capital The emergence of new centers of capital in places such as Miami, Dubai and Singapore has significantly increased the number of markets able and willing to write risks that previously might have had no choice but to go to London. While no one could pretend that these new centers of capital have London’s depth of knowledge or range of skills today, they are a lot cheaper to operate in, as London remains challenged from a cost perspective. Over time these new centers will surely become far more viable alternatives and compete far more effectively for the North American (and other markets’) premium pool, putting further pressure on London’s share. 6. Improving data analytics and placement technology The London market remains resolutely analog. This in part reflects the relationship-based nature of the industry and the importance of face-to-face conversations in developing and maintaining client relationships and understanding and placing the risk. But it is also partly a defense mechanism – it is hard to disintermediate paper. The suspicion, however, must be that a significant proportion of the premium that currently comes through the London wholesale market could be placed electronically. Bronek Masojada, CEO of Hiscox, has been quoted in the FT as saying that 80% of what is done at Lloyd’s could be done entirely electronically -- there would seem little reason to think that the wholesale market was any different. And once the Pandora’s box of electronic placement is opened, how long before U.S. brokers or wholesalers look to place directly into Lloyd’s or other London based markets, circumventing the wholesale market entirely? Further, could analytical capability become decisive in winning and retaining accounts -- in other words, will the bonds of historic relationships become increasingly strained if these are not supported by leading edge analytics and insight, which many wholesale brokers do not have the resources or capabilities to build? None of this is to underestimate the London market’s ability to shoot itself in the foot when it comes to technology. But things are improving, the direction of travel is clear and the disruptive impact of enhanced analytics and placement technology could in time lead to significant parts of today’s wholesale market being placed direct, with Lloyd's brokers reduced to the status of electronic post-boxes. These gravitational forces suggest a number of important long-term implications for the London wholesale market: The market will shrink as changes in supply, market structure and competition reduce the amount of premium available to the market. While recently the market has been able (to its considerable credit) to more than counteract this through driving innovation to win market share, over time, the trends listed above will gain in momentum, and gravity will make itself felt. Arguably, JLT (by merging its Lloyd & Partners business with its specialty division) and Willis (by selling its wholesale business to Millers), to name but two, concluded several years ago that the best days of the London wholesale market were firmly behind them (although in JLT's case the decision was a perhaps unavoidable consequence of establishing itself as a U.S. retailer -- you can't wholesale where you retail, at least not without considerable difficulty.) In the short term, as players fight over a smaller pie, this will almost certainly put pressure on commission rates and margins that have historically rarely moved. The market will consolidate further and faster. Faced with the pressures outlined above, the market will consolidate to drive efficiencies and grow market share and mitigate the commission/margin pressure. Witness, for example, Besso coming together with Ed. This trend is further being accelerated by the growing cost of regulation and technology, which is squeezing the smaller end of the market and fueling M&A. Managing FX risk has also become increasingly important given Sterling’s recent volatility, something that is only typically affordable by larger brokers. It is also increasingly hard to grow by hiring talent, which for many years has been the preferred way of acquiring business and growing share – the market has wised up significantly in the last few years, and non-competes and other restrictive covenants are far more prevalent and effective than they used to be. Further, as the U.S. wholesale market has professionalized and moved to more of a preferred supplier model, so some of the larger U.S. relationships have become more institutionalized, and the opportunity of hiring one person in the hope that they will be able to shift an entire book of business, far riskier. For shareholders of smaller wholesale brokers, this should be good news as competition for assets and a race to the top drives multiples up. Anecdotally, I have heard of something of a demographic “cliff” in the market, in any case, with many wholesale brokers set up in the '80s and '90s and their owners now looking for an exit. In that sense, there may well be no losers from these changes – even those not equipped to compete effectively should be able to sell out at a good price, although inevitably the drive for deal synergies will mean that, unfortunately, not everyone will survive the cut. However, caveat emptor! -- scale is not growth, and the forces alluded to elsewhere in this article suggest that buyers may well end up saddled with all the cost and far less of the revenue than they thought they were buying over the longer term. The market will become more international. While there is significant pressure on premium flow from the North American market, the overwhelming bulk of global economic growth over the next 50 years will be in the emerging markets, in particular Asia. The depth and sophistication of underwriters in these markets is improving but remains far below that seen in more developed markets. This suggests a real opportunity for wholesalers able to establish more of a global footprint, partner with local brokers, reduce their historic reliance on North America, take a longer-term view and ride the emerging market growth wave, although, as in the U.S., they will find themselves competing against large international brokers who have invested in their local retail operations, channeling premiums back through their internal placement teams. Further, as outlined above, some of these local markets are themselves developing new centers of capital. The client proposition of a broker not just able to access London but also these emerging centers of capital to get a better outcome, should be significantly enhanced. Clearly, though, only the larger brokers will have the resources to pursue such a strategy, further bolstering the consolidation story. See also: ‘Organic Insurance’: Back to Basics   The placement chain will collapse. The cost and complexity of the current placement process is unsustainable, and it will collapse faster than most expect or understand, driven by rating and margin pressures. Even beyond the threat of the U.S. wholesale market going direct, how long before the global firms look to remove their own London offices from the placement process of their international business, accessing London insurers directly from source? Where is the logic in Lloyd’s underwriters writing U.S. or Australian MGA business through a Lloyd’s broker? Why would a client not wish to contract directly with the facultative reinsurance market that currently pays 15% commission to a broker that is in all likelihood owned by the same firm providing both retail and wholesale services (Marsh/Bowring Marsh/Guy Carpenter for example)? What has worked for the last however many years simply won't fly anymore. The market leaders will need to have clear specialization and edge. The pressures on the market mean that those that do emerge as market leaders, with sufficient scale and attractive growth momentum, will have succeeded by outcompeting and winning share, rather than from any growth tailwind. I am reminded of the joke about the two people who come across a tiger in a clearing. When one of them carefully reaches into his backpack for a pair of trainers and starts lacing them up, his friend asks him what he is doing, as there is no way he can possible outrun the snarling beast. “I don’t need to,” comes the reply. “I just need to outrun you!” The reality is that the market leaders will inevitably all be competing for the same talent, the same acquisition targets and the same supplier deals with the large U.S. wholesalers. At the risk of stating the obvious, therefore, the winners will be those who have deep pockets (probably PE backed), clear areas of specialization and a distinctive cultural edge, that they can articulate in a compelling way. Wholesale broking remains a people business. The best wholesale brokers, perhaps more than any other type of broker in the market, save perhaps for some reinsurance brokers, are often able to move millions of dollars’ worth of business through their personal relationships. Winning the PR game and positioning yourself as a winner will become even more important to win the war for talent and emerge as the destination of choice. I suspect there is room here for a new entrant, able to attract talent and backing and drive to scale quickly with a non-legacy platform. All of the above needs to be set against the potential findings of the FCA review into the sector, with the publication of its initial findings now expected during Q1 of 2019. The aim of the study is to “explore how competition is currently working and whether it could work better in the interests of clients.” Their work is covering how brokers compete, whether they use their bargaining power to get clients a good deal, what conflicts of interest there are and how these are managed and how they might affect competition and client outcomes. A specific concern is the growing use of facilities and captive MGAs by larger firms, in particular, placing smaller firms at something of a disadvantage and potentially raising conflict issues. It is hard to know what the findings will be and whether it is the wholesale activities of the large international brokers, as opposed to the independent wholesale players, that are particularly in the FCA's cross-hairs. Potentially the remedies could be seismic, turning much of what I have said above into something of a sectoral footnote. Certainly the tone of the FCA's communications so far would suggest that the sector will find itself caught between the "rock" of scale and consolidation on one side and the "hard place" of the regulatory concerns that such scale raises on the other. The good news in all of this is that NASA doesn’t think that Bennu 101955 will hit us, if at all, until 2175 and 2199 at the earliest. Who knows, by then we may well be living on Mars anyway! But for those working in and around the London wholesale market, the challenges, while far less dramatic, are much more immediate, and those convinced of the longevity of the London market wholesaler its current guise, are at best naive, at worst complacent. You would hope that the various players are alive to all these factors and have a plan. Although I can't help but be reminded of what Mike Tyson once said: "Everyone has a plan. Until they get punched in the mouth."

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