The UK referendum to leave the European Union was a long drawn out play of "Should I stay or should I go?"  Well, in the end the UK decided to "go", causing most people to wonder at least one thing: how do professional bookmakers get things so wrong? The day before the vote it was 9:1 odds in favor of remaining. 

Anyone who had visited London in the past two weeks felt a palpable sense of fear and disbelief amongst many in the insurance and reinsurance industry about the possibility that "Leave" voters could actually prevail and that economic chaos, predicted by so many, would thereafter ensue.

Within the risk community there were outliers to this thinking. We noted that Hiscox founder and Chairman emeritus Robert Hiscox, who remains one of the company's largest shareholders, and who now occupies himself as the owner of the venerable White Horse Bookshop in Wiltshire (we will admit to being envious!), let loose a fusillade of invective aimed at "Remain" proponents. 

It was clear that there were strong opinions on both sides.  As an American, in this season of our own presidential political turmoil, one has become sensitized to not advancing too far in any discussion lest you discover that you are actually dealing with a Trump or Hillary supporter or, when in London, a Leave or Remain proponent. Once "identities" are established the conversation can proceed avoiding ideological sinkholes.

That particular problem is all behind the UK now. The vote has been cast.   David Cameron is resigning. The new UK Prime Minister will negotiate the terms of its EU exit. Leaders are reassuring the public and themselves that nothing will change in the short term. The Financial Conduct Authority has even gone so far as to warn that UK laws based on EU regulatory guidelines must still be followed until or if Parliament repeals them.

The future, just possibly, might not be as dire as some believe but it will take a lot of work to get there.  Dover is still 20.6 miles from Calais. The EU will remain England's biggest trading partner. British democracy (as proven by the Brexit vote) works as well if not better than any democratic process on the continent. The telecoms link between England and Europe won't be severed. The Channel Tunnel won't be walled up. It's not as if two years from now London is going to find itself transformed into Pyongyang.

Is it possible that a post-exit understanding could be reached that is mutually acceptable to England and Europe?  We believe that it's inevitable. Britain, like many Democracies, is a deeply divided country when certain issues are involved.  Regardless of who Cameron's successor is, he or she will need to recognize the immutable geographical and financial realities of a wholesale British volte face away from Europe. Some sort of understanding, acceptable to both sides, will need be reached.

If there is one thing the vote proved it is that deep discontent existed in England with the EU structure.  Opinions polls indicate the same exists in other European countries. It may be time for the remaining 27 EU members to take note and tackle the problem of addressing the issues causing the discontent. One would think that they must or risk other countries following the British path.

There seems to be little dispute that reinsurers have just about deployed all their weapons to ward off the effects of the current soft market. It's a little bit like the "quantitative easing" policies implemented by central banks in response to the 2008 recession.  Financial markets wonder how many more tricks do Mario Draghi at the ECB and Janet Yellen at the Federal Reserve have left up their sleeves?  We can't help but wonder the same about the reinsurance market.

Articles this month warned that additional claim reserve releases would be suicidal; that insurers who broke ranks on underwriting discipline to take in premium at any price were in trouble; and that investment yields on many sovereign bonds had actually turned negative. These disturbing trends, when coupled with intensive expense cuts being made by many reinsurers, mean that there aren't too many more moves which a prudent reinsurer can take to generate profit.  As long as rates keep decreasing the "dark period" will continue.

What more can be done?  There have been creative responses.  Reinsurers have quickly adapted to the alternative capital influx and many have now added unrated capital to diversify their capital base. As the cost of alternative capital is cheaper than equity capital some carriers are using the less expensive capital to underwrite risk at a lower premium and still maintain underwriting discipline. 

We've also seen aggressive moves from reinsurers to get closer to the risk, and better control more of the premium originating from that risk, thereby eliminating distribution costs. If an entity controlled by a reinsurer, whether an MGA or insurer, insures the risk at the primary level the whole premium can remain "in-house" if the overall parent is diversified enough to keep the whole exposure on its balance sheet.

This is what Warren Buffett signaled last year when he began to comment about how the best days of reinsurance were past and that  Berkshire Hathaway Specialty Insurance was going to aggressively move globally to underwrite risk on the primary level, keeping it all in house as exposure is passed to Berkshire's reinsurance arms.

Other reinsurers have been quick to follow that model and we've even seen that alternative capital has done the same.  It's not especially complicated. If someone is taking a slice of the pie at every level reinsurers don't get a slice until after payments of retail broker commissions, client ceding commissions and reinsurance broker commissions. By the time the pie reaches the reinsurer the amount of premium left can make the risk unattractive when compared to the exposure the reinsurer is being asked to assume. Short-circuiting the process, and getting to the risk first, can make sense to a reinsurer. The increased premium received, and the expenses that are eliminated, can allow a large, diversified carrier to spread that risk globally within its aggregate portfolio and remain within underwriting guidelines.

Large ILS funds like Nephila can do the same although there can be challenges as they get "closer to the risk".  Reinsurer investors are familiar with underwriting mechanics. The extension of underwriting to primary insurance, and augmenting existing treaty, facultative and quote share expertise, doesn't necessarily require much shareholder education. The move is viewed as a simple extension of existing expertise, aided by modelling, to keep more premium in house.

For the ILS funds it's a different challenge. ILS investors, seeking returns not correlated to equity indexes or interest rates, can readily interpret a model analysis on a pool of Florida windstorm risks that attach at a specific retention level and has a maximum exposure cap. This has been the very successful premise of ILS funds like Nephila.  Investors weren't interested in underwriting details of individual risks as their investment supported broad swaths of thousands of risks that in aggregate had to incur certain claim levels before their collateralized investments were at risk.

We weren't surprised to see comments from the Dutch pension giant PGGM that said ILS investors wanted to know which carriers their ILS managers write business for in the same way that other asset managers disclose the equity securities they hold. PGGM is concerned about concentration of risk if the pension fund happens to own stock in an insurer that their ILS investment is also providing reinsurance to. A catastrophic event could have a downward effect on the insurer's stock, lowering the value of the pension fund's investment. PGGM wants to know if it has also invested in an ILS pool providing reinsurance to the same insurer for the same CAT event.

The moves toward picking up the coverage at the primary level are part of the reinsurer response to the current crisis.  We've seen warnings from analysts about further claim reserve releases too, the premise being that some believe that certain carriers are releasing reserves that they should be maintaining. It's the other side of the coin to the warning about not sacrificing underwriting discipline. In some respects a breach of claim management discipline can be just as disastrous.

There reaches a certain point when reinsurers simply can do no more. We don't mean to sound like the Peter Sellers character Chauncy Gardner but after you've weeded your garden, planted the seeds, faithfully watered and carefully pruned the output, what more can be done? 

Enter the high cost of distribution and what is becoming an open quarrel about broker remuneration. 

Richard Watson is the chief underwriter officer for Hiscox. His title alone should give a sense of his credibility. Watson, speaking at the Association of Lloyd's Members on May 23rd, said Lloyd's was a "horribly expensive market to operate in", particularly given the level of broker commissions. He, like others before him ( see Validus' Ed Noonan), challenged broker's methods for coping with the soft underwriting market, such as the growing use of facilities. He said "I don't blame them for trying to fund better solutions, but they seem to be less than perfect, and seem to come with less work than the commissions."

There's been no shortage of "facility-bashing" by reinsurance executives over the months so Watson's comments didn't particularly raise our eyebrows.  At first glance brokers don't seem to have the arsenal of levers available to them as does a large reinsurer to respond to a market downturn. Their remuneration is based on a percentage commission of the premium and if premium levels drop so do commissions. 

Brokers are creative people though. That's part of their job. Client contact leads to thought, which can lead to discussion with underwriters, which can lead to development of new types of coverages.  And new coverages  can lead to new revenue and overall betterment of the market as new types of business are introduced.  That classic definition, of what some think a broker should be doing, is called into question by creation of large follow form facilities. Brokers charge membership fees to those markets joining the facility. Underwriting is limited only to the lead markets. Those following simply adhere to the terms negotiated by the lead and, after paying the joining fee, as well as a facility commission, hope to make money on slices of risk they would not have had the chance to see had they not joined the facility.

The fear is that smaller syndicates who don't join the facility (or haven't been invited) will see less and less business while more and more risks will come into Lloyd's via super-highways created by the brokers which underwriters have to swallow whole as part of the joining terms. One sees what Watson meant when he criticized the underwriting culture at Lloyd's saying that there had been "too little pioneering, and too little new and innovative action."  

Others are less respectful. We can't count the times we've heard industry figures say "any product that costs 35%-40% of each dollar to deliver to the customer" is doomed in this era of advancing technology.  According to David Long, CEO of Liberty Mutual the cost of distribution is too high and with increased transparency, intermediaries should start to interrogate their charging structure. Speaking at the S&P Insurance Conference in New York Long said there had to be a lot more attention paid to expenses in the system and distribution costs. 

Long said "If somebody asked you to donate a dollar to a non-profit and 65 cents on the dollar went to the cause and the rest went to administration or frictional cost, you'd have a problem." He said "As customers and consumers get more transparency and policy sourcing options become more free for them I think intermediaries need to take a hard look at the compensation and commission structure with less emphasis on policy sourcing."

At the same conference WR Berkley CEO Robert Berkley said "Clearly if you look at the cost of distribution in this industry it is unusually high compared to other industries." Scott Carmilani, CEO of Allied World added that at the top end, brokerage was "getting way too expensive" and that "it has been forever".

This unusually sharp criticism from the markets come at a time when, as we've noted, despite their own best efforts reinsurers are having a difficult time generating returns.  There is also another factor and that's the increasing sophistication of models and data management products (like CATEX's Data Vera) which are used to set premiums. Markets, it seem, are starting to think that the marketplace knowledge which brokers bring to them can be increasingly replaced with data analytics.

Is this a fair criticism or just part of a general frustration that the entire market is experiencing?  We did notice Axa's Jon Walker's comments earlier in the month at the BIBA conference when he said brokers trying to negotiate for more commission, using their books of business as a bargaining chip, does not fit in a climate of fairness and transparency. Walker said Axa is taking a stronger stance by saying no to brokers who don't put forward a "compelling" case when looking for increased commission.

Earlier this month Allianz commercial and personal lines general manager Simon McGinn said insurers were more cautious about paying brokers increased commission without seeing something in return.  Picking up on that Axa's Walker said insurers had a role in helping to reverse the trend of approving increased commissions they had helped fuel. "We have said yes over a long period of time," he said. "It has created a mind-set of 'I might as well ask because there is a fair chance I will get a yes to that question'.

Think about these comments for a second. We were unaware that brokers could obtain added commission by simply asking for it.  If the new stance of markets is to demand that they see "something in return" before granting extra commission it would fit with their efforts to cut distribution costs, reduce the cost of capital, hold back on reserve releases and adhere to strict underwriting discipline. What's the sense of locking the front door, securing the windows but leaving the back door wide open at the same time? 

Then we saw comments from the  European Insurance and Occupational Pensions Authority (EIOPA), a European Union financial regulatory institution. EIOPA, based in Frankfurt, observed that thus far technology in insurance has seen "most insurers put a focus on optimizing existing tools instead of significantly reviewing and transforming their business models."  EIOPA believes that over time technology will cause profound change in the industry in the coming years by disrupting traditional business models."

One of the most imminent disruptive threats to the industry from technology, EIPOA says is the "disintermediation process". New distribution methods, peer-to-peer, pooling of risks and insureds, group buying and smart contracts are all business models which are set to disrupt the insurance and reinsurance markets. 

It's one thing for reinsurers to complain about broker commissions. As Marsh CEO Peter Zaffino said at the S&P conference, after Liberty Mutual's David Long complained about distribution costs, "What a shock that insurance companies think that acquisition expenses are too high."  Zaffino's response is indicative of a sense of the eternal yin and yang between brokers and markets --which is presumably what he wanted to convey. 

It's another thing entirely though for EIOPA to officially speculate that technology is an imminent, disruptive threat to the current intermediation process. However, brokers are familiar with technology too. In fact some of the most comprehensive systems for transactions and analytics have been built by them. Being familiar with what technology can do, and the possible threat it represented to them, is something brokers didn't need the regulators at EIOPA to tell them. They had long understood that potential.

Everyone in the industry knows that markets complain about commissions, just as everyone in the industry knows that markets depend on the business brokers bring them.  This discussion is background noise except in times like now when rates are low; investment returns non-existent; and huge amounts of capacity are available.  Reinsurers are fighting for their lives and, to them, it seems as if brokers can pick who they want to see the best business or business at all.  

To be sure it's not all quite this simple. Long-term cedent-reinsurer relationships do matter, as do T&C and pricing, but there is a definite sense on the part of some markets that brokers have the upper hand at the moment. If it was a hard market, with little available capacity, it would be the broker going from market to market desperately trying to get a line written for a client. That's not the case today.  Some would say that the facilities set up by brokers are the complete opposite of a hard market. 

Perhaps it's not quite so black and white as pointing to soft prices and abundant capacity as the reasons for the real or perceived leverage possessed by brokers. It's hard for us to know if the "leverage" is real or not, but when we see stories about increased commissions it's a tip off that someone believes they have more leverage than they did back when the commission rate they are trying to renegotiate was set.

That's why we thought this next story was very interesting. Since the earliest days of Internet based technology, we too have heard the disintermediation warnings most recently voiced by EIOPA. As we've noted the brokers have not been idle in response to these warnings. As an example of just how prepared the brokers are for this disintermediation push we thought AJG's Dave McGurn's comments to be especially interesting. 

McGurn, Gallagher's former chairman of risk placement services, and now a special adviser to the company, was on a call with investors earlier this month. He knew what he would say would be reported. He said AJG deserves the commission it is paid because it has more and better data than insurers.  While insurers are trying to cut payments to brokers, McGurn believes Gallagher now has more information to help during negotiations.

He said "Insurers are always pushing back, but because we have the data to support what they are paying us, or ask for more, we tend to at least keep what we have. In some cases we get a bit more, because they agree that on that particular transaction we are right," he added.

McGurn went on to observe "Would they like to find a way to curb our appetite for more? Sure. The carriers used to have all the information and we had to go with what they told us, but now we have more information than they do."  He said "The tone of the conversations has shifted dramatically over the last couple of years where we have a lot more to say than we used to."

Data, data and data.  It seems that it's all one reads about sometimes.  But what McGurn said reveals a stark truth.   Those brokers who have been smart about technology and data have managed to amass a treasure trove of it. That data, when combined with analytics enabled by sophisticated modeling, can easily surpass the data possessed by a single ceding client or even, with the exception of a very few large, diversified reinsurers, provide information exceeding the data held by reinsurers.  

Why wouldn't a broker track prior years of negotiating price movements correlated back to placement scale and terms? Why wouldn't a broker track movements of specific market appetite to discern which price level or capacity level or change in T&C would appeal to a specific market? Why wouldn't a broker examine available reinsurer aggregate exposure information and perform their own analysis to find areas of exposure concentration or pockets of unused capacity and then present risks that precisely match those imbalances?  

Brokers used to try to do these things with spreadsheets and legacy systems but the challenges were immense.  Now the tools are readily available to both capture this data and to analyze it. And of course, the larger the broker the more business it sees, and that means its data pool is larger and more representative of the entire market.

Aon realized this a long time ago when they introduced its GRIP system which "is the world's leading global repository of risk and insurance placement information. By providing fact-based insights into Aon's USD 78 billion in bound premium flow, Aon GRIP helps identify the best placement option regardless of size, industry, coverage line or geography." 

Think of the benefits data like this can provide to a broker during negotiations with a market. And if AJG, which is far smaller than Aon, and with presumably a smaller data set, is making public comments about data imbalances that now exist in its favor,  imagine the imbalance that might exist if the Aon data is considered?  The Carpenter/Marsh data? The Willis Towers Watson data?

We will certainly continue to read articles like "Broker revenue harvesting intensifies" in Insurance Insider, replete with market complaints about creeping broker commissions and extra charges. But, even if Dave McGurn is only half-right, it would seem that the brokers have prepared well for that day, predicted by the Association of British Insurers, when regulators will force greater transparency of broker commissions.

This period of crisis, prompted by a host of factors converging chronologically in an unprecedented manner, might be looked back upon as the time when the industry took the necessary steps to ensure its survival for generations to come. One can hope.

"The retailer is the most important person in the chain.  DeCarlo has said  "The retailer goes to church, plays golf, goes to the Rotary Club meeting to gain trust in risk transfer and that is not done through a call center. It is not done through London, it it is not done from Singapore - it is local."

When you add the pricing analytics that Aon has, to the existing value of the retail relationships owned by Aon, you can see why managing agents might be a bit intimidated.  If the concept proves itself it would seem that Aon would be able to open the spigot as needed. It still seems to us that Carrier Link will eventually be a big hit for the Cheesegrater.