Constructing the Niche

In the early 70s most commercial line insurance products were generic. Brokers approached the underwriter with risk particulars and the underwriter provided a coverage quote, subject to the standard commercial insurance forms and endorsements used by the insurer.

If customization or a risk specific coverage was required, it was strictly up to the broker to request the endorsement or have a rider added to the policy. Special packages for retail stores, offices, manufacturers or contractors were virtually non-existent but policies were occasionally customized but only with standard, not “industry specific,” coverage.

PRE-PACKAGE PAYOFF

In many respects, this approach was suited to the evolving world of business in Canada. Most small businesses were “mom and pop” enterprises that were built to the individual owner’s personal tastes and there was not a great deal of uniformity within risk classes. It was not long however, before insurers realized it is less expensive to create pre-packaged coverages that facilitates most small retail store and office owners. Brokers can rate and issue fixed policies, binding the risk, without the initial requirement of an underwriter’s quote. After overcoming the mental barrier of broker-issued, pre-packaged policies, many new packages and industries were added to available packaged product lines available from insurers.

Along the way, brokers recognized an opportunity to create products more suited to their customers’ needs. Burgeoning forth, brokers created unique products targeted to consumers in affinity markets in which they could generate sales through their adept knowledge of the business and its relationships. Although broker-initiated programs have been around for a long time, the development of this type of business has accelerated in the past 15 years.

SECTORING OFF FOR SOMETHING SPECIAL

Segmentation and specialization of insurance products (see table 1) has, in many ways, evolved with the Canadian economy and commercial development. Specialty retailers have replaced the once ubiquitous department stores because of a shift in business motivation – today, recognizable brands dominate all product categories. In addition, franchising revolutionized the food service business; today, the majority of restaurants operate under a franchise banner, supported by extensive advertising and brand development.

SHORTER, SWEETER AND SPECIALIZED

The need for greater specialization and segmentation has affected the insurance industry in other ways. Underwriters have taken a close look at their own business operations and have decided to pare back their activities and, rather than try to write every type of risk offered, they are concentrating in areas where they have proven expertise. The result has been tighter underwriting parameters, fewer exceptions made and a longer list of excluded classes. Where insurers previously said, “If the risk doesn’t fit our profile, we prefer not to write it;” now they are saying, “If the risk doesn’t fit our profile, we will not write it.” This approach has been described as “class underwriting,” which is more the result of strategic planning by larger insurers, rather than the traditional market cycles. In response, the market has segmented into niche insurers who accept business through MGAs and other intermediaries. The niche idea, however, is not so niche as it has resulted in a larger industry than there has been seen for 30 years.

The growth of the niche insurer/MGA market is partly a result of the fact that most insurance brokers focus primarily on retaining insurers who will write their home and auto business – these are the individuals who will help grow their personal lines, the driving force behind their business. Many insurers who are effective in home and auto are not interested in operating a diversified commercial lines insurance business. Consequently, many brokers who focus on personal lines might only have two or three markets. These markets will often have a restrictive list of commercial risks that interest them. If the broker obtains a client whose profile does not match the preferred risk of his insurance markets, the broker will have no alternative but to look to a wholesale MGA to place the coverage in order to retain the customer.

Often a personal lines broker will run into situations where one or even two of their markets will underwrite the risk, but they are restricted in their capacity and cannot write the entire line of business. The wholesale MGA therefore becomes the method of filling the line using capacity it has pre-arranged with its niche insurers.

Insurers are also bolstering the niche/MGA market because they realize that the expense of visiting and maintaining a brokerage relationship in commercial lines requires a critical mass. If a broker is too focused on personal lines, they will not have sufficient volume to justify providing the support needed to maintain a relationship. By working with a wholesale MGA to obtain business from smaller producers, the niche insurer can transfer that maintenance cost to the MGA, making it a variable rather than a fixed cost.

Insurers also recognize the need to have ‘spread of risk’ not only on an overall basis but also within a specific class of business. Wholesale MGAs can bring significant volumes of business to the niche insurer. If the wholesale MGA specializes in a limited number of industry classes, they can provide sizeable volumes within certain types of business. This stabilizes the niche insurer’s results, as a larger group of similar risks will have normalized experience, as the law of large numbers takes effect.

Insurers operating a business that has low loss frequency but potentially high severity must control underwriting procedures, develop specialized expertise and build up large volumes of business to insulate themselves against “shock losses.” This has led to specialist insurers and MGAs for pollution liability, accident and sickness, marine business, high value homeowner and higher risk commercial property.

GROWING BY KNOWING NICHE NEEDS

The outcome of the segmentation of markets and specialization of expertise has been felt most dramatically by insurance brokers. In order to satisfy their clients’ needs, they must be able to do more than analyze the customers’ exposures and recommend appropriate insurance coverage. They must also be able to match the clients’ needs with a niche insurer and/or MGA who can provide the product needed for the client. This search has become time consuming. Standard insurers revise their underwriting template every year and brokers get a surprise when something that was acceptable last year is not on the list of acceptable classes for this year. This leads to the need for brokers to cultivate many relationships in order to ensure they have markets available to look after their customers.

Ultimately, the effect of a restricted market is felt by commercial lines businesses which see premiums increase dramatically or available coverage limits fall below the amount of coverage they feel they need. The result of increased prices and restricted markets is often a search for alternative risk financing. This phenomenon has also increased dramatically in the past 30 years in response to market conditions. Once an alternative risk transfer facility is implemented, it is usually here to stay. As time marches on, more large corporate clients and associations have begun to retain some or all of their risk through various risk pooling and retention arrangements.

COMBINING NUMBERS, REDUCING RISKS, NECESSITATING NICHE

Clients or groups of clients (and their brokers) often require a niche insurance company to assist them in the structuring and developing of a viable risk retention program. The niche insurer can provide risk coverage for amounts required in excess of the retention and “fronting” of the retention where required by law, as in cases of mandato ry automobile insurance coverage. The insurer can also provide unbundled adjudication and other services on the retained claims, as well as management of the group’s pooled funds, including investment services.

In certain cases, an owned insurance or reinsurance captive (or rent-a-captive alternative) may be the best vehicle to carry the client’s retained risk. The broker or niche insurer can organize a team of legal and accounting professionals to assess the viability of and make recommendations on any proposed structure.

Market segmentation and the growth of niche insurers may continue in so far as standard carriers continue to decline in numbers, tightening their focus on commodity personal lines. Niche opportunities exist in both personal and commercial lines, by aligning themselves with flexible niche insurers offering a wide range and various combinations of services, brokers and MGAs will continue to create successful programs.