DARWINISM: a new philosophy driving consolidation

“What happened to the ‘best of the best’,” comments Thomas Rodell, the chairman of The Council of Insurance Agents and Brokers (CIAB) in his opening address to the 2001 Russell Miller National Insurance Leadership Symposium. Rodell’s observation refers to the market shifts over recent decades whereby leading companies in the p&c business have fallen out of the “top ten”, some into obscurity, and others now merely ghosts of the past. What led to these changing power shifts, which in some cases resulted in extinction?

“Market Darwinism”, a process of “natural selection” has been coined within the corporate world to define commercial evolution and the process of survival in an increasingly global marketplace, says Gerald Greenwald, the author of “A Roadmap for Managers in the 21st Century”. A former executive director at auto manufacturer Chrysler during the period of the group’s financial troubles and current chairman of United Airlines, Greenwald notes that market consolidation has been a driving force of many industries for some time. Removing duplication and achieving the cost efficiencies derived from volume of business have become critical to not only gaining success, but survival in a new world that is ever evolving in its sophistication.

And, Greenwald points out, the demise of many companies resulted from becoming “too comfortable” during their periods of success and not learning from past mistakes. Chrysler made the mistake of losing control of its costs twice, he observes, while the recent financial fallout and liability losses that impacted Ford and tire manufacturer Firestone over defective product use could have been avoided if the problems identified had been dealt with in a timely manner. “The worst business problems are those that have just been lying there, then one day they raise their heads like snakes.”

As such, Greenwald cautions the Symposium’s CEO audience to not become complacent with their operations. Strategizing for the future, regardless of a current sense of comfort, is paramount to the process of survival, he adds. Management tend to think of mergers or partnerships when faced with hardship, “it’s when things are good that it’s time to put together something with partners”. In addition, Greenwald notes, “it’s much easier to manage survival in an enterprise than success”.

P&C consolidation trends

A four-member panel of insurers and brokers moderated by financial insurance analyst V.J. Dowling picked up the consolidation question and examined the activity that has taken place in the p&c sector over recent years, and whether these mergers and acquisitions have had a pronounced impact on the marketplace. The panel members also provided their insight to whether “big really is better”.

Notably, Dowling observes, the shakeout within the corporate brokerage market has resulted in two houses of AON and Marsh currently controlling approximately 73% of the U.S. commercial marketplace. Has this “shift in power” partly contributed to the weakness of market rates?

In contrast, he notes, the extent of consolidation among primary insurers has been limited with most of the activity occurring on the personal lines side of the business. Is the primary market too fractured, and why are insurers and investors not buying up their competitors particularly in lieu of the excess capital awash within the industry?

In response to consolidation within the brokerage community, Bruce Guthart the president of Kaye Insurance Associates (which was recently acquired by Hub) does not believe that the size of organizations like Marsh and AON have been significant forces in driving commercial rates downward. The weak price cycle has more to do with the fundamentals of the carrier marketplace – namely excess capital and too many players chasing the premium dollar.

Indeed, Dowling observes, the current circumstance facing insurers is akin to what he describes as “the prisoner’s dilemma” whereby everyone in the market is aware that writing business at an 8% return is unacceptable, “but if you turn the business away, then someone else will write it”. The fact that the industry cannot get beyond a 7% to 8% range on return on equity (ROE) is reason for the lackluster investment interest in the p&c sector. “The capital trap of this business is that you can get your money in, but you can’t get it out.”

And, although listed insurance stocks in the U.S. have risen sharply over last year, Dowling believes this has more to do with institutional investment “safety trades” rather than a firm view that insurers are set on real profit recovery. “Fund managers withdrew from the technology sector last year and parked capital in ‘safe stocks’ such as the financial services sector, but don’t expect this to continue [this year].”

In order for insurers to deliver adequate market returns, companies would have to lift ROEs to around 12%, Dowling says. “To achieve this based on the current industry [U.S.] average of writing business on a one to one premium/surplus ratio, companies would have to operate at a 94% combined ratio. What are the chances that anyone will achieve this?”

Ironically, the strong performance of the investment markets has been the undoing of the industry, says Jeff Post, president of Fireman’s Fund Insurance Company. Capital growth within the industry surged during the latter part of the 1990s, he notes, which led to the breakdown in underwriting discipline. The current move toward a firming price market has had a lot to do with Wall St. analysts and rating agencies picking up their beating sticks, he adds. This external pressure will likely continue to drive financial improvement of the sector. A return to acceptable investor returns will likely signal renewed consolidation in the p&c industry, he surmises.

Financial performance has not been the only factor hindering merger and acquisition activity, says Cary Blair, CEO of regional insurer Westfield Companies. The only buyers of insurance companies thus far has been other insurance companies, he notes. One of the biggest hurdles is organizational integration, he adds, which focuses on two factors – socialization and technology. Robert James, president of CNA E-Business, concurs that “technology integration” has been a stumbling block to not only consolidation among companies, but as well partnerships with intermediaries. “We’ve been disappointed with the pace of integration,” he comments, and it is this uncertainty that is causing potential consolidators to stay back in the shadows.

Big is better?

The market’s philosophy suggests that scale would indeed seem to matter when it comes to claims management, particularly among regional insurers writing personal lines business, Dowling says. The question remains, however, to whether larger more diversified companies have really achieved the expected cost-efficiencies of growing through acquisition. And, from a regional perspective, are carriers not risking over concentration of their underwriting portfolios by acquiring other players operating in the same areas of business? Notably, Dowling adds, rating agencies like A.M. Best are offering insurers “credits” for diversification of their risks and the strength of the parent company. “How does a regional carrier carrying a large capital book compete in this environment,” he asks.

In response to the latter quandary, Blair contends the theory of over-concentration. “We have a US$1.2 billion book of business, my feeling is that we need to be bigger to absorb hits on the underwriting side.” He also points out that the approach to being “big” hinges on the structure of the company, for instance the lines of business it operates in. As such, Blair does not believe that financial services product diversification, or for that matter a multi-line spread, is the right strategy for regional operators. “We, like many regional carriers, are focussing on niche markets and staying away from multi-line business.”

Conversely, how a company’s business can be leveraged is the deciding factor to whether “big” is an advantage, says Post. “The ability to leverage pr oducts across the financial services spectrum under one umbrella is what we regard as big.” That said, Post agrees that trying to be “all things to all people” is not the right course to follow, targeting niche markets, whether geographical or by line, and achieving a diversified mix across these market exposures, is likely to provide the richest returns.

This argument was taken up by James, who observes that CNA had previously followed a strategy of trying to write across all lines, partly in order to satisfy its broker/agent relationships. The company has subsequently adopted a more cautious approach of how it can leverage the business for profit before venturing forward. “We’re now looking at a more specialized focus and how we can be more nimble in responding to market trends.”

Into the future

What will be the core business of the p&c industry in coming years? This was the question posed to a second panel at the Russell Miller Symposium. In response, the five-member panel each outlined their individual takes on current developments.

Kenneth le Strange, chairman of AON Risk Services expects “relevance” and “cost” will be the biggest issues facing the industry. “We need to evolve products to make them more relevant to clients. Ours is the last financial services sector facing the ‘cost revolution’, and the current cost structure of the industry is not sustainable over the long-term.”

According to Hugo Warns, an analyst at Legg Mason Wood Walker, Inc., the biggest challenge ahead of the industry is grounding leadership from the top – greater emphasis is needed from senior management to regain focus on underwriting management, he says. Furthermore, Warns concurs with the view that the industry needs to put more effort into innovative product design as well as management approach. “Other industries have moved far ahead in innovation, in contrast, insurers are still doing business the same way they did 15 years ago.”

In addition to which, comments Bill Smith, president of Kemper Insurance Companies, the industry cannot avoid the fact that it has to account for the “cost of capital”. “And we’re going to be forced to,” he predicts, “this I expect will have a fundamental impact on the business this year. We’ve got to start operating efficiently.” Smith also believes that the longer-term challenge facing the industry lies in distribution – “I think the prime driver is how we are going to distribute 10 years from now, this is really going to be about whether our distribution systems meet up with consumer needs.”

Kurt de Grosz, chief strategy officer at BenefitPoint Inc., points out that the Internet as a selling mechanism is “not going to go away”. Thus far, p&c insurers have not been subjected to real competition, he contends, and online selling of insurance products by outside low-cost producers will signal the beginning of a new era for the industry. “I think competition will be a healthy development for the industry. The reality is that our industry has always operated almost like a monopoly in that it has been shielded from outside competitors. Make no mistake, the Internet is definitely here, and it’s real.”

Another challenge before the industry is attracting new talent, notes John Cay, CEO of Palmer & Cay Inc. With the current degree of management uncertainty within the industry, combined with a future outlook of increased volatility based on the assumption that ownership of companies will be changing hands more frequently, something has to be done to appeal to new recruits, he cautions.

Broker future

“I think the industry will become very client driven, the future is going to be about knowing your market well, and customizing your business,” says le Strange. This refocusing of the business process will place increased emphasis on the role of the intermediary, from both buyer and underwriter perspectives,” he surmises.

Cay adds his support to this theory, pointing out that consumers may be more willing to do the research into their insurance needs, but ultimately, “they want someone to validate the transaction, so brokers will be around for a long time”. Warns notes that the current rise in insurance prices will likely solidify consumer confidence in the role of the broker. “It’s when rates are going up that buyers see value in the broker.”

However, le Strange says, increased transactional transparency, combined with the drive within the industry for cost efficiency, will likely mean that insurers will have to cut commission margins. De Grosz agrees with this view, but notes that research carried out by his firm suggests that the majority of insurance buyers have not had a problem paying for the service level received from their intermediaries. “Disintermediation is not about how brokers get paid, but evolution of the role of the broker. But, I think we will see shrinking commissions and a broader movement to fee-based services.”