Broker Behaviour through the Insurance Market Cycle
The cycle is said to consist of two primary phases: the hard market and the soft market. During a hard market, insurance premiums rise while capacity decreases, and underwriting standards become stricter.
Conversely, in a soft market, capacity expands while competition intensifies among insurers and this typically results in premium decreases.
Understanding the market cycle is important for insurance buyers. Obtaining adequate insurance during a hard market requires much more work. Buyers need a strong understanding of their risk tolerance and appetite so that they can make informed decisions about how much to transfer via insurance. On average policy limits purchased by companies will reduce and deductibles will increase; companies opt to retain more risk as the cost of transfer becomes uneconomical.
During a soft market, where there is more capacity available and more competition, companies will retain less risk by purchasing higher limits and taking lower deductibles.
In our 17 years as outsourced insurance managers to some of Australia’s largest organisations, Risk Advisory Services (RAS) has been able to observe the way that the behavior of brokers, as well as insurers, changes over a market cycle.
Broker Behavior in a Hard Market
In a hardening market, the dynamics of broker income and their service provision to clients undergo significant shifts. For example:
1. Increased Earnings
In a hardening market where premiums rise, brokers often experience an increase in their commission earnings. Higher premiums directly translate to more income on commission-based accounts. Broking fees also tend to increase, especially for large or hard-to-place accounts, to reflect the greater amount of work required to secure insurance terms.
2. More Use of Offshore Capacity
As local capacity shrinks, and Australian insurers become more selective, there is a greater need for brokers to source capacity from overseas. This requires the Australian broker to engage with brokers in overseas markets, thereby increasing the frictional cost to the client. Most large international broking firms use their own overseas offices for this and therefore this strategy can result in a higher overall revenue for the broker.
3. Greater Focus on Ancillary and Value-Add Services
Insurers require much more underwriting information in a hard market, and clients are required to maintain a more rigorous insurable risk infrastructure – for example up-to-date valuations, risk engineering programs, and detailed methodology for estimating business interruption exposure. There is also an increased benefit from analytics and loss modelling services to assist clients in selecting appropriate policy limits and deductibles. In a hard market large brokers will grow their expertise in these areas and offer these services for a fee to more clients. Smaller brokers will often partner with independent consulting firms in order to promote these services to their clients.
4. Greater Focus on Alternative Risk Transfer & Retention
As capacity becomes tighter, many companies take a greater interest in utilising alternative methods of transferring or retaining risk, such as captives, protected cell companies (PCCs), parametric insurance, and participation in mutuals. Broking firms with expertise in these areas often experience strong growth in a hard market and will be more proactive in selling these solutions to their clients.
Strategies to get the most out of your broker relationship in a hard market
1. Make sure your terms of engagement are fee only
Removing the possibility of earning commission from insurers largely resolves a broker’s conflict of interest and will improve the quality of advocacy they provide in a hard market. RAS recommends drafting a contract which specifically addresses commissions, as most standard terms of engagement offered by brokers will allow commissions to be earned even if they are charging a fee.
2. Make sure the fee is adequate and is linked to performance
Following on from the first point, effective insurance placement in a hard market is more time consuming and requires greater expertise and it is important that this is recognised in the broker fee.
3. Review required policy limits
Limits trend upwards during a soft cycle as insurers will offer higher limits to maintain their premium pool. When the market hardens make sure your policy limits are supported by documented worst-case scenarios to avoid over-buying.
Impact of a Softening Market on Broker Behaviour
In a soft market, the overarching theme is increased competition. With more insurers vying for market share, brokers experience pressure to offer competitive pricing to attract and retain clients.
1. Commission-Based Income Reduction
In a softening market where premiums decrease, brokers often face a reduction in their commission earnings. As a result, brokers might experience financial pressure due to decreased earnings from commissions. This conflict of interest may lead to brokers being less motivated to negotiate the lowest possible premiums from the market.
2. Reduced Underwriting Rigor
In a more competitive market with prices trending downward, underwriters need to write more policies and attract more new clients to maintain earnings. This leads to lower thresholds of required underwriting information and acceptance of previously ‘marginal’ risks. In general, placing business in a soft market requires less effort and expertise from brokers and underwriters. A prolonged soft market can result in complacency in maintaining risk quality and risk information as the effort of doing so does not appear to provide a return on investment. We have seen many businesses caught out when the market hardens again and they suddenly have insufficient risk information to secure cover.
3. Staff Redundancies and Under-Resourcing of Accounts
Broking firms are at their most profitable during a hard market and will pay far above market rates to recruit senior executives in order to attract high-value clients. When the market softens this will often be followed by a wave of redundancies. This, combined with reduced profitability of labour-intensive accounts, can lead to large accounts being under-resourced which will often translate as a perceived drop in quality of service.
4. Increases in Policy Limits
A softening market will make more capacity available at attractive prices and this often translates into brokers offering policy limit increases at renewal. As more clients purchase higher limits this becomes reflected in the limit benchmarking that is regularly offered to assist clients with limit selection. This cycle results in an upward trend in policy limits during soft markets.
Strategies to get the most out of your broker relationship in a soft market
1. Don’t neglect your insurable risk profile
A soft market will not last forever and when it ends it will be essential that insurers can be given a complete picture of your risk profile. If your business includes a portfolio of high-value or high-risk property, then make sure you maintain the discipline of obtaining annual insurance valuations and risk engineering surveys and adhering to survey recommendations.
2. Maintain competitive tension
Brokers will not always push insurers for price reductions in a softening market. If you are being quoted “roll over” terms at renewal don’t be afraid to push back and ask if further reductions are possible. Competitive tension can also be maintained by keeping an open dialogue with alternative brokers or by conducting an insurance broking tender every 3 to 5 years.
3. Make sure your terms of engagement are fee only
This advice holds true in a hard market as well as a soft one. Without commissions, a broker’s earnings volatility is reduced and you are more likely to receive consistent service.
4. Review required policy limits
Limits of liability should always be justified by a documented worst-case loss scenario. Ensure your limits are selected on this basis and avoid over-buying.
The market is showing clear signs of softening in the first half of 2024 following a protracted hard cycle and it is a good opportunity to review your insurance arrangements and take advantage of the changing conditions. As always RAS is here to support our clients through all stages of the market cycle so if you require any assistance or advice don’t hesitate to contact a RAS consultant.
Sept 2024