A level playing field

Simon Threadgold examines the issue of vertical integration in the broker market and looks at the benefits and potential conflicts of interest associated with insurers owning their own distributors

In industries other than insurance, vertical integration is a common business strategy. A company will buy up a distributor in order to obtain better delivery of its products to market. So it is hardly surprising that insurers have similarly seen fit to buy distributors such as insurance brokers and estate agents.

Many of these acquisitions were made at a time when insurers faced uncertainty over what was going to happen to personal lines distribution. Consequently, they decided to have a foot in both camps. Now that the picture has cleared, however, it is hard to see the rationale for continuing to own subsidiaries that could be spending 90% of their time selling competitors' products.

Surely it would be better to turn them into tied agents? Another option would be to convert the broker's policyholders into clients of your own direct selling operation, as Norwich Union has succeeded in doing to a large extent, with customers of its former broking subsidiary, Hill House Hammond.

Problem area

Without doubt, there are disadvantages to a major insurer owning a major broker. In a regulated market, such an ownership structure could make the broker very nervous about placing large blocks of business with that insurer.

It could also have a negative effect on insurer panels. Big intermediaries commonly devise their own contracts, for example household policies, and nominate a panel of insurers as carriers. This can lead other insurers to question the value of belonging to a panel ultimately owned by a competitor.

A former employee of HHH states: "An issue we used to face was that other insurers on our panel suspected that, while it appeared to be a level playing field, in practice NU was getting the best business and they were getting the rest. It wasn't true, but the idea was hard to dispel."

The closure of HHH leaves Swinton as the largest surviving high-street broker. Swinton is owned by French mutual insurer MMA, a medium player in UK personal and commercial lines. MMA is one of the top five or six insurers to which Swinton directs business, but this is nothing new - there was a substantial relationship between the two before MMA bought Swinton from Royal and Sun Alliance a few years ago.

Swinton's chief executive, Patrick Smith, and MMA's marketing and underwriting director, Derek Plummer, are also well known to each other from when both worked for NU. However, Mr Plummer insists: "Our relationship with Swinton is the same as any other insurer - the Financial Services Authority needed to satisfy itself that we were two separate trading companies."

Having a broker in its stable provides MMA with a reliable profit stream, which makes the insurer less dependent on the underwriting cycle. Similar reasons were advanced by NU's former general manager, Albert Mills, when the insurer originally bought HHH. This did not prevent the broker chain being scrapped after his retirement. However, MMA has consistently denied speculation that it wants to sell Swinton and states that it has no intention of taking the broker's business in-house.

Diversification appears to be the reason why Highway, a quoted motor insurer, has formed a retail division comprising three brokers - Elite, A-quote and Directmotorline. These brokers will quote for a number of risks that Highway either cannot or will not take. Paul Cosh, managing director of Highway Retail, explains: "Broking can still be profitable when rates soften, because there is less churn and, therefore, less administrative expense."

Company structure

As well as being supervised as a group by the FSA, Highway maintains Chinese walls between its different divisions and has separate reporting.

Mr Cosh declares: "We'll work as well with other insurers as with Highway. Everyone will be given a fair chance. We'll also explain the reasoning behind panel shares to our panel members."

Other organisations comprising both insurers and brokers tell a similar story. Insurer NIG is a subsidiary of Royal Bank of Scotland Insurance, and one of a limited number of players in the motorcycle market. Yet, RBSI also owns leading motorcycle insurance broker Devitt Insurance Services.

NIG's director of marketing and compliance, David Grant, emphasises: "We're all very conscious of the need to demonstrate impartial advice. Owning a broker enables us all to understand the broker market a bit better."

Besides outright ownership, general insurers retain several minority holdings in leading brokers. In 2002, RSA announced its intention to take stakes in eight brokers by the year-end and up to 20 brokers by 2005.

In practice, only three investments were made - in RP Hodson, Jelf Group, and Smart and Cook. Since then, RSA has sold its shareholdings back to Jelf and Smart and Cook, and its holding in RP Hodson has been diluted by the latter becoming part of Oval, the commercial insurance broking consolidator.

RSA has had more urgent calls on its capital - like shoring up its balance sheet. Managing director of commercial lines Brendan McManus comments: "Providing capital to brokers is not a strategic priority. One of our motives was to ensure diversity in broking and enable medium-sized brokers to survive. They can now find adequate backing elsewhere."

Spending spree

Smart and Cook brought in RSA in 1999 when the brokerage was running short of funds for acquisition. However, RSA did no more than take a relatively small shareholding (17%). Smart and Cook then cast around for a larger investor, and succeeded last year in attracting a £57m injection from venture capitalist 3i.

"With 3i as a substantial shareholder, we are better placed for a flotation or a trade sale, if we so wish," says managing director Paul Meehan. One of the drivers for change was the question of succession. The sad and sudden death of chairman and majority shareholder Geoff Cook last month underlined the importance of such forward-thinking.

Venture capitalists typically look to a five to seven-year timescale, within which they anticipate realising a profit on their investment. This may not always coincide with the needs and aspirations of their clients but for Mr Meehan, this is not a worry. "We believe it would be folly for them to do anything against our wishes and, in any case, there's always the possibility of exchanging for another venture capitalist." He also appreciates the benefits of objective advice from a venture capitalist, which has wide experience outside the realms of insurance.

Axa has a 38.9% holding in the ordinary shares of broker Layton Blackham, but Axa's head of broker development, Colin Calder, states there are no plans for any further equity stakes. Axa still has a handful of broker loans outstanding, made for the purpose of acquisition or development.

Mr Calder confirms: "We're still making advances to brokers - the ones that are prepared to give blocks of business to an insurer. In return, we get a market rate of interest. We're in the business of ensuring we have viable distribution."

Cash incentive

When Layton Blackham originally needed capital, it was a relatively small company of insufficient size to interest a venture capitalist. "In those circumstances, you look to your friends and partners in the first instance," observes director Charles Whitfield. He is quick to underline that Axa's holding is an institutional investment, and that Layton Blackham maintains scrupulous control over impartiality of advice and confidentiality of data.

Oval is trying to build a network of superior regional brokers. In return for selling up, the owners receive a mixture of cash and shares in Oval.

The idea being that the management that built up the firm retains a strong sense of ownership. "We want to keep as much of the entrepreneurial flavour as possible," says John May, a director of Caledonia Investments, the driving force behind Oval.

At the end of last year, Oval added Midlands brokerages Beddis and Partners and Halkett and Associates to earlier acquisitions RP Hodson and Bland Bankart. Mr May says this placed Oval ahead of its anticipated position for 2004. The eventual outcome of this expansion drive could be a listing for Oval on the Alternative Investment Market and brokers with stakes in the company would then easily be able to sell their holding whenever they wanted.

Vega Insurance Services, an offshoot of the Primary Group, is another organisation interested in acquiring commercial brokerages. Vega's managing director, Bob Screen, believes scale is increasingly important because larger brokers can secure realistic remuneration whereas small ones cannot.

All Vega's acquisitions so far are 100%-owned, though Vega would be willing to take a majority stake, with the former owners retaining perhaps 40%.

Primary Group is an insurance distribution organisation that embraces an underwriting agency and risk-carrying functions as well. Cox Insurance operates on similar lines, and the UK insurance market will undoubtedly continue to see the development of such hybrid organisations.

As to the position of the FSA, it does not have the power to ban insurers from owning brokers - or to prevent stakes being built up - but the regulator is very keen on transparency and has imposed certain obligations. Insurance Code of Business 4.2.8R (5) requires that an intermediary disclose to clients any holding an insurer has in it that represents more than 10% of its capital or voting rights.

The FSA also insists that brokers must operate in a way that eliminates conflict of interest. ICOB 2.3.2R states: "The ownership arrangement may well create material conflicts and so could be in breach of the rule. It is a matter for firms to judge."

Unfortunately, one person's value judgement about what is above board may not coincide with that of another. Only time will tell whether any regulated body will run into trouble on this point.

Money to be made

Nevertheless it is fair to say that mainstream insurers have retreated from investment in brokers at a time when broking has rarely been so profitable.

Any broker not making money hand over fist during the past three years is arguably in the wrong business. Banks such as Lloyds TSB have been very supportive with credit facilities, and the hard market has meant returns on capital of 40% or 50% for venture capitalists that spotted the broking sector's potential. In an era of consolidation, they have been trying to spot the winners and make a killing.

The question now is whether broking will continue to be attractive to investors as the market softens, premiums and commissions decline, and profitability comes under pressure. Brokers may well be deprived of some profit-related commission income by the Spitzer effect. And, on top of this, they now have to meet the cost and complexity of FSA compliance.

This is proving more demanding than some brokers anticipated and it is not just the FSA's fees. Top management's time is being spent making sure they are compliant, rather than winning new business. Some brokers, even though they have just gained authorisation, may decide that they have had enough.

These forces could well depress the price that acquisition-hungry organisations are prepared to pay. The cost of buying a broker has historically been based on a multiple of turnover but valuing a broker at, say, two or three times income is hardly scientific. Buyers are now more interested in profits than volume, and are only likely to purchase for a sensible multiple of profit.

Despite this, broker consolidation is forecast to increase in 2005. In the end, supply and demand will determine prices paid, and it will be most instructive to see which way they move.

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