True Motivations

A recent ACORD report estimated that 75% of mergers and acquisitions by reinsurers and multiline insurers destroy value. The worst performers were motivated to do deals to acquire scale.

​Scale is not a determining factor in this industry. Management intelligence and execution matter far more than scale. Scale enables management teams to hide poor results more easily, and no one should ever doubt that motivation.

At the carrier level, I’ve analyzed results of around 80 carriers that write around 80% of all premiums. I analyze these results in detail annually. Scale is not the difference maker in growth rates, profit margins, or even the cost of capital. Quality of management is the difference maker. That is what moves the needle. Scale is what executives say when they have run out of other options.

Scale may play a role for private equity by enabling a higher multiple in insurance distribution. But this is an interesting point. Adjusted for rate inflation, most of these entities, including more than one publicly traded broker, have achieved almost 0% organic growth in the last five years. I suspect that if I had access to their true financials, some would even be smaller. In these cases, they must keep buying agencies to hide their negative organic growth rate.

“Scale” is one of those wonderful terms used on Wall Street and taught in MBA programs with the aura that if used, the audience should not question the logic.

Another story that appeared in Carrier Management discussed how AI is changing the role of insurance brokers. I am certain it is too early to make any conclusions, but it will change the role at some level going forward. Human brokers will be forced to become more knowledgeable and more holistic because the only reason businesses or consumers should pay brokers a full commission price going forward is if the broker provides high-quality advice. The value of paying for transactions is on its way down.

Scale may therefore become important with distributors that are nothing more than transactional intermediaries. At low commission rates, scale becomes important, and most of the agencies these firms have purchased are nothing but transactional entities. Even if they were consultative, many of the consultative brokers were the owners who have now retired. There is rarely a strong program to replace them. This is because the short-term bump in EBITDA is more valuable than long-term growth.

The next day, Carrier Management’s email headline was, “The Growing Gap between Insight and Execution.” The point of the article was how carrier models are built for static worlds rather than dynamic reality (my words). Scale does not help here because the problem is not computing ability. The problem is executive IQ.

A very long time ago, I took a class from a world-famous economist who predicted we would run out of oil in 20 or so years. I was quite positive he was dead wrong, so I spoke up and made a rather garbled point that supply and demand are dynamic. His model was static, as if the same amount of oil was pumped at the same price, all the oil would be used in 20 or so years. I still cannot believe anyone could become world famous with such a silly model, but the same kind of model, a static model, even with AI, is being used today by insurance companies.

The model the professor should have been using was one of price elasticity for both production and consumption. The higher the price, the lower the consumption and the greater the production. This should have included the insight that, at a high enough price, new discoveries would be made. (And this goes beyond the scientific fact, even back then, that the DNA in some wells was different than the original oil, suggesting oil was not as finite as thought even today.) The result is that the world has more oil at a more affordable price today (adjusted for time and inflation) because, at some point, it became so expensive that more discoveries were made.

When modeling for insurance, elasticity must be considered, as well as the impact on competitors’ motivations if the company achieves success. Currently, property prices are high. Price elasticity of demand is driving people to go bare. The market for property insurance is shrinking on a same-store basis. If insurance companies continue to increase rates, the market will continue to shrink and would shrink further if not subsidized by mortgage requirements. The rates are far too high for good underwriting. Good underwriting of property, where risk management is a real factor rather than a superfluous conversation, can increase supply at a lower rate. In other words, rates are high enough now that a dynamic model will identify the opportunity to use quality risk management to reduce rates and increase supply.

Moreover, the carriers using static models will be caught flat-footed. Their initial reaction will be to cut rates without improving underwriting. One specific carrier is doing that as I write this. Their combined ratios are averaging around 110%. The dynamic model recognizes this and assesses how much surplus it can acquire, enabling it to either reduce its profit margin and/or further improve its risk management. If the flat-footed carrier is large enough with enough surplus, this may be a war of attrition. Scale will help in a war of attrition, but the most important scale is the amount of surplus relative to premium, not the dollar amount of premium.

At the distribution level, those going for scale are so wrapped up in mergers and acquisitions and raising more money and fighting off competitors poaching their employees (why would good producers with large books opt for a smaller employer if scale was so omnipotent?), that a dynamic model for smaller entities is not that important because no one is going to notice how they are taking clients one-by-one. The bigger distributors, though, are losing because their models are static and, given their scale, they need dynamic models, especially given how cutthroat the industry is at that level.

However, the price is not yet high enough to change the motivations of most established entities to develop the technology to drill for shale oil. This focus then on scale presents one of the best opportunities I’ve seen in this industry for more nimble, smarter executive teams who recognize and accept market dynamics and are willing to build dynamic models that take into consideration price elasticity for both supply and demand.

Consumers, especially smart commercial consumers, would rather spend money reducing losses if they can save enough on insurance premiums. Otherwise, they want to “use” their insurance, meaning having enough claims to pay back their premiums. Static carriers and brokers will, in the short term, write these accounts all day long. Let them.

Build dynamic models and take the best accounts without worrying about scale!

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