A capital conundrum

What’s happened to the London market? It has been a difficult year for the capital’s brokers, outflanked by both domestic and foreign competition, resulting in an 1.1% drop in revenues among the top 50 brokers with a presence in the sector.

A number of players, most notably global brokers, have stood still in terms of growing their business, with the top five seeing their brokerages slip by an average of 2.3% – double the overall decline for the sector.

While softening in the London market continues, attempts to exploit the growth potential of the UK regional markets have proved challenging, thanks to the rise of the consolidators and broker networks. Moves towards web-based and direct trading models in the SME space have eroded London players’ ability to leverage their expertise.

Meanwhile, mid-tier operators, such as Cooper Gay, THB, Hyperion and RK Harrison have made strides through organic and acquisition-led growth.

The decline in revenues is widely put down to three factors: cut-throat competition in a soft market; adverse exchange rates; and the migration of business into emerging global markets, where it can be serviced locally.

“You have a strong pound, low premiums and the capacity that exists in the world markets is pulling business away from London,” says David Howden, chief executive of Hyperion, in which private equity heavyweight 3i took a £50m stake this year.

Rob Woods, chief executive of Aon Global UK’s broking teams, agrees. “Competition in the London market for certain classes is extremely fierce,” he says.

Pressure on rates has prompted a focus on the top line for some and the bottom line for others, including the global brokers. “It’s a very competitive environment ‘ ‘ in terms of brokers. It’s that simple,” says Andrew Agnew, chairman of Jardine?Lloyd Thompson (JLT), whose parent recently bought London market rival HWS for £8.75m.

Mark Grice, broker analyst at Mazars, says the impact of foreign exchange is also significant. “Currency is a major revenue driver,” he says , pointing out that while London market brokers transact around half their business in dollars, expenses are paid in sterling.

Vic Thompson, THB chief executive, says: “The exchange rate has a much more significant impact than investment earnings.” He estimates that currency conversions have taken £5m off the bottom line since the company floated in 2002.

“It’s a very competitive environment in terms of brokers.
It’s that simple.

Andrew Agnew, JLT

Retaining risk

The problem is compounded by changing buying habits. “Clients are continuing to retain more risk,” says Christopher Hood, insurance group senior manager at Pricewaterhouse­Coopers (PWC).

Tim Leggett, insurance partner at Ernst & Young, adds: “People are become more aware of what brokers charge.” He cites

the disclosure-driving impact of the Spitzer investigations on transparency. Clients are increasingly trying to do deals with brokers to reduce their fees. This is something of a newer phenomenon.”

JLT’s Thompson says premiums are not the only thing falling. “My feeling is softening is happening at around 15% a year. Also, we’re seeing a reduction in primary layers. If London had 50% last year this has shrunk in many cases to around 35%.”

Despite huge losses in engineering and mining this year, it will take something literally earth-shattering to remedy the situation. Hyperion’s Howden says: “Capital has to be serviced. Rates will only rise when capacity comes out of the market. Only a global catastrophe can do that.”

The soft market also impacts smaller and wholesale brokers in the London market who rely heavily on commission revenues. “Fees are more applicable to the larger brokers because smaller brokers often don’t have the necessary risk management in place to service the client entirely,” says Mazar’s Grice.

Yet it is the same larger brokers that are adding to pricing pressures. “One mistake the global players have made is being willing to collapse on fees,” says the chief executive of one UK top 30 broker.

“Wholesale brokers are exposed,” adds a source at a London market broker body. “If rates sink, fees do not go down at the same rate as commissions. But in a hard market, if and when rates go up commissions do not necessarily follow.”

“The wholesale book is primarily driven by pricing and available capacity,” says Aon’s Woods. “The change in [Lloyd’s] rules, when balanced against the globalisation of capacity and ease of communications, will make it much more difficult for the ‘generalist wholesale’ broker to demonstrate what value they are adding to the end client.”

“Rates will only rise when capacity comes out of the market. Only a global catastrophe can do that.

David Howden, Hyperion

While commissions offer little stability in terms of existing business, the London market is also losing some of the business it is already used to placing.

“Some business historically placed in the London market can now find other forms such as direct or web-based trading,” says Paul Bridgwater, chief executive of RK Harrison, which puts revenue growth of 16% in the past year down to specialisation and poaching and retaining talent.

“London holds on to business that requires talent to broke. That’s why business comes here – to access to systems and talent. In the regions it is more about local servicing.”

“Big complex risks still find their way to London and Lloyd’s,” adds Leggett. “There are not many places where you can replicate the type of support services, expertise and access to clients that you get in the London market.”

The emergence of rival hubs with lower cost bases, including Bermuda, complicates the picture further. PWC’s Hood says that business migrating from London is a question of geography.

“Where there is capacity being provided overseas in places such as Asia or the Middle East, local brokers may be more likely to be involved in placing this business and they may not necessarily be part of London market broking groups.”

“Brokers also want to make sure they pick up easy risks but London is a high-cost place for brokers to do business,” says Leggett.

If you can’t beat them join them, says Thompson whose company THB, having sold its UK provincial network two years ago, grew by over a third with its acquisition of rival PWS earlier this year.

International viability

Thompson continues: “Brokers that are purely London market operations will struggle. Part of the rationale for the acquisition of PWS was it gave us instant international viability. The difficulty is foreign investment is an expensive road to travel and if you want to go global, the brokers you can buy are few.

“Brokers want to make sure they pick up easy risks, but London is a high-cost place.

Tim Leggett, Ernst & Young

“On bigger risks placed through the international market, I’d be surprised if London’s share hadn’t reduced,” he adds.

JLT’s Agnew believes not all the business that is moving away from London will be doing so on permanent basis. “I think that US domestic market is extremely competitive but if you show them business that is exposed to natural catastrophe, it gets tricky,” he says

Commenting on Bermuda, Agnew adds: “It is becoming more and more of a swing market. When capacity becomes tight ‘ ‘ business moves there – when capacity is readily available more business is likely to stay within the domestic markets.”

While more international business is remaining exactly that, the view from the UK regional markets which account for around a quarter of London market revenues is equally gloomy. The proliferation of broker networks helps smaller regional brokers maintain their position and enhance their offerings, while direct SME players and consolidators overlap ever further with their London market counterparts.

“There are a lot of Lloyd’s brokers that have good products, but don’t have distribution,”

says Howden. Given the perilous position in which many London market players find themselves, what can be done? Focusing on client retention and products and lines that are not as influenced by declining rates, such as political risk, is one option.

Aon says it has delivered growth by focusing on markets in which it was previously underweight.

Growth is the rationale behind JLT’s acquisition of HWS and Cooper Gay’s purchase of Heath Lambert’s UK wholesale division, FSJ, three months ago.

Ernst &?Young’s Leggett says: “Brokers will be looking at their costs base. Interest rates are also down, which puts more pressure on [building brokerage].”

The move to cut costs has been led by the global players, with Willis setting an operating margin goal of 29% by 2010 and Marsh and JLT 20% by 2010 and 2011 respectively.

“Financial metrics will become unsustainable... and consolidation will be inevitable

Rob Woods, Aon Global

“The four big brokers have tiers of expense, and layers of bureaucracy. They have wasted a lot of money on bad systems,” a chief executive of a leading Lloyd’s broker says. “But the move to cut expenses indicates they are having difficulty growing the top line.”

PWC’s Hood says: “Some brokers have been slow to diversify into providing other services to clients outside of broking and to charge them for it.” The list includes employee benefits and consulting, and employing new staff such as actuaries, to enhance their service.

But the most recent evidence of this trend, emphasising the convergence of the insurance and capital markets, is the dealing of Insurance Linked Securities – the form of insurance risk distributed to capital market investors – which will inevitably gather pace following Benfield’s $50m (£25m) investment in its investment management arm, Juniperus Capital, which launched in June.

Handing the underwriting pen to brokers has also taken off in the past year. Both JLT and THB have unveiled ring-fenced underwriting business, Thistle and Unicorn, while others including Willis and Cooper Gay are setting up managing general agency agreements with blue-chip insurers.

For those that can neither focus nor diversify, only one outcome is likely, which one senior market source calls the “clearing of the decks”, or what Mazar’s Grice describes as the decline of the “lifestyle business”.

Financial metrics

“Competition is squeezing margins and, coupled with wage escalation due to the war for talent, the financial metrics will become unsustainable… consolidation in the sector will be inevitable,” says Woods.

But the next wave will not be limited to the smaller players, with sources maintaining that many of the best candidates remain in play even after AXA’s blockbuster buy of SBJ and Willis’ purchase of Glencairn in recent months. And it looks like there could be ample buyers in the frame.

“We’ll see more activity at the top end,” says Leggett. “It’s not doom and gloom. Brokers just have to be more imaginative.”