FSA regulation - virus or medicine?

The coming of regulation to the general insurance industry is seen by many as the inevitable cost of doing business in the modern world.

The widely held view is that regulation will add a cost and administrative burden.

While the FSA is keen to stress that it strives to keep the cost of regulation to a minimum consistent with its duties, most practitioners would not agree.

It is generally assumed that the costs associated with increased regulation will hit brokers' profits, particularly for smaller brokers, and thereby drive industry consolidation.

Extending this logic, the argument runs that the greater the cost of regulation the lower the profits that are made by an industry. The UK pig industry presents a parallel. Regulation, in the form of higher UK welfare standard, was imposed on the industry over the past two decades, but not matched on the continent and elsewhere. The higher cost of implementing these controls for UK pig producers have given importers of foreign pig produce a cost advantage over their home-supplied rivals. This squeezed already wafer-thin margins ("the profit's in the tail"), resulting in lower UK output, an increase in imports and, arguably, a decrease in overall animal welfare.

Profitable industry

So, regulation is seen as damaging to the financial health of an industry.

Why go as far afield as the pig industry when we only have to look at the life sector?

Another less rural example may be useful. One of the most - if not the most- regulated industries is pharmaceuticals. However, it is also one of the most profitable and valuable. GlaxoSmithKline alone was capitalised at £77bn at the end of 2003. Compare this with the leading lights in the insurance industry.

At the year end Aviva and Prudential were capitalised at around £10bn each.

Regulation (including patent protection) has created enormous barriers to enter the pharmaceuticals industry. But, in reality, the regime it imposes provides the trading environment for huge profits to be made. Executives may whinge about the cost of regulation, but without it they would have much more to fear from price competition.

It simply does not follow that higher regulatory costs lead to lower profits. Indeed, depending on the characteristics of the specific industry, the opposite may well be the case.

Economics professor John Kay wrote in his Financial Times column in October 2003 that "fallacies of DIY economics are mostly the result of generalisations".

He argues that we use our experience of a small part of an industry and apply it to the whole. So it is with regulation. The cost of regulation that a single broker has to bear cannot be applied to the whole industry simply as a regulation cost. The whole industry may, in fact, become more profitable with regulation, as in the pharmaceutical sector.

Does distribution of general insurance products have more in common with the agriculture sector or the pharmaceutical sector?

Most industries are made up of sub-sectors, with general insurance being clearly split between personal and commercial lines. Their performances over the past 30 years has been very different.

With the rise of the telephone (and now the internet) as a key method of doing business, the driver of personal lines has switched from physical accessibility to brand. This has been achieved by targeting over-priced low risks and by driving down business acquisition and administration costs. Direct Line was created as a brand based around quality and value.

Branding is why Tesco has so successfully entered this sector of the market. Brands don't come cheap and small players can't afford them, which leads to consolidation through merger or closure.

While the personal lines industry has been transformed, the commercial sector of the business is structurally little different. Marsh may have taken over Sedgwick, but many medium-sized firms are still competing effectively on service and cost.

Changes in the Lloyd's capital base has drastically reduced the number of underwriting syndicates over the past 15 years, but Lloyd's brokers, although reduced in number, remain diverse and buoyant.

People can substitute chicken for bacon if it gets too expensive; but when insuring, the cheaper alternative is effectively non-insurance. For many this is not an option, except at the margin. So if insurance premiums go up 2% because of regulation, it will be passed on to the customer in much the same way as the insurance premium tax was. For this not to happen, you would have to be offered the choice of the traditional product or a cheaper, non-regulated version. The regulatory regime impacts at the point of consumption not manufacture, unlike within agriculture.

In personal lines regulation impacts at the point of sale between client and broker. But there is no particular customer relationship between them, as the client can, and does, buy from many other sources. But in commercial lines there is a key relationship between the buyer and the account handler who has a good knowledge of the buyer's particular business. Regulation will have no impact on this relationship. The buyer cannot choose to go to a non-regulated alternative supplier.

Crucially, account handlers in larger broking companies tend to be more mobile, both internally and externally than their smaller broker counterparts. This lack of continuity can represent a considerable "diseconomy" of scale and explains why smaller commercial brokers have continued to flourish, by being able to offer a higher level of continuity of staff.

When small to medium size enterprises (SMEs) change brokers, they tend to go to another non-national broker, perceiving that they will not get the personal, long-term relationship they require from a major. This is in stark contrast to personal lines where, other than high net worth clients, none of us receives a really personal service - which gives the larger brand-led providers a competitive advantage.

Brokers' advantage

The success of many larger commercial brokers is based on the need of larger companies for a range of skills, geographical coverage, and security, that even a good quality smaller local broker cannot provide.

We do not expect FSA regulation to have any significant impact on the speed of consolidation in the commercial market. In our view, the marginal additional cost of compliance for commercial brokers will not be sufficient to outweigh the advantages that many smaller brokers have over their larger competitors.

In personal lines, however, the additional cost of compliance is further shifting the advantage to the large, branded players. Smaller players, particularly commercial brokers, will decide that the rewards do not justify the efforts and exit the market.

Cost of capital

Areas in which larger brokers have significant advantages over smaller brokers are their cost of capital and management resources. While the natural buyer for a broking business is, more often than not, the existing management of the business, their access to finance is limited. Typically this precludes them from being able to make an acceptable offer for the business.

Consequently, the consolidation activity in the UK commercial market is being driven by access/cost of capital issues rather than operational efficiencies. Accordingly, age will remain the determining factor in the consolidation process as, at retirement, valuation - ultimately reflecting the cost of capital and the advantage that larger firms have here - becomes paramount.

In the Top 50 review the consolidators are predominantly in the £15m to £50m revenue range. Importantly, such businesses are of a size where they have ready assess to banking and other forms of finance. There are also numerous targets that would have a significant impact on their own operations.

Unlike the farming industry, regulation in the insurance industry will not give rise to "cheap imports" though major companies will continue to seek out lowest cost processing (such as call centres in India).

The costs of regulation will be passed on to clients as there is no non-regulated substitute. Brokers should use the one-off opportunity of increased regulation to improve their terms of trade with customers.

Typically, regulators start with a low bar and raise it over time, especially to new entrants. In the future it is likely to become harder for individuals to leave the larger brokers and set up on their own, thus keeping value in the existing businesses as competition from new entrants is reduced.

Regulation will drive out marginal businesses and with it an element of competition. Such departures will give other brokers the opportunity to increase pricing.

We see the industry benefiting from regulation: as it will create barriers to entry and also enhance professionalism.

FSA regulation may actually increase the long-term profitability of the industry by increasing barriers to entry. But regulation will not result in a restructuring of commercial distribution, where consolidation will remain driven by age and cost of capital issues. For personal lines the additional costs will give further impetus to the ongoing consolidation process.

The fact that medicines are good for you does not make them any more pleasant to take. So it is with regulation for commercial insurance brokers.