As the MGA sector continues to expand in size and influence, the financial relationship between MGAs and their capacity providers is starting to come into sharp focus. Are existing practices sustainable, equitable or is new financial engineering on the horizon, muses Mike Keating, CEO of the MGAA.
The financial relationship between MGAs and their capacity providers has been more or less the same for years, with capacity providers more often than not calling the shots. But pressure for change is mounting as MGAs increasingly look to question the costs of doing business at a time when the regulator is also starting to look to scrutinise distribution costs.
The majority of MGA capacity deals centre around a fairly standard model, with a book of business targeted at hitting a set combined operating ratio. This COR is made up of a mixture of elements including the all-important ultimate loss ratio, commission, regulatory or government levies, reinsurance costs and a host of additional costs usually lumped under “underwriting expenses.” Of course, alternative models do exist including the target being composed of ULR and commission only, however, in this case, the ULR is often inflated to recognise expenses.
Overall, however, it is the area of underwriting expenses and reinsurance contribution that see the greatest lack of consistency and that can be a bone of contention for MGAs.
Underwriting expenses are the additional costs that insurers put into their financial models and include the charges that an insurer places on the MGA to cover the cost of using its paper and security rating. This is augmented by a host of other costs around governance and oversight, through to hosting quarterly meetings and audits. Some MGAs have always pushed back and questioned how much they should be paying – especially remonstrating against paying for insurer’s plush offices around the globe - but many don’t and accept these as the terms, or rules, of the game.
Reinsurance cost allocation is another area where there have been rumblings of concern – especially when insurers add in a charge to cover their reinsurance costs, even though the book in question won’t attract any cover at all.
Clearly insurers do need to cover their costs – that is not up for debate. And a lack of consistency is to be expected as they all have different internal structures and operating models. But that said, it can seem, from an MGA’s perspective, that the expenses allocations – are sometimes, well, random. These costs matter, as every point added to the financial model impacts the financial viability of the trading relationship – and of course, the end price that customers are charged.
A fair share
Expense and reinsurance allocations aside, there is also disquiet in some quarters over the inability of successful MGAs to increase their share of the underwriting profit. MGAs which can demonstrate a very predictable, strongly performing portfolio in terms of loss ratio, (clearly supported by historic data) are presently limited as to how much of the underwriting profit that they generate that they can access. And even where there is a quota share profit agreement in place, they have to share any excess gains with their capacity provider, even if the insurer in question has already achieved their shareholder return. Again, perhaps this is fair as the capacity provider has taken, in theory, a risk on the MGA. However, in many financial models the MGA takes the risk through a ‘slider’ or ‘loss corridor’ which clearly illustrates their ‘skin in the game.’
Whatever your perspective, the reality is that this inability to gain more income from highly successful books of business may lead some MGAs to consider sourcing alternative capacity with fewer hurdles to go over – and therefore less costs attached - or even consider setting up their own mini-insurer or syndicate – as one notable MGA did recently.
The question for the insurance market, and one that was discussed in depth at the MGAAs’ annual conference in September, is, will, or should, the models change? And if they don’t, will cheaper, alternative capital flood into the most profitable MGAs? Can insurers’ do things differently, and is there a need for a more equitable model?
The FCA’s initiative around Fair Value – under which the manufacturers of insurance products are to be held responsible for ensuring the fair value of their product at the point of sale – also adds impetus to this debate. The Fair Value agenda certainly invites further scrutiny over the financial arrangements between capacity providers and MGAs – not to mention brokers – as to whether additional costs are fair and justifiable, and ultimately, whether the financial relationship between the MGA and capacity provider are just serving to push up end customer prices.
There has never been a better time for the insurance sector to look closely at the financial relationship between MGAs and capacity providers, and the dynamics in play, and for both parties to be open and transparent. The increased use of technology and digitalisation, resulting in frictional cost reduction, also underpins the need for collaborative discussion. There is no simple answer, and traditional ways of operating may be the most equitable, but the time is certainly right to ask the question and it is an issue that the MGAA will no doubt be addressing through its Technical Underwriting Forum over the coming year.