Brave new world: regulatory probes with the power to reshape financial service markets

Citation

Gentle, C. (2005), "Brave new world: regulatory probes with the power to reshape financial service markets", Journal of Risk Finance, Vol. 6 No. 4. https://doi.org/10.1108/jrf.2005.29406daf.001

Brave new world: regulatory probes with the power to reshape financial service markets

Brave new world: regulatory probes with the power to reshape financial service markets

In recent years, various investigations into the practices of some financial activities in the US have unleashed powerful forces of change. By stripping away much of the opacity that had shrouded these business practices, previously ill-understood processes are seeing a radical shift in business economics. Parts of the finance industry as diverse as investment banking and reinsurance have come under scrutiny. The resulting loss of trust in these activities and the financial institutions operating in these markets has created a brave new world. The man behind many of these probes is Mr Elliot Spitzer, Attorney General in New York. What is striking about his investigations – in contrast to regulations emanating from traditional financial authorities and supervisory institutions – is that they have arguably brought more transparency and transformation for financial institutions in these arenas. The message for financial service companies is clear – ensure the highest standards possible, moving the culture of the organization beyond a pure, box-ticking compliance mindset. It is useful to see how this process is unfolding in the insurance broking industry.

The recent settlements reached between the large US property and casualty (P&C) insurance brokers, and the NY Attorney General provides some resolution to the allegations of fee manipulation. Specifically, it was mandated that the affected companies introduce new compliant business models for insurance placement that exclude the criticized compensation. Such legal settlements eliminating particular broker fees may be viewed by some as windfalls for the insurers who no longer need to pay them. However, this period is likely simply to mark the beginning of what will likely be a difficult, but necessary, restructuring of the insurance industry's business economics and compliance operations.

Insurers and broker intermediaries need to redefine their roles, and formulate new financial models that eliminate industry cross-subsidies. To that end, they must identify the core services that differentiate their offerings and devise fee structures that reward value from these activities in an explicit way. To enable profitability in a more regulated post-settlement paradigm, they may also need to rationalize non-core commodity services across the insurance-placement process.

Underlying these evolving financial models are changes in the business economics of insurance distribution. Expect to see that the rationalization across the insurance-placement process will transform the interfaces between insurers, broker intermediaries, and buyers. While the recent investigations provide an impetus for this transformation, its nature and course of change will likely be determined by industry choice.

The investigations and settlements highlight a need for change in insurance financial and business economics. However, in order to evolve the existing transaction models in a rational way, the industry must first expose the inconsistencies that led to this call. It is, therefore, critical that any transformation be guided by greater transparency and a tone of compliance reform. The insurance trade needs to focus proactively on improving the public's perception of its integrity, or risk further scrutiny and regulation. While the initial investigations focused on the property and casualty market, attention appears to be broadening to other areas of the industry.

Such shifts in perception and power will naturally affect the development of business models for insurance distribution. Industry consolidation can reduce competition among insurance players and choice for insurance purchasers. This, in turn, can lower market efficiency, which may artificially raise the costs of risk transfer along the distribution chain. In fact, heightened consolidation has made it virtually impossible for large corporate insurance buyers to complete an insurance program without using every major player in the marketplace. On the other hand, the same industry consolidation can enable significant economies of scale for the companies that remain, thereby improving profitability. These offsetting consequences will necessarily affect the interactions between insurance providers, intermediaries, and buyers, and the evolution of business economics between them.

Before the insurance trade can effect new practices to improve financial and business economics, it must first restore public trust in its integrity. As is frequently the case, the devil is in the details. It is only through controlled implementation and execution that insurance players can create additional value from the compliance process and, in this way, distinguish themselves. Insurers and brokers need to change themselves now, or risk having it done for them by potentially overzealous regulators following in the footsteps of Spitzer. Such reform will likely become increasingly important, as public scrutiny of the insurance industry expands.

Whether it is insurance broking or investment banking, the recent passage of history has been a turning point for scrutiny of the financial services industry. Mr Spitzer has slain some sacred cows – in an industry that had far too many. Financial institutions should prepare for a brave new world in the public spotlight.

Chris GentleDelloite, London, UK