Guidance department: reinsurance brokers can help insurance companies successfully manage rapid growth.

Key Points

* Steady insurance company revenue growth is correlated with enhanced shareholder returns, but very rapid growth puts these returns at risk, according to a recent study.

* Reinsurance brokers possess skills, experience and data to support fast-growing insurance companies in ways well beyond the placement of reinsurance.

* The broker's compensation must be aligned to the service delivered.

Rapid revenue growth is gratifying and slightly alarming to any company. For an insurance company, however, planning is required to ensure that the sound of the alarm bells doesn't become deafening and the gratification doesn't become short-lived.

Unlike other businesses, insurers don't learn their cost of goods sold until long after the sales have occurred. Nasty, surprises may lurk in the flood of premiums. And even if the business written is of high quality, it may not always be easy to convince investors that this is the case.

Recent research by management consultants Bain & Co. has shown a correlation between strong, steady revenue growth and exceptional shareholder returns. Perhaps surprisingly, Bain found that common measures of profitability, such as low combined ratios, showed no such correlation. However, where revenue growth was very rapid--more than 25% a year--the relationship to enhanced shareholder returns deteriorated.

For insurance company management, these findings suggest that revenue growth is a valid objective. But they are not of practical value in managing the risks that such growth entails. (Bain's study sample concluded with 2004 results, before hurricanes Katrina, Rita and Wilma catapulted the phrase "risk management" to the forefront of the dialogue between the management of many insurance companies and their investors.)

This is where the reinsurance broker adds value. A good reinsurance broker is well positioned to guide fast-growing insurance companies.To understand why, consider the imperatives that determine the reinsurance broker's effectiveness. To deliver maximum client value, a reinsurance broker must:

* Know the primary and reinsurance markets intimately, understanding the competitive dynamics at both levels;

* Possess a strong strategic trader-standing of its clients' business goals and constraints; and

* Be able to help clients optimize their capital structure to maximize returns at an acceptable risk tolerance, whether employing traditional reinsurance or tapping a broadening array of other capital sources.

What other adviser to insurance companies combines such weighty responsibilities with access to such rich sources of data relevant to its clients' needs? Management consultants do not, nor do investment banks or consulting actuaries. All have relevant expertise, but they lack the practical, day-to-day exposure to the insurance and reinsurance markets to put this expertise into context.

An Expanding Role

Traditionally, the reinsurance broker has only helped to answer the questions contained in the Rapid Growth Scenarios (see page 40) that pertain directly to the availability and price of reinsurance coverage. But this limited role underutilizes the reinsurance broker's unique skill set and market knowledge. A good broker will have valuable contributions to make in addressing all of the challenges presented by the Rapid Growth Scenarios.

Rapid Growth Scenarios

The following scenarios must be considered when managing revenue
growth.

Existing Lines
(organic)

* Will this dangerously
reduce our diversification
and unbalance our portfolio?

* Do we have the financial
flexibility to accommodate
the potentially more
volatile loss patterns that
could result?

* How will our reinsurers
respond?

* How will investors perceive
such growth?

* What view will the rating
agencies take?

New Lines
(organic)

* Is this business within
our core competence?

* Do we truly understand the
competitive environment?

* If we wish to withdraw
from this business, how
long will that take (for
operational or regulatory
reasons)?

* Is our distribution strategy
optimized to bring us
the kind of business we
are targeting?

* What level and type of
reinsurance support
should we seek?

* Will investors penalize
us for not "sticking to our
knitting"?

New Geographies
(organic)

* Have we factored in
regulatory differences from
the territories in which we
currently operate?

* Do we truly understand
the competitive environment?

* If we wish to withdraw
from this geography, how
long will that take (for
operational or regulatory
reasons)?

By Acquisition
(portfolio or company)

* All or any of the questions
relating to organic
growth (left) may arise,
plus ...

* Are we satisfied that
this business meets all
our underwriting criteria
and is business that we
ourselves would have
underwritten if we could?

Research among our clients and prospective clients last year uncovered strong demand for wide-ranging strategic relationships with their reinsurance brokers. Some reinsurance buyers spoke enthusiastically of the role that the reinsurance broker could play, not only in managing downside risk but in evaluating opportunities to grow business and round accounts. As one put it, "We leverage more and more for business intelligence. The business consulting piece has tremendous potential for us. For example, suppose there was a line of business we didn't write and we wanted to know whether this was hurting us in the eyes of brokers. We could ask our reinsurance broker to find out. And they might come back and say 10 out of 12 of your competitors are willing to write this business. They can give us a 50,000-foot view of the competitive landscape. They can also tell us about its profitability. Our own marketing people have a harder job aggregating this kind of data."

Reinsurance brokers are well-equipped to help their clients navigate such waters. A client seeking to extend its existing business into a new state could turn to its broker to evaluate the tenor of the new market it is considering (regulatory, legal or claims climate, etc.). And for clients expanding into a new business line in existing states, the broker can analyze historic results for the line in question.

Services such as these clearly entail a dramatic expansion of the reinsurance broker's traditional role. Historically, reinsurance brokers' main contribution to their clients' growth has been through fairly ad hoc "reciprocal" arrangements, whereby the broker alerts the client to an opportunity (often program business) on the understanding that it will be able to place the reinsurance.

But not all brokers find it a stretch to assume a more strategic role. It is simply a question of leveraging information that the broker either currently possesses or can readily obtain. This is the broker's great advantage: It is at the confluence of a unique range of information flows--about the primary markets, about the reinsurance markets and about the broader capital markets. Add to that the familiarity with insurance regulation and rating agency policies that all good brokers should possess, and the power of the broker's position becomes apparent.

Remuneration can be a stumbling block. Most of reinsurance brokers' services are currently paid for by commissions on the reinsurance business they place. Certainly, some additional reinsurance business may flow from a decision to enter a market the broker has helped appraise. But to make this the broker's sole form of compensation would seriously bias the objectivity of its appraisal.

In common with primary insurance brokers, reinsurance brokers aren't experienced at pricing their services to reflect the value they represent. And reinsurance buyers aren't used to paying fees directly to their brokers. But if the client really wishes to unlock the value that the broker can provide, the broker's compensation must be aligned to the service delivered.

Sources of Capital

Advising on capital management is--or should be--another part of the broker's service in the context of rapid growth. The best groundwork for such advice is dynamic financial analysis of the client's asset and liability portfolios. Potential growth initiatives can be considered in the light of the strains that they could impose on the insurer's financial flexibility. This can be particularly valuable in anticipating eating agency responses.

Again, the reinsurance broker's advantage is not technical expertise per se (others possess that) but the breadth of its perspective. Traditionally quota share reinsurance has been the principal form of capital that insurers have sought to tap when entering new and relatively unfamiliar geographic markets or lines of business. Informed by dynamic financial analysis, the reinsurance broker can and should put reinsurance into its appropriate context as one of a number of capital sources available to the client.

What is lacking to effect this transformation in the broker's role? All professional advisers talk of their desire to be seen as strategic partners to their clients. The challenge for both sides is to reach a shared appreciation of the value that the broker can offer. Analytical rigor is a necessary but not sufficient condition for success. The final, extra ingredient is imagination.

Contributor John Spencer is group chief executive of BMS Group, a reinsurance broker based in London. He can be reached at [e-mail].