Insurance brokers set to stay

Few sectors are more cyclical than insurance. Periods of high profitability encourage insurers to fight for new business, causing premium rates and profits to fall, which in turn eventually brings a return to more favourable pricing. So the opportunities are often best just when the earnings look weakest.

Earnings have certainly been weak over the past few years for large parts of the commercial insurance market, including property, vehicle, and workers compensation coverage for companies. But with premium rates rising recently, profits should improve for big insurers like of Insurance Australia Group, QBE Insurance Group, and Suncorp Group.

The impact may be even greater, though, for the brokers that act as middlemen between insurers and business clients. These brokers take much of the hassle out of finding appropriate insurance cover at decent prices, saving time, money and effort for clients. That's why they distribute and manage over 70% of commercial insurance.

A key feature of the broker business is that they don't take on the underlying insurance risk. That falls to the insurers. Instead, brokers earn a range of fees and commissions tied to the premiums they collect. So, rising insurance prices tend to help their margins and earnings.

Of course, the market knows this, which is why the two largest insurance brokers on the ASX, Steadfast and AUB Group, are currently priced at 20 times and 17 times forecast earnings for 2019.

The bigger question for long-term investors, however, is how they will cope with the threat of disruption and potential changes to industry structure.

Market power

Despite there being nearly 1700 brokers in Australia, many of them are tied - either by affiliation or ownership - to networks. Meanwhile, the large international broker groups tend to focus on big corporate and government clients, which leaves much of the small to medium enterprise (SME) market to the domestic broker networks of AUB Group and Steadfast.

Between them, these companies' networks have a market share of over 55% of the total broker-led commercial insurance premiums, but an even greater share of the SME market. This creates formidable barriers to entry, in terms of lower costs, established relationships and breadth of capabilities. What's more, their market clout has been growing as they consolidate the industry. 

Disruption ahead     

The greater threat is not from other broker networks, but from technology enabling customers to bypass them entirely.

Straightforward - commodity-like - insurance cover, such as car insurance, is already arranged directly between insurers and customers. Commercial insurance is more difficult because coverage needs vary considerably between businesses. Yet insurers are pushing towards selling more of it directly, as we highlighted when we recommended selling AUB Group four years ago.  

Since then, IAG has said it expects to increase direct sales to small SME clients. These parties tend to have simpler needs and are not lucrative for many brokers. In any case, it seems inevitable that a portion of broker clients will choose to interact directly with insurers.

Brokers respond

It's hard to imagine brokers disappearing entirely, though. They provide a valuable service, are growing, and are investing to remain relevant.

They may even be the disrupters.

Steadfast, for example, has developed a software platform that brings together brokers and insurers to simplify and speed up the usual process. Management believes that 80% of its $5.3bn of network premiums could eventually be transacted through the platform compared to just $231m that was processed in fiscal 2018. And if it works, it makes sense to roll out the platform beyond Steadfast's network.

For now, Steadfast's earnings largely come from its stakes in 64 brokers and from providing marketing and administration services to a network of 377 brokers in Australia, New Zealand, and Singapore.

That model has yielded good growth since the company listed in 2013, with earnings up 80%. The risk is that brokers could choose to leave the network, although they'd have to bear some switching costs - such as moving onto new administrative systems - and replace Steadfast's good deals with insurers.   

Variant models

Steadfast also has equity stakes in 25 underwriting agencies - which design and develop policies for unique risks that insurers can then cover - and is expanding overseas through a 40% position in a global broker network, unionSteadfast.

Similarly, AUB takes stakes across a proportion of its broker network in Australia and New Zealand, though its strategy suggests that part-ownership is a key focus. AUB has stakes in more than 50 brokers and we expect that to rise in time.

A joint venture with another broker network, IBNA, helps boost its network strength and extent of support services provided by AUB. The combined premiums across the network are smaller than Steadfast's and totaled $4.5bn in 2018.

Along with some underwriting agencies, AUB also operates a risk-management consultancy that diversifies the group away from traditional broking activities.

Keep watch

Both Steadfast and AUB are decent businesses, but we prefer the former. While earnings prospects are good for both over the next few years, with premium rates likely to continue rising, Steadfast seems better positioned to navigate longer-term industry changes. It's also the larger player in an industry where scale matters and it can expand overseas.   

The market seems to agree, based on Steadfast's higher valuation. However, at these prices neither stock looks compelling, but we'll be keeping a close watch.