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Insurance brokers take no risk
Most customers, businesses and people alike, don't really care who their carrier is as long as it is highly rated and known to pay claims. Any of the top carriers will do. That gives the broker a tremendous say in the decision.
Carriers are large and capital intensive, and the capital is what they bring. Capital is a wonderful thing, but it is a bit of a commodity, scarcer at some times than others. Commodities don't get the same value as driving customers to a decision, so whoever owns the customer relationship should draw a larger share of the profits in the whole ecosystem.
A broker could take on risk only over the long term, by placing bad risk with a carrier until the carrier cuts it off. That would be adverse selection, which doesn't show up when a broker's loss ratios are consistent with the industry's and with other brokers placing premium with that carrier.
Why is capital a commodity in insurance?
Capital can come from many sources beyond traditional insurers. Reinsurers, hedge funds, and pension funds all supply it. When capital is abundant, carriers compete on price for the same business. Catastrophe bonds, first issued in the mid-1990s after Hurricane Andrew, let investors take on disaster risk directly.
Why does adverse selection arise in insurance?
People who expect to file claims are more likely to seek coverage. The insurer can't always see who they are, so its pool ends up riskier than average. Economist George Akerlof described this kind of information gap in his 1970 paper on used cars. He shared the 2001 Nobel Prize in economics for that work.
How do carriers watch the business a broker sends?
Carriers track the loss ratio of each broker's book, which is claims paid divided by premium earned. They compare it with their overall results and with other brokers' books. A book that runs far worse than the rest draws scrutiny and can lead a carrier to restrict or end the relationship. Carriers commonly review these figures every year.
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