Core economic functions of intermediaries
Intermediaries operate in many different markets such leisure and business travel, real estate, credit, pensions, etc. Essentially, intermediaries can be found in many markets in which a customer only occasionally seeks to buy a product or a service.
The theoretical and empirical analysis of the role of intermediaries has identified 4 core economic contributions of intermediaries which also apply to insurance intermediaries:
- Through their activities intermediaries decrease search and matching costs
Intermediaries enhance market performance by coordinating market transactions. They act as a matching mechanism: they match consumers with specific needs to suppliers that offer particular products and, by doing so, they increase the overall volumes of trade.
In a market characterized by differentiated products and by consumers with various needs and preferences, the activity of searching plays an important role as it allows consumers to gather information about products and price quotations. Consumers can avoid costly market search by relying on intermediaries that present them with a range of products or services. Similarly, lenders seeking to reach consumers can make use of credit intermediaries, thus avoiding the need to open branches, advertise, and promote their products.
The magnitude of this benefit depends on whether the intermediary is tied to a single supplier or a few suppliers, or covers the market at large
Typical intermediation activities reduce customers’ search costs by:
- searching themselves for the appropriate products and services,
- providing price information (e.g., price quotes or estimates).
Intermediaries also assist suppliers establishing links with potential clients, distributing products and services and promoting and advertising suppliers’ products and services.
- Through their activities intermediaries allow economies of scale to be reaped
In many instances, parties trading directly between themselves engage in a variety of costly and time consuming activities (e.g. bargaining, negotiating, and writing contracts). Where intermediaries handle a high volume of transactions with multiple buyers and sellers, they can potentially achieve significant economies of scale.
For instance, clients may have high opportunity costs of undertaking administrative tasks related to the process of obtaining a good or service, and might prefer dealing through an intermediary. Similarly, an intermediary may assist a supplier in the preparation of the sales agreement (e.g. by writing contracts and undertaking associated administrative tasks).
- Through their activities, intermediaries help reduce adverse selection
In some markets, information asymmetries between the trading parties may be so severe as to cause a form of market failure known as “adverse selection”. This is a market process in which consumers select a product of inferior quality (or do not purchase it at all) due to having access to a different information set to the provider of the product.
In economic theory it has been argued that adverse selection that arises in a direct exchange market can be alleviated if the two sides of the market deal through an intermediary.
In a credit market setting, asymmetric information works at two levels: on the one hand consumers are not fully aware of the characteristics of a credit product and, on the other hand, lenders do not know the risk of default of borrowers.
In this context, problems of adverse selection are represented by trading opportunities that would be lost due to consumers’ lack of confidence (e.g. a borrower does not purchase a potentially suitable product because he does not fully understand its characteristics), or lenders’ reluctance to offer credit to a potentially valuable client (e.g. a lender’s inability to recognise the creditworthiness of borrowers).
If they are perceived as experts and succeed in acting as quality guarantors for both sides of the market, credit intermediaries may alleviate these problems. For instance, credit intermediaries may assist borrowers in the purchase of products or services by:
- Suggesting suitable products and services
- Warning clients about the risk associated with specific products or services; and
- Explaining contract terms.
Typically, intermediation activities aimed at alleviating borrowers’ asymmetric information are more significant for relatively complex products or services. In contrast these activities are relatively less important in the case of relatively simple and standardised products or service.
- Through their activities, intermediaries help overcome moral hazard issues
Moral hazard arises when a party insulated from a risk may behave differently from the way it would behave if it were fully exposed to that risk. In order to mitigate moral hazard problems significant resources must be allocated to collect information in order to monitor the post-contractual behaviour of a party in cases where such a post-contractual relationship exists. Economic theory suggests that, in many markets, intermediaries are able to collect information more efficiently and to do so at lower opportunity costs than individual clients.
