Thanks James, appreciate the speedy response. I found huge amounts of information on URL structure, but many varying points of view and nothing I could relate specifically to the situation.
The site does have a good amount of content for each state and region landing page – which are all top level in the current flat structure at the moment.
There are over 100 different regions, so I did feel that there would be value in the directory that the digital agency had recommended, but also felt there is a risk (large) of traffic loss introducing the new sub-directory / hierarchical structure. General rule of thumb being 15% PR loss for any URL changes...
So I'm trying to do a bit of a risk / benefit analysis – what the client may lose in traffic initially, will they gain back overtime.