Financial Services Convergence: Big Bang or a Whimper?
Financial Services Convergence: Big Bang or a Whimper?
While banks are the fastest growing distribution channel of life insurance, many companies continue to face challenges when marrying the two environments.
Most think of bancassurance as a simple solution to an intractable distribution problem: upstanding banks sell reasonably priced insurance to grateful customers. This mantra was broadcast for years to a captive audience as horses and jockeys alike waited for the starting bell. After the $83 billion Citibank and Travelers combination, analysts on both sides of the aisle assumed that the die had been cast: bancassurance in the United States would be driven by the civil unions of waifish insurers and steroid popping banks. Investment bankers and consulting actuaries alike salivated at the thought of a spate of high profile mega-mergers and years of corporate counseling for the winners to cope with post traumatic integration disorders.
Due to the subsequent lack of marquis deals, many who did not follow the market closely believed bancassurance in the United States to be quiescent, if not dead. This is far from the case, as the market has been busily pursuing many different approaches to cracking the code to access the fabled bancassurance riches including: insurer banks, insurance agency rollups, brokerage programs and marketing agreements of all types.
Background
Bancassurance, or the sale of insurance products through a banking retail channel, has been very effective in Europe. In 2004, over 60 percent of life insurance and pension products in France, Italy and Spain were sold through the bancassurance platform. The European bancassurance model was successfully exported to Latin America in the '90s, where penetrations of insurance sold through banks eventually reached as high as 80 percent of the total life market in Brazil. A similar conquest is underway in Asia with varying degrees of success due to cultural and regulatory problems.
A bank's primary objective with bancassurance is to expand non-interest income, diversifying interest rate risk and providing stability of bank earnings, thereby stabilizing market valuations and driving P/E multiples. The bank's second overriding interest is expanding market share as policyholders of the insurer become targets for cross selling of loan and deposit products. The ultimate goal is to expand customer "wallet share," the number of products the customer has with their brand, increasing persistency and profitability.
Step back to the late '90s in the United States: Halcyon days, full of potential (and silly stock multiples). Pundits and cheerleaders had for years anticipated that bancassurance would catch fire if regulatory hurdles were removed. This scenario started to play out following the Supreme Court's pivotal 1996 decision in Barnett Bank versus Nelson. Before this judgment, Florida law prohibited banks from selling insurance; although, federal law permitted the practice. In Barnett Bank, the Supreme Court held that federal law trumped state law in this area and that states could not prevent banks or other financial institutions from selling insurance. This ruling led to the federal preemption of state insurance law, paving the way for banks to acquire agencies and sell products.
Barnett was a big victory, but the "big bang" was the $83 billion bet placed by Citibank CEO John Reed and hard charging CEO Sandy Weill of Travelers even before enabling legislation was passed. The 1998 merger predated the federal legislation and is widely cited as the catalyst for pushing long stalled financial services regulatory reform through Congress, resulting in the passage of the Graham-Leach-Bliley Act (GLB) in late 1999. When the law went into effect March 13, 2000, insurance premiums at banks amounted to less than 1 percent of the U.S. total.
However, GLB was much more than a Bancassurance act. Dubbed the Financial Services Modernization Act, it repealed Glass-Steagall, but reaffirmed the McCarran- Ferguson Act which gives the power of insurance regulation to the states. Perhaps of more importance to the banking industry, it tore down the wall between commercial and investment banking.
Bancassurance and Insurer Banks
The Citigroup model was an attempt to create a financial services superstore, commonly termed "financial services convergence." Using a holding company model with three separate retail channels: Citibank for banking, Travelers for insurance and Salomon Smith Barney for brokerage. However, they did not attempt to brand the different arms of their sprawling retail distribution systems. Over the past five years, large chunks of this merger appear to have been coughed up seemingly undigested as more and more of the original acquisition is spun off with (relatively) little fanfare.
While Citigroup tried a frontal assault, there were other early attempts to scale the bank/ insurance platform from different directions. Principal Financial Group and State Farm Mutual Insurance formed "virtual" banks (on-line and telephone-based) under federally insured thrift charter, but without the splash and fanfare of a Sandy Weill merger. While Citigroup had an extensive brick and mortar network, the virtual banks required consumers to interact almost exclusively via the on-line and call center channels. Although agents were able to assist with applications and product inquiries, they were not authorized to accept deposits.
In early 2001, MetLife became the first insurance company under GLB to receive approval to purchase a federally chartered bank, Grand Bank of Kingston, NJ. One of the objectives is to retain assets after the payout of a claim. Insurers hope to leverage their brand identities and increase wallet share. Experience has shown that over 80 percent of the bank customers are in fact existing insurance customers.
Bank One is one of a handful of banks that are participating in the underwriting profits by reinsuring sales. Bank One's partnership with producers allows the manufacturer more comfort that post sale the bank has an interest in servicing the customer relationship. Persistency rates can be 5 percent above the industry average, meaning a significant jump in profitability on both sides of the equation. Given the regulatory flexibility in on-shore captive havens such as Vermont, South Carolina and the District of Columbia, reinsurance deals can be structured using a captive structure rather than through acquiring an underwriter.
One of the most important challenges that multi-line distributors have had to face is providing a seamless interface between the banking and insurance environments. This has proven to be a far greater challenge than originally anticipated as companies try to manage disclosures, security and flexibility while working with existing information architecture.
Agency Rollup
Banks were quick to identify distribution as an area with stable cash flows and the potential to arbitrage high returns, while underwriting was viewed skeptically as a segment with low margins and high volatility. Banks saw product manufacturing as a separate business, not a core competency and not a part of their relationship building strategy. As a result, many banks have taken the position that they are not interested in the manufacturing process, but are single mindedly pursuing the distribution avenue instead.
Although hardly even on the radar screen when GLB was coming to fruition, this realization has resulted in a spree of bank acquisitions of insurance agencies. As a result, there has been a shift in banks experimenting with small agency acquisitions and an increase in the number of players focusing on larger acquisition targets. This trend is the realization that success in the insurance market is a by-product of acquiring quality agencies that are sufficient in revenue to employ quality underwriters and a large institutionalized production staff. The continued consolidation is putting more competitive pressure on smaller insurance agencies that do not have the power, efficiency and broad service sweep of the larger agencies.
The successful agency rollup approach follows a model of first identifying a high performing agency within the core market territory of the bank. As this agency will form the foundation of future acquisitions, the bank will be willing to pay a premium to acquire quality. Other high quality acquisitions are pursued in other metropolitan areas to fill out the bank footprint. Subsequent fold-ins increase critical mass and create regional profit centers and, presumably, stabilize bank operating margins.
Agency transactions are typically constructed with a blend of upfront and earn-out consideration, averaging a guaranteed consideration at closing of 50 percent to 80 percent. The balance is paid over three to five years based on performance thresholds set at closing. Banks are not looking to retire the management team in an acquisition; they need people who are engaged and will continue to contribute. This is one of the reasons for emphasis on earn-outs in the pricing structure. Intangibles are critical; banks are looking for human capital, client relationships and brand identity. When banks spot an agency that is going to fill in a piece of their puzzle, their pricing methodology is more aggressive than larger insurance agencies.
There are a number of reasons why the synergy proves to be productive for both the bank and the agency. From the agency's perspective, a portion of the embedded value is unlocked and paid to the current owners. Going forward, the bank brings a common technology platform and a more effective set of tools, bringing the agency up to current state of the art. Typically, the bank also provides HR support, a help desk with technical support and, very importantly, redundant systems for disaster recovery. Thus, the agents get to focus on what they do best, which is building relationships while the bank partner takes care of the back office.
The goal of the partnership is to provide more and better services to small and medium business owners as well as your affluent and mass affluent. The agencies maintain an independent relationship with the bank and insurance manufacturers. The banks provide references to agencies and agencies provide small and mid-size business references to the bank.
One of the issues these partners struggle with is that a good bank customer is not necessarily a good insurance customer. Banks take deposits from all comers, whereas insurers rely on underwriting to screen claims risk. Bank products are transaction based, whereas high quality agencies typically provide unique customized problem solving skills to develop solutions in the areas of risk assessment, loss control and claims analysis. Smaller accounts are provided by agencies as an accommodation to business owners; the infrastructure and processes of most acquired agencies is not built to cater to a large number of small accounts. Banks must recognize that the acquisition of a large insurance agency will not automatically meet the insurance needs of the bank's core customer base. Finally, most bank acquisitions of insurance agencies/brokers have been in the commercial lines property & casualty sector where the agency isn't even focused on retail customers.
Despite the challenges, bank-owned agencies have obtained significant revenue growth and are now major players in the insurance distribution system. Seven of the top 30 insurance agencies in the United States were bank-owned in 2003 versus seven of the top 100 in 1998. From 1999 to 2003, there were close to 1,000 publicly announced insurance agency transactions of which banks and thrifts accounted for close to one-third of them. Wachovia recently purchased 137-year-old Savannah, Ga., based Palmer & Cay. Along with the acquisition, Wachovia Insurance Services will have over 1,800 employees, making it one of the top 10 insurance agencies in the country.
Note that this was not a level playing field. Some banks were grandfathered and others had favorable state legislation. Branch Bank-ing and Trust was already buying insurance agencies as early as 1922. Focusing primarily in the southeast, BB&T has quietly become the 9th largest financial holding company and 2nd largest insurance brokerage (based on fee income) in the country.
According to Michael White Associates, Citibank is No. 1 with $650 million in insurance brokerage fee income and BB&T is No. 2 with $590 million. Chase Manhattan Bank is a distant 3rd with $213 million. Bank fee income on insurance brokerage increased 22 percent from $2.97 billion in 2003 to a record $3.63 billion in 2004. Nearly half the banks in the United States engage in some sort of insurance related activities, and participation increases as bank size increases. Approximately 75 percent of the banks with over $10 billion in assets participated in insurance brokerage activities and accounted for the same portion of total insurance brokerage fee income.
Brokerage Programs
At the turn of this new century, brokerage houses had some significant advantages over insurers. They were much quicker to make use of and develop their own Internet technology to provide customers real time access to their accounts. Insurance back office systems were not fully integrated, and it was often difficult for customers to get a satisfying online experience.
Today, insurers have largely transformed their on-line platforms, offering access to a full range of products. But this may be too little too late as banks acquire brokerage houses and integrate a suite of financial offerings. The competition to provide a full suite of financial services for the mass affluent will increase. Online discount brokerages primarily offer transaction-based products such as term life insurance. Even the largest online brokers fail to offer integrated portfolio management tools for their mutual funds and variable insurance products.
Bank brand value resides in customer relationships, so discount brokerage is not a good fit for most banks. More of the "mass affluent" are seeing the need for financial planning and a holistic view of their financial needs. While less than 2 percent of bank broker/dealers currently have a CFP or other advanced designation, the expectation is that this percentage will rise as much as 20 percent over the next five years. Clearly the industry trend is toward financial planning and away from transactional business. Many reps are licensed to sell annuities and simple term life, but are not prepared for the more complex life products. Thus, many banks see the wisdom in hiring a dedicated life specialist.
For the same reasons, banks are pursuing agencies, top banks are striving to acquire brokerages to complete convergence's virtuous circle. In 2004, the top three bank brokerage programs in terms of brokerage revenues (primarily commissions from the sale and service of mutual funds and fixed and variable annuities) were $1.3 billion for Bank of America, $574 million for Wachovia and $485 million for J. P. Morgan Chase. North Carolina's BofA vaulted to the top spot with their 2004 purchase of FleetBoston, while Wachovia maintained their number two spot with their 2003 purchase of Prudential Securities.
However, thanks to scandal, increased regulatory scrutiny and disclosure requirements, it appears as though the pendulum has swung against small banks employing their own broker/dealers (series 7 licensed agents) as required to sell securities and variable products. More banks are transitioning back to the third party marketing firms who can make larger investments in technology as well as provide more compliance oversight. NASD audits are grueling multi-day affairs. Banks are unaware of potential surprises awaiting them, including customer complaints and possible NASD arbitration process, incurring additional liability.
Due to these increased burdens, the volume of business needed to achieve the critical mass necessary to offset these costs has grown dramatically. A standalone bank broker/dealer program probably needs between $40 million and $50 million in annual program revenue to make it worthwhile, while banks likely need $5 billion in assets in order to make this synergy make sense.
Marketing Agreements
Guardian Life has successfully stepped into the smaller bank niche and has dedicated life insurance agents to selling exclusively in bank branches. Guardian launched its bank program in 2002 focusing on smaller institutions ($2 billion in deposits or less) that lacked insurance programs. Their primary target is business customers and the emerging affluent. Guardian focuses on the process, providing a broad sweep of financial services to its customers which depend on which life stage they are in. They note that business sold through banks in this manner tends to have a higher persistency.
Guardian realized that they needed to create not only a strong relationship with their bank partners and their individual customers, but also with their commercial loan officers which prove to be more useful in providing leads than tellers. And it was important that the loan officer be confident that the agents would treat their customers and their customer relationships well. Guardian has been very successful in the credit union market where the customers identify and trust their credit unions and, due to their smaller size, have not typically developed their own internal programs or have the critical mass to do so.
It is not easy to go this route successfully. The consensus is that life insurance is too difficult for banks to sell. Agents that are comfortable selling one kind of product and making a good living see no incentive for expending the energy to take a risk to try something new. However, the same was once said about annuities and today banks are the leading distributors for some companies, including Hartford. Annuity revenue is currently about 15 times larger than the life revenues at the typical bank.
In order to make a successful transition, incentive structures must be applied. It is not enough to have overall production goals; they must be split out by category of product. A certain amount of life sales needs to be encouraged in order to get people over the threshold.
Specific branches are going to do better than others and usually this can be traced back to the activity and knowledge of a particular individual. Find out what they are doing to encourage productivity and see if that translates to other branches. It is important to create an awareness in the branch of the importance of making these referrals or even asking the question.
Research has shown that even in the best programs only 50 percent of a bank's customers are even aware that they can purchase insurance within the bank. Taking steps to increase that awareness through multiple marketing touches, both outside and inside the bank lobby, are very important to increase mind share and then wallet share.
Challenges Ahead
Perhaps the primary reason why mergers between banks and insurers ended up being non-starters is the difference in shareholder expectations between the two sectors. Banks earn an ROE of 15 percent and higher, whereas insurers plod along at 12 percent or lower. P/E ratios of typical insurers are 25 percent lower than comparable banks, making for immediate challenges. Projected synergies of bank and insurer mergers have apparently not been enough to convince directors and shareholders to overcome these hurdles, in addition to the normal risks associated with M&A.
Despite this setback, other strategies which effectively separated manufacturing and distribution grew in popularity. But technology continues to be an obstacle. The financial planning paradigm encourages consumers to take a holistic view of their assets, earnings and retirement needs. Agents can easily perform integrated needs assessments on laptop computers. Customers want an aggregated view of their bank, brokerage and insurance accounts. Leaders in integrated financial services will need to be able to bring real time information to bear on line. After five years of trying, very few providers have yet overcome this hurdle. Combining insurance, brokerage and banking information is far more difficult than it seems, to say nothing of being able to manage these accounts on line.
Although GLB broke the barrier, insurance regulation continues to be a maze of multi-state regulators. Although most large banks have multi-state operations and deal with multiple regulators, a bank association had already introduced a Bill in 1998 to come up with a two-track system-insurance companies and agents will have the option of being chartered and regulated at either the state or new federal insurance commissioner, similar to the dual chartering system that has existed for banks for over 130 years. Federal track regulation is still being battled by special interests of every size, shape and variety.
Finally, one cannot discount New York Attorney General Eliot Spitzer and his recent effect on the minds and actions of CEOs and boardrooms alike. Financial supermarkets are increasingly hesitant to have the captive distribution force push their in-house proprietary products at the expense of consumers and their financial well-being. How companies respond to this seemingly growing dilemma after all the years of preaching "one stop shopping" remains to be seen.
Conclusion
Bank distribution started small and still only encompasses 2 percent to 3 percent of overall life distribution, but banks are by far the fastest growing distribution channel for life insurance. This growth can be traced back to the more consultative approach driven by financial planning as opposed to transaction driven sales. Typically, there needs to be a champion on both sides of the equation: someone enthusiastic in the insurer about the distribution channel as well as somebody at a high level at the bank who serves as an internal champion supporting the insurance strategy. No matter which approach is taken, it is important to develop a strategic plan and meet regularly with the partners to gauge what is working, what is not and the extent to which things are going to plan.
Jim Toole, FSA, MAAA is the managing director of the Life & Health MBA Actuaries, Inc.
Laughton Sherman is the founder and CEO of LMC Capital, an investment banking firm dedicated exclusively to the insurance industry.