US insurers are eyeing affiliations with banks in anticipation of financial services reform. Cynthia Crosson reports.

The US financial services industry is waiting for no one's permission to modernize. While legislators and regulators in Washington remain mired in debate over who will govern financial services in the next millennium, the banking, securities and insurance industries are positioning themselves to compete in the new world they see emerging.

Customer demands and competition from foreign financial services conglomerates that can freely underwrite and distribute insurance products have drawn a bull's eye around the Depression-era regulatory structure that separates banks from other industries, such as insurance. These forces - assisted by incremental reform through the courts and the Office of the Comptroller of the Currency - have precipitated a convergence of the three industries toward becoming a single industry that transcends product lines and national borders.

The fate of H.R. 10 - the Financial Services Modernization Act of 1998 - is far from certain. Even if the measure makes it out of Congress, it is vulnerable to a Presidential veto. Treasury Secretary Robert Rubin has said that President Clinton would veto a bill that is not sufficiently friendly to the banking industry.

A matter of control

The regulatory dispute centers on control. The issue is who will have primary control over the activities of the operating subsidiaries within a bank holding company structure. The financial services organizations envisioned under reform legislation include banks, insurance companies and securities firms, all of which now have their own regulators. These regulators, which include the Federal Reserve Board under chairman Alan Greenspan, the Treasury Department under Mr Rubin and the insurance commissioners of the 50 states, have been locked in a turf battle, with periodic concessions keeping the bill alive.

H.R. 10 envisions separate insurance and banking affiliates underneath the bank holding company. The bank holding company would be regulated by the Fed, which also would oversee the activities of the insurance affiliate and any other non-bank affiliates.

Treasury would regulate the bank affiliates, as happens now, but it would have no jurisdiction over the insurance or other non-banking affiliates.

Mr Rubin wants more control over these non-banking activities and wants the bank affiliate to be able to have an operating subsidiary that can conduct them. State regulation of insurance underwriting would continue in either case.

Citicorp-Travelers sets deadline

The planned Travelers-Citicorp merger announced earlier this year promises to keep Congress and the regulators focused on resolving these and numerous other issues. It is a direct challenge to the regulators and Congress and has, in essence, given them a deadline for passing legislation.

The transaction, which is due to close by the end of the year, is not legal under current law. It will be effected by a merger of Citicorp into the Travelers group. Travelers would then apply to the Board of Governors of the Federal Reserve System to become a bank holding company and request a two-year grace period under the bank holding company act. The company could then apply for three one-year extensions. That is why the legislators are seen as having five years to get something done, even if H.R. 10 does not survive.

Before the Travelers-Citicorp announcement, others in the industry had taken a more circuitous route around Congress, seeking a thrift charter from the Office of Thrift Supervision. This would allow them to conduct most banking activities without the need for new legislation.

Industry change spawns new strategies

Despite the seemingly endless legal wrangling in Washington, the rapid pace of change in the market is forcing insurers to take a hard look at their competitive positions in relation to banks and determine whether it is sustainable.

Insurers currently enjoy distinct competitive advantages through protections that are vulnerable to legislative change. For example, they are the only participants in a bank-insurance partnership that can legally manufacture insurance products. Under H.R. 10, banks would be allowed to underwrite insurance products through a separate insurance arm, and eventually they may be able to underwrite insurance directly. Would banks still need the insurance company as a partner if that happened?

In addition, some of the most popular insurance products have tax advantages that make them extremely attractive to bank customers. They are, therefore, also vulnerable to legislative changes, as we have seen in the case of variable annuities and corporate-owned life insurance - products that currently provide the industry with significant growth. Congress and the Clinton administration have repeatedly attacked the tax advantages of these products in the search for additional revenue.

Products and technology are key

How can insurers stay strong in the face of these legislative threats? They must focus on the competitive advantages they can control, and these generally will be advantages derived from one or more core competencies. They also must focus on what banks are looking for in insurance partners. Banks generally want simple products geared to the middle market. Insurers with strong product-development expertise can tailor products to the bank market by providing easy-to-understand products that require minimal underwriting. Technology can help companies do this profitably by incorporating underwriting software for term life products, for example, that can reduce the time it takes to make the sale from weeks to minutes.

Insurers that can deliver a high level of service to the bank and its customers through high-quality, high-tech systems that provide 24-hour service and rapid processing and fund transfers may have a sustainable advantage - particularly since the investment required to develop these systems is a barrier to entry.

The assumption of risk and the management of the capital required to back insurance liabilities also could be a competitive advantage for insurers that have a better understanding of the unique nature of insurance liabilities. It also may be that a bank simply would not want to hold the capital required to support the products, because it could not get the return required by investors.

Asset management offers opportunities

Asset management is another area in which an insurance company may provide value. Insurers that hold and manage their own assets are generally more profitable, because they are not giving up fee income to outside managers. Of course, if the performance is not there, the companies may be better off paying an outside manager.

The ability to sell proprietary annuities through the bank channel is also a potential advantage, although few insurers offer the brand-name, high-performing funds that banks are seeking. MassMutual, with its Oppenheimer Fund subsidiary, is a notable exception.

An insurer does not have to be strong in all areas. The bank partner may be particularly interested in the administrative systems capability, for example. If the insurer can deliver this while maintaining profitability and competitive pricing, it stands a good chance of being a leader in this market.

Commitment to true partnership

To succeed in any of these markets, however, insurers have to make a significant commitment of capital and resources and be willing to push through cultural change within their organizations to ensure a true partnership with banks. Most insurers are reaching banks through third-party marketers, thereby avoiding the need to carry out the internal change that is needed to reach the bank market successfully.

Third-party marketers also add a layer of cost and keep banks at arm's length at a time when they are increasingly interested in developing direct relationships with one or two primary carriers and a few subordinate carriers. The banks have the same need for revenue as insurance companies do, and they are reluctant to give up fee income to third parties. Such companies as Hartford, the leading writer of annuities through banks, are exceptions because of their scale. Hartford sells in a quarter what many companies sell in a year, and this scale enables it to operate profitably through a third party. It also is a significant barrier to entry to would-be competitors.

A true partnership with banks cannot happen unless insurers include them in the decision-making process at all levels. Some insurers have set up bank divisions in their organizations, but the bank partners still can be overruled by proponents of existing distribution channels. This could be an important issue for insurers that are not set up to deal directly with banks - or with the middle market, for that matter.

Reinsurers, which have faced slow growth and do not have the cultural baggage of the traditional direct insurers, also are making inroads into the bank market. In some cases, they have been able to approach banks seeking to offer insurance products and act as an intermediary with a direct writer. The reinsurer may be able to tailor products to the bank market and provide simplified underwriting systems for term life products, for example, which enables the banks and the insurance companies to sell the product profitably.

Since the bank cannot underwrite the insurance directly, it needs a direct insurer. The reinsurer provides the link with the direct writer and then reinsures the business that is written. LifeRe and Lincoln National are examples of companies exploring this opportunity.

This strategy can be a win-win situation for all involved. In addition, if legislation is passed allowing banks to underwrite directly, the reinsurers still would be well positioned to provide their service.

Cynthia Crosson is a senior financial analyst at A.M. Best Company.