Now that HR 10 is once again high on the post-Monica legislative agenda in Washington, conventional wisdom is predicting a flurry of deals between banks and insurers.
With legislative restrictions finally removed, industry convergence would probably accelerate. However, the path it takes may not be so conventional.
Banks that are thoughtful - as well as aggressive - acquirers will look before they leap.
Though banks have had the power to underwrite credit insurance products for years, for the most part they have not done so. But that might be changing. And some are looking at offshore reinsurance facilities as a next step.
However, this emerging interest should not be interpreted as a trend. And we have yet to see a stampede down the Travelers-Citicorp path.
The reasons are pretty clear.
In this age of focusing on quarterly earnings, an insurance acquisition would likely be dilutive - perhaps for a long time. The life insurance industry earns around 12% on equity, with property and casualty companies earning a bit more.
For example, Aegon reported that its recent purchase of Transamerica had been priced assuming a 9% unleveraged return. Contrast this with banks earning 15% to 17%, and you have some very real dilution issues.
Inefficient cost structures are largely responsible for the disparity. High distribution costs lead the way, but administrative and other infrastructure processes are also expensive.
CSC Continuum Inc. reports that North American life insurers spend about $45 billion to administer $2 trillion of consumer assets, though the mutual fund industry administers $3 trillion of assets for only $2 billion. These are not costs that easily lend themselves to cutting in a consolidation, particularly with a noninsurance partner.
Many so-called legacy systems could almost be considered poison pills to a noninsurance acquirer, and more than 70% of the industry still operates policy-driven, instead of customer-driven, data bases that often cannot even identify customers who have more than one policy.
As a result, the issue for banks might well be how much you have to spend on systems, not how much you can save. It seems clear that those who decide to acquire will probably be doing it for strategic reasons, not financial ones, because the acquisition economics of most bank-insurance deals are simply not strong enough to compel ownership.
What is compelling, however, are the economics of bank insurance distribution. Because of the strong competitive advantages in a very underserved consumer market, banks need to be in the business. Though there are many valid strategic reasons for equity ownership of an insurance company, there are also viable alternatives.
Many banks will find that a "virtual" ownership approach can achieve most of the strategic objectives without creating stock price dilution, high capital utilization, and the potentially greater earnings volatility that may accompany equity ownership.
Of course, ownership does have appeal. Insurance has an attractive and - in the case of life insurance - fairly predictable flow of premium income from policyholders.
Ownership also provides control over product design, service quality, and customer relationships. In many ways, in fact, ownership ultimately boils down to a control issue. But does it have to be equity ownership?
The concept of virtual ownership is built on the proposition that most, if not all, of a life insurance company's functional components can be "acquired" through outsourcing.
Many, in fact, can be acquired at much lower costs than are incurred by insurers in managing the functions. This also explains the increasingly robust third-party administrator market.
A bank could, for example, acquire a shell company to house the capital and business license and to retain selected functions where existing capabilities or scale can add value, such as distribution, asset management, and customer service. The rest can be outsourced without relinquishing control.
Actuarial firms will design and price products, professional service companies will underwrite and administer policies, and the entire book of business can be reinsured to transfer the risk in whole or in part - all according to the bank's wishes. The bank would "own" the company and control its processes but without the traditionally high cost structure and underwriting risks.
Of course, none of the above precludes acquiring one or more agencies as well.
Besides offering an established clientele, a distribution infrastructure, and business development activities, an agency could be the distribution platform for branded (or cobranded) third-party products, supplementing the bank's proprietary products.
The approach in this case would be reminiscent of banks' entrance into the mutual fund business by creating virtual investment companies and retaining asset management while outsourcing much of the rest to meet the appropriate regulatory definitions.
Through this structure, bank securities affiliates have been able to offer a full line of mutual fund products while also building their own mutual fund brand in the marketplace.
For many, a virtual combination of these businesses would be a logical next step and supply the basic ingredients for a true proprietary variable annuity product.
Understanding the corporate and product economics of the life insurance business is crucial in assessing a bank's post-HR 10 options.
For many, simple selling agreements will still be the right choice. For some, various forms of strategic alliances and joint ventures make more economic sense. For a few, ownership may offer the greatest potential for strategic reasons, and virtual ownership can make it palatable from a financial standpoint as well.
Judging from the number of companies who have asked us to serve as an "architect" and-or "general contractor" in creating the structure that suits them best, the bank insurance market is poised to heat up considerably.