The sum of its parts?

The latest Basel committee proposals to force insurance subsidiaries’ equity to be financed with the parent’s Tier I capital poses a threat to the bancassurance business model, already wounded from high-profile failures. The increased cost of capital risks are obscuring the diversification benefits that were its strongest selling point, but the distribution advantages may yet provide a way out. Laurie Carver reports

The Basel Committee on Banking Reform had a message for the bancassurance industry in its long-awaited revisions to its latest regulatory guidelines: the party’s over.

The revisions, published in the committee’s consultative document, Strengthening the Resilience of the Banking Sector, in December last year, took aim at many aspects of the financial services industry, but one proposal could pose a threat to the bancassurance model that until recently was held up as the way to get the best from lenders and insurers.

Under the new proposals, banks’ investments in insurance companies incur a deduction in their regulatory capital “applied to the same component of capital for which [the investment] would qualify if it was issued by the bank itself.” In other words, equity held in insurance firms will have to come out of a bank’s own Tier I holdings.

This removes the loophole in the European Union (EU) Capital Requirements Directive (CRD) – the directive that implements the Basel II accord into EU legislation – whereby bancassurers can finance this equity partly with debt. Under a ‘national discretion’ clause, individual regulators can allow the capital deduction to be split across Tiers I and II, with the UK’s 50/50 split limit being typical. According to 2008 EU data, the most recently available, all the major EU economies except Italy and Spain had applied for national discretions.

“The purpose… is to remove the double counting of capital in the banking sector and… the wider financial system,” states the report. Aligning the tiers is supposed to counter the threat of further crises. “It will help ensure that when capital absorbs a loss at one financial institution this does not immediately result in the loss of capital in [the parent]. This will help… reduce systemic risk.”

The impact of the new proposal is estimated to cost European banks, or financial holding companies with insurance holdings, E27 billion (£24.3 billion) in capital, according to a report by Zurich-based Credit Suisse, quantifying the impact from Bank of International Settlements regulations. A stunning E12 billion was the estimated impact on the French life market’s second biggest life insurance player, Paris-based bank Credit Agricole, alone.

As banking groups tend to demand a higher return on equity than their insurance cousins, this would obviously severely impact on profitability. Coming on the back of several high-profile bancassurance failures in the crisis, the proposals – currently in a consultation period until April 16, ahead of final standards to be decided by the year’s end, and becoming binding in 2013 – are leading some to call time on the bancassurance model.

“The recently proposed regulatory changes will likely make it harder for a bancassurer to achieve as significant a diversification benefit,” says Jim Bichard, a partner in the insurance practice of UK consultancy PricewaterhouseCoopers (PwC).

Growth
Bancassurance had begun to boom in the 1970s and 1980s as continental deregulation abolished Chinese walls separating the business models, first in France, then Spain, the rest of Europe and the UK. Loud promoters of the business model saw the nature of life insurance and banking products as complementary: diversifying a firm’s market risk across the two investment profiles freed up capital to sell more products. A period of rapid mergers and acquisitions-driven growth followed in the 1990s and 2000s.

By 2004, bancassurers accounted for E179 billion in premiums Europe-wide, with E65 billion in France alone. They held 60% of the life market in France, Italy, Spain and Portugal, and half of Belgium’s. The two largest players in the French life market were the Paris-based CNP Assurances, distributing through two banking channels, and the life subsidiaries of Credit Agricole, which between them accounted for nearly 35% of the domestic life market.

Belgium had the Brussels-based trio of Dexia, KBC and market leader Fortis. The Netherlands had the $1.8 trillion bancassurance conglomerate, Amsterdam-based ING, which accounted for nearly a quarter of the domestic life market on its own.

Bancassurance plays a less significant role in the UK, but still accounts for about 20% of the country’s life business. London-based bank Lloyds TSB, now Lloyds Banking Group, bought Scottish Widows just before the millennium. Similarly, its Edinburgh-based rival Royal Bank of Scotland bought a series of property and casualty insurance firms and insurer Standard Life launched its own banking subsidiary.

The drivers for these decisions were not just pecuniary, it is a sign of how market sentiment has changed in a few short years; as a result of a number of mis-selling scandals across Europe in the 1990s, banks were perceived as more trustworthy than insurers. A 2005 report by French insurer Scor, for example, claimed that “life insurance products are generally long-term products, which require customers to have complete confidence in the institution that invests their money. And we now know that, in many countries, banks have a better image and are more trusted than insurance companies”. 

Contagion
This all changed in the meltdown of 2007–09. Bancassurers such as Fortis and ING saw their insurance operations dragged down by the actions of the banking side, a reckless banking parent or partner, and were forced to restructure as a condition of state aid (see Breaking up the Bancassurers, left). According to PwC’s Bichard, insurers are now falling over themselves to distance themselves from banking models.

“There is a risk of contagion. It complicates things to the extent that we have seen several European insurance companies be quite clear that they are not a bancassurer, and do not have the problems the banks do.”

Paris-based insurer Axa is a case in a point. It was keen to distance itself from the banking model in a presentation to analysts for its 2009 results. When a Bank of America Merrill Lynch analyst pressed for an approximation of their Solvency II solvency capital requirement (SCR), he was unconvinced by the inclusion of the firm’s value in force (VIF) securitisations in Tier I capital.

“How can that be? Tier I is defined as being immediately available to absorb losses at any point in time, [so] how can [VIF] be included in that?” Denis Duverne, a member of Axa’s management board giving the presentation, countered: “The insurance industry is not the banking industry. There is no liquidity issue. If you have losses in an insurance company, it doesn’t mean you need liquidity.”

Despite this, Axa has been expanding its bancassurance activities. It recently signed a joint venture with Bharti Axa, launching a partnership with Nashik District Central Co-operative to give it presence in India, and extended its partnership with Italian bank BMPS. This is in addition to a large Japan-based bancassurance programme, with 12 major distribution deals giving Axa a 3% Japanese market share in 2004.

But a spokesman was keen to stress the firm’s focus was on the distribution side, and not a move to position the Paris-based company as a bancassurer. “We do not think having a large insurer and a large universal bank on a single balance sheet is a good thing,” he says.

The sensitivity of the issue is reflected in the fact that, other than Axa, all the firms mentioned in this article, and the Basel committee, refused multiple requests for comment.

Attack
Patrick Fell, a director in the regulatory practice at PwC, sees the new proposal as a common sense move towards converging standards. “In the existing set-up there is a kind of arbitrage, where you can fund half of your equity investment in a subsidiary with Tier II capital. Equity should count as equity, whether it is in the banking business or an insurance subsidiary,” he says.

The change to the deduction requirements would seem to favour the partnership bancassurance model (see box below, What is a Bancassurer?), where the favourable distribution relationship can be kept without the group being penalised by a capital deduction. This is certainly the view of Axa, whose spokesman says “banks can be a good distribution network for insurance products. Basel III does not change this.”

The firm remains open to joint ventures, but accepts that Basel III may diminish the appetite of banks to play ball. “We’ll see how banks react, but we remain open to all kinds of bank distribution partnerships. Banks’ appetite for direct investment in insurance does not change anything about their clients’ need for insurance products.”

The changes may lead to consolidation, with more joint ventures and captives dissolving their capital entanglements and becoming partnerships, according to Alain Branchey, a senior director in Fitch Ratings’ financial institutions group in Paris.

However, he sees this as concentrated in the markets where the model has been less successful – the UK, the Netherlands and Germany. “It’s more likely that in the markets where distributing through banks makes sense, banks will do a lot to keep their captive bancassurance subsidiaries, even if it means divesting other businesses. We’ve see this with Dexia and KBC. Even Fortis Bank has kept the distribution agreements post-nationalisation.”

The 2013 implementation date is the same as Solvency II, whose design may favour bancassurers. “By necessity, the products they offer tend to be simple, and are backed with correspondingly low-risk assets that will have lower capital requirements,” says Marc-Philippe Juilliard, analyst at Fitch Ratings.

According to PwC’s Fell, large investment banks have already started to enlist the firm to look for ways in which product design can be altered to fit the different requirements of Solvency II and the CRD, although he will not give names and says it is too early to see where the opportunities will lie.

The risk to the bancassurance model is of being hit from two sides as the current conservative state of the calibrations could lead to tougher capital requirements for insurance subsidiaries and leave bancassurers struggling for core capital to shore them up.

“I don’t know if it’s a double whammy,” says Bichard, “but it definitely makes things more complicated, and might change the profitability of some of their products. The proposed changes look like they will be quite significant, and so will definitely have an impact.”

The combination of capital disincentives with enforced restructuring could leave the impression that the bancassurer model was being deliberately targeted by the supervisor. Not so, according to Branchey, who sees the regulatory changes as unrelated to the EU restructurings. “It’s not that the EU is hostile to bancassurers – the states just want their money back,” he says bluntly.

Not so dead
So with the capital incentives to marrying banking and insurance businesses disappearing, does this mean the end of the bancassurer? Not according to Branchey.
“Bancassurance as a model is independent of capital structure. We keep hearing: ‘bancassurance is dead’. No, it’s not. In some countries it makes sense to sell life insurance products through banks as they are the main distributors of these products – France, Belgium, Italy and Spain – whereas in others this is not the case – the UK, Netherlands, Germany and Switzerland. The fundamental reasons driving this haven’t changed over the crisis.”

This is borne out by the experience of the Belgian bancassurers. The restructuring of Dexia in February explicitly allowed its domestic bancassurance operations to survive intact, while KBC kept all its bancassurance subsidiaries. Fortis may have been nationalised and broken up, but BNP Paribas-Fortis and AG insurance have kept their predecessors’ exclusive distribution deal.
And with the UK’s Financial Services Authority overhauling the adviser remuneration system with its retail distribution review (RDR), bancassurance could be poised for a comeback in a market where it never fully took hold. The shift in commission responsibility from the provider to the policyholder will put a premium on the in-house distribution force at banks, which will be allowed to continue to be compensated by the bank.

“The big point is that bancassurers are better placed to make money from the mass market than pure insurers,” says Fiona Fry, a partner at consultants KPMG and head of its RDR team, although she also stresses the challenges to product design, distribution and regulation. “With the demise of the direct sales force, many insurers have become isolated from the consumers, while banks have a direct relationship with their customer base.”

Consumers essentially think financial services should be free – think of the outrage over current account charges – and now that they will have to pay upfront for advice rather than have the charge wrapped into a premium, the demand for IFAs will shrink, and their numbers reduce by perhaps 25–30%. “As a result, we should see more partnerships along the bancassurance lines,” says Fry.

Bichard sees the juggling of the two aspects – capital and distribution – as the crucial point. “There’s a trade-off here, with the risk-based capital on one side and the distribution advantages on the other.” 

 

Breaking up the bancassurers
The financial crisis spelled the end for some bancassurers’ existing business models, as EU competition rules meant governments insisted on their breaking up to repay state aid.
Amsterdam-based ING, a bancassurance conglomerate (see What is a Bancassurer?) with €1.3 trillion of assets under management, was forced to split its insurance and banking operations completely by 2013, after receiving €10 billion in support from the Dutch government.
Jan Hommen, the firm’s chief executive officer, admitted that although ING had been “a strong advocate for combining banking and insurance”, the crisis had made the bancassurance model untenable. “The combination [had] provided us with advantages of scale, capital efficiency and earnings stability through a diversified portfolio of businesses. However, the financial crisis… has made a split the optimal course of action.”

Brussels-based Fortis was nationalised to the tune of E16.8 billion by the Dutch and Belgian governments, with the banking arms in Belgium sold to Paris-based bank BNP Paribas, and the rest wound up. The remaining insurance group returned to a healthy E1.2 billion profit in 2009, while its flagship Belgian arm is being humbly rebranded as the uncapitalised ageas,
to show that “we don’t want to force our opinions on anyone”, according to the launching press release.

The other major Belgian players, KBC and Dexia, are also restructuring to pay off their state aid, but will keep their bancassurance subsidiaries largely intact. Dexia sold its holdings in its Italian, Spanish and Slovakian banking subsidiaries and is not allowed acquisitions until 2012. KBC will be obliged to reduce its balance sheet by 20–25%, but is expected to do so by divesting banking business, primarily in eastern Europe.

In the UK, Edinburgh-based Royal Bank of Scotland – now 71% owned by the UK government, with the possibility of that rising to 84% – will be required to sell off its property and casualty businesses, including Direct Line and Churchill, after failing to find a buyer even at knock-down prices in 2008. By contrast, London-based Lloyds Banking Group remains in control of its life subsidiaries, including Edinburgh-based Scottish Widows.

Edinburgh-based insurer Standard Life soured on bancassurance independently of any state aid or EU interference, by selling its banking arm to London-based Barclays Bank for £226 million in January, with its chief executive Sandy Crombie saying “we no longer believe increasing the lending activity of the bank is consistent with our long-term financial objectives”.

What is a bancassurer?
The term bancassurance is often used to describe any merger, partnership or acquisition involving an insurer and a bank, including conglomerate models (such as Amsterdam-based ING, with separate insurance and banking arms) and insurers’ banking subsidiaries (such as Paris-based Axa’s Axa Banque), but is more properly applied when the two businesses are integrated. This will typically involve insurance products being distributed through the bank and/or group capital, taking account of diversification in the two businesses’ investments. There are three principal types:

• Partnerships are when an insurance company enters into a distribution deal with a bank; this need not be underwritten by a single holding company, although one company may hold a stake in the other. The deal might be exclusive or not, the latter case being known as an open architecture partnership. Examples: London-based Lloyds Banking Group has a 100% underwriting-free stake in Edinburgh-based Scottish Widows; Paris-based Axa’s 12 Japanese bank distribution deals.
• Joint ventures involve insurers and banks taking stakes in a new insurance subsidiary, which distributes exclusively through the banks involved. Examples: Edinburgh-based Royal Bank of Scotland has a joint venture with UK insurer Aviva; Axa recently expanded its BMPS Italian joint venture.
• Captive insurers distribute their products entirely through a banking parent, paying commission while receiving management fees. Examples: wholly owned subsidiaries of banks such as Credit Agricole, Lloyds, or the former Fortis group (see Breaking up the Bancassurers).