Financial Update (October-December 1999)
Banks Selling Insurance: Risky Business?
by Michael Padhi, economic analyst
ommercial banks traditionally earn income from interest derived from loans (minus the interest paid for deposits) as well as non-interest income related to loans and deposits such as monthly fees on checking accounts. Banks can also generate income through various bank-permissible activities that go under the name "nonbanking." Some examples are selling mutual funds, underwriting municipal bonds and credit insurance, and selling insurance.
This article looks at bank holding companies (BHCs) engaged in the nonbanking activity of insurance sales. (BHC underwriting of insurance is not discussed.) Banks and BHCs have been increasingly involved in insurance agency activities and may become more involved, depending on the passage of financial modernization legislation. This article reviews the laws governing bank insurance sales, rationales for and public interest in such sales, and the impact insurance sales might have on bank safety and soundness. It also presents recent data on BHC insurance agency activity.
Banks in Insurance Sales
Various state and federal banking regulations and state insurance regulations govern the extent to which banks and BHCs are able to engage in insurance sales. A banking company may engage in insurance sales directly, through an operating subsidiary or through a subsidiary of the bank's holding company. General insurance agency powers (those beyond credit-related insurance) can be granted by federal banking regulators under certain circumstances, such as to agencies in small towns (under 5,000 persons), to a BHC having under $50 million in assets and to banking companies that have grandfathered insurance sales powers.
Why would a bank want to sell non-credit-related insurance? First, the incremental costs of selling insurance can be small. The insurance agency arm of a banking organization can occupy a portion of existing facilities. Second, a bank can take advantage of existing customer relationships to generate insurance sales. Third, engaging in insurance sales allows revenue diversification. Unlike net interest income from traditional banking activities, fee and commission income from insurance sales is not subject to interest rate risk. The different risks of insurance and traditional bank products may reduce variability in profits. Finally, consumers may prefer the convenience of buying bank and insurance products from the same institution.
Bank Safety and Soundness
Banks and consumers aren't the only parties with an interest in bank insurance sales, however. Because the public provides banks with an explicit and implicit safety net, the public has an interest in the effect insurance sales would have on the safety and soundness of banks. Several studies regarding the effect of bank insurance sales have generally concluded that such sales would not increase banks' risks.
Data on Insurance Agency Subsidiaries of BHCs
Data on the performance of insurance agency subsidiaries of bank holding companies can give some insight into their most recent returns, size and capital levels.
Profitability and Capitalization. From 1987 to 1998, BHC-owned insurance agencies earned a higher average return on assets than their affiliate banks while also maintaining a much higher average level of capitalization than their affiliate banks. In general, agencies controlled by small BHCs have higher returns and capital levels than agencies controlled by large BHCs.
Risk. While one might assume that higher average returns and capital levels would improve a bank's safety and soundness, these measures may not adequately indicate the risk an insurance agency adds to or subtracts from a bank holding company. High capital levels may merely be a function of higher risk faced by the agency, and high average returns do not necessarily reduce risks if the returns are highly volatile. Other ways to gauge risk would be to compare the relative variation of agency and bank returns and to measure the correlation between agency and bank returns. A higher variation in agency returns and a positive correlation between agency and bank returns indicate higher risk; a negative correlation indicates that the agency lowers risk via a smoothing effect so that when bank profits go down, agency profits tend to go up.
During the 1987–98 period, agency profits varied less than bank profits. In addition, there was a negative correlation between returns for insurance agencies and bank affiliates of small BHCs. For large BHCs, however, the correlation was positive. Insurance agencies tended to lower holding companies' risk, although this tendency was less apparent for large BHCs than for small ones. (Bank insurance agency returns, however, were more variable than the entire insurance agency industry returns between 1987 and 1995.)
Sixth Federal Reserve District. Data for insurance agency subsidiaries of Sixth Federal Reserve District bank holding companies show agencies had higher average returns, capital levels and variation in returns relative to the national data. Correlation between agencies and affiliate banks of Sixth District BHCs was negative, suggesting that these insurance agency subsidiaries have had a smoothing effect on returns of their BHCs.
Other Trends. The number of BHCs with insurance agency subsidiaries has been on the rise nationally and in the Sixth District, particularly in 1998. Whether these insurance agency subsidiaries lower or raise risk, they account for less than 1 percent of the assets of their bank affiliates nationwide and only 1.62 percent of Sixth District bank affiliate assets.
There are other important and complicated issues involved in permitting banks to expand their insurance powers: tying arrangements and coercion; the fairness of permitting transfer of safety-net subsidies by allowing banks or operating subsidiaries, instead of BHC affiliates, to sell insurance; application of Community Reinvestment Act requirements to bank insurance activities; and the permissibility of insurance underwriting.
However, bank insurance sales should not pose significantly greater risks for a well-managed bank holding company. Recent data and research on BHC involvement in insurance agency activities seem to support this belief. These results, however, should not be interpreted to mean that insurance sales by banks provide no other threat. As banks become more involved in insurance sales, management risks could rise because of the need to attend to both insurance sales and traditional bank functions.
2Variability is measured by the coefficient of variance of aggregate returns between 1987 and 1998. Coefficient of variance = standard deviation/mean x 100%.
3Correlation = covariance of agency and bank returns/(standard deviation in bank returns x standard deviation in agency returns). Correlation has a range of –1 to +1 where –1 means perfect negative correlation and +1 means perfect positive correlation.
4Agencies controlled by bank holding companies that have less than $1 billion in bank assets.
5Agencies controlled by bank holding companies that have more than $1 billion in bank assets.