Over the threshold: before banks will enter unions with insurers, ways must be found to reduce risks and maximize profit potential. (Life/Health: Banks in Insurance).

The expected rush of banks to affiliate with insurers has largely failed to materialize, despite the removal two and one-half years ago of barriers separating financial services firms with the passage of the Gramm-Leach-Bliley Financial Services Modernization Act.

Banks have been cautious about entering an industry that differs greatly from their own in terms of how business is sold and profits are generated. While banks have had success distributing annuities and mutual funds, these transactions are much less complicated than life insurance products. Life insurance sales typically involve longer-term relationships nurtured by an agent who provides direction to the consumer throughout the underwriting process.

Low Profits

Then there's the profit picture. Bank sales of annuities and securities have not translated into significant profits, even with a sales approach that is less "hands-on" than life insurance. Some experts point out that sales of these products only contribute about 2% to a typical bank's annual income, and sales of life and health insurance are significantly less than that. This may be due to a profit time horizon that is shorter for banks than insurers. As a result, banks focus on immediate distribution (commission) income, while "leaving on the table" significant money generated through underwriting profits that take longer to materialize.

There is also little incentive today for a bank to purchase a life insurer, since studies show the banking industry's return on equity has outpaced that of the insurance industry. Any acquisition could drag down the bank's performance and lower shareholder confidence.

Clearly, for banks to embrace life insurance and annuities as viable additions to their product portfolios, ways must be found to minimize the risks of entering the marketplace, while boosting the potential for profit. This can be accomplished by making it possible for banks to share in the underwriting profits without assuming all the risks of a product manufacturer. For example, as distributors, banks can negotiate the payment of a variety of bonuses that serve to partially transfer manufacturing profits from their insurance company partners.

Bonus Income

Persistency bonuses are common in the life insurance business and reward distributors for keeping business on the books. They are applicable to products accumulating cash or account values (such as universal life insurance and deferred annuities) and are often expressed as a percentage of the existing account value, which is a proxy for accumulated assets. The percentage typically varies based on the proportion of business that persists. Bonus compensation usually begins after the fifth policy year for universal life products, or after the surrender charge period expires for annuities. This occurs when both products begin generating meaningful profits and initial acquisition costs have been amortized.

Production bonuses, which have been used in the insurance industry for many years, pay a distributor more for selling more business. Insurance company profits tend to increase as the volume of sales increases (thus neutralizing fixed costs), and it would be appropriate for the insurance company to share some of these profits with the distributor that helped create them. This type of bonus compensation program could also be designed to coincide with a persistency requirement.

"Account- or asset-based trailers" are a form of persistency bonus often associated with annuities. They are a simple way to combine the benefits of persistency and production compensation programs. Distributors are given a variety of compensation options that include some proportion of up-front sales commission (percentage of initial premium) and renewal-year compensation (basis points of account value). The level of compensation is related to how much of the business was originally produced, how much of it persists in each renewal year and how many of the policies' account values have accumulated to specified target amounts. Typical trailer bonuses are in the range of 25 to 50 basis points.

Sharing the Risk

While these bonus compensation structures generate additional income to distributors of life insurance and annuities, they fail to provide the substantial advantages available from true risk-sharing relationships. For banks, one workable option is to establish a reinsurance captive and cede a portion of the business they produce for their insurers into that facility.

Banks that decide to take this important step are motivated by three factors. First, they believe strongly in the profitability of the life insurance and annuity business. They recognize the quality of the business because it is obtained from the same customer base that purchases their other products. As a distributor, their financial rewards are tied very loosely to the actual profits of the business. However, as a partial owner of the business, the bank shares in the profits or losses.

Second, banks that enter the reinsurance business understand the tax advantages of being a partial owner. All of the incentive programs discussed previously result in payments that must be treated as ordinary income. By being a reinsurer, banks participate in the profitability of the business they produce, and they also may receive favorable tax treatment on profits in the form of long-term capital gains. Of course, these banks are at risk for their portion of the business if conditions deteriorate.

Third, these banks have a strong desire to influence the product development process. Since they have a well-defined customer base that they have come to know from marketing other financial services, they have a clear understanding of the needs and desires of this target market. As a part owner of the life insurance and annuity business aimed at this market, they can play an important role in designing products that address specific needs and result in increased profitability.

The incentive for the insurer to reinsure a portion of the bank's business is the belief that aggregate profits on the business will be greatly improved, even though a portion of the profits will be shared. Tailoring products to the needs of the bank's customer base should boost the quality and volume of the business written.

Reinsurance Structures

The most common forms of reinsurance structures routinely used in the life insurance and annuity industry are coinsurance and modified coinsurance. The premise of reinsurance is that a portion of the risk is transferred from the insurance company partner to the reinsurer. In return for accepting the risk, the reinsurer either receives a reinsurance premium or is entitled to a portion of the underlying emerging profits on the business reinsured.

Under coinsurance, both liabilities and a corresponding amount of premium are transferred from the direct writer to the reinsurer. In one variant, "coinsurance with funds withheld," funds due the reinsurer remain with the direct writer. In effect, the insurer borrows back the funds from the reinsurer. A version called "coinsurance with a letter of credit," in which the reinsurer backs the liabilities it receives with a bank letter of credit, is used in cases where the reinsurer is not authorized to transact business in the jurisdictions of the insurer.

Modified coinsurance also involves transferring the risk to the reinsurer. The insurer retains the assets, however, and continues to show the reinsured liabilities on its books. This type of reinsurance benefits insurers because they maintain control over more of the funds generated by their own business, while keeping many of the attributes of coinsurance.

Choosing the Right Form

Coinsurance and modified coinsurance are typically used for life insurance and annuity business. Either form can be used for fixed account business, while the modified version is preferred for variable account business.

Depending on how taxes and expense allowances are structured, a bank reinsurer with a typical coinsurance or modified coinsurance agreement or treaty can expect to generate statutory profits that look like a proportionate share of the insurer's. This typically would include a loss in the first year, followed by small gains during the surrender charge period and larger gains if a reasonable amount of business persists beyond the surrender period. Under generally accepted accounting principles, the initial year losses are capitalized and amortized over a period of years, producing more level earnings. A key for the bank is to adopt the insurer's long-term view that accepts short-term losses in anticipation of profits emerging in later years.

By being a reinsurer, banks can successfully align their interests with those of the insurer. Both parties would have an incentive for business to persist that would help them achieve their targeted returns. Both also would benefit from an increase in sales volume, allowing expenses to be spread over a larger block of business.

Before entering the reinsurance business, however, there are several hurdles to clear. First are the initial start-up costs to establish the company and conclude treaties, including fees charged by advisers. Ongoing costs will be incurred to maintain operations of the new enterprise. It also will take time to negotiate and draft treaties, although this should decrease as the bank gains experience in the field. Regulatory factors also come into play, including approvals usually required by state insurance commissioners for reinsurance treaties.

More Dollars and Sense

Despite these short-term challenges, banks willing to extend their profit horizons can grow beyond their current role as distributors and position themselves to realize significant underwriting profits over the long term. Besides the financial benefits, these banks will gain first-hand experience in the life insurance industry, including how to carefully underwrite new business to generate favorable mortality experience, how to establish favorable persistency rates that boost profits, and how to manage underwriting, distribution and maintenance expenses that also affect the bottom line.

For a bank that plans to eventually become an insurer, the experience and confidence gained as a reinsurer could provide a distinct "leg up" on its less-well-informed competitors. It's an opportunity worth exploring.

Larry N. Stern is a fellow of the Society of Actuaries, where he served as chairman of the Product Development Section, and a member of the American Academy of Actuaries. His career in the life insurance and financial services industry spans 30 years.