BANCASSURANCE

Bancassurance
Nadege Genetay and Philip Molyneux

palgrave
macmillan
© Nadege Genetay and Philip Molyneux 1998
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To our families
Acknowledgements

This book was inspired by doctoral work conducted in the University

of Wales, Bangor, and is the fruit of continuing collaboration between
a doctoral student and her former supervisor. In the course of the
original doctoral research, three individuals were most helpful in
giving insights and comments and hence had a direct input to this
book; these include Mrs Margaret Brown from University of Wales,
Bangor, Professor Richard Maeve, London School of Economics, and
Professor Ted Gardener, University of Wales, Bangor. Their help was
most appreciated. Special thanks are also due to Professor Keith
Hoskin and Ms Pam Edwards (both UMIST). Maureen Simmons,
who did a fantastic job indexing this book, went beyond the call of duty
by pointing out errors in the text. We thank her for her attention to
detail. It goes without saying that we bear the burden for remaining
errors.
Thanks also to other colleagues from the School of Accounting,
Banking and Economics at the University of Wales, Bangor, the
Institute of European Finance, Bangor, and the Manchester School of
Management at UMIST, who were most supportive of this project.
Finally, we would like to thank our families and loved ones for their
support and encouragement while working on the text, especially,
Nidal (unfortunately a Chelsea supporter), Delyth and the children.

The authors and publishers are most grateful to the following organ-
isations and authors who kindly gave permission to use copyright
material: Addison-Wesley Longman Ltd; A. Steinherr, A.M. Best,
Banque et Strategie, Elsevier Science, Houghton Mifflin Company,
Kluwer Academic Publishers, McGraw-Hill Publishing Company,
OECD, Swiss Re.

Every effort has been made to trace all the copyright holders, but if
any have been inadvertently overlooked, the publishers will be pleased
to make the necessary arrangements at the first opportunity. .

vi
Contents

List of Tables xiii

List of Figures xv
Preface xvii

1 Introduction 1

2 Evolution of the Bancassurance Concept 4

Introduction 4
2.1 The concept of bancassurance 4
Banking and insurance: differences
and similarities 5
Differences between banking and insurance 5
Similarities between banking and insurance 6
Definition of the bancassurance concept 7
Historical developments of bancassurance 10
2.2 Evolution of the demand for financial services 13
Demographic changes 13
Trends in savings patterns 16
Increasing customer awareness 19
2.3 Evolution of the competitive environment
in the financial services industry 21
Changes in the competitive environment of banks 21
Evolution of the competitive forces in
the banking industry 21
Profitability trends in banking 26
Changes in the life insurance industry 28
The growth patterns in the life assurance market 28
Competition in the life assurance industry 31
The new face of distribution in life assurance 33
2.4 The success of bancassurance 36
The extent of the bancassurance phenomenon 36
Barriers to success in bancassurance 38
Customer resistance 38
Choice of organisational structures 39
Cultural conflicts in bancassurance 40

vii
viii Contents

(Jeneral insurance 42
Conclusion 43

3 Bancassurance in the United Kingdom 44

Introduction 44
3.1 Regulatory changes in the United Kingdom 44
The Financial Services Act (1986) 45
The Building Societies Act (1986) 48
3.2 Major bancassurers in the United Kingdom 51
The precursors 51
TSB (Jroup 52
Barclays Bank 54
The second tier bancassurers 56
Lloyds Bank 56
Midland Bank 57
Britannia Building Society 58
National & Provincial Building Society 59
Woolwich Building Society 59
Royal Bank of Scotland 60
Recent additions to the bancassurance scene 61
National Westminster 61
Abbey National 62
The very latest bancassurers 62
~surbanque' in the United Kingdom 63
3.4 Main features of bancassurance in
the United Kingdom 65
Modes of entry in bancassurance 65
Organisational structures 67
Distribution: the key to success in bancassurance? 68
Main channels of distribution in bancassurance 68
Managerial efforts to achieve distribution synergies 69
Conclusion 70

4 Bancassurance in Europe 72
Introduction 72
4.1 Bancassurance in France 72
French bancassurers in the life sector 72
(Jeneral insurance 77
French bancassurance environment 79
4.2 Bancassurance in (Jermany 80
(Jerman bancassurers 80
 Contents ix

German bancassurance analysis 82

4.3 Bancassurance in Italy 82
Italy's bancassurers 82
Italian bancassurance development 84
4.4 Bancassurance in the Netherlands 85
Dutch bancassurers 85
Analysis of Dutch bancassurance 88
4.5 Bancassurance in Spain 89
Spanish bancassurers 89
Analysis of Spanish bancassurance 91
4.6 Bancassurance in Europe: a cross-country comparison 92
Country-specific factors in the bancassurance trend 92
Entry routes in different European countries 94
Level of bancassurance integration in Europe 95
Conclusion 96

5 The Theory of Corporate Diversification 97

Introduction 97
5.1 The nature of the corporate diversification
process 98
Categories of diversification strategies 98
Classification of corporate diversification strategies 98
Rumelt's specialisation ratio 101
Entry vehicles 104
Entry through internal development 104
Entry through acquisition 105
Sequenced entry 106
Organisational structures 107
Vertical differentiation 107
Horizontal differentiation 108
5.2 Theoretical rationale for conglomerate
diversification 108
Agency theory 110
Profitability of target 113
Synergies 115
Financial synergies 117
Risk-reduction motive 119
5.3 Empirical evidence 122
Testing various hypotheses of corporate
diversification 122
Methodology 122
x Contents

Results 123
Testing the performance of related and
unrelated diversification 126
Methodology 126
Results 129
5.4 Applicability of corporate diversification
literature to bancassurance diversification 129
The nature of the process of bank
diversification in insurance 130
Theoretical motives for bancassurance diversification 130
Growth in size 131
Profitability of life insurance 133
Synergies 133
Financial motives 135
Risk reduction 136
Conclusion 137

6 Review of the Empirical Studies on Bank

Diversification and Risk 138
Introduction 138
6.1 Background to corporate diversification 138
6.2 Bank risk and diversification: studies that
use actual bank experiences 139
6.3 Bank diversification and risk: studies that
use hypothetical business combinations 141
Variance-covariance analyses 145
Portfolio simulations 146
Merger simulations 154
6.4 Data issues 164
Market versus accounting data 164
Return measures 168
Risk measures 170
Industry weighted and unweighted averages 176
6.5 Literature appraisal and its applicability to
bancassurance and risk 178
Bank diversification and risk: studies using actual
bank experiences versus hypothetical combinations 178
Studies using hypothetical combinations:
portfolio versus merger simulations 180
Applicability to the research question 184
Conclusion 185
 Contents xi

7 The Risk Effects of Bank Diversification into

Bancassurance 187
Introduction 187
7.1 Methodology 187
Methodology 188
Risk and return measures 189
Return 189
Standard deviation 190
Coefficient of variation 190
Z-score 191
Industry statistics 192
Accounting for life assurance 194
Industry structure - mutual and composite insurers 194
Reporting practices 195
Designing proxies for life insurers' performance 198
Data 202
Banking sample 202
Life assurance sample 203
7.2 Descriptive statistics of sample firms 205
Sample firms as a percentage of total population 205
Asset growth and profitability trends 207
Sample performance 209
7.3 Results 214
Hypothetical industry 1: Building Societies-
mutual Insurers 215
Hypothetical industry 2: Building Societies-
proprietary life insurers 216
Hypothetical industry 3: Commercial banks-
mutual Insurers 216
Hypothetical industry 4: Commercial banks-
proprietary life insurers 217
Conclusion 219

8 Regulatory Issues 221

Introduction 221
8.1 Regulatory trends in the financial services industry 221
8.2 State of regulations regarding bancassurance 224
Regulations pertaining to production 224
Regulations pertaining to distribution 225
Regulations pertaining to ownership 226
EU regulations pertaining to bancassurance 227
xii Contents

8.3 The rise of regulatory concerns 232

Competition 232
Consumer protection 233
Risk of double gearing 234
Risk of contagion 236
Transparency and authority for supervision 238
8.4 Other regulatory issues 239
Conclusion 240

9 Conclusions 242

Bibliography 244
Index 262
List of Tables

Table 2.1 Growth rates of premium volumes and

mathematical reserves from 1980 to 1990
in six countries 17
Table 2.2 Customer awareness in the United
Kingdom 1981-91 19
Table 2.3 Awareness of investment schemes by
age in the United Kingdom (in %) 20
Table 2.4 Savings banks in Europe 1992 24
Table 2.5 Commercial banks: net interest income in
various countries (in %) 27
Table 2.6 Distribution of life assurance in five
European countries 1989/1990 35
Table 2.7 Percent of life insurance distributed
through banks 38
Table 2.8 Organising appropriately: some choices
and challenges 40
Table 3.1 Modes of entry of UK bancassurers 66
Table 4.1 French bancassurers in the life insurance sector 73
Table 4.2 Major French bancassurers' market shares 1992 76
Table 4.3 Commissions and expense ratios of French
life insurers 1991 77
Table 4.4 German bancassurance links 80
Table 4.5 Italy's bancassurance links 83
Table 4.6 Netherlands' bancassurance links 86
Thble 4.7 ING insurance distribution channels 1995 88
Table 4.8 Spanish bank-insurance link-ups 89
Table 4.9 Entry routes in various European countries 95
Table 5.1 Main characteristics of various organisational
structures 109
Table 5.2 Studies that test various hypotheses of
corporate mergers 124
Table 5.3 Studies of performance of related and unrelated
diversification strategies 127
Table 6.1 Studies using actual bank experiences 142
Table 6.2 Event studies on bank diversification in
non-bank lines 144

xiii
XlV List of Tables

Thble 6.3 Studies using hypothetical business combinations 165

Table 6.4 Advantages and disadvantages of studies using
actual experiences and studies using hypothetical
combinations 179
Thble 6.5 Main characteristics of portfolios and merger
simulations 183
Table 7.1 Sample retail banks and building societies 203
Table 7.2 Sample life insurers 205
Thble 7.3 Total assets held by sample building societies
in 1992 (societies-only) 206
Table 7.4 Share of world-wide ordinary premium income
of sample firms in 1992 206
Table 7.5 Average size at year end 1988 and 1992
and evolution 207
Table 7.6 Yearly return on assets of sample firms over
the period 208
Table 7.7 Risk and return characteristics of sample firms
and differences between the subsamples 209
Thble 7.8 Correlation between returns of banking
institutions and life insurer (1988-92) 214
Thble 7.9 Number of firms in the four simulated industries 215
Table 7.10 Risk-return characteristics of the simulated
mergers - comparison with banking firms on
a standalone basis. 216
Table 8.1 Regulations pertaining to the distribution
of banking and insurance products in major
economies 226
Thble 8.2 Ownership regulations of bancassurance 227
Table 8.3 EC Directives in the banking sector 228
Table 8.4 EC Directives in the insurance sector 229
List of Figures

Figure 2.1The bancassurance continuum 10

Figure 2.2Matrix of strategic choices in bancassurance 10
Figure 2.3The evolution of bancassurance 11
Figure 2.4Percentage of the population above 65 in
12 EC countries 14
Figure 2.5 The model life cycle of private households 16
Figure 2.6 Share of life insurers' mathematical reserves
in the financial assets of private households
in 1980 and 1990 18
Figure 2.7 Model of the competitive forces in
the banking industry 22
Figure 2.8 Gross premium growth in various countries
(index 100 in 1990) 29
Figure 2.9 Direct life premiums as a percentage of GDP
from 1990 to 1995 30
Figure 2.10 Structure of premium volumes of life assurance
business (1990) 31
Figure 2.11 Percentage of new individual life premiums
distributed through Banks 1989 37
Figure 3.1 Personal financial services - the regulatory
framework 46
Figure 3.2 The main provisions in the Building Societies'
Act (1986) 49
Figure 3.3 Organisational restructurings at TSB 53
Figure 4.1 Bancassurance integration in Europe 95
Figure 5.1 Growth vectors in diversification 100
Figure 5.2 Stages of corporate growth and development 100
Figure 5.3 Assigning diversification categories 102
Figure 5.4 The multidivisional structure 110
Figure 6.1 Efficient frontier, iso-impairment and debt
capacity schedule 159
Figure 6.2 Efficient frontier and adjustment for debt
for First Pennsylvania 173
Figure 7.1 Example of Form 9 of returns to the DTI 201
Figure 7.2 Risk-return trade-off of subsamples using
standard deviation of returns 212

xv
xvi List of Figures

Figure 7.3 Risk-return trade-off of subsamples using

coefficient of variation 212
Figure 7.4 Risk-return trade-off of sample firms using
Z-score 213
Figure 7.5 Return-standard deviation positions of the
simulated industries 217
Figure 7.6 Return-coefficient of variation positions of
the simulated industries 218
Figure 7.7 Return-Z-score positions of simulated industries 218
Figure 8.1 Trends in financial markets 223
Preface

Universal banking has long been the norm in Germany and Switzer-
land, but it was not until the EU's 1992 banking legislation was fully
incorporated into domestic banking law that universal banking prac-
tices were permitted across EU countries. The type of model that has
evolved and which now dominates European banking has some simil-
arities but also some differences from long-established German and
Swiss models.
Traditionally, universal banking in Germany and Switzerland was
characterised by bank domination of capital market firms, as well as
widespread shareholdings in industrial and other non-financial firms.
The latter is still much less common in other European banking
systems.
In contrast, universal banking in other European banking systems
refers to commercial banks being able to provide a wide range of
financial services - banking, insurance and securities - under one roof.
Barriers between different types of financial service firms become
increasingly irrelevant, protected franchise values are eroded and
competition intensifies across the whole spectrum of the financial
services industry.
The largest European banks have fully embraced universal banking,
buying securities firms and investment banks as well as acquiring or
establishing substantial insurance activities. To date, the majority have
predominantly focused on cross-selling savings-related insurance and
pensions products to retail customers. Some of Europe's largest
insurers have also sought to establish bank links by buying stakes and/
or encouraging mergers (as with Store brand and Christiana Bank in
Norway).
The largest German and Swiss banks have also moved more in line
with the EU-impelled definition of universal banking. Over the last
two years, they have sought to reduce their equity holdings in
industrial and other concerns, and they have also placed greater
emphasis on forging stronger links with the insurance sector. This
process has been accelerated by structural adjustments in the Euro-
pean banking market which have been impelled by preparations for
European Monetary Union (EMU).

xvii
xviii Preface

Many of the trends in Europe are apparent, to differing degrees, in

other banking markets. The reorganisation of the Japanese market
is expected to promote a rush of bancassurance deals and unleash
various forces which attempt to inject credibility, soundness and
competition into the domestic financial services industry. Similarly, the
erosion of US Glass-Steagall regulations is also attempting to achieve
the same ends in the United States - namely allowing commercial
banks access to investment banking and insurance business.
The trend is towards the establishment of the universal banking
model as the global norm. A critical element of which relates to banks
undertaking insurance business. The main aim of this text is to provide
some insight into the evolution of the bancassurance concept and the
risks and returns associated with this type of activity.

Nadege Genetay Philip Molyneux

Manchester School of Management Institute of European Finance
UMIST University of Wales
Manchester Bangor, Gwynedd
M601QD LL572DG
1 Introduction

1.1 BACKGROUND TO THE STUDY

Banking markets have experienced a general trend towards con-

glomeration in recent years, which has been facilitated by the deregu-
lation of banks' activities in most Western countries. A particular
feature of financial conglomeration has been the diversification of
banks into insurance activities, and especially life assurance. This has
been labelled 'bancassurance', using a term pioneered in France where
this strategy has been particularly significant. Although many Euro-
pean banks have become actively engaged in the bancassurance
strategy through acquisitions, joint ventures and de novo entries, there
has been little empirical evidence on the performance ofthis strategy.
The need for further research has been emphasised by a member of
the executive board of the ING Group:

Banks and insurers have in common that financial intermediation is

at the heart of their production process. ( ... ) What happens if these
processes are brought together in one financial services group?
( ... ) What is the resulting risk profile of a merged financial services
group? We have made this choice and we are convinced that we now
have better possibilities to spread risks and to control them. But we
would welcome contributions in this field from the research side.
(Holsboer, 1993, p. 397)

This book has two main objectives. One is to provide a comprehensive

review of the concept and market characteristics of the bancassurance
phenomenon. This book reviews the main developments of this
strategy and how the concept of bancassurance came to be a topic of
study in its own right. 1 It also undertakes a thorough review of ban-
cassurance in the United Kingdom and in five European countries:
France, Germany, Italy, the Netherlands and Spain. An attempt is
made to analyse the reasons behind the varying developments of
bancassurance in these countries. Given the significance of banks' in-
volvement in life insurance rather than general insurance, we chose
to focus on the former. However, we also recognise the potential
significance of the latter strategy.

1
2 Bancassurance

The second aim of this book is to investigate the risk effects of bank
diversification into life assurance, with an empirical focus on the
United Kingdom. Our methodology simulates the risk and return
characteristics of a hypothetical industry, composed of combinations
of specific firms from both industries. We include building societies in
our analysis, because they have been active participants in the ban-
cassurance strategy, as well as mutuals who are major players in the
life assurance industry. Theoretical precedents to our framework come
from the US literature, where various studies have investigated the
risk effects of bank diversification in nonbank activities generally. This
book hopes to evaluate whether bancassurance increases bank risk or
whether there are some risk-reducing benefits to this strategy. This has
been a subject of debate in the literature (Knauth and Welzel, 1993).
Our review of the US literature suggests some consensus as to the
existence of diversification effects in the combination of banking and
life assurance activities. This is one of the few activities where the
findings are consistent among various studies. It suggests that life
assurance may be a desirable area of bank diversification.

1.2 STRUcruRE PLAN

This book is divided into nine chapters. Chapter 2 describes the

evolution of the bancassurance concept, as well as the likely factors
that have contributed to its emergence in Western markets. We examine
conflicting definitions of the bancassurance concept, and some of the
characteristics of the financial markets that are likely to have influ-
enced this strategy. Against this background, Chapter 3 focuses on the
bancassurance market in the United Kingdom and summarises some
of the key aspects of this strategy, including the importance of regu-
latory factors and practical implementation of this strategy. This
chapter also outlines the history and characteristics of major UK
bancassurers. Chapter 4 undertakes a review of five major European
financial markets: France, Germany, Italy, the Netherlands and Spain.
All have been affected by the bancassurance phenomenon to a varying
degree. We examine the development of major bancassurers in each
country and provide an analysis of the differences between various
countries' bancassurance developments.
Chapter 5 reviews the theory of conglomerate diversification and
theoretical motives for this strategy. This analytical framework is put
into perspective to analyse the bancassurance trend. Chapter 6 reviews
 Introduction 3

the empirical studies that have investigated the relationship between

bank diversification in nonbank lines and risk in the United States.
This is the support for our empirical study of the risk effects of bank
diversification into life assurance in the United Kingdom. The data,
methodology and findings of this empirical study are shown in Chapter
7 while Chapter 8 provides an outlook on the aspects of financial
regulation relevant to the bancassurance trend. Finally, Chapter 9
provides a conclusion.

Note

1. Unconvinced readers should be made aware that there are university

degrees in bancassurance in France (Daniel, 1995).
2 Evolution of the
Bancassurance Concept

INTRODUCTION

The 'bancassurance' catchword has been a topic of interest for analysts

of the financial services industry in recent years. It has become so
prominent in financial markets that Elkington (1993) suggests that this
French expression will soon take its place in the Oxford Dictionary. In
this chapter, we undertake a comprehensive analysis of what is bancas-
surance and the factors that have prompted the development of this
strategy.
In Section 2.1, we analyse the concept of bancassurance. First, we
examine differences and similarities between the business of banking
and insurance, both in theory and practice. Second, we attempt to
define the widely used expression of bancassurance. Finally, we exam-
ine the historical development of this concept.
In Section 2.2, we examine the demand factors that have influenced
the development of bancassurance. We relate the changing behaviours
of retail customers to two major interrelated factors: demographic
trends and changes in savings patterns.
In Section 2.3, we examine the competitive environment facing
the banking and insurance industries over the last decade. Section
2.4 investigates the extent of the bancassurance phenomenon. Here
we identify some organisational barriers to success in bancassurance
and examine the bancassurance evolution in the general insurance
field.

2.1 TIlE CONCEPT OF BANCASSURANCE

A common argument in the field of bancassurance has been that

banking and insurance have differences but also conceptual similar-
ities that help to explain the bancassurance phenomenon. In practice,
bancassurance has been defined in various ways; these are linked with
the historical development of bancassurance.

4
 Evolution of the Bancassurance Concept 5

Banking and insurance: differences and similarities

Although banking and insurance have often been differentiated, both

activities have a common feature, which is that they are part of the
financial services industry. Some authors have tried to show that sim-
ilarities between the two businesses go beyond this obvious feature
and that the demarcation line between the two activities is less obvious
than is commonly thought. They also show that in practice, differ-
entiating between banking and insurance products can be problematic.

Differences between banking and insurance

Banks traditionally had the monopoly on delivering means of payment
whereas insurance companies exerted a monopoly on products linked
to a contingency. Therefore, an important distinction between the
business of banking and insurance is that the latter depends more
directly on contingencies. The claim event, be it in general or life
insurance, is independent of anybody's control. In the case of life
insurance, the event - death - is certain but not the time of occur-
rence, which is beyond the policyholder's or insurer's predictions
(Gumbel, 1991).
An important distinction between banking and insurance that has
been made in the literature is that banking is generally more short-
term oriented than is insurance. Delporte (1991) argued that the
separation line between the two activities springs from their nature:
banks take short- and medium-term savings while insurers take long-
term savings and insure possessions. Moreover, both businesses have
different specialisations: insurance companies are in the business of
handling risk, and the handling of money (investment of technical
reserves) is a byproduct of their main function. Banks, on the contrary,
manage funds (Levy-Lang, 1990). This is particularly obvious where
credit insurance is concerned, an activity that is closely related to both
businesses: banks grant credit and insurers guarantee default risk
(Bastin, 1990). The deposit-taking institution requires the borrower to
take out credit insurance in order to avoid bearing the risk of default;
on the contrary, the insurance institution bears the credit risk for the
borrower policyholder.
The traditional view therefore underlines that banking deals with
payments, especially short- and medium-term funds, and risk avoid-
ance while insurers bear risk and manage long-term funds. This per-
spective suggests a clear separation line between the two activities.
6 Bancassurance

Similarities between banking and insurance

Some authors have nevertheless questioned the traditional view con-
tending that banking and insurance are different. They emphasise the
similarities between the two businesses, often as a means to promote
the idea that banks could produce insurance and vice versa. Insurance
in its broadest sense was defined by Arrow (1971) as a set of risk-
shifting activities. Lewis (1990) used this definition to show that
financial intermediaries and banks in particular, can be viewed as a
form of insurance. Lewis derived a model of the insurance nature of
banking for four main types of banking activities: retail, wholesale,
international and off-balance sheet. On the retail side, Lewis (1990)
emphasised the intermediation function of banks, to which lenders of
funds delegate their monitoring of borrowers' attributes. This function
is based on information gathering and processing. Banks also perform
a 'maturity transformation' function that solves the mismatch of
lenders' and borrowers' decisions, whereby funds are lent for shorter
periods of time and borrowers can obtain funds over longer periods.
Under direct financing, these decisions must match. The intermedi-
ation process, Lewis (1990) argued, provides financial security to both
parties. If the lender of funds finds himself short of liquidity, he can
withdraw his funds, in effect making a claim against the bank. This is
not unlike a policyholder making a claim after suffering a burglary. In
fact, banks provide a guarantee to lenders that they may withdraw
their funds at par and short notice, and protect borrowers against
interest rate fluctuations or premature repayments.
Lewis (1990) then explained how banks are able to give these
guarantees. He argued that they take advantage of economies of scale
in portfolio management, which arise from the law of large numbers.
The pooling of deposits means that withdrawal becomes independent
of other withdrawal decisions. Insurance economics rely on the law
of large numbers, which states that the expected loss distribution
approaches the true loss distribution as the sample grows (Cummins,
1991). This enables insurance companies to pool individual reserves to
protect against adversity. Similarly, banks provide the insurance of
financial security for their clients; the insurance premium is reflected
in service charges and the spread between interest rates on loans and
deposits (Lewis, 1990).
Levy-Lang (1990) argued that insurance companies undertake some
form of funds management (a banking attribute) through the invest-
ment of their technical reserves. This function brings them closer to
banking, especially in life insurance.
 Evolution of the Bancassurance Concept 7

Gumbel (1990) summarised the affinities of banking and insurance

as follows. Both operate with reserves, rely on the law of large num-
bers, use economies of scale, and have expertise in administration and
money management. They create liquidity and assume a risk-spreading
function through reinsurance or refinancing.
The theories of banking and insurance therefore contain a number
of similarities that contradict the traditional distinctions between the
two businesses. Practice supports this assertion. Endowment policies
have long been a means for UK home buyers to repay the capital
element of their policies. In 1988, 83% of mortgages were financed in
this way as opposed to straight repayment mortgages (Butt, 1989). In
France, most bancassurers experienced growth through capitalisation
products, originally single-premium policies, which are very similar to
time deposits (Pitt, 1990). Although these products have been clas-
sified as insurance, they are in direct competition with traditional
banking products. As insurers have developed more products with
shorter maturities, savings have become a focus of competition for
banks and insurance companies.
Another similarity between banking and insurance is that they often
relate to the same purchase. They are in a sense complementary, if not
similar. Banks require their borrowers to insure against various risks,
including death, unemployment and property damages. These guar-
antees become an inherent component of the loan that is granted.
Both banking and insurance products provide means of savings and
insurance.
In general, banking and insurance have more in common that their
separation might suggest. The traditional view is that banks handle
funds and insurers take risks. However, funds management and risk-
bearing are clearly features of both types of activities. Banking and
insurance rely on the pooling of resources to protect financial secur-
ity (banking) or protect against adverse events (insurance). In prac-
tice, some insurance products are really savings vehicles. Moreover,
banking and insurance are often complementary, as is the case for
mortgages that require credit and property insurance. Bancassurance
appears therefore a natural outlet for both businesses to diversify.

Definition of the bancassurance concept

Many definitions have been attached to bancassurance since it has

become an area of interest. The following attempts to clarify what is
meant by the bancassurance concept.
8 Bancassurance

Hoschka (1994, p. 1) provided the following definition of bancas-

suranCe:

This trend towards bancassurance or Allfinanz refers primarily to

banks entering the insurance sector by offering insurance products
to their retail customers.

Huizinga (1993), executive director for lNG, the Dutch financial

conglomerate, offered a pragmatic insight into this concept:

Allfmanz is distribution.

The above definitions of the bancassurance concept focus on dis-

tribution and cross-selling. They do not encompass the underwriting
aspects of insurance in relation to distribution and do not define the
relationship to the insurance counterpart either.
In contrast, some analysts have restricted the definition to integ-
rated institutions, where there are capital links between insurance and
banking activities. Chatillon, president of the French Association for
Credit Institutions, for example, defined bancassurance as (ll"ibune de
l'Assurance, 1993, p. 6):

It is a business strategy - mostly initiated by banks - that aims at

associating banking and insurance activities within the same group,
with a view to offer these services to common customers who, today,
are mainly personal customers.

Similarly, Elkington (1993, p. 2) defined bancassurance as:

Bancassurance is basically the provision of and selling of banking and

insurance products by the same organisation under the same roof.

These two definitions underline the integration of the two activities in

a single entity, instead of focusing solely on the distribution aspect of
bancassurance.
Leale-Green and Bloomfield (1994) argued that the definition of
bancassurance differs from one institution to another as well as from
one country to another. They proposed this broad definition (p. 16):

( ... ) the provision of a complete range of financial services, prim-

arily to the individual, through the union of traditional banking,
insurance and investments.
 Evolution of the Bancassurance Concept 9

The advantage of this definition is that it does not preclude specific

links between insurance and banking.
The broader definition was provided by Swiss Re (1992, p. 4):

As a rule, bancassurance can be described as a strategy adopted by

banks or insurance companies aiming to operate the financial ser-
vices market in a more or less integrated manner. In practice, the
term 'bancassurance' is consistently used to describe a new strategic
orientation of financial institutions in private customer business.

And they went on to summarise the view of bankers and insurers

(Swiss Re, 1992, p. 4):

Both of these sectors understand the term 'bancassurance' to mean

first the interlinkages of different financial services and second the
distribution of these products.

Swiss Re (1992) also underlined the confusion surrounding the term

'bancassurance', as well as close substitutes that are used inter-
changeably, such as allfinanz, finanzia globale and assurbanque. All
the different meanings that have been attributed to bancassurance
illustrate the fact that this strategy can take multiple forms. In fact, we
would argue here that broader definitions of bancassurance are better
suited to recent developments where the demarcation lines between
the insurance and banking industries have become blurred. Overall,
Swiss Re's definition (1992) appears the most appropriate to this
strategy. It illustrates a new orientation of financial institutions, that
consists of grouping all financial (banking and insurance) needs of
their customers, instead of focusing on product lines. Morgan (1994)
argued that a proper approach is one whereby financial institutions
can be placed along a continuum denoting the degree to which they
have moved towards bancassurance. The ultimate stage is where an
insurance company and a deposit-taking institution co-exist within a
common structure (holding company) but also integrate their strat-
egies. Morgan's continuum is shown in Figure 2.1 from the deposit-
taker's point of view.
A similar analysis is made by Vaquin (1990). He described the
development of bancassurance along two dimensions: the degree of
integration and product profile (life or general insurance).
Figure 2.2 illustrates the various stages of bancassurance integra-
tion. The matrix suggests that the ultimate bancassurer controls the
10 Bancassurance

Figure 2.1 The bancassurance continuum

No No ties (deposit Tied (insurer Holding company

insurance _ taker independent) _ independent) _ (full bancassurance)

Source: Morgan (1994), p. 155.

whole process of production and distribution of life and general in-

surance products. However, the simple distribution of life assurance
products by a bank can also be termed 'bancassurance'.
The above suggests that the concept of bancassurance differs from
one observer to another. This is because the integration of insurance
and banking can vary from a simple distribution agreement to some
type of capital link between the two activities. The degree of inte-
gration of the two activities determines the extent to which an insti-
tution can be regarded as a bancassurer. The historical development
of this concept may explain the lack of consensus regarding the exact
meaning of bancassurance, as we will see in the next section.

Figure 2.2 Matrix of strategic choices in bancassurance

General
3 --------~~ 4

Life
---------------~~ 2

Distribution Vertical integration

Production

Source: Vacquin in Banque et Stratigie, No. 65, 1990, p. 10.

Historical developments of bancassurance

Although bancassurance has been subject to academic scrutiny only

recently, banking and insurance operations have been combined
for decades. In Belgium, CGER (Caisse Generale d'Epargne et de
Retraite), in Spain, Caixa of Barcelona, and .in France, CNP (Caisse
 Evolution of the Bancassurance Concept 11

Nationale de Prevoyance) have provided banking and insurance ser-

vices since the nineteenth century (Daniel, 1995). Despite this, it is
only recently that observers have realised the existence of this concept
and the fact that the two services can be complementary. To under-
stand the way in which bancassurance has developed, we will borrow
the framework used by Daniel (1995). He provided an analysis of how
'bancassurance' products have evolved, which reflects the way the
concept of bancassurance itself grew. The analysis by Daniel is based
on the French market with reference to other European countries. We
believe this is appropriate to examine the emergence of bancassurance
as France has been a major proponent of this strategy. Daniel divided
the evolution of bancassurance products into three periods. In the first
period, prior to 1980, banks sold insurance guarantees that were a
direct extension of their banking activities. After 1980, savings prod-
ucts that benefited from advantageous tax regimes associated with life
assurance flourished in the banking markets. Around 1990, the supply
of insurance products by banks became much more diversified not
only in terms of life but also general insurance products.
Figure 2.3 illustrates the diffusion of bancassurance over time.

Figure 2.3 The evolution of bancassurance

1980 1990

Products
*
Extension of Savings products *Diversification of supply:
banking classified as life pure life and complex
assurance financial products

In the first period, products sold as a direct extension of banking

activities were not associated with insurance. For example credit
insurance has been an inherent feature of consumer credits and other
loans in France. This type of contract was not generally regarded as
bancassurance. The joint sale of credit and insurance in Spain, how-
ever, is relatively scarce. Therefore, one should really see such prod-
ucts as the outcome of the bundling of banking and insurance.
Moreover, most banks require that their clients buy buildings in-
surance when they apply for a mortgage. In France, banks have taken
little advantage of this opportunity to act as intermediaries for such
policies. Conversely, in Great Britain, building societies and banks
have been traditional intermediaries for home insurance, to the point
12 Bancassurance

that it is divided between buildings insurance, usually sold by the

banking institution, and contents insurance, whereby clients insure
through a company of their choice. Other areas where guarantees
have been offered as a direct extension to banking have been in the
context of account openings in the 1960s and 1970s. For example, new
accounts were tied to guarantees that provided for the payment of
funds in the event of the accountholder's death. Consumer associ-
ations in France started to protest against the inclusion of some in-
surance services that were imposed on consumers. In other European
countries such auxiliary contracts to banking operations were also
frequent, for example in Belgium and Spain (Daniel, 1995). In Italy,
insurance coverage for thefts at the point of withdrawal has been
widely offered by banks. Daniel (1995) argued that the period up
to the 1980s constituted a learning experience for banks and their
salesforce. Although the insurance products involved were relatively
basic, they allowed a progressive familiarisation with the concept of
insurances.
The second period distinguished by Daniel (1995) started around
1980, when banks began developing fmancial products of a very
different nature, in what is considered as the true emergence of
bancassurance. This is when banks started exploiting capitalisation
products, i.e. endowment contracts, whereby a lump sum is repaid
after a fixed-term period. Despite the existence of an insurance ele-
ment, it was an auxiliary factor to the savings objective of these prod-
ucts. In fact, this period saw the generalisation of bancassurance in
France, but some observers have noted that these products were in
direct competition with banking rather than insurance products (Pitt,
1990).
The third period that was identified as crucial in the development
of bancassurance by Daniel (1995) was the end of the 1980s. Ban-
cassurance had generated the interest we have already discussed and
banks tried to exploit more synergies between the two activities. They
started innovating, moving away from the very basic products they had
supplied until then. Banks offered products that responded to cus-
tomers' needs but required some amount of financial engineering on
their part. These included unit-linked and investment-linked policies
that came under variable-life insurance arrangements. These policies
were pioneered by UK insurers in the 1960s. In parallel with ban-
cassurance innovation, banks also started selling pure life assurance
products (Daniel, 1995). In other European countries, this period also
marked the emergence of a much more diversified line of insurance
 Evolution of the Bancassurance Concept 13

products by banks, for example in Spain where bank branches started

to sell whole-life insurance policies (Daniel, 1995).
The above broad overview of bancassurance development appears
to be appropriate for a number of European [mancial markets,
although there are differences across countries. The second phase in
particular, where capitalisation savings-like products were introduc-
ed, has been emphasised in a French context more than any other.
Morgan et aJ. (1994) attributed the difference between the develop-
ments of bancassurance in France and the United Kingdom to the
emphasis of French banks on developing such products rather than
pure insurance products. Nevertheless, developments in the French
market appear representative of the product evolution that raised
interest in the bancassurance strategy.
This overview of the bancassurance concept underlines the various
forms of bancassurance, which in practice has varied from simple
distribution agreements to capital links between the two activities. The
degree of integration between the two activities seems to be the best
way of defining a true bancassurer. It has varied as bancassurance has
grown in importance, embracing both the distribution and production
of insurance over the years. The evolution of bancassurance led to
what is now a fairly diversified offering of banking and insurance
products by a single institution, i.e. a customer-driven approach to the
delivery of financial products.

2.2 EVOLUTION OF THE DEMAND FOR FINANCIAL

SERVICES

The demand for retail [mancial services has experienced fundamental

changes in recent years that can be attributed to three major factors.
First, demographic changes in Western populations have created dif-
ferent needs for retail banking services. Second, savings patterns have
changed, due to different economic conditions. Finally, customer
awareness has generally increased, forcing banks to offer more com-
petitive and sophisticated products than they did in the past.

Demographic Changes

The importance of demographic changes in shaping the demand for

retail banking has been acknowledged by a variety of researchers
(Gardener and Molyneux, 1990; Lafferty, 1991; McGoldrick and
14 Bancassurance

Greenland, 1994; Hoschka, 1994). We examine the demographic

trends in developed economies and their consequences on the demand
for financial products.
The most significant demographic trend in Western countries in
recent years has been the decline in population growth rates and the
associated population ageing. A major reason for this evolution is the
decrease in birth rates. The dramatic increase in life expectancy in
developed economies due to advances in medical care and better
living conditions has also contributed to ageing (Hoschka, 1994). As a
result, the dependency ratio, that is the number of retirees that must
be supported by the working population, is set to rise dramatically.
Projections by the DECD (1992) forecast an increase in the de-
pendency ratio from a current level of 21 % to 37% by 2030 in the EC.
Figure 2.4 shows some of the statistics relating to the evolution of
the population over 65 years of age in selected European countries.
Statistics for Europe show that the proportion of population above

Figure 2.4 Percentage of the population above 65 in 12 EC countries

25,0

20.0

15.0

[I] 1980
10,0
. 1985
0 1990
5.0 . 1994
.2000(E)
o 2020(E)
0.0
CD ~ u.. (!) II: g: ...J Z 0- CI) ~
0 (!) ::l

Notes: B: Belgium, DK: Denmark, F: France, G: Germany, GR: Greece, IR:

Ireland, I: Italy, L: Luxembourg, N: NOIway, P: Portugal, S: Sweden, UK:
United Kingdom.
Source: Euromonitor (1993), p. 28.
 Evolution of the Bancassurance Concept 15

65 years has risen from 8.7% in 1950 to 12.4% in 1985 and it is

estimated that this proportion will rise to 18.4% in 2025 (CPA, 1989).
The natural outcome of these demographic trends is an increasing
burden on the national pension schemes of those countries that pro-
vide government pensions. The economic implications of such trends
are tremendous: if the German pensions system were to remain in its
present state, the tax levels needed to support it by 2030 would have
to rise from 18.5% to 42% (Lafferty, 1991). Accordingly, various
incentives have been put into place by governments in order to en-
courage investment in personal pensions. In the United Kingdom, for
example, prior to 1988, personal pensions were restricted to the self-
employed and those in non-pensionable employment. In 1988, the
British government introduced new rules which provided incentives to
individuals wishing to contract out of SERPS (State Earnings Related
Pension Scheme) or to replace an occupational scheme. Besides this
important change in 1988, individuals were permitted in 1987 to set up
freestanding additional voluntary contributions (FSAVCs) outside
their company pension schemes (McGoldrick and Greenland, 1994).
Similar government incentives have been instituted in various coun-
tries to relieve the strain caused by these demographic changes
(Hoschka, 1994).
In addition to pensions plans, the ageing of the population provides
a strong marketing tool for life insurers. The increased longevity of
women and the fact that they live on average longer than men implies
that the need for financial security in households where the man is the
main wage-earner is growing. This argument is frequently used by life
insurers who base their advertisements around the theme of 'ensuring
financial security for your family' (Hoschka, 1994). Swiss Re (1993)
analysed the financial demands of households in terms of their life
cycles. Figure 2.5 illustrates the evolution of these needs. The report
argued that insurance savings are for the most part intended as pro-
visions for old age. As a consequence, the ageing of the population
provides a considerable source of growth for these types of savings
products.
Demographic trends suggest that populations, in particular in
Europe, are ageing considerably. The most obvious consequence of
this trend is that the working population will have to sustain more
retirees; in tum this should imply an increasing reliance on personal
pension schemes. In parallel to these pensions schemes, various life
insurance products which ensure that financial security is provided for
all family members in their old age have become more widespread.
16 Bancassurance

Figure 2.5 The model life cycle of private households

-- -- ---
/-C;~ital accumulation
/',' I capital
I liquidation
...........
.......... .

___ --.1-/,' capital requirements

Time
Expenditure to maintain
standards of living
6<Hi5
Income from work retirement age
Retirement annuities

Source: Swiss Re, Sigma no. 3/93.

Trends in savings patterns

Savings patterns have changed dramatically in recent years, due both

to demographic changes and to higher prosperity and higher expec-
tations of standards of living. As a consequence, demand for long-
term, high-yield financial savings is increasing. In addition, a growing
emphasis on capital markets investment has rendered sophisticated
instruments more attractive than low-yield bank deposits (Lafferty,
1991). Low inflation rates have also made long-term investments more
secure and have contributed to boost longer-term contractual savings
such as insurance, to the detriment of short-term deposits. Thus,
savings are being moved out of bank deposits into life insurance
products, especially unit-linked and individual pensions, that often
carry fiscal advantages for policyholders (International Financial Law
Review, 1991).
Swiss Re (1993) undertook an analysis of the growth of life insurance
from 1980 to 1990 in selected economies. Both premium growth and
growth in mathematical reserves were considered. The former meas-
ures new business as opposed to business in force, while the latter
measures the provisions which insurance companies retain to ensure
that past and present claims are met in the future. Swiss Re (1993)
argued that the nature of mathematical reserves ensures that the path
of growth is more consistent. Over a long period, however, both
growth rates are expected to converge. Table 2.1 shows the growth of
 Evolution of the Bancassurance Concept 17

Table 2.1 Growth rates of premium volumes and mathematical reserves from
1980 to 1990 in six countries

Country Growth * in premium Growth * of mathematical

volume (1980-1990) reserves (1980-1990)

United States 7.4% 6.8%

Japan 10.4% 15.5%
United Kingdom 10.1% 9.2%
France 14.8% 17.3%
Germany 4.6% 7.7%
Italy 14.4% 11.1%

• average annual inflation-adjusted growth rate.

Source: Swiss Re, Sigma no. 3/93.

premium volumes and the growth of mathematical reserves over the

period 1980-1990.
A striking feature of Table 2.1 is that there are significant differ-
ences in the way both measures approximate growth over the period.
Swiss Re (1993) suggested that differences for Japan and France are
related to the fact that premiums slowed down in 1989 and 1990. In
Germany, the historical significance of life insurance may help to
explain why mathematical reserves have apparently grown more rapid-
ly. The discrepancy observed in Italy, conversely, can be explained by
the dynamism of the emerging life insurance market. Both measures
suggest, however, that there has been a considerable growth of life
insurance markets in all countries observed, especially in France and
Italy.
These results are difficult to interpret in terms of their relative
growth compared with other forms of savings. However, mathematical
reserves can be measured against the financial assets of private
households to estimate the share of life insurance in private household
savings (Swiss Re, 1993). Figure 2.6 shows the share of life insurance
in household savings in 1980 and 1990.
Figure 2.6 suggests that the share of life insurance in household
savings has increased in all six countries over the period reviewed.
France, Japan and Italy showed an impressive increase of the share of
life insurance in total savings, although in Italy, the share remains
quite modest. Swiss Re (1993) suggested that the share of life insurance
in US savings increased because of a modest savings ratio, despite
sluggish growth in the life assurance market. FinaIly, UK life insurers,
18 Bancassurance

Figure 2.6 Share of life insurers' mathematical reserves in the financial assets
of private households in 1980 and 1990.

In%
16.0
14.0
12.0
10.0
8.0
6.0
4.0
o 1980
2.0 • 1989
0.0
en
::I
c
III
Co
.
~
::I
.
CD
(.)
>-
C
III
2:-
~
• 1990

C
III
'")
£!! E
"-
II.. CD
(!l

Source: Swiss Re, Sigma no. 3/93.

who had a substantial share of the savings market in 1980, managed to

increase this ratio to more than 15% by 1990.
There has been a noticeable shift of demand towards longer-term
savings in the last decade. However, this trend has also been encour-
aged by the innovative ability of insurers who have seized upon the
growing need for more flexible products than were provided by tra-
ditional life insurance. Unit-linked policies under which units of
investments are allocated for each premium paid are a notable example.
These products emerged against a background of rising markets at the
beginning of the 1980s and their emphasis was on short-term perform-
ance rather than long-term payments (O'Neill, 1993). This illustrates
how changing savings preferences have influenced the supply of
financial services.
Demographic and economic changes have prompted households
to shift from short-term deposits to longer-term savings. In most
economies, life insurance savings have grown considerably, at the
expense of other forms of savings, including traditional bank short-
term deposits.
 Evolution of the Bancassurance Concept 19

Increasing customer awareness

In parallel to the above savings trends, customers have become in-

creasingly aware and active in managing their money (Clarke et al.,
1992). McGoldrick and Greenland (1994) reported an analysis by
Pinpoint Analysis Ltd, using information from the 1991 Census that
shows changes in the financial awareness of customers in the United
Kingdom. Table 2.2 shows the changes in customer awareness between
1981 and 1991.
Table 2.2 clearly indicates a substantial increase in the degree of
financial information of households in the United Kingdom from 1981
to 1991. Moreover, the proportion of financially active households
increased while the proportion of passive households dropped.
Middleton (1987) attributes these behavioural changes to three
main factors:
1. The alteration of attitudes to money during the runaway inflation
of the 1970s and 1980s.
2. The effects of the industry's advertising and media efforts on
consumers' financial education.
3. Governmental efforts to encourage and facilitate personal sector
investments, in both equity markets (through privatisations pol-
icies) and pensions.
Inflationary pressures made consumers aware of alternative savings
instruments and thereafter they found that in non-inflationary periods,
they could turn to longer-term investments (Lafferty, 1991). In the
same way, the heavy advertising expenditures of non-bank financial
providers, especially during the 1980s, started bringing home the idea
that alternative instruments could be the recipients of private house-
holds' money (Middleton, 1987). According to Farrance (1993), the

Table 2.2 Consumer awareness in the United Kingdom 1981-1991

1981 1991

Financially active 18% 24.3%

Financially informed 23% 41.1%
Financially conscious 23% 18.7%
Financially passive 28% 15.8%

Source: McGoldrick and Greenland, Retailing of Financial Services, copyright 1994,

McGraw-Hill with kind permission from McGraw-Hili Publishing Company.
20 Bancassurance

Table 2.3 Awareness of investment schemes by age in the

United Kingdom (in %)

16-24 25-34 35-44 45-64 65+

Backing interest-paying current 42 53 48 30 28
account
Bank deposit account 40 50 49 48 43
Building society account 58 75 68 71 61
National savings 27 35 31 29 25
TESSAs 17 24 24 25 18
Personal equity plans (PEPs) 6 14 13 13 8
Shares 17 27 21 22 18
Unit trusts 9 13 19 19 9
Investment trusts 4 8 10 11 6
Personal pension 35 45 44 34 14
None of these 22 15 9 13 22

Source: McGoldrick and Greenland, Retailing of Financial SeTVices, copyright 1994,

McGraw-Hili with kind permission from McGraw-Hili Publishing Company.

emergence of a 'middle-age' society is likely to accelerate this demand-

side discriminating behaviour. In fact, surveys indicate that this strand
of society is the most aware of investment opportunities. Thble 2.3
shows the percentage of each generation aware of investment schemes.
Table 2.3 suggests that the awareness of customers is particularly
vivid in the 25-44 range. This is in accord with Farrance's (1993)
comments on the 'middle-age' society. These layers of the population
are also those most likely to have started families, purchased property,
been exposed to important advertising campaigns as well as govern-
ment incentives to promote long-term savings.
Another aspect of consumer awareness relates to increasing con-
sumerism with the emergence of more consumer bodies of official and
semi-official standing that are defending the rights of financial cus-
tomers (Farrance, 1993). In the United Kingdom these include or-
ganisations such as the National Consumer Council, Office of Fair
Trading, ombudsmen and consumer associations. In other countries,
similar consumer associations have also emerged. Some countries
have passed legislation to encourage banks to disclose more informa-
tion about their savings and investments products (Daniel, 1995).
These measures have forced banks to disclose more information on
the pricing of their services.
The last decade has seen the emergence of a much greater customer
awareness in the financial services industry. Various factors have
 Evolution of the Bancassurance Concept 21

contributed to this increasing sophistication, including the emergence

of consumer groups and substantial marketing and advertising by
financial service providers. This increased consumer awareness, along
with technology advances and deregulation, have also increased the
level of competition in the provision of financial services.
Demographic, social and economic factors have prompted retail
customers to become more demanding financially. In particular, it
appears that retail customers have been keener to move their short-
term bank deposits into higher yield savings instruments. There has
been a shift from supply to demand-led banking and financial services
business (Clark et al., 1988).

2.3 EVOLUTION OF THE COMPETITIVE ENVIRONMENT IN

TIlE FINANCIAL SERVICES INDUSTRY

In this section, we use Porter's (1980) framework to review the main

competitive forces that have affected the financial services industry in
recent years. The general increase in the degree of competition in the
financial industries has been a crucial determinant in the emergence of
bancassurance.

Changes in the competitive environment of banks

Porter's industry analysis (1980) identifies five main competitive

forces: rivalry among firms, threat of new entrants, threat of substitutes,
bargaining power of suppliers and bargaining power of customers.
These factors encompass crucial elements of change in the competitive
environment of banks, which have been accompanied by shrinking
profit margins in many European systems from the mid-1980s on-
wards. The general recession, experienced first by the UK economy in
the late 1980s and then throughout Europe in the 1990s, reduced bank
net interest margins and forced banks to depend more on non-interest
income as a source of income (see EC Commission, 1997). These
trends have significantly altered the structure of European banking
markets.

Evolution of the competitive forces in the banking industry

Porter's (1980) five main forces that influence the level of competition
in an industry are shown in Figure 2.7. This shows the strategic
22 Bancassurance

Figure 2.7 Model of competitive forces in the banking industry

- Foreign banks
Rivalry - Non-bank financial
among firms
- Retailers

Rivalry
Consumerism among Consumerism
Multibanking existing Multibanking
firms
- Depositors - Consumerism
- Capital markets - Multibanking
-Increased
sophistication

Rivalry - Insurance products

among - Capital markets
- New products

Source: Model adapted from Porter (1980).

pressures that can be induced in the banking industry by a variety of

competitive forces. These are discussed below.

Rivalry among firms The level of competition among banks has

gradually increased in recent years. This is due to a combination of
factors, including technological innovation, structural deregulation
and socio-economic change. The broadening of the product bases of
financial institutions has resulted in a greater variety of FSFs (financial
services firms), operating in a more competitive environment. There is
now a whole range of FSFs ranging from conglomerates to specialists,
agents and franchisers that undertake either universal banking busi-
ness or aim to fill market niches. This increased competition has
forced banks to change their traditional supply-led business, which
enabled retail bankers to lock-in passive customers through their
branch network (Gardener and Molyneux, 1990). Kessler (1987) calls
this the 'intensive stage' of banking production, where market shares
must be gained from competitors. The over-saturation of the market
means that banks have had to find new ways to attract customers: this
has led to the increasing use of marketing concepts in order to fully
exploit market potential; this evolution is Il;nalysed by Clarke et al.
 Evolution of the Bancassurance Concept 23

(1988). There has been an increasing trend towards the cross-selling of

services to specific market segments, which has led banks to adopt
relationship-pricing techniques, whereby they offer customers pre-
ferential prices when they use several services (Gardener and Moly-
neux, 1990).

New entrants Widespread deregulation in the financial sector has

suppressed some of the barriers to entry into the banking market.
Three main types of new entrants can be identified: foreign banks,
non-bank financial institutions and retailers. The level of penetration
of these new entrants has varied from one national market to another,
but there are similarities in the way alternative institutions have en-
tered the banking market.
The internationalisation of trade and trade agreements have fa-
cilitated the entry of banks into most foreign countries. Under EC
regulations, banks of member states are able to set up in other states
with the assurance of home country control. Llewellyn (1990) suggests
that the lowering of entry barriers in Europe will have most impact on
those countries where competition was essentially domestic (such as
Italy, for example) rather than liberal countries (such as the United
Kingdom) that were already subject to foreign pressure. This view, in
fact, is confirmed in EC Commission (1997) which evaluates the
impact of the '1992' programme on European banking markets. The
systems where the level of competition increased most dramatically as
a result of the EU's Single Market Programme were those that were
previously most restricted, such as Spain, Italy, Portugal and Greece.
Structural deregulation in national markets has also meant that
non-bank financial firms have been able to offer similar product
ranges to traditional banks. The main recipients of this deregulation
trend have been savings-like institutions which have been able to com-
pete directly with ballks. Table 2.4 shows the importance of savings
banks in various European markets.
In recent years, the function of savings banks has started to evolve
considerably in man) European countries, with some savings banks
converting into commercial banks (Caja de Madrid and La Caixa in
Spain). In Germany, Sweden and Spain, new reforms have permitted
savings banks to raise additional capital (Leach, 1993). Savings
institutions in Europ'~ have a strong 'high-street' presence and have
proved to be major competitors for banks. In France, commercial
banks have protested against unfair advantages given to some of these
institutions that have traditionally had tax-advantageous regimes
24 Bancassurance

Table 2.4 Savings banks in Europe 1992

Country Number of Number of Deposit market

savings banks branches share
Belgium 30 5338 28.6%
Denmark 115 695 37.4%
France 31 5789 16.7%
Germany 748 19480 37.4%
Greece 1 909 10.9%
Italy 83 4600 23.1%
Netherlands 17 963 6.5%
Portugal 1 1547 23.9%
Spain 56 13857 40.7%
United Kingdom 1 1489 3.0%

Source: Alan Leach (1993), 'European Bancassurance: Problems and Prospects to

2000', FT Management Report, p. 55.

(AFB, 1985). The mutual UK building societies, whose primary

business is the provision of mortgages, and who have a particular
significance in the United Kingdom, have experienced a similar broad-
ening of their powers.
Less traditional new entrants include retailers. Large commercial
conglomerates have been present in the US banking industry for some
time, for example Sears has been significantly involved in financial
services since 1977 (Grant, 1992). This phenomenon is more recent in
Europe and has been associated with the development of credit cards
as well as electronic money transfers. In France, the Carrefour super-
market chain has been one of the first retailers to offer true banking
services; it has now expanded in the insurance field and in banking
(Daniel, 1995). In the United Kingdom, several national retail stores
offer credit card services and personal loans (Llewellyn, 1990). Marks
and Spencer, which holds a banking licence, has now launched life
assurance services (Braid, 1995) and two large supermarket chains,
Tesco's and Sainsbury's provide limited banking services.
New entrants - especially low-cost telephone-based financial service
suppliers - represent a serious threat for traditional banks. With more
institutions entering an already saturated market, competition has
considerably sharpened in recent years.

Substitutes The emergence of technological facilities for money

transfers has led to some important financial innovations. Most of
 Evolution of the Bancassurance Concept 25

these have been targeted towards corporate customers who simul-

taneously turned to capital markets for their financing needs (Broker,
1989). Structural deregulation has permitted banks to enter securities
markets and undertake underwriting/investment banking business
on a greater scale. Credit cards have also contributed to change the
face of retail banking (Farrance, 1993). These have been promoted,
not only by banks, but also by a variety of institutions, including credit
card giants (e.g. Visa and MasterCard), savings institutions and
retailers. Finally, we have stressed the increasing demand for longer-
term savings in the previous section. Insurance companies have in-
troduced new savings-like products that directly compete with banks'
traditional deposits. This has led Pitt (1990) to wonder whether banks
were entering the insurance market or rather insurance companies
were stealing market shares from the savings market. According to
Lusk (1984), the shift of insurance companies towards flexible in-
vestment-oriented products was prompted by the need for the industry
to better respond to customer demand. Deregulation removed many
constraints on financial products, thus allowing the emergence of
serious contenders for banks' traditional sources of funds. On the
lending side, many alternative cheaper sources of financing have also
been made available to bank customers. As a consequence, banks have
needed to innovate in order to offer better terms compared with
traditional services.

Suppliers Banks' traditional providers of funds, mainly depositors

and capital markets, have changed considerably in recent years. Capital
markets have been liberalised and the growth of securitisation, where
companies access capital markets directly, has placed many banks at a
bargaining disadvantage (Broker, 1989). Moreover, with the growth of
capital markets, the importance of size and reputation have become
vital for banks' access to wholesale funds. On the retail side, the exist-
ence of alternative products and market saturation (measured by the
number of persons with bank accounts) has led banks to price products
more aggressively, providing cash-like deposit facilities to attract new
customers and retain existing ones (Broker, 1989). The struggle for
depositors has resulted in an intensification of competitive pressures in
the financial services industry, as banks have been obliged to attract
what was traditionally a cheap and undemanding source of funds.

Customers We have emphasised earlier various aspects of the

demand for financial services. We have stressed in particular the
26 Bancassurance

increased sophistication of retail customers as well as the growth of

consumerism in the retail sector. This has led to customers' decreasing
loyalty, through multibanking relationships for both persons and
businesses. While the expansion of branch networks was the main
source of business expansion until the late 1970s, this strategy has
fallen out of favour in recent years, as the number of 'unbanked'
persons decreased and customers demanded a wider range of more
sophisticated and cost-effective banking services. As Gardener and
Molyneux (1990, p. 89) put it:

Customers are demanding more services, better information, and

most importantly, value for money.

This changing customer behaviour has forced banks to alter their

cultural orientation towards retailing.

The above framework indicates increasing competitive pressures for

banks in recent years. They have been threatened in their traditional
business by new entrants from abroad and across industry boundaries,
by substitute savings and credit services. At the same time, the bar-
gaining position of both their suppliers of funds and their customers
has improved, as they have shown more awareness of alternative
sources and uses of funds. These combined factors have increasingly
put banks under considerable competitive pressures.

Profitability trends in banking

Banks' core function is to gather deposits and give loans. Traditionally,
therefore, the main profits of banks arose from the spread between
interest earned on assets and paid on liabilities. If this spread
diminishes then banks' profits will diminish if they remain exclusively
tied to the same product and service areas. It has been argued by
Chrystal (1992) that there has been a general tendency for banks to
lose control on this spread. Several factors can explain this shrinkage.
In the previous section, we examined the increasingly competitive
environment of banks. However, more technical reasons contribute
towards explaining why bank profitability has fallen. The removal'of
interest rates' ceilings in most countries, the general state of the
economy and the regulatory constraints on bank balance sheets
have all had a significant impact on bank profitability. For example,
Chrystal (1992) argued that the existence of ceilings meant that banks
 Evolution of the Bancassurance Concept 27

did not need to watch their costs and pricing strategies closely. Put
simply, banks primarily engaged in non-price competition such as
branch expansion (Howcroft and Lavis, 1989). With the eventual
fragmentation of European oligopolies, pricing mechanisms had to
change and cross-subsidisation principles became unsustainable. As
explicit pricing did not exist in retail banking, banks managed to
benefit from a very cheap source of funds from depositors and current
account holders and provided loans parsimoniously. With the removal
of ceilings, they became obliged to compete on interest rates (Chrystal,
1992). Moreover, falling interest rates in many countries meant that
returns on current account balances were reduced (Leach, 1993).
The general world-wide recession more recently also had a negative
impact on bank profitability. Prudential requirements put an addi-
tional constraint on bank profitability. To maintain required adequacy
ratios, banks have had to maintain liquid assets, that are by nature less
profitable (Chrystal, 1992).
The results of these combined factors have been a sharp decrease in
banks' net-interest income, the traditional main source of banks'
profits. Table 2.5 illustrates this downward trend.
Table 2.5 illustrates the decline in traditional banks' profits margins
in many countries. The main implications of these trends has been that
banks have turned to fee-earning products as a means of increasing
profits as well as hedging against interest rates fluctuations. Fee in-
come has become a major source of profits for banks. Fee-earning

Table 2.5 Commercial banks: net-interest income] in various countries (in %)

Country 1988 1989 1990 1991 1992 1993

Belgium 1.60 1.57 1.49 1.48 1.51 1.30

France 2.12 1.77 1.68 1.51 1.25 0.93
Germany 2.19 2.04 2.04 2.16 2.21 2.18
Italy 3.27 3.54 3.62 3.59 3.55 3.17
Luxembour~ 0.95 0.82 0.77 0.83 0.84 0.77
Netherlands 2.30 2.08 3 1.823 1.78 1.83 1.823
Spain 4.06 4.04 3.92 3.96 3.39 3.16
United Kingdom 3.25 3.14 2.95 2.97 2.62 2.45

1 As a percentage of average balance sheet total

2 All banks
3 Break in series
Source: DECO data, Financial Market Trends, No. 61, June 1995. Copyright DECO.
28 Bancassurance

products have been generated from several sources: fees on customer

electronic services, financial advice, investment products and finally
insurance products. However, banks have not yet resolved the pricing
of traditional deposit services (Chrystal, 1992). Cross-subsidisation in
this area persists with customers maintaining high balances subsidising
the use of payments of customers with low average payment balances.
Howcroft and Lavis (1989) predicted that pricing will have to become
more explicit (and objective) if banks are to sustain reasonable prof-
itability levels.
Interest margins in commercial banking have been on a downward
slope in recent years. This decline can be associated to competitive
pressures, but also to regulatory changes, such as the liberalisation of
interest rates and increasingly demanding capital requirements. The
decline in interest margins from the late 1980s onwards throughout
Europe has prompted banks to seek sources of fee income, that might
guarantee profits' stability.
In this section, we stressed the importance of competitive pressures
on banks in recent decades. While various forces interacted to increase
the level of competition, their action was made possible by deregula-
tion, that lifted entry barriers for new competitors and products. This
fierce competition put considerable pressure on banks, who started to
adopt more competitive techniques, in order to retain customers and
increase their competitive edge. The pressure on interest margins also
prompted banks to diversify into fee-generating activities.

Changes in the life assurance industry

The most significant feature of life assurance markets in recent years

has been their dramatic growth in most Western countries. This sec-
tion examines the degree of competition and changing distribution
structures of the industry.

The growth pattern in the life assurance market

Life assurance markets across Europe have grown substantially over
the last decade (Hoschka, 1994). This trend is demonstrated in Figure
2.8.
Figure 2.8 shows that, over the period 1990-1993, all DEeD
countries depicted have seen an increase in life insurance premiums.
Portugal and Greece, in particular, have experienced a high growth
rate that can be related to prior low levels of coverage.
 Evolution of the Bancassurance Concept 29

Figure 2.8 Gross premium) growth in various countries (index 100 in 1990)
450
400
350
300
250
200
Cl 1990
150 • 1991
100 o 1992
1:1 1993
50 • 1994
a o 1995
B OK F G GR IR J N P S UK US

) Net premium for the United Kingdom (i.e. after deducing outwards
reinsurance).
Notes: B: Belgium, OK: Denmark, F: France, G: Germany, GR: Greece,
IR: Ireland, I: Italy, J: Japan, L: Luxembourg, N: Netherlands, P: Portugal,
S: Spain, UK: United Kingdom, US: United States.
Source: OECD data, Financial Market Trends, June 1997, No. 67, June 1996,
No. 64, June 1995, No. 61, June 1994, No. 58, June 1993, No. 55, June 1992,
No. 52. Copyright OECD.

Levels of penetration also differ considerably across different world-

wide economies. Figure 2.9 shows the percentage of life insurance
direct premiums in the GDP of different countries and the evolution
over the 1990-1995 period. Of the EU countries, the UK life assur-
ance sector stands well ahead of most countries, which might suggest
that the market is reaching saturation level. The general trend is for an
increased level of penetration, although 1991 seems to have been the
highest point for life assurance in a number of countries.
As was underlined in previous sections, demographic trends and
changes in savings patterns have had a significant impact on the
growth of life assurance. However, the different levels of penetration
in various OEeD countries shows that national characteristics impact
on the pattern of growth of this sector. Privileged tax treatment of life
assurance in different countries can increase the demand for such
services. In most countries there are some tax advantages associated
with life assurance products. This is mainly related to government
incentives for increased self-reliance as far as retirement provisions
are concerned. Some form of tax relief, applying either to premiums or
to their proceeds exists in many European states, except in Denmark,
the United Kingdom or the Netherlands. This may significantly affect
30 Bancassurance

Figure 2.9 Direct life premiums as a percentage of GDP from 1990 to 1995
8 ,---------------------------------------,
7
E 6
-:1 Q.
Eo 5
!!?el
~o 4
=~ o 1990
'0 tJl 3
!!?<II • 1991
C 2 o 1992
l...1 ftI C 1993

o ~~Lm~~~~I ~~~~I~flg~
I UL~~,~II~AD~~~~ ~ :~
B OK F G GR IR J N P S UK US

1 Net premium for the United Kingdom.

Notes: B: Belgium, DK: Denmark, F: France, G: Germany, GR: Greece,
IR: Ireland, I: Italy, J: Japan, L: Luxembourg, N: Netherlands, P: Portugal,
S: Spain, UK: United Kingdom, US: United States.
Source: OECD data, Financial Market Trends, June 1997, No. 67, June 1996,
No. 64, June 1995, No. 61, June 1994, No. 58, June 1993, No. 55, June 1992,
No. 52. Copyright OECD.

the demand for whole-life insurance. As life assurance has drawn

closer to savings products, banks have contested continuing tax
advantages on such products. Deregulation to abolish some of these
privileges has been implemented in the United Kingdom and the
Netherlands, but it is likely that government concerns for private
retirement provisions will sustain such tax benefits (Hoschka, 1994).
The structure of premium volumes is significantly influenced by na-
tional features. In some countries, individuals have been encouraged
by regulations to invest in individual products, in addition to national
insurance systems. Figure 2.10 shows the distribution of premium
volumes into individual and group capital sums and annuities in var-
ious countries.
Figure 2.10 illustrates the varying emphasis on group or individual
insurance. In Italy and France, for example, the emphasis on in-
dividual insurance is very strong. This is due to the fact that social
insurance systems are particularly generous in these countries, leaving
little room for additional group coverage (Swiss Re, 1993). Conversely,
group insurance plays a significant role in both the United Kingdom
and the United States.
In the previous section, we examined some of the trends in the retail
demand for fmancial services, and we argued that long-term insurance
 Evolution of the Bancassurance Concept 31

Figure 2.10 Structure of premium volumes of life assurance business (1990)

100% T'""1.--r---r-r--r-r--r---..--r-....----r---r-,
90%
80%
70%
60%
50%
40%
30% o Group capital sum
20% and annuity
10% • Individual capital sum
0% and annuity
Germany Italy France Japan US UK

Source: Swiss Re, Sigma no. 3/93.

was a beneficiary of these trends. The growth of the life assurance

markets in recent years in most DECO countries supports this
argument and is illustrative of the fact that life assurance has become
as much a savings vehicle as a pure insurance protection instrument.

Competition in the life assurance industry

Competition in life assurance markets has increased significantly in
recent years, both as a result of greater rivalry between established
insurers and because of the entry of new competitors.
The 1980s experienced a wave of industry consolidation. In a special
report on European Insurance, The Economist (1990) emphasised the
importance of a single market for life insurance as a catalyst for
insurers' expansion. The Third Life Directive has established freedom
of establishment and services, opening the doors to a market of 325
million persons. The high fragmentation of the European market has
traditionally, however, been viewed as incompatible with a truly
competitive single market. As a consequence, insurers have sought to
consolidate in their domestic market, in the expectation that medium
and small companies will have to struggle to survive in a more com-
petitive environment. In national markets, fierce competition has been
taking place. The Economist (1990) gave three examples: German life
insurers have entered into a policyholder bonus war, Italians have
been trying their utmost to get under-employed unit-trust salesmen to
32 Bancassurance

sell their policies, and in Britain insurers have struggled to keep down
the costs of commissions.
While financialliberalisation has made competition tougher among
national insurers, they have had to face the entry of new competitors,
from abroad but also from non-insurers, mainly banks but also re-
tailers. Foreign competition has been mainly prompted by the opening
of the EU's single market. This has resulted in a wave of mergers and
acquisitions across borders, in particular towards the southern Euro-
pean countries where life assurance has generally been behind their
northern counterparts (Brimecome, 1990).
Bancassurance has been a major factor in changing the face of
competition in life assurance. As banks brought with them large
branch networks and tied customer bases, they have become sig-
nificant competitors in the life assurance sector in particular (although
the importance of banks in the insurance market varies from country
to country). Finally, a new phenomenon has also emerged through the
entry of retailers. Retailers have been making inroads in the financial
services industry for some time, but it is only lately that they have
expanded into insurance. In the United Kingdom, Marks and Spencer
has been one of the latest additions to the list of retailers in that field.
With three million people already using their credit cards, they have
an impressive database of customers to use for cross-selling such prod-
ucts. Virgin has also formed a joint venture with an insurer, Norwich
Union, that carries the Virgin name and uses telesales techniques to
distribute various life-related products. In France, one of the biggest
department store groups, Cofiga, offers a range of insurance through
its outlets. A large hypermarket chain, Carrefour, has also started
selling life products from Axa under its own brand name, after suc-
cessful inroads in other financial services (Youngman, 1995). Many
more retailers have also started general insurance products related to
their core business (such as Mercedes Benz's motor insurance tele-
broker). Youngman (1995) has suggested that customer and database
selling are the crucial path to success in today's markets, undermining
ad hoc selling of insurance products.
The increased competition in a growing life assurance market sug-
gests that life insurers will have to become more marketing-oriented if
they are to survive against their national and foreign competitors as
well as against banks and retailers that have made a successful entry
into insurance markets in recent years. The latter development is likely
to transform the structure of insurance distribution in the years to
corne.
 Evolution of the Bancassurance Concept 33

The new face of distribution in life assurance

The major transformations in the distribution of life assurance have
come from two main quarters: direct business and banks. Con-
sequently, there has been a shift from traditional insurance agents
and independent advisors, mainly because they constitute one of the
most expensive distribution channels (Leach, 1993). A new distribution
channel, in the shape of retailers, has also emerged more recently.
While new entrants in the market have sometimes initiated these
changes, the insurance industry has been keen to diversify its dis-
tribution channels, allowing access to new markets. Moreover, market
uncertainties make it risky to focus on a single distribution channel.
However, some disadvantages of this strategy have been pointed out
by analysts. Leach (1993) stressed the significant costs involved in
establishing a multidistribution strategy. First, an insurer must be
quite large to justify the expensive investment in administration and
systems needed to run multiple channels. Second, it might be difficult
to operate a multiple distribution strategy in a focused fashion: de-
cisions must be made regarding the allocation of costs and the way it
affects commission systems, product development and advertising.
The third argument put forward by Leach (1993) has been experi-
enced by several insurance companies across Europe: conflicts of
interest might arise between different distribution channels. This was
at the heart of a conflict between Nationale-Nederlanden and its
brokers, when the latter announced its plan to merge with NMB
Postbank in 1990. Fearing the competition of a robust bank network
and the introduction of a dual pricing system between the two chan-
nels, brokers voted a boycott of NatNed products. Brokers used to
distribute 80% of NatNed's insurance products (Lafferty, 1991).
Similar conflicts developed at UAP and Axa in France and at INA and
RAS in Italy (Leach, 1993).
Etherington (1993) has stressed the dangers associated with in-
surers' distribution through banks. As they have no direct relationship
with customers, they are vulnerable to substitution by another com-
pany. In particular, this is illustrated by the development of the banc-
assurance phenomenon in the United Kingdom where banks and
building societies have shifted from a position as simple third-party
supplier, to eventually setting up in-house life companies. Having used
the experience generated by their contacts with life insurers, they have
become keen on retaining all profits generated by the business.
Marketing agreements can become a real threat to insurers as they
34 Bancassurance

cannot guarantee the continuity of this channel. The most flagrant

example of this in the United Kingdom was Abbey National's decision
in 1988 to abandon their tie with Friends Provident, whom they had
provided previously with around 30% of their new business. Another
recent example was the decision by the biggest building society,
Halifax, to break its link with Standard Life and set up its own life
assurance subsidiary. Some insurers such as Legal and General and
Sun Alliance have therefore entered into multiple ties with medium-
sized banks or building societies in order to reduce the risk of sub-
stitution (Etherington, 1993). Etherington suggested that insurers
should ensure themselves a stake in their banking partners in order to
further reduce the risk of being cannibalised.
There have been two major developments in the direct business
area in recent years, through the emergence of direct marketing (mail,
newspaper) and direct sales (over the phone). An independent report
suggested that the direct channel would capture 8% of the life assur-
ance market by 2000 (Lindisfarne, 1995). Hoschka (1994) showed
that insurance has become an increasing share of UK total direct mail
in recent years. The increase in direct mail as a marketing channel
(regardless of the products sold) has been substantial. The annual
growth rate of the direct channel has averaged 7% in Europe, with
France, the United Kingdom, the Netherlands, Belgium, Spain and
Denmark achieving above-average growth rates, over the last few
years (Hoschka, 1994).
Finally, the evolution of retailers as life insurance distributors has
been a recent addition to these multiple distribution channels. Nor-
wich Union has helped Virgin set up a telesales operation recently.
The success of this operation is yet to be assessed. Jayne-Anne Gad-
hia, operations director at Virgin Direct, said that they would consider
underwriting their own products instead of those of Norwich Union if
this became more cost-effective (Downing, 1995). This again under-
lines the dangers for insurers engaging in such strategies.
These new distribution channels have developed into a serious
threat against traditional agents, and the conflicts between some
insurers and their agents reflect the awareness of the latter about the
competitive edge alternative channels may have. The main disad-
vantage of specialised agents is that their commissions remain much
higher than those paid to banks. A comparison of the expense ratios of
life insurers in France in 1991 showed that insurers relying on tradi-
tional agents had considerably higher expense ratios than banks' in-
house companies. The latter showed ratios va!)'ing from 3.1 % to 9.1 %
 Evolution of the Bancassurance Concept 35

Table 2.6 Distribution of life assurance in five European countries 1989/90

UK France Netherlands Germany Ireland

Banks l 16 52 25 20 27
Brokers 30 5 60 20 58
Tied agents 9 13 2 1
Direct sales force 43 21 5 57 15
Direct marketing 2 9 8 2

1 Include building societies and savings banks

Source: Lafferty Group Management Report, 'The Allfinanz Revolution·Winning
Strategies for the 199Os'. 1991.

while traditional insurers had expense ratios from 10.5% to 23.7%

(Hoschka, 1994, p. 47). In the United Kingdom, a study showed that
bancassurers had a substantial cost advantage over average UK life
offices of similar profiles in 1988: TSB Life enjoyed a 30.2% cost
advantage and Black Horse Life 22.2% (Diacon, 1990a).
Table 2.6 shows the share of life assurance distribution enjoyed by
various channels in five European countries in 1989/90. The develop-
ment of new distribution channels has contributed to the reshaping of
the life assurance industry. Two channels in particular, banks and
direct sales, are likely to bring life assurance into a price war that may
well signal a dramatic decrease in the number of traditional insurance
agents. A major aspect of this transformation in distribution channels
is that distributors have started to expand vertically and enter their
suppliers' markets, in order to reap the benefits of a growing market:
this is true in the case of banks, but can also be extended to retailers
who have been the latest addition to a crowded network of life assur-
ance distributors.
The life assurance industry has experienced dramatic developments
in the last decade: an impressive growth rate that has been precipitated
by demographic changes and an increased demand for savings prod-
ucts; a global increase in the level of competition through the entry
of foreign companies, banks and retailers, prompting a wave of con-
solidation in the industry; finally, distribution has shifted from tradi-
tional insurance agents towards direct channels, banking institutions
and retailers. These developments are likely to continue and result in
a major transformation of the industry. The next stage in this process
is likely to be 'user-friendly' Internet-based broking services where
clients can chose from a myriad of different products and services.
36 Bancassurance

The above provides a brief overview of the main changes that have
taken place in the banking and insurance industry over the last decade
or so. In both industries, we found evidence of increased competition
and integration, with both sectors engaged in a 'battle' to supply
customers' savings and insurance needs. This has led to more acute
pricing in these previously highly regulated markets and also emphas-
ised the efficiency of the distribution channel as an important com-
petitive ingredient. Bancassurance is a natural development of these
changes in the financial industry and is at the heart of the competition
that started between the two sectors.

2.4 THE SUCCESS OF BANCASSURANCE

This section undertakes a review of the impact of the bancassurance

strategy in recent years, including the extent of this phenomenon in
various European countries. The increasing number of experiences
in the bancassurance field has uncovered operational difficulties in
the management of integrated bancassurance operations, which have
impeded the success of this strategy. Nevertheless, enterprising Euro-
pean banks have expanded their involvement in the insurance field by
entering the general insurance market.

The extent of the bancassurance phenomenon

Banks have taken a larger market share of the distribution of Euro-

pean life assurance in recent years. However, this should not conceal
national differences. Figure 2.11 shows the share of life assurance
distributed by banks in selected European countries. As can be seen in
Figure 2.11, France comes well ahead of its counterparts with banks
responsible for more than half of the distribution of new business in
1989. This has been attributed to the fact that French banks have
concentrated on relatively restricted insurance products lines, in par-
ticular, capitalisation products that are very close to traditional bank
savings (Pitt, 1990). Tillinghast (1991) estimated that 53% of new
business distributed through banks was capitalisation business, while
47% was traditional life assurance. The figure for Spanish bancas-
surance probably includes banks' interests in insurance companies and
probably does not constitute a valid comparison with the other
countries.
 Evolution of the Bancassurance Concept 37

Figure 2.11 Percentage of new individual life premiums distributed through

banks (1989)1

In%
60
52
50 r-

40 35
30 27 -
20
25
roo-
25
.....- -
20 16 r-
-
10 4
o n
N>. :.c >.
c: '"c:
'0 E '0
c: "'c:
Q)
::> :::> (,.)
c:
~ nI
E .!!! '0> nI 'iii nI
Q; Q; q)
III
~ C.
C/l It
(!l .c
a;
Z

1 Figures based on new business (annual and 10% of single premiums).

2 This is low but 15% distributed by financial salesforce, originally selling
mutual funds.
3 This percentage is an estimate.
Source: Tillinghast (1991).

The above figures conceal a dramatic evolution of this channel in

recent years. The estimated share of French banks in the distribution
of life assurance was estimated to be 23% in 1983 (Swiss Re, 1992).
Lafferty (1991) showed a similar evolution of this channel in the
United Kingdom and Germany. They estimated that banks accounted
for only 3% and 2%, respectively of life assurance premiums in 1986.
Table 2.7 shows the estimated market shares of banks in 1994 as well
as an estimate for 2000.
Moreover, banks have shifted in recent years from a role as passive
distributors towards that of manufacturers of life assurance through
their own in-house life assurance subsidiaries. These have mainly been
the result of ventures with life insurers. In addition, there have been
national as well cross-border ventures. Tillinghast (1991) reports as
many as 12 cross-border ventures between banks and insurance
companies in Spain and four in Italy.
38 Bancassurance

Table 2.7 Percent of life insurance distributed through banks

Country 1994 2000·

France 55 60
Netherlands 22 35
Spain 21 40
Belgium 20 40
United Kingdom 16 28
Italy 12 30
Germany 8 14

• projected
Source: Best's Review®, Property/Casualty Edition - June 1996 © A.M. Best Company-
used with permission.

Barriers to success in bancassurance

Three main aspects of the bancassurance strategy have been identified

as crucial factors of success: customer resistance, organisational
choices (mode of entry and organisational structure) and cultural
conflicts. Experiences have shown that failure to adequately manage
these aspects could adversely affect a bank's bancassurance strategy.

Customer resistance
Some observers have criticised the bancassurance trend on the
grounds that customers may not appreciate the concept of 'one-stop
shopping'. Marketing economies, which are a major incentive for bank
entry into bancassurance, crucially depend on customer preferences.
Some customers may be reluctant to 'put all their eggs in the same
basket' and prefer to spread their financial investments across a
number of financial institutions. Another element of customer
resistance to buying insurance from his banker relates to personal
reluctance to let his insurance agent know about the size of his bank
balance or to rely on his bank manager to give best advice on how to
make insurance arrangements (Gumbel, 1991). The latter involves
issues of privacy, that are regulated in most countries. In France, the
Law 'Informatique et Libertes' of 1978 prevents companies from
communicating personal details to other companies, even if they are
affiliates (Nerbonne, Lauriol and Roussel, 1990). Although banks
may be prosecuted if they infringe this principle, several questions
remain as to how such laws should be interpreted. In most European
 Evolution of the Bancassurance Concept 39

countries, companies can only access personal information with the

individual's written permission, contrary to the United States, where
more permissive laws exist (Leach, 1993). The International Insurance
Report (1992) recognises that, although restricting laws exist in vari-
ous countries, the issue of customer confidentiality remains open to
argument. Finally, some reports suggest that some forms of tie-ins
exist in bancassurance; which may lead consumer associations to
oppose this type of distribution practice (Eaglesham, 1992). In sum-
mary, alleged synergies of consumption can have downside effects.
Therefore, the success of bancassurance strategies may depend on
customer behaviour.

Choice of organisational structures

There have been four main types of entry routes in bancassurance:

• distribution agreements
• mergers and acquisitions
• joint ventures
• start-ups

The relative success of these entry routes was the main focus of
interest of Hoschka (1994). He criticised co-operation agreements as
well as joint ventures because they can give rise to divergence of
interests between the insurer and bank partners. Moreover, such
contracts can be relatively unstable. He further criticised mergers and
acquisitions because they give rise to managerial problems in achiev-
ing integration of two previously separate entities. Hoschka (1994)
argued that these disadvantages render start-ups the most promising
route to entry into bancassurance. None the less, it may be argued that
the crucial factor in bancassurance is not the chosen entry mode but
rather the success of bancassurance integration within a given struc-
ture (Genetay, 1993).
Nicholson (1992) identified four main areas of integration that
can be crucial to bancassurance. Table 2.8 summarises his arguments.
Nicholson underlined the need for a careful assessment of what
functions should be centralised in order to achieve synergies in a
bancassurance context. In turn, these choices impact on organisational
structures. In particular, organisational structures in bancassurance
must allow a group to reap potential synergies benefits and therefore
requires a certain degree of integration between the two activities.
40 Bancassurance

Table 2.8 Organising appropriately: some choices and challenges

Choices Challenges
Distribution Direct response Insurance vs. bank culture
Insurance salespeople in Customer protectiveness
branches Identifying leads
Branch staff sell insurance
Rationalisation of channels
Treasury/ Separation of instruments Managing own money/
investment Profit vs. cost centres reserves
Managing others' money/
reserves
Pay/status of units
Risk assessment! Centralised vs. Preservation/pooling
underwriting decentralised expertise
Expert systems Analytical system
implementation
Administration/ Separate/combined Customer service delivery
processing processing Transferring effectiveness
Centralised vs. insights
decentralised

Source: Nicholson, Chapter 6 in The New European Financial Marlretplace. Steinherr

and Huveneers (1992). p. 100. Reprinted by permission of Addison Wesley Longman
Ltd.

This might take place at different levels of the organisation, but this is
especially crucial at the distribution level in bancassurance. In recent
years, banks have started to favour organisational forms that focus on
customer groups rather than product lines (Revell, 1991). However,
this requires integrating two activities such as banking and insurance
to a greater extent. In bancassurance, there have been numerous
restructurings following the failure to achieve integrated distribution
(Knights et al., 1994). A major barrier to success in bancassurance
relates to the integration of both activities. Although, the effect of
different entry strategies can be controversial, there is a clear-cut need
to achieve cultural unity in a bancassurance conglomerate. We discuss
potential cultural conflicts in the next section.

Cultural conflicts in bancassurance

There are two main aspects to cultural conflicts in bancassurance. One
relates to different organisation cultures. The other relates specifically
 Evolution of the Bancassurance Concept 41

to different cultures in terms of distribution and raises the issue of

remuneration packages.
A major difficulty associated with mergers in particular relates to
the different cultural backgrounds of the merging top management.
The objectives of both sides might diverge, with each party trying to
secure a dominant position. Another difficulty lies in creating a clear
understanding of each other's business. Morgan et al. (1994) reported
a case study in France, where clashes between the two entities arose
because the supplier (insurer) was not adapting its products to the
bank, and felt that the bank did not understand much about insurance.
However, cultural conflicts can be most decisive in bancassurance at
the distribution level. In particular, conflicts may arise between two
co-existing channels of distribution. Insurance sales in bancassurance
arrangements often depend on branch staff passing leads to special-
ised insurance agents. Morgan (1993) analysed three anonymous
bancassurers in the United Kingdom and reported one case where co-
operation was withdrawn, because branch staff resented the presence
of highly paid insurance sellers. This is a crucial aspect of bancas-
surance: while bank employees receive a salary, insurance agents are
paid commissions. This dual system may raise serious conflicts
between the two sets of staff. Wein (1993) stressed the importance of
recognising the contribution of branches in the bancassurance process.
Morgan (1993) also reported a case where the bancassurance strategy
was driven by sales, hence creating some pressure on employees. This
strategy made the staff of the branch reluctant to pass on leads to
more specialised agents, since this resulted in them not reaching their
own targets. Finally, Morgan (1993) quoted the case of another ban-
cassurer in which bank staff had been used to sell insurance. The
management felt that bank employees did not have enough incent-
ives to exploit this opportunity to its full, favouring traditional sales
instead. This case study also illustrated the reluctance of bank
employees to speak of death to their clients, and engage in more
selling arguments than for banking products. This illustrates a com-
mon adage: insurance is not bought but sold (Gumbel, 1990).
This section illustrates that there are barriers to the success of a
bancassurance strategy. First, customers may not value the commodity
of 'one-stop-shopping' in financial services. Second, the choice of
organisational structures must be carefully assessed for each company
in order to reap potential synergies. Finally, cultural clashes may arise
from two different selling cultures in particular, and dual remunera-
tion systems may raise some resentment from the parties concerned.
42 Bancassurance

<ieneral insurance

In this ovelView of bancassurance, we have concentrated on long-term

insurance. However, banks have also made incursions in the area of
general insurance. In the Netherlands, banks captured 10% of the
distribution of non-life products in 1991; in Germany, banks achieved
a 5% market share which is not too far from their share of the life
assurance market (Leach, 1993). The trend towards more involvement
in general insurance, although less generalised than in the life assur-
ance sector, has been quite clear-cut in France where several large
banks have set up subsidiaries or reached marketing agreements with
general insurers (Daniel, 1995). There are indications that this trend
will continue, with banks moving from an experimental phase to an
industrial one, where costs are the focus of attention (Lemoine, 1994).
The Royal Bank of Scotland formed a successful direct motor in-
surance operation, which in less than 10 years has become the largest
private motor insurance provider in the United Kingdom (Wood,
1995).
Vacquin (1990) predicted that full bancassurance integration in-
volved stepping from the life assurance sector into the general insur-
ance sector. However, there has been a clear reluctance from banks to
get involved in this area. Leach (1993) attributed the small number of
banks involved in general insurance, to the fact that the latter requires
a completely different set of skills to life insurance and also carries the
risk of high claims. Pitt (1990) stressed the dangers of engaging in
aggressive selling of general insurance products and alienating clients
through subsequently poor selVice. Disputes over claims for example
might lead banks to lose their banking relationship as well. Moreover,
good banking clients might not be good policyholders (Daniel, 1995).
Pitt (1990) proposed that banks should emphasise the separate func-
tions of banking and insurance, by stressing that the policy is under-
written by a different company. However, bank employees, as sellers
of the policy, could still incur clients' displeasure.
Despite these potential problems, however, the industry has
experienced the emergence of bancassurance in the general insurance
field. French banks, which have been major proponents of bancas-
surance in the life assurance field are becoming largely involved in this
market. In spring 1995, only one large bank, Societe Generale, did not
have a general insurance arm (Daniel, 1995). Moreover, there are
clear-cut synergies between the two activities at the point of sales:
banks provide mortgages and consumer credits for cars and they could
 Evolution of the Bahcassurance Concept 43

easily extend their offering to household and motor insurance (Pitt,

1990).
Banks have been reluctant to engage in general insurance because
this activity yields different skills and may endanger their customer
relationships. Nevertheless, there are clear indications that this re-
luctance is diminishing and although banks might engage with more
care in this sector, it is likely that more banks will gradually enter into
a potentially profitable market.
The shares of banks in the distribution of life assurance testify to the
importance of the bancassurance phenomenon. None the less, ban-
cassurance experiences have suffered setbacks, mainly due to cultural
conflicts between the two activities. These problems, however, have
not prevented European banks from venturing into the general
insurance field, which is also likely to become a significant strategy in
years to come.

CONCLUSION

Banking and insurance industries have strong similarities that might

have contributed to their natural rapprochement. This chapter shows
that bancassurance can take different forms and has rapidly developed
from a relatively restricted product offering to a wide range of act-
ivities. The changing demands of an ageing population, as well as
developments in the banking and insurance industries, have been
important factors promoting the bancassurance trend. Crucial devel-
opments in the banking industry include increasing competitive pres-
sures and decreasing profitability. In parallel, the life assurance
industry has experienced substantial growth rates and has developed a
range of products that include savings instruments that compete head-
on with banks' traditional products. This has made the life assurance
industry an attractive alternative for banks seeking to diversify their
earnings and make a more efficient use of expensive branch networks.
These factors have promoted the generalisation of the bancassurance
strategy, with banks achieving a substantial share of the life assurance
market in many European countries.
3 Bancassurance in the
United Kingdom

INTRODUCTION

This chapter provides a review of the development of bancassurance in

the United Kingdom which is recent and has considerably evolved
over the last decade. In the first section of this chapter, we review the
major regulatory changes that have had an impact on the bancas-
surance trend. This includes the Financial Services Act (1986), which
reshaped the regulation of investments products and has led to new
regulatory requirements for the distribution of insurance. The section
then examines the impact of the Building Societies Act (1986) on the
development of bancassurance. In Section 3.2, we review the emerg-
ence and strategy of UK bancassurers. We start by analysing the two
earliest bancassurance operations in the United Kingdom, those of
TSB and Barclays, who set up life assurance operations in the 1960s.
Then, we examine the wave of new bancassurance operations estab-
lished in the 1980s. Finally, we examine the bancassurance operations,
established in 1993 to 1995.
Section 3.3 examines the structure of bancassurance operations
in the United Kingdom, which includes various modes of entry and
organisational structures. Finally, this chapter identifies the integra-
tion of distribution systems as a key to bancassurance success in the
United Kingdom.

3.1 REGUlATORY CHANGES IN TIlE UNITED KINGDOM

Two major developments in the UK regulatory environment have

substantially affected the bancassurance industry: these are the Fin-
ancial Services Act (1986), which set new rules on the marketing of life
assurance in particular, and the Building Societies Act (1986), which
levelled the playing field between commercial banks and building
societies by expanding the powers of the latter.

44
 Bancassurance in the United Kingdom 45

The Financial Services Act (1986)

The Financial Services Act (FSA) legislated the regulation of the

investment industry. Its provisions had a substantial impact on the
selling of long-term insurance products and it provided the framework
for the main institutions that would be responsible for the supervision
of investment products providers.
The FSA embraced all types of financial investment, and the
management and marketing of investment products. Two key features
of the Act were (1) providing a consistent treatment between compet-
ing types of financial services and, (2) the reliance on self-regulation
(Wright and Diacon, 1988). Under the FSA, individuals or companies
transacting investment business have to be authorised by an appro-
priate self-regulatory organisation (SRO) or the Securities and Invest-
ments Board (SIB), the designated agency responsible for supervising
the SROs. Initially, five main SROs were created, two of which were
particularly relevant to the marketing of life assurance: the Life
Assurance and Unit Trust Regulatory Organisation (LAUTRO), and
the Financial Intermediaries, Managers and Brokers Regulatory Asso-
ciation (FIMBRA). Figure 3.1 shows the hierarchy of supervision in
financial services set by the FSA in 1986.
Three principles adopted by the organisations that emerged after
the FSA had a direct impact on the marketing of life assurance. These
are disclosure requirements, the 'best execution, best advice' principle
and most importantly of all, the 'polarisation' principle. Disclosure
proposals focused on commissions and expenses provisions. The ori-
ginal LAUTRO proposal consisted of 'soft disclosure', i.e. at the re-
quest of the customer. This was dismissed by the Office of Fair Trading
(OFT) who insisted on 'hard disclosure', i.e. the disclosure in full by
intermediaries of their commissions earnings. The OFT also insisted
that expenses should be revealed, so that less costly providers might
pass their cost advantages to customers. This disagreement illustrated
OFT's concern over regulatory capture, whereby SROs may in fact
favour the interests of the institutions under their rule, rather than
those of policyholders (Wright and Diacon, 1988).
The second important ruling emerging from the FSA was that of the
'best advice, best execution' principle. This principle, specified in the
FIMBRA rulebook, obliged all salespeople of investment products, be
they tied or independent, to give the client the best advice on the type
of investments that should best suit his needs (Wright and Diacon,
1988). This effectively meant that independent intermediaries should
46 Bancassurance

Figure 3.1 Personal financial services - the regulatory framework

Building
Societies
Building
Societies ~
Commission
Building
Commission
General :
~
Regulates :
Societies . supervision of . : banking money :
Commission :building societies: :.~nd gilts marXets:
Building .......::.'................ .
Societies .......

......
SIB
Securities and ,: ..
Building Building investments Board
Societies Societies Regulation of :
Building Building investment :
Societies Societies business for :
i~~.Clr.Prtl~IIc:ti()Il:

Building
RIEs RPBs
Building
Recognised
Societies Recognised
Societies
Investment
Building Professional
Building
Exchanges
Societies Bodies
Societies
Building
Building
Societies
Societies

Building Building
Societies Societies

L - - _ - - ' .. ·····1 LAUTRO I

..............

Overlapping of responsibilities
Direct hierarchical links

Source: Wright and Diacon (1988), p. 84.

regularly undertake a thorough market survey to assess the best terms

available to their clients.
The 'polarisation' principle was clearly the key feature of the FSA.
It forced intermediaries to opt for either of two positions vis-a-vis the
sale of insurance products: tied or fully independent. The 'tied' status
implied that an intermediary could be representative of a single
 Bancassurance in the United Kingdom 47

company only. By contrast, an independent intermediary would be

able, in principle, to sell the products of any company in the market,
but had to illustrate to its customers (and regulators) that it was
providing best advice by quoting a broad range of competing products.
The polarisation principle also applied to financial conglomerates,
which in effect prompted various banking institutions to opt for the
'tied' status, which had less heavy requirements than the independent
route. However, separate entities of a group could opt for different
status. Subsequent to the FSA, all major banks, except National
Westminster, chose the tied route. Although most building societies
chose to remain independent immediately after the FSA, they gradu-
ally shifted to the tied status (Wright and Diacon, 1988). The latter
phenomenon was attributed to the high costs of membership of
FIMBRA, that weakened the position of many independent inter-
mediaries, contrary to the original spirit of the FSA (Lindisfarne,
1990). Moreover, the failure of the polarisation rule was shown in the
fact that banks owning an independent intermediary could still direct
their customers to that channel (Wright and Diacon, 1988). Another
major failure of the FSA was related to the compensation schemes,
aimed at compensating policyholders in the case of failure of a
member. FIMBRA found itself with the weakest financial base and the
highest number of claims (Hodgin, 1992).
In response to major criticisms of these organisations, an initiative
was launched in September 1992 to promote a single regulatory body
for personal investments. The Personal Investment Authority (PIA)
replaces FIMBRA and LAUTRO among other SROs (Llewellyn,
1994). At first, it received a hostile reaction from banks and building
societies in particular, that prefered to remain under SIB control
(Lindisfarne, 1993). The PIA's objectives were to:

• reinforce high standards of integrity, fair dealings, and compet-

ence;
• make full and proper use of the power available to protect in-
vestors;
• set rigorous standards of training and professional competence;
• help investors to protect their own interests by establishing de-
manding standards of relevant disclosure;
• provide effective mechanisms for the handling of investor com-
plaints and for securing redress for investors who have been dis-
advantaged.
(Llewellyn, 1994, p. 34)
48 Bancassurance

The advent of the PIA coincided with the enforcement of com-

mission disclosures and full expenses disclosure. This development
had the effect of harming traditional players which did not have the
benefits of banks' and building societies' corporate buying and mar-
keting power (Pratt, 1995). The PIA has also been firmer on ethical
principles linked to the marketing of long-term products. In particular,
the PIA has been responsible for ensuring that insurance firms, in-
cluding the life assurance subsidiaries of banks and building societies,
identify and where necessary compensate investors who have lost
money through the mis-selling of personal pension schemes between
1988 and 1994 (Banking World, 1994). If insurers find that investors
suffered loss and it can be shown that this was because advice fell short
of the FSA requirements, they have had to provide redress. This has
had a significant impact on the industry - most noticeably the Pru-
dential - although many banks and building societies, whose sales
forces did not comply with the basic training requirements have had to
undergo substantial retraining.
The FSA has had a strong impact on the marketing of long-term
insurance products. It is likely that these developments prompted
the weakening of smaller independent intermediaries, while it became
more attractive for banks and building societies to go it alone in
bancassurance and tie to their own subsidiary. Nevertheless stricter
rules regarding the training of insurance salespeople has imposed high
costs on the providers of long-term [mancial products in the future.

The Building Societies Act (1986)

While the FSA changed the marketing of investment products through

new regulatory measures, the Building Societies Act (BSA) changed
the playing field between banks and building societies through the
deregulation of building societies' traditional powers. We review the
main principles of the Act in this section.
Traditionally, building societies had been restricted to a relatively
simple business, raising retail deposits and making mortgage advances.
Due to a lack of competition in the mortgage market prior to the
1980s, they held a virtual monopoly in that market. The level of
competition then started to increase dramatically. In the retail deposit
market, building societies faced competition from National Savings,
banks, and equity investments (privatisation issues, unit trusts). In
parallel, banks started to enter the mortgage market, when they were
freed of lending constraints in 1981 (Drake, 1989). This led to the
 Bancassurance in the United Kingdom 49

dismantling of the building societies' interest rate cartel in 1983. In

fact, the increased competition led buildirig societies to become much
more profit-oriented than was hitherto the case. It also put pressure
on building societies to diversify both sides of the balance sheet. They
started increasing their use of wholesale funding and, in 1986, their
powers to diversify were substantially increased by the BSA (Drake,
1989). This was aimed at levelling the playing field between building
societies and commercial banks. Drake (1989) argued that the BSA, in
contrast to prior legislation, did not simply amend existing regulations
but set an entirely new regulatory framework. The BSA allowed
societies, particularly the larger ones, to provide a much wider range
of services than before. The main provisions of the Act are sum-
marised in Figure 3.2.
Provision was made in the Act for the range of services to be
increased or varied by regulatory instrument (Drake, 1989). This was

Figure 3.2 The main provisions in the Building Societies Act (1986)

Unsecured lending Limit to £5000 per person and to larger

societies
Housing provision Societies to be allowed to own and develop
residential properties but limited to larger societies
and restrictions on extent.
Integrated house Restrictions on conveyancing for own customers;
buying allowed to offer estate agency services but only
through subsidiaries so as to avoid conflicts
of interest.
Agency services Societies allowed to act as agents for other
organisations.
Financial services Postponed for sale of shares.
Personal pensions in new Social Security Act.
Insurance broking Extension of current services to offer a comprehensive
package.
Formation of Societies can set up subsidiaries.
subsidiaries
Money Larger societies can offer money transmission service.
transmission Can offer cheque guarantees.
Joint ventures Societies can become involved in joint ventures.
Money raising At least 80% of funds should come from members and
up to 20% of wholesale sources (raising of the latter to
40% if Commission agrees).

Source: Wright and Diacon (1988).

50 Bancassurance

used in the context of insurance activities. The BSA authorised

building societies to enter into direct competition with life assurance
companies as regards personal pensions. This was subject to building
societies operating through authorised unit trust subsidiaries, which
therefore came under the regulation of the FSA. A review of building
societies' powers took place in 1988, that revised the previous Sched-
ule 8 in the BSA. This provided for six broad services: banking, in-
vestment, insurance, trusteeship, executorship and land services
(Drake, 1989). Under the revised Schedule, building societies were
permitted to own up to 100% of the equity of a life assurance com-
pany, while a maximum 15% stake was imposed for general insurance,
because of its inherently higher risks (Drake, 1989). They were also
allowed to own stockbrokers although they were unable to become
involved in stockbroking directly. Finally they were permitted to
undertake fund management, including unit trust management gen-
erally, rather than solely for pensions. In parallel, the new Schedule 8
reviewed the power to hold new forms of assets (e.g. residual mort-
gage debts and mortgage finance rights) and provided for an increase
in commercial assets limits to their statutory maximum under the BSA
by 1993. Drake (1989) argued that the new powers exhausted the
diversification possibilities foreseen in the context of the 1986 Act.
The review of the BSA by the Treasury in 1994 further enlarged
building societies' powers. The main provisions were to increase limits
on the funds societies can raise on the wholesale market; to allow
societies to establish subsidiaries to make unsecured loans; and the
right of building societies to wholly own general insurance companies
which offer housing-related products (Ben-Ami, 1994). The review
aimed at promoting evolutionary change, rather than radical trans-
formation. Therefore, building societies that would feel constrained
in their ability to diversify would need to consider conversion to pic
status. The latter was the object of a Bill that coincided with the BSA.
A number of rules were set in respect to conversion procedures and
building societies which changed status would then fall under the
supervision of the Bank of England (Drake, 1989). The possibility
of such conversion was first exploited by Abbey National in 1989. 1
Following this, Lloyds Bank attempted an aborted bid on Cheltenham
& Gloucester in 1994 and Halifax and Leeds Building Societies
announced their decisions to merge in 1995, with a plan to convert
in 1997 (Altunbas, Maude and Molyneux, 1995). Since then, Chelten-
ham & Gloucester became a pIc within Lloyds Bank, National and
Provincial was absorbed by Abbey National in 1996, and Woolwich,
 Bancassurance in the United Kingdom 51

Alliance and Leicester and Northern Rock announced decisions to

convert in 1997 (The Economist, 3 February 1996 p. 75).
The above review of the BSA underlines the convergence of
building societies' powers to encompass much of the activities open to
commercial banks. Moreover, the possibility of conversion means that
larger building societies can alleviate any remaining constraints that
might put them at a competitive disadvantage with banks. The playing
field between building societies and commercial banks has been con-
siderably levelled by the Act, which contributed to enhancing com-
petition in the financial services industry.
The 1986 FSA and BSA have to a large extent transformed the
financial services industry in the United Kingdom. The FS~s 'polar-
isation principle' in particular has rendered the tied status attractive
for distributors of life products. It has arguably led commercial banks
to form their own life assurance subsidiaries to which they tied. As
building societies were allowed to own a life assurance company after
the BSA, they have followed the lead of the commercial banks. Both
Acts have therefore had a decisive impact on the emergence and
precipitation of the bancassurance trend.

3.2 MAJOR BANCASSURERS IN THE UNITED KINGDOM

Three main periods can be distinguished in the history of bancassur-

ance in the United Kingdom. The most active period of bancassurance
link-ups followed the developments in the regulatory framework for
financial services, that prompted several banks and building societies
to set up their own tied life assurance subsidiary. UK bancassurance
experiences have also been characterised by the fact that they were
mostly initiated by banks, with few life insurers taking the initiative in
the combinations of the two sectors.

The Precursors

The first UK experiences of bancassurance started with the setting up

in 1967 by TSB of an insurance subsidiary, which aggressively adopted
a bancassurance strategy. Barclays Bank took a similar step as early as
1969 by setting up its own life assurance subsidiary. Both bancassur-
ance subsidiaries had nevertheless a radically different development as
we will see in this section.
52 Bancassurance

TSB Group
The TSB nust Company was launched at the initiative of the TSB
Association meeting in 1967. At the time, there were 77 Trustee
Savings Banks, each with a chairman, trustees, a general manager, and
a head office; a few of these were reluctant at first to support the new
venture (Lafferty, 1992). Nonetheless, its rapid success soon changed
this attitude. The diversification represented a defmite innovation, as
'bancassurance' was still in its infancy. TSB Trust Company steadily
increased its expertise and experienced rapid success with its unit-
linked policies in particular. By 1984, insurance and unit trust products
contributed £23.6 million or around 15% of the operating profits of
the group. One of the revolutionary concepts launched by TSB was to
allocate specialist sales forces into the bank branches. From just seven
persons in 1972, the number of full-time specialists amounted to 240
by 1984. TSB Trust came well ahead of its competitors because of this
access to a tied customer base. It became tangible proof of the validity
of distributing insurance and investment products through bank
branches (Lafferty, 1992). In parallel to this success in long-term
insurance, TSB introduced home insurance schemes as early as 1979
and motor insurance products in 1985. By 1985, TSB Trust Company
(the investment and insurance arm of the group) offered credit
insurance, as well as loan-related schemes (sickness, unemployment,
death) and home, travel and motor insurance. The policies were
designed by TSB Trust Company and marketed under the TSB name,
although underwritten by a variety of companies. General insurance
premiums amounted to £30 million in 1984, compared with £80 mil-
lion for life policies (TSB, 1986). In 1989, TSB ranked second in the
market for pension and life assurance sales with 6% of the market,
behind the market leader Prudential (10%).
This success in the insurance field led TSB to the acquisition of
Target Life, a life and unit trusts group, in 1987. It quickly became
obvious that the acquisition was unsuccessful and TSB was induced to
sell the subsidiary in 1991 to Equity and Law (British subsidiary of the
French insurer Axa), generating a loss on the sale of £80 million.
O'Mahony (1991) attributed the acquisition's lack of success to the
difficulty in finding a correct management balance. In 1987, TSB also
undertook a diversification in the investment field by acquiring Hill
Samuel, a merchant bank, using the proceeds of its market flotation in
the same year (Revell, 1992). Cultural problems led to the entire
restructuring of the Group whereby Target was placed under the Hill
 Bancassurance in the United Kingdom 53

Figure 3.3 Organisational restructuring at TSB

Previous TSB
Structure l TSB
Group
I
J
I I I
Insurance
I
Retail Corporate and Commercial
Banking Banking Investment Division
Services
Branch banking Hill Samuel TSB Trust Noble Lowndes
Banking services Company Swan National
HS Financial Wesco I
Services

NewTSB
Group
Structure

Hill Samuel Hill Samuel

Hill Samuel
Hill Samuel Hill Samuel

Hill
TSBSamuel
branch
banking
Hill Samuel
TSB
Hill Trust
Samuel

Source: TSB Group Review (1991).

Samuel branch in anticipation of its sale. Figure 3.3 shows the changes
in the organisation of the Group. The aim behind the restructuring
that took place at TSB was to adopt a more customer-focused struc-
ture. Moreover, both banking and insurance activities were integrated
at the top management level (Hoschka, 1994).
'Rvo sets of sales force co-exist under the TSB structure: the in-
surance specialists that are linked to one branch, and a direct sales
force (around 2(0) that are aimed at direct marketing initiatives and
customers who do not frequently visit the branch. The former com-
prise some 850 employees according to Hoschka's estimates (1994).
They require complete co-operation from the branch staff, who pro-
vide them with leads. The branch staff identify potential customers
and analyse the customer's needs with the help of a specifically
54 Bancassurance

designed database depending on various characteristics (age, financial

status, etc.). The branch manager then writes to the customer identi-
fied in this way and suggests a product and appointment with a TSB
insurance specialist. Besides meeting customers in the branch, these
specialists might make home calls. The incentive for insurance spe-
cialists to co-operate with branch personnel are obvious, given that
they are dependent on the latter to pass on leads. They are paid on a
salary basis but can double their salary with commissions. Although
branch employees do not receive commissions, both sets of employees
are assessed as part of the same unit and according to specified tar-
gets.
Despite the apparent integration of both activities, the restructuring
of TSB in 1991 showed that managerial conflicts had been part of
the history of the TSB bancassurance experience. Nonetheless, TSB
experienced substantial success since it paved the way to bancassur-
ance in 1967. The profits from the insurance divisions averaged 30%
of the group's total profits between 1989 and 1992 (Hoschka, 1994).
This makes it one of the most quoted examples of the success of
bancassurance. In 1993, the chief executive, Brian Brown, said that the
TSB had 'the most integrated bancassurance operations in the United
Kingdom' and that the whole group would continue to focus on these
activities (RBI, 29 January 1993). TSB was acquired by Lloyds Bank in
1995.

Barclays Bank
Barclays Bank has been active in the bancassurance sector since 1969
when it acquired Unicorn (a unit trusts company) and set up Barclays
Life, an own life assurance subsidiary. Although this link was well
established, the advantages of cross-selling insurance products did not
constitute a priority for the bank until 1986, when it chose to tie to
Barclays Life. This had the effect of boosting sales in an impressive
fashion (Fagan, 1990). The organisational structure at Barclays is
different from TSB, as the life subsidiary is headed by Barclays Fin-
ancial Services, which also encompasses two trust subsidiaries, an
insurance broker and Barclays Insurance Services (Lawson, 1988).
From 1988 onwards, considerable emphasis was placed on leads from
the bank branches, with 80% of sales resulting from that channel in
1992 (Hoschka, 1994).
The distribution of insurance services at Barclays relied on three
main channels in 1988 (Lawson, 1988):
 Bancassurance in the United Kingdom 55

• through regional forces, including insurance brokers and Barclays

Life representatives;
• through Barclays Bank branches;
• through direct marketing to the public from head office.

The first channel mainly relied on introductions to bank customers.

Alternatively, the branch staff completed the sales. The importance of
the Barclays Life sales force has increased in the early 1990s with the
number growing from 900 in 1989 to 1525 in 1993; and this sales force
also provided around 90% of total sales (Hoschka, 1994). Like TSB,
Barclays branches have an extensive database that allow them to
identify customers' insurance needs. However, the incentives system is
slightly different. Although branch employees do not receive any
commissions for passing on leads, Barclays Life sales force was mainly
remunerated on a commission basis, with only a small base salary. This
system was changed in 1994, to shift towards a salary-dominant
structure to avoid the possibility of hard-selling (Hoschka, 1994).
Moreover, a restructuring has taken place with the removal of man-
agement due to fears that the sales force could fall foul of the regu-
lators, because of questionable selling (Robinson, 1994c). Although,
the emphasis on bancassurance has been more delayed than at TSB,
Barclays has experienced a significant growth in its insurance opera-
tions, especially with unit-linked products, starting at the end of the
1980s. The contribution of insurance to the profits of the Group in-
creased steadily from 7% in 1988 to 40% in 1991. 2 Moreover, Barclays'
management estimated that with 1 million policyholders, only 7-8% of
the potential customer base had actually a contract with Barclays
Financial Services. However, 1993 was a poor year for Barclays with
sales of life products falling by 10%. In 1994, the annual report of
Barclays justified the poor performance of Barclays Life as follows:

In common with the rest of the UK life assurance industry, Barclays

Life was also affected by the speed and impact of regulatory change.
The resulting reduction in the number and productivity of sales
advisers, coupled with difficult trading conditions generally, ac-
counted for a 22% decrease in total sales of life, pensions and unit
trust products. During the year, Barclays Life also bore the addi-
tional costs of a major programme to enhance the training and
competence of its sales force and revised the bases of their re-
muneration, now a mix of sales bonus and commission.
(Barclays Pic Annual Report 1994, p. 16)
56 Bancassurance

These problems provide an example of how UK bancassurers in the

early 1990s had to review their selling practices in order to comply with
regulatory (PIA) requirements.
TSB and Barclays Bank were precursors in the bancassurance arena
in the United Kingdom, but the companies have had very different
developments. While TSB emphasised right from the beginning the
opportunities to cross-sell insurance products to bank customers,
Barclays Bank did not embark on this strategy until the 1980s, when
they tied their branches to Barclays Life and subsequently developed
a distribution system favouring contacts between insurance rep-
resentatives and branch staff. However, by the beginning of the 1990s
both companies had established similar distribution systems and in-
centives which aimed at increasing co-operation between insurance
representatives and bank staff.

The second tier bancassurers

Although TSB and Barclays set the trend towards bancassurance

practices, the emergence of this strategy was significantly promoted by
the FSA and BSA in 1986. Immediately following this legislation, a
number of banks and building societies started to establish stronger
links with life insurers, either through joint ventures, start-ups or
equity stakes. This included Lloyds Bank's acquisition of Abbey Life in
1988 and Midland's joint venture with Commercial Union in the same
year, while building societies such as Britannia, National & Provincial
and Woolwich, as well as the Royal Bank of Scotland, entered the
bancassurance market in 1990.

Lloyds Bank
It is slightly inaccurate to classify Lloyds Bank in the 'second tier
bancassurers' category, given that it owned a life insurer, Black Horse
Life, as early as the 1960s. Nonetheless, Lloyds Bank's name in the
context of bancassurance became known only when it acquired 57.6%
of Abbey Life's shares in 1988. The renamed Lloyds Abbey Life is a
quoted company on the stock exchange (Leach, 1993). In December
1988, Abbey Life merged with five of Lloyds' insurance subsidiaries,
including Black Horse Life. According to Hoschka (1994), Lloyds
Bank was seeking to expand its life insurance business in order to offer
one-stop shopping. Moreover, it perceived that life insurance provided
a stable stream of earnings, that was less prone than banking to
 Bancassurance in the United Kingdom 57

business fluctuations. It opted for an acquisition that, unlike a start-up,

would quickly bring the needed expertise to establish a successful life
insurance operation. The rationale for the deal from the point of view
of Abbey Life was that it offered an opportunity to broaden its cus-
tomer base through a new channel (Lloyds' branches) and improve
productivity through higher levels of sales per agent.
Soon after the merger, executives of Abbey Life joined the man-
agement team of Black Horse Financial Services. A massive training
programme was launched for Lloyds' branch employees: in the first
year alone, 3000 participated in this form of training. In 1992, there
were about 1000 sales consultants and 900 dedicated bank employees
who specialised in insurance. Bank employees focused on transaction-
based life products such as mortgage endowments, bonds and other
savings products. Where a bank employee felt the need for a more
comprehensive financial analysis, the lead would be passed to an
insurance agent, who could also offer services outside branch opening
hours. In 1991, insurance agents were integrated in the branches in
order to facilitate co-operation with branch staff.
Bank employees were remunerated on a salary basis but insurance
agents had to reach a certain level of sales to receive a salary. How-
ever, branch managers were rewarded partly according to perform-
ance, and had targets for life insurance sales. This gave branch
managers an incentive to motivate branch staff selling these types of
products and not simply passing on leads to insurance agents.
Black Horse Financial Services experienced impressive growth rates
and new premiums were greater than those of Abbey Life by 1992. In
the meantime, the performance of Abbey Life stagnated, explained by
the fact that it did not have access to the distribution channel of the
bank's branch network. Nevertheless, Lloyds Abbey Life profits con-
stituted 37% of the Group's profits in 1992, by far the most profitable
unit. In 1992, 16% of Lloyds Bank's customers had purchased in-
surance policies through Lloyds Abbey Life. Although the merger has
been referred to as the most successful merger in bancassurance (The
Economist, 20 October 1990), integration between Black Horse and
Abbey Life was less successful than expected. This may have been due
in part to regulatory constraints that limit potential synergies between
the two units (Hoschka, 1994).
Midland Bank
The decision of Midland Bank to create a joint venture from scratch
was mainly determined by the advent of the FSA. Having hitherto
58 Bancassurance

acted as an independent intermediary, the bank faced the common

dilemma of reconsidering its position; the conclusion was that Mid-
land could not satisfy the independent status requirements and
needed to tie to an insurer. The options for doing so raised con-
siderable debate inside the bank (Lafferty, 1991). Finally, Midland
decided to form a joint venture with an existing insurer, that would
quickly bring the expertise needed to build such an operation. They
opted for Commercial Union because the latter was willing to provide
relative autonomy to the bank. Midland Life was launched in 1988
with Midland Bank holding a 65% equity stake in the newly formed
company (Lafferty, 1991). They raised their stake later, and in 1994
Commercial Union's contribution amounted to only 12% of Midland
Life's equity (Hoschka, 1994).
A major difficulty was faced by management in the training of bank
staff. They had opted for the training of 8000 bank employees in 1988
but they found that, while the staff were quite willing to sell simpler,
loan-related insurance products, they were more reluctant to sell other
forms of life assurance products. Midland found that one of the main
difficulties in boosting sales from branch employees was the lack of
incentives related to the sale of these relatively complex products. As a
result of this lack of success, Midland management decided to im-
plement a direct sales force of around 250 people, that would follow
leads from the branch staff. The organisational structure followed a
similar path to that of Barclays with all insurance and investment
activities brought together in 1991 to form Midland Financial Services.
While there were no particular incentives for branch staff to pass on
leads, branch performance was assessed on the basis of the profit-
ability of its customer base, including insurance profits. To avoid cul-
tural conflicts due to the fact that the insurance sales force received
commissions on top of a basic salary, a route was provided for branch
employees wishing to tum to insurance sales (Hoschka, 1994). Although
Midland management have stressed that profitability was satisfactory,
the penetration of the customer base has been less successful than in
other bancassurance experiences, with Midland Life having contracts
with only 2-3% of their bank customers (Hoschka, 1994).

Britannia Building Society

Britannia's entry into bancassurance is an interesting case study
because it involved a merger with a mutual insurer. It was also the first
building society in the United Kingdom to move into wholly owned
 Bancassurance in the United Kingdom 59

insurance product 'manufacturing' (Leach, 1994). In 1990, Britannia

acquired demutualised FS Assurance, which was renamed Britannia
Life. The move occurred for two main reasons. FS Assurance had
been in a difficult position following the decline of the IFA (in-
dependent financial advisors) market and were seeking an option to
cut down costs and assure their policyholders a reasonable return: they
thought that this could only be achieved by being part of a larger
group. In parallel, Britannia was reconsidering its independent posi-
tion, feeling that the costs of continuing independence were too high.
FS circulated a shortlist through a third party, in order to identify
potentially interested acquirers and Britannia quickly reacted to the
proposal: a few months later, Britannia Life was formed (Lafferty
Conference Transcript, 1991). The new company appointed a Rep-
resentative Division to deal with the relationship between Britannia
Life and the Society. This Division also had the aim of convincing the
traditional IFAs of former FS Assurance that their position would not
be threatened by the new arrangements. The management recognised
that they underestimated the role of local inspectors that traditionally
recommended the sales force, who found it difficult to adjust to this
void. This resulted in a change in the structural organisation to
improve distribution systems (Lafferty Conference Transcript, 1991).
Britannia Life relied on three main distribution channels: the
building society, its estate agent subsidiary, and former FS Assurance's
existing IFA business. Britannia Life's growth was steady with new
premiums rising from £70 million in 1991 to £105 million in 1992
(Leach, 1994). Moreover, the life arm brought in one-quarter of the
group's profits in 1993 (Jarman, 1994).

National & Provincial Building Society

National & Provincial followed the move towards tying to an insurer,
when they started a joint venture with General Accident in February
1990. The latter had a 25% equity stake in the newly formed N&P Life
Assurance Company. The deal made General Accident responsible for
administration and processing handling (Elkington, 1993). In early
1992, N&P Life acquired a unit trust company, Key Funds Management,
and in 12 months doubled the funds under management (Leach, 1993).

Woolwich Building Society

Woolwich Building Society had a similar experience to National &
Provincial. Woolwich Life was launched in October 1990, a joint
60 Bancassurance

venture with Sun Alliance which had a 49% equity stake (Leach, 1993).
This agreement was due for review in 1995 and in 1994, Woolwich
decided to take over control of the subsidiary (Jarman, 1994).
Products of Woolwich Life are sold via two channels: the building
society and its estate agency subsidiary (Leach, 1993). The products
have been kept at a minimum. Four main products were sold, including
an ordinary endowment product, a mortgage protection scheme, a
level term policy and a guaranteed income bond (Etherington, 1993).
Unit trusts were offered by the company and could be bought using a
card at any of the branches (Leach, 1993). In 1992, the Society sold £98
million new premiums compared to £25 million in 1991.

Royal Bank of Scotland

The Royal Bank of Scotland's involvement in insurance started in
1985, when it launched a direct motor and household insurance sub-
sidiary, Direct Line. The latter is one of the only examples of British
bancassurance in the field of general insurance and has experienced a
dramatic success since its creation (Wood, 1995). However, the bank
did not get involved with life assurance until 1990, when it launched a
joint venture with Scottish Equitable, which owns 49% of Royal
Scottish Assurance. This decision was attributed to the polarisation
requirement introduced by the FSA in 1986 (Lafferty, 1991).
The venture started with a range of seven core products and 3500
branch staff were trained to sell basic insurance products. A specialist
force, which is based in the branches but is composed of employees of
the insurance subsidiary, handles more sophisticated demands. The
remuneration principles follow those of many bancassurers, with the
branch being remunerated for leads and sales completion. The insur-
ance sales consultants are paid on a salary basis but can gain bonuses if
they reach their targets. In the first year of operations, the venture
seemed to be satisfactory for both partners (Lafferty, 1991). This
seemed due to the fact that Scottish Equitable was not depending on the
subsidiary for its business. The contribution of life assurance to the
profits of the banking division, increased from less than 1% in the first
year of operations t05.6% in 1993 and 15.2% in 1994 (Annual Reports).

There were a number of linkages between banking institutions and

insurance companies at the end of the 1980s. This was largely related
to the polarisation requirement that prompted banks to secure long-
term links with single insurers. The main ~oute chosen by the new
 Bancassurance in the United Kingdom 61

bancassurers was the joint-venture form that allowed them to tap into
the expertise of an existing insurer. Although sales organisations have
needed restructuring in some instances, the new entities have largely
depended on a system of leads from branch staff to insurance sales-
staff. In some instances, the branch staff were trained to sell less
complex life products.

Recent additions to the bancassurance scene

With the growth of bancassurance in the 1980s, banking institutions

which were not involved in this strategy became rare in the UK
market. Five large banking institutions ultimately followed the ban-
cassurance trend. These recent bancassurers include National West-
minster and Abbey National in 1993, as well as Leeds, Halifax and
Nationwide Building Societies.

National Westminster
National Westminster Bank was the only clearing bank which opted
for independent status after the FSA. At the time, it found itself
satisfied with the brokerage income it received, and it retained the
flexibility to go down the tied route or set up its own company in the
future (Fagan, 1990). The latter was achieved when it launched a joint
venture with Clerical Medical in 1993, of which National Westminster
held 92.5%.
An interview with P. Feeney, strategic planner at National West-
minster Life in 1993 emphasised the merits of the mode of entry
chosen (Genetay, 1993). First, Feeney emphasised the difficulties in-
volved in the previous independent strategy, where branch staff,
broker, and life insurance companies were involved in selling, which
raised three levels of potential distribution break-down. He also ar-
gued that tying to an own joint venture permitted National West-
minster to get the necessary expertise from an established insurer,
Clerical Medical, which could provide funds management to the newly
formed company on a competitive basis. Moreover, the deal involved
an option to buy back the stake of Clerical Medical in 1998. Feeney
also compared the stability of life assurance earnings with those in
banking, and emphasised the overall beneficial effects these could
have on the Bank's earnings. The organisation was concerned with the
need to establish a culture that would integrate insurance products. It
rejected the principle of a commission-based incentives structure and
62 Bancassurance

instead used a sales force, who posed as bank employees, and were
paid a basic salary and bonus (Genetay, 1993). In 1993, the Group had
a 1400-strong specialist sales force, with access to the records of
branch customers. The latter is permitted because the sales force are
regarded as employees of the Bank. The set-up, however, raised crit-
icisms from the Office of Fair 'frading (Robinson, 1994a).
The newly formed company benefited from a large investment of
£150 million and expectations ran high at the time of formation. lWo
years after the launch, part of these expectations had been realised
with National Westminster Life ranking tenth among the top life
insurance companies in 1994 (National Westminster Group Annual
Report, 1994). This was in contrast to the downturn in fortunes
experienced by other more established bancassurers at that time, such
as Barclays Life and Lloyds Abbey Life (Robinson, 1994b).

Abbey National
The main characteristic of Abbey National was that it was the first
building society to use the conversion procedure permitted under the
1986 new framework. After converting in 1989, the new pIc then ter-
minated a tied agreement with Friends Provident, to which it provided
30% of new premiums. It intended to tie to its own life assurance
subsidiary, a joint venture with Scottish Mutual, itself an acquisition of
Abbey National in 1988. Scottish Mutual provided the expertise of
an established insurer to set up the new company, while it continued
working through its main channel of distribution, the IFA market.
Abbey National Life's staff was drawn from within the insurer's and
bank's ranks as well as through external recruitment (O'Mahony,
1991). Abbey National Life was expected to use fmancial services
advisers, based in the branches but not remunerated on a commission-
dominant basis (Lysaght, 1992). Sales would also be made through the
400 branches of the estate agency subsidiary, and through direct and
telephone marketing (Lysaght, 1992). The contribution of Abbey
National Life and Scottish Mutual to the Group's profits increased
from 4% in 1992 to 8% in 1993, with a good performance of the new
company in its first year of operation (Abbey National Group Annual
Reports, 1993).

The very latest bancassurers

The most recent additions to bancassurance have been in the building
societies' market, with Leeds Permanent taking the lead by estab-
 Bancassurance in the United Kingdom 63

lishing Leeds Life in 1994, Halifax and Nationwide following in 1995.

This indicates the growing importance of building societies in the
bancassurance market in the United Kingdom. Leeds Life is paying
General Accident Life, an established insurer, to provide adminis-
tration systems but is designing its own products. Leeds Life took
advantage of the new impending regime to move close to full com-
mission disclosure, as soon as it was launched in July 1994. Halifax
Life was launched at the beginning of 1995, with similar objectives in
mind. It planned to charge a standard fee on all its range of products.
Halifax Life's sales force would be remunerated on salary mainly, with
25% as bonus from sales (Jarman, 1995). Finally Nationwide launched
Nationwide Life in 1995. All three building societies terminated ex-
isting tied agreements: Halifax with Standard Life, Nationwide with
Guardian RE and Leeds Permanent with Norwich Union (Jarman,
1994). Halifax, for example, used to account for 18% of Standard
Life's new business (Lindisfarne, 1992).
Finally, the three UK banking subsidiaries of National Australia
Bank (Yorkshire Bank, Clydesdale Bank and Northern Bank) were
expected to begin selling the products of National Australia Life,
subsidiary of the parent company, in 1995, probably under their own
brand name. They would also terminate their existing ties with UK
insurers when moving to this more active bancassurance strategy
(Smith, 1994).

These more recent additions to the bancassurance scene have involved

five strong members of the retail banking industry. They were among
the top five banks and building societies, respectively. This suggests
that these new entries will raise the level of competition in the market
even further and this may cause some casualties in the life assurance
market, which runs the risk of becoming overcrowded. The first casu-
alties could be the life insurers to which banking institutions were tied
and who may find substitution difficult in the short term.

'Assurbanque' in the United Kingdom

~surbanque' is a catchword that has been used to designate the

involvement of insurers in banking, through the distribution of bank-
ing products, or capital involvement in the banking industry. This has
been quite limited in the United Kingdom, but there has been a not-
able exception in Standard Life's substantial shareholding in the Bank
64 Bancassurance

of Scotland. More recently, some insurers have shown interest in the

banking market.
The Bank of Scotland tied to Standard Life in November 1989,
which at the same time acquired a 33% stake in the bank, which
cemented the distribution agreement. All the 4000 branch employees
received training and had to sit examinations from Standard Life. The
bank staff pass on leads to financial consultants - roughly 110 in 1993
- who were recruited from the Bank and trained by Standard Life.
These financial consultants are paid on a salary basis with a bonus
payment dependent on performance. Although life insurance sales
did experience high growth rates, these were below expectations
(Hoschka, 1994).
More recently, some insurers have become involved in the selling
of banking products. Pearl Assurance came up with 'Reward', a tele-
phone banking service which is aimed at its 2.5 million customers for
the deposit of their maturity cheques. As Pearl does not have a
banking licence, the account is run by Midland Bank (Hislop, 1995). In
the same way, Scottish Widows has announced the establishment of a
bank (Hislop, 1995). More recently, Wesleyan Assurance Society has
gained a banking licence for the Wesleyan Savings Bank (Banking
World, 1995). Finally, Prudential obtained a banking licence in 1996.
Such moves should be welcome by some observers who have crit-
icised the passivity of insurers facing the bancassurance trend, e.g.
Etherington (1993).The latter emphasised the paradox for insurers
who helped banks to set up their own insurance operations, either by
engaging in minority joint ventures or by making short-term dis-
tribution agreements, whereby banks learned fundamental insurance
skills. These insurers run the risk of seeing the end to these agree-
ments and losing precious distribution channels (this was the case of
Friends Provident when Abbey National chose to terminate their tied
agreement). Etherington (1993) argued that insurers may well be at a
competitive disadvantage with bancassurers in an integrated financial
services industry. They might have to engage in a strategy already used
by their European counterparts, of diversification into banking
(Etherington, 1993).
Overall, the FSA provided a substantial boost for the emergence of
the bancassurance strategy, which has been acknowledged by a num-
ber of bancassurers, who set up a life assurance subsidiary at the end
of the 1980s. This trend appears to have continued unabated during
the 1990s with banks and building societies now setting up their
own in-house insurance subsidiaries. Bancassurance has become a
 Bancassurance in the United Kingdom 65

significant characteristic of the financial services industry in the Uni-

ted Kingdom.

3.3 MAIN FEATURES OF BANCASSURANCE IN THE

UNITED KINGDOM

This section summarises the main characteristics of the UK bancas-

surance trend that emerges from the above review. First, we review the
modes of entry ,chosen to enter the bancassurance market. Second, we
examine the type of organisational structures that have been estab-
lished in these bancassurance conglomerates. Finally, we examine the
main aspects of bancassurance distribution, which was identified as a
key factor in the success of various bancassurance operations.

Modes or entry in bancassurance

A summary of the modes of entry by the aforementioned bancassurers
is shown in Table 3.1. This table excludes distribution agreements
which were not accompanied by some kind of capital link. However, a
number of building societies that are not involved in any capital links
with insurance companies act as tied or independent intermediaries
for the latter. Thble 3.1 shows that the main route of entry into ban-
cassurance has been in the form of set-ups of new life assurance
companies by banks, either on their own or through ventures with
insurers.
The rationale for choosing the joint-venture route has been mainly
the need for an insurer's expertise in starting an operation. This was
underlined by National Westminster (Genetay, 1993) as well as Royal
Bank of Scotland (Lafferty, 1991). These ventures have been subject
to alterations as was the case for Woolwich Building Society, which
decided to take full control of the operation four years after its
creation (Jarman, 1994) or Midland that increased its stake from 65%
to 88% in Midland Life. The main reason for the joint-venture entry
appears therefore to be the perceived need for different skills, which
are unfamiliar to banking institutions. In some cases, the administra-
tion back-up is entirely provided by the insurance partner (National
Westminster with Clerical Medical or N&P with General Accident).
In most cases, start-ups are the consequence of a sequenced entry
(Porter, 1985), whereby banks have acquired insurance expertise
through previous agreements with established insurers.
66 Bancassurance

Table 3.1 Modes of entry of UK bancassurers

Banking institution Insurance company Type of link Date

TSB Bank TSB Life Start-up 1967
Barclays Bank Barclays Life Start-up 1969
Bank of Scotland Standard Life Standard owns 34% of 1986
the Bank
TSB Bank Target Acquisition 1987
Midland Bank Midland Life JV 65% w. Commercial 1988
Union l
Lloyds Bank Abbey Life Acquisition 57.6% 1988
Britannia FS Assurance 2 Acquisition 100% 1990
National & N&P Life JV 75% w. General 1990
Provincial Accident
Woolwich Woolwich Life JV 51 % w. Sun Alliance3 1990
Royal Bank of Royal Scottish Life JV 75% with Scottish 1990
Scotland Equitable
Abbey National Scottish Mutual Acquisition 1991
Abbey National Abbey National Life JV w. Scottish Mutual4 1993
National Nat West Life JV 92% w. Clerical 1993
Westminster Medical
Halifax Halifax Life Start-up 1994
Leeds Leeds Life Start-up 1994
Nationwide Nationwide Life Start-up 1995

1 Increased to 88% in 1994. 2 Now Britannia Life. 3 Increased to 100%.

4 Scottish Mutual is a wholly owned subsidiary of Abbey National. JV =joint
venture

There have been few acquisitions in the bancassurance market

in the United Kingdom. Examples involve Lloyds Bank's acquisition
of 57.6% of Abbey Life's shares and Britannia's acquisition of FS
Assurance. The rationale of the former was to quickly acquire the
expertise necessary to boost sales of the former subsidiary Black
Horse Life, to which they tied (Hoschka, 1994). The latter became a
subsidiary of Abbey Life. For Britannia, the interest shown by FS
Assurance in becoming part of a larger financial services group
precipitated the decision to abandon the independent status and tie
to a subsidiary with ready-made expertise. For Abbey National, the
acquisition of Scottish Mutual was the first step towards integrated
bancassurance, which was fmalised by setting up Abbey National Life
with the collaboration of the wholly owned Scottish Mutual.
Whatever the route chosen by UK bancassurers, their strategy was
often preceded by previous experiences in the life assurance field that
 Bancassurance in the United Kingdom 67

helped them build their own operations. For those that did not start
up a company on their own, the main rationale was to benefit from an
established insurer's expertise, that they felt was needed to launch a
life assurance operation. Bancassurers in the United Kingdom have
been equally divided between the own or joint-venture start-ups with
few institutions seeking an outright acquisition.

Organisational structures

An important decision following the establishment of a life assurance

subsidiary is how to integrate the new subsidiary into the existing
structure of the banking group. Although most groups kept both lines
of business separate, efforts to integrate both activities were made by
various institutions. This included efforts to integrate the subsidiary
under the leadership of an insurance and investment services division
(Barclays, Midland), but also to integrate both banking and insurance
services in the same division.
Barclays opted from the beginning for an organisational structure
that would embrace all investment and insurance activities of the
group in the same division, Barclays Financial Services (Lawson,
1988). At Midland Group, the insurance operation was first placed as
an independent subsidiary of the group, but in 1991 that structure was
altered in order to integrate the strategy of the subsidiary into that of
the group (Hoschka, 1994). Midland Life and other insurance and
investment subsidiaries were brought together under the leadership of
Midland Financial Services.
Lloyds adopted a similar structure following its acquisition of Abbey
Life in 1988. In exchange for the stake, it gave Abbey Life control over
five insurance and investment subsidiaries, including Black Horse Life,
its life assurance subsidiary (Abbey Life, 1988). Abbey Life managers
joined the executive board of the latter.
Although the above structures seem to have succeeded in bringing
bancassurance benefits, TSB followed a different route in 1991, fol-
lowing fears that integration was insufficient to meet the corporation's
objectives to fully integrate both activities. It formed a division that
embraced both retail banking and insurance operations (see Figure
3.2). There were two sides to this move: one was to adopt a more
customer-focused approach and the other to integrate both top
managements. According to the scheme, employees of both com-
panies were assessed as part of the same unit, i.e. at the branch level.
68 Bancassurance

Such efforts were aimed at increasing the integration of insurance

agents under branch leadership.
The main rationale behind the choice of an organisational structure
for bancassurers is the need to promote collaboration between the
bank staff and insurance agents of the subsidiary company. Ultimately,
the goal is to achieve distribution synergies between the two entities,
so that bank customer penetration increases. This suggests that dis-
tribution is the key factor that might be considered by banking groups
in choosing an organisational structure.

Distribution: the key factor to success in bancassurance?

Life assurance subsidiaries of banks have relied on various distribution

channels. Nonetheless, the main objective of bancassurers is success
in selling insurance products to their bank customers. This objective
faces obstacles that relate to motivation; this in turn suggests that
bancassurers have to find an appropriate incentive system to achieve
distribution synergies.

Main channels of distribution in bancassurance

Barclays Life provides an example of a bancassurance subsidiary that
relies on a variety of channels. It has three main aspects in its
distribution strategy: direct sales (e.g. using mailing techniques), a
regional force composed of brokers and representatives, and bank
branches. The latter represents more than 90% of sales and relies on
two forces: the branch staff and Barclays Life representatives that are
allocated to bank branches. This is a scheme common to other banc-
assurers that seek to integrate both activities by increasing contacts
between insurance agents and bank staff. The importance of Barclays
Life representatives in branches has grown with the total number
increasing from 900 in 1989 to 1525 in 1993 (Hoschka, 1994).
At TSB, there are insurance specialists that are linked to one branch
(around 850) and follow leads from branch staff, plus a direct sales
force of around 200 agents. At Lloyds, a training programme for 3000
bank employees was launched but in 1991, 1000 sales consultants were
integrated into the branches with 900 dedicated bank employees
making simpler sales. At Midland, a similar change took place: after
training 8000 bank employees, the bank shifted to a specialist sales
force of around 250 that follow leads from branches. At Royal Scottish
Assurance, the distribution of products is similarly divided between a
 Bancassurance in the United Kingdom 69

specialist sales force integrated in the branch, and a direct sales force.
Similarly financial consultants exist at Abbey National branches, and at
the Bank of Scotland 110 fmancial consultants complete more complex
sales, while training was given to 4000 bank employees.
The system whereby insurance specialists are allocated to branches
requires the co-operation of bank employees to identify and pass on
leads to customers requiring insurance products. They are likely also
to be assisted by a database that includes customer attributes, as in
most banks such as Barclays Bank and TSB. A problem associated
with bank employees who sell insurance products is the possible lack
of skill and qualifications of this sales force. This has become a sig-
nificant source of concern for regulators as well as insurance (and
pensions) intermediaries in recent years (Robinson, 1994a).
The main distribution channel for bancassurers is bank branches. To
achieve customer penetration, most have used insurance specialists
that are allocated to bank branches and rely on leads from bank staff.
The collaboration of both units is crucial to the distribution process
and has been the focus of managerial efforts.

Managerial efforts to achieve distribution synergies

The main difficulty faced by managers in bancassurance is to motivate
bank staff to make insurance sales or pass on leads to insurance
specialists. There may be some conflicts of interests between insurance
and bank staff, who are known to have different cultures, with the
former traditionally known for their hard-selling techniques and
commission-based remuneration. There have been three main re-
sponses of bancassurers to this difficulty.
The first response of managers to facilitate contacts between branch
staff and insurance specialists has been to integrate insurance spe-
cialists into the branch networks. By doing so, they ensure that con-
tacts between the two parties are frequent and increase the feeling of
belonging to the same entity. Lloyds integrated sales consultants to the
branches in 1991 to increase this type of co-operation.
The second response to potential conflicts of interests has been the
initiative by some banks to integrate insurance sales in the assessment
of branch performance. This is the case at all the main banks - it
encourages branch managers to motivate their staff to sell insurance.
At the Royal Bank of Scotland, commissions of sales referrals and
completion are fed into the branch account. Hoschka (1994) argued
that this type of group assessment should work as a stimulus if salaries
70 Bancassurance

are made partly dependent on achieving target branch sales. Many

banks operate such schemes.
The third response to avoid clashes between insurance specialists
and branch staff is to base the remuneration of the former in line with
bank employees rather than traditional insurance agents. Several banks
in the United Kingdom have opted for a salary-based remuneration for
branch-based agents. At Lloyds, sales consultants at branches receive
a salary that is based on reaching a target level of sales. At Abbey
National, the Bank of Scotland and National Westminster, the emphasis
is also on a salaried insurance sales staff. At TSB, bonuses can double
salary for such agents while Barclays has shifted in 1994 from a
commissions-basis to a remuneration based mainly on salary. The fact
that more recent bancassurance operators have chosen the salary-base
route may indicate that they have learned from experiences of ban-
cassurers in the United Kingdom and elsewhere, who had to face
cultural conflicts based on remuneration differences.
Bancassurers have placed a strong emphasis on integrating in-
surance specialists in the banking organisation, in order to achieve the
penetration of the bank customer base. Although motivating branch
staff to sell insurance and pass on leads to insurance consultants has
been a source of difficulties for bancassurers, the latter have estab-
lished a number of responses to increase the cultural unity between
the two sets of employees so that insurance agents are integrated into
branch units. Such efforts are aimed at levelling the playing field be-
tween the incentives of both parties.
De novo entry - own start-ups or joint ventures - has been the
preferred choice of British bancassurers. Particular attention has been
placed on integrating both activities, through the choice of an appro-
priate organisational structure but mainly through achieving integra-
tion in the distribution function. The latter was sought through the
integration of insurance specialists in the branch and by reducing
potential conflicts of interests between bank employees and these
agents through similar remuneration treatments. The success of this
integration appears fundamental in determining the success of entry
into bancassurance.

CONCLUSION

This chapter examined the development of bancassurance in the UK

market. First, we reviewed some regulatory changes that have been
 Bancassurance in the United Kingdom 71

perceived as important determinants of this trend. The deregulation of

building societies' powers played a part by allowing these institutions
to own life assurance subsidiaries in 1988. The polarisation concept in
the FSA (1986), that obliged banks and building societies to choose
between tied and independent status, precipitated ties of these
institutions to their own subsidiaries. The change in regulations cor-
responded with an acceleration of the bancassurance trend. Overall,
the analysis presented in this chapter indicates that UK bancassurers
have mainly chosen to set up new subsidiaries, particularly through
ventures with existing insurers. UK bancassurers have also been
characterised by sustained efforts to achieve the integration of both
activities, so that distribution synergies can be achieved. In particular,
they have tried to integrate the bank staff and specialist insurance
agents. Contrary to traditional insurance representatives, specialist
sales forces integrated at bank branch level have had their re-
muneration based on salary (plus bonus) schemes rather than being
entirely commission-oriented. Overall, bancassurance has become an
increasingly significant phenomenon in the United Kingdom. With
16% of the distribution of life premiums in 1994, banking institutions
in the United Kingdom still lag behind some of their European
counterparts, but the entry of new bancassurers in the market recently
is expected to help narrow this gap. The bancassurance diversification
process is therefore a significant strategic evolution for banks. The
motives behind this strategy may be found in a more global analysis of
corporate diversification, which we will review in a following chapter.

Notes

1. This conversion is reviewed in detail in ~bbev National: Conversion to

PIc', by Reid (1991). -
2. This high figure reflects a bad year for Barclays Group in other activities.
4 Bancassurance in Europe

INTRODUCTION

This chapter examines the development of bancassurance in various

European countries, including France, Germany, Italy, the Nether-
lands and Spain. It also examines the major bancassurers in each
country and aims to identify the factors that led to the development of
this strategy. The analysis serves as a basis for our cross-country
comparison in the latter part of the chapter. We compare the ban-
cassurance strategies in different countries according to three dimen-
sions: the importance of country-specific factors in promoting the
bancassurance phenomenon, the entry structures dominating in dif-
ferent countries, and the level of bancassurance integration.

4.1 BANCASSURANCE IN FRANCE

French bancassurance is one of the most integrated in the world.

Banks' shares of the life insurance market has grown at a dramatic
pace since the 1980s and French banks have recently started an
aggressive entry in general insurance. Many French bancassurers are
well-known models for foreign counterparts, but French bancassur-
ance has long been characterised by specificities that make its success
difficult to imitate.

French bancassurers in the life sector

Most banks in France have distribution agreements or cross-share-

holdings with life insurers. The most significant link-ups are shown in
Thble 4.l.
French precursors in the field of bancassurance were probably little
aware of the future success of this strategy. The development of the
ACMs, or Assurances du Credit Mutuel, springs from the very nature
of Credit Mutuel, a co-operative movement for farmers, created in the
nineteenth century and heavily present in Eastern, Central and West-
ern areas of rural France. Credit Mutuel is still organised in inde-
pendent regional federations. The heavy pres~nce of Credit Mutuel in

72
 Bancassurance in Europe 73

Table 4.1 French bancassurers in the life insurance sector

Bank Insurance company 1Ype a/link ~ar

Credit Mutuel ACM Vie Start-up 1970

Credit Lyonnais Medicale de France Acquisition 100% 1971
Societe Generale UMAC Acquisition 1973
Compagnie Bancaire Card if Start-up 1973
BNP Natio Vie Start-up 1980
Banques Populaires Fructivie Joint venture w. Cardif 1982
Societe Generale Sogecap Start-up 1984
CIC GAN GAN owns 82% of CIC 1985
BNP Assu-Vie Joint venture w. GAN 1985
Credit Lyonnais Union des Start-up 1985
Assurances
Federales Vie
Credit Agricole Predica Start-up 1986
Caisses d'Epargne Ecureuil Vie Joint venture 51 % w. CNP 1988

Source: Authors' own compilation.

AIsace (near the German border), partly explains its early entry into
the insurance sector. It is seen as a follower of the Raffeisen und
Volkensbank (R&V) movement in Germany, a co-operative move-
ment which promoted both insurance and banking products. The
ACMs (life and general insurance) started operations in A1sace in
1975 1 and the experiment was then taken up by federations around
France (Daniel, 1995). By 1992, insurance premiums amounted to
FF8.5 billion (75% in life assurance) and policyholders to approxi-
mately 3 million. Credit Mutuel estimated that 20% of its new cus-
tomers were gained through its insurance activities.
For Credit Lyonnais, bancassurance started with an opportunity to
take over La MedicaIe de France (an insurance company specialised in
health care) in 1971. However, a former executive at Credit Lyonnais,
admitted that this was more a chance acquisition than a long-term
strategic choice to engage in insurance operations. Credit Lyonnais
was most interested in capturing the banking business of its medical
clients than in insurance per se. This attitude changed in the 1980s
when bancassurance became the norm among French banks and
Credit Lyonnais followed suit by engaging in a variety of insurance
operations domestically and abroad (La Tribune de l'Assurance,
1993). Assurances Federales Vie which realises around 98% of its
sales through the branches has been characterised by the fluctuating
74 Bancassurance

nature of its growth; after actually decreasing between 1989 and 1991,
Assurances Federales Vie experienced a strong growth between 1992
and 1994 (Daniel, 1995). In 1993, sales at Assurances Federales Vie
amounted to FFlO,799 million (Lemoine, 1994). Most of the growth
was attributed to branch sales of simple investment products, similar
to many other French bancassurers.
Compagnie Bancaire had a more visionary approach when it started
Cardif in 1973. The bank wanted to maximise the commercial
potentialities of its numerous specialised subsidiaries and reflected on
the cross-selling opportunities of insurance activities. Cardif, a life
assurance operation was created, and soon became one of the most
innovative life assurance companies in France. By 1976, it developed a
mail order distribution system, and in 1980 it designed a pension plan
package for corporations. In 1985, the company's turnover grew by
118% (La Tribune de I'Assurance, 1993).
The beginning of the 1980s marked the entry of other large banks
into the bancassurance market, and a clearer strategy to cross-sell
insurance products through bank branches. BNP (Banque Nationale
de Paris) started up Natio Vie in 1980. BNP posted insurance spe-
cialists in branches, who co-operated with branch employees to sell life
insurance products. Natio Vie had become extremely successful in the
beginning of the 1990s after a relatively modest debut. Sales were
boosted in the 1980s when BNP decided to form a joint venture, Assu-
Vie, with GAN (third insurer in France) in the hope to gain expertise
from its partner in the venture. The strategy bore fruit: 1992 saw
a boost of around 87% of Natio Vie's premiums (Leach, 1993).
The company's sales grew at a still impressive + 23% the next year
(Lemoine, 1994).
Banques Populaires chose a gradual approach to bancassurance. It
created Fructivie with Cardif in 1982. Cardif managed the new com-
pany at first but products were distributed via the network of
independent banks that form Banques Populaires. Soon the banks
increased their participation to 51%, with Cardif keeping only a
minority stake in the company (La 1fibune de I'Assurance, 1993). The
company's sales grew at an impressive +52% rate between 1993 and
1994 (Lemoine, 1994).
Societe Generale acquired 85% of the shares of a small life insur-
ance company, UMAC, in 1973, and extended its control to 98% in
1984. Sogecap was officially launched in 1984 and has displayed strong
differences with other bancassurers. It has always insisted on retaining
a life insurance culture rather than integrating fully within the banking
 Bancassurance in Europe 75

group. Sogecap's range of products reflects this by including pure life

policies, in contrast to most bancassurers (La Tribune de l'Assurance,
1993). It has not experienced the impressive growth rates of its ban-
cassurance counterparts and experienced a slight decline in sales
between 1992 and 1993 before growing by 57% in 1994 (Daniel, 1995).
Sogecap fared rather better than other bancassurers when activity
slowed down in 1990, due mainly to the removal of advantages on
'bons de capitalisation'. The wider range of products of Sogecap has
acted as a stabiliser to its growth but the company is sensitive to
changes in Societe Generale's strategy. The bank's varying degree of
interest in promoting insurance products also contributes to explain
the counter-cyclical nature of Sogecap's growth.
The French star of bancassurance, Predica, was established in 1986
by Credit Agricole, the country's largest. Credit Agricole has a wide-
spread presence all over France, and a ready customer base of 10
million households (La Tribune de l'Assurance, 1993). Pitts (1990)
wrote the following about the start-up:

The real French prodigy has been Predica, the life assurance sub-
sidiary of the Credit Agricole bank. Predica has exploited the bank's
10,000-strong branch network so effectively that in four years it has
grown into the second biggest life assurance company in France with
turnover last year [1989] of FF 21.6 b.

Predica exploited one of the major factors that had promoted

French bancassurance, the development of 'bons de capitalisation', i.e.
long-term contracts mostly in the form of single premium policies.
Until 1988, it was the only product that enabled French savers to
accumulate capital and to get tax relief on the income at the end of the
accumulation period. The main product of Predica, Predicis, which
contributed 80% of turnover in 1988 and 60% in 1989, was a single
premium six-year contract which incurred no capital gains at the end
of the period making it effectively a savings contract (Pitts, 1990). This
feature should not undermine the success of Predica whose turnover
grew by 161.4% between 1987 and 1988 and a still impressive 25%
between 1988 and 1989. Moreover the company managed to maintain
low expenses which gave it a substantial cost advantage over the other
market participants. It was shown that Predica managed commissions-
to-turnover ratios of 1.7% and expenses to commissions ratios of 1.3%
in 1987 compared to respective ratios of 3.5% and 11.5% in the rest of
the profession (Pitts, 1990). Premium income in 1992 amounted to
76 Bancassurance

FF 18,306 million, up around 35% from the previous year (Leach,

1993). It was up another 64% a year later (Lemoine, 1994).
Caisses d'Epargne, another large federation of savings banks in
France with 4300 branches, have long been involved in the distribution
of CNP's life products but it was not until 1988 that a formal separate
entity was created to accommodate CNP's need to differentiate its
various distribution agreements with banks. Ecureuil Vie is a joint
venture between Caisses d'Epargne and CNP who each hold half of
the entity. The manufacturing process and the administration of con-
tracts still takes place at CNP but the new company is in charge of the
distribution and marketing of the policies. In 1994, sales turnover was
FF 22.5 billion (Daniel, 1995). Ecureuil Vie thus made a late but
significant entry into the French bancassurance market.
The most striking aspect of French bancassurance, in particular
in the field of life insurance, is the substantial market share banks
achieved in a relatively short period. McDaniel (1996) estimated that
63% of new life insurance sales in 1994 came through banking chan-
nels. Thble 4.2 shows the market shares achieved by the major French
bancassurers in 1992.
A major factor for French bancassurers' success has been their
ability to achieve substantial costs savings in comparison with their
insurance counterparts. Table 4.3 illustrates this advantage.
Another interesting feature of French bancassurance is what some
have named 'assurbanque'. This catchword relates to the recent in-
volvement of insurance companies in banking activities and especially
the involvement ofGAN, the third insurer in France (measured by asset

Table 4.2 Major French bancassurers' market shares 1 1992

Company Market share (%)

Predica 7.0
Ecureuil Vie 4.5
Natio Vie 3.8
Sogecap 3.5
Assurances Federales Vie 3.2
Socapi 2.5
ACMVie 1.8
Fructivie 1.5

1Computed as premiums as a percentage of total market

Source:Computed from Thble 5.6, p. 63, in European BancassUIflnce, by Leach, FT
Management Report, 1993.
 Bancassurance in Europe 77

Table 4.3 Commissions and expense ratios of French life insurers 1991

Company Commissions and

expenses to gross premiums
Bancassurers Ecureuil Vie 3.1%
Sogecap 4.0%
Natio Vie 4.7%
Predica 5.0%
SOCAPI 5.5%
ACM Vie 7.5%
CNP 10.5%
Traditional insurers Mutuelle du Mans 13.8%
Axa Assurances Vie 16.9%
UAP Vie 17.6%
AGF Vie 18.0%
GANVie 22.0%

Source: Selection from Table 4.3 p. 47 in European Bancassurance, by Leach, FT

Management reports, 1993.

size). GAN broke into the world of bancassurance when it acquired

CIC. This acquisition took place in three stages: GAN first acquired
34% of CIC's shares in 1985, then increased its participation to 51%
in 1989 and to 82% in 1991. By 1986, both companies created a life
assurance venture, SOCAPI. In 1989, GAN decided to accelerate its
bancassurance operations, i.e. to actively promote SOCAPI's products
inside CIC branches. The turnover of SOCAPI tripled reaching FF3
billion by the end of 1989; in 1992, it amounted to FF6 billion (La
ltibune de I'Assurance, 1993). The striking feature of this association is
that it includes two major players of the banking and insurance industry.
These 'assurbanque' links encountered much scepticism among
insurers who argued for adherence to their original expertise. For
example, the chief executive at UAP underlined that, despite their
links with BNp, they were not willing to engage in further banking
operations (Pitts, 1990) Moreover French insurers mostly see banc-
assurance as a means for banks to reinforce a poor capital base (Pitts,
1990) to the detriment of insurers.

<ieneral insurance

Historically, Credit Mutuel was the first French bank to engage

in general insurance business. ACM lard was launched in 1971.
According to Lemoine (1994), ACM lard was the only bancassurer
78 Bancassurance

which could successfully claim to be a success in distributing general

insurance. Sales amounted to FF2.4 billion in 1993 up around 11 %
from the previous year, half of which were made in motor insurance.
The key to ACM lard's success has been low costs: it achieved a 18.9%
ratio of expenses and commissions to gross premiums compared to
30% for traditional companies (Lemoine, 1994).
The experiment of BNP in this area has raised much interest,
especially because it involved one of the two largest commercial banks
and the leading insurance company in the French market, UAP. Both
financial institutions were government-owned in 1989 when they
swapped 10% of their equity, which undoubtedly facilitated the cross-
shareholding agreement. For BNP, the advantages of the agreement
were obvious: they gained the proven expertise of UAP in general
insurance and could distribute their products through their 2000-
branch network, knowing that their image would not be damaged by a
low-quality product. BNP and UAP created a 50-50 brokerage firm,
Natio Assurance, which trades UAP products. The agreement was that
UAP would be responsible for underwriting and claims handling -
home, car, health insurance - while the policies would be sold through
BNP branches (La 1Tibune de l'Assurance, 1993). This arrangement
met with some resistance from UAP's representatives but in return
they were allowed to sell some BNP products to their own customers.
The distribution agreement started in five experimental areas and only
five products were involved: two car policies, two home insurance
policies and one health insurance contract (Vaquin, 1990). By 1992,
1300 out of 2000 BNP branches were involved. The results in 1992
showed some success: 45,000 policies were sold: 58% of which was
home insurance, 37% car insurance and 5% health insurance (La
Tribune de I'Assurance, 1993). In 1994, BNP held 90,000 policies in its
portfolio (Lemoine, 1994).
Predica's success led Credit Agricole to announce in June 1990 the
creation of a non-life subsidiary, Pacifica, owned jointly by Credit
Agricole (which held a 60% stake) and by a 50-50 holding company
with Groupama, a large French insurance company. Launched in
1991, Pacifica sold 35,000 policies during the first year in operation
and 105,000 in 1992, 55% in home insurance and 45% in motor in-
surance (Lemoine, 1994). Pacifica experienced a 147% growth from
1992 to 1993, with sales turnover reaching FF266 million, two-thirds of
which was achieved in motor insurance (Lemoine, 1994).
Lemoine (1994) argued that the experimental phases of banks' entry
into general insurance were over, and that banks were 'stepping up a
 Bancassurance in Europe 79

gear' . French bancassurers have been less successful in general

insurance compared with life insurance and they account for around
4% of the general insurance market (Swiss Re, 1996).

French bancassurance environment

An important feature in France lies in the inherent weakness of the

insurance industry. The insurance industry has been characterised by
the importance of compulsory insurance and a lack of competition -
general agents exerted a virtual monopoly on the distribution of in-
surance products until the 1980s. The dispersion and generally low
level of qualifications of these agents contributed to the uncompetitive
nature of the industry (Duchesne, 1990). This environment facilitated
greatly the entry of banks in the market. Attempts by agents' syndic-
ates to lobby insurance companies to protect their privileged position
met with little success. As a result of the entry of banks in the in-
surance market, the number of agents fell dramatically from 40,000 in
1980 to 20,000 in 1987 (Marbacher, 1992).
The growth of 'bons de capitalisation' also contributed to banks'
increasing market shares of the life insurance market in France. These
simple endowment products are more similar to savings products than
to life assurance policies. They are thought to have boosted banks'
share of the life market by almost 60% between 1984 and 1988 (The
Economist, 1990). Although the trend towards savings-oriented life
assurance products is observable among other European countries
such as the United Kingdom (with the development of endowment
and unit-linked policies), it has been most significant in France. The
tax-advantageous feature of these endowment policies has made the
product attractive to customers and their simplicity has necessitated
little training of bank staff. It is no wonder that banks have aggress-
ively entered this market.
Another factor in French bancassurance development has been the
authorities' implicit encouragement of the strategy. The state had a
substantial stake in French banks and insurance companies (although
privatisation programmes have altered this situation) and the ban-
cassurance link-ups between government-owned companies have been
on a grand scale, e.g. UAP-BNP and GAN-CIC. The latter link-up was
directly induced by the government who asked GAN in 1985 to rescue
financially distressed CIC (La Tribune de I'Assurance, 1993). The
insurance companies are 'cash-flow machines', a French banking
analyst said (Retail Banker International. 31 January 1991), and
80 Bancassurance

poorly capitalised banks have been eager to capture their healthy

capital bases. As the government itself induced several bancassurance
linkages, no doubt it contributed to accelerate the growth of this
strategy in France.
Finally, it is worth pointing out the importance of banks' rivalry in
prompting bancassurance link-ups. The involvement of Credit Lyon-
nais in general insurance activities was a major factor for the decision
of BNP - its direct competitor - to enter the market (La Tribune de
l'Assurance, 1993).

4.2 BANCASSURANCE IN GERMANY

German bancassurance is considerably less developed than in France,

and is characterised by its focus on distribution and co-operation
agreements. We examine a few German bancassurers and summarise
the main characteristics of the market.

German bancassurers

Table 4.4 summarises the main links between German banks and in-
surers.
The concept of bancassurance in Germany dates back to the begin-
ning of the century and can be traced down to the German co-oper-
ative banks (Raffeisen und Volkensbanks) which created the famous
R& V Lebensversicherung.2 The co-operative banks provide the life
insurance company with 80% of its new business although the banks
have no obligation to co-operate (Warth and Le Deroff, 1997). This

Table 4.4 German bancassurance links

Bank Insurance company 1Ype of link ~ar

R&V R&V Lebenversicherung Marketing agreement 1922

Citibank KKB-Life Start-up 1985
Berliner Bank Gothaer Lebenversicherung Marketing agreement 1986
BfG Bank Aachener und Munchener Acquisition by A&M
Deutsche Bank DB Leben Start-up 1989
Dresdner Bank Allianz Marketing agreement 1989
Commerzbank DBV Versicherung Acquisition 25% 1990
Deutsche Bank Deutsche Herold Acquisition 1993

Source: Authors' own compilation.

 Bancassurance in Europe 81

co-operative movement has had a strong impact in Germany over the

twentieth century (it commands a healthy market share of around 20%
of the banking market) and R& V Lebensversicherung captured
around 2.9% of the life insurance market in 1991 (Leach, 1993). It has
also influenced the Belgian ~ssurances du Boerenbond Beige' and
Credit Mutuel's expansion in insurance in France (Daniel, 1995).
Other German ventures in bancassurance have been characterised
by co-operation rather than absorption or start-ups. For example,
Berliner Bank has a marketing agreement with Gothaer Insurance
Group, which resulted in a strong growth in life insurance sales, and
more recently in other insurance lines. Gothaer agents also sell Ber-
liner Bank's banking products. The group is heavily present in Berlin
and the Brandenburg area and benefited from inflows due to German
reunification.
The Aachener & Munchener and BfG (Bank fur Gemeinwirtschaft)
co-operation differs from traditional co-operations because the insur-
ance group is the senior partner in the co-operation. It owned more
than half of the capital of BfG and sales staff manned the bank
branches. Despite the acquisition of a majority stake in BfG by French
Credit Lyonnais, Aachener & Munchener kept a stake of 25% in the
bank and the marketing agreement has subsisted.
Dresdner Bank has long operated a strategy of marketing insurance
products of selected insurers. Its entry strategy has been one of
regional co-operation with the insurance sector, a fact that can be
explained by the 25% stake of Allianz in the bank (Tillinghast, 1991).
The privileged relationship between the bank and the insurer has
meant that Allianz is one of the principal partners of the bank but
other significant partners include Hamburger Mannheimer and
Deutsche Krankenverischerung (Leach, 1993).
Commerzbank acquired a stake in two insurance companies, DBV
and Partnerversicherung. It doubled its stake in DBV from 25% in
1992, hence becoming the majority shareholder in the company, only
to cede it to Winterthur in 1994 in a complex deal involving the two
companies (Williams, 1994).
1\vo banks have adopted a more integrated approach to bancas-
surance. Citibank established KKB-Life in 1985 (Tillinghast, 1991).
The company was renamed Citibank Privatkunden in September 1991
(Lafferty, 1991). However, Deutsche Bank was the first bank to
establish a life insurance company on a significant scale. In 1989,
Deutsche Bank launched DB Leben. Prior to the launch, 4000 mem-
bers of staff underwent extensive training, in a display of Deutsche
82 Bancassurance

Bank's ambition in the insurance market. DB Leben was among the

top 15 insurers in 1992 (The Economist, 199325 September). Despite
claims that Deutsche Bank's management was committed to a
go-alone strategy in insurance, it bought 65% of Deutsche Herold in
1993 and transferred its insurance operations to Herold. Deutsche
Bank is now relying on bank branch sales as well as Herold's 15,000-
strong sales force, and its wide range of general and life insurance
products. This new strategy may seem like a reversal of the start-up
avenue taken at the end of the 1980s. Nonetheless, DB Leben's
experience has shown that integrated bancassurance strategies can
succeed in the German market.

German bancassurance analysis

Although bank link-ups are nothing new to the German market,

bancassurance is not a significant strategy in Germany: it was esti-
mated that German banks distributed around 8% of life insurance
products in 1994 (McDaniel, 1996). Moreover, the German bancas-
surance market has not experienced the same degree of integration as
in other European countries. Most banks have marketing agreements
with insurers and have at best cross-shareholdings with them. The
conservative nature of the German insurance market has been a
determining factor in preventing the integration of bancassurance
operations. It also reflects a tradition of cross-shareholdings within the
German economy, which has promoted a strategy of co-operation over
that of aggressive marketing. While Deutsche Bank's start-up strategy
renewed concern among insurers of a fuller entry of banks in their
market, it has not been a widely followed strategy of German banks.

4.3 BANCASSURANCE IN ITALY

Bancassurance in Italy is a recent phenomenon, (mainly due to pre-

vious regulatory constraints), but it has rapidly developed since 1990.
We will examine some of Italy's bancassurance experiences and
comment on some of the major characteristics of the market.

Italy's bancassurers

It is estimated that within half a decade, Italy'S banks have managed to

capture a quarter of life insurance sales. This has been prompted by a
 Bancassurance in Europe 83

Table 4.5 Italy's bancassurance links

Bank Insurance company 1jpe of link lear

Monte dei Paschi di Siena Montepaschi Vita Acquisition 1991

ICCRI Eurovita Italcasse Joint venture 1991
San Paolo San Paolo Vita Start-up 1992
Cariplo Carivita Joint venture w. 1992
CNP & TSB
Banca Nazionale del Lavaro BNL Vita Start-up 1992
Banca di Roma INA Alliance 1992
Banca Commerciale Italiana Assiba Joint venture 1993

Source: Authors' own compilation.

flurry of activities in this area at the beginning of the 1990s. The main
bancassurance links in Italy are shown in Thble 4.5.
In 1989, Monte dei Paschi di Siena acquired Compagnia di Assi-
curazione Ticino, through its mortgage section. It is an insurance
company that operates in the general and life insurance businesses
through two subsidiaries, Montepaschi Vita SpA and Ticino Assicur-
azioni SpA (McElree, 1993). The two subsidiaries became direct
participations of the Monte Group in May 1991 after laws were passed
in Italy allowing bank participations in insurance. Advised by Predica,
the insurance arm of French Credit Agricole, Montepaschi Vita cap-
tured 200 billion lire of premiums in its first year of operations (The
Economist, 1992). Most of its success was linked to one product,
Cresco, a basic savings product (Leach, 1993). Montepaschi Vita
recorded an average 43% annual growth between 1991 and 1994
(Warth and LeDeroff, 1997).
Eurovita Italcasse was started as a joint venture between the central
body operating 26 Italian savings banks, ICCRI, and Axa Assicur-
azioni in 1991 (Leach, 1993). The relatively simple savings-like prod-
ucts of Eurovita are distributed through the branches of the small
savings banks (Leach, 1993).
San Paolo, a large public sector bank, launched San Paolo Vita in
1992. Its main strategy is to sell its products through the bank's
branches but it also has a network of tied agents (Leach, 1993). San
Paolo Vita experienced an impressive average annual growth record of
+ 126% between 1991 and 1994 (Warth and Le Deroff, 1997).
Cariplo underwent a conversion into a joint-stock company on
20 December 1991. Carivita, its life insurance subsidiary, was launched
84 Bancassurance

in 1992 in conjunction with TSB Trust Company (UK) and Caisse

Nationale de Prevoyance (France). Cariplo holds a 60% stake in the
subsidiary (BankWatch, 1993). Carivita started with a range of four
products, and had the most success in selling a simple savings-like
policy which accounted for about 95% of its premiums (Leach, 1993).
Banca Nazionale del Lavoro launched BNL Vita in January 1992,
with a wide range of products, and the objective to distribute the
policies mainly through its branch network but also through its own
sales-force, Interbancaria (Leach, 1993). This approach is character-
istic of the Italian financial services market, i.e. the existence of a
strong unit-trusts sales-force. BNL Vita recorded a strong average
annual growth of +81% between 1991 and 1994 (Warth and Le
Deroff, 1997).
Cariro merged with Banco di Santo Spirito (BSS), a regional bank
based in Rome, in March 1991. This new group in turn merged with
Banca di Roma (BdR) in 1992 - the enlarged organisation adopting
the Banca di Roma name - and resulted in a new force in Italian
banking (Law et al., 1993). Banca di Roma established a co-operation
agreement with INA, one of Italy's largest insurance groups, in 1992,
which envisaged the sale of Roma's products in 185 of IN.Ns agencies,
and INXs products sales in the bank's 1200 branches and 7000-strong
sales force (The Economist, 1992). The agreement envisaged also that
INA would manage the bank's insurance activities, while drawing on
Roma's advice in managing its small banking business, Inabanca. In
December 1992, the two groups began co-operating in four towns
(Law et al., 1993).
Banca Commerciale Italiana "(BCI) linked up with three Italian
insurers: Assicurazioni Generali, Taro Assicurazioni and Ras-
Riunione Adriatica di Sicurta to form a life assurance group, Assiba,
with a capital of 200 billion lire. BCI owns 22% of the equity in the
venture. Assiba is effectively managed by Generali but the key dis-
tribution channel for the company is BCI's expanding branch network.
Assiba's first product, a savings plan, was launched in May 1993
(Poulter, 1993). Similarly to other Italian bancassurers, Assiba also
sells some of its products through the bank's sales-force subsidiary.

Italian bancassurance development

Italian bancassurance is as yet a recent phenomenon. This is due to

regulatory provisions that prevented banks having equity stakes
in insurance companies, hence limiting ~ancassurance to a few
 Bancassurance in Europe 85

distribution agreements. This situation was altered in 1991, following a

regulatory reform that allowed large banks to have equity links with
insurers, as long as the investment was limited to 20% of the bank's
capital (Moro, 1993).
However, the banks that have engaged in the bancassurance strat-
egy are set to make a big impact in a relatively underdeveloped market,
where life insurance is enjoying a strong rate of growth, but still lags
behind most other European countries: between 1991 and 1994, life
insurance premiums grew at an annual rate of 16.6% (Warth and Le
Deroff, 1997).
One of the major obstacles in the Italian bancassurance market
stems from the weakness of the banking sector, characterised by
government control and dispersion. Despite the 1989 Amato Law,
which aimed at a concentration and privatisation of the industry, most
banks are still small and under government control. This makes it
difficult to fight the strong tied sales-force, which is characteristic of
the Italian insurance sector.
Nonetheless, the young Italian bancassurance market is expected to
grow, as concentration increases in the industry and there is some
indication that this growth will be by equity links rather than dis-
tribution agreements. Moreover, the success of Italian bancassurers
such as Montepaschi Vita in marketing simple savings-like insurance
products may indicate that this will be the strategic choice of future
bancassurers. In 1994, it was estimated that Montepaschi Vita held
seventh place in the life insurance market with a 3.2% market share
and that the combined market shares of the six largest bancassurers
made up 9% of direct premiums (Galpin, 1996).

4.4 BANCASSURANCE IN THE NETHERLANDS

The concentration inherent in the Dutch financial industry is one of

the driving forces in the sector. Thus our examination of Dutch ban-
cassurers will be focused on four large financial groups.

Dutch bancassurers

Thble 4.6 shows the main bancassurance links dominating the Dutch
market.
Rabobank had a long-standing distribution agreement with Inter-
polis, who depended on the co-operative banks for around 75% of its
86 Bancassurance

Table 4.6 Netherlands' bancassurance links

Bank Insurance company 1Ype of link }ear

Rabobank Interpolis Acquisition 1990
VSB AMEV Merger 1990
Nationale-Nederlanden Postbank Merger (ING) 1991
ABN AMRO ABNAMRO Start-up 1993
Lebensverzekering

Source: Authors' own compilation.

distribution. Rabobank also held a 15% stake in the insurer, the

regulatory maximum under pre-1990 laws (Hoschka, 1994). The
removal of this constraint by regulatory authorities in 1989 led Rabo-
bank to increase its stake to 95% in 1990 and subsequently to 100%.
This increased the dependence of the insurer on the bank channel of
distribution to 90% of new sales (Hoschka, 1994). Rabobank is the
central bank of the Dutch co-operative banks and it boasted the lar-
gest branch network in the Netherlands through its 800 member
banks. At the time of the acquisition, it claimed a 40% share of the
small business market (90% in agriculture) as well as 40% of the
private savings market. Interpolis held the fifth place in the Nether-
lands in terms of premium income, with involvement in both life and
general insurance (King, 1991). However, 1991 was a poor year for
Interpolis with the company falling behind the industry's growth rate
and losing relative market share (Hoschka, 1994). The company also
experienced difficulties in the following year, when a proposed merger
with AVCB, a large insurer, failed in 1993, arguably because of Rabo-
bank's demands for an equity stake in AVCB (Coffey, 1994). The
merger failure might have constrained Interpolis' ability to expand its
distribution channels. However, it took over a small direct writer,
Sterpolis, in 1993. Rabobank also has an alliance with Robeco, the
largest independent European fund manager, in 1993. The three
entities (Rabobank, Interpolis and Robeco) developed joint invest-
ment, savings and insurance products (Coffey, 1994). Despite some
setbacks, the Rabobank-Interpolis link marked the beginning of an
era of consolidation on a grand scale in the Dutch financial services
industry.
The next major consolidation took place in 1990 with the merger of
savings bank VSB and AMEY, a large insurer which soon thereafter in
 Bancassurance in Europe 87

1991 merged with the Belgian insurer AG, forming the Fortis Group
(Holsboer, 1993). VSB started selling AMEV insurance policies and
AMEV insurance intermediaries were given the opportunity to sell
VSB banking products. In 1993, Fortis also bought a 49.9% stake in
the Belgian conglomerate ASLK-CGER (Coffey, 1994). The Fortis
group displayed the strategy of international and domestic diversi-
fication that has characterised the Dutch financial scene in the early
1990s.
The most remarkable example in Dutch bancassurance remains
ING Group, which is the result of a merger in 1991 between the then
largest insurer, Nationale-Nederlanden, and the third largest bank,
NMB Postbank (Coffey, 1994). Despite the high publicity surrounding
this bancassurance merger, its process was not smooth. Gumbel (1991)
outlined the conflicts of interests facing Nationale-Nederlanden when
it announced its decision to deliver insurance products through Post-
bank's outlets in 1990. The insurer was boycotted by Dutch brokers
who provided it with 80% of its business. Vankoren, a member of the
Board for ING Retail Activities, reported Nat-Ned's promise to the
agents' federations that they would not disrupt the market for in-
dependent agents, which led NatNed to delay the sale of motor
insurance - a crucial proportion of the agents' sales - in Postbank
branches (Coleman, 1993). However, the new group managed to
maintain a multi-distribution strategy, whereby sales are conducted
through independent intermediaries, a captive sales force, bank
branches, home banking, and post offices (Leach, 1993).
Early difficulties apart, ING has become the largest financial ser-
vices provider in the Netherlands. In 1993, it reorganised its opera-
tions to further the integration of its diverse activities. The new
structure separates four management centres: ING International, ING
Investments, ING Real Estates, and ING Nederland. However, the
corporate legal structure has remained unchanged to satisfy different
regulatory requirements in banking and insurance (Holsboer, 1993).
ING Nederland has been structured into four units which reflect
different distribution channels (independent intermediaries, direct
sales force, bank branches and direct marketing). Each of these
channels offer banking and insurance products. Their relative shares
of insurance distribution in 1995 is shown in Table 4.7.
The difficulties faced by ING to satisfy its various distribution
channels have probably compromised its chances to achieve synergies.
This is reflected in the heavy reliance of ING on its independent
intermediaries five years after the merger.
88 Bancassurance

Table 4.7 ING insurance distribution channels 1995

Channel Number % of life % of non-life

premiums premiums

Independent intermediaries 10,000 82 82

Tied agents 1,200 12 14
ING bank branches 400 2 2
Post offices/direct writing 2,000 4 1

Source: ING - Company report, by Van Der Velden, ABN-AMRO HOARE

GOVETI, 15 April 1997.

Another major factor in lNG's development has been its inter-

nationalisation. It acquired a 20% stake in Banque Bruxelles Lambert
in 1997, building on its previous 20% stake. Another famous acquisi-
tion was that of the failed UK merchant bank, Barings Bank, at a cost
of NLG 1.7 billion in 1995 (the sum being necessary to bring back
Barings' capital to solvency requirement). ING Group generates 49%
of its insurance business and 34% of its banking business outside the
Netherlands (Van Der Velden, 1997). This gives validity to the
Group's claim that it is a truly international financial conglomerate.
ABN AMRO is the result of the merger of the two largest banks in
the country in 1990. It has been content to act as a broker for various
insurance companies for many years but finally launched its life
insurance subsidiary ABN AMRO Levensverzekering in Rotterdam at
the end of September 1993. ABN AMRO's strategy has been - even
more than its competitors - to expand abroad. The Dutch bank has a
second home market in America where it acquired LaSalle in Chicago
in the early 1990s. In 1994, ABN AMRO realised 47% of its net profits
abroad (Smit, 1995). This may explain the reluctance of the bank to
engage in substantial bancassura:nce operations. US regulations do not
allow link-ups between insurance companies and banks and ABN
AMRO clearly chose to expand abroad rather than embark on sig-
nificant domestic diversification (Van de Krol, 1992).

Analysis of Dutch bancassurance

The bancassurance trend evident at the beginning of the 1990s was

prompted by deregulation, but the involvement of Dutch banks is not
new: 13% of all insurance policies were sold by banks acting as agents
in 1989 - prior to deregulation (Lapper, 1992). The main change has
 Bancass{lrance in Europe 89

been that banks have taken greater equity interests in their insurance
partners, hence increasing the scope for cross-selling. Nonetheless, the
reliance of Dutch banks on multi-distribution channels has illustrated
the difficulties associated with bancassurance integration (see above
the conflict between ING and its traditional insurance partners). The
main feature of Dutch bancassurance is the concentration of the
market into the hands of a few powerful players and in the case of
lNG, the merger of two giants of both industries. The Dutch scene
also reflects the features of a small domestic market. The large Dutch
conglomerates have looked closely at foreign expansion since gains in
their domestic markets are, by definition, limited.

4.5 BANCASSURANCE IN SPAIN

Spanish bancassurance is a new phenomenon which exists on the

background of a growing insurance market. We examine a few
examples of banking-insurance link-ups and investigate the strength of
the bancassurance phenomenon.

Spanish bancassurers

Table 4.8 shows some of the well-known bancassurance link-ups in

Spain.
Spain is quite unique in its bancassurance development in that
banks have a long history of owning part or whole insurers. It was

Table 4.8 Spanish bank-insurance link-ups

Bank Insurance company Type of link

Banco Bilbao Vizcaya Euroseguros Start-up

Banco Espaftol de Banfenix Joint venture w. Union
Credito* y el Fenix
La Caixa Vida Caixa Start-up
Banesto Banesto Seguros Joint venture w. Axa
Banco Santander Seguros Genesis Joint venture w.
Metropolitan Life
Caja de Madrid Caja de Madrid Vida Start-up

• Banesto
Source: Authors' own compilation.
90 Bancassurance

estimated that in 1988, direct sales through captive insurers and sales
of controlled affiliates of the six leading banking groups amounted to
37% of total insurance premiums (Hanley et at., 1990). The life and
pensions markets were also boosted in the mid-1980s by the appear-
ance of single premium policies, free of withholding tax and structured
as bearer instruments. Euroseguros, the wholly owned insurance
subsidiary of Banco Bilbao Vizcaya (BBV) benefited from this activity,
but the eventual demise of the instruments did not halt the growth of
the company. BBV also distributed the products of three affiliated
companies which placed its combined insurance business into the top
five insurers in Spain in 1988. BBV introduced fire and casualty pro-
ducts through its network in 1989, and sold 20,000 policies within
three months (Hanley et at., 1990). In 1992, BBV joined with Axa, the
French insurance giant to create a 50-50 holding company for their
respective nonlife insurance operations, Aurora Polar (BBV) and Axa
Seguros. In 1994, Euroseguros announced its plans to boost its 5.26%
market share to 9% the next year by offering its products through the
BBV's telephone banking arm, mainly to boost its home and accident
business (Expansion, 1995b). By 1994, BBV group had a 7% share of
the total insurance market in Spain (Expansion, 1995a) and around
20% of new life assurance premiums (Parry, 1995).
Banco Espaiiol de Credito (Banesto) and its 50%-controlled
insurance affiliate, Union y el Fenix, set up a joint venture, Banfenix
(75% owned by the bank), to develop sales in life and credit life
insurance though the branch network. This venture had little success
(Hanley et at., 1990) and its growth was prevented by problems at
Banesto which necessitated the intervention of the Bank of Spain. In
1991, Banesto Seguros was set up to sell AGF Seguros products
through the branch network, at a time when problems at the bank
were still under control. The near-collapse of Banesto led to the
acquisition of Union y el Fenix by AGF (Parry, 1995) and Banesto was
eventually acquired by Banco Santander.
La Caixa, Spain's largest savings bank, set up an insurance sub-
sidiary Vida Caixa in 1988. The venture experienced a strong growth
which increased its domestic position to fourth, in terms of premium
income, by the early 1990s. A 50-50 holding company CALIFOR was
formed between La Caixa and Fortis (the Dutch group) in 1992.
CALIFOR holds 80% of Vida Caixa shares with Caixa retaining the
remaining 20%. Vida Caixa distributes policies through La Caixa's
branch network and two agency networks (Leach, 1993). Vida Caixa
was the leader in life policies in 1995 (Expansion, 1996) and La Caixa
 Bancassurance in Europe 91

insurance interests accounted for 11.3% of the total insurance market

in 1994 (Expansion, 1995a).
Seguros Genesis is the 50-50 joint venture between Banco San-
tander and Metropolitan Life, an American life insurer, launched in
1987 (Hanley et al., 1990). It received some publicity as one of the first
foreign joint ventures of its type in Spain. The company sold its pol-
icies through Banco Santander's branch network as well as a network
of agents. It ranked fifth in 1991 in terms of individual annual pre-
miums (Leach, 1993). Banco Santander also has a captive subsidiary,
Cenit, that markets credit life insurance in connection with bank loans.
Caja de Madrid chose the start-up route to bancassurance with the
launch of Caja de Madrid Vida that markets life products branded
with the savings banks' own name. In 1992, Caja de Madrid held 4.6%
of the pensions market. Caja de Madrid also has distribution agree-
ments for the marketing of general insurance policies linked to loans
(Leach, 1993).
Corporacion Mafpre is a startling example in Spain of an insurer
taking over a bank. In 1989, the corporation took over Inverbank, a
subsidiary of Banco Herrero (Hanley et al., 1990). Banco Mafpre was
created in 1990 and had 60 branches by end 1992 (Leach, 1993).
Corporacion Mapfre is part of Sistema Mapfre, the largest insurance
organisation in Spain. The latter is headed by Mapfre Mutualidad, a
mutual auto insurer, which itself owns 52% of Corporacion Mapfre, in
which most of Sistema Mapfre's other operations are consolidated.
Corporacion Mapfre is run on an independent basis but derives
significant benefits from its association with Sistema Mapfre through
a shared distribution network. The seemingly complex nature of
the group clearly illustrates the extensive potential for cross-selling
between the various members of the group (Shea et al., 1995). Banco
Mapfre contributed only 1% of Corporacion Mapfre's operating profit
in 1994 but its network quickly grew to over 100 branches and its assets
grew at an average rate of 40% between 1991 and 1994 (Shea et ai.,
1995). Banco Mafpre clearly benefited from its association with the
Mapfre name, and its ability to sell banking services to insurance
customers of Sistema Mapfre. However, there has been little selling of
insurance products through Banco Mapfre branches.

Analysis of Spanish bancassurance

Spanish bancassurance has its own peculiar growth linked to the fact
that banks have long owned insurance companies as well as distributed
92 Bancassurance

their products. Bancassurance was, however, given a boost when dis-

tribution methods were liberalised in the beginning of the 1990s,
allowing the banks to exploit the bank-insurer link more fully. The
Spanish insurance market is considered under-developed and the
scope for banks to sell simple savings-like products has been eagerly
exploited since the mid-1980s. Another feature of the market has been
the entry of foreign companies, which have been eager to exploit a
market which is as yet unsaturated. It was estimated that foreign
companies held almost a quarter of net written life premiums in 1993
(Galpin, 1996).

4.6 BANCASSURANCE IN EUROPE: A CROSS-COUNTRY

COMPARISON

The extent of the bancassurance trend across European banking

markets differs considerably. This section aims to identify common
features which help to explain the different levels of bancassurance
penetration. We use three criteria to conduct this analysis. First, we
examine the importance of country-specific factors in promoting the
bancassurance strategy. Second, we compare the entry structures
predominant in different countries. Third, we compare the level of
bancassurance integration of various countries across two dimensions:
market shares and link types.

Country-specific factors in the bancassurance trend

The structure of the insurance and banking industries in various

European countries contributes to explain the varying developments
of bancassurance. The French insurance market's inherent uncom-
petitiveness played a significant role in promoting bancassurance by
allowing banks to capture unprotected market shares. The ease of
entry into the life insurance market convinced banks that insurance
distribution could be an effective way to utilise expensive branch
networks to cross-sell a variety of products. The high degree of rivalry
among banks themselves also meant that French banks would be
reluctant to be left out of a market where other competitors flour-
ished. In Germany, conservative marketing rules in the insurance in-
dustry had an opposite effect. It made it difficult for German banks to
profitably distribute insurance products. Moreover, a tradition of
cross-shareholdings in the financial industry has meant that banks
 Bancassurance in Europe 93

have chosen to collaborate with insurance companies rather than

develop in-house bancassurance?
Italy's bancassurance development has been hindered by a weak
banking industry. However, the potential for high growth rates in life
insurance fares well for bancassurers but further consolidation in the
industry is needed for Italian banks to compete with the large tied
financial sales forces that characterise the industry.
Dutch bancassurance developments are associated very closely with
the financial industry concentrated structure. The concentration of the
industry in the hands of a few powerful players led to bancassurance
giants who market their products through multi-distribution channels.
Spanish bancassurance, similarly to Italy, was characterised by an
underdeveloped insurance market. This left plenty of scope for banks
to exploit their long-standing ties with insurance companies with a
view to cross-sell insurance products. Spanish insurance-banking links
are old although the full cross-selling potential of bancassurance has
been exploited only recently. One of the features of recent years is the
entry of foreign companies, which have promoted such links.
A major factor in promoting UK bancassurance was the high costs
associated with traditional insurance distribution channels. While
there are highly competitive insurance companies in the United
Kingdom, the long-standing reliance on expensive independent fin-
ancial intermediaries gave banks the opportunity to develop cheap
alternative channels of distribution.
Other factors contributed to the differing levels of bancassurance
integration in various European countries. One such factor relates to
the existence of tax-advantageous life insurance products, which bear a
strong resemblance to banks' traditional savings products. The main
advantages of such products is the ease with which banks have been
able to train their sales staff. French bancassurance was undoubtedly
boosted by 'bons de capitalisation', single premium long-term policies
that entitled holders to tax relief on the income generated over an
accumulation period. Spanish bancassurance was initially boosted by
single premium policies free of withholding tax. In Italy, some ban-
cassurers based their success on similar savings-like products. The
growth of endowment products in the United Kingdom also facilitated
bancassurance development. Such products had probably most impact
in France and Spain. However, the tax advantages associated with the
products have gradually eroded and banks have introduced a wider
range of more complex insurance products over time in order to in-
crease their market shares.
94 Bancassurance

Another major factor for bancassurance development is regulatory

changes. In the Netherlands, bancassurance became predominant in
1990, after the relaxation of ownership limitations between the
banking and insurance sector. In the United Kingdom, the polarisa-
tion principle laid down in the Financial Services Act led banks and
eventually building societies to tie to a single insurer, and thus made
equity links between the two sectors more attractive. In Italy, the 1991
reform that relaxed equity constraints between the two sectors
prompted a flurry of links in the financial sector. One of the reasons
why bancassurance has been slow to develop relates to the remaining
constraint that banks' investment in insurance companies cannot ex-
ceed 20% of bank capital, this in a country where banks are small by
international standards. The reform of life insurance marketing in
Spain also played a significant role in boosting bancassurance sales. In
France, the government's implicit encouragement of bancassurance
links probably had an impact on the generalisation of this strategy.
Clearly, national differences in bancassurance stem from the varying
characteristics of the financial industry in each country. The degree
of competitiveness in domestic financial sectors made bancassur-
ance initiatives more or less successful. Similarly, the design of life
insurance products made it more or less easy for banks to train their
staff in selling insurance products; moreover, tax advantages made
some products highly attractive to consumers and hence encouraged
banks to enter the market. Finally, domestic regulatory changes by and
large relaxed constraints on cross-shareholdings between the banking
and insurance sectors, and thus acted as a facilitator to the bancas-
surance strategy. Bancassurance growth is undoubtedly linked to
regulatory reforms in some countries such as in the Netherlands and
Italy.

Entry routes in different European countries

Table 4.9 shows the preferred entry routes in various European

countries. It shows that bancassurers in different countries adopted
different entry routes into the insurance market. In France, banks
mainly selected the go-alone route by starting up their own insurance
operations whereas in many other countries, banks have been eager to
associate with insurance companies to start up operations. This is true
of Italy, Spain and the United Kingdom. In contrast, Dutch bancas-
surers resulted from mega-mergers between the two sectors. German
bancassurance is as yet limited mostly to marketing agreements that
 Bancassurance in Europe 95

Table 4.9 Entry routes in various European countries I

Country Start-ups Jomt Mergers and Distribution Total

ventures acquisitions agreements
France 6 3 3 12
Germany 2 3 3 8
Italy 2 3 1 1 7
Netherlands 1 3 4
Spain 3 3 6
United Kingdom 5 6 6 17

I The figures shown are extracted from Tables 4.1, 4.4, 4.5, 4.6, 4.8, and 3.1. These are
not meant to be an exact representation of each country's bancassurers but is a biased
sample of the most known bancassurers in each country.

exclude equity links. It is interesting to note that French banks, who

predominantly chose to start up their own operations, achieved the
greatest bancassurance market shares.

Level of bancassurance integration in Europe

We compare the degree of bancassurance integration across two

dimensions: the market shares achieved by bancassurers in selected
countries and the type of link between the two activities from dis-
tribution agreements to full ownership. Figure 4.1 shows the position
of several countries in terms of their level of bancassurance integ-
ration.

Figure 4.1 Bancassurance integration in Europe

Market share
'"France
"'Netherlands
"'S .
'" pain
UK
"'Italy

'"Germany
Distribution only Full ownership
96 Bancassurance

The matrix in Figure 4.1 shows France well ahead of its counterparts
in the bancassurance trend. The greater level of integration of French
bancassurance operations where insurance subsidiaries mainly serve
the needs of their banking parents might explain why French banks
were successful in achieving high market shares. Other countries
achieved significant market shares by integrating their operations in a
similar way. The exception among the countries reviewed is Germany.
The German model of co-operation with the insurance industry
appears to have prevented German banks achieving significant market
shares in insurance.

CONCLUSION

This chapter analysed the developments of bancassurance in France,

Germany, Italy, the Netherlands and Spain. It was shown that various
factors influenced the success of bancassurance strategies in various
countries. In particular, structural and product regulations had a sig-
nificant effect on the development of this strategy. The different levels
of competitiveness of the insurance industry also played a significant
role. The different growth rates of insurance in some countries clearly
had an impact on banks' involvement in bancassurance. The low level
of saturation in Spain and Italy suggests that banks have opportunities
to significantly increase their market shares in the next few years,
in contrast with other countries where the level of penetration of
insurance is already saturated, e.g. the United Kingdom. Although
individual European countries are shaped by the traditional structure
of their domestic financial industry, it appears that the model of
bancassurance which met with most success is where banks have
started up their own bancassurance operations, suggesting that this
strategy facilitated a more rapid integration of both activities.

Notes
1. Prior to 1975, the general and life insurance companies' only clients were
the federations' employees.
2. Lebensversicherung is German for life assurance.
3. Deutsche Bank has been a notable exception by starting up its own life
insurance operation but it now co-operates with an insurer to promote
the subsidiary's operations.
5 The Theory of Corporate
Diversification

INTRODUCTION

This chapter reviews the theory of corporate diversification to provide

an insight into why banks should seek to diversify into insurance and
other areas. The literature on corporate diversification has been the
focus of interest of researchers in both the management and finance
fields. Interest was raised, in particular, by the creation of an organised
corporate mergers and acquisitions (M&A) market in the United
States during the 1960s when many financial and non-financial firms
embarked on diversification strategies. An important question, in both
the management and finance fields, has been to understand why
corporations engage in such strategies and whether these diversifica-
tion moves have been successful.
Section 5.1 of this chapter draws upon the management literature,
which focuses on the nature of the corporate diversification process.
First, we describe different categories of diversification strategies. In
particular, a distinction has been made in the literature between
related (including horizontal, vertical and concentric types) and conglo-
merate diversification strategies. We also examine alternative indexes
of the extent of corporate diversification. We then examine the entry
vehicles that have been used by different corporations in their diversi-
fication process. Finally, we briefly review the organisational struc-
tures that have been adopted by diversified corporations.
Section 5.2 of this chapter lists the motives that have been advanced
by researchers to explain corporate diversification strategies. These
alleged motives can be divided into five main categories: agency
theory, profitability of target, synergies, financial motives, and risk-
reduction.
Section 5.3 presents some of the empirical evidence on the risk and
return consequences of corporate diversification. One objective of
such empirical studies has been to test the validity of the alleged
motives for corporate diversification. Another objective has been to
examine the effects of such strategies on performance and identify
what diversification strategies, if any, yield superior benefits.

97
98 Bancassurance

Section 5.4 examines whether theories on corporate diversification

are applicable to bancassurance diversification. The aim of this section
is first to examine the nature of this diversification process in ban-
cassurance. Second, we try to identify what theoretical motives for
corporate diversification are likely to apply in the merger of banking
and insurance firms.

5.1 TIlE NATURE OF THE CORPORATE DIVERSIFICATION

PROCESS

The corporate diversification process involves fundamental strategic

decisions, including the type of diversification to undertake and the
mode of entry and organisational structure to adopt. These various
strategic choices determine to some extent the diversification process.

Categories of diversification strategies

Corporate diversification can take various forms. In particular, a dis-

tinction has been made in the literature between horizontal, vertical,
concentric and conglomerate diversification.

Classification of corporate diversification strategies

The strategic management literature has traditionally relied on four
main classifications of diversification strategies that can be traced to
Ansoff (1957). These include horizontal, vertical, concentric and
conglomerate diversification strategies.

Horizontal diversification Horizontal integration can be defined

as seeking ownership or increased control over competitors (David,
1989). In most cases, such a strategy will be characterised by the
merger with, or acquisition of, a competitor. It is classified as a con-
centration position, as it implies increasing the corporation's level of
activity in its present products, markets, or both. A major limitation
to this strategy for large firms is that they might fall under competi-
tion (anti-trust) law violations (Comerford and Callaghan, 1985).
Horizontal-type expansion strategies have also been defined as those
strategies involving selling unrelated products to existing customers.
David (1989) distinguished between horizontal integration which
involves buying a competitor, and horizontal diversification that
 The Theory of Corporate Diversification 99

involves adding new products or services. This second category might

not involve the setting up or acquisition of a new entity but might be
totally integrated in the firm's existing structure.

Vertical integration Vertical integration can be defined as an

expansion of the scope of a company's activities to include those
activities of its suppliers or customers. There are two types of vertical
diversification. The first is labelled backward integration and involves
seeking ownership or increased control over the firm's supply (inputs)
activities. The second type or forward integration involves gaining
control over distributors or retailers (David, 1989). This might involve
acquiring a distribution system or establishing one internally. One of
the main disadvantages of vertical integration is that it might tie a
business to an input producer while lower-cost producers exist in the
market. Moreover, technological change means that vertical integra-
tion can create the hazard of tying to obsolete technology. Finally,
under demand uncertainty, vertically integrated units may encounter
co-ordination difficulties (Hill and Jones, 1989). However, costs sav-
ings, avoidance of market costs, control of quality and protection of
proprietary technology are potential benefits of this strategy.

Concentric diversification Concentric diversification involves adding

new but related products to the existing product line of the corpora-
tion (David, 1989). The new products must have some technological or
marketing synergies with the firm's present products. It can easily be
seen that this classification has some commonality with horizontal
diversification (adding new but unrelated products), as well as with
vertical integration - inputs might be considered as new related prod-
ucts. Arbitrary choices may be made to classify a diversification strat-
egy in one or the other category.

Conglomerate diversification The conglomerate category embraces

diversification strategies with no obvious marketing or technological
synergies or cross-selling opportunities (Comerford and Callaghan,
1985). This strategy has been common in the 1960s and has been
questioned extensively in the literature (Porter, 1985). Hill and Jones
(1989) suggested, however, that unrelated diversification can be more
profitable than related diversification as the latter raises organisa-
tional difficulties.
Figure 5.1 summarises the main aspects of the four strategies and
illustrates the customer and technology vectors exploited under various
100 Bancassurance

Figure 5.1 Growth vectors in diversification

[S
Ir.ustomers
Related
technology
.. Unrelated
technology

Horizontal
Same
dlv....lflcation

Firm is
customer V.rtlcal div....lflcatlon
(supplier)

(1) (2)
Similar
Concentric
div....lflcation

New Conglom.rate
(3) dlv....lflcatlon

(1) Marketing and management related

(2) Marketing related
(3) Technology related
Source: Adaptation of Ansoff (1986), p. 116.

Figure 5.2 Stages of corporate growth and development

Stage 1: Concentration on a single

business in a single national market

1
Stage 2: Vertical integration and/or
global expansion to strengthen
position in core business

1
Stage 3: Diversification to invest
excess resources in value creation
activities

Source: Hill, Charles W. and Garreth R. Jones, Strategic Management: An

Integrated Approach. Copyright © 1989 by Houghton Miffiin Company. Used
with permission.
 The Theory of Corporate Diversification 101

forms of diversification. However, it can be seen that labelling a given

diversification in one or the other of these categories can be ques-
tionable. Hill and Jones (1989) suggested that these strategies corres-
pond to different stages of corporate development and Figure 5.2
illustrates the potential pattern of growth of corporations. Figure 5.2
suggests a consistent pattern of growth for corporations and that
diversification in unrelated areas is generated by the existence of excess
funds.

Rumelt's specialisation ratio

There has been a recognised need for economists to develop ways
to measure diversification in order to evaluate the influence of vari-
ous strategies on corporate performance and overall position in an
industry. In particular, the wave of conglomerate acquisitions of the
1960s has given rise to a vivid interest in classifying corporate acquisi-
tions and diversification performance. Rumelt's (1986) classification
attempted to deterministically classify various corporations according
to their diversification strategies. 1 A specialisation ratio formed the
basis for this formal classification. It represents the proportion of a
firm's revenues that can be attributed to its largest business in a given
year. It is completed by a related ratio that computes the proportion of
a firm's revenue that are attributed to its related business. Finally the
vertical ratio computes the proportion of a firm's revenues that arise
from all byproducts, intermediate products and end-products of a
vertically integrated sequence of activities. Various measures for these
three ratios determine the way in which to classify a diversified cor-
poration. Figure 5.3 illustrates the decision rules that determine the
.classification process. Figure 5.3 indicates the critical values for the
three diversification ratios in order to classify a corporation in one or
the other of four main categories: single product, dominant, related
and unrelated. Single-product corporations are those for which at least
95% of revenues are devoted to the core business.
The dominant-business category includes those firms that have
diversified to some extent but still derive most of their revenues from
a single business. Vertical-dominant firms include firms that derive
more than 70% of their revenues from vertically integrated business.
Dominant-constrained firms include firms that built on the skills or
resources of the core business while the dominant-linked category
refers to firms that have built to some extent on different skills,
resources, etc. so that diversified activities are somehow all related
102 Bancassurance

Figure 5.3 Assigning diversification categories

Single YES
business

Dominant 4-Y_E_S_<
vertical

YES

Dominant-
constrained or YES
dominant-
linked
Related-
constrained or
related-linked
Unrelated business
or conglomerate
SR = Specialisation ratio
RR = Related ratio
VR = Vertical ratio

Source: Rumelt (1986), p. 30.

with some other of the firm's activities. The dominant-unrelated class
comprises firms where most of the diversified activities are not related
to the core business.
The related business category refers to non-vertically integrated
firms that have mainly diversified in fields related to old activities.
Related-constrained refers to those firms that have expanded in
activities where they could build on a particular skill or resource while
in related-linked firms, expansion has been built on skills or resources
that are different each time.
Unrelated businesses comprise corporations that appear to have
diversified without regard for relationships between new businesses
 The Theory of Corporate Diversification 103

and current activities. Acquisitive conglomerates refer to firms that

have aggressive programmes of unrelated diversification and which
have satisfied the following three conditions over the last five years
under examination:

• earnings per share (EPS) growth rates of at least 10%;

• made at least five acquisitions, three of which are in unrelated
businesses;
• issued new equity at least equal to the amount of dividends paid
during the period.

Unrelated businesses that did not satisfy the above conditions were
classified as unrelated-passive.
Although Rumelt's classification offers a framework to study the
relationship between various diversification strategies and perform-
ance, the analysis requires some discretion in the evaluation of each
firm's category. The literature has mostly concentrated on studying the
differences between the performance of specialised and diversified
corporations or related diversified and conglomerates. Although such
quantifying techniques might be useful, they are ultimately hardly
replicable as each researcher's judgement might be exerted differently.
The SIC (Standard Industrial Classification) system provides an
alternative resource for researchers seeking to examine the partici-
pation of corporations in various industries. However, Rumelt (1986)
noted the shortcoming of this system that does not permit discretion
over product and industry counts. In particular, the digit system pre-
vailing in the SIC system does not take into consideration the weights
of various activities in total revenues. Moreover, SIC classifications
might be arbitrary as various industry classifications are used. Rumelt
quoted the example of a firm adding plastic cups to its traditional
business of paper cups. The SIC system would classify this as a new
industry (unrelated) while the individual researcher might choose to
ignore this difference.
Rumelt suggests that there are major obstacles to accurately
classifying various diversification strategies. Researchers have often
used an arbitrary measure of diversification, but Rumelt (1986) argued
that they might in fact choose that which better suits their needs. The
difficulty inherent in distinguishing between alternative strategies
suggests that any analysis of the performance of alternative strategies
has to focus on two generic strategies: related versus unrelated or
single product versus diversified. Finally, the challenge that is faced by
104 Bancassurance

researchers is mainly to assess different strategies' performance and

whether the corporate motives for given diversification moves are
fulfilled. This suggests that mixed motives might lead corporations to
diversify, which in turn makes any strategic assessment all the more
difficult.

Entry vehicles

Porter (1980) distinguished between two main entry strategies: entry

by internal development and entry by acquisition. He also identified a
third alternative entry form, the sequenced entry.

Entry through internal development

Porter (1980) defined entry through internal development as follows:

Entry through internal development involves the creation of a

business entity in an industry, including new production capacity,
distribution relationships, sales force, and so on.
(Porter, 1980, p. 340)

Joint ventures can also satisfy the criteria of this definition, as they
constitute new entrants in the industry. According to Porter (1980),
three main costs have to be weighted against the expected cash flows
from being in the industry when an internal development diversifica-
tion strategy is followed. The first obvious factor is the investment
costs to set up an operating entity. However, Porter (1980) underlined
further costs that are more easily ignored by decision-makers: one
consists of structural entry barriers and the second of incumbents'
retaliation to the new entrant. Diversifying corporations often ignore
costs that are not directly linked to the obvious costs involved in set-
ting up an operating unit. Structural entry barriers include such costs
as brand identification (i.e. existing firms benefit from an established
brand name), and proprietary technology. Established firms ~ight
have tied distribution channels and suppliers, so that they get exclusive
distribution rights or advantageous supply terms. Moreover, new entry
raises competition and can raise the prices of scarce resources in the
industry by its mere existence. New entrants in an industry also change
the supply-demand balance in the industry: in fact new entry might
create an excess capacity in the industry, thereby forcing exits of other
suppliers. It is also necessary to consider the probable competitors'
 The Theory of Corporate Diversification 105

response to the new entry. If new entrants are considered as a threat

by existing firms, it is likely that they will respond by marketing efforts,
including price cuts, extension of customer services and the like. New
entrants will have to respond to these marketing efforts by spending
more on these aspects than might originally have been forecast.
The above framework underlines some of the main costs and benefits
for de novo entry. These are essentially the same as for joint ventures,
but joint ventures bear the additional cost of co-ordination between
partners. In particular, both parties must have identical objectives for
the joint venture. They must have identical expectations as to the level
of return on investment, time to recover the initial investment and
potential capital increases. Such joint ventures might become unwork-
able if the partners' policies diverge. On the other hand, costs of entry
are lowered in joint ventures and risks are shared by both partners.
Moreover, it has often been the case that joint-venture partners share
some of the expertise in the management of the newly created entity
(one may be in charge of distribution while the other lends its expertise
in terms of production). In such a case, the costs associated with
overcoming structural entry barriers might be lowered. Harrigan (1988)
argued that co-operative agreements can be examined in a similar
framework to joint ventures. The main distinction is that such agree-
ments do not involve equity. The main motives for co-operative beha-
viour found in both joint ventures and agreements involve creating
internal strength, risk-sharing and uncertainty reduction (Harrigan,
1988). Harrigan also argued that such behaviour will increase with in-
creased levels of competition as the costs of investing in skills and assets
to keep up with change rises beyond the risk tolerances of firms. Finally,
Comerford and Callaghan (1985) identified three main types of joint
venture. Those involving unrelated partners often include one partner
that needs an expertise existing in a different industry in order to adapt
that industry's technology to its own needs. Joint ventures involving
related partners suggest that both parties decide to pull units together
that could not survive on their own. Finally, joint ventures have been
common in a dual-nationality context, where foreign partners join
forces in order to overcome cultural, political and social obstacles.
Entry through acquisition
The fundamental difference between entry through internal develop-
ment and through acquisition is that the second form does not involve
the addition of a new firm in an industry (Porter, 1980). The factors
associated with additional supply (such as excess capacity, entry
106 Bancassurance

barriers and competitors' retaliation) are therefore not valid in the

acquisition context. Comeford and Callaghan (1985) underlined a num-
ber of factors that might contribute to the preference of an acquisition
over internal growth. First, an acquisition might be a faster way to
enter a new market as no start-up delays are involved. Second, it is
possible that employment costs (training, relocating, hiring) will be
lower under the acquisition scenario. Moreover, set-ups involve reg-
ulatory costs that may be bypassed in the acquisition alternative (for
instance, such things as building construction authorisation, business
authorisations, etc.).
Finally, financial benefits may arise from merger transactions. For
example, stock mergers can allow acquiring firms to raise new ex-
pansion capital. This alternative will be all the more attractive if the
target firm is cash-rich and undervalued. However, integration of two
merger partners might create cultural frictions that might jeopardise
the success of the new entity. Stockholders of both acquired and
acquiring firms can show dissatisfaction on the terms and wisdom of
the merger. Anti-trust actions can also blockade a merger process
(Comerford and Callaghan, 1985).
The high costs of acquisitions, however, may cast doubt on the
wisdom of this type of strategy (Porter, 1980). Since the price of an
acquisition is determined in a market that is supposedly efficient, any
above-average profits from an acquisition should be eliminated. The
success of acquisition routes will therefore depend crucially on
potential imperfections of the market for companies, the height of the
floor price required by the seller (i.e. the price of the seller's altern-
ative to keep the business) and possible unique abilities of the
acquiring firm to operate the target firm (Porter, 1980). There are
some non-economic factors that might contribute to the decision of
a corporation to acquire a firm above its market valuation. The
acquiring firm might believe that it can uncover undervalued firms or
that it can better manage the company than its existing managers do.
While there may be reasons for these beliefs, Hawawini and Swary
(1990) caution against the potential arrogance of managers who
believe that they are better informed than the market and more effi-
cient than other managerial teams. We will refer to this hypothesis
(the hubris hypothesis of mergers) later in this chapter.
Sequenced entry
This alternative form of entry has been identified by Porter (1980). It
can be linked to both of the above although involving less risk than
 The Theory of Corporate Diversification 107

either. Sequenced entry consists in making a limited entry in one

group initially, and then moving from one group to another. For
example, a diversifying firm may acquire a small regional business and
invest from this base in order to expand the new activity nationwide.
Costs of entry into a given target industry might be lowered through
moving from an initial group that has similar production or expertise.
Such entry suggests that the diversifying firm wants to gradually
acquire knowledge and capital to enter a target activity.

The above analysis suggests that alternative entry modes have differ-
ent implications on the costs and speed of entry. These must be care-
fully weighted in a diversification strategy in order to reap expected
benefits from the diversification process. Porter (1980) questioned the
possibility of reaping any above-average return on investment from
any of the above entry modes. He argued that, in perfectly efficient
markets, such strategies should not meet the success that the wide-
spread corporate diversification experiences might suggest. Sections
5.2 and 5.3 investigate these concerns in more detail.

Organisational structures

An important aspect of corporate diversification strategies is their

impact on the design of organisational structures. Two main aspects of
organisational design are differentiation and integration. The first
refers to the way people are allocated to various tasks. Integration
refers to the means by which a company tries to co-ordinate people
and functions to accomplish organisational tasks. Both characteristics
determine how the corporate structure operates (Hill and Jones,
1989). Different organisational structures should consider both
aspects in order to operate successfully. Two main decisions have to be
made in order to design the corporate structure: vertical differentia-
tion and horizontal differentiation.

Vertical differentiation
Vertical differentiation refers to the way decision-making authority is
allocated in a corporation. The main differentiations that can be made
are tall and flat structures (Hill and Jones, 1989). In the former, there
are more levels of decision making and therefore a relatively narrow
span of control at each organisational level. A flat structure, in con-
trast, allows more flexibility for each organisational level to decide on
108 Bancassurance

the conduct of its operating tasks. Another distinction can also be

made between centralised and decentralised structures. In the former,
most decisions are left to the upper levels of hierarchy while in the
latter, authority is delegated to functional departments. Both altern-
atives have advantages and there has been a trend to decentralise in
order to facilitate better communications within companies (Hill and
Jones, 1989). However, decentralisation in its stronger form can have
the effect of the corporation losing control of its decision making and
therefore making it more difficult to reach broad corporate objectives.
These problems can be overcome by a suitable horizontal differ-
entiation choice.

Horizontal differentiation
Horizontal differentiation refers to the way tasks are divided and
grouped to meet business objectives. There are a number of structural
designs in real-life corporations that are summarised in Table 5.1.
Table 5.1 illustrates that different corporations might have various
needs as to the most suitable structure. For example, matrix structures
will be more relevant in technology-intensive industries where projects
can constitute long-term tasks.
The multidivisional structure is most suited to very large corpora-
tions that are involved in unrelated activities. Figure 5.4 schematically
illustrates the shape of a multidivisional structure.
The diversification process can lead to major restructuring inside
the corporation which can be inspired from the above structures.
However, relating various units (whatever the organisational struc-
ture) might be a complicated task. As Figure 5.4 suggests, interrela-
tions between various divisions of a corporation and the supervision of
these divisions are complex. Diversification in related businesses
suggests that the choice of an organisational structure that enables the
corporation to exploit synergies between the various entities is funda-
mental. Failure to recognise this need might ultimately jeopardise the
success of a diversification strategy.

5.2 THEORETICAL RATIONALE FOR CORPORATE

DIVERSIFICATION

Five main theories have traditionally described corporate diversifica-

tion. Agency theory provides the theoretical framework for studies
 The Theory of Corporate Diversification 109

Table 5.1 Main characteristics of various organisational structures

Organisational Characteristics
structure

Simple structure No formal organisation. Unique person is often in

charge of all managerial tasks.
Functional People are grouped together according to their
structure common expertise and resources (sales function, R&D,
finance)
Product or Activities are grouped by product/area. At the top,
geographical CEO and support functions (sales, accounting) are
structure centralised.
Matrix structure Two levels of authority. Functional managers that
centralise functional tasks and project managers that
supervise teams of employees of various functional tasks
on a given project.
Multidivisional Corporate headquarters supervise the interrelations
structure between various self-contained divisions that include all
support functions and can choose their own structures.
Strategic business Variant of the above. Divisions are grouped in order to
unit (SBU) create synergies. These SBUs have their own head-
structure quarters and become individual profit centres. The
SBU office is in charge of allocating resources among
its divisions.
Conglomerate Variant of multidivisional when there are no synergies
structure between divisions. Functions as a holding company
where each division is evaluated as an autonomous
profit centre.

Source: Review of Hill and Jones (1989).

which have linked diversification to managers' preferences. The

separation of owners and managers in large corporations is viewed by
agency theorists as the catalyst for corporate involvement in non-profit
maximising strategies, which may relate to corporate diversification.
Other studies have argued that corporate diversification has tradi-
tionally been targeted towards corporations yielding above-average
profits, hence suggesting that diversification is motivated by profit
maximisation. A third theory argues that corporate diversification is
motivated by the search for synergies, while another set of studies has
more specifically emphasised the search for financial synergies. Finally,
a stream of literature has focused on the risk-reducing potential of
110 Bancassurance

Figure 5.4 The multidivisional structure

Corporate headquarters staff

Functional
managers

Functional Product
structure structure
Matrix
Project manager structure

Source: Hill, Charles W. and Garreth R. Jones, Strategic Management: An

Integrated Approach. Copyright © 1989 by Houghton Mifflin Company. Used
with permission.
diversification strategies. In this section, we review the literature on
these various rationales for corporate diversification. Most of the lit-
erature has concentrated on diversification using the M&A route and
we likewise concentrate on this aspect of the literature.

Agency theory

Agency conflicts have often been viewed as a motive for diversification

strategies. Some studies relate corporate diversification to managers'
growth preferences, while others focus on the risk-return trade-off
between owners and managers.
It has been argued in the literature that managers may pursue goals
that are different from stockholders' wealth maximisation. One such
alternative goal has been to pursue growth in physical size (Mueller,
1969). Marris (1964) presented some evidence that both the pecuniary
and non-pecuniary rewards of managers are more closely related to a
firm's growth than to its profits. Managerial salaries, bonuses, stock
options and promotions appear to be directly tied to firm size (or
changes in size). Similarly, it is argued that non-pecuniary rewards
(power, prestige, perquisites) depend largely on firms' size rather than
performance. This relationship between ~anagers' rewards and
 The Theory of Corporate Divers~fication 111

growth is a direct consequence of an imperfection of managers'

incentives contracts.
Mueller (1969) developed an alternative explanation of the growth
maximisation objective of managers and argued that self-interest may
prompt managers of acquired firms to seek merger partners. Man-
agers who approach retirement may help an acquiring firm to bring
about the merger in return for bonuses or options in the new com-
bined firm, which will capitalise their past involvement in the acquired
company. Another situation in which managers may help a third party
firm to acquire their company is where they are the target of an
acquisition which can be disadvantageous to existing managers. When
a corporation is the target of a take-over bid by a company which
threatens existing managers' positions, managers might seek an
alternative merger partner with which they hope to secure better
positions for themselves. They may therefore try to sell the company at
a lower price. Effectively, mergers can serve as a defensive tool against
hostile take-overs (Mueller, 1969).
Both these hypotheses (rewards and defence) apply to managers
with a short time horizon in a company. Moreover they suggest that
a managerial team as a whole displays the same preferences. Even
under the second hypothesis, where managers of target firms feel their
positions under threat, some managers may favour allying to a more
aggressive firm because it offers better promotion opportunities. Such
strategies depend on the risk preferences of managers in the acquired
firm. The growth hypothesis results partly from market imperfections.
It suggests that managers act for their own utility's sake and their
pursuit of growth appears to be incompatible with stockholders'
interests.
Hawawini and Swary (1990) argue that similar arguments can hold
if managers' compensation is related to corporate risk. If managers
feel that their job security, remuneration or prestige are dependent
solely on stock returns, they may seek to reduce the volatility of those
returns. This argument relies on the theory that separation of own-
ership and control means that managerial decisions might diverge
from shareholders' interest. This is inherently a market failure borne
from the unobservability of managerial efforts.
Diamond and Verrechia (1982) proposed an alternative theory
of the relationship between owners and managers in their model of
optimal managerial contracts. According to this theory, managers'
decisions depend on the incentives provided within the corporation.
These incentives can be explicit (in the employment contract) as well
112 Bancassurance

as implicit (the fear of dismissal or negative effect on their reputation).

They determine the anticipation of managers regarding the con-
sequences of various observable outcomes, e.g. output levels, which
provide information to owners to determine whether managers are
effective in their functions. However, a firm's output is not solely
determined by the level of managerial efforts but also by stochastic
elements. Therefore the level of managerial efforts cannot be inferred
directly from firm output; any piece of information which enables
owners to distinguish further between managerial efforts and random
fluctuations in the output constitutes a valuable clue to include in an
optimal managerial contract. It reduces the risk borne by managers
because they know that their efforts are not assessed according to
random output fluctuations.
Amihud, Dodd and Weinstein (1986) extended this theory to the
diversification process and argued that the degree of observability of
managerial efforts determines managers' attitude toward risk. In a
case of perfect observability where shareholders can indicate which
level of risk they are prepared to bear, managers have incentives to act
according to those preferences. However, in situations where man-
agerial efforts are not readily observable, stock prices constitute the
major indicator of managerial efforts. In that case, risk-averse man-
agers will be reluctant to make decisions involving high levels of risk
because they fear that a negative output will endanger their status. To
incur more risk, they will require higher compensation, because they
also bear part of the output risk which determines their reward. As the
costs of observability are borne solely by shareholders, they may prefer
managers to choose less risky projects because they do not need to
monitor managerial efforts or compensate managers for the extra risk
borne.
Marshall, Yawitz and Greenberg (1984) put forward similar argu-
ments. They argued that corporate diversification may bring closer
together the objectives of shareholders and managers. As managers'
risk tolerances are closely related to one firm, their risk perception
depends on that unique firm's volatility of returns. They may be willing
to exchange some of the expected return for a decrease in risk.
Conversely diversification increases managers' risk tolerances, there-
fore giving them less incentives to give up expected return for risk
reduction.
Lewellen, Loderer and Rosenfeld (1989) found little empirical
evidence that the managerial theory of mergers holds, i.e. that there
is a significant positive relationship between larger managerial
 The Theory of Corporate Diversification 113

shareholdings and the occurrence of risk-reducing mergers. Hence

there is no significant evidence that firms with large managerial
shareholdings engage in more risk-reducing acquisitions. Other
studies have also underlined this lack of evidence (see for example
Amihud, Dodd and Weinstein, 1986; Jahera, Oswald and McMillan,
1993). This suggests that managerial risk-aversion is not altogether a
conclusive rationale for merger.
Agency theory suggests that managers' objectives might diverge
from profit maximisation. Diversification allows managers to achieve
objectives that are unrelated to firm performance per se, i.e. growth
in physical size and risk-reduction. However, empirical studies are
divided as to the view that mergers occur more frequently in manager-
oriented firms.

Profitability of target

The profitability rationale in the corporate diversification literature

assumes that acquiring firms can generate excess profits through the
acquisition process. This rationale relies on three possible scenarios.
The first scenario implies that the target firm has an above-average
rate of return. The second scenario involves a market mispricing
opportunity whereby acquiring firms identify undervalued targets. The
third scenario implies that diversifying firms have unique capabilities
to improve their targets' performance.
Smith and Schreiner (1969) suggested that there is a potential for
increasing the profitability of combined firms, if the rate of return in
the acquired industry is greater than the cost of capital for the acquir-
ing firm. Therefore we would expect diversifying firms to invest in
profitable industries. Entry by merger in such an industry has great
advantages because it allows the acquiring firm to rapidly capture the
investment opportunities of that industry. Alberts (1966) showed that
as long as an acquired firm, A, sells at its intrinsic value, and there is
no synergism, B, the acquiring firm, will earn an internal rate of return
no greater than its cost of capital. This is because the price of A should
also reflect all the profitable growth that A is expected to experience
over time. That is, the superior growth of A is already capitalised in
the value of the firm so that the internal rate of return of the invest-
ment of B in A will equate to its cost of capital. As a consequence,
even if the merger increases B's total earnings and dividends, it does
not in fact affect the stream of payments to the owners of B's out-
standing shares. Therefore B's shareholders will not gain from the
114 Bancassurance

merger process. This undermines the probability of such benefits

accruing to acquiring firms.
The market mispricing hypothesis was analysed by Lewellen (1971).
He argued that some acquisitions are based on acquiring firms' belief
in the existence of market valuation errors. If an acquiring firm can
identify a firm whose value is underestimated by the marketplace, it
will try to acquire that firm at a bargain price compared with its revised
evaluation of the true value of the firm. The acquisition process gives a
signal to the market that the value of the target firm was under-
estimated and a reappraisal should therefore take place. For the
acquiring firm to make profits, the acquisition price must remain less
than its own revision and cover for the premium paid in the merger
process. Lewellen (1971) suggested that opportunities for such errors
in the market valuation process must be rare and that obtaining
a reasonable margin out of the acquisition must be all the more
infrequent, as the market is supposed to adjust after it realises its
original valuation error. Another theme of the market-mispricing
argument is that investors only look at the short-term pedormance of
a firm rather than at its long-term prospects. However, Kaen (1995)
has suggested that evidence shows that investors tend to reward long-
term investment projects. The mispricing argument was also devel-
oped by Hawawini and Swary (1990). They suggested that this
hypothesis implied that acquiring firms possess insider information
which is not available to the market (the information hypothesis). This
is consistent with market efficiency in its semi-strong form (the market
is aware of all publicly available information). However, it is inefficient
in its strong form (stock prices do not reflect private information).
This hypothesis has a drawback which is labelled the hubris
hypothesis (Hawawini and Swary, 1990). Roll (1986) developed this
hypothesis as an explanation of the behaviour of bidding firms' man-
agers. According to this hypothesis, managers' arrogance leads them
to believe that they can uncover bargains. They are ready to pay a high
price to acquire the firm they believe is undervalued, thereby reducing
the available margin from the process. This behavioural theory sug-
gests that a kind of race can follow, when several bidders are involved,
resulting in 'bargains' being acquired at overvalued prices. One of the
underlying assumptions of Roll's explanation is that markets are
efficient and provide the best indicator of the value of a firm. However,
this framework suggests an alternative reason why some take-overs
result in a decrease in the price of the acquiring firm. In effect the
hubris hypothesis suggests that the stock price of the acquiring firm
 The Theory of Corporate Diversification 115

decreases because take-over is not in the interests of shareholders and

the target firm's stock price increases, because the acquirer is likely to
pay a premium in excess of the true value of the target. These com-
bined effects should result in a negative aggregate effect when take-
over costs are included. The hubris hypothesis cast doubt on the
possibility that managers can have superior information.
A final theory suggests that acquiring firms believe that they can
raise their targets' value by implementing better management. Hawa-
wini and Swary (1990) labelled this theory the 'inefficient-management
hypothesis'. This hypothesis suggests that acquiring firms uncover
firms whose management is inefficient and through the process of
merger enable the removal of that management. This hypothesis is not
comparable with a synergy-type theory of mergers because removal of
inefficient management does not require the combination of both
firms. The inefficient-management hypothesis is similar to the in-
formation hypothesis stressed before. It is primarily motivated by the
belief that the acquiring firm's management can better manage its
target's resources. According to Gaughan (1991), this means that
acquirers believe that targets' values will increase under their control.
Thus acquiring firms are willing to pay a premium for their acquisi-
tions (in excess of their current stock price). There are cases where
managerial improvement seems a reasonable assumption, for example
when the considered target is a small firm, which lacks the managerial
skills to manage its growth: this managerial expertise can be a valuable
asset from the larger acquiring firm. In general, target managers dis-
like being described as inefficient. Therefore, acquisitions justified on
the grounds of managerial efficiency can often turn into hostile take-
overs (Kaen, 1995).
The above hypotheses suggest that mergers that generate excess
profits arise from market inefficiencies in the communication of
information. Even if these imperfections exist, the literature suggests
that managers are generally overestimating their ability to identify and
manage undervalued firms.

Synergies

Synergies refer to the phenomenon of '2 + 2 = 5', i.e. the ability of a

corporate combination to be more profitable than the individual profits
of the firms that were combined. This may include some of the hypo-
theses stated above, such as the removal of inefficient management. In
116 Bancassurance

this section, we focus on operating synergies and their two main

sources: economies of scale and economies of scope.
Economies of scale occur when spreading fIXed operating costs over
a larger production volume decreases average production unit costs.
Economies of scale imply the existence of 'indivisibilities', such as
people, equipment and overheads which provide increasing returns
when spread over larger output units (Copeland and Weston, 1979). In
manufacturing operations, this can be heavy machinery that requires
optimal utilisation. Economies of scale can be best exploited in hori-
zontal mergers, whereby a firm acquires another firm with similar
production. For economies of scale to be achieved, however, one must
assume that the firms were operating at a level that fell short of
exploiting these potential scale economies. Furthermore, mergers
occur between firms that do not have perfectly flexible cost structures.
Assuming economies are due to fIXed costs, they might not be
achieved without closing the production facilities of one of the com-
bining firms (Jacquemin and Slade, 1988).
Economies of scope can be defined as the ability of a firm to utilise
one set of inputs to provide a broader range of products and services
(Gaughan, 1991, p. 104). When the costs of producing two products
jointly are less than the costs of producing them separately, cost sav-
ings are realised. In general, economies of scope are achieved in
specific functions, such as distribution, R&D and technology. Again,
similarity between the businesses will increase chances for such sav-
ings. However, it need not be the case. Technological economies can
be derived from two different but converging activities. The definition
of convergence can be flexible. For example, transportation costs may
justify the merger of two firms in order to share the fixed costs of
investment in trucks rather than incurring the costs of rentals. Plants
and equipment may not be mobile but they may be flexible in possible
uses (Marshall, Yawitz and Greenberg, 1984). When sharing between
firms is costly, there may be a rationale for merger between two firms
whose activities appear unrelated.
Spare capacity can arise from two sources. One source is that
demand has been over-estimated so that a firm does not maximise the
utilisation of its assets. It is thus likely to seek diversification in an area
where its assets can be used. Another source comes from the 'lum-
piness' of capital outlays. As some investments cannot be divided in
successive, small purchases, it may be useful for a firm to ally with
a company that also needs such resources. This can apply to firms
in different industries. According to Copeland and Weston (1979),
 The Theory of Corporate Diversification 117

synergies can also arise in conglomerate mergers. Economies can be

traced to generic management functions. The importance of such
functions (planning, control, organising, information systems) and of
functions centralised at the top management level (research, finance,
legal) generates relatively high managerial costs for small firms.
Consequently, the costs of managing large diversified firms are sub-
stantially reduced compared to the total costs of managing each
component separately.
Synergies have long been at the heart of debates among researchers.
While synergies are often alleged by managers of diversifying firms,
evidence as to their reality and frequency is lacking. For every poten-
tial economy, potential diseconomies can be identified, e.g. under-
utilisation of some existing factors, increased co-ordination problems.
Gardener (1987, p. 13) warned about the danger of relying on such
economies.

We have all heard of synergy, some even claim to have experienced

it, but nobody has apparently run it on earth.

Financial synergies

The previous section highlights the difficulties in achieving operating

synergies: they are unlikely to occur frequently in unrelated mergers
given the absence of shared inputs, and costs savings might be difficult
to achieve in related mergers, where sharing opportunities exist. If
the objective of the merger is not to take benefit of operating gains,
financial motives may underlie diversification strategies. Taxation for
example can be directly affected by a merger. Alternatively, financing
structures can be altered favourably through a merger process. Finally,
the lender's assessment of the credit risk of a firm can be modified
after a merger.
The potential effects of a merger on the tax liability of an acquiring
firm has been examined in depth by Gaughan (1991). A firm can be
attractive to an investing company if it has transferable tax losses that
an acquirer can use to offset income. 2 It can therefore use this tax
asset in determining the price it claims from the acquirer. Therefore
tax considerations can dictate both the merger transaction and its
valuation. Moreover, tax synergies can arise because the merger pro-
cess allows firms to use tax shields which one of the independent firms
could not utilise fully beforehand. Gaughan reported a study by
Auerbach and Reishus (1988) that showed that a substantial fraction
118 Bancassurance

(one-fifth) of their merger sample (318) comprised a firm with con-

straints on its ability to use tax benefits while its partner had not. They
showed that the average gain from tax synergies averaged 10.5% of the
market value of the target in those mergers; however, these gains were
substantial (over 10%) in only 6.5% of the sample. Other authors have
emphasised the possibility of the tax motive for conglomerate mergers
(e.g. Hawawini and Swary, 1990; Lintner, 1971). However, Gaughan
(1991) suggested that taxes are merely a secondary concern when
firms consider merger partners, rather than a determining factor in
merger decisions.
The 'unused debt' hypothesis was discussed in depth by Lewellen
(1971). This hypothesis suggests that mergers seek to more fully utilise
the unused debt capacity of one of the merger partners. Debt is
cheaper than equity, because interest payments are tax-deductible.
Therefore, under-utilisation of the range of debt available to one firm
might give an opportunity to the acquirer to rearrange additional
borrowing. This implies that debt capacity can be identified within a
measurable range? It should be underlined that these financial gains
merely arise because of a prior deficiency of one of the firms involved
in the merger (the firm which did not fully utilise its debt capacity),
therefore generating a latent debt advantage for a prospective merger
partner. It follows that merger is not necessary to bring about this
benefit which could have been achieved by the rearranging of the debt
structure of individual firms.
An extension of the above motive for mergers is drawn out by Levy
and Sarnat (1970). They argued that there can be capital cost savings
through mergers because large firms have better access to capital
markets. This holds for those mergers that cause capital restructuring
as well as for mergers in general. These cost savings reflect 'at least in
part, the reduction in lenders' risk achieved through diversification'
(Levy and Sarnat, 1970, p. 801). The impact of merger on lending risk
is a hypothesis which was further developed by Lewellen (1971). The
hypothesis states that the combination of two probabilistic income
streams results in a joint income stream with less variability. As
lenders are concerned with the probability that borrowers might not
service their debt, they fix a limit to borrowing which is related to the
probability of 'disaster'. As this probability decreases, they are willing
to adjust the lending range above the limits they originally assigned to
independent firms. As long as two merging firms have less than per-
fectly correlated cash flows, the resulting merged firm may have a
lower probability of generating cash flows insufficient to service its
 The Theory of Corporate Diversification 119

combined debt. Therefore, lenders will allow the new firm a greater
credit range than was available prior to merger. They perceive the
juxtaposition of two cash flows in a single entity as a kind of partial
co-insurance for corporate loans which does not prevail in the absence
of merger, since a counterpart will not be liable for one firm's cash
flow inadequacy. The increased creditworthiness of the merged com-
pany is not dependent on there being only one lender involved. The
creditor group gains collectively in the decreased probability of default
of the combined firm whatever the reshuffling of creditor priorities
through the merger process (Copeland and Weston, 1979). The dif-
ference between lender diversification and borrower diversification
should be underlined. While lenders can spread risk by lending small
fractions of their portfolios to numerousdifferent companies, they can
never affect the probability that one of the firms in their portfolio
defaults. By diminishing that probability through the merger process
(borrower diversification), firms give 'a kind of participating interest-
and-repayment possibility to lenders' (Lewellen, 1971), which lenders
could not achieve by lending to individual corporations. Consolidation
provides consequently a real additional borrowing capacity for merger
partners, as lenders' perception of their creditworthiness increases.
Financial motives can provide a strong support for mergers. How-
ever, it has been argued that they are not value-creating. The tax and
unused debt capacity hypotheses both rely on inherent market failures.
Their occurrence should therefore be rare. While the last hypothesis
(reduction in lenders' risk) seems more likely to occur, it can be
argued that it only affects bondholders but weakens the position
of shareholders, because their limited liability is less, as borrowing
increases. As the value of a firm is the sum of these two constituent
parts, there is no increase in value (see Copeland and Weston, 1979).
However, this argument is interesting because it provides a rationale
for conglomerate mergers as opposed to related mergers, where such
benefits should be small given the high correlation of income streams.

Risk-reduction motive

Risk-reduction is viewed as a potential rationale for mergers, and in

particular, for unrelated mergers. The basis for this argument is based
upon portfolio theory, which suggests that combining two negatively
correlated income streams will result in reduced volatility. Smith and
Schreiner (1969) describe the portfolio approach as an ex ante model
which is built upon expectations of returns and their standard
120 Bancassurance

deviation. To measure the diversification of a portfolio of securities,

the cotangent of the angle to the efficient frontier (described by the
line from the risk-free asset to the optimal portfolio) can be used as a
proxy of the extent to which a portfolio is diversified. Smith and
Schreiner (1969, p. 417) suggest that a similar approach can be used
for corporate diversification.

It is necessary to think of a conglomerate firm as investing in a

number of distinct activities - just as an investor would consider
investing in various securities.

This approach has a number of shortcomings. One is that a corpora-

tion invests both capital and management in an acquisition. Another
shortcoming is that an investor can vary freely the extent of each
investment, as well as decide to disinvest without incurring substantial
losses: conversely, a corporation has less discretion on the extent of its
investment, and disinvestment can be costly. Finally, while stocks of
the same company are identical in each investor's portfolio, every
corporate acquisition is unique (Smith and Schreiner, 1969). It is not
possible, therefore, to compare directly the acquisition portfolio of
a diversified company with another. One inherent difficulty of this
approach of corporate diversification is that it suggests that corporate
diversification duplicates investor diversification through capital
markets. It has been argued that risk-reduction should not be a motive
for corporate diversification, because investors can achieve the same
result by diversifying their own securities portfolio. Levy and Sarnat
(1970) showed that in perfect capital markets the risk-return char-
acteristics of an optimal portfolio of N firms is the same before and
after the merger of two of those firms. Therefore, mergers should have
a neutral effect on the value of the firms. However, market imper-
fections may exist so that an investor may only be able to invest in a
subset of firms. This market imperfection may arise from transaction
costs or indivisibilities. As investors must bear portfolio constraints,
they may not be able to attain an optimal position. If a merger occurs
between one firm of the subset of firms accessible to an investor and a
firm outside that subset, the opportunity set of the investor has
effectively been improved. At the same time, however, investors have
lost the opportunity to invest directly in the shares of these two
individual firms (Levy and Sarnat, 1970). Lintner (1971) also sug-
gested that market imperfections cause investors to be restricted to a
subset of the optimal market portfolio. Accordingly, the value of a
 The Theory of Corporate Diversification 121

stock should vary inversely with the risk tolerances of investors who
have it in their portfolio. As the underlying risk of that stock is
reduced, its price is increased. Portfolio theory can provide some
interesting insights into corporate diversification effects. However,
Lubatkin and O'Neill (1987) have suggested that portfolio theory may
not be an ideal framework to examine the risk consequences of mer-
gers because managerial actions can alter the risk profiles of merging
businesses. Risk-reduction benefits are therefore not straightforward
from the shareholders' point of view.
Alternative motives for risk-reducing mergers can, however, be
found: reduction in the probability of bankruptcy and defensive diver-
sification. The first motive has been reviewed partially in a previous
section under the heading of lending risk (developed by Lewellen,
1971). Whether reducing lending risk can be a motive for mergers is a
matter of debate among researchers. 4 However, it can be argued that
mergers may reduce the probability that cash flows reach disastrous
levels, therefore reducing the probability of failure. Stakeholders of a
corporation (creditors, employees, suppliers, customers, etc.) may be
interested in seeing a decrease in the probability of failure. This
suggests that there are benefits from a reduction in a firm's probability
of failure which are not necessarily reflected in stock prices but rather
in the long-term wealth of the company.
Weston and Mansinghka (1971) developed the theory that mergers
are motivated by the fear of reduced growth in firms' traditional
markets. The results of their empirical study were consistent with the
hypothesis of defensive diversification. Defensive diversification can
be thought of as fulfilling the task of preserving ongoing entities and/
or restoring the earnings powers of such entities. Its consequence may
be to avoid bankruptcy costs. Empirical evidence supports this motive
if firms that engage in such strategies have lower performance than
their competitors before merging, and reach the same levels of per-
formance after this is achieved. Gahlon and Stover (1979) obtained
similar results, by comparing the risks of firms before and after mer-
ging. They argued that the average performance of conglomerate firms
can be explained by the joint action of defensive diversification (which
reduces the volatility of earnings of the corporation) and the increased
use of debt resulting from mergers. Gaughan (1991) underlined the
benefits of merging two companies whose business cycles are not
correlated. A company which is procyclical (whose sales and earnings
are highly responsive to fluctuations in the economy) may be inter-
ested in acquiring firms which are non-cyclical (i.e. whose earnings are
122 Bancassurance

not directly affected by economic downturns). Such defensive diver-

sification strategies help preserve the wealth of an entity. Defensive
motives provide interesting explanations for the low performance of
corporate diversification strategies. Seeking risk-reducing mergers in
order to secure the future earnings of a corporation which operates in
a saturated market does not imply market failures, like agency pro-
blems between managers and shareholders. Whether it will be highly
valued by stockholders is an empirical matter.

5.3 EMPIRICAL EVIDENCE

This section summarises empirical studies that have explored the

motives and performance of corporate diversification. 'lWo main aspects
in particular have been empirically tested. A number of researchers
have concentrated on various hypotheses about the motives under-
lying conglomerate diversification. Other studies have evaluated the
relative performance of related and unrelated diversification.

Testing various hypotheses of corporate diversification

In this section, we review the methodologies and results of studies that

tested for various motives of corporate diversification.

Methodology
The most common approach to corporate diversification evaluation
has been to use event-type studies. Event studies are defined as an
empirical investigation of the relationship between security prices and
economic events (Strong, 1992). In particular, studies on corporate
diversification have studied the reactions of shareholders to merger
announcements. Event studies vary along a number of dimensions,
including how returns are operationalised, the length of the event
window, and the benchmark for abnormal returns. The main idea is to
measure the extent of abnormal returns for firms around the date of a
particular event (in particular, acquisition announcements). It is not
our purpose to discuss the various methodologies used in event stud-
ies; one might refer to a comprehensive review of event studies by
Strong (1992) that evaluates various methodologies.
Event studies provide an interesting framework for analysing the
motives underlying the diversification process .. They have been used to
 The Theory of Corporate Diversification 123

test the agency theory argument. This approach has been used in
particular to test the differences in abnormal returns to shareholders
of manager and stockholder-controlled firms (Amihud, Dodd and
Weinstein, 1986; Lewellen. Loderer and Rosenfeld, 1989). Another
approach has been to compare risk and returns prior and after the
merger in order to test for potential synergies (Haugen and Langetieg,
1975). Event studies have also been a way of measuring the relative
gains for acquiring and acquired firms, thereby giving some insight
into allegations of abnormal profits (Mandelker, 1974).
A second approach has been to compare the performance of
diversifying and non-diversifying firms. This has been commonly used
to measure the extent to which diversification motives can underlie
diversifying strategies. In particular, suggestions of defensive diversi-
fication motives can be reinforced by finding that diversifying firms
suffer low performance prior to the diversification move (e.g. Weston
and Mansighka, 1971; Fox and Hamilton. 1994).
Finally, regression-type analyses have been used to study the rela-
tion between different variables for diversifying and non-diversifying
firms (Gahlon and Stover, 1979). Logit analyses have also been used in
this context (Norton. 1993).
Table 5.2 provides a review of studies testing various hypotheses of
diversifying mergers. It is by no means exhaustive but illustrates how
researchers have dealt with the issue of corporate diversification.

Results
The sample of studies reviewed in Table 5.2 suggests that diversifica-
tion rationales are consistent with corporate diversification strategies.
Weston and Mansighka (1971) and Fox and Hamilton (1994) found
some evidence that firms diversify in order to compensate for poor
performance. Smith and Schreiner (1969) and Silhan and Thomas
(1986) also found that conglomerate firms have achieved a high degree
of diversification, measured against market portfolio diversification,
which, they argued, suggests risk decreases. However, Lewellen.
Loderer and Rosenfeld (1989) found that diversifying firms display
higher risk than non-diversifying firms (which appears to be incon-
sistent with the agency theory of merger); contrary to other studies
they did not concentrate on conglomerate mergers. Overall, these
studies suggest little evidence of agency motives, where managers act
against shareholders' benefits. They also suggest that diversification
strategies are not offensive (to take advantage of synergies, for
 Table 5.2 Studies that test various hypotheses of corporate mergers .....
~
Authors Sample Period Hypothesis Methodology Results

Smith and 19 conglomerates 1953~7 Diversification Cross-sectional analysis of Find that conglomerates
Schreiner 8 mutual funds conglomerate performance have managed high degree
(1969) 67 industries with mutual fund and of diversification
optimal portfolio
Weston and 63 CM Control: 1958-68 Defensive Cross-sectional analysis CM outperform other firms
Mansighka 63 industrial, diversification of performance CM and in terms of growth. ROA was
(1971) 63 industrial & control firms. Growth less for CM in 1958, same as
non-manufacture rates and earnings other firms in 1968
Mandelker 241 acquiring 1948-67 Abnormal gains Event study. Measures Find abnormal gains to
(1974) firms hypothesis abnormal returns and acquired firms in 7-month
167 acquired Chain-letter (PIE) beta for acquiring and period before merger. Gains
firms hypothesis Jointly acquired firms to acquiring firm are
test perfectly commensurate to risk level.
competitive and Suggests efficient market for
efficient market M&A
hypotheses
Haugen and 59 mergers 1951~8 Synergism Event study. Compare Find that results would be
Langetieg risk of CM and matched the same if stockholder had
(1975) control pairs before and combined shares by himself
after merger
Gahlon and 37 CM 34 non- 1960-75 Defensive Regression analysis - No major risk-increase in
Stover conglomerate diversification Return adjusted beta and any sample.CM have high
(1979) Increased debt financial variables leverage and are highly
capacity diversified
Amihud et al. 236 CM of which 1967-74 Agency theory Event study. Difference No statistical difference
(1986) 197 manager- (risk-reduction) between abnormal returns between both groups
controlled, for stockholder and
39 stockholder manager-controlled firms
controlled
Silhan and 60 firms 1967-78 Risk-reduction Merger simulations for Forecast errors decrease
Thomas conglomerate for a varying as number of segments
(1986) # and size of segments. increase. Performance
ROE and MAPE (mean increases. Mergers of large
absolute percentage error) units better than small units
Lewellen 203 mergers 1963-84 Agency theory Event study. Measures Find risk-increase and
et al. relation between no evidence of accrued
(1989) managerial holding and risk-reduction in manager-
risk using CAPM controlled firms
Norton 120 mergers 1972-77 Agency theory Logit analysis for Variables have hypothesised
(1993) versus Pecking conglomerate and sign for pecking order.
order non-conglomerate firms Significant
Berkovitz and 330 tender offers 1963-88 Synergy motive Event study. Examines 75% takeovers have positive
Narayanan Agency theory gains and relationship gains and synergy motive
(1993) Hubris hypothesis with target gains. dominates. Evidence of
correl > 0 => synergies agency motive for negative
correl = 0 => hubris gains subsample
correl 0 => agency
Fox and 103 firms 1975-85 Agency theory Cross-sectional analysis Evidence of problem
Hamilton versus Stewardship ROA, growth rates performance before merger.
(1994) Similar performance to
other firms after merger
IV
CM = Conglomerate mergers Ul
-
126 Bancassurance

example) but rather defensive (stabilise depressed earnings). Haugen

and Langetieg (1975) found that investors could have done as well by
combining various shares in their portfolios.
One of the main difficulties in the above studies is the assumption
that various financial developments reflect the motives for corporate
diversification. Several motives could underlie a merger process. For
example, it is difficult to state whether risk-reducing mergers were
motivated by managers' concern for the continuing well-being of the
corporation (and ultimately that of their shareholders) or rather by
their inherent risk-aversion (regardless of that of their shareholders).
The cause-effect relationship might be interpreted in different ways
according to the message various researchers want to communicate.
The subjectivity inherent in these studies suggests that perhaps
researchers should take any inferences on merger motives with caution.

Testing the performance of related and unrelated diversification

In this section, we review the literature on the relative performance of

related and unrelated mergers. We examine both the methodologies
and results of these studies.

Methodology
Table 5.3 presents a summary of selected studies of the performance of
related and unrelated diversification strategies. The main methodo-
logical approach has been to examine the relationship between the
degree of 'relatedness' of different diversification strategies and vari-
ous performance measures. Regression-type analyses have been the
main instrument for such studies. One of the main differences
between the studies under review is the way they account for 'related-
ness'. In a review of previous research, Jahera, Yawitz and Greenberg
(1993) found that Rumelt's categories5 have been the main source
of diversification definition in the literature (Jahera, Yawitz and
Greenberg, 1993, p. 2). Various other measures have been used such
as SIC classification categories (or its foreign equivalents) and the
FTC (Federal Trade Commission) merger categories. Jahera, Yawitz
and Greenberg (1993) present an alternative measure that computes
the correlation between the stock and the whole market. The main
disadvantage of the latter is that it assumes that corporate diversi-
fication duplicates portfolio diversification which is a question
especially addressed in some studies.
 Table 5.3 Studies of performance of related and unrelated diversification strategies

Authors Sample Period Methodology Results

Thompson 41 mergers 1965-74 Relationship risk and relatedness Find risk increase in diversifying
(1983) Univariate and multivariate tests mergers
Industry digit UK
Bettis and 35 related 1973-77 Relationship performance and Unrelated diversification does not
Mahajan constrained, relatedness yield good performance results.
(1985) 24 related-linked, Cluster analysis and Related diversification is not very
25 unrelated comparison with above-average successful either
performing firms
Rumelt's index
Lubatkin 297 mergers 1954-73 Cross-sectional analysis of risk No mergers reduce unsystematic
and O'Neill in related and unrelated mergers risk. Related mergers decrease
(1987) Window: 67 months systematic risk. Diversification is
before 64 after more efficient in bear markets
FTC classification
Campbell 4 related 1973-88 Observes effects of diversification Finds that unrelated diversification
(1990) 2 unrelated on risk of non-ferrous yields higher risk
metal companies

.....
N
-.l
 ~
-
Table 5.3 (contd.)

Authors Sample Period Methodology Results

lahera et al. 645 firms 1982-87 ANOVA technique Shows that excess returns increase
(1993) Test relationship between with diversification (measured
diversification and performance by correlation firm stock w.
and influence of ownership market) after controlling for
Stock correlation with market ownership and size
D'Aveni and 466 vertically 1975-77 Cross-sectional regression analysis Vertical integration results in
Ravenscraft integrated Variables: 5 cost and 2 profit economies in most departments
(1994) firms measures against vertical except production costs.
integration, market share Higher production costs in
and total diversification backward integration only
Pennings, 462 expansion 1966-88 Proportional hazard rate analysis Finds that related expansions are
Barkema projects of Examines effects of organisation more successful.
and Douma 14 firms learning on diversification Fully owned and acquisitions do
(1994) Success is measured by venture better than internal developments.
survival Industry digit Expansion is more successful
Netherlands if prior diversification is higher
 The Theory of Corporate Diversification 129

Results
The studies reviewed in Table 5.3 are striking in that they consistently
favour the performance of related over unrelated diversification
strategies (Lubatkin and O'Neill, 1987; Thompson, 1983; Bettis and
Mahajan, 1985; Pennings et al., 1994). Lubatkin and O'Neill (1987)
argue that this is due to the fact that managers alter the risk profiles of
the firms they acquire. Jahera, Yawitz and Greenberg (1993) found,
however, that diversification can boost excess returns. The studies also
suggest that related mergers can yield superior benefits because they
can exploit synergies and improve their competitive position (Lutbakin
and O'Neill, 1987; D'Aveni and Ravenscraft, 1994). An interesting
study by D'Aveni and Ravenscraft (1994) showed that vertical in-
tegration strategies yield economies especially in terms of general
functions (administration, distribution) but that diseconomies can
occur from backward integration whereby the absence of competition
can raise the costs of production of the supplying unit.
Studies comparing the performance of related and unrelated
diversification strategies illustrate the trade-off between theoretical
benefits of diversification and the costs of administering such strat-
egies. This may lead to below-average performance of given diversi-
fication strategies where benefits (earnings diversification, synergies)
were expected.
The above empirical evidence indicates that evaluating diversifica-
tion strategies is difficult, because the immediate benefits from diver-
sification depend on individual firms' characteristics. However, most
studies have found that diversification strategies can be defensive
rather than aggressive corporate policies.

5.4 APPLICABILITY OF CORPORATE DIVERSIFICATION

LITERATURE TO BANCASSURANCE DIVERSIFICATION

This section relates the literature on corporate diversification to ban-

cassurance or bank diversification in life assurance. First, we explain
the nature of the bancassurance process and then provide a discussion
of the theoretical motives which can apply to bancassurance diversi-
fication. The review of diversification motives in the previous sections
provides a basis for this discussion. Several theoretical motives which
have been identified for corporate diversification seem likely to apply
to banks acquiring insurance companies.
130 Bancassurance

The nature of the process of bank diversification in insurance

Section 5.1 identified three main characteristics of the diversification

process: the degree of relatedness, entry vehicle, and organisational
structures. In this context, it is interesting to note that the term 'finan-
cial conglomerate' has been used to encompass banking institutions
which conduct various activities, including securities and insurance
activities. In contrast with industrial conglomerates, that have been
described as groups with little complementary or similarity, financial
conglomerates describe institutions with a high degree of complement-
arity between their different services. In Chapter 2, we emphasised the
complementarity and similarity of banking and insurance both in
theory and practice, and in particular, the importance of potential
synergies in the distribution function. This suggests that bancassurance
is a form of related diversification. Referring to Ansoff's classifications
(see Figure 5.1), bancassurance can be classified as a concentric diver-
sification strategy, where distribution and marketing are the main
areas of relatedness.
The entry vehicles used by proponents of bancassurance have been
diverse (see Table 2.5). All forms of corporate diversification have
been used in the context of bancassurance: co-operative agreements,
joint ventures, mergers and acquisitions and start-ups. In the same
way, bancassurers have devoted much attention to the selection of an
appropriate organisational structure. Chapter 3 showed that UK
bancassurers have restructured their activities in order to integrate
both activities.
This suggests that the bancassurance process involves the same
decisions as those faced by other diversifying institutions. These
choices relate to the need to reap benefits by appropriately selecting a
diversification strategy. Therefore, the literature on corporate diver-
sification is relevant to the study of the bancassurance process.

Theoretical motives for bancassurance diversification

The various diversification hypotheses outlined in Section 5.2 provide

interesting insights to the bancassurance trend. General corporate
diversification motives can be compared to those observed in ban-
cassurance. Surveys of the bancassurance trend have commonly
identified a number of rationales. First, it has been argued that diver-
sification into life assurance has facilitated banks' growth. Second, the
profitability of the life assurance industry has been pointed out as a
 The Theory of Corporate Diversification 131

rationale for banks' entry in this activity. The search for operating
synergies has been one of the most often-quoted reasons for the trend
while financial synergies have in rare instances been cited as a motive
for diversification. Finally, many analysts have suggested that the
bancassurance phenomenon was borne out of the difficulties experi-
enced by banks, suggesting a defensive strategy, and a search for risk
diversification. In this section, we will examine each of these motives in
turn.

Growth in size
The corporate literature argues that motives such as growth in size
may underlie diversification strategies. Agency theorists argue that
managers' rewards are often linked to growth in size: this may induce
managers to seek growth over profit-maximising projects. The growth
rationale is particularly relevant in the context of bancassurance. In an
analysis of the mergers and acquisitions market in European banking,
Revell (1992) emphasised the build-up to 1992 that witnessed the
expansion of European banks, cross-border, nationally, and across
industry frontiers (including insurance). He also warned against the
overshooting effect that took place in the build-up to 1992 and pre-
dicted that some divestitures would occur where markets would prove
less profitable than previously forecast (this happened on a large scale
in real estate ventures). McKinsey (1990), Shaw (1990), and Abraham
and Lierman (1990) have all criticised the large universal bank model
on the grounds that it might entail some organisational difficulties
and because large conglomerate groups might lose their flexibility.
Although growth might have been sought by banks during the 1980s,
it appears that they have had to be more selective in their strategies
in order to create efficient organisations. Marbacher (1992) acknow-
ledges the inherent bias towards growth, which leads most executives
to opt for growth even if it has little or no impact on earnings. This
bias can be linked to the fact that shareholders tend to attribute high
dividend payments to the failure to invest in the long-term future of
a company. Acknowledging this managerial bias, the question of
whether growth is a value-creating rationale can be reduced to asking
whether synergies can be achieved.
In 1993, a Member of the Executive Board of ING Group, emphas-
ised the need to reach a pan-European size to compete in a liberalised
Europe and the fact that bancassurance offered banks new opportun-
ities to do so. Duchesne (1990) similarly argued that size may be a
132 Bancassurance

source of competitive advantage. Gumbel (1991) noted that both

banks and insurers rely on the law of large numbers for the balance of
their operations. Thus size is an inherent objective of both lines of
business which may provide an explanation for growth strategies. In a
survey of six large US fmancial conglomerates, Grant (1992) reported
that five companies emphasised size benefits as a rationale for diversi-
fication; size was mainly viewed as conferring a competitive advantage
for entry into new financial services. In a comprehensive review of
bancassurance, Hoschka (1994) underlined the growth potential of life
insurance as a motive for bank diversification. He argued that, in most
European countries, high growth rates in life insurance were expected
to continue through the 1990s because the life insurance market was
perceived as being underdeveloped in many EU countries. Even in
saturated markets such as Britain and Germany, projected growth
rates for insurance remained stronger than in banking (Hoschka,
1994).
It has also been argued that banks and insurers have established
closer links in order to protect themselves from hostile bids (The
Economist, 1990). Within an integrated Europe, it has become more
attractive for medium-sized and larger institutions to seek friendly
alliances. The head of SE-Banken admitted that the decision to
cement links with Skandia was precipitated by the threat that foreign
rivals might 'beat them to it' (The Economist, 1990, p. 146).
Some analysts have criticised the way bancassurers have promoted
the benefits of high growth rates in life insurance (Pitt, 1990; The
Economist, 1990). The market shares acquired by banks in the life
insurance sector may have been at the expense of bank deposits ( the
'cannibalisation' problem). The competition for savings has consid-
erably increased in recent years and life insurers have been particu-
larly active in capturing new savings, with innovative products and tax
advantages. However, tax privileges have been withdrawn in some
countries in recent years which may render such tax-oriented products
less attractive in the future (Hoschka, 1994).
Many practitioners have highlighted growth as a rationale for ban-
cassurance, in particular in a pan-European context, where reaching a
critical size has been seen as paramount to a European presence. In
theory, however, stockholders may not reap the benefits of such
strategies if growth is used as a substitute for improved performance.
Hence, evaluating the importance of agency problems in bancassur-
ance requires us to evaluate whether value-creating motives have also
contributed to its rise. In addition, growth in the life assurance sector
 The Theory of Corporate Diversification 133

has been somewhat at the expense of traditional bank savings, which

may suggest that growth motives may have been part of a defensive
strategy undertaken by banking institutions.

Profitability of life insurance

Some practitioners have underlined the profitability of the life insur-
ance industry as a motive for bank diversification (e.g. Fagan, 1991;
Hislop, 1995). Fagan (1991) emphasised the high gross margins avail-
able to distributors of life insurance products. Many bank managers
appear to believe that they can raise the efficiency of life insurers
through the acquisition process. This is motivated by the widespread
belief that synergies can occur through the combination, thereby
cutting distribution costs. Thus, life insurance's inherent profitability is
not in itself viewed as the rationale for bancassurance but rather it is
felt that banks' declining profit margins can be boosted by expanding
in an area where they can use their competitive advantages in terms of
distribution. A comparison of the expense ratios of life insurers in
France in 1991 showed that insurers relying on traditional agents had
considerably higher expense ratios than banks' in-house companies. 5
The latter showed expenses ratios varying from 3.1% to 9.1% while
traditional insurers had expense ratios ranging from 10.5% to 23.7%
(Leach, 1993). In the United Kingdom, a study showed that bancas-
surers had a substantial cost advantage over average UK life offices of
similar profiles in 1988: TSB Life enjoyed a 30.2% cost advantage and
Black Horse Life 22.2% (Diacon, 1990). 6

Synergies
The synergy argument for the merger of banking and insurance has
been the object of much scrutiny by practitioners. Herring and San-
tomero (1990) distinguished between two types of economies of scope
for integrated financial services corporations: economies of produc-
tion and economies of consumption. On the production side, the main
economy arises from cutting the cost of managing a client relationship.
This can be observed in terms of image, human resources and dis-
tribution channels. The wide branch network of banks in particular is
an attractive outlay to cross-sell insurance products to a 'warm cus-
tomer base' (Richardson, 1993). Information economies also arise in
the management of a customer relationship (Gardener, 1987). As a
bank gets more involved in the management of a customer's wealth,
information asymmetries decrease. Moreover, shared information
134 Bancassurance

systems can also give rise to such economies of production. Herring

and Santomero (1990) underlined the greater innovation potential of
banks when they get involved with different financial services which
allows them to respond to changing customer needs in a quicker and
more flexible manner.
'Consumption economies' also arise on the demand side. Bank
customers may value the advantages of 'one-stop shopping' that save
transaction costs, time and energy in finding an additional supplier of
financial services. Nicholson (1992) also emphasised the convergence
of some insurance and banking services; in cases where the funda-
mental need of a customer is a mortgage for example, additional
insurance coverage might be required. In such a case, customers are
interested primarily in the mortgage transaction. The customer 'cap-
ture point' refers to the understanding of this purchasing behaviour
(Nicholson, 1992). Economies in terms of time and energy arise for
the customer looking for a mortgage transaction if he/she can com-
plete an associated insurance transaction. There is little evidence in
the literature of the extent of synergies in the combination of banking
and insurance. However, there is some evidence that distribution costs
are lower for integrated bancassurers (Diacon, 1990). Grant (1992)
conducted a thorough analysis of the motives for large financial ser-
vices firms' diversification in the United States. He conducted various
interviews and reviewed the public statements of top management
regarding their diversification strategies. He found that the exploita-
tion of synergies was at the core of such strategies. However, he found
that the only diversification moves that proved profitable were those in
insurance. In fact, when divisional profitability was examined, in-
surance divisions were more profitable in large diversified firms than
in their specialised counterparts. However, only six large diversified
firms were examined against 10 'specialised' counterparts. Moreover,
there is no convincing evidence that this superior profitability stem-
med from the exploitation of synergies specifically. In a survey of over
50 European bancassurers, Coopers and Lybrand (1994) found that
70% of those interviewed mentioned the need to squeeze more rev-
enues out of expensive distribution channels as a driving factor for
bancassurance; 51 % were planning to achieve scale effects through
better customer and management information.
While most practitioners would point out various forms of synergies
as the main rationale for bank diversification into life insurance, there
is little evidence that synergies can be achieved. Cross-seIling oppor-
tunities, and the possibility to use expensiye distribution channels
 The Theory of Corporate Diversification 135

more efficiently, seem the most likely benefits of the bancassurance

strategy. The cost of running bank branches is particularly high
(Leach, 1993), suggesting a need to use such facilities as efficiently as
possible. The use of relational databases can be seen as an effective
way to cross-sell a range of services to bank customers at a low cost.
Such practices, however, fall under the scrutiny of data protection
regulations (Leach, 1993; Coopers and Lybrand, 1994). Bergendahl
(1995) made one of the only attempts to estimate the profitability of
bancassurance strategies by comparing the costs of setting up a ban-
cassurance operation (including the development of computer systems
allowing banks to take advantage of cross-selling opportunities, per-
sonnel training and marketing costs) with benefits such as sales mar-
gins and other indirect benefits (e.g. increasing customer loyalty).
Bergendahl (1995) used data from two banks (Belgian-based Kre-
dietbank and German-based Deutsche Bank). His results suggested
that bancassurance strategies would be most profitable for those banks
with a high number of customers per branch and high cross-selling
ratios. Bergendahl also suggested that banks with large branch net-
works may face unacceptably high administrative costs of setting up
bancassurance operations. In a survey, Coopers and Lybrand (1994)
found that a majority of bancassurers with long-term bancassurance
experience indicated the need for investment in new technology to
reap the benefits of this strategy. This also suggests that smaller
players may find it more difficult to achieve such synergies.
Overall, it appears that the search for synergies through cross-sell-
ing and distribution economies has played a major role in the drive for
bancassurance. However, we have little empirical evidence of the
extent of these synergies. Potential benefits in terms of customer
satisfaction are difficult to measure and other benefits may prove
elusive (achieving high cross-selling ratios may prove more difficult
than alleged). However, the evidence suggests that achieving low-cost
distribution is paramount in the insurance market, a trend which is
reflected both in the entry of banks and direct writers in that market
(Leach, 1993).

Financial motives
Few bancassurers have claimed that financial synergies have motivated
their entry in the bancassurance scene. However, in a survey of Euro-
pean bancassurance, Coopers and Lybrand (1994) found that a major
Dutch institution attributed its bancassurance success to the improved
136 Bancassurance

creditworthiness of the bank following the merger with an insurance

company. This was due to the fact that its rating, following the com-
bination, improved, resulting in cheaper borrowing in the capital
markets. Others have emphasised the possibility for banks to benefit
from low-leveraged insurance partners (Pitt, 1990). Hence, the exist-
ence of financial synergies may in some instances have played a role in
banks' entry into life assurance.

Risk-reduction
Earnings diversification in the context of bancassurance have been
emphasised in a number of studies. Knauth and Welzel (1993) argued
that banks' credit risk and insurers' technical risk are non-concurrent;
therefore there is no interdependence between their risks. Diamond
(1984) emphasised the potential complementarity between the bal-
ance sheets of banks and life insurers. Insurers' liabilities and assets
are mainly long term, while banks predominantly carry medium-term
assets financed by short-term liabilities. Pooling may therefore result
in risk-reduction. The potential for risk-reduction is limited, however,
by regulatory constraints on asset separation. There is also a consensus
that long-term insurance is less risky than lending activities. Hoschka
(1994) emphasised the different reactions of both industries to recent
economic conditions. While the recession of the early 1990s hit banks
badly through loan losses, life insurers were positively affected by the
stock market boom that boosted their investment income and realised
and unrealised gains.
The potential risk diversification arising from the combination of
two lines of business must be weighed against the danger of reducing
customer diversification through cross-selling services to the same
segment of customers (Gardener, 1987). The synergies inherent in
bancassurance may therefore reduce its diversification potential.
Nonetheless, the defensive diversification argument is supported by
recent trends in banking profitability. A number of factors have
adversely affected European banks' profit margins in the last decade,
while at the same time life insurers have experienced substantial
growth rates, although a slowdown has been observed in the mid-
1990s. Pitt (1990) argued that the bancassurance phenomenon can be
explained by life insurers' growing share of the market for savings.
Both factors may explain banks' desire to compensate for depressed
earnings by diversifying into a growing market; in particular if this
growth is at the expense of their own traditional business. A number of
 The Theory of Corporate Diversification 137

studies have emphasised the opportunity to spread sources of risk and

revenues as a motive for the bancassurance trend (Cazalet, 1991;
Holsboer, 1993; Leale-Green and Bloomfield, 1994; Wein, 1993).

CONCLUSION

This chapter examined the main theoretical motives for corporate

diversification, including diversification strategies, and the use of
various entry vehicles in new markets and their consequences for firm
organisational structure. Overall, the main motives for corporate diver-
sification appear to be related to above-average profit expectations,
alleged synergies, financial motives and risk-reduction. Agency theory
suggests that managers seek diversification for reasons (including
some of the above) that conflict with shareholders' benefits. The
empirical evidence suggests that defensive-type diversification under-
lies many conglomerate mergers and that related mergers are gen-
erally more successful than unrelated mergers, suggesting some
operating or financial synergies. Bancassurance can be analysed in the
same theoretical framework as corporate diversification and practi-
tioners suggest that expected synergies and earnings diversification are
significant rationales for the bancassurance trend.

Notes

1. Rumelt's classification draws on an earlier research by L. Wrigley: 'Divi-

sional Autonomy and Diversification', unpublished doctoral dissertation,
Harvard Business School, 1970.
2. Such tax transfers depend on national regimes but most countries have
some type of tax transfers opportunities.
3. Modigliani and Miller (1963) support the view that a rise in the borrow-
ing ability of the acquiring firm will increase the value of the merged
firms.
4. See the discussion by Copeland and Weston (1979).
5. Measured as commissions and expenses to gross premiums (Leach, 1993,
p.47).
6. This is based on computations by Diacon of the typical expenses-to-UK
ordinary premium income ratios of UK life insurers.
6 Literature Review: Bank
Diversification and Risk

INTRODUCTION

This chapter examines the literature on bank diversification and risk,

that is, the risks inherent in the diversification of banks into non-bank
activities. In particular, this mainly US literature considers the expan-
sion of bank holding companies into non-bank activities. The main
objective of these US studies was to predict the potential impact of
more liberal laws governing bank holding companies' (BHCs) per-
missible activities. Most studies have concentrated on the asset risk of
BHCs and, using portfolio theory, attempted to estimate potential
risk-reducing effects. The first section of this chapter briefly discusses
the application of portfolio theory to corporate diversification.
The US literature on bank diversification and risk can be broadly
divided into two approaches. Section 6.2 reviews the first type of
approach which uses actual experiences of bank combinations with
non-bank activities. This includes studies that: examine the relation-
ship between BHC risk and non-bank involvement; compare the risk
and return performance of diversified and specialist banks; and con-
struct portfolios of various BHCs with their non-bank subsidiaries to
estimate optimal investments in these activities. Section 6.3 reviews
studies which simulate hypothetical business combinations. These
include variance-covariance analyses, portfolio simulations, and mer-
ger simulations. Section 6.4 examines various issues arising from
these methodologies. These include the choice between market and
accounting data, and the return and risk measures. Section 6.5 under-
takes a literature appraisal by comparing the two main approaches.
This helps in determining the applicability of the relevant methodo-
logies for our subsequent analysis of the risk-return characteristics of
the UK bancassurance phenomenon covered in Chapter 7.

6.1 BACKGROUND TO CORPORATE DIVERSIFICATION

In the banking literature, Gilbert (1988) suggested that there are

five main factors that determined the efficiency of a diversification

138
 Literature Review: Bank Diversification and Risk 139

strategy: the relative size of the businesses; the profitability of the non-
bank activity; the riskiness of that activity; the correlation between the
flows in banking and those of the non-bank activity; and, finally, the
extent of alleged synergies between the two activities.
Portfolio theory incorporates the variables that determine the
effects of non-synergistic corporate diversification. It has therefore
been a primary choice for researchers trying to predict the effect of
corporate diversification strategies.
A common feature of studies of bank diversification has been to test
one of the following hypotheses:

• Non-bank activities are riskier than banking; therefore expansion

might endanger the stability of banking entities (e.g. Liang and
Savage, 1990).
• Risk-reduction stems from the low correlation of the profits
between the two activities (e.g. Litan, 1987).
• Risk, defined as volatility, may increase through the expansion
process but it is more than compensated for by an increase in
returns, which results in a decrease of the probability of capital
impairment (e.g. Boyd and Graham, 1988).

The following reviews studies which have followed these approaches.

6.2 BANK DIVERSIFICATION AND RISK - STUDIES THAT

USE ACfUAL BANK EXPERIENCES

Studies that have examined the riskiness of actual combinations

between banking and non-banking activities have used different
approaches. One of these methodologies consists in analysing the
relationship between BHC risk and involvement in non-bank activities.
A similar methodology shifts the focus of the analysis to the rela-
tionship between BHC risk and non-bank subsidiaries' risk. Both
these approaches rely on regression-type techniques. A third approach
undertakes the comparison of the performance of specialised and
diversified banks. The fourth approach consists of portfolio simula-
tions. Using data on existing bank holding companies (BHCs) and
their non-bank subsidiaries, various simulations are conducted to
predict the overall effect of the combinations on risk. Finally, we
briefly discuss event studies that have been conducted in this field.
140 Bancassurance

Thbles 6.1 and 6.2, that summarise the main aspects of the studies
reviewed here, are displayed at the end of this section.
Some studies looked at the relationship between the riskiness of
bank holding companies (BHCs) and their involvement in non-bank
activities or, alternatively, they evaluated the relationship between
BHCs' risk and the risk of their non-bank subsidiaries (see, for
example, Boyd and Graham, 1986; Brewer, 1989; Wall, 1986). These
studies yield contradictory results. Boyd and Graham (1986) and Wall
(1986) found a positive relationship between BHC involvement in
non-bank business and risk whereas Brewer (1989) found a negative
relationship between BHC involvement in non-bank activity and risk.
A study by Eisenbeis and Kwast (1991) compared the risk and return
profiles of banks diversified into real estate and 'specialised' banks,
and found that banks that had been diversified for a long period
yielded higher returns and less risk than their specialised counterparts.
A number of studies have used portfolio simulations to evaluate the
maximum share of assets that can be devoted to specific non-bank
activities in a BHC without increasing the latter's risk. Boyd et af.
(1980) found that virtually any involvement in non-bank activities
would increase risk. Kwast (1989) found that the maximum investment
at which risk would remain constant is around 4% of bank investment
in securities activities.
Event studies have also been used to determine the impact of bank
diversification. The main goal of event studies in this field is to
examine the stock market reactions to mergers of banks with non-
banking firms or to acquisitions of banks by non-bank firms. This has
often been combined with the occurrence of a regulatory change
aimed either at restricting bank powers or providing banks with a more
flexible regulatory framework. lYPical event studies that examined the
impact of bank diversification include studies by Apilado et aZ. (1993),
Born et af. (1988) Eisenbeis et al. (1984), Swary (1983), and Wall and
Eisenbeis (1984). The results of these studies are presented in Thble
6.2. Event studies focus on the behaviour of share prices in order to
test whether their stochastic behaviour is affected by the disclosure of
firm-specific events. Non-zero abnormal returns indicate that the
information signal has information content related to the event ana-
lysed (Strong, 1992). The main difference between the various event
studies is the methodology they use to measure abnormal returns. A
major disadvantage of event studies is that they concentrate on returns
rather than risk. Moreover, it is impractical to establish a precise event
date, which might significantly affect the reliability of the results.
 Literature Review: Bank Diversification and Risk 141

There is a high degree of uncertainty in determining an event date

where merger announcements are concerned: one must make a choice
between, for example, the first press announcement, the confirmation
date or the merger date.
The main advantage of analyses using actual combinations of
banking and non-bank activities is that they capture both the operating
and financial economies or diseconomies resulting from bank-non-
bank combinations. It has been suggested that non-bank subsidiaries
of BHCs and independent firms in their respective industries could
display different profiles. One such difference could arise in the case
where a subsidiary is meant to operate in the market of its parent
bank. Combined managements could produce synergies and better
capital allocations, resulting in above-average performance. There-
fore, analyses using actual data on non-bank subsidiaries permit
researchers to account for differences in the performance of BHC non-
bank subsidiaries and their industry counterparts. Unlike hypothetical
simulations, actual data also incorporate financing alternatives at the
time of the combination.
However, it is often difficult to dissociate the contribution of
different segments of a BHC in its overall risk-return profile.
Documenting the relationship between a BHC and its different
subsidiaries is not a straightforward task. Part of the difficulty arises
from the fact that consolidated data are not segmented into the activ-
ities of concern, therefore data on subsidiaries and parents' books
may differ because of interaffiliate transactions or double leverage
practices. Moreover, actual bank diversification experiences are
scarce, especially where expansion has been limited by regulations.
The summary of the findings of the above studies is displayed in Tables
6.1 and 6.2.

6.3 BANK DIVERSIFICATION AND RISK - STUDIES THAT

USE HYPOTHETICAL BUSINESS COMBINATIONS

Studies that use hypothetical business combinations have been char-

acterised by their cross-sectional nature. The main idea is to compare
the simulated risk profile of a diversifying banking industry with the
banking industry on a standalone basis. Variance-covariance analyses
explore the potential risk consequences of bank diversification. The
risk of alternative activities and the covariance of their returns are
 ......
N
""'"
Table 6.1 Studies using actual bank experiences

Authors Sample Period 1Ype of study Methodology Results

Brewer, Fortier 40 BHCs 1979-83 Relate BHC risk MD: stock returns Strong negative correlation
and Pavel and involvement in and ROA Standard
(1988) non-bank activity deviation
Boyd and 64 BHCs 1971-83 Relate BHC risk- AD: ROA Standard Over 1971-78, strong positive
Graham (1986) return and non- deviation and POF correlation. No significant
bank involvement relationship otherwise
Brewer (1989) 109 BHCs 1978-86 Relate BHC risk OLS and Fuller- Significant negative
and non-bank Battese MD: ROE relationship
activity Standard deviation
and POF (2)
Wall (1986) 267 BHCs 1976-84 Relate BHC risk Rank order Strongest correlation between
to subsidiaries' correlation BHC risk and banking
risk AD: ROEPOF subsidiaries. Positive
correlation with non-bank
activity.
Negative correlation between
involvement and risk of
non-bank activities
Liang and 298 BHCs 1986-87 Relate BHC risk to AD: ROA Capital, Non-bank activities are more
Savage (1990) subsidiaries' risk loan losses, POF profitable, have better capital
but are riskier
Eisenbeis and 13,000 banks 1978-88 Cross-sectional AD Various Real estate banks had
Kwast (1991) 1000 real analysis specialised/ performance earnings performance at par
estate banks diversified banks measures with other banks. Those
involved for a long time, had
higher return, less risk
Meinster and 2 BHCs 1973-77 Portfolio AD: CF and BHC less risky than bank
Johnson (1979) 1975-77 simulations incl. interest payments alone if CF considered.
debt schedules POF When including debt in
computations, BHC slightly
riskier than bank
Boyd et al. (1980) 469 banks and 1971-77 Portfolios AD: ROA POF If minimum risk considered
1126 non-bank simulations UWA no diversification possible. If
subsidiaries of arbitrary risk is set, some
19 industries potential appears to exist
in 16 industries (actual
investment lower)
Kwast (1989) 180 banks 1976-85 Portfolios AD: ROA and Slight potential for
trading in simulations trading income diversification pre-1979.
securities Standard deviation Actual investments higher
UWA than optimal investment
in rest of the period

MD = market data; AD = accounting data; ROA = return on assets; ROE = return on equity; ROI = return on investment;
COY = coefficient of variation; POF = probability of failure indicator; WA = weighted industry averages; UWA = unweighted industry
averages.

.$:0-
~
-
 Table 6.2 Event studies on bank diversification in non-bank lines ....
t
Authors Sample Period Event Study Methodology Results

Eisenbeis et al. 35 MBHCs 1968-75 1970 Amendment CR = Fisher Positive AR before Amendment in the
(1984) 43 banks Restrict use of Index and four weeks surrounding announcement
OBHCs to weighted of formation of OBHe. No AR after
expand portfolio of announcement. Suggests that
MBHCs diversification is valued by markets
Swary (1983) 74 BHCs 1971-76 1970 Amendment CR = CAPM Positive abnormal returns in the period
Expands of announcement of proposed merger.
permissible After Board accepts or rejects
activities expansion. negative AR for both
groups (accepted and denied). Risk
increases in denied group (21 firms)
Wall and 11 companies 1979-82 Acquisition of Bond market Insignificant AR. Main interest:
Eisenbeis financial firms reactions alternative use of bonds in the study
(1984) CR = control
period returns
Born etal. 16 non-bank 1977-83 Relaxation of CR = various Insignificant abnormal returns.
(1988) 21 BHCs interstate indexes weeks Suggests that shareholders do not
restriction -3 to +2. value diversification benefits
Apilado et al. 42 BHCs 11 3/2/1987 Approval for CR = factor- Significant positive AR for money-
(1993) investment to 27/7/87 expansion of analytic days centre banks; positive, not significant
banks securities -5 to +5 for regional. Negative not significant
underwriting for investment banks. Non-significant
powers reduction in total risk for banks

CR = control returns; AR = abnormal returns; MBHC = multi-bank holding company; OBHC = one-bank holding company.
 Literature Review: Bank Diversification and Risk 145

examined to determine whether a potential exists for risk-reducing

diversification. Other studies simulate hypothetical combinations of
various activities. One such methodology is to compute the risk-return
of alternative portfolios composed of banking and other activities.
Alternatively, firms of two or more industries are hypothetically
merged.
Table 6.3 at the end of this section summarises the main aspects of
the studies that use hypothetical combinations.

Variance-covariance analyses

Variance-covariance analyses are based on comparisons of the risk of

banking and non-bank activities, as well as the correlation of returns
between the two to estimate potential diversification benefits.
Heggestad (1975) provided an early contribution using a variance-
covariance approach. The background to the study was portfolio
theory. The methodology consisted in comparing the risk of various
activities with banking, and the correlations between their returns, in
order to identify potential risk-reducing areas. Heggestad (1975)
computed the coefficients of variation of returns for non-bank and
banking industries and the degree of correlation between the returns
of non-bank activities and banking, using industry weighted averages.
The coefficient of variation of returns was preferred to the standard
deviation of returns to measure risk, because it adjusts for different
levels of profitability. Tests were carried out using accounting return
on equity and return on assets. The results for the period 1953-67
suggested that 9 out of 13 activities were safer than banking as meas-
ured by variability of return on capital (11 using return on assets).
Banking returns had negative correlation coefficients of return on
capital with six activities, suggesting potential diversification benefits
(seven activities using return on assets). The lowest correlation coef-
ficients with banking were found in real estate, leasing and insurance
agents and brokers. The study did not undertake further explorations
on the extent of these benefits. Moreover, the author underlined the
bias arising from the use of industry data, which might have overstated
the profitability of given activities. However, the main disadvantage of
using industry weighted averages is that they conceal intra-industry
variations. They also tend to bring correlation coefficients away from
zero (Boyd and Graham, 1988). It is likely that such statistics under-
estimate correlations and standard deviations of returns. As such, it
has been suggested that using such measures may not be appropriate
146 Bancassurance

in the context of studying diversification opportunities across different

industries.
Wall and Eisenbeis (1984) looked at the coefficient of variation and
coefficient of determination of the return on assets of selected activ-
ities. The study was conducted over the period 1970-80. It comprised
eight global industries, that were divided into 23 focused industries.
Out of 23 sub-industries, nine sub-industries appeared less risky than
banking. Insurance and 'insurance agents, brokers and services' were
the only industries that were overall less risky than banking. Banks
were also riskier than BHCs. The authors compared their results
to those of Heggestad (1975) and noted several differences in the
evaluation of the riskiness of certain activities. They also noted that
several of the riskier activities displayed negative coefficients of cor-
relation with banking, which suggested a potential for diversification.
There were important negative coefficients with savings and loans,
personal credit agencies, security brokers and life insurance. The study
was conducted using the variance-covariance characteristics of return
on assets. The authors pointed out that double leverage practices of
BHCs make the study of return on equity less meaningful when
comparing different industries.
The above studies both find some evidence that there could be some
diversification benefits if banks undertook diversification in certain
non-bank activities. The approach underlined above, however, is
based on a crude analysis, which does not explore the combinations of
both sectors as such. This suggests that the scope of such studies is
limited.

Portfolios simulations

Taking the above approach further, various studies have conducted

hypothetical portfolio combinations of banking and non-bank activ-
ities. We review seven studies that use this approach to investigate the
potential diversification effects of bank expansion in non-bank activ-
ities.
Eisemann (1976) simulated portfolios of banking and various non-
bank activities. Using weighted industry stock returns over the period
1961-68, the author derived returns, variances and covariances of
returns for each activity as well as an efficient frontier for portfolios
including these activities. Three groups of activities were defined
according to whether banks were allowed to. enter in these fields of
 Literature Review: Bank Diversification and Risk 147

operations (those permissible, those possible and those explicitly for-

bidden to BHCs). The results for efficient BHCs including permissible
activities indicated that banks could have improved their returns
considerably ( + 74%) while maintaining risk. When the set of possible
activities was included, the potential increase was + 136%. Non-
permissible activities were present in some of the efficient portfolios in
the third simulation including all activities but contributed little to
raise efficiency. Some activities were systematically excluded from
efficient portfolios, such as life insurance. Eisemann suggested that
restricting the size of investments in certain allowable or possible
activities might have prevented BHCs from reaching an optimal
portfolio structure, as the average BHC lay below the three efficient
frontier sets. This study gave little information as to the degree of
involvement which was potentially risk-increasing and whether specific
industries were risk-reducing. It was difficult in particular, to separate
diversification effects between non-bank industries and between those
non-bank industries and BHCs.
Stover (1982) used a different framework. Relying on a value-
maximisation approach, the author built a basic programming model
to determine an optimal set of investment alternatives, which max-
imised the firm value for a given probability of insolvency. An arbitrary
value of 10% was given to this probability. Given the net present value
of an investment, an iso-impairment schedule (the risk-return trade-
off where the probability of capital impairment is constant) was cal-
culated for the additional debt service required by the new activity.
The data sample used by Eisemann (1976) was adapted for the pur-
pose of this study. The results showed that only investments in per-
missible activities yielded a positive net present value. However, when
financing alternatives were taken into consideration, it appeared that
several non-permissible activities, whose earnings were highly corre-
lated with banking, could have maximised value. Stover (1982) also
tested for the potential bias of industry data. He simulated various
combinations of specific non-bank firms with banks and found that
combinations with non-permissible activities would have improved
bank performance. The study suggested potential benefits from
diversification into non-bank activities. However, the introduction of
an arbitrary probability of failure in the model appears questionable.
Boyd et al. (1980) set an arbitrary probability of one in a thousand in a
similar context which might suggest that 10% is fairly high.
Litan (1987) reported the results of a study based on paiJwise
combinations of banking and non-bank activities. His data covered the
148 Bancassurance

period 1962-82. Measures of profitability and data sets were discussed

by the author. The limitations of certain data sources which did not
disaggregate properly among different lines of business were stressed,
as well as the restrictions associated with constructing a representative
sample from stock market data (in many cases only data about large
banks were available). Litan (1987) also suggested that BHCs tended
to capitalise their non-bank subsidiaries differently from the typical
firm, therefore, return on assets was used as the preferred measure of
profitability (Litan, 1987, pp. 86--87).
The coefficient of variation and the coefficient of determination of
returns on assets were computed for each pairwise combination which
suggested a potential for diversification into non-bank activities. Sev-
eral activities, including real estate and insurance agents, appeared
less risky than banking and BHCs, measured by the coefficient of
variation of returns. Several negative coefficients of correlation of
returns were identified between commercial banks and other non-
bank activities, in particular insurance activities, securities brokers and
savings and loans activities. Assuming 75% of assets were devoted to
banking and the rest to a non-bank activity, pairwise simulated port-
folios suggested that the coefficient of variation of returns would be
lower or equal to banking alone, for seven out of the nine activities
considered. The least risky pairwise combinations included combina-
tions with life insurers and insurance agents (coefficient of variation of
0.15 versus 0.22 for banks alone). When fewer assets were devoted to
banking, Litan noted that risk increased significantly. Efficient port-
folios were derived in order to simulate the combination of banks with
several activities simultaneously. The analysis suggested that 'the
average banking organisation could have significantly reduced risk if it
had been able to diversify into other non-bank activities' (Litan, 1987,
p. 91). Out of the 16 efficient multiple-activities portfolios, banks were
included 13 times, followed by commodities (12), personal credit (11)
and life insurance (9). Of the 13 portfolios including banking, com-
modities were included in 11 cases, personal credit in 9 cases and life
insurance in 8 cases. The study suggested that these activities might
have substantial diversification benefits. The main disadvantage of this
study is that it used industry weighted averages, which are likely to
understate intra-industry differences. However, the study confirmed
previous findings as to the benefits of given activities, including
insurance.
Wall, Reichert and Mohanty (1993) updated the study by Litan
(1987). Their study carried out the analysis over a longer period
 Literature Review: Bank Diversification and Risk 149

(1971-89 compared with 1971-81) and used an additional data set. In

the second data set, they used regulatory returns; this was used to
account for tax distortions and the fact that taxable earnings are
generally less than GAAP (Generally Accepted Accounted Principles)
earnings. Industry accounting data were used and two sub-periods,
1974-80 and 1981-89, were defined. Industries were divided into two
subgroups, traditional l and non-traditional BHe activities, to con-
struct efficient portfolios. This disaggregation was necessary due to
multicollinearity problems in the computation of efficient portfolios.
The results suggested that risk-reduction could have arisen from
combinations between banking and non-traditional bank activities.
They found that life insurance was the least risky activity followed by
insurance agents in the first period, while they were respectively
ranked eleventh and eighth in the second period. The lowest corre-
lation coefficients of returns with banking were real estate operators
and commodity brokers in the first period, but these coefficients fell to
rank 2 and 9, respectively in the second period. Wall, Reichert and
Mohanty (1993) simulated pairwise portfolios with 5,10,25,50, 75 and
90% of assets devoted to non-bank activities. They found that various
combinations were potentially risk-reducing. Finally, they simulated
efficient portfolios combining multiple activities. Using the IRS data
set, they found that BHes were included in 9 out of 28 efficient
portfolios using non-traditional activities. The most frequent occur-
rences were for regulated investment companies (26), commodity
brokers (24), insurance agents and brokers (23) and life insurance
(19). When traditional activities were considered, BHes were included
in all 20 efficient portfolios followed by personal credit institutions (18
occurrences). Using taxable earnings instead of the IRS data the
results indicated less potential for risk-reduction. All efficient port-
folios for non-traditional activities included insurance agents and
regulated investment companies, and 7 out of 13 portfolios included
life insurers and commodity brokers. However, BHes were only pre-
sent in three portfolios. For combinations with traditional activities,
the same pattern as in the IRS data set emerged, with BHes and
personal credit institutions present in all portfolios. Overall, this study
enforced Litan's results even though Wall, Reichert and Mohanty
(1993) found more diversification benefits than Litan (1987). As in the
two previous studies, the use of weighted industry averages might have
slightly biased the results.
Brewer, Fortier and Pavel (1988) adopted an identical approach in a
study which covered the period 1979-83. In the first part of the study,
150 Bancassurance

they used both accounting and market data to examine the relation-
ship between BHC risk and involvement in non-bank activity.
In the second part of the study, Brewer, Fortier and Pavel (1988)
used daily stock market data for individual BHCs and non-bank firms,
which were averaged across firms to yield daily returns for each
industry. Three years were examined to account for different phases of
the business cycle (1980,1982 and 1986). The main difference with the
studies reviewed above is that industry statistics were computed as the
unweighted averages of all firms in that industry. These unweighted
industry statistics were used to simulate portfolios combining banking
and selected non-bank activities. The risk of hypothetical pairwise
combinations between a representative BHC and a non-bank firm was
computed, with the percentage of assets devoted to non-bank activities
ranging from 5, 10 and 25%. The authors noted that at 25%, the risk
of the combinations increased significantly. The following equation
illustrates the computation of variance of returns on this hypothetical
combination:
~ = 0.952~ + 0.052~B + (0.95)(0.5)aBo"NBRB, NB (6.1)
where:
R B , NB represents the correlation between the returns of banking and
non-banking activities;
a indicates the standard deviation of returns.

The authors found that pairwise combinations with insurance agents

and life insurers would reduce variance if 5 or 10% of assets were
invested in those activities. At 25%, variance would be higher than for
banking alone.
Multiple activities portfolios were simulated using all 13 activities.
Brewer et al. (1988) found that the least risky BHC would have
invested 87.6% of its assets in banking, 7.5% in insurance agents and
brokers and 4.9% in life assurance. This would have reduced risk by
3% but would have caused an identical decrease in return.
The authors concluded that insurance was the major non-
permissible activity which would have reduced risk. They argued that
permissible non-bank activities, even when they appeared risky in
isolation, seemed to have reduced BHC risk. Moreover combinations
of two activities within a BHC might have had risk-reducing effects by
themselves. The authors suggested that diversification effects seemed
limited when specific activities were considered in isolation. An
interesting aspect of this study was that it used unweighted industry
 Literature Review: Bank Diversification and Risk 151

averages that should better reflect the riskiness of a representative

firm in the underlying industry. Finally, the choice of market data
might have influenced sample selection as it is likely that smaller firms
in non-bank industries were excluded because they are not actively
traded. There were 170 banking firms in the sample compared with
325 non-bank corporations from 13 activities. This implied that only
the largest firms of non-bank industries were considered, which might
have biased the selection process.
The study by Rosen, Lloyd-Davies, Kwast and Humphrey (1989)
differed from the previous ones because it attempted to measure the
extent of the diversification potential of combining real estate and
banking. The methodology used consisted in computing returns and
standard deviations of returns for real estate and banking and the
correlation of returns between both sets. These measures were used to
determine the variability of a portfolio composed of both activities.
Two data sets were used to measure the riskiness of real estate
activities. One included large and diversified equity real estate. A second
data set was used including the returns from real estate services at
thrift institutions. Returns on investment were used for these real
estate activities and accounting return on assets for banks.
The percentage of bank investment in real estate at which bank risk
remained constant was computed using both sets of data. Results
indicated that there was no potential risk-reduction from diversifica-
tion in real estate using data from thrift institutions. However, risk
would have been reduced with up to 4% of assets invested in real
estate. Overall, the authors suggested that there was a modest
potential for the diversification of banks into real estate and recom-
mended to either restrict investment in such activities or impose
capital back-up to the new activity.
Saunders and Walter (1994) conducted a comprehensive study
based on the same type of analysis. The dataset comprised US banks,
securities houses, property/casualty and life insurance companies. The
data were based on daily stock returns for individual firms. The sample
period was 1984-88 which was a particularly uncertain environment
given the stock market crash in 1987, an insurance cycle turning point
and a crisis in property/casualty insurance in 1984-85. Daily returns,
standard deviation of returns and the return per unit of risk ratio
(inverse of the coefficient of variation of returns) were computed for
each industry for each year and for the whole sample period. Summary
figures for each industry were computed as the unweighted averages
of the figures for individual firms in each industry. The first results
152 Bancassurance

showed that insurance activities were less risky than banking. Corre-
lations between banking and other activities were significantly differ-
ent from one.
Two additional measures of risk were provided. Using a two-factor
market model, the individual {3s of each company were computed.
One {3 represented the systematic market risk coefficient, the second
gave the systematic interest-rate risk coefficient of the firm. The {3s
were generated by the following model:
Rit = Q: + {3im Rmt + {3i1 Ril + Uit (6.2)
where:
{Jim is the systematic market risk coefficient
{3i1 is the systematic interest rate risk coefficient
Rim is the return on the market index
Ril is the change in interest rates
Uit is the unsystematic risk for firm i.

Insurance activities had a relatively low market {3 (less than 1), com-
pared with money centre banks (1.17). This was consistent with
potential gains of combining both activities. Interest rate {Js were
consistently negative for most activities (i.e. stock prices showed an
inverse relationship to positive shocks in interest rates) except for
securities brokers and dealers for which interest rate {3s were positive.
This suggested potential benefits for banks diversifying in these
activities.
The second part of the study consisted in simulating synthetic
minimum-risk combinations by including two, three, four or five activ-
ities in the portfolios. The aim was to determine which weight should
be attached to banking and which to another activity (or other activ-
ities) to minimise the risk of the combination. This was undertaken at
the industry level. The standard deviation and correlation of returns
were similar to those from the analysis in the first part (averages for
the industry). The minimum-risk combination for any given activity
was generally lower than for the typical undiversified bank. The
highest return per unit of risk was found in the combination between
banking and property/casualty insurance. The weights for each activity
in the various minimum-risk combinations were used to compute
combined returns. One major problem with these simulations is that
they assume that the optimal combinations yield the lowest risk, re-
gardless of return concerns. However, it is unlikely that this would be
the objective for bank managers.
 Literature Review: Bank Diversification and Risk 153

The third part of the study addressed this major drawback. To

account for the fact that an optimal combination may be one with
higher returns but higher risk, efficient portfolios of various activities
were derived both at the industry and individual firm level.
The stock returns for the synthetic universal bank industry were
computed as the weighted sum of the returns of individual industries.
The equities of both industries were merged to obtain an average
industry market value of capital or weight for each industry. The
return and risk of alternative combinations were simulated using these
weights and the industry measures of risk and correlation computed as
before. The results were similar to those in the earlier analysis. The
optimal combination for five activities yielded a standard deviation of
0.1346 compared with a minimum-risk combination of 0.1258.
At the firm level, a global opportunity set was simulated using a
similar procedure. The simulations were conducted for all possible
portfolios of individual firms (247,104 in total). The results were much
the same as in the former analyses. In the five-activity case, the
average standard deviation would have been 0.1452, which is lower
than for the typical bank on a standalone basis (0.2024).
An interesting feature of the study was to sum up equities, rather
than book assets, to determine the weights of different combinations.
This avoids biasing portfolios towards more banking assets due to
higher leverage effects. Moreover. it suggests an effort to account for
the relative size of different industries. One of the major drawbacks of
the first part of the study was that it examined the best possible
combinations (least risky or most efficient) and compared them with
the average bank on a standalone basis. Obviously, this methodology
biases the results towards risk-reducing findings. One might wonder
if this is an appropriate comparison as the best bank might have a
superior performance to those optimal combinations. At the same
time, the worst combinations might be highly inefficient or risky. This
criticism holds generally for all portfolio simulations.
Portfolio simulation studies give various results as to the potential
diversification benefits of bank involvement in non-bank activities.
One of the major drawbacks of these studies, however, is that they
consider that the degree of involvement in non-bank activities can be
freely determined by banks. They tend to focus on the best possible
combinations that can be achieved, without considering the structures
of both industries. Moreover, most portfolio simulations focus on
industries rather than individual firms, while in reality such diversi-
fication would be firm-specific.
154 Bancassurance

Merger simulations

In contrast to the above approach, various studies simulate mergers

using actual existing firms from the banking and non-bank sectors.
These include studies by Boyd and Graham (1988), Boyd, Graham
and Hewitt (1993), and Santomero and Chung (1992).
Boyd and Graham (1988) adopted a significantly different approach
to bank diversification effects. One major objective of their study was
to account for those banks which might seek riskier ventures. The
authors defined an indicator of the probability of bank failure. As
failure affects the overall system, it is supposed to be the focus and
variable of interest to regulators. The aim of the study was to provide
some empirical evidence about the likely risk-return consequences
of the incorporation of non-bank subsidiaries by BHCs. The main
empirical question was whether BHC risk of bankruptcy would
increase or decrease if BHCs were permitted to enter non-bank lines
of business.
The methodology comprised two steps. First, the relative risk-return
characteristics of BHCs and non-bank activities were analysed. The
objective of this analysis was to provide an objective picture of the
historical risk and profitability of the industries under consideration.
In the second part, hypothetical mergers of BHCs and selected non-
bank activities were simulated and their risk-return characteristics
were analysed (the first part of the study providing the basis for
comparison ).
The data used by Boyd and Graham deserve particular attention for
two reasons. First, they used unweighted averages to compute industry
statistics: in a previous study, Boyd et al. (1980) showed that using
industry-wide statistics tends to lower riskiness as it does not account
for intra-industry differences. They also showed that the discrepancy
between both sets of statistics could be significant. Moreover the
authors were not interested in the riskiness of an industry but in the
riskiness of an average firm in the industry. Another interesting fea-
ture of the study is that it was conducted using both accounting (book)
and market (stock) data. We will concentrate on the accounting data
analysis below.
In the first part of the analysis, return on average equity, standard
deviation and probability of failure were calculated for each firm over
the period 1971-84. The data were summarised into a median statistic
for each industry.
 Literature Review: Bank Diversification and Risk 155

Return for a specific firm i for the period j = 1 to m was therefore

computed as:
m
f; = ~)27rj/(Ej + Ej_J))/m (6.3)
j=1
where:
f; = mean return on average equity for firm i
E = equity
7r = profits before taxes, treated as a random variable.
The return for the industry was then computed as:
n
R/ = 2.:f;!(n - 1) (6.4)
i=1
where:
R/ = average return for industry I.
Similarly, the standard deviation for firm i was computed as:
m ) 1/2
S; = ( 2.:(r;.j - f;)2/m (6.5)
J=I

and the summary statistic for the industry was:

n
SI = LS;!(n - 1) (6.6)
;=1
Failure was defined as the probability that losses exceed equity in a
specific year of the period. This definition implicitly assumes that
BHCs can be defined as single consolidated organisations that can fail
as entities. Defining k as the ratio of equity to assets, the following
probability was derived:

J
k

p(ir < -E) = p(R < k) = cp(r)dr (6.7)

-')C

Where ¢ is the cumulative density distribution of returns.

Boyd and Graham (1988) assumed that returns were normally dis-
tributed and rewrote equation (6.7) as:

J
z

p(R < k) = N(O,l)dz (6.8)

-ex
156 Bancassurance

Where N(O, 1) is the standard normal distribution.

Substituting for the sample estimates of the mean and standard
deviation of returns p and S, z was derived as:
k-p
z=-S- (6.9)
where p is the mean of returns and S the standard deviation of returns.
For each firm i in the sample, Z was defined as -z and equalled:
[(2::}:1 (27Tj/(Aj+Aj_t})/m) + (2::}:1 «Ej+ Ej_t}/(Aj+Aj_t})/m)]
Zj=~------------------~~~--------------------~~
Sj
(6.10)
Where 7r are profits; A assets; E equity; S the standard deviation of
returns on assets.
This measure is specific to each firm and high values of Z are
associated with lower risk. The median of this measure for all
individual firms summarised the Z-scores for an industry.
The results suggested that BHes were neither the most nor the least
profitable firms. However, they were the least risky, closely followed
by life assurance companies, measured either by the standard devia-
tion of returns or Z.
The second part of the study concentrated on merging BHes with
alternative non-bank companies. The process of consolidation was
inspired by the accounting method of consolidation by pooling: the
assets, equity and income of a specific bank and a specific non-bank
firm are summed up. Simulations were conducted for 100 randomly
selected mergers in each industry. Statistics for the hypothetically
merged industry were obtained by taking the medians of individual
combinations' risk and return characteristics. This facilitated the
comparison with the results of the first part of the study. Boyd and
Graham ignored the approach used by other authors (e.g. Litan 1987
or Brewer et al. 1988) who used the portfolio theory framework to
simulate the risk-return profile of the merged industries. A previous
study by Boyd et al. (1980) suggested that the underlying distributions
of industry returns did not offer desirable statistical properties.
The results of the hypothetical mergers suggested that BHes would
have incurred small increases in returns by expanding in other activ-
ities. This might result from the relative larger size of BHes in the
sample. However, mergers with even small non-bank companies would
have resulted in an increase in risk except in the case of life assurance
where risk would have been slightly reduced.
 Literature Review: Bank Diversification and Risk 157

There was a significant difference between the results using

accounting and market data. The results were different for the property
insurance and insurance agents/brokers industries where the results
suggested risk-decreasing opportunities. However when Z-scores
using market and accounting data were compared with actual credit
ratings on firms, accounting data seemed to classify companies more
accurately according to their riskiness. Overall, the authors slightly
favoured the use of accounting data.
This study proposed an alternative framework to simulate corporate
diversification. The authors suggested that portfolio simulations were
inappropriate because one of their assumptions, namely the joint
normality of industry returns, was violated. Notwithstanding this crit-
icism of portfolio simulations, this alternative methodology allowed
Boyd and Graham to use a different risk measure (Z-score). However,
the measure of risk proposed had some limitations; in particular
bankruptcy was defined in a one-year context, while it is likely that
successive losses would more likely lead to bankruptcy. We will discuss
the Z-measure later in this chapter.
The study by Boyd and Graham (1988) was updated in a later
version of the paper by Boyd, Graham and Hewitt (1993). The main
objective of the study was to determine an optimal (risk-minimising)
combination of banking and non-banking activities, similarly to the
studies by Kwast (1989) and Rosen et al. (1989). The second addition
to the 1988 study concerned the length of the period considered as
well as the size of the sample.
To introduce different portfolio weights in their simulations, Boyd,
Graham and Hewitt (1993) undertook a scaling procedure on the
merger simulations. The merger simulation procedure was similar to
the one followed in the 1988 study: one bank and one firm from a
given industry were randomly selected, and their assets, equity and net
income were summed up to simulate the merger. Non-banking data
were adjusted for an initial weight in the period where both firms
supposedly merged. Defining N as the initial portfolio weight for a
given simulation (0 < N < 1), Ab as the total assets for a BHC and An
as the total assets for the non-bank firm, the scaling factor, s, was
defined as:
N Ab
s = I-NAn (6.11)

The weight N is a (t - 1) condition, i.e. it was assumed that this asset

distribution prevailed in the year preceding the sample period.
158 Bancassurance

If Ab is defined as bank assets and An as non-bank assets for the

period, the following table shows the evolution of assets over the
period span:

Ab
Year 1 30 10 (25%)
Year 2 35 20 (36%)
Year 3 35 15 (30%)
Year 4 40 25 (38%)

The number in parentheses is the weight of non-bank assets in the

combination.
If the initial portfolio weight is fixed to N = 0.2, then s is computed
as:
0.2 30
s = 1 _ 0.2 10 = 0.75

Assets figures for non-bank firms would be obtained by multiplying

actual figures by the scaling factor.

Ab An
Year 1 30 7.5 (20%)
Year 2 35 15 (30%)
Year 3 35 11.25 (24%)
Year 4 40 18.75 (32%)

This scaling procedure allows the weights to vary and does not disturb
the path of growth over time.
After assets, equity and income were transformed using this scaling
procedure, the merger simulations followed the initial pattern of
consolidation. A number of BHC-non-bank pairs were randomly se-
lected (1000 in total for each non-bank industry), and the procedure
was repeated for the same hypothetical combinations with N varying
between 0 and 99.99% (24 values of N were used).
A series of figures illustrate the riskiness of alternative combina-
tions. Figure 6.1 shows such a representation. The Y-axis accounts for
the Z-score summary statistic for 1000 simulations of pairs of BHC-life
insurers. The X-axis shows the initial portfolio weight of non-bank
assets (each point is associated with a set of 1000 simulations). The
lines resulting in this figure are referred to as the 'risk-portfolio-
 Literature Review: Bank Diversification and Risk 159

Figure 6.1 Risk measures from merger simulations for various

non-bank shares

100 BHe Life Insurance Accounting data

90
80

~g 1
§ 50
~
40 ;a:;--x--x ·- x_
30 ~ x - - x - - x -,-x _ _ x __ ~
20 --<>---<:-~<>-_
10 --<>----<>---¢
o -- - - - - -
o 0.1 0.2 0.3 0.4 0.5 0.6 0.7 0.8 0.9
Non-bank share
-0--- 10% Z·score - x- - Median Z-score

Source: Reprinted from Journal of Banking and Finance, 17, Boyd, Graham
and Hewitt, "Bank Holding Company Mergers with Nonbank Financial
Firms", copyright 1993, p]p. 43-63, with permission from Elsevier Science.

weight' (RPW) function. RPW50 refers to the line featuring the

median Z-score for the set of simulations and RPW 10 to the line
featuring the 10th percentile of the distribution of Z-score for the set.
The objective of this alternative function was to provide an idea about
the riskiness of the worse combinations. The point of reference of the
RPW functions is the point at which the non-bank share equals zero.
Any potential for risk-reduction implies that there is a point on the
RPW line for which Z is higher (by construction, higher Z-scores
imply lower risk) than at this all-bank point.
The results (using accounting data) indicated that for four out of six
industries considered, combinations of BHCs and non-bank industries
increased the BHC's risk of failure at virtually any portfolio weight
(this included insurance agentlbroker, securities, real estate develop-
ment and other real estate). For life insurance and property/liability
insurance, the RPW50 reached a maximum (minimum risk) at 16-20%
and 3-6%, respectively. Moreover Z was higher (lower risk) than for
the BHC alone when up to 60% of assets were invested in life
insurance and up to 11 % in property/liability insurance. The results
using market data reinforced the impression that diversification in
these two industries could be risk-reducing. Risk-reduction reached a
maximum between 40% and 50% of non-bank assets invested in life
insurance and between 12% and 20% in property/liability insurance.
160 Bancassurance

The results for the three other industries were roughly the same using
market data. However, combinations with insurance brokers and
agents produced more favourable results using market data with the
RPW50 reaching an interior maxima at about 5% and remaining
higher (less risky) than the BHC alone up to about 16% non-bank
share.
This approach incorporated both the combination of individual
firms and the determination of the extent of non-bank involvement
that would be acceptable (optimal) for BHCs. However, while gaining
this extra information, information relating to the true relative size of
different bank-non-bank firms was lost. Even though banks could
theoretically vary their participation in non-bank corporations, this
relative size is crucial. Merger simulations appear to have this advantage
over portfolio simulations but the latter adaptation seemed to
neutralise this effect. This sacrifice might be traced to the preference
of Boyd and Graham (1992) for the determination of the optimal
weight at which BHC diversification opportunities are exhausted.
Santomero and Chung (1992) adopted a more complex approach to
the issue of bank diversification and risk. They heavily criticised the
lack of theoretical bases in previous studies, in particular the use of
volatility measures based on stock data as well as the use of accounting
data. They argued that stock volatility only measures the volatility of
equity values and not that of rate of return on assets. Moreover,
accounting data do not reflect true economic values. They proposed
an alternative approach that relied on option-based valuation models
to measure the volatility of the rate of return on the market value of
assets. As the market value of assets is not directly observable, the
volatility of returns on assets cannot be computed directly. According
to the option pricing literature, the asset return volatility can be cal-
culated from the total equity value (E), the promised payments to
debtholders (B) at the time of maturity (T), the risk-free rate (r) and
the total market value of assets (A). The theory also suggests that the
latter can be expressed as a function of the same parameters (E, B, T
and r) and the asset return volatility. Using a system of both functional
relationships, both unknown parameters, total market value of assets
(A) and volatility of asset returns, can be estimated. This procedure
allows for the computation of the volatility of 'instantaneous rates of
return'.
The above procedure was used to measure volatility of asset returns
for each firm in the sample and each industry subset. To get a more
complete picture of the riskiness of BHCs, market-based average
 Literature Review: Bank Diversification and Risk 161

returns on assets were computed for each firm as well as an indicator

of the probability of failure or Z, as used in Boyd and Graham (1988).
The Z-score measure used in this study differed from the above
because it was based on market-based estimates. Expected returns on
assets for each firm of the sample were computed as the return on
equity multiplied by the equity-to-asset ratio (computed for each
quarter). Following Boyd and Graham (1988), Z-scores were com-
puted as the sum of average return on assets and average equity-
to-asset ratio adjusted for the standard deviation of return on assets.
A similar procedure was used to examine the riskiness of hypo-
thetical BHCs, merged with other activities. There were six subset
industries in the study. The banking industry was divided among
money-centre and regional banks, the insurance industry between life
insurers and property/casualty insurers and the securities industry
between regional and national firms. The study used data over the
period 1985-90. Hypothetical industries were simulated by randomly
merging two and three firms of alternative industries. To estimate the
volatility of assets returns for hypothetical BHCs in a simulated
industry, the market value of equity was estimated as the simple sum
of the market value of equity of each firm involved in the merger. Total
liabilities were measured as the sum of individual firms' liabilities. The
standard deviation of stock returns could not be computed directly in
these hypothetical mergers. It was assumed that it could be generated
from the series of stock returns by the following linear equation
(presented in the three-industry merger case):
(6.12)
where:
RHB = hypothetical daily stock return of an hypothetical BHC
RB, Rl, RS = actual daily stock return of a BHC, insurance company
and securities firms, respectively
WB , WI, Ws = daily weight of the market value of equity of a BHC,
insurance company, and securities firm respectively, to the sum of
daily market value of equity of the three firms.

Return on equity for each quarter was computed for the hypothetical
industry using equation (6.12). To estimate return on assets, this
quarterly average return on equity was multiplied by the estimated
equity-to-asset ratio (equity and assets being the sum of the individual
firms' equity and assets). The average return for an hypothetical
industry was computed as the weighted mean of the returns of
162 Bancassurance

individual hypothetical firms of each hypothetical industry, using the

estimated market value of assets as weights. The same averaging
procedure was used to measure the volatility of asset returns and Z
measure for the hypothetical industries.
Further simulations were conducted to account for investments of
various sizes in non-bank activities. It was assumed that a BHC could
invest in non-bank activities according to its own asset size. Simula-
tions were conducted for proportional investments of 5%, 10%,50%,
100% and 200%. For example, to estimate the effect of a 5% invest-
ment in non-bank activities, implied volatilities and Z were measured,
assuming that each BHC obtained additional equity and debts
amounting to 5% of their value. The added equity had the same return
characteristics as the equity of the non-banking firms involved in the
merger. The implied return was computed as follows (in the case of a
three-industry merger):

RHB = RB + w(R/ + RS) (6.13)

(1 + 2w)
where:
w = proportion of investment in nonbank e.g. 5%

To estimate implied volatilities, some adjustments were necessary to

compute the debt and equity of an hypothetical BHC as follows (for a
three-industry case):
EHB = (1 + 2w)EB (6.14)

DHB = (1 + 2w)DB (6.15)

where:
EHB and DHB = total equity and debt for an hypothetical BHC,
respectively
EB and DB = total equity and debt for a BHC of the sample.

Finally the authors computed the estimated correlations between

industry asset returns for the 20 quarters of the period 1985-90 using
the following formula: .
aic = p2~AB + (1 - p)2~AN + 2P(1 - P)qaABOAN (6.16)
where:
q = correlation coefficient
 Literature Review: Bank Diversification and Risk 163

P = proportion of market value of assets of a BHC in the combined

assets of the merger
l7AB, l7AN and l7AC = implied standard deviations of rate of return on
BHC assets, non-bank assets and combined assets, respectively.

The correlation coefficient, q, was computed for two-merger cases (12

industries). The average correlation for every two-merger case was the
simple mean of the individual correlations for merger partners of
these hypothetical industries.
The results indicated that correlation coefficients were all positive
and that the highest correlation coefficient of returns was between
BHCs and national securities firms industry (0.34), the lowest being
with regional securities firms (0.09). All coefficients were below 0.4.
As far as volatilities were concerned, no merger appeared to result
in reduced risk (many resulted in increased volatility). However, the
results using Z as the measure of risk suggested that universal banking
was less risky than narrow banking. This was not the case for most
of the two-industry mergers. Finally, the results using proportional
investments in non-bank activities suggested that partial investment (5
to 50%) in non-bank activities would have reduced the risk of failure
of BHCs. It must be noted that this may be a partial view as most of
the results using the volatility of asset returns suggested risk-increasing
effects, although it was dismissed in some cases as insignificant
(Santomero and Chung, 1992). The conclusions of the authors sup-
ported the view that there may be diversification effects stemming
from BHC involvement in securities and insurance activities. The
results were also in unison with those by Boyd and Graham (1988),
except for property/casualty insurers that appeared the riskiest activity
in Santomero and Chung'S study (1992).

Overall, the studies of Boyd and Graham (1988), Boyd, Graham

and Hewitt (1993), and Santomero and Chung (1990) find consistent
results, that is there is some evidence of risk-return advantages
associated with bank diversification into non-bank activities. Merger
simulations constitute an alternative approach to the issue of bank
diversification and risk. Unlike portfolio simulations, they do not
make assumptions about managers' risk preferences. Moreover, they
conserve the path of growth of independent firms over time. A further
advantage of this methodology is that it focuses on individual firms,
which has rarely been undertaken in a portfolio simulation context.
164 Bancassurance

The main disadvantage of studies that examine hypothetical com-

binations is that they ignore capitalisation issues, possible synergies
and potential diseconomies (restructuring costs etc.) resulting from
the combination of two firms. However, the nature of these studies
renders them useful in the current environment, where the bundling of
financial services has become an increasingly important strategy.
These studies can provide some indication of the diversification
potential of alternative combinations.
The relative advantages of the 'merger simulation approach' over
'portfolio simulations' are not easy to identify. Portfolio simulations
help determine the extent to which banks can diversify into non-bank
lines without increasing risk. Merger simulations estimate the risk-
return profile of a fully merged industry, including combinations of
individual firms of each industry. Even though there is a difference
between the two approaches, one would expect that both methodolo-
gies indicate similar net risk effects. There is consensus in various
studies about the potential diversification benefits from banks
undertaking life insurance business (Boyd and Graham, 1988; Boyd,
Graham and Hewitt, 1993; Brewer et al., 1988; Litan, 1987; Wall,
Reichert and Mohanty, 1993). However, there are mixed findings
regarding bank investment in securities activities in particular. Table
6.3 summarises the findings of studies using hypothetical business
combinations.

6.4 DATA ISSUES

The studies we have reviewed in this chapter have differed in their

methodological approaches, but also in the choice of their data which
includes the choice between accounting and market data, return and
risk measures, and the way in which industry figures are calculated.

Market versus accounting data

One of the major disadvantages of market data is that they are only
available for publicly quoted companies and most of the aforemen-
tioned studies have typically examined relatively large firms. This is
particularly problematic in the case of non-bank activities. In many
non-bank activities, where firms tend to be medium-sized, stocks
might not be traded. Moreover, mutuals are by definition excluded
from the sample, which again is not representative for some industries
 Table 6.3 Studies using hypothetical business combinations

Authors Sample Period Type of study Methodology Results

Heggestad 13 industries 1953-67 Variancel AD: ROA and ROE: 9 industries safest than banking
(1975) covariance ROECOVWA and 6 have negative correlations with
analysis banking. ROA: 11 and 7 respectively
Wall and 6 industries 1970-80 Variancel AD: ROACOV 9 subindustries are less risky than
Eisenbeis and 22 covariance WA banking. Significant negative correlations
(1984) subindustries analysis with 6 industries incl. personal credit, life
insurance, security brokers and savings
and loans
Eisemann 19 banks 79 1961-68 Portfolios MD: stock + 74% return same risk if expansion in
(1976) firms of 20 simulations returns permissible activities. + 136% in possible.
industries Variance WA Not much contribution of
non-permissible
Stover (1982) 20 industries 1959-68 Portfolios NPV frame-work Positive NPV in permissible activities
simulations with MD: POF (10%) only using WA. Using individual
set probability WA and firm- companies data, diversification in
of failure specific possible and nonallowable
Litan (1987) 9 industries 1971-82 Portfolios AD:ROA 7 activities would lower risk if combined
simulations COVWA with 75% assets in banking. Lowest risk
with life insurance and insurance agents
Wall, Reichert 6 industries 1974-89 Portfolios AD: ROA Standard Several pairwise combinations reduce
and Mohanty 22 sub- simulations deviation and COV risk at various weights. Efficient
(1993) industries WA (two datasets: portfolios frequently include regulated
regulatory and IRS investment, commodity, insurance agents
returns) and life insurance (IRS). Less diversifi- .....
0\
VI
cation potential w. regulatory returns
Brewer, 40 BHCs 1979-83 Portfolios MD: stock Pairwise combinations: life insurance
0-
Fortier and simulations returns and insurance agents reduce risk up at 0-
-
Pavel (1988) Variance WA 10% weight. Least risky portfolio invests
7.5% in insurance agents and 4.9% in
life insurance
Rosen et al. 319 banks 1980-85 Portfolios AD: ROA; MD: No potential for diversification for thrift
(1989) 2 real estate simulations ROI for equity real services. Up to 4% of bank assets in
data sets estate Standard equity real estate projects
deviation. WA
Saunders and 32 banks 32 1984-88 Portfolios MD: stock returns Multiple portfolios risk-reducing both
Walter firms of 5 simulations Inverse COV; 2 {3s; industry and firm-specific. Most
(1994) industries standard deviation frequent occurrences from insurance
WA activities
Boyd and 146 BHCs 1971-84 Mergers AD and MD: ROE Risk-reduction only in the case of life
Graham 103 firms of simulations Standard deviation assurance with AD. Risk-reduction in
(1988) 6 industries and POF UWA life and PIC insurance and insurance
agents w. MD
Boyd, Graham 141 BHCs 1971-87 Mergers AD and MD: ROE AD: Risk-reduction in life insurance up
and Hewitt 229 frrms of simulations Standard deviation to 60% and 11 % in PIC insurance. MD:
(1993) 6 industries and optimal and POF UWA similar plus insurance agents up to 16%
investments
Santomero 123 BHes 45 1985-89 Mergers Variables from No risk-reduction when standard
and Chung insurance 17 simulations option-pricing MD: deviations are considered. Risk-
(1992) securities ROA Standard devia- reduction w. POF for multiple-firms
tion and POF UWA mergers

MD = market data; AD = accounting data; ROA = return on assets; ROE = return on equity; ROI = return on investment;
COY = coefficient of variation; POF = probability of failure indicator;
WA = weighted industry averages; UWA = unweighted industry averages.
 Literature Review: Bank Diversification and Risk 167

(e.g. insurance), where mutuals constitute major participants in the

marketplace.
Market data are also difficult to interpret in terms of risk. The
volatility of stock returns may be associated with random noise or
some exogenous factors which are not directly related to the true
profitability of the firm. Moreover they are victims of the so-called
look-ahead bias (Boyd and Graham, 1986).2
The main problem associated with accounting data is the intentional
smoothing of earnings (Santomero and Chung, 1992). In particular,
acquisitions are valued at historical cost (cost at the time of acquisi-
tion) and do not reflect the true value of the underlying assets. The
differences in accounting standards for different industries further
distort the valuation of assets. With market data conversely, an increase
(decrease) in the price of an acquisition should be recognised.
To examine the comparative advantages of both methods, Boyd and
Graham (1986) conducted an explicit test. They compared risk mea-
sures using both accounting and market data for their BHC sample.
Significant differences appeared in some places. A measure of the
riskiness of a specific firm should be best expressed in its debt rating.
The authors showed that accounting Z-scores were more highly cor-
related with credit ratings than market Z-scores. It is worth noting that
market and accounting data gave approximately the same results when
diversification alone was considered: in fact, activities that were risk-
reducing using accounting data were also risk-reducing in the market
data analysis. However, in the latter analysis, one or two activities were
identified as potentially risk-reducing while they were not identified as
such in the analysis using accounting data (Boyd and Graham, 1988
and Boyd, Graham and Hewitt, 1993).
Santomero and Chung (1992) heavily criticised the use of standard
deviation of stock returns by previous studies (for example Brewer,
1989). They argued that this was not a valid proxy for the volatility of
the rate of return on assets and failed to capture the true riskiness of a
firm. Furthermore, this measure had a tendency to overestimate the
true variability of asset returns, as stock market returns are usually
sensitive to exogenous shocks which are independent of the rate of
return on assets. Santomero and Chung (1992) proposed an alter-
native framework, based on option-pricing theory, to measure asset
returns at market values. Contrary to other studies using market data,
Santomero and Chung were able to measure the volatility of asset
returns and not that of equity as in traditional studies that use stock
returns.
168 Bancassurance

As underlined above, both sources of data have inherent weak-

nesses. In addition, the type of market considered may also determine,
to some extent, the choice of the data type. For example, in industries
where the number of medium-sized or mutual firms is significant,
stock market data unavailability that accounting data are the main
source of company information.

Return measures

Studies using market data have mostly used stock market returns. The
only exception of those studies reviewed above is the one undertaken
by Santomero and Chung (1992), which used a market rate of return
on assets. The authors recognised the bias of market rates of return on
equity, namely that such a measure is subject to random noise and
firm-exogenous factors. To circumvent this difficulty and avoid the
smoothing bias inherent in accounting data, Santomero and Chung
(1992) derived a measure of return on assets for individual firms as
follows:
MA = ME (EjA) (6.17)
where:
ME = average of daily rates of return for each quarter
E = total value of equity at the end of each quarter
A = calculated market value of assets at the end of each quarter.

In equation (6.17), the market value of assets (A) is not directly

observable. To find an estimate of A, Santomero and Chung used the
option pricing framework first developed by Black and Schole (1973).
Merton (1974) showed that this framework can be used to derive the
market value of equity. Merton's findings were adapted for the pur-
pose of the research, using two assumptions. First, knowing that the
US Federal Deposit Insurance Corporation (FDIC) usually lets a bank
continue operating for some time after its value has fallen below total
debt, a policy parameter was introduced that allowed closure when
asset value was below the book value of debt. Second, Santomero and
Chung (1992) assumed that debt was issued at the risk-free rate of
interest.
The following equation was derived from the option pricing frame-
work.

E =AN(dJ) - pFN(d2 ) (6.18)

 Literature Review: Bank Diversification and Risk 169

where:
d 1 = (lnCAI pF) + a3t T 12)
aAVT

d2 = d 1 - aAvT
p = policy parameter taking value 0 to 1 at the discretion of FDIC
F = face value of total debt liabilities
N( ) = cumulative density of a standard normal random variable
T = time to maturity.

Merton (1974) showed that the standard deviation of return on assets

can be related to standard deviation of return on equity as follows:
aEE
aA = AN(dt} (6.19)

Equations (6.18) and (6.19) comprise two simultaneous equations in

two unknowns: A and aA. The other parameters were obtained as
follows. p was flXed to 0.97 for BHCs following the empirical work of
Ronn and Verma (1986), 1 for other industries. 3 T was fixed to 1
assuming that firms were audited every year.
Even though the process slightly complicates matters, the authors
argue that this approach is preferable because it avoids certain criti-
cisms associated with other traditional data sources. Santomero and
Chung (1992) underlined that they did not believe that the market rate
of return on assets so obtained was exact (note 28, p. 19). However,
they suggested that it was an acceptable proxy because it did not
distort industry rankings in terms of profitability. Moreover, one
expects that this process lessens the random noise associated with
market measures.
Two main measures of profitability have been used in the studies
using accounting data. One such measure is the rate of return on
accounting equity, the other the rate of return on book assets. There
has been some discussion in the literature as to which measure is the
most appropriate. Boyd and Graham (1986) used return on assets as a
measure of profitability, but in subsequent studies (Boyd and Graham,
1988; Boyd, Graham and Hewitt, 1993) used return on equity instead.
The only explicit mention of a choice between the two appeared in the
1986 study, and only refers to greater simplicity.
Other authors have provided further arguments as to why this
choice of data is preferable. Litan (1987) highlighted the problems
170 Bancassurance

associated with rate of return on equity that can be distorted by dif-

ferent leverage structures. Litan (1987) argued that BHCs are often
more leveraged than other firms because they implicitly benefit from a
deposit insurance guarantee. Rate of return on equity would therefore
overestimate the true profitability of BHCs. Rosen et al. (1989) also
favoured the use of the return on assets for similar reasons. Both
authors suggest that this measure gave 'a clearer picture of the
underlying riskiness of the assets themselves'.
The choice of profitability figures appears directly related to the
type of data (accounting or market) used. However, random noise has
traditionally been associated with stock returns. 4 Santomero and
Chung (1992) proposed a market rate of return on assets, that under-
mines these exogenous effects. In studies using accounting data, several
authors underlined the superiority of return on assets for comparing
different industries because this measure is not affected by different
leverage structures (Litan, 1987; Wall and Eisenbeis, 1984).

Risk measures

Another major difference in the way different authors have addressed

the issue of bank diversification is in the choice of a risk measure. The
various risk measures used include the standard deviation and vari-
ance of returns, the coefficient of variation of returns and measures of
the probability of failure. An important reason why these measures are
broad measures of risk is the need to compare two or more industries,
in which risk can take different forms. It is therefore unlikely to find
specific measures of risk without losing the comparability of these
measures in different industries. Four of these generic risk measures
are discussed below.
The wide use of standard deviation of returns as a measure of risk in
the studies reviewed above can be explained by the theoretical back-
ground to the analyses. Most of the studies rely on the portfolio theory
framework. The major analogy between portfolio theory and these
studies is to treat different industries as securities in which a bank
(BHC) might invest. From portfolio theory, the (expected) mean
return of a conglomerate banking institution is a linear weighted sum
of the returns stemming from the activity it undertakes, i.e.
n
fc = Lf;W; (6.20)
;=1
 Literature Review: Bank Diversification and Risk 171

where:
fc is the mean return of the diversified firm;
fj the mean return on each respective activity;
Wj the proportion of activity i in the conglomerate.

The risk (the variance of returns) is accordingly measured as:

n n n
(J~ = L w;a; + L L
j=1 1=1 J~l
WjWjPij(Jj(Jj (6.21 )
l1''.:i

where:
07 is the variance of returns from activity i;
pjj the correlation between the returns on activity i and j.

According to equation (6.21), the risk of a diversified firm depends on

the correlation of returns between different activities, for any given
risk and relative weights of those activities. As the correlation moves
away from 1, potential diversification effects increase.
The variance or standard deviation of returns have often been used
as a measure of risk in other frameworks. Both measure the extent to
which returns vary from their mean (for example in a time series
analysis). A frequent criticism of these measures is that they do
not account for the level of associated returns and therefore are
inappropriate for comparisons of different firms. On occasions, for
example, the expected profit of a firm is so large that it will be
considered relatively safe, even if the variance (standard deviation) is
relatively high.
Some authors have advocated the use of the coefficient of variation
to overcome the shortcomings of standard deviation (Weston and
Brigham, 1972). It is defined as:
COV = (Ji (6.22)
fi
In this measure standard deviation is adjusted for the mean returns of
the firm. Alternatively, the inverse of this coefficient has been used in
the literature (e.g. Saunders and Walter, 1994). It can be seen as the
return per unit of risk. These measures, by explicitly incorporating the
concept of return, better capture the risk-return trade-off of firms'
performance. However, the coefficient of variation does not overcome
all difficulties encountered in measuring risk-return performance. The
following example illustrates the issue.
172 Bancassurance

Retum Standard deviation Coefficient of variation

FirmA 0.01 0.0001 0.01

Firm B 2 0.1 0.05

In this example, firm B appears more risky than firm A. However,

every rational individual would find the risk-return performance of
firm B more attractive because of its greater return: assuming one
standard deviation from the mean return, it would still be much higher
than that of firm A. This example illustrates the need to exert con-
siderable caution in examining potential merger partners, as well as
the need to consider both performances dimensions in parallel. While
the coefficient of variation of return removes some of the difficulties
associated with the standard deviation of returns, it does not provide a
foolproof tool for comparison between different performances.
An alternative measure of risk is the probability of failure. The
probability of failure is defined as the probability that losses exceed
equity in a particular period. The underlying theory behind this defi-
nition can be found for example in Blair and Heggestad (1978) who
developed a model relating bank portfolio to its probability of failure.
Assuming banks exhibit a risk-averse behaviour and choose an asset
portfolio which maximises the expected utility of their uncertain
profits, an efficient frontier can be derived in a mean standard
deviation space. The optimal bank asset portfolio is represented by the
point of tangency between the efficient frontier and the highest
attainable indifference curve. Defining a specific disaster (1oss), a, the
least upper bound of the probability of failure (maximum probability)
can be derived as follows:
P(1i- < a) $ a2(7l' _ a)2 (6.23)
Figure 6.2 illustrates the probability of failure. It can be derived that
the least upper bound of the probability of failure will be given by the
square of the reciprocal of the slope of the ray from a to the optimal
portfolio M. For a given disaster, this probability is smaller, the steeper
the ray to the portfolio selected. Given the focus of interest (prob-
ability of bank failure), the disaster can be defined as - E (the negative
of equity, i.e. a loss equal to equity).
Brewer (1989) slightly adapted this definition of the probability of
failure. The probability of failure was defined as the probability that
losses exceed equity in a particular year, i.e.
 Literature Review: Bank Diversification and Risk 173

PROB = P{ir < -E) (6.24)

where:
7r = profits
E = equity.

Dividing both terms of the inequality by E, it follows:

PROB=P(i< -1) (6.25)

Using Chebychev's theorem, the upper bound of this probability

for any symmetric distribution with a finite variance can be obtained.
That is:
J

P(r ~ -1) ~ IT 2 (6.26)

(1 + f)
where:
f = average return on equity;
a = standard deviation of return on equity over the period.

Figure 6.2 Illustration of failure probability

Profit

o r---~~-------------------------------+
Standard
deviation

(l

Source: Adapted from Blair and Heggestad (1978).

174 Bancassurance

Although the theory behind the probability of failure suggests that it is

superior to a simple coefficient of variation of returns, one may argue
that the former is a simpler explanation of the latter. Moreover, some
authors have argued that return on equity is sensitive to leverage
structures and may not be suitable to compare different industries
(Litan, 1987; Rosen et al., 1989). The same criticism might hold for
this measure.
Boyd and Graham (1988) used a similar framework except that they
based their estimation on return on assets, as follows:

P(B) = P(n < -E) = pG < -~) = P(fA < k) (6.27)

where:
E = equity
A = total assets
n = random profits, regarded as a random variable
fA = return on assets
k = -E/A.

If the distribution of fA has (unknown) finite mean 11 and standard

deviation a, then P(B) can be expressed in standardised form as:

P(B) = P(fA < k) = P ( fA - 11 k - 11)

- 1 7 - < -17- (6.28)

Boyd and Graham (1988) substitute the known sample mean fA and
standard deviation S to obtain the approximation:

P(B) = p(fA ~fA < -z) (6.29)

Z can be expressed as:

fA-k
Z =-S- (6.30)

In general, Z is greater than zero. Z is used as an indicator of

downside risk: the greater the value of Z, the lower the risk of failure,
and vice versa.
If fA has a normal distribution, Z can be interpreted as a Z-score,
i.e. the number of standard deviations below the mean, below which
return on assets must not fall to avoid bankruptcy. Effectively Z is, in
this case, the reciprocal of the coefficient of variation of a normal
variate.
 Literature Review: Bank Diversification and Risk 175

For an accounting estimate, Z is calculated for firm i in the sample

as:

[(2:i=1 (27Tj/(A j +Aj-d )/n) + (2:i=1 «Ej + Ej_J)/(Aj +Aj_tl)/n )]

Zi=~----------------~--~----------------------~
Si
(6.31 )

where:
n = number of accounting periods
S = standard deviation of returns on assets 7r;/Ai'

One of the problems associated with this measure is that deterministic

and random variables are both included in the derivation (in parti-
cular, equity and profits in equation (6.31». However, this framework
has been used frequently in the literature (Santomero and Chung,
1992; Wall, Reichert and Mohanty, 1993; Brewer, 1989). By capturing
both the level of returns and the cushion provided by equity capital,
the Z-score measure avoids the fallacy of returns' volatility underlined
above. At the same time it incorporates an essential variable, capital,
which is often monitored by regulators in the financial services
industry as a necessary indicator of solvency.
There are two other major criticisms that can be made about the Z-
score measure. The first is that this measure implicitly assumes that
losses overcome equity in the context of a one-year period. In reality, it
is much more likely that successive losses will lead to bankruptcy.
Z does not incorporate such downward trends. Moreover, Z-score
measures would fail to recognise a loss exceeding equity in a particular
year. Therefore, they might fail to capture bankruptcy. Nonetheless,
Furlong (1988) notes that such measures rely on the assumption that
regulators always close a bank when the latter is found to have
negative net worth upon examination. However, regulators would not
necessarily declare a bank bankrupt under such circumstances. The
second major criticism relates to the normal distribution assumption
for returns. A number of studies in the literature, some of which are
specific to banking, have argued that financial ratios do not follow a
normal distribution (Bedingfield et aI., 1985; Kolari et al., 1989). The
study by Bedingfield et al. (1985) submitted 11 financial ratios to
thorough testing for a large sample of commercial banks over the
period 1974-77. They used the Kolmogorov-Smirnof technique to test
for the normality assumption. None of the ratios could accept the null
176 Bancassurance

hypothesis that the distribution is normal. This evidence tends to

undermine assumptions of the normal distribution of returns. Finally,
return on equity has been criticised in the context of industry com-
parisons because various firms may have different leverage structures
that are inherent in their industries. By incorporating equity-to-asset
ratios in the construction of the Z-score, Boyd and Graham (1988)
raise the issue of whether this is suitable for the purpose of industry
comparison.
There are shortcomings in the construction of the Z-score measure,
but it has been widely used in the US literature, where bankruptcy
concerns are high. An interesting feature of this measure is that it
takes into account returns, volatility of returns and capitalisation.
However, this last element may raise questions as to the appro-
priateness to compare industries on the basis of leverage structures.
As can be seen from the above definitions, there are significant
differences in the way various studies have measured risk. In some
cases, this may be the reason why studies have found different risk
consequences for similar bank/non-bank combinations. In particular,
some studies that use two different measures fmd contradictory
results. For example, Santomero and Chung (1992) found that results
using volatility of asset returns suggested that expansion into specific
non-bank activities increased risk, while results using Z-scores sug-
gested potential risk-reduction. Alternatively, one may argue against
the usefulness of the volatility measure because it does not consider
return and capital considerations. Although there are shortcomings to
the Z-score measure, it gives additional information and can therefore
be a useful indicator to use in parallel with other risk measures.

Industry weighted and unweighted averages

Studies also vary in their choice of weighted or unweighted average

industry data. While most studies use industry weighted averages, a
number recognise the inherent bias of using these statistics to provide
a picture of the typical firm in an industry (Heggestad 1975; Wall and
Eisenbeis, 1984; Utan 1987). A comprehensive analysis of the
potential bias stemming from this difference was undertaken by Boyd
et al. (1980). They underlined the weaknesses of previous studies in
using weighted industry-wide statistics, which they compared to using
a return index for each non-bank activity where the BHC would act as
a passive mutual fund holder. They argued that this methodology was
inadequate in the light of the studies' objective, i.e. to determine
 Literature Review: Bank Diversification and Risk 177

whether the merger or de novo entry of a BHC in a non-bank activity

would affect its risk-return profile. Such a BHC would not invest in an
industry, but in a specific firm of that industry. It is also very unlikely
that BHes would simply invest in such subsidiaries and not become
involved in their management. Previous studies have shown that BHC
non-bank subsidiaries tended to have distinguishing features from
independent companies in the same industry (Talley, 1976; Rhoades,
1978), which seems to support this assertion.
The main impact of weighted averages is to conceal intra-industry
variability. The difference stems from the way these data are com-
puted. When variance is computed, unweighted industry data average
the variance of individual firms; conversely weighted averages com-
pute the variance of the returns of a hypothetical firm, the industry.
The difference in the process clearly illustrates that variance will be
biased downwards by an unknown amount when industry weighted
averages are used.
To estimate the differences unweighted and weighted industry
average calculations can have, Boyd et al. (1980) compared results
using both methodologies. Returns proved to be substantially different
depending on the average used. When standard deviations and cor-
relations of returns were considered, in 19 activities out of 20 standard
deviations were higher using unweighted averages (deviations were as
much as 5 to 10 times higher). Correlations of returns between
banking and non-bank activities were also higher in 19 out of 20
activities for industry-weighted data. These results suggest that aver-
aging tends to cancel out intra-industry variability. Similarly, correla-
tions of returns between individual firms are expected to be less as
variations are not only attributable to industry factors but also to
individual firms characteristics. The findings of Boyd et al. (1980)
confirmed the intuitive assumption that standard deviations are biased
downwards and correlations taken away from zero.
Another study by Kwast (1989) attempted to measure the extent of
these differences, and he too found that returns tended to be different,
standard deviations were lowered and correlations rose when industry
weighted averages were considered. Stover (1982) reached similar
conclusions.
The above suggests that there might be a bias inherent in using
weighted averages to estimate diversification benefits. In the context
of studies on diversification and risk, the objective is to estimate the
risks associated with the merger of various banks with specific non-
bank firms. Banks would not invest in industries but specific non-bank
178 Bancassurance

companies. Boyd et al. (1980) argued accordingly that unweighted

industry statistics are more appropriate to the studies' objective.

6.5 LITERATURE APPRAISAL AND ITS APPLICABILITY TO

BANCASSURANCE AND RISK

This section undertakes a critical appraisal of the existing literature

on bank diversification and risk. In the first part of this section, we
examine the comparative advantages and disadvantages of studies
using actual bank experiences and those examining simulated combi-
nations. In the second part, we analyse the differences between two
approaches using hypothetical combinations, namely portfolio and
merger simulations. Finally, we discuss the potential contribution of
these approaches to the study of bank diversification into life assur-
ance, the bancassurance phenomenon.

Bank diversification and risk: studies using actual experiences versus

hypothetical combinations

The above analysis suggested relative advantages and disadvantages

from studies using actual bank experiences and those relying on
simulations. These are summarised in Table 6.4. As can be seen from
Table 6.4, it is difficult to make definite assessments as to a 'best'
methodology. The objectives pursued as well as the availability of data
might determine the choice of the appropriate methodology. Both
approaches serve as a reference for the risk consequences of mingling
bank and non-bank activities, but none can determine the success of
specific combinations. However, they might give useful hints to a
managerial team seeking to diversify away the volatility of its earnings
in the traditional banking business. They may also be of interest to
regulators who may be considering permitting or limiting bank powers
in specific areas.
Studies using actual bank experiences show how the components of
existing business combinations are related and whether their combi-
nation is likely to generate diversification advantages. Studies that use
hypothetical business combinations tend to estimate the potential of
combinations between specific activities. They can highlight potential
risk-reducing opportunities and provide a caution against risk-
inducing combinations. Both approaches attempt to give generic policy
benchmarks for the combination of specific activities with banking.
 Literature Review: Bank Diversification and Risk 179

Table 6.4 Advantages and disadvantages of studies using actual experiences

and studies using hypothetical combinations

Advantages Disadvantages

Studies of actual bank 1. Potential synergies 1. Lack of actual experi-

experiences and diseconomies. ences.
2. Merger or start-up 2. Unconsolidated data
terms. scarce.
3. Potential different 3. Differences in parent's
profile of bank sub- and subsidiaries'
sidiaries. books.
Studies of hypothetical 1. Data availability. 1. Ignores merger terms.
combinations 2. Prospective nature. 2. Ignores synergies/dis-
economies.

The random factor involved in choosing combination partners in the

second approach (hypothetical combinations) suggests that merger
benefits are undermined, because an equal weight is given to favour-
able, average and unfavourable combinations. It can be argued that
BHC managers would choose the best merger partners from non-bank
industries. This educated selection should be better reflected in the
first approach using actual mergers. However, this argument does not
incorporate the fact that those non-bank firms would be the most
attractive to investors, which would render acquisition costly. More-
over, as the number of firms in an industry is necessarily limited, we
may assume that BHCs might seek to merge with the remaining less
attractive non-bank firms. The argument that the second approach
does undermine true potential diversification benefits is therefore not
so straightfOlward.
Adopting either approach appears to be circumstantial, that is it
depends on data availability. Real-life examples of bank-non-bank
combinations may be limited. This might be regulation-induced, i.e.
such combinations have not been permitted, or deregulation is recent
thus limiting data availability. In other cases, the limited number of
existing combinations may be market-induced: banks might not have
taken opportunity of their expanding powers. suggesting the target
industry was not attractive. Market developments might have altered
the desirability of such combinations but this development could be too
recent to be widespread. In those cases where only few combinations
180 Bancassurance

can be studied, it is likely that the second approach (hypothetical) will

be appropriate, because insufficient data are available.

Studies using hypothetical combinations: portfolio simulations versus

merger simulations

Studies using hypothetical business combinations have followed two

main approaches. The first one, most commonly used in the literature,
can be described as portfolio simulations. The second approach, as
characterised by the studies of Boyd and Graham (1988) and Boyd,
Graham and Hewitt (1993), undertakes hypothetical merger simula-
tions.
The main hypothesis underlying portfolio simulations is that dif-
ferent activities are treated as securities in which a BHC might invest.
Portfolio theory formulae for securities portfolios are adapted for the
purpose of business diversification. It might be appropriate to recall
the assumptions underlying portfolio theory (DiCagno, 1990) i.e.

• investor's utility function is quadratic;

• or/and returns are regarded as jointly normally distributed.

The first assumption implies risk-aversion. Boyd and Graham (1986)

argue that many economists would question the existence of even mild
risk-aversion from banks. Given the opportunity to diversify so as to
reduce risk, managers would not necessarily do so: risk-aversion is an
attribute of investors and not corporations, who are concerned with
maximising returns. Moreover, the moral hazard function of deposit
insurance for banking corporations might further affect bankers' risk
preferences. This indicates that the first assumption might not hold in
the context of bank diversification.
The second assumption, i.e. the normality assumption, was also
questioned by Boyd et al. (1980). In the studies reviewed, industry
average returns were used. In fact, the methodology implies merging
two securities, both of which are industry indexes. Boyd et al. (1980)
suggest that industry returns are often neither joint normally dis-
tributed nor time stationary. This observation led the authors to use
a different approach in later papers (Boyd and Graham, 1988). San-
tomero and Chung (1992) further argued that returns on equity are
unlikely to be normally distributed. They quoted Benston (1989) who
questioned the normality of realised rate of returns on assets using
return on equity from either book or market data. They further argued
 Literature Review: Bank Diversification and Risk 181

that it is not unreasonable, however, to assume a normal distribution

of instantaneous rates of return on assets at any given point of time.
Both basic assumptions of portfolio theory appear to be questioned
in the literature. It must also be noted that such an approach has not
been solely restricted to students in the banking field but has also been
used in many studies of corporate diversification (see Chapter 4).
Smith and Schreiner (1969), who used a similar framework to compare
conglomerate diversification with mutual fund performance, under-
lined three further shortcomings of the approach. First, corporations
invest not only dollar resources but capital and management in a
diversification process. Second, while an investor can vary the extent of
each investment, a corporation either acquires a firm or not and
cannot reverse the process easily (Smith and Schreiner, 1969). One
should note at the outset that a firm might acquire part of a corpor-
ation's shares and divest (even though the latter may prove costly). A
third important limitation is the lack of investment homogeneity for
corporations. While a share is the same in any portfolio, every cor-
porate acquisition is unique. This methodology further ignores
synergies, diseconomies and the costs of entry in a new activity
(merger terms, for example). Notwithstanding these apparent theore-
tical flaws, portfolio simulations have been often used in the literature
on corporate diversification.
In the literature on bank diversification and risk, three main
research questions have been addressed:

1. Is there a potential for asset diversification through less than

perfectly correlated returns?
2. What is the share of assets invested in a specific non-bank activity
that would minimise BHC volatility?
3. Which is the maximum share of assets that can be devoted to a
specific non-bank activity without increasing BHC risk (volatility
or probability of failure)?

The last two questions imply having some kind of benchmark to

compare simulated optimal values and banking risk measures. In the
literature, the reference point has been the average for the industry.
This treatment is likely to overestimate potential diversification benef-
its because optimal values are based on the best combinations while
banking measures are averages of the 'best' and 'worst' banks.
Merger simulations are based on summing up the balance sheets of
prospective partners and hence deriving a consolidated balance sheet
182 Bancassurance

for a hypothetical firm, composed of both firms. For example, assets

for the newly merged ftrm are assumed to be the sum of the assets of
both independent ftrms. The same holds for equity and proftts. The
return for the hypothetical ftrm is deduced from these figures.
The main assumption of this approach is that mergers take place
without creating any restructuring of the formerly independent firms.
No synergies, merger terms or capitalisation issues are considered.
This is admittedly an important shortcoming but avoids making sub-
jective case-by-case assumptions about the merger conditions. Boyd
and Graham (1988) argue that some of these omissions would influ-
ence the results downward while others would have the opposite
effect. Overall they thought that the single most important bias would
be the assumption of no merger premiums and conservative post-
merger capitalisation. If this is the case, simulations would tend to
underestimate risk.
Silhan and Thomas (1986) described the process of merger simu-
lations as providing accounting benchmarks that can be used to
evaluate the risk-return performance of non-synergistic mergers. In
accounting terms, the procedure is similar to consolidation by pooling,
ignoring any common costs or inter-segment transactions. As no
synergies are allowed through the procedure, the results must be seen
as lower bounds to potential performance.
Finally, it is assumed in this approach that random mergers or
systematic mergers of each bank with each non-bank are a good proxy
for a mixed industry. Obviously we would expect that banks would
choose those specific merger partners which improve their perform-
ance most. This strategy, however, is constrained by the limited
potential partners of that industry. Moreover, the better performing
the target, the higher will be the merger terms.
Despite these weaknesses, one might recall the main question that
the merger simulations address:

1. Would an industry composed of mergers of banks and a non-bank

ftrm be less risky than the banking industry on a standalone basis?

Given that the question pertains to a general assessment of likely

effects of diversiftcation at the industry level, the weaknesses under-
lined above might be lessened as they deal with specific combinations.
The assumptions which are criticised have the merit of avoiding sub-
jective hypotheses about specific merger terms or capitalisation issues.
While it is worthwhile keeping these shortcomings in mind, the results
 Literature Review: Bank Diversification and Risk 183

should be interpreted as giving an indication of the direction of the

risk effects of diversification strategies.
Boyd, Graham and Hewitt (1993) expanded the initial research by
Boyd and Graham (1988) to answer the following question:

2. What share should be devoted to non-bank assets to minimise risk?

They simulated different weights (from 0 to 100%) for the simulations

in the first year of the period and simulated the path of growth of the
independent firms over time. The main objection to this treatment of
mergers is that an important advantage of merger simulations, i.e.
reflecting actual relative sizes, is lost through this procedure. The
advantage of estimating the share at which potential diversification
effects are maximum does not seem to outweigh this disadvantage.
The main interest of this additional information is to indicate whether
such share is significant or not (which might be a subjective assess-
ment). Moreover, this involves choosing the proper benchmark to
identify at what level risk is minimised or where it is not increased.
Whether regulators would find this tool useful in assisting them in
limiting bank involvement in specific non-bank activity is a matter of
discussion. Table 6.5 summarises the main aspects of both approaches.

Table 6.5 Main characteristics of portfolio and merger simulations

Portfolio simulations Merger simulations

Focus on industry Firm-specific

Weighted averages for performance
measures
Weights are simulated
Portfolio theory focuses on risk-
reduction
Compute efficient combinations
Unweighted averages for performance
measures
Actual firm-specific weights
Risk can decrease/increase
Compute risk-return of hypothetical
firms of a newly formed industry

The main differences between the two approaches can be sum-

marised as follows:

1. Portfolio simulations focus on the combination of industries,

whereas in merger simulations the focus is on firm-specific com-
binations.
184 Bancassurance

2. The benchmark measures for the standalone banking industry and

combined hypothetical industry are computed using weighted
averages for portfolio simulations while in merger simulations
unweighted averages are used.
3. In merger simulations, the relative shares of each partner follow
the growth of the firms on an independent basis; in portfolio
simulations, weights are mostly simulated and do not correspond
to the relative size of the participants in different industries.

The above differences must be put in perspective with the broad

objective of the studies: to shed light on the potential risk con-
sequences of bank involvement in specific non-bank activities. Boyd
and Graham (1988) argued that the issue at stake is the merger of
specific banks with specific non-bank firms, which supports the use of
the second approach (merger approach). It can also be argued that
this approach accounts for the 'best' and 'worse' case combinations
from a risk point of view. Supporters of the portfolio simulation
approach would argue that regulators are more concerned about an
estimate of risk consequences for the industry as a whole.

Applicability to the research question

The aim of this research is to determine the risk consequences of bank

diversification in life assurance in the United Kingdom. We are par-
ticularly concerned with the adoption of this strategy by the largest
retail financial institutions (banks and building societies) in recent
years.
As yet, the existence of bancassurance conglomerates is recent (see
the study undertaken by Van den Berghe, 1995). The limited num-
ber of bancassurance link-ups does not permit us to undertake empir-
ical work on actual bank/insurance link-ups. The empirical analysis
conducted in the following chapters will therefore concentrate on
approaches that use hypothetical business combinations.
The two main approaches to using hypothetical combinations have
been outlined above. The disadvantages of the portfolio approach
were underlined, in particular the fact that studies violate the
assumptions of portfolio theory. Moreover, the analysis of the studies'
objectives, that is, to estimate the impact of mergers of firms from the
banking and non-bank industries, suggested that the focus of the
research should be on firm-specific combinations. The merger simu-
lation framework, that was used in the study. by Boyd and Graham
 Literature Review: Bank Diversification and Risk 185

(1988), appears to provide a suitable context for estimating the effects

that an increasing number of banking institutions moving into life
assurance would have on the risk of the banking industry. It will the
basis for the empirical study in the next chapter.

CONCLUSION

This chapter provides a comprehensive review of existing studies on

bank diversification and risk. Overall, the US empirical evidence on
bank diversification into insurance, and in particular, life assurance,
suggests substantial risk/return benefits (Boyd and Graham, 1988;
Boyd, Graham and Hewitt, 1993; Brewer et ai., 1988; Litan, 1987;
Wall, Reichert and Mohanty, 1993). Two main approaches were
identified in the literature: studies that rely on existing bank experi-
ences and studies that use hypothetical business combinations. Over-
all, it is argued that the latter approach is the most appropriate in
situations where combinations between firms of the two sectors have
been limited. Studies focusing on hypothetical bank/non-bank com-
binations can be further divided into two main categories: portfolio
simulations and merger simulations. The former has been the most
common approach in the literature on bank diversification and risk (as
well as in the literature on corporate diversification more generally).
One of the main disadvantages of this type of approach is that it
focuses on industry rather than firm-specific simulations. However, we
suggest that greater attention should be paid to investigating mergers
of specific banks with specific non-bank firms.
Our empirical research will adopt a merger simulation framework to
explore the risk effects of bank diversification into life assurance in the
UK.

Notes
1. 'Traditional activities' means activities in which banks have been tradi-
tionally engaged.
2. Boyd and Graham (1986) contend that market data respond to the
publication of accounting data, which typically occurs later than the end
of the reporting period. All firms do not have the same publication date.
If the end of the accounting reporting period is chosen as the date at
which market data are computed, it may imply that investors are able to
186 Bancassurance

make perfect forecasting. Even if this is not the case, it will be difficult to
find a date which adjusts for the publication of all firms in the sample.
3. There is no difference when Santomero and Chung (1992) set p = 1
instead of 0.97.
4. Santomero and Chung (1992); Boyd and Graham (1988).
7 The Risk Effects of Bank
Diversification into
Bancassurance

INTRODUCTION

This chapter outlines the methodology taken to investigate the

potential risk effects of UK banking institutions' involvement in life
insurance. The previous chapter identified two main approaches in the
US literature on bank diversification and risk: portfolio and merger
simulations. The approach taken in this chapter adopts a merger
simulation framework. The first part of the chapter describes the steps
followed in order to undertake merger simulations and the second
part outlines our main findings.

7.1 METHODOLOGY

Both UK commercial banks and building societies have engaged in

life assurance in recent years, with many institutions gaining owner-
ship control over insurance companies. The main objective of this
chapter is to investigate the risk consequences of banking institutions'
involvement in life assurance activities in the UK. To do so, we
simulate combinations of banking institutions with life insurers and
measure the extent to which risk levels are affected by this type of
diversification. We study four possible types of merger combinations
separately: commercial banks with mutual life insurers, commercial
banks with proprietary insurers, building societies and mutual life
insurers and building societies and proprietary life insurers. This
should contribute to our understanding of recent bancassurance
strategies, as well as provide some indications as to the risk effects of
such diversification.
The review of the US literature in Chapter 6 underlined two main
approaches to the risk effects of bank diversification. The critical
appraisal of these approaches suggested that portfolio simulations vio-
late some of the assumptions of portfolio theory. Moreover, portfolio

187
188 Bancassurance

simulation work has generally focused on industry combinations

rather than on specific firms. We argued that this does not properly
illustrate the main objective of these studies, which is to estimate the
risk effects of the combinations of individual firms. The merger
simulation approach therefore represents the main methodology
outlined in this chapter.

Methodology

Our model uses the framework developed by Boyd and Graham

(1988) to conduct mergers simulations between banking institutions
and life insurers. The methodology consists of merging individual
firms, similar to the accounting principle of consolidation by pooling.
This principle entails summing up balance-sheet items from both
formerly independent firms to simulate a hypothetical merger.
The methodology comprises the following successive steps:

1. Select the first bank and the first insurer in the sample.
2. Add the profits, assets and equity of both firms for each year of the
sample period.
3. Derive the time series of returns and equity-to-asset ratio for the
added figures. These represent the hypothetical times series of
returns for the merger of a bank and an insurer.
4. Compute risk and average return measures over the period for the
hypothetical merger.
5. Repeat steps 2 to 4 for mergers of the first bank with every insurer
in the sample.
6. Repeat steps 2 to 5 for each bank in the sample. Individual risk
and return measures are available for n x m hypothetical mergers
(n and m being the total number of banks and insurers, respect-
ively).
7. Derive summary risk and return measures for the hypothetical
industry composed of n x m firms.
8. Compare measures for the hypothetical industry to those for the
banking industry on a standalone basis.

This analysis is conducted for mergers between commercial banks and

mutual insurers, commercial banks and proprietary insurers, building
societies and mutual insurers and building societies and proprietary
insurers, separately.
 The Risk Effects of Bank Diversification into Bancassurance 189

The above stages of the simulation process should provide an

indication of the potential effects of mergers between firms in the
banking and life insurance industries. In particular, it should indicate
whether the generalised mingling of both sectors would increase or
reduce risk. Moreover, we conduct the analysis for the combinations
of commercial banks or building societies and mutual or proprietary
insurers. This should show whether mergers between specific types of
institutions appear more desirable.

Risk and return measures

Return
Return on total assets is used as an indicator of profitability. Unlike
return on equity, this measure is not affected by different leverage
structures. In particular, banks are commonly seen as highly leveraged
structures compared with other industries (Utan, 1987). To avoid
making assumptions as to the way both activities are capitalised,
return on assets will be used instead of return on equity. In addition,
we examine various institutions in this research, some of which are
mutuals. To compare the performance of various institutions, return
on assets seems more appropriate than return on equity, as it under-
mines the effect of equity.
We measure income as net income after taxes. This is due to the fact
that pre-tax measures could not be obtained for mutual life insurers.
Total assets are used as the denominator. Return on assets for a bank
or insurance company is therefore computed as:
n
f = l)7rdAd/n (7.1)
i=l

where:
f = average return
7r = net income after taxes
A = total assets
i = year i = 1 to n from the sample period
For a hypothetical firm h, the result of the merger of bank b and life
insurer 1, the return for any year i can be computed as:

(7.2)
190 Bancassurance

where:
rh,i = return on assets for the hypothetical merger h in year i

The average return for hypothetical firm h is therefore computed as

follows:
n
fh = L:>h,dn
i=l
(7.3)

where:
fh = average return for hypothetical firm h over the period

Three indicators of risk are used in our approach: the standard

deviation of returns that indicates the variability of returns, the coef-
ficient of variation of returns that gives a measure of risk-adjusted
return, and the Z-score measure, developed by Boyd and Graham
(1988), which provides an indicator of the probability of failure (this
measures the number of standard deviations a firm's return would
have to fall below its mean before exhausting equity). Chapter 6
underlined a number of limitations associated with this measure, in
particular the normality assumption for the returns distribution. Here
it is used as a third risk measure, because it provides additional
information, the notion of capitalisation, for the assessment of risk. All
three measures of risk are derived from return on assets.

Standard deviation (0)

The standard deviation of returns on assets is derived as follows:
n
(J = 2)ri - f)2/(n - 1) (7.4)
i=l

where:
ri = return on assets in year i
f = average return on assets over the n-year period
Coefficient of variation (COV)
The coefficient of variation of return on assets is a measure of risk
adjusted for return that is computed as follows:

COV=~ (7.5)
f
 The Risk Effects of Bank Diversification into Bancassurance 191

Z-score (Z)
The Z measure is derived similarly to Boyd and Graham (1988).
However, we use returns on total assets instead of average assets.
The probability of bankruptcy P(B) in a year or period is defined as
follows:

P(B) = P(if < -E) = p(~ < -~) (7.6)

= P(r < k)
where:
E = equity
A = total assets
if = after tax profits (random variable)
r= if/A
k = -E/A

If the distribution of r has (unknown) finite mean J.L and standard

deviation a, then P(B) can be expressed in standardised form as:

P(B) = P(r < k) = pC ~J.L < k: J.L) (7.7)

The known sample mean f and standard deviation S are substituted to

obtain the approximation:
r- r )
P(B) =P ( S<-Z (7.8)

where:
f-k
Z=-S-

Z is used as an indicator of downside risk: the greater the value of Z,

the lower the risk of failure, and vice versa. We assume that ris normal
so Z can be interpreted as a Z-score, i.e. the number of standard
deviations below their mean to which returns on assets must fall to
incur bankruptcy.
Finally, we compute Z from the sample as:

(7.9)
192 Bancassurance

where:
n = the number of accounting periods
S = the sample standard deviation of the return on assets 1C;/Ai

Equity is not defined for most life insurers, therefore a proxy was used
instead, as is explained later in this chapter.
The main advantage of using three different risk measures is that
they give a more complete picture of the riskiness of the underlying
industries. Therefore, this enlarges our analysis of the potential ming-
ling of both activities.
Industry statistics
The approach adopted in this study uses unweighted averages rather
than weighted averages to measure average return and risk for an
industry. This aims to represent the typical firm's characteristics in the
industry rather than the industry characteristics. This is the focus of
attention in this research, because we seek to estimate the effect of
mergers of individual firms in the industry and not of the merger of
both industries. This argument was developed by Boyd et al. (1980).
The merger simulation process entails an automatic incorporation
of the relative size of the independent businesses merged, as we sum
the assets, profits and equity of the firms in absolute value for each
year. Therefore, the hypothetical firms adequately reflect the relative
sizes of the independent insurers and banks over the period. Statistics
for the hypothetical industry give equal weight to any newly formed
conglomerate and should therefore better illustrate the effect of the
bancassurance strategy on individual firms. Summary statistics for the
hypothetical industry are computed as follows:
m
TH = LTh/q (7.10)
h=l
where:
m = number of merged firms
TH = average return for the hypothetical industry of q firms
Th = average return for the hth hypothetical merger

(7.11)

where:
OH = average standard deviation of return on assets for the hypo-
thetical industry
 The Risk Effects of Bank Diversification into Bancassurance 193

ah = standard deviation of return on assets for the hlh hypothetical

merger
m
COVH = L COVh/q (7.12)
h=l
where:
COVH = average coefficient of variation of returns for the hypothet-
ical industry
COY h = coefficient of variation of return on assets for the hlh hypo-
thetical merger

(7.13)

where:
ZH = average Z for the hypothetical industry
Zh = Z indicator of the probability of failure for the hlh hypothetical
merger

The same procedure is used to compute statistics for individual

standalone industries. The figures for the banking industry provide a
benchmark against which the hypothetical industry's performance is
assessed.
The above methodology does not incorporate merger terms and
capitalisation issues relating to the merger event. In particular, merger
premia can be substantial and would arguably reduce the potential
benefits from the merger. In addition, the way the merger is financed
can have an impact on the capital structure of a newly formed firm.
Incorporating merger and capitalisation issues into the simulation
process would require subjective assumptions which are beyond the
scope of this chapter and could be questioned on a case-by-case basis.
In this simulation procedure, we assume that the merger does not
affect the structures of the formerly independent firms.
Another shortcoming of this analysis is that it ignores potential
synergies or diseconomies stemming from the mergers. In particular,
the exploitation of synergies has been forcefully argued by the pro-
ponents of the bancassurance strategy. The study of the extent of
possible synergies in bancassurance is a different area to explore and
this research does not attempt to model it into the simulation process.
To that extent, this simulation exercise gives a lower bound to potential
diversification benefits.
194 Bancassurance

Finally, we estimate the whole set of potential mergers between

both industries. This might give little credit to bank managers' ability
to identify the most desirable partners. By estimating the impact of
less favourable mergers, we believe that we are guarded against over-
optimistic outcomes of mergers. In addition, potential partners are
limited in the industry and the most desirable merger partners are
firms that may require the payment of high merger premia, that might
in tum reduce the benefit of the combination. The above approach,
therefore, gives a more realistic picture of the generalisation of the
bancassurance strategy.
The limitations of the above approach present a simplistic picture of
the effects of bancassurance strategies. However, we argue that this
simplicity allows us to estimate the effects of diversification in a broader
context, where no assumptions are made about a priori success of
bancassurance strategies. It can be seen as a lower bound to diversi-
fication benefits.

Accounting for life assurance

Given the definition of our return and risk measures, differences

between accounting practices in UK banking and life assurance forced
us to construct proxies for our insurance sample. This section under-
takes a brief review of the accounting framework in life assurance and
describes these proxies.

Industry structure - mutual and composite insurers

1Wo main aspects of the UK life assurance industry impact on its
accounting practice. The first one is the importance of mutual com-
panies in the industry. In 1992, 13 of the top 30 UK life insurers in
terms of world-wide premiums were mutuals. 1 Mutuals are non-profit
corporations, owned by policyholders. There is no concept of profit as
such, as excess income is supposed to be returned to the policyholder/
owner in the form of bonuses or to reduce premiums. Similarly, as
there are no shareholders of such corporations (the policyholders are
the owners), the concept of equity does not exist for mutuals.
The second aspect of the insurance industry which yields immediate
consequences for accounting data is the number of composite com-
panies. A composite insurer is a corporation that conducts both gen-
eral and long-term business. This feature makes it difficult to allocate
basic resources (e.g. equity) to each line of business because insurance
 The Risk Effects of Bank Diversification into Bancassurance 195

companies are required to report long-term business in a separate

account, but shareholders' funds are usually included in the general
business account or a separate balance sheet for regulatory purposes.

Reporting practices
In the United Kingdom, accounting standards rely on SSAPs (State-
ments of Standard Accounting Practice), which set precise accounting
principles, including faithful representation, privilege of substance
over form, and neutrality, prudence and completeness. The prudence
principle particularly applies to the timing of cost and revenue
recognition, where several approaches co-exist (historic cost, market
value, replacement cost). By law, reporting should provide a true and
fair view and should only recognise profits made at the balance-sheet
date. These requirements may not always meet otherwise stated
accounting standards (O'Brien, 1994). Most companies in the United
Kingdom follow Schedule 4 of the 1985 Companies Act which requires
true and fair reporting but insurance companies follow Schedule 9A of
this Act which exempts them from the true and fair concept for given
items. These differences arise from the inherent nature of life assur-
ance where revenues are not pure transactions but contain a large
component of transfer payments (O'Brien, 1994).
The Insurance Companies Act (1982) in the United Kingdom
requires that life assurance transactions should be reported in a long-
term business fund. A transfer from that fund to the shareholders'
fund can only be made following an actuarial investigation of the
valuation of assets and liabilities.
The EC Insurance Accounts Directive is aimed at harmonising
insurance accounting in Europe and provides a number of guidelines
to governments and companies. There have been a number of debates as
to the best way to apply the Directive in practice (see Horton, Maeve
and Hoskin (1994) for a detailed discussion). Since 1995, all insurers
have had to present their accounts in a form which satisfies the
requirements of the EC Directive. Some insurers have taken the lead to
introduce changes in their reporting practices. However, in the period
covered by our analysis, most insurance companies still presented
accounts following the 'statutory solvency method' as shown below.
The statutory solvency method follows reporting guidelines of the
UK's Department of Trade and Industry (DTI) for which insurance
companies prepare yearly returns. These regulatory returns are based
on solvency considerations rather than true and fair representation of
196 Bancassurance

profits (O'Brien, 1994). There might be slight differences between the

reporting in annual reports and DTI returns, as the latter require each
separate entity to fill in returns, while companies produce annual
reports on a consolidated basis. In their annual reports, insurance
companies report their long-term business in the long-term revenue
account: it summarises the assets, liabilities, expenses and income in
respect of this activity. Profits arising in the long-term business fund
can only be transferred out of the fund following an investigation by an
actuary to determine whether the fund is sufficient to meet the liab-
ilities of the long-term business. Insurance companies have discretion
in determining on which specific assumptions they value liabilities.
The actuarial valuation will also vary according to the mix of business
of individual companies (KPMG-Peat Marwick, 1992). There is no
compulsory requirement to disclose an actuarial report. Another dif-
ference among companies is the recognition of profits on life con-
tracts: while British regulators recently appeared to favour an accrual
basis which recognises risk at each stage, insurance companies have
traditionally widely differed in the timing of recognition of premiums
and claims (KPMG-Peat Marwick, 1992). Likewise some discretion
is allowed in the recognition of insurers' investment income and
especially capital gains or losses.
These peculiarities of insurance accounting have a particular impact
on the determination of a profit figure. Insurance company directors
have discretion in determining the amount of the transfer from the
long-term business fund. The surplus arising from the long-term fund
can be allocated in three different ways:

1. It can be retained in the long-term business fund.

2. It can be transferred to with-profit policyholders in the form of
bonuses. Under conventional with-profit contracts in proprietary
companies, total distributed surplus is shared between policy-
holders and shareholders, usually in the ratio of nine to one
(O'Neill, 1993).2
3. It can be transferred to shareholders in proprietary companies.

As with-profit transfers are regulated under that 90-10% distribution,

it is likely that directors try to manipulate the growth of the surplus to
give a steady rate on bonuses. This leads to profits being smoothed
and obscures the performance in a particular year. Where business is
growing (new premiums), surplus is likely to be understated (KPMG-
Peat Marwick, 1992).
 The Risk Effects of Bank Diversification into Bancassurance 197

The above analysis shows that the statutory solvency method may
not provide a true picture of the performance of a life insurer in a
particular period. Banks have been particularly keen on an alternative
approach, the embedded value approach, to recognise profits from
their life assurance subsidiaries. The embedded value is part of the
total value of the life company. The Institute of Actuaries Working
Party (1990) gave the following definition of embedded value:

(a) the discounted value of those present and future surpluses which
are expected to be generated in respect of presently in-force busi-
ness within the statutory long-term business fund and to be trans-
ferable (after allowing for all relevant taxes) to the profit and loss
account, and
(b) the value of net assets held outside the long-term business fund
which are available for the purposes of the company's long-term
business.

The embedded value profits include the profit transferred under the
statutory solvency method plus the increase in the shareholders' value
of long-term business after the profit transfer, that is part (a) of the
above definition (O'Brien, 1994). The total embedded value profit is
then obtained by the addition of profits in the shareholders' fund.
Banks have found this approach adequate because it avoided mixing
assets and liabilities of a different nature in their consolidated balance
sheet. They could therefore show the profitability of their investment
under a different item. This 'bancassurance' approach may not be
sustained, however, because the 'embedded value' approach openly
conflicts with accounting principles as it recognises future rather than
past performance. It is, however, a step by the life industry to make
accounts more adequate for use by investors. The accruals approach,
which represents a compromise between the two approaches described
before is supported by the Association of British Insurers (Horton,
Maeve and Hoskin, 1994). In the 1993 regulations, the ABI laid out the
basis for two new reporting approaches. To comply with the modified
statutory solvency method, profit under the statutory solvency method
must be adjusted for any movement in deferred new business acquisi-
tion costs and movements in certain reserves attributable to share-
holders held within the long-term fund for solvency purposes (ABI,
1995). The ABI admitted that this method (aimed at solvency
requirements) does not recognise all shareholders' interests in expect-
ed future cash flows to the business from contracts which have been
198 Bancassurance

written, so that further adjustments are necessary. The second basis set
out in the exposure draft of the ABI (1995) is labelled the achieved
profits method, and aims at recognising profit as it is earned over the
life of an insurance contract. In contrast with the modified statutory
solvency method, the timing of profit recognition does not depend
directly upon the emergence of statutory surplus or the incidence or
amount of bonus distribution. The method recognises as profit the
cash release from the fund together with the estimated additional
movements in shareholders' interest in expected future cash flows from
insurance contracts in force, and the investment return on assets not
included in the cash release (ABI, 1995). Both methods are intended
for an experimental use by proprietary insurers. Although, we would
have been keen in this research to use such alternative approaches, it
would have been inconsistent among firms as few have included such
values in their accounts up to now. Most companies report their results
following the statutory solvency method. We therefore use data which
has been calculated using this reporting method, while recognising the
income smoothing practices of life insurance companies.

Designing proxies for life insurers' performance

We have shown that reporting practices in life assurance differ widely
from usual corporate practices. Moreover, the presence of mutuals in
the industry makes it difficult to appraise profits in the same way as for
proprietary companies. In addition, most life insurers are composites;
it is therefore impossible to obtain a precise figure for the amount of
equity backing long-term business. In this section, we design two
proxies for profits and equity that allow comparisons to be made
between mutual and proprietary performance as well as between life
insurers and banking institutions.
There is no direct figure available in insurance companies' accounts
for equity, as most life insurers are in fact composites, which also
conduct general business. Equity is not disaggregated among these
separate lines of business. However, the DTI requires companies to
submit statements of solvency from which we can estimate the portion
of assets that can be allocated for solvency purposes. Figure 7.1 shows
an example of Form 9 of the returns to the DTI.
We are interested in Item 25 in the Form, i.e. 'available assets for
long-term business required minimum margin'. This is computed as
long-term admissible assets plus other than long-term business assets
allocated towards the long-term businesses required minimum margin
 The Risk Effects of Bank Diversification into Bancassurance 199

(i.e. for proprietary insurers net assets, that are often matched with
paid-up share capital) minus mathematical reserves and other liabil-
ities. Mathematical reserves represent the amount the actuary deter-
mines the insurer needs to meet claims. Therefore, net assets are a
broad estimate of equity, based on the difference between assets and
liabilities.
Although this measure may not appear like a direct estimate of
equity, it is consistent for both mutual and proprietary life insurers. It
gives us an idea of the capitalisation of these institutions, although this
may encompass other items than strict equity. However, the con-
servative appreciation of assets by insurers means that net assets are a
reasonable estimate of equity. One might argue whether we should
extract the portion of equity that belongs to policyholders. However,
as policyholders can be viewed as shareholders of mutuals, it appears
fair to include all available assets to estimate equity, so as to examine
capitalisation on a common basis for both types of institutions.
One of the difficulties faced in assessing available assets is to obtain
data that are comparable with the figures stated in annual reports. In
particular, insurance groups present a consolidated long-term balance
sheet and income statement. However, DTI returns must be com-
pleted for each subsidiary company separately. It may be difficult in
some instances to reconcile both sets of accounts. Large companies
have foreign subsidiaries, whose results might be included in the
annual reports but which are not required to be in the DTI returns.
Therefore our available assets proxies might slightly underestimate
equity for those larger companies in particular. We do not expect that
this should significantly affect our results.
Proprietary companies generally disclose a figure for shareholders'
profits before and after tax for long-term business. They obtain a pre-
tax figure, by summing up taxes to an after-tax figure (O'Brien, 1994).
This shows that taxation is an artificial process in life insurance and
raises further questions about the validity of profit figures in insurance
accounts.
For mutuals, there is no figure for pre-tax or after-tax profits.
Mutual companies usually disclose a surplus figure as a note in their
reports rather than as part of the accounts, as there is no transfer to the
shareholders' account as in proprietary offices. This surplus is there-
fore a measure of the surplus arising during the accounting period and
available for distribution (as bonuses or reserves). This figure of sur-
plus includes bonuses that are allocated to policyholders as part of
with-profit policies. Therefore, surplus figures would overestimate the
200 Bancassurance

Figure 7.1 Example of Form 9 of returns to the DTI

Retums under insurance companies legislation Form 9

Statement of solvency (Sheet 1)
Name of company
Global business
Financial year ended: 31st December 1992

Company GlobaV Period ended For

Registration UK/CM official
Number Units use

1F9 I 1
Day Month 1Year £0001 1

II
GL 31 112 11992 Source

_s
As at the end of As at the end of Form Une Column
the financial year 1 the previous year 2
GENERAL BUSINESS
Available

Other than long term business assets See Instructions 1

allocated towards general business and 2 below
required minimum margin
Required minimum mervin
ReqUired minimum margin for general 12 12.49
business
Excess (deficiency) of available assets 13
over required minimum margin (11-12)
Implid Hems admitted under 14
regulation 10(4) of the Insurance
Companies Regulations 1981
LONG·TERM BUSINESS
Avallable_
Long term business admissible assets 21 10.11
Other than long term business assets 22 See Instructions 1
allocated towards long term required and 3 below
minimum margin
Total mathematical reserves (after 23 See Instruction 4
distribution of surplus) below
Other Insurance and non insurance 24 See Instruction 5
liabilHies below

Available assets for long term business 25

required minimum margin
(21+22-23-24)
Implicit Itema admltlecl under regulation 10(4) of the
Insurance Companies Regulations 1981

Hidden Reserves

Total of available assets and implicH

Hems (25+31+32+33)
 The Risk Effects of Bank Diversification into Bancassurance 201

Required minimum ....rgin

Required minimum margJl1for long term 41 60.13
business

Explicit required minimum margin (116 42

x 41 or minimum guarantee fund H
graater)

Excess (deficiency) of available assets 43

over explicit required minimum margin
(25-42)

Excess (deficiency) of available assets 44

and ,mplicH Hems over the required
minimum margin (34-41)

true profitability of mutual companies as opposed to proprietary

companies that exclude such bonuses from their profit figures.
In proprietary companies, a statutory ratio of one to nine for surplus
arising from with-profit business was mainly caused by the necessity to
compete with mutuals on the terms of their policies (McCrindell,
1981). This meant that no more than 10% could be allocated to
shareholders on these lines of business. One way to compare organ-
isational performance is to consider the true profits of mutuals as 10%
of the distributed surplus. The idea behind this process is to estimate a
profit element of policyholders' dividends, which captures the profits
flowing to policyholder-owners of mutual companies. Arguably, this is
a rough estimate as some companies may not have the majority of
their business in with-profit lines. However, we did not have at our
disposal a comprehensive distribution of business between with- and
without-profit lines to undertake a finer analysis.
Schiller-Myers (1984) followed the same conceptual approach in
order to compare mutual and stock-owned companies' performance in
the United States. She used a model that extracted the portion of
dividends 3 in mutuals that were attributable to profits. Instead of
assuming that this portion was the same for participating and non-
participating policies, similarly to what we do in this research, she
extended the model to account for different lines. The model isolated
the overcharge (policyowners' bonuses) in participating premiums for
stock life insurers: this was labelled the 'redundancy' element. The
reciprocal of this redundancy element was the profit element assumed
in mutuals and was added back to net gain from operations after
dividends (bonuses) to policyholders and tax. This process was under-
taken for all types of policies. In our approach, we assume that this
profit element is uniformly 10% of total surplus. Albeit simplistic, this
is conceptually similar and permits us to compare mutual and pro-
prietary companies' performance.
202 Bancassurance

The 10% rule, albeit imperfect, should provide a fair idea of the
amount that would go to shareholders were mutuals to convert to pIc
status. We will therefore use this estimate as a measure of mutuals' net
income in the remainder of the empirical research.

Data
Banking sample
Chapter 3 described the evolution of bancassurance in the United
Kingdom. This stressed that the main participants in this strategy have
been retail bankers and building societies, both of which are equally
active high street distributors of financial products. The BSA (Building
Societies Association) provided a list of 87 building societies, that were
in existence by the end of 1992. This was the basis for our selection of
building societies.
We selected commercial banks that had been involved in retail
banking, as bancassurance has traditionally been a strategy aimed at
the personal customer. We used the classification in the Quarterly
Bulletin of the Bank of Eng/and (February 1994) as the source of
identification of our commercial banks sample; 16 retail banks were
selected. In fact, most of these commercial banks engaged in ban-
cassurance strategies during the period of study (see Chapter 3).
We used a world-wide financial database, EURA-CD (renamed in
1995 as Bankscope), as the main source of our bank data. This pro-
vides a comprehensive source of accounting data for banking institu-
tions, including building societies. This database provided five-year
data (1988-92) for our sample firms. Not all building societies were
listed on a continuous basis in the database, but we could obtain
information for 66 building societies.
Our final banking sample therefore constituted 82 firms shown in
Table 7.1.
The EURA-CD database displays data on a consolidated as well as
on an unconsolidated basis. We selected data on an unconsolidated
basis, which ensures that we examine the returns from banking
operations and not other securities, insurance or non-banking services.
For all 82 firms, we extracted three accounting items on a yearly basis
over the period 1988 to 1992. These were:

• net income after taxes;

• equity;
• total assets.
 The Risk Effects of Bank Diversification into Bancassurance 203

Table 7.1 Sample retail banks and building societies

Building societies (66) Retail banks (16)

Alliance & Leicester Leek United Abbey National
Barnsley Manchester Bank of Scotland
Bath Investment & Mansfield Barclays Bank
Beverley Marsden Clydesdale Bank
Birmingham Midshires Melton Mowbray Co-operative Bank
Bradford & Bingley Mercantile Coutts & Co
Bristol & West Monmouthshire Girobank
Britannia National & Provincial Lloyds Bank
Cambridge National Counties Midland Bank
Chelsea Nationwide National Westminster
Bank
Cheltenham & Newbury Northern Bank
Gloucester
Chesham Newcastle Royal Bank of Scotland
Cheshire North of England TSB Bank
City and Metropolitan Northern Rock TSB Bank Scotland
Coventry Norwich & Peterborough Ulster Bank
Cumberland Nottingham Yorkshire Bank
Darlington Portman
Derbyshire Principality
Dunfermline Progressive
Earl Shilton Saffron Walden Herts &
Essex
Furness Scarborough
Gainsborough Skipton
Greenwich Staffordshire
Halifax Stroud and Swindon
Hanley Economic Swansea
Harpenden Teachers'
Heart of England Tynemouth
Hinckley & Rugby Universal
Ipswich Vernon
Kent Reliance West Bromwich
Lambeth (UNe) West Cumbria
Leeds & Holbeck Woolwich
Leeds Permanent Yorkshire

These data were used to compute various performance measures that

are used later in the empirical research.
Life assurance sample
Our sample insurance companies include both mutual and proprietary
life insurers. Mutuals are major participants in the life assurance
204 Bancassurance

market in the United Kingdom. By the end of 1992, 13 of the top 30

life insurers as measured by world-wide long-term premiums were
mutuals (Nottingham University, 1994a). Moreover, as financial
deregulation spread in the industry, mutuals became possible acquisi-
tion targets. There have also been recent take-overs which have involved
the demutualisation of the target company (Armitage and Kirk, 1994).
For example, Britannia Building Society acquired the former mutual,
FS Assurance, in 1990. In 1996, Halifax Building Society announced it
would pay £800 million for Clerical Medical (The Economist, 30 March
1996, p. 7). Given the importance of the mutual insurance sector we
thought it important that we included such firms in our analysis.
For data on insurance companies we relied primarily on information
provided by the Nottingham University Insurance Centre. We used
three publications from this Centre including:

• The British Insurance Industry: A Statistical Review 1991/1992, by

Carter and Diacon (1991): including data for the period 1987 to
1989.
• Insurance Company Peifonnance 1992, University of Nottingham
(1992): including data for 1990.4
• Insurance Company Peifonnance 1994, Part II, University of Not-
tingham (1994b): including data for 1991 and 1992.

These publications provided a listing of all significant players in the

UK market, as well as disaggregated data (long-term and general
business) on those companies. In particular, tables displaying available
assets for long-term business of most life insurers for the period 1988-
92 were available. These figures were obtained from Form 9 of the
DTI returns. These provided us with estimates of equity for a large
sample of firms, listed by the University of Nottingham. They are
shown in Table 7.2.
Net income after tax, surplus and total assets were obtained from
the annual reports. A number of annual reports were directly available
in the Institute of European Finance at the University of Bangor and a
mailing was additionally sent to those companies for which reports
were not available for the complete period of study; 21 companies
graciously provided annual reports that allowed us to complete our
dataset. The compilation of these reports provided a sample of 41 life
insurers, 14 of which were mutuals.
 The Risk Effects of Bank Diversification into Bancassurance 205

Table 7.2 Sample of UK life insurers

Mutual life insurers (14) Proprietary life insurers (27)

Clerical Medical Allied Dunbar
MGM Barclays Life
National Farmers Britannic
National Mutual Life Commercial Union
National Provident Institution Comhill
Norwich Union Eagle Star
Reliance Mutual Ecclesiestical
Royal National Nurses Equity & Law
Scottish Equitable General Accident
Scottish Life Guardian R.E.
Scottish Provident Hill Samuel
Scottish Widows Laurentian Life
Standard Life Legal & General
Wesleyan Assurance L10yds Abbey Life
London and Manchester
Pearl
Prolific Life
Provident Life
Prudential
Refuge
Royal Insurance
Sun Alliance
Sun Life
TSB Life
United Friendly
Windsor Life
Zurich Life

7.2 DESCRIPTIVE STATISTICS OF SAMPLE FIRMS

Sample firms as a percentage of total population

Our sample of commercial banks includes a minor percentage of the

total UK banking industry as broadly defined. However, we stressed
that we were only interested in those banks primarily involved in the
retail market. Therefore, the definition of retail banks by the Bank of
England (1993) corresponds to virtually the entire population.
We could not obtain data on all building societies in existence by the
end of 1992 in the EURA-CD database. There were 87 building
societies listed by the Building Societies Association at year-end 1992.
Table 7.3 shows the share of total assets of our sample firms at that date.
206 Bancassurance

Table 7.3 shows that our sample building societies held more than
99% of total assets for all UK building societies, which is a meaningful
coverage of the whole industry. We could obtain data for 41 life
insurers that belonged to the UK's largest 74 companies in terms of
world-wide long-term new business premiums in 1992 (Nottingham
University, 1994a, Table 4, p. 25). There were 234 UK companies that
were authorised to conduct long-term business in Great Britain at the
end of 1992: these included 52 composites and 182 life-only offices
(DTI Insurance Annual Report, 1992).

Table 7.3 Total assets held by sample building societies in 1992

( societies-only)

Total assets sample Total assets UK Sample firms total assets

building societies building societies as a % of total population
261,395,125 262,496,956 99.58%

Source: Building Societies Association database 1992.

To obtain an estimate of the market share of our sample firms,

we computed their total world-wide premium income (excluding
industrial business). Table 7.4 summarises our findings.

Table 7.4 Share of world-wide ordinary premium income of sample firms in

1992 (in £m)

World-wide ordinary World-wide ordinary Sample firms premium

premium income of premium income of income as a % of total
sample firms all UK companies
38926.83 51090 76.19%

Sources: Insurance Company Performance, University of Nottingham, 1994a; Insurance

Statistics ~arbook 1983-1993, ABI, 1993.

Table 7.4 shows that our sample firms held more than three-quarters
of UK companies' world-wide premium income in 1992.
In summary, the sample comprises 123 firms, including 16 com-
mercial banks, 66 building societies, 14 mutual life insurers and 27
proprietary life insurers. The sample period ran from 1988 to 1992.
For all firms, yearly accounting estimates were obtained for post-tax
profits, total assets and equity. This was the basis for our empirical
research.
 The Risk Effects of Bank Diversification into Bancassurance 207

Asset growth and profitability trends

Table 7.5 shows the average size of each subsample at the end of the
first and last year of the period under study, 1988-92. The last row
shows the growth rate over this period. We compute the average
growth rate as the average of individual firms' growth rates.

Table 7.5 Average size at year end 1988 and 1992 and evolution (in £m)

Building Commercial Mutual life Proprietary

societies banks insurers life insurers
Average total assets 2140 22507 3781 4001
(end 1988)
Average total assets 3898 34777 6852 6654
(end 1992)
Average growth +41% +36% +75% +83%

Table 7.5 illustrates features of the banking and life insurance

industry. First, we observe that commercial banks are, on average,
considerably larger than the building societies in our sample. This
hardly comes as a surprise, given that we included 66 building socie-
ties, most of which were known to be relatively small institutions.
We also observe that the typical mutual life insurer is very similar
in terms of size to the typical proprietary life insurer, both at the
beginning and end of the period. On average, life insurers are five
times smaller than the typical commercial bank and approximately
twice the size of the typical building society in 1988. These ratios
improve marginally in favour of life insurers over the period as the
latter experience greater growth rates than their banking counterparts,
as can be seen in the last row of Table 7.5. This computes the typical
growth pattern of firms in the subsamples, that is the average of in-
dividual firms' growth. We find that the typical commercial bank
experienced an increase of +36% in total assets over the period 1988
to 1992. The increase is slightly higher, +41%, for the typical building
society. In the meantime, mutual insurers grew by 75% and proprie-
tary life insurers by 83%.
Average premium growth rates in life assurance have been higher
than 10% per year over the period 1986-91 (Hoschka, 1994). This
must be put in parallel with a slower bank growth. One might wonder
whether there has been some form of savings transfer between the two
208 Bancassurance

Table 7.6 Yearly return on assets of sample firms over the period

}ear Building Commercial Mutual life Proprietary

societies banks insurers life insurers
1988 0.824% 0.855% 0.398% 0.548%
1989 0.923% 0.503% 0.370% 0.628%
1990 0.778% 0.644% 0.410% 0.711%
1991 0.637% 0.551% 0.356% 0.657%
1992 0.573% 0.506% 0.310% 0.571%

industries. The above analysis perhaps suggests that bank involvement

in bancassurance has been an attempt to reap the benefits of a fast
growing industry. Table 7.6 summarises the average return in each year
of the period for the subsamples. Average return on assets is com-
puted as the simple mean of the return for each firm of the subsample
in that year.
Table 7.6 suggests clear-cut patterns in the bankinglbuilding society
industries. In particular, it suggests that banking profitability followed
a downward trend over the period, mainly resulting from the economic
recession and downturn in the property market experienced by the
UK economy between 1989 and 1992. Life insurers experienced a
peak in profitability in 1990 but have seen returns on assets decrease
after that date. This may suggest that the costs associated with asset
growth have been substantial. This is particularly true in life assurance
business, where accounting practices tend to allocate most costs re-
lating to a policy at the beginning while revenues are collected over a
longer period of time. Where business is growing (which our data
suggest occurred over the period), a firm can experience a paradoxical
'loss' from the new business strain (O'Brien, 1994). Moreover, in the
case of mutuals, the major source of growth financing is reserves.
Therefore, surplus will be lower where growth is higher.
The above analysis illustrates two opposite patterns of both
industries over the period. Life assurance experienced substantial
growth which perhaps made the industry particularly attractive to a
'relatively' depressed retail banking market. These results provide an
interesting element in the study of bancassurance developments. They
give some basis to the hypothesis that bancassurance might be a
defensive strategy. However, we find that life insurers experienced a
decrease in rates of return starting in 1990. The latter could be related
to the costs of growth and to life~assurance ac;counting practices.
 The Risk Effects of Bank Diversification into Bancassurance 209

Sample performance

In this section we examine the risk and return performance of banks,

building societies and the two types of insurance companies (mutual
and proprietary). Table 7.7 presents summary statistics for these
institutions and also shows tests for the differences between the per-
formance of these various firms. Five variables are examined: average
return on total assets, standard deviation of returns, coefficient of
variation of returns, Z-score and average equity-to-assets ratio. In the
remainder of this section we examine the significance of the differ-
ences within each industry (between building societies and commercial
banks and between mutual and proprietary life insurers) as well as
differences between banking institutions and our subsample of life
insurers. We conduct two-sample (-tests to test for the differences
between the means of the subsamples.

Table 7.7 Risk and return characteristics of sample firms and differences
between the different subsamples

Average a COV Z·score Average

ROA E/A
Building societies 0.747% 0.00202 0.285 52.62 5.837%
Commercial banks 0.612% 0.00322 1.451 5 27.10 6.458%
Mutual insurers 0.369% 0.00058 0.164 365.9 18.28%
Proprietary insurers 0.623% 0.00254 0.278 231.8 14.79%

A(BS-CB) 0.00135 -0.00120" -1.166 25.52" -0.00621

(1.16 ) (-2.41) (-1.51) (3.61) ( -1.25)
A(MLI-PLI) -0.00254* -0.00196" -0.114 134.1 0.0349
( -2.34) ( -3.34) (-0.95) (1.68) (1.05)
A(BS-MLI) 0.00378" 0.00144" 0.121 " -313.28" -0.1244*
(9.28) (7.04) (3.91) (-5.36) ( -4.90)
A(BS-PLI) 0.00124 -0.00052 0.007 -179.\8" -0.08953"
(1.17) ( -0.84) (0.05) (-3.27) ( -4.16)
A(CB-MLI) 0.00243 0.00264" 1.287 -338.8" -0.11822"
(2.04) (5.69) (1.05) (-5.82) (-4.60)
A(CB-PLI) -0.00011 0.00068 1.173 -204.7* -0.08332"
( -0.07) (0.93) (0.57) (-3.75) ( -3.82)

( ): (·statistic *: significant difference at the 95% confidence level;

BS: building societies; CB: commercial banks; MLI: mutual life insurers;
PLI: proprietary life insurers.
210 Bancassurance

As is illustrated in Table 7.7, there are significant differences

between the performance of building societies and commercial banks.
A quick observation of the summary statistics for both subsamples
shows that, on average, building societies were more profitable, less
risky although less well capitalised than commercial banks. However,
differences between the two subsamples are only significant (at the
95% confidence interval) for two risk variables: the standard deviation
of returns and Z-score measure. Both measures indicate that building
societies are significantly less risky than commercial banks.
These observations, combined with the analysis of the average size
of these institutions suggests that we should conduct the analysis of the
impact ofbancassurance on these institutions separately. These results
confirmed reports of difficulties at commercial banks over the period
and also on relatively high rates of return being earned by building
societies: 'Building societies are UK's strongest and most profitable
financial institutions, leaving the banks and insurance companies
trailing' (RBI, 13 January 1993).
Table 7.7 shows that mutual life insurers were on average less
profitable, more highly capitalised and less risky than proprietary life
insurers. These results are consistent using all three measures of risk.
However, the difference is significant (at the 95% confidence interval)
for only two variables: return on assets and standard deviation of
returns on assets. These results are in agreement with the common
belief that mutuals are less risky than their privately owned counter-
parts. This was explained in the United States by the fact that mutuals
have traditionally a higher proportion of participating policies (low-
risk) compared to proprietary firms (Lamm-Tenant and Starks, 1993).
Our treatment of surplus (using 10% as a measure of profits) may also
slightly underestimate mutuals' profitability. The seemingly higher
equity ratios of mutuals - although not significantly larger than their
proprietary counterparts - can be explained by the fact that these
institutions have to rely on reserves to sustain growth.
These results suggest that the return on assets and risk (measured as
the standard deviation of returns) of mutual life insurers and pro-
prietary life insurers is significantly different. Therefore, the outcomes
of simulations for one or the other sample should be different. We
propose accordingly to examine both subsamples separately in the
remainder of this chapter.
One of the main differences between banking subsamples and life
insurers is that the latter have considerably higher equity-to-assets
ratios. Given the way Z-scores are constructed, this leads to higher
 The Risk Effects of Bank Diversification into Bancassurance 211

values of Z-scores for life insurers. Z-scores are computed as the sum
of average return and average equity-to-assets ratio divided by
standard deviation of returns. We emphasised previously that our
equity proxy could be an overestimate for life insurers. Even though
this might be the case, the difference between the two subsamples is
large enough to support this finding, i.e. life insurers are better capital-
ised than their banking counterparts. O'Brien (1994) criticised the
excessively prudent view of life insurers, that leads them to keep
higher reserves than seem necessary from a solvency point of view. For
all four pairwise comparisons (building societies and mutual life
insurers, building societies and proprietary life insurers, commercial
banks and mutual life insurers and commercial banks and proprietary
life insurers), we find that differences between the mean equity-
to-asset ratios are significant at the 95% confidence level, suggesting
that life insurers are better capitalised. We also find significant dif-
ferences between mean Z-scores, suggesting that life insurers are less
risky.
Another interesting result was that all five measures were sig-
nificantly different for building societies and mutual life insurers.
These figures indicated that building societies were significantly more
profitable. riskier and had lower capitalisation than mutual life
insurers. This suggested that there might be risk-reducing opportun-
ities in the merger of both types of firms. although it could be at the
expense of profitability.
Finally, the comparison between commercial banks and mutual life
insurers shows that risk patterns are significantly different when
measured by either standard deviation of returns or Z-score. This
stems mostly from the fact that mutuals have significantly lower vo-
latilities of returns than any of the other subsamples. However, this is
not reflected in the differences between the coefficient of variation of
returns (i.e. volatility adjusted for returns) except when compared with
building societies. This is because mutual life insurers constitute the
least profitable subsample.
The following figures show the risk-return trade-off for each of the
four subsamples. Figure 7.2 uses standard deviation as a risk indicator,
Figure 7.3 uses coefficient of variation of returns and Figure 7.4 uses
the Z-score. All are depicted against average return on assets.
Figures 7.2 to 7.4 clearly indicate that the best risk-return trade-off
is achieved by building societies, as they have high profitability while
maintaining relatively low risk, measured by all three measures.
Conversely, mutual life insurers achieve relatively low profitability but
212 Bancassurance

Figure 7.2 Risk-return trade-off of subsamples using standard deviation

of returns

0.0075 - o
~ 0.0065 -
~
o
CD
~ 0.0055 -
o building societies
~ o commercial banks
0.0045 -
<> mutual insurers
0.0035 -~<>---'r------.------r---' I:!. proprietary life insurers
I I

0.001 0.002 0.003

Standard deviation

Figure 7.3 Risk-return trade-off of subsarnples using coefficient of variation

0.0075 - 0

E 0.0065 -
::I
~ 0
CD
Cl 0.0055 -
E!!
CD o building societies
~
0.0045 - o commercial banks
<> mutual insurers
0.0035 <> I:!. proprietary life insurers

0.0 0.5 10 15
Coefficient of variation

have the lowest level of risk, using all three risk variables. Commercial
banks appear the riskiest firms while achieving only moderate returns.
Finally, proprietary life insurers achieve moderate profitability and
risk.
Overall, the comparison between the performance of the four
subsamples suggests a number of points. First, mutual and proprietary
life insurers have significantly different risk-return patterns. In the
same way, commercial banks and building societies appear to have
significantly different risk patterns: the former is significantly riskier
than the latter according to two risk variables, standard deviation of
 The Risk Effects of Bank Diversification into Bancassurance 213

Figure 7.4 Risk-return trade-off of sample firms using Z-score

0.0075 - 0

E 0.0065 -
::3
"§.1 0
Q)
Cl 0.0055 -
!!!
Q) o building societies
~
0.0045 - o commercial banks
<> mutual insurers
0.0035 -.,...---,-----.----.,..--<>--,-1 6. proprietary life insurers
0 100 200 300 400
Z-score

returns and Z-score. This suggests that the four subsamples should be
treated separately in our analysis of the potential risk effects of
combinations between the retail banking and life assurance sector.
Second, the single most significant pairwise difference appears
between building societies and mutual life insurers. This suggests
significant potential diversification benefits through the combination
of these two subsamples. Finally, life insurers appear to have signific-
antly higher equity ratios than their banking counterparts. Although
the difference appears quite large, this finding is in line with others'
observations. For example, the chairman of the French Insurance
Association commented that bancassurance was an alibi for banks in
need of equity (Pitts, 1991).
We also examined the correlation of returns between commercial
bankslbuilding societies and mutual life insurers and proprietary life
insurers. These are computed as the average of the individual corre-
lations between each firm of the subsamples. This should provide an
indication of how the performance of the respective sectors was
related over the 1988-92 period and whether there was strong po-
tential for diversification benefits.
Table 7.8 presents the average correlation of return on assets
between all four types offinancial institutions. It also shows an indicator
of the dispersion around the mean correlation coefficient. The table
indicates that the returns between banking institutions and life
insurers were largely uncorrelated over the period 1988-92 suggesting
strong diversification benefits.
214 Bancassurance

Table 7.8 Correlation between returns of banking institutions and life insurer
(1988-92)

Mutual life insurers Proprietary life insurers

Building 0.25485 -0.01065
societies (0.5260) (0.5475)
Commercial 0.26512 0.004328
banks (0.5012) (0.5438)

( ): dispersion indicator (standard deviation).

All four average correlation coefficients are close to 0, indicating

that there was little relationship between the patterns of returns
between the two industries. However, the significance of this corre-
lation is undermined by the fact that individual correlation coefficients
range over a large interval. The index of dispersion (standard devia-
tion) is substantial, given that the overall range is [-1;1], and yields
around 0.5 for each possible combination. This suggests that there
might be combinations of individual firms for which the correlation of
returns is very high.
This analysis nevertheless suggests that, on average, risks in life
assurance and retail banking are non-concurrent. This could arguably
enable some commercial banks or building societies to reduce the
variability of their earnings by combining with specific life insurers.

7.3 RESULTS

The first step in the merger simulation approach consisted of selecting

each bank with each insurer and summing up their assets, income and
equity for each year between 1988-92. From the times series of returns
obtained, the average return on assets, standard deviation of returns,
coefficient of variation, average equity-to-assets ratio and the Z-score
for each hypothetical combination were computed. The average
equity-to-assets ratio was used to compute the third measure of risk,
Z. Each hypothetical industry was therefore composed of n x m
hypothetical firms, n being the number of banking institutions (banks
and building societies), and m the number of life insurers. Table 7.9
summarises the number of simulated hypothetical firms for the various
combinations of our sample banking and life assurance firms.
 The Risk Effects of Bank Diversification into Bancassurance 215

Table 7.9 Number of firms in the four simulated industries

Hypothetical industry Number of finns

Building societies-mutual life insurers 924

Building societies-proprietary life insurers 1782
Commercial banks-mutual life insurers 224
Commercial banks-proprietary life insurers 432

Table 7.10 Risk-return characteristics of the simulated mergers - comparison

with banking firms on a standalone basis

Average ROA (T COV Average E/A Z

BS alone 0.747% 0.00202 0.285 5.837% 52.62

BS-MLI 0.470% 0.00086 0.185 14.21% 257
(11.09)* (6.01)" (3.80)* (-24.25)* (-22.25)*
BS-PLI 0.664% 0.00181 0.23 12.40% 196
(3.16)· (1.06) (0.98) ( -20.07)* (-17.29)*
CB alone 0.612% 0.00322 ] .451 1 6.458% 27.10
CB-MLI 0.511% 0.00254 4.3 9.24% 74.4
(0.86) (1.44) ( -0.86) ( -5.75)* (-6.44)*
CB-PLI 0.590% 0.00265 1.08 9.11% 67.6
(0.19) ( 1.23) «(J.48) ( -5.38)· (-7.30)*

( ) : t-statistic *: significant difference at the 95% confidence level;

BS = building societies; CB = commercial banks; MLI = mutual life insurers;
PLI = proprietary life insurers.

The summary statistics for the four hypothetically merged industries

are shown in Table 7.10. This also shows the t-test statistic of the
difference between the means of the hypothetical industry and the
banking industry on a standalone basis.

Hypothetical industry 1: building societies-mutual insurers

The results suggest that mergers between building societies and mu-
tual life insurers would significantly reduce risk. There is a significant
difference between the means of the average risk of the building
societies industry on a standalone basis and that of the hypothetically
merged industry, measured by all three risk variables. Our simulations
suggest that building societies could achieve significant risk-reduction
through merger with mutual insurers. For example, the results sug-
gest that the building society industry could decrease risk by 58%,
216 Bancassurance

measured by the standard deviation of returns, and by 34% measured

by the coefficient of variation of returns. However, this risk-reduction
would be accompanied by a parallel reduction in return on assets of
-38%. The difference between the mean profitability of building
societies and merged firms is significant at the 95% confidence level.
Building societies would also significantly increase their equity ratios,
were they to merge with insurers. In practice, this should have little
bearing on the solvency requirements of either sector, as regulators
require asset separation.

Hypothetical industry 2: building societies-proprietary life insurers

The results suggest that any risk-reduction stemming from the com-
bination of building societies and proprietary life insurers would be
insignificant, measured by the standard deviation of returns. This is
an interesting conclusion given the fact that proprietary insurers
appeared riskier on average than building societies. This suggests that
both activities have uncorrelated returns. 6
Results using the Z-score indicate that combinations of building
societies and proprietary insurers would result in significant risk-
reduction. However, this seems to be a direct consequence of the high
equity ratios of life insurers. The third risk measure, coefficient of
variation of returns, indicates a non-significant risk increase.
The profitability of the typical merger would be significantly lower
than the typical building society's profitability. This indicates that the
merger process leads to a decline in terms of profitability. Overall,
these results suggest that mergers between building societies and
proprietary insurers are unattractive as they appear to significantly
lower returns, while there is only slight evidence of risk-reduction.

Hypothetical industry 3: commercial banks-mutual life insurers

The simulations of mergers between commercial banks and mutual life

insurers display lower risk characteristics than commercial banks for
all three risk measures. They also display lower average returns and
higher equity ratios. However, the differences observed are not sig-
nificant for either average return, standard deviation or coefficient of
variation. The results suggest a significant increase in equity-ta-assets
ratio and Z-score. Again, the sharp increase in Z-score (which implies
a sharp risk-reduction) appears mainly because of high equity ratios.
 The Risk Effects of Bank Diversification into Bancassurance 217

This combination yields some risk-reducing effects, but these are not
significant for two risk variables.

Hypothetical industry 4: commercial banks-proprietary life insurers

The simulations of mergers between commercial banks and propri-

etary life insurers lead to similar results to those with mutual life
insurers. There is a slight reduction in returns which is accompanied
by a small decrease in risk measured by all three risk variables.
However, none of the variables change significantly, except the equity-
to-assets ratio and Z-score. Equity ratios would be significantly in-
creased by the merger process but we doubt that banks could exploit
this increase to its full potential, as they are forbidden (because of
asset separation rules) to do so under current laws. Results using the
Z-score risk indicator suggest a significant reduction in risk but again
this appears to be mainly dependent on higher equity ratios. Overall
this combination suggests slight risk-reducing effects.
Figures 7.5 to 7.7 show the risk-return trade-off using three mea-
sures of risk for the combined industries and the banking industries on
a standalone basis. This should provide a graphical indication of the
relative positions of these industries and the potential gains brought
about through hypothetical mergers.
Figures 7.5 and 7.7 illustrate that potential risk-reduction benefits
exist for all combinations, while Figure 7.6 shows that gains are
questionable using the return-adjusted measure of risk (coefficient
of variation). The most significant deviation from the standalone

Figure 7.5 Return (standard deviation) positions of the simulated industries

0.0075 o o Building societies

1 • Building societies-

•
c:
~ Proprietary insurers
~ 0.0065 ® Building societies-
Q)
C) Mutual insurers
~
CI)
o Commercial banks
~ 0.0055 • Commercial banks-
Proprietary insurers
181 Commercial banks-
® Mutual insurers
0.0045
0.001 0.002 0.003
Standard deviation
218 Bancassurance

Figure 7.6 Return (coefficient of variation) positions of the simulated

industries

fI
0.0075 - o Building societies
• Building societies-

•
c:
=:; Proprietary insurers
~ 0.0065 - ® Building societies-
CD Mutual insurers

.~
CI
I!!
CD
o Commercial banks
~ 0.0055 - • Commercial banks-
Il!I Proprietary insurers
Il!I Commercial banks-
0.0045
® Mutual insurers
0 2 3 4
Coefficient of variation

Figure 7.7 Return (Z-score) positions of simulated industries

0.0075 0 o Building societies
• Building societies-

•
E Proprietary insurers
~ 0.0065

0,\
® Building societies-
CD
CI Mutual insurers
I!! o Commercial banks
~ 0.0055 • Commercial banks-
Il!I Proprietary insurers
Il!I Commercial banks-
0.0045
® Mutual insurers
0 50 100 150 200 250
Z-score

industries is the combination of building societies and mutual life

insurers. Another interesting aspect of the above figures is that they
show that risk-reduction is always accompanied by a sacrifice of
profitability.
In general, the results using the merger simulations approach sug-
gest that mergers between building societies and mutual life insurers
would lead to a significant risk-reduction (-58% measured by the
standard deviation of returns) although this would be accompanied by
a significant decrease in returns (-38%). This combination appears
therefore attractive in terms of risk-reduction. The mergers of building
 The Risk Effects of Bank Diversification into Bancassurance 219

societies with proprietary life insurers, however, are more ambiguous

in terms of risk. Measured by the coefficient of variation of returns,
this would increase, although not significantly. However, mergers
would result in a significant decrease in returns. Overall, this combi-
nation appears the least attractive from a risk/return standpoint.
Mergers between commercial banks and mutual insurers would
arguably decrease risk, which would be accompanied by reduced re-
turns. However, these reductions are not statistically significant in
either case. The same holds for mergers of commercial banks with
proprietary life insurers. For both types of mergers, however, results
suggest a significant decrease in risk, using the Z-score risk measure,
as well as a significant increase in the equity-to-assets ratios.
Overall, the most attractive mergers appear to be those between
building societies and mutual life insurers. Risk-reduction appears to
be at the expense of profitability; however, mutuals might have to rely
less on reserves to finance growth were they to be taken over, there-
by altering their surplus distribution policies. In contrast, mergers
between building societies and proprietary life insurers seem the least
attractive combination in the sample. Finally, mergers of commercial
banks with either mutual or proprietary insurance firms seem to
generate risk-reduction although this is not statistically significant. All
results using Z-score suggest significant risk-reducing effects. The
main conclusion that can be drawn from these simulations is that
bancassurance expansion does not threaten risk positions of banking
institutions and at the least may yield mild risk-reducing effects.

CONCLUSION

This chapter reports the results of an empirical simulation of mergers

between banks/building societies and life insurers. The methodology
was aimed at providing a lower-bound estimate of the diversification
effects of bancassurance strategies in the United Kingdom. We found
no evidence of risk-increasing features of this strategy but some evid-
ence that mergers between building societies and mutual life insurers
in particular could generate significant risk-reduction although this
was shown to be at the expense of profitability. Arguably, the cross-
selling benefits of bancassurance were not modelled in our empirical
research and these might have had positive effects on the risk-return
trade-off of this strategy. The above analysis also suggests various
avenues for future research, including further investigation into the
220 Bancassurance

firm-specific effects of bancassurance as well as the synergies gener-

ated through bancassurance strategies.

Notes
1. See University of Nottingham (1994).
2. Not all policies are with-profit, therefore some profits can be 100%
allocated to shareholders. For a discussion of this issue, see O'Neill, 1993.
3. In the United States, policyowner dividends for mutuals refer to the
British concept of bonuses.
4. We would like to thank Mr Tim Orton who provided us with data on
long-term assets and margins for 1990 which were not included in this
publication.
5. This is based on 15 banks. We dropped Co-operative Bank from the
sample as it had a large negative coefficient of variation that substantially
biased the sample mean downwards.
6. This is confirmed in our computations (see section 7.2).
8 Regulatory Issues

INTRODUCTION

This chapter outlines the regulatory environment that has evolved with
the growth of bancassurance and also considers recent issues con-
cerning the regulation of financial conglomerates. The first part of the
chapter examines trends in the regulation of the financial services
industry in recent years and then goes on to review the regulations
pertaining to bancassurance in various European and non-European
countries. The remainder of the chapter examines the scrutiny under
which bancassurance has been placed in recent years and the issues
relating to the supervision of financial conglomerates. We outline the
main features of the new types of regulations that are likely to be
introduced to handle the increased mingling of banking and insurance
businesses.

8.1 REGULATORY TRENDS IN THE FINANCIAL SERVICES

INDUSTRY

The last two decades have been characterised by the deregulation

of financial services and markets in many economies. In parallel to
deregulation, new regulations have been put into place that have
aimed in particular at the re-capitalisation of banking institutions.
These regulatory trends have been well documented and this section
just seeks to summarise the main changes that have taken place.
Steinherr (1990) has identified two major factors that led to a
substantial deregulation of the banking sector in the 1980s:

1. The increasing internationalisation of non-financial sectors.

2. The obsolescence of existing regulations.

Steinherr argued that the latter prompted banks to concentrate their

innovation potential on circumventing regulations. These combined
factors forced regulators to rethink their approaches in order to keep
control over financial markets.

221
222 Bancassurance

Steinherr proposed a framework that relates the evolution of eco-

nomic structures to the major changes of this period including inter-
nationalisation, deregulation, de specialisation, and innovation. Figure
8.1 summarises these relationships. The interrelations between these
factors have contributed to reshape the financial sector. National and
international efforts have been made to adapt regulations to this new
environment and in tum have had a significant impact on the despe-
cialisation of financial institutions.
Lubochinsky and Metais (1990) emphasised the effects of regula-
tion-induced innovations (described by Silber, 1975) as a motive for
deregulation. They also stressed the concern of regulators to increase
efficiency and flexibility in order to increase the contribution of the
financial sector to economic performance. Finally, national regulators
have had to reinforce the international competitiveness of their
financial intermediaries, in order to avoid regulatory arbitrage. This
has led to competitive deregulation world-wide. These regulatory
changes have occurred at the product as well as institutional level. At
the product level, a major change occurred when most countries
relaxed interest rates ceilings. In the United States, Regulation Q was
phased out gradually up to 1986 (Steinherr, 1990). In the United
Kingdom, the last set of ceilings (known as the Corset) were removed
in 1980 (Chrystal, 1992). In France, complete liberalisation of time
deposit rates occurred in 1986 (de Boissieu, 1990).
Structural changes resulted in a substantial breakdown in
demarcation lines between particular business areas in most banking
jurisdictions during the 1980s. For example, building societies in the
United Kingdom were allowed to offer much of the same services as
banks from 1986 onwards and 'Big Bang' in the City of London
allowed banks to own brokers on the Stock Exchange. Similarly, in
France, the monopoly of stockbrokers was removed in 1988. As far as
European countries were concerned, the impact of 1992 had been
crucial to this liberalisation process. As the European Union decided
to open the frontiers to financial services, regulators chose to adopt
the universal banking principle, whereby banking and commerce
could be conducted jointly (Steinherr and Huveneers, 1992 and EC
1997).
In parallel to these deregulatory moves, re-regulation took place at
the international level. This was prompted by the need to ensure that
banks' foreign operations were not escaping supervision. In 1978, the
Bank for International Settlements (BIS) endorsed the proposal that a
bank's capital adequacy should be monitored ~m a consolidated basis
 Regulatory Issues 223

Figure 8.1 Trends in financial markets

Evolution of
financial structures ~
..

Main features of:

1. Financial innovations:
Rapid growth of Euromarkets
Syndicated loans
Securitisation and disintermediation
Features. options and derived products
Swaps

2. Despecialisation
Universal bank model spreads
Banking and insurance are being combined
Securities trading and broking tend to combine
New specialised competitors merge from non-financial sector
Growth of specialised boutiques in financial sector

3. Internationalisation
Above-trend growth of trade finance
International issuing. placing and trading of securities
Fund management growingly international
Internationalisation of payment systems
International acquisitions and mergers

4. Deregulation
Limited branch banking and separation between commercial and investment
banking in decline (US and Japan)
Capital controls in retreat (France. Italy. UK)
Deposits rates liberalised
Credit ceilings eliminated or reduced (France)
New products admitted (futures. options. money market instruments)
Fixed commissions and fixed (national) membership or management for
bond issues revised (Germany. Switzerland)
Stock exchange regulations revised (big Bang)

Source: Kluwer Academic Publishers, "Financial Institutions in Europe

under New Competitive Conditions", 1990, Chapter V, by A. Steinherr, p.52,
edited by Fair & de Boissieu, copyright 1990, with kind permission from
Kluwer Academic Publishers and A. Steinherr.
224 Bancassurance

(Steinherr, 1990). In 1988, the Basle agreement set risk-based capital

adequacy rules for banking authorities of the major industrial coun-
tries (Key and Scott, 1992).
Deregulation has reshaped the face of the financial services industry
over the last two decades. It has taken place to keep up with the
globalisation of markets and create a regulatory level playing field
between countries. Continued innovations have been used by banks as
a means to escape regulatory control, and regulators have tried to
recapture control over financial markets through liberalisation mea-
sures, as well as stricter prudential rules. These factors have con-
tributed to the modem day financial environment where institutions
enjoy more structural freedom but are forced to comply with stricter
capital adequacy and other prudential rules. These two forces have
commonly been referred to as structural deregulation and supervisory
re-regulation. The former refers to the liberalisation of financial
markets - the breakdown in demarcation lines between particular
business areas. The latter refers to the fact that, if one allows fmancial
institutions to undertake business activities in areas which are new to
them, they must do so in a safe and proper manner, hence increased
supervisory requirements. In particular, bancassurance is a product of
structural deregulation.

8.2 REGULATIONS AND BANCASSURANCE

There are three main categories of regulations that govern cross-

industry penetration such as bancassurance: regulations regarding
production, distribution and ownership of a bank or an insurer.

Regulations pertaining to production

Regulators in most countries forbid the production of insurance

products by banks and vice versa. Hoschka (1994) suggested that the
most compelling argument for this strict separation is the fear that
banks may use the long-term reserves of life assurance to satisfy short-
term liquidity needs. Supervisors may find it hard to enforce the
segregation of capital between both activities if no legal separation of
entities exist between the two activities. This same argument is used to
justify the separation of long-term and general insurance. In practice,
regulators have found it preferable to forbid in-house production, and
to require that the activities should be conducted in two legal entities,
 Regulatory Issues 225

one of which however, could be the parent. A survey by the OECD

(1992) found that both banks and insurers are prohibited from pro-
ducing insurance and banking products, respectively in the former 12
EC members, Japan and the United States.

Regulations pertaining to distribution

Distribution of insurance products by banks is allowed in most major

economies, with some notable exceptions including Japan and the
United States. However, in Japan, 'Big-Bang' reforms to be imple-
mented by the end of 1999 will substantially revise the regulatory
framework and allow for bancassurance relationships. The precursor
to the 'Big-Bang' reforms - the Financial System Reform Bill of 1992-
proposed that the mutual interpenetration of traditional business
areas by financial intermediaries be allowed to proceed through the
establishment of majority-owned, separately capitalised subsidiaries;
first to embrace banks and securities companies but later to include
insurance companies (Hall, 1994). In the United States, the Bill
written by the House Banking Committee in 1995, made no mention
of insurance powers. This was to avoid possible blocking of the
Reform, as insurance agents' lobbies have proved very successful in
preventing bank sales of insurance (RBI, 12 May 1995).
In most countries, insurance companies have been constrained in
their ability to penetrate the banking market, compared with the
powers of their banking counterparts, and some countries including
Denmark, France and the United Kingdom have recently recon-
sidered their regulations in order to avoid competitive distortions
(Hoschka, 1994). This type of regulation has been linked with the first
EC Directives on Insurance, which were understood as prohibiting
such practices. Table 8.1 summarises an early OECD survey that
reviewed regulations pertaining to banking and insurance product
distribution in various countries.
Table 8.1 shows that some countries in Europe constrained the
distribution of insurance products by banks. For example, in Greece,
distribution was only permitted in towns of fewer than 10,000
inhabitants. In Portugal, distribution was authorised on the condition
that no advisory functions were undertaken (Hoschka, 1994).
Such regulatory differences nowadays, however, are in most cases no
longer apparent. With the EU's single market programme legislating
for a universal banking model, the breakdown in demarcation lines
between different financial service firms and increased competition
226 Bancassurance

Table 8.1 Regulations pertaining to the distribution of banking and insurance

products in major economies

Country Distribution by banks Distribution by insurers

of insurance products of banking products
Belgium Allowed Forbidden (E)
Denmark Allowed Allowed
France Allowed Limited
Germany Allowed Forbidden (E)
Greece Limited Forbidden (E)
Ireland Allowed Forbidden (E)
Italy Allowed Forbidden (E)
Luxembourg Limited Forbidden (E)
Netherlands Allowed Forbidden (E)
Portugal Limited Forbidden (E)
Spain Allowed Forbidden (E)
United Kingdom Limited Limited
Japan Forbidden Limited
US Limited Forbidden (E)

(E): except when products are linked to insurance activity.

Source: OEeD (1992).

from direct sellers of banking and insurance products - bancassurance

has become the 'norm' rather than the exception.
In such an environment, regulators have found themselves under
increasing pressure to create a level playing field for the distribution of
bank and insurance products. Banks in the United States, for example,
have been urging their regulatory authorities to deregulate as they
claim they are at a major disadvantage compared with their European
competitors in the areas of securities and insurance business (Mac-
Donald, 1987).

Regulations pertaining to ownership

There are two aspects to the entry of banks or insurers in each other's
industry. One relates to start-ups and the other to acquisitions. These
modes of entry do not follow the same regulatory restrictions. Thble
8.2 summarises ownership regulations in 14 major countries.
With regard to start-ups of insurance companies by banks, a survey
by the OECD in 1992 showed that most European countries allowed
these entry moves, while Japan strictly forbade such practices and the
United States strictly limited them. Belgium was one of the European
 Regulatory Issues 227

Table 8.2 Ownership regulations of bancassurance

Country Start-up by Start-up by Equity stake Equity stake

bank of insurer of by bank in by insurer in
insurance banking an insurer a bank
subsidiary subsidiary

Belgium Strictly limited Allowed Strictly limited Allowed

Denmark Allowed Allowed Allowed Allowed
France Limited Limited Limited Limited
Germany Allowed Allowed Allowed Limited
Greece Allowed Allowed Allowed Limited
Ireland Allowed Allowed Allowed Limited
Italy Allowed Allowed Allowed Allowed
Luxembourg Allowed Allowed Allowed Allowed
Netherlands Allowed Limited Limited Limited
Portugal Allowed Allowed Allowed Limited
Spain Allowed Allowed Allowed Allowed
United Allowed Allowed Allowed Allowed
Kingdom
Japan Forbidden Forbidden Strictly limited Strictly limited
US Strictly limited Strictly limited Strictly limited Strictly limited

Source: OECD (I 992).

countries limiting such entries, although some banks have nonetheless

been allowed to set up insurance subsidiaries there. France also
imposed some limitations on these entries while in the United King-
dom, building societies have until recently been limited in their set-ups
of general insurance companies. (Ben-Ami, 1994). Similar permissive
regulations apply to insurance companies setting up banking sub-
sidiaries, with Netherlands and France limiting some entries (Hos-
chka, 1994).
In contrast, equity stakes often require approval by regulators. The
survey by the OEeD showed that Japan, the United States and Bel-
gium were the only countries surveyed that strictly limited such par-
ticipations. There were more restrictions for insurance companies'
equity stakes in banks than for banks taking equity stakes in insurers.

EU regulations pertaining to bancassurance

The European Union has traditionally adopted separate legal frame-

works for the banking, insurance and investment sectors. At the heart
of the legislation is the objective to create a single market in financial
228 Bancassurance

Table 8.3 EC Directives in the banking sector

Directive Main provisions

The Second Banking In conjunction with Own Funds and Solvency
Co-ordination Directive Ratio Directives, gives EC incorporated banks
(effective 1/1/93) the right to branch into or operate into any
other EC country.
The Own Funds Directive Defines what is meant by capital for banks;
(effective 1/1/93) effectively the same as Basle requirements.
The Solvency Ratio Directive Establishes the amount of capital banks need
(effective 1/1/93) to hold (related to weighted risk assets using
BIS method).
The Consolidated Requires supervisors to regulate banking
Supervision Directive groups on a consolidated basis.
(effective 1/1/93)
The Money Laundering Imposes certain obligations on credit
Directive (effective 1/1/93) institutions to prevent money laundering.
The Large Exposures Places limits on the exposures to individual
Directive (effective 1/1/94) companies or groups that the banks can take
on (in general 25%).
The Investment Services Gives single passport to EC non-bank invest-
Directive (effective 1/1/96) ment services firms. Will become operational
with associated Capital Adequacy Directive.
The Capital Adequacy Applies risk-based capital requirements to
Directive (effective 1/1/96) non-bank investment firms. Introduces
consolidated supervision, and own funds
requirements for those firms. Banks will
have to carry capital on their trading book.
Prudential Supervision Adopted in response to the collapse of BCCI.
(post-BCCI) Directive Strengthened powers of authorities with
(effective 1/1/96) regard to refusal of authorisation where a
group structure was not sufficiently
transparent. Financial institutions to
maintain their head and registered offices
in the same member state.
Conglomerate Supervision Legislation on the supervision of financial
Directive (proposed in conglomerates expected to follow many of
early 1995 but unpublished the recommendations laid down by the BIS
by January 1998) (1995) Report of the Tripartite Group of
Bank, Securities and Insurance Regulators
on, 'The Supervision of Financial
Conglomerates' .

Source: Adapted from 'Europe's Single Market and the role of State Autonomy',
P. Molyneux, IEF Working Paper, 1994/10 and authors' updates.
 Regulatory Issues 229

Table 8.4 EC Directives in the insurance sector

Directive Main provisions

First Non-Life Directive Establishes freedom of establishment for
73/239 non-life insurance. Compliance with host
country control.
First Life Directive 79/267 Establishes freedom of establishment for life
assurance. Compliance with host country
control.
Second Non-Life Directive Introduces freer regimes for large risks, with
88/357 mass risks still subject to host country rule.!
Motor Insurance Directive Assimilates motor insurance to large risks, i.e.
90/618 no need for administrative authorisation of
host country.
Second Life Directive 90/619 Introduces freer regimes for services that are
at policyholder's initiative in particular.
Third Non-Life Directive Establishes single passport principle in non life
(effective 1/7/94) insurance (head office responsible for
regulation).
Third Life Directive Establishes single passport principle in life
(effective 1n/94) assurance.
Insurance Accounts Directive Covers layouts of accounts and contains rules
(effective 1/1195) for valuation of assets for both life and non-life
business.
Prudential Supervision Adopted in response to the collapse of BCCI.
Directive (post-BCCI) Strengthened powers of authorities with
(effective 1/1/96) regard to refusal of authorisation where a group
structure was not sufficiently transparent.
Financial institutions to maintain their head and
registered offices in the same member state.
Insurance Group Directive Covers the supervision of insurance groups
(proposed 22/2/95) dealing with intra-group exposures and double
gearing.
Conglomerate Supervision Legislation on the supervision of financial
Directive (proposed in early conglomerates expected to follow many of the
1995 but unpublished by recommendations laid down by the BIS (1995)
January 1998) Report of the Tripartite Group of Bank,
Securities and Insurance Regulators on , 'The
Supervision of Financial Conglomerates'.

J Mass risks relate to personal customers.

Source: Adapted from M. Boleat, The European Single Market in Insurance', The
Geneva Papers on Risk and Insurance, 20 (no. 74, January 1995),45-56 and authors' own
updates.
230 Bancassurance

services, by providing banks and other financial institutions with a

single passport to operate in the Community, subject to the rule of the
home member state (Molyneux, 1994 and EC, 1997). Tables 8.3 and
8.4 summarise various banking and insurance Directives aimed at
creating a free market in financial services.
The summary of Directives in the financial services sectors shows
that there is an increasing trend to harmonise the regulations of var-
ious types of financial institutions. However, none of these Directives
explicitly tackles the issue of bancassurance conglomerates. None-
theless, the Consolidated Supervision Directive increased the extent to
which credit institutions must be supervised on a consolidated basis
(Anderson, 1993). It stated that consolidated supervision must be
applied in calculating and applying prudential ratios. It also required
that consolidation be applied when a credit institution has a partici-
pation of 20% or more in another financial institution. This also
applied to financial holding companies (Osborne, 1993). Where the
parent of a credit institution is a so-called mixed-activity holding
company, I competent authorities must have the power to require any
information from the parent or subsidiary for the purpose of super-
vision of the credit institution. Moreover, the Directive laid down
some proposals for determining which national authorities were to
exercise supervision of the group.
The first attempt to regulate financial conglomerates was
represented by the so-called post-BCCI Directive,2 that takes a hori-
zontal approach to conglomerate regulations, i.e. it legislates for banks
as well as insurance companies and investment firms (Wooifson,
1994). This proposal concentrates on four main aspects: the trans-
parency of group structures, maintenance of head office in the state
where office is registered, improving information between supervisory
authorities and increasing duties of auditors to report irregularities.
Moreover in its Legislative Programme for 1994, the Commission
announced that they would tackle the prudential aspects of financial
conglomerates and that this may be done on a 'horizontal' basis
(Woolfson, 1994). On this issue, they might well meet the opposition
of various bodies. Insurers in particular seem to favour the use of a
deduction method for prudential supervision, whereby investments in
a company of a financial group are deducted from the capital of the
insurance company (Woolfson, 1994). On the contrary, the banking
sector is subject to consolidation rules. 3
Despite the adoption and implementation within the EC of a range
of directives covering banking, securities and insurance sectors the
 Regulatory Issues 231

Community has not yet been able to develop a complete response to

the regulatory difficulties associated with financial conglomerates. The
Community, however, is considering the introduction of common
minimum standards for the prudential supervision of financial con-
glomerates following the establishment of a working group in 1994
which reported its findings to the Commission in mid-1995 (Walker,
1996). This was the precursor to an expected draft directive on
financial conglomerates (the proposed Conglomerate Supervision
Directive) which had not been published by early 1998.
Attempts to harmonise the regulation of bancassurers is prob-
lematic given the substantial differences that exist in insurance regula-
tions across EU countries. The insurance sector has until now only
been covered by separate insurance-specific measures and, even then,
only on an individual and not a group basis. Since late 1994 the
European Commission has attempted to secure a set of common
provisions for insurance groups, especially with regards to the super-
vision of intra-group exposures and the prevention of double-gearing
(under a proposed Insurance Group Directive). Walker (1996, pp.
92-93) notes that, 'Instead of imposing consolidated supervision in
this area, however, the early drafts of the proposed Insurance Group
Directive have provided for solo-plus supervision with three capital
options being provided to prevent double gearing in insurance
groups,.4 Solo-plus supervision relates to where 'Individual entities are
supervised on a solo basis according to the capital requirements of
their respective regulators. The solo supervision of individual entities
is complemented by a general qualitative assessment of the group as a
whole and, usually, by a quantitative group-wide assessment of the
adequacy of capital' (BIS, 1995). This, in fact, is the usual regulatory
approach taken to supervise bancassurers. This approach contrasts
with consolidated supervision (as defined by the BIS, 1995) which
focuses on the parent or holding company. While individual entities
within the group may be supervised on a solo-plus basis, to assess
capital requirements, assets and liabilities of individual companies are
consolidated and capital requirements applied to the consolidated
entity at the parent company level.
The above brief review of EU regulatory issues indicates that,
whereas the production of insurance products is strictly regulated and
segmented in most major economies, the legal environment for the
distribution of insurance products by banks appears to be relatively
liberal. As far as ownership is concerned, banks can generally start up
insurance subsidiaries while the regime is slightly more severe for
232 Bancassurance

insurance companies. Acquisition of equity stakes is subject to slightly

more limitations and, again, European insurers are placed at a dis-
advantage compared with their banking counterparts. This is in con-
trast with Japan and the United States where there are strict
limitations on both distribution and ownership. Recent regulations at
the EU level have also attempted to address the supervision of ban-
cassurance groups although reform is slow given the varying
approaches to consolidation and insurance supervision throughout the
EU. In addition, another major obstacle to harmonised group super-
vision relates to the complexities associated with comparing bank and
insurance company solvency (capital) requirements. Van den Berghe
(1995) details these differences and highlights the potential problems
associated with consolidated supervision of bancassurers.

8.3 THE RISE OF REGULATORY CONCERNS

Bancassurance has benefited from the trend of structural deregulation

that emerged during the 1980s in most European countries. Faced
with the rise of financial conglomerates, some observers have ques-
tioned the various risks involved in this conglomeration trend. The
main concerns fall under five headings: competition considerations,
consumer protection, risk of double gearing, risk of contagion and
problems relating to supervisory difficulties (transparency and
authority).

Competition

Several US observers have argued that competition may be threatened

if regulators were to allow financial institutions to penetrate each
other's industry (Horvitz, 1985; Herring and Santomero, 1990). There
are two sides to this argument: fear of monopoly power and excessive
concentration of economic and political power. The former means that
financial conglomerates, by controlling the full range of substitutes for
a financial product, may acquire a dominating position whereby they
can raise prices over marginal costs. Herring and Santomero (1990)
argued that such concerns are effectively eliminated by the highly
contestable nature of financial services. Moreover, large mergers be-
tween banks and insurers - such as the deal announced between
Credit Suisse and Winterthur in August 1997 - in any event would
 Regulatory Issues 233

be scrutinised by the relevant competition policy agencies which

should ensure that such deals did not act against the public interest.
Horvitz (1985) has also pointed out that this issue relates to the
combinations of specific firms (the three or four largest of the banking
and insurance industry) rather than to the combinations of both ac-
tivities generally.
Concerns over competition in the combination of banking and
insurance appear over-rated in the context of fierce competition in the
financial services industry. Current barriers in the form of antitrust
policies should eliminate any source of concerns in this area.

Consumer protection

Attention on both sides of the Atlantic has been paid to the issue of
consumer protection in the combination of various financial services
offered under the same roof. The main aspect to this issue is the tie-in
opportunities that might be taken advantage of by unscrupulous
financial institutions. Horvitz (1985) argued that the natural connec-
tion between some insurance and banking products might lead banks
to coerce borrowers in particular to buy insurance from the bank. He
also acknowledged that this may not be a deliberate action from banks'
part but that borrowers may feel that their loan application would be
better received if they bought insurance from the bank. Nicholson
(1992) argued that banking and insurance are natural complements
because insurance may often be an auxiliary service to a main pur-
chase, such as a mortgage, which is the true objective of the consumer.
He described the understanding of this consumer behaviour as the
capture point: customers are less willing to shop around for the aux-
iliary products. Such analysis gives credence to the argument that tie-
ins may occur even if these are not the result of banks' deliberate
action. The Governor of the Bank of England (1984) stressed that
linkages between banks and insurance gave rise to concerns about
unfair competition and consumer abuse.
Horvitz (1985) proposed some simple regulatory remedies to the
tie-ins issues: instituting cooling-off periods during which customers
can cancel their policies, prohibiting banks to solicit insurance until
after credit is granted, requiring banks to accept substitute policies in
the cancellation period and increase disclosure of consumer rights.
In the United Kingdom, Eaglesham (1992) distinguished between
two types of tie-ins: required services and trigger services. The former
are defined as those products that the lender requires to buy as a
234 Bancassurance

condition of the loan being granted. The latter deals with those pro-
ducts bought in conjunction with a loan where the terms and condi-
tions of the loans are varied. The aforementioned study also reported
the results of a survey of the Consumers' Association that showed that
19% of respondents stated that their mortgage lenders insisted on
their choice of house buildings (insurance) policy. The Consumers'
Association also surveyed the 16 largest mortgage suppliers and found
that, although none insisted on tied services as a condition for the
loans, 14 were offering trigger schemes. Although most of the ties
applied to house insurance, life insurance and pensions products also
featured. Eaglesham (1992) also reviewed government proposals to
tackle this issue and found them wholly inadequate and insufficient.
Similar issues have arisen in various European countries. At the
European level, the main regulations that pertain to customer pro-
tection are those that address the issue of the formation of insurance
intermediaries, in particular, rules advocating the need for bank staff
to receive professional training (Mollet, 1991). Some countries have
individually imposed some constraints on the ability of bank staff to
sell insurance: for example, in France, bank employees must qualify as
insurance agents (CEA, 1992).
Tie-ins opportunities in the context of bancassurance have raised
the question of potential customer abuse. Various observers have
advocated the need for greater compulsory disclosures and customer
protection devices to reduce the occurrence of such practices.

Risk of double gearing

The risk of double gearing can be defined as the risk that a group's
total capital amount is not sufficient to absorb the group's risk due to
capital being used several times to support both the parent company
and its subsidiaries. (Sigma, 1992). This could mean that their 'net' or
'consolidated' solvency is considerably lower than the sum of the own
funds of members of the conglomerate. Van den Berghe (1995) notes
that 'cross-shareholdings and other kinds of investments in daughter -
or sister - companies are forms which lead to double gearing espe-
cially in cases where there is no consolidated approach' (p. 69).
Knauth and Weizel (1993) have argued that there is a risk of double
gearing if business and participation risks are highly correlated. In
particular, when a parent institution is a credit institution, the risk of
double gearing exists because credit institutions. depend on the state of
 Regulatory Issues 235

the economy and are affected simultaneously. The Directive on the

Consolidation of Credit Institutions (EC, 1992) requires that groups
should be supervised on a consolidated basis and could prevent this
risk. Insurance companies, however, are not supervised on a con-
solidated basis and Knauth and Weizel (1993) have argued that this is
not desirable. They argued that insurance companies are subject to
technical risk which is not sensitive to economic cycles.
For different parts of the group to be affected by simultaneous
increases in risk, entities should have similar business portfolios, i.e.
for business risk and participation risk to be highly correlated, asso-
ciated companies must have concurrent risks. Knauth and Weizel
(1993) concluded that consolidation requirements are generally not
relevant in the insurance sector or in bank and insurance conglom-
erates.
The concerns about the risks of double gearing for bancassurers is
that insurance capital may be used twice as guarantee capital to sup-
port both insurance and banking activities and vice versa. Woolfson
(1994) suggested that there are two methods to avoid double gearing:
consolidation and deduction. The consolidation principle is favoured
by banking supervisors, but, as we have noted above, there are several
difficulties associated with it. First, both sectors are subject to different
regulations regarding solvency and one may wonder what standards to
apply. Second, insurance regulations require a strict separation of life
and non-life business that would hinder full consolidation. Third,
insurance companies are not required to follow these consolidation
practices. In summary, both sectors have different regulatory
requirements that might ultimately conflict with the consolidation
principle. Woolfson (1994) suggested that there is a second method,
that is favoured by the insurance sector: the deduction method. Under
this method, investments in an associated company should be auto-
matically deducted from the capital of an insurance company's or
bank's capital. In fact, as capital may exceed the minimum solvency
requirements, some regulators may deduct the margin of the sub-
sidiary and the parent from the amount of regulatory capital from the
parent (Woolfson, 1994). It is likely that the European Commission
will recommend various measures to monitor the risks taken by
insurance entities on a group basis to ensure the consolidation of
technical reserves where there are cross guarantees between different
insurance entities and more generally to increase the transparency of
groups containing insurance companies. As we have already noted,
however, these proposals have not yet come to fruition.
236 Bancassurance

The above indicates the concern from regulators regarding the risk
of double gearing. Hesberg and Karten (1994) examined the various
aspects of solvency that surround financial conglomerates and argued
that solvency control based on consolidated equity capital is not
appropriate for a holding of banking and insurance companies.
Nevertheless, most EC countries have rules that effectively limit the
risk of double gearing. The Comite Europeen des Assurances (CEA)
(1993) summarised these rules under two different headings. First,
regulations on participation (of banks in the capital of insurance un-
dertakings and of insurance companies in the capital of banks). Sec-
ond, techniques to prevent the multiple use of own funds of insurance
companies or banks within financial conglomerates (see Van den
Berghe 1995 for extensive coverage of this issue). In the first category,
limitations on participations, the CEA survey suggested that many
countries have in fact some kind of limitation on the cross-participa-
tion between the two sectors. In the second category, techniques on
the multiple use of own funds, the survey suggested that some coun-
tries require that holdings in banking or insurance subsidiaries be
deducted from consolidation on which the solvency ratio is calculated.
This is the case in France for banks, and in Denmark for insurance
companies. In the United Kingdom, any participation that exceeds
20% must be deducted from the own funds of the banking parent
when the latter verifies compliance with respect to minimum capital
requirements. Calculations on holdings in an insurance undertaking
are based on the net assets value or on part of the assets minus
liabilities plus the solvency margin (CEA, 1993).
The above has stressed the regulatory concerns for double gearing
of bancassurance conglomerates. In some individual countries, there
are limitations on the ability of parent companies to integrate the
funds of their subsidiaries in the computation of their own capital
requirements. The current EC debate highlights the conflict between
the banking and insurance professions, who propose two different
approaches for supervising groups on a consolidated basis (Woolfson,
1994).

Risk of contagion

'Contagion is recognised as one of the most important issues facing

supervisors in relation to conglomerates' (BIS, 1995, p. 6). The idea is
that the failure of a subsidiary may endanger the group as a whole
(Litan, 1987). As banking and insurance benefit in most countries
 Regulatory Issues 237

from schemes aimed at preventing runs by extending insurance

schemes, there is a concern that the social costs of coping with failure
will be greater in a conglomerate because it would disrupt a wider
range of activities (Herring and Santomero, 1990). Another issue is
that of depositors' confidence in particular: were the insurance sub-
sidiary of a banking group to fail, this might result in depositors' loss of
confidence in the group as a whole. Mester (1992) argued that bank
holding companies are viewed as a single corporate entity, therefore
the market would view problems in one affiliate as signalling problems
with other affiliates. She emphasised that bank holding companies
have tended to behave in this way, by rescuing their failing affiliates. In
Ireland, the Irish government had to take steps to rescue AlB Bank in
1985, following its disastrous acquisition of IBI, a life and general
insurance company. The investigation that followed showed that the
bank had guaranteed some of the high-risk policies of the insurer
abroad (Lafferty, 1991).
Another issue associated with contagion risk is that regulatory
conflicts may arise. Regulators of banking and insurance business have
different objectives, protecting the interests of depositors in banking
and those of policyholders in insurance, respectively (Horvitz, 1985).
However, Horvitz (1985) argued that, depending on the organisational
form adopted, such conflicts may be minimised, especially if both
activities are managed through a holding company. Individual coun-
tries in Europe have in fact implemented prudential rules to limit large
financial exposures by one element of a conglomerate vis-a-vis another
(CEA, 1993). In France, for example, banks must limit exposures by
the same client or group of clients (including insurance) to 40% of
their own funds, and total commitments that individually exceed 15%
of own funds to eight times the amount of own funds. In the United
Kingdom, the legislation provides that the long-term funds of an
insurance company can only be used for the purposes of the business.
More generally, regulators may impose restrictions on exposure on a
discretionary basis, as in Ireland, in order to avoid adverse effects on
the financial stability of a group (CEA, 1993).
The BIS's (1995) report on 'The Supervision of Financial Con-
glomerates' identifies both intra-group exposures as well as large
exposures at the group level as possible problem areas. In the case
of the former it was recognised that certain difficulties arose due to
their exclusion from a consolidated balance sheet as a result of netting
and due to the nature of the transactions. The BIS recommended
that solo-supervision at both the parent and subsidiary levels, with
238 Bancassurance

appropriate reporting obligations, liaison between supeIVisors, and

regulatory discretion to prohibit such exposures would constrain the
build-up of large intra-group exposures. In the case of large exposures
at the group level the BIS (1995) noted that:

Wide differences between the large exposure rules pertaining in the

banking, securities and insurance sectors provide ample scope for
regulatory arbitrage, and the differences are such that it is difficult
to envisage the gaps being bridged in the foreseeable future.
(BIS, 1995, p. 6).

In the case of large exposures at the group level, the BIS suggested
that the introduction of reporting obligations to the parent, or lead
regulator, would make it easier to assess the extent of large exposures
to single counterparties.
At one level, the risk of contagion from one activity to another is
generally restricted by the fact that both activities are conducted in two
distinct legal entities. At another, however, the problem may be
compounded as such a structure creates ample scope for regulatory
arbitrage in relation to building-up excessive intra-group and other
exposures. Domestic and international regulators are clearly aware of
such difficulties although the considerable differences between bank
and insurance regulations make it impossible for bancassurance con-
glomerates to fully integrate (Kessler, 1987).

1hlnsparency and authority for supervision

Knauth and Weizel (1993) postulated that one of the main reasons for
the EC's determination to regulate financial conglomerates is the need
to simplify the operation of the regulatory bodies. We have stressed
above that conflicts of interests are likely to arise between regulators,
in case one activity runs into trouble. Knauth and Weizel (1993)
argued that the way to increase transparency is to increase co-opera-
tion between banking and insurance authorities. The EU's post-BCCI
Directive constitutes a step towards more transparency between the
two activities by requiring: 1) that the registered and real head offic~
of financial conglomerates be located in the same member state; 2) an
additional exchange of information between supeIVisory authorities
and other specified boards in member states; and 3) auditors must
immediately report any relevant information concerning potential
troubles in a bank or insurance company to the supeIVisory authorities
 Regulatory Issues 239

(Hesberg and Karten, 1994). This Directive represents a significant

step towards viewing insurers in the context of their corporate group
as a whole, as is already the case for banks (O'Neill, 1994).
In individual countries, various regulations have been implemented
in order to facilitate the supervision of bancassurance conglomerates.
In Denmark, Norway and the UK there are now single financial
supervisory authorities. Many countries have implemented some reg-
ulations, protocols or agreements that facilitate information exchange.
These may be informal (Greece, Ireland), while in the Netherlands,
there is a specific Protocol; in Spain, there is a lead regulator, and
(prior to the creation of the Financial Services Authority in 1997) in
the United Kingdom, there are 'gateways' for insurance supervisors to
disclose confidential information to banking authorities.
Other means to increase transparency include regulations relating
to the publication of accounts on a consolidated basis, as well as the
compulsory use of external auditors. Finally, there are rules in some
countries that designate which supervisory authorities are competent
to control the group as a whole: in the United Kingdom there are
colleges of relevant regulators for financial conglomerates. Although
regulators retain control over the undertakings in their own area, a
lead regulator - chosen by mutual agreement - convenes meetings
during which information is shared. In the Netherlands, the Protocol is
the basis for the supervision of financial conglomerates.
Various countries have adopted different means of retaining control
over the increasingly diversified activities of their financial institutions.
Most have sensed the need to increase the exchange of information
between regulatory bodies that are involved in the supervision of a
single group.

8.4 OTHER REGULATORY ISSUES

In addition to the issues covered above there are various other general
principles, suggested by the BIS(1995), which should be considered
when supervising financial conglomerates. These include issues
relating to:

• Fit and proper tests for managers - while supervisors generally have
sufficient powers to confirm the suitability of managers of regu-
lated firms, managers from other firms within the group may not
240 Bancassurance

be subject to such scrutiny. The BIS suggested that supervisors

should have extended powers of approval or review.
• Management autonomy - supervisors need to know who is
responsible for compliance with legal and supervisory require-
ments. As such, management structures in financial conglomerates
need to be sufficiently independent from adverse/undue inter-
group influences.
• Greater co-operation between supervisors in the distinct fields of
financial supervision and identification of impediments to the
exchange of appropriate information between regulators.

While many proposals have been put forward suggesting improve-

ments to the supervision of fmancial conglomerates the EC has been
slow to produce harmonising legislation in this area. Most EU coun-
tries adopt a solo-plus approach to the regulation of bancassurers but
still major differences exist across countries - mainly because of the
big differences in insurance accounting, rules and regulations. Given
that these differences are likely to persist it seems unlikely that a
simplified all-encompassing framework for the regulation of bancas-
surers will soon emerge.

CONCLUSION

This chapter provides a picture of the regulatory environment for

bancassurers in Europe and also highlights the main issues relating to
the supervision of financial conglomerates. The growth of bancassur-
ance has taken place in a supervisory environment, characterised by
structural deregulation. New prudential requirements have been im-
plemented to ensure that the entry of banks in these new activities
would be safe. The regulatory regime for bancassurance has entailed a
great degree of flexibility as far as distribution and ownership are
concerned, although strict limitations prohibit the joint production
of banking and insurance services. Nevertheless, regulators have
expressed concerns over the potential risk-increasing features and the
lack of transparency of financial conglomerates, and new prudential
regulations are still (at the beginning of 1998) being considered in
order to reduce these concerns.
 Regulatory Issues 241

Notes

1. This is dermed as 'a parent undertaking other than a financial holding

company or a credit institution, the subsidiaries of which include at least
one credit institution'. Art.l, Council Directive 92/30 OJ 1992 LllO/52.
2. See Official Journal of the European Communities, 25.8.93, No C 229/10:
'Proposal for a Directive amending Directives 77n80fEEC and 89/646/
EEC in the field of credit institutions, 73/239fEEC and 92/49fEEC in the
field of non-life insurance, 79/267fEEC and 92/96fEEC in the field of life
insurance, and 93/22/EEC in the field of investment firms in order to
reinforce prudential supervision'.
3. Council Directive on the Supervision of Credit Institutions on a Con-
solidated Basis (OJ, 1992 L280).
4. The capital options were included to deal with the different accounting
practices presently operating across Europe. The UK, Ireland and the
Netherlands have developed a deduction and aggregation method which
operates on a 'bottom-up' method to calculate capital backing, France
and Spain use a top-down accounting consolidation procedure. Denmark
uses a variant of deduction and aggregation.
9 Conclusions

Many European banks have adopted a bancassurance strategy in

recent years, but there has been little empirical evidence, if any, of the
consequences of this strategy on bank performance. This book aimed
at providing some empirical evidence on the risk/return effects of bank
diversification into life assurance.
The August 1997 announcement by Credit Suisse that it was to
acquire the largest Swiss insurer, Winterthur, exemplifies the way a
decline in profitability in traditional business is prompting banks
across the globe to diversify into different product and geographical
markets. It also exemplifies the ways in which bancassurance deals are
rendering barriers among different types of financial services in-
creasingly irrelevant, as competition increases across the whole spec-
trum of the financial services industry.
The bancassurance phenomenon has been a product of various
forces, including structural deregulation, increasing competition and
changes in customer demands. Its growth has been widespread in
Europe, although its impact has varied among different countries. In
the UK, the deregulation of the financial services industry has been
crucial in the development of bancassurance. In particular, two pieces
of legislation, the Financial Services Act (1986) and the Building
Societies Act (1986), have encouraged banks and building societies to
tie to their own life assurance subsidiaries. Most large banks and
building societies in the UK have by now set up or acquired a life
assurance company, whose products are distributed through their
branch networks. Deregulation has also been a driving factor in many
other countries. In this study, we suggest that country-specific factors,
such as the relative tax advantages of alternative financial products,
also go a long way in explaining the discrepancies in observed banks'
shares of life insurance business. Analysis of the forces that have led to
the development of bancassurance suggests that this strategy may have
been some form of defensive diversification, whereby banking
institutions have attempted to diversify competitive earnings and
cross-sell insurance products to their existing customers. The litera-
ture on corporate diversification suggests that such diversification
should be accompanied by a reduction in risk. The empirical analysis of
bancassurance in the UK market provides support for the hypothesis

242
 Conclusions 243

that bancassurance is a form of defensive diversification. Our results

also suggest that there may be some risk-decreasing features in the
combination of banks and life insurance firms, although, this is at the
expense of reduced returns. The main conclusion of this empirical
investigation is that, over the period of study 1988-92, the mingling of
banks (building societies) with life insurers would not have raised
significant risk concerns.
This is a critical finding given the global trend towards the universal
banking model and the current restructuring of financial systems in
Europe, the United States and South East Asia. Given the potential
risk-reducing benefits that can be derived from bancassurance strat-
egies it is almost certain that this trend will accelerate over the next
decade.
An area of concern that has yet to be resolved relates to the regu-
latory treatment of bancassurance financial conglomerates. While the
BIS (1995) has issued proposals relating to the supervision of banc-
assurers these have yet to be formalised in domestic or EU legislation:
for instance, the Insurance Group Directive and Conglomerate Su-
pervision Directive have yet to be published. A major stumbling block
relates to achieving a sufficient degree of equivalence between the
consolidated supervision approach applicable to banking and invest-
ment firms throughout Europe, and the solo-plus options being
developed for insurance undertakings. Given the marked differences
between the solvency rules and other regulatory treatments of banks
compared with insurance companies it is difficult to see how complete
supervisory equivalence can be achieved. Nevertheless, the pioneering
work of the BIS (1995), together with legislation at the EU level
should help to create the relevant legal structure for the supervision of
financial conglomerates in the future.
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Index
Aachener & Munchener 80, 81 country comparisons 92~
Abbey Life 56-7, 66, 67 current trends 36-43,72-96
Abbey National 34, 50, 61, 62, 64, customer resistance 38-9
66,69, 70, 203 definition 7-10
Abbey National Life 62, 66 distribution channels 68-70
ABN AMRO 86, 88 entry routes 39, 65~, 67, 94-5
ABN AMRO Levensverzekering 86, 88 growth possibilities 131-3
ACM Vie 73, 76, 77-8 historical development 10-13
accounting practices organisational problems 40-1
EC Insurance Accounts Directive 195 organisational structures 39-40
market v. accounting data 164-8 profitability 133
UK accounting practices 194-202 regulatory issues 224-32, 243
acquisitions see mergers and acquisitions risk 136-7, 187-220
AG 87 synergies 39,42, 69-70, 13~
agency theory 110-13 see also under individual countries
AGF Seguros 90 Banco Bilbao Vizcaya (BBV) 89, 90
AGFVie 77 Banco di Santo Spirito 84
AlB Bank 237 Banco Espaftol di Credito (Banesto)
allfinanz see bancassurance 89, 90
Alliance and Leicester Building Banco Herrero 91
Society 51, 203 Banco Mapfre 91
Allianz 80, 81 Banco Santander 89,90,91
Allied Dunbar 205 Banesto Seguros 89, 90
Amato Law 85 Banfenix 89, 90
AMEV 86-7 Bank for International Settlements
ASLK-CGER 87 (BIS) 222-4, 228, 229, 231,
Assiba 83, 84 237-9, 243
Assicurazioni Generali 84 Bank fiir Gemeinwirtschaft (BfG) 80,81
Association of British Insurers 197-8 bank holding companies (BHCs)
Association of Futures Brokers and diversification and risk studies 138-86
Dealers (AFBD) 46 Bank of England 46, 50, 205, 233
Assurances du Boerenbond Beige 81 Bank of Scotland 63-4, 66, 69, 70, 203
Assurances Federales Vie 73-4, 76 Bank of Spain 90
assurbanque see bancassurance banking
Assu-Vie 73, 74 branches 69
Aurora Polar 90 changing requirements 13-21
AVCB 86 competition 21-8
~ 32,33,52,77,90 EC Directives 228, 238-9
Axa Assicurazioni 83 profitability 26-8
~ Seguros 90 relationship with insurance 5-7,43
risk 138-86
Banca Commerciale Italiana (BCI) supermarket banking 24, 32
83,84 Banque Bruxelles Lambert 88
Banca di Roma 83, 84 Banque Nationale de Paris (BNP)
Banca Nazionale del Lavoro 83, 84 73, 74, 78, 79, 80
bancassurance Banques Populaires 73
competition 32 Barclays Bank 44, 51, 5~,
corporate diversification theory 66, 67, 70, 203
129-37 Barclays Financial Services 54, 55, 67

262
 Index 263

Barclays Insurance Services 54 Chesham Building Society 203

Barclays Life 54, 55, 56, 62, Cheshire Building Society 203
66, 68, 69, 205 Christiana Bank xvii
Barings Bank 88 CIC 73, 77, 79
Bamsley Building Society 203 Citibank 80, 81
Basle Agreement see Bank for Citibank Privatkunden 81
International Settlements City and Metropolitan Building
Bath Investment and Beverley Society 203
Building Society 203 City Panel 46
Belgium Clerical Medical 61, 65, 66, 204, 205
bancassurance 10, 12, 37 Clydesdale Bank 63, 203
bank profitability 27 CNP 76,77
demographic trends 14 Cofiga 32
direct marketing 34 Comite Europeen des Assurances
life assurance industry 29, 30 (CEA) 236
regulation 226, 227 Commercial Union 58, 66, 205
savings banks 24 Commerzbank 80, 81
Berliner Bank 80, 81 Compagnia di Assicurazioni 83
Birmingham Midshires Building Compagnie Bancaire 73, 74
Society 203 Companies Act 1985 195
Black Horse Financial Services 57 competition
Black Horse Life 35, 56, 66, 67, 133 bancassurance 32
BNL Vita 83, 84 banking 21-8
Bradford and Bingley Building life assurance 28-36
Society 203 regulatory issues 232-3
branches of banks 41, 69 see also under individual countries
Bristol and West Building Society 203 concentric diversification 99
Britannia Building Society 56, conglomerate diversification 99
58-9, 66, 203, 204 consumer protection 20, 233-4
Britannia Life 59, 66 contagion 23fr.8
Britannic 205 Co-operative Bank 203, 220n
building societies see United Kingdom: co-operative banking 80-1
building societies CornhiJI 205
Corpora\;ion Mapfre 91
Caisse d'Epargne 73, 76 corporate diversification 97-137
Caisse Genchale d'Epargne et de agency theory 110-13
Retraite (CGER) 10 concentric diversification 99
Caisse Nationale de Pn:voyance conglomerate diversification 99
(CNP) 10,84 diversification strategies 98-101
La Caixa 10, 23, 89, 90-1 economies of scale 116
Caja de Madrid 23, 89, 91 economies of scope llfr.17
Caja de Madrid Vita 89, 91 empirical evidence 122-9
CALIFOR 90 entry strategies 104-7
Cambridge Building Society 203 horizontal diversification 98-9
Cardif 73, 74 mergers and acquisitions 105-6
cards 25 organisational structures 107-8
Cariplo 83-4 profitability of target 113-15
Cariro 84 relation to bancassurance 129-37
Carivita 83-4 risk-reduction motive 119-22
Carre four 24, 32 Rumelt's specialisation ratio 101-4,
Cenit 91 126, 137n
Chelsea Building Society 203 synergies 115-19
Cheltenham and Gloucester testing hypotheses 122--6
Building Society 50, 203 testing performances 12fr.9
264
corporate diversification (contd.)
theoretical rationale 108-22
vertical integration 99
Coutts and Co 203
Coventry Building Society 203
credit cards see cards
Credit Agricole 73, 75, 78, 83
credit cards 25
Credit Lyonnais 73-4, 80, 81
Credit Mutuel 72-3, 77, 81
Credit Suisse 232, 242
Cumberland Building Society 203
customers
bancassurance resistance 38-9
banking behaviour 25-6
consumer protection 20, 233-4
financial knowledge 19-21
Darlington Building Society 203
data
diversification and risk studies 164-78
industry averages 17/H!, 192-4
market v. accounting data 164-8
risk and return measures 168-76,
189-94
DB Leben 80, 81-2
DBV Versicherung BO,81
demographic trends 13-16
Denmark
demographic trends 14
direct marketing 34
life assurance industry 29, 30
regulation 225, 226, 227, 236, 239
savings banks 24
Department of Thade and Industry
(DTI) 46, 195-6, 198-201
Derbyshire Building Society 203
deregulation see regulation
Deutsche Bank BO, 81-2, 900, 135
Deutsche Herold 80, 82
Deutsche Krankenverischerung 81
Direct Line 60
Directives see EC Directives
direct marketing 34
distribution agreements
bancassurance entry route 39
distribution channels
bancassurance 68-70
life assurance industry 33-6
diversification
bank diversification: bancassurance
risk effects 187-220; general
risk effects 138-86
building societies, UK 202-3
Index
corporate diversification 97-137:
agency theory 110-13; concentric
diversification 99; conglomerate
diversification 99; diversification
strategies 98-101; economies of
scale 116; economies of scope
116-17; empirical evidence
122-9; entry strategies 104-7;
horizontal diversification 98-9;
organisational structures 107-8;
profitability of target 113-15;
relation to bancassurance 129-37;
risk-reduction motive 119--22;
Rumelt's specialisation ratio
101-4, 126, 137n; synergies
115-19; testing hypotheses
122-6; testing performances
126-9; theoretical rationale
108-22; vertical integration 99
diversification and risk studies
164-78; industry averages 176-8,
192-4; market v. accounting
data 164-8; risk and return
measures 168-76, 189--94
double gearing 234-6
Dresdner Bank 80,81
Dunfermline Building Society 203
Eagle Star 205
Earl Shilton Building Society 203
EC Directives 227-32, 235, 243
banking Directives 228, 238-9
insurance Directives 31, 195,
225,229
Ecclesiastical 205
economies of scale 116
economies of scope 116-17
Ecureuil Vie 73, 76, 77
employees
branch staff 53-4, 55, 69-70
motivation 69--70
pay 57,70
training 57,58
entry routes 39,65-7,94-5, 104-7
Equity and Law 52, 205
EU Single Market Programme 23
Europe
bancassurance trends 36-43,
72-96
bank profitability 26-8
Comite Europeen des Assurances
(CEA) 236
demographic trends 14-15
direct marketing 34
 Index
EC Directives 31, 195,225,
227-32, 235, 243
life assurance industry 28-36
savings banks 23-4
see also individual countries
Euroseguros 89,90
Eurovita Italcasse 83
Federal Deposit Insurance Corporation
(FDIC) 168
Federal Trade Commission (FJ'C)
126
Financial Intermediaries, Managers and
Brokers Regulatory Association
(FIMBRA) 45-7
Financial Services Act (FSA) 1986 44,
45-8, 71, 94, 242
Financial Services Authority 239
financial services industry
general trends 13-21
regulatory issues 221-4
finanzia globale see bancassurance
Form 9 198-201
Fortis Group 87,90
France
'assurbanque' 76-7
bancassurance: current trends 13,
36, 37, 38, 42, 72-80; entry routes
94-5; Europe comparisons 92--{j;
general insurance sector 77-9;
historical development 10-13;
life assurance sector 72-7;
market share 95~; product
adaptation 41; taxation 93
bank profitability 27
demographic trends 14
direct marketing 34
insurance industry; general industry
features 92;
life assurance industry 16-18,
29, 30, 31, 34-5, 92, 133
mortgage finance 7
privacy issues 38
regulation 94, 222, 225, 226,
227, 234, 236, 237
savings banks 23-4
taxation 93
Friends Provident 34, 62, 64
Fructivie 73, 74, 76
FS Assurance 59, 66, 204
Furness Building Society 203
Gainsborough Building Society 203
G~ 73, 74, 76-7, 79
265
General Accident 59, 65, 66, 205
General Accident Life 63
Germany
bancassurance: current trends 37,
38, 42, 80-2; .entry routes 94-5;
Europe comparisons 92--{j;
market share 9~
bank profitability 27
co-operative banking 80-1
demographic trends 14
insurance industry: general industry
features 92; life assurance
industry 16-18,29,30,
31,35
pensions 15
Raiffeisen und Volkensbanks 80-1
regulation 226, 227
savings banks 23-4
Girobank 203
Gothaer Lebenversicherung 80, 81
Greece
bank competition 23
demographic trends 14
life assurance industry 28, 29, 30
regulation 225,226,227,239
savings banks 24
Greenwich Building Society 203
Groupama 78
Guardian Royal Exchange 63, 205
Halifax Building Society 34, 50,
61, 63, 66, 203, 204
Halifax Life 63, 66
Hamburger Mannheimer 81
Hanley Economic Building Society 203
Harpenden Building Society 203
Heart of England Building Society 203
Hill Samuel 52-3, 205
Hinckley and Rugby Building
Society 203
Holland see Netherlands
horizontal differentiation 108
horizontal diversification 98-9
IBI 237
ICCRI 83
INA 33, 83, 84
Inabanca 84
ING Group 87-8, 89, 131
Institute of Actuaries 197
Insurance Companies Act 1982 195
insurance industry
Comite Europeen des Assurances
(CEA) 236
266
insurance industry (contd.)
EC Directives 31, 195,
225,229
life assurance: competition 31-2;
distribution channels 33-6;
general trends 16-18, 28-38;
profitability 133;
taxation 29-30
relationship with banking 5-7,43
savings products 15
see also under individual countries
Interbancaria 84
Internet 35
Interpolis 85-6
Investment Management Regulatory
Organisation (IMRO) 46
Ipswich Building Society 203
Ireland
bancassurance 37, 82-5
bank rescue 237
demographic trends 14
life assurance industry 29, 30, 35
regulation 226,227,237,239
Italy
Amato Law 85
bancassurance: current trends 37,
38, 82-5; entry routes 94-5;
Europe comparisons 93-6;
historical development 12;
market share 95-6;
regulation 226, 227;
taxation 93
bank competition 23
bank profitability 27
demographic trends 14
life assurance industry 16-18,
29,30,31
regulation 85, 94
savings banks 24, 83
taxation 93
Japan
life assurance industry 16-18,
29, 30, 31
regulation 225, 226, 227, 232
joint ventures
bancassurance entry route 39,
65-6,67,70
corporate diversification 104-5
Kent Reliance Building Society 203
Key Funds Management 59
KKB-Life 80, 81
Kredietbank 135
Index
Lambeth Building Society 203
LaSalle National Bank 88
Laurentian Life 205
Leeds and Holbeck Building
Society 203
Leeds Life 63, 66
Leeds Permanent Building
Society 50,61,62,63,66, 203
Leeds United Building Society 203
Legal and Generru 34, 205
life assurance see insurance industry
Life Assurance and Unit Trust
Organisation (LAUTRO) 45,46
Uoyds Bank 50,54.56-7,66,67,
68,69,70,203
Uoyds Abbey Life 56-7,62,205
London and Manchester 205
Luxembourg
bank profitability 27
demographic trends 14
regulation 226. 227
Manchester Building Society 203
Mansfield Building Society 203
Mapfre Mutualidad 91
marketing 34
Marks and Spencer 24, 32
Marsden Building Society 203
MasterCard 25
La Medicrue de France 73
Melton Mowbray Building Society 203
Mercantile Building Society 203
Mercedes Benz 32
mergers and acquisitions
bancassurance entry route 39, 66, 67
corporate diversification 105-6
merger simulations 154-65,214-19
Metropolitan Life 89, 91
MGM 205
Midland Bank 56, 57-8, 64, 65,
66, 67, 68, 203
Midland Financial Services 58, 67
Midland Life 58, 65, 66, 67
Monmouthshire Building Society 203
Monopolies and Mergers Commission
(MMC) 46
Monte dei Paschi di Siena 83
Montepaschi Vita 83, 85
Mutuelle du Mans 77
N&P Life Assurance Company 59,66
Natio Vie 73, 74, 76, 77
National and Provincial Building
Society 50, 56, 59, 65, 66, 203
 Index
National Australia Bank 63
National Consumer Council 20
National Counties Building
Society 203
National Farmers 205
National Mutual Life 205
National Provident Institution 205
National Westminster Bank 47,
61-2,65,66,70,203
National Westminster Life 61-2,66
Nationale-Nederlanden 33, 86, 87
Nationwide Building Society 61,
63,66,203
Nationwide Life 63,66
Netherlands
bancassurance
current trends 37, 38,
42, 85-9
entry routes 94-5
Europe comparisons 93-6
market share 95-6
bank profitability 27
co-operative banks 86
direct marketing 34
life assurance industry 29, 30, 35
regulation 87,94, 226,227, 239
savings banks 24
Newbury Building Society 203
Newcastle Building Society 203
NMB Postbank 33, 86, 87
North of England Building
Society 203
Northern Bank 63, 203
Northern Rock Building
Society 51, 203
Norway
demographic trends 14
regulation 239
Norwich and Peterborough
Building Society 203
Norwich Union 32, 34, 63, 205
Nottingham Building Society 203
Nottingham University 204
Office of Fair Trading (OFT) 20,
45,46,62
ombudsmen 20
organisation of bancassurance
organisational problems 40-1
organisational structures 39-40,
67-8
Pacifica 78
Partnerversicherung 81
267
pay 55, 57, 70
Pearl Assurance 64, 205
pensions
effects of demographic trends 15
see also under individual countries
Personal Investment Authority
(PIA) 47-8, 56
population trends see demographic
trends
portfolio simulations 146-53
portfolio theory 121, 145,
170,180-1
Portman Building Society 203
Portugal
bank competition 23
demographic trends 14
life assurance industry 28, 29, 30
regulation 225, 226, 227
savings banks 24
Predica 73, 75--6, 77, 83
Principality Building Society 203
privacy issues 38-9
profitability
bancassurance 133
banking 26-8
corporate diversification 113-15
life assurance industry 133
Progressive Building Society 203
Prolific Life 205
Provident Life 205
Prudential Insurance 48, 52,
64,205
R& V Lebenversicherung 80-1
Rabobank 85-6
RAS 33
Ras-Riunionc Adriatica di Sicurta 84
recognised investment exchanges
(RIEs) 46
recognised professional bodies
(RPBs) 46
Refuge 205
regulation
EC Directives 31, 195,225,
227-32,235,238-9,243
inter-country comparisons 94
regulatory issues: bancassurance
224-32, 243; financial services
industry 221-4; future
concerns 232-9; general
principles 239-40
see also under individual countries
Reliance Mutual 205
remuneration 55,57, 70
268 Index

risk self-regulatory organisations

bancassurance risk 136-7, 187-220 (SROs) 45-7
bank risk 138-86: data issues selling methods
164-78; literature appraisal bank branches 41
178-85; real studies 139-41; direct marketing 34
theoretical studies 141-64 sequenced entry 106-7
building societies, UK 202-3 Single Market Programme 23
contagion 236-8 Sistema Mapfre 91
diversification and risk studies size
164-78: industry averages 176-8, corporate diversification
192-4; market v. accounting theories 131-3
data 164-8; risk and return Skandia 132
measures 168-76, 189-94 Skipton Building Society 203
double gearing 234-6 SOCAPI 76, 77
portfolio simulations 146-53 Societe Generale 42, 73, 74
risk and return measures 170-6, Sogecap 73, 74-5, 76, 77
189-94: industry statistics 192-4; Spain
Z-score 156, 157, 159, 161, bancassurance: current trends 36, 37,
174-6, 191-2,209-11,213, 38, 89-92; entry routes 94-5;
214-15,216-19 Europe comparisons 93-6;
risk-reduction motive 119-22 historical development 10, 11,
variance-covariance analyses 145-6 12, 13; market share 95-6;
Robeco 86 taxation 93
Royal Bank of Scotland 42, 56, 60, bank competition 23
65,66,69,203 bank profitability 27
Royal Insurance 205 direct marketing 34
Royal National Nurses 205 life assurance industry 29, 30
Royal Scottish Assurance 60, 68 regulation 94, 226, 227, 239
Royal Scottish Life 66 savings banks 23-4
Rumelt's specialisation ratio 101-4, taxation 93
126, 137n staff see employees
Staffordshire Building
Saffron Walden, Herts and Essex Society 203
Building Society 203 Standard Industrial Classification
Sainsbury's 24 (SIC) 103, 126
salaries 55, 57, 70 Standard Life 34, 63-4, 66, 205
San Paolo 83 start-ups
San Paolo Vita 83 bancassurance entry route 39,
savings 65-6,67,70
current trends 16-18 Storebrand xvii
insurance products 15 Stroud and Swindon Building
savings banks 23-4 Society 203
see also under individual countries Sun Alliance 34, 60, 66, 205
Scarborough Building Society 203 Sun Life 205
Scottish Equitable 60, 66, 205 supermarket banking 24
Scottish Life 205 Swansea Building Society 203
Scottish Mutual 62, 66 Sweden
Scottish Provident 205 demographic trends 14
Scottish Widows 64, 205 savings banks 23
SE-Banken 132 synergies
Securities and Investments Board bancassurance 39,42,69-70,
(SIB) 45,46 133-6
Securities Association, The (TSA) 46 corporate diversification 115-17
Seguros Genesis 89, 91 taxation 117-18
 Index 269
Target Life 52-3, 66 11; life assurance 34;
taxation merger simulations 214-9;
life assurance products 29-30 pensions 50;
synergies 117-18 regulation 44,48-51;
see also under individual countries Schedule 8 revision 50;
Teachers' Building Society 203 statistical information ·205-14;
Tesco 24 Treasury review 50
The Securities Association (TSA) 46 City Panel 46
Third Life Directive 31 Companies Act 1985 195
Ticino Assicurazioni 83 consumer protection 20
Toro Assicurazioni 84 customer awareness 19-21
training 57,58,61 demographic trends 14
TSB Group 44, 51, 52-4, 56, 66, Department of Trade and Industry
67, 68, 69, 70, 203 (DTl) 46, 195-6, 198-201
TSB Life 35,52-3,66, 133,205. direct marketing 34
TSB Trust Company 52, 84 diversification and risk studies
Tynemouth Building Society 203 187-220: data 202-5; life
assurance accounting 194-202;
lJPlP 33, 77, 78, 79 merger simulations 214-9;
lJlster Bank 203 methodology 188-9; risk and
lJMAC 74 return measures 189-94;
lJmac Vie 73 statistical information 205-14
lJnion y el Fenix 89, 90 Financial Intermediaries, Managers
lJnited Friendly 205 and Brokers Regulatory
lJnited Kingdom Association (FIMBRA) 45-7
accounting practices 194-202 Financial Services Act (FSA) 1986
Association of British Insurers 44, 45-8, 71, 94, 242
197-8 Financial Services Authority 239
Association of Futures Brokers and Form 9 198-201
Dealers (AFBD) 46 Institute of Actuaries 197
bancassurance: 'assurbanque' 63-5; Insurance Companies
current trends 32,33-4,37, Act 1982 195
38, 42, 44-71, 242-3; insurance industry: banking
distribution channels 68-70; products 64; life assurance
entry routes 65-7,70, 94-5; accounting 194-202; life
Europe comparisons 93-6; assurance industry 29, 30,
historical development 11-13, 31,32,34, 133,203-5,205-14;
51-65; life assurance sector life assurance regulation 45;
34-5; market share 95-6; life assurance trends 16-18;
organisational problems 41; merger simulations 214-19;
organisational structures 67-8; motor insurance 42
regulation44-51; taxation 93 Investment Management Regulatory
Bank of England 46, 50, 205, 233 Organisation (IMRO) 46
banks: merger simulations 214-19; Life Assurance and lJnit Trust
profitability 27; statistical in- Organisation (LAlJTRO)
formation 205-14 45,46
building societies: bancassurance 34, Monopolies and Mergers Commission
47; Building Societies Act (MMC) 46
1986 44,48-51,242; Building mortgage finance 7
Societies Association (BSA) National Consumer Council 20
202, 205; Building Societies Office of Fair Trading (OFT) 20,
Commission 46; competition 45,46.62
48-9, 50; diversification and risk ombudsmen 20
studies 202-3; home insurance pensions 15, 48
270
United Kingdom (contd.)
Personal Investment Authority
(PIA) 47-8, 56
personal investment
regulation 45-8
recognised investment
exchanges (RlEs) 46
recognised professional
bodies (RPBs) 46
regulation 44-51, 94, 222,
225,226,227,233-4,
236,237,239
savings banks 24
Securities and Investments Board
(SIB) 45,46
self-regulatory organisations
(SROs) 45-7
supermarket banking 24
taxation 93
The Securities Association
(TSA) 46
see also individual banks, building
societies and insurance firms
United States
bank diversification and risk 138-86:
data issues 164-78; literature
appraisal 178-85; real
studies 139-41; theoretical
studies 141-64, 201
bank holding companies
and risk 138-86
competition 232
consumer protection 233
Federal Deposit Insurance
Corporation (FDIC) 168
Federal Trade Commission
(FTC) 126
Index
life assurance industry 16-18,
29,30,31
privacy issues 39
regulation 222,225,226,
227, 232, 233
size of conglomerates 132
synergies 134
Universal Building Society 203
variance-covariance
analyses 145-6
Vernon Building Society 203
vertical differentiation 107-8
vertical integration 99
Vida Caixa 89,90-1
Virgin 32, 34
Visa 25
VSB 86-87
wages 55, 57, 70
Wesleyan Assurance Society 64, 205
Wesleyan Savings Bank 64
West Bromwich Building Society 203
West Cumbria Building Society 203
Windsor Life 205
Winterthur 81, 232, 242
Woolwich Building Society 50,
56,59-60,65,66,203
Woolwich Life 59-60, 66
Yorkshire Bank 63, 203
Yorkshire Building Society 203
Z-score 156, 157, 159, 161,
174-6,191-2,209-11,
213, 214-15, 216-19
Zurich Life 205