|Can Insurance Sales Keep Revenue Afloat? (September 2010)|
That depends on whether banks commit or dabble. Community banks stand to gain the most, but have to clear Relevance, Capital, and Knowledge hurdles.
The answer depends on whether banks commit or dabble. Community banks stand to benefit the most but have to clear three hurdles
By Jim Campbell
In the late 1990s, as banks were wading into the insurance brokerage business, they were motivated by two objectives. One was to grow non-interest income. The other was to capitalize on what seemed to be a rich cross-selling opportunity. Both objectives were significant motivators, but the latter was the more compelling.
Today, these objectives have reversed. The American Bankers Insurance Association (ABIA) recently conducted a survey of 113 banks that sell insurance products. Nearly two-thirds (63%) of the surveyed banks responded that their primary objective for selling insurance is to “increase non-interest income.” By comparison, only 27% responded that their primary objective is to cross-sell (see Exhibit 1, p 34). These results are statistically consistent with those of a 2008 ABIA survey, indicating that positions on this issue are stabilizing.
This shift in objectives is due in part to the sobering realities of cross-selling. Many banks have struggled to crack the code for selling insurance products to their customers. And though some cross-selling success has been achieved, it has generally not been at the lofty levels expected.
The larger reason for this shift, however, is more fundamental to the banking business. Over the past 15 years, the industry has experienced steady erosion in its net interest margin, resulting in a total margin decline for many banks of 50 to 100 basis points, or more.
To offset the declining net interest margin, banks have sought to increase non-interest income. And they have succeeded. According to an SNL Financial index of U.S. banks, the ratio of non-interest income to operating revenue increased from 35.1% in 1995 to 45.8% in 2009. However, most of this gain was achieved by larger banks. Specifically, the non-interest income ratio for banks with assets greater than $10 billion increased substantially over this period, while the ratio for banks with assets of less than $10 billion barely moved.
Although smaller banks have struggled to grow non-interest income, they have at least enjoyed relative stability in these income sources. Conversely, as larger banks have expanded their non-interest income portfolios, they have become exposed to greater volatility. Trading account gains and fees, for example, contributed more than 10% of 2007 non-interest income for banks larger than $10 billion, but plummeted to a negative contribution the following year. As this and other income sources collapsed, total non-interest income for larger banks fell dramatically in 2008. Meanwhile, non-interest income for smaller banks, anchored in less glamorous but more predictable sources, remained relatively constant.
Today, however, non-interest income, especially for smaller banks, may be destabilized by regulatory change. Deposit account service fees, including overdraft charges, are the leading source of non-interest income for community banks. But changes to Regulation E, which became effective July 1, take direct aim at this income. As a result, many community banks are forecasting a 10% to 20% reduction in non-interest income.
The pressure on community banks is significant. Their net interest margin has been squeezed and their non-interest income is about to take a hit. Can the insurance brokerage business help community banks ease the pressure by providing an additional source of non-interest income? The answer is “yes,” but the banks that will benefit are those prepared to navigate three challenges: 1. the relevance challenge, 2. the capital challenge, and 3. the knowledge challenge.
The Relevance Challenge
According to the 2010 Michael White–Prudential Bank Insurance Fee Income Report, nearly two-thirds of U.S. bank holding companies participated in the insurance brokerage business in 2009. In fact, more BHCs sold insurance products last year than sold mutual funds, annuities, or securities. But the aggregate contribution was insignificant as insurance brokerage accounted for less than 2% of all non-interest income for the banking industry last year. Bottom line—many banks are only dabbling in the insurance business.
There are, however, exceptions to this rule. Few banks have had more success in the insurance brokerage business than has The Adirondack Trust Company (ATC), a community bank in Saratoga Springs, N.Y., with assets of $857 million. ATC entered the insurance brokerage business through an agency acquisition in 2001 and has continued to grow the business since. In 2009, ATC reported $10.7 million in insurance brokerage revenues, representing more than two-thirds of its total non-interest income. By comparison, deposit service fees were a minor contributor. According to Charles Wait, chairman and CEO of ATC, “It would be fine with me if insurance was 90% of our non-interest income. It requires little infrastructure, the risks are relatively low, and the bottom line has exceeded our expectations.”
And Adirondack Trust is not alone. More than 30 BHCs earned at least 30% of their total 2009 non-interest income selling insurance, more than 50 earned at least 25% and more than 60 earned at least 20%. What do most of these BHCs have in common? They are relatively small. In fact, of the 50 BHCs that earned the highest percentage of their 2009 non-interest income from insurance brokerage, 39 have assets between $500 million and $2 billion.
Smaller banks are having more success achieving financial relevance because the insurance brokerage business is highly fragmented and building scale is difficult. To illustrate, assume two banks with assets of $25 billion and $1 billion, respectively. Further assume that, for both banks, total non-interest income is equal to 1.5% of assets. For the larger bank, this translates to $375 million of non-interest income. In order for the insurance brokerage business to represent 20% of this non-interest income (a working definition of “relevance”), it would need to generate $75 million in annual revenue. If so, it would be among the 50 largest insurance brokers in the U.S. By comparison, only $3 million in insurance brokerage revenue is required to represent 20% of non-interest income for the smaller bank.
Due to the challenges of building scale, achieving financial relevance is inversely correlated with bank size. Smaller banks hold the advantage. But just because relevance is more attainable for a community bank, doesn’t ensure it will be realized. Many community banks have failed to build their insurance business to relevant scale, often due to a lack of planning. Nearly two-thirds of the banks participating in the 2010 ABIA survey have not even defined a targeted percentage of their non-interest income to be derived through insurance sales. Without a target to guide their strategies, banks that sell insurance are at risk of falling short of financial relevance, and perhaps even joining the ranks of the dabblers.
The Capital Challenge
While community banks hold an advantage over larger banks in achieving financial relevance, the smallest community banks may be at a disadvantage when it comes to the capital challenge.
Consider the following example. Assume a bank with $250 million in assets is contemplating an agency acquisition strategy. As applied above, the financial relevance test (20% of non-interest income) indicates the bank would need to acquire an agency with at least $750,000 in revenue. But the bank determines that an agency of that size won’t provide it with an adequate insurance platform. Specifically, the bank determines that the leadership, production, carriers and infrastructure needed to support its strategy will require a larger agency—one with approximately $2.5 million in revenue.
Assume further that the bank will need to invest $4.25 million (a revenue multiple of 1.7) to acquire an agency of this size. Because most of the value of the agency is recorded as goodwill, it will be deducted from Tier 1 capital. A larger community bank may have no problem with such a substantial deduction to Tier 1 capital, but for some small community banks, it’s a show-stopper that could drop their leverage ratio to an unacceptable level.
Given the recent economic environment and the resulting pressure on bank balance sheets, many banks are already in capital-preservation mode. And regulatory reforms, which threaten to bring about more stringent capital requirements for banks, are adding to the uneasiness. As a result, uncertainty regarding capital is curtailing investments. In light of this constraint, an insurance agency acquisition strategy may be a tough sell for smaller community banks, other than for the most well-capitalized.
The Knowledge Challenge
Many banks, however, may be derailed before they even have the chance to navigate the relevance and capital challenges. Based on the results of a second ABIA survey, targeted specifically at community banks that don’t currently sell insurance, the greatest barrier to these banks entering the insurance brokerage business may be knowledge.
Overwhelmingly, the surveyed banks acknowledge an increasing need for additional non-interest income. In addition, these banks generally find the insurance brokerage business to be an attractive option that is at least as appealing as alternative sources of non-interest income. Yet, most remain hesitant to enter the business. The primary reason for their hesitancy, sited by 42% of the surveyed banks that don’t anticipate entering the insurance business, is their “lack of knowledge of insurance.”
Charles Wait understands this reluctance since he experienced it himself. “I didn’t have a lot of knowledge about insurance and so I wasn’t interested at first,” says Wait. “Fortunately, a local agent persisted. He was interested in selling to us and I told him “no” twice. The third time, he prevailed and we began to set some simple targets.” Serendipitously, at about that time, Adirondack Trust Co. had the opportunity to hire an experienced insurance executive to help bridge the knowledge gap.
Most bank CEOs are relatively unfamiliar with the operational and financial aspects of insurance brokerage. Before they can be an effective advocate, they will need to raise their own comfort level. Whether through acquiring, hiring, or developing insurance expertise, bridging the knowledge gap is a prerequisite for bank executives to lead on this issue, as Charles Wait has shown.
As the pressure to find new sources of non-interest income continues to mount, the case for selling insurance is strengthening—especially for community banks. But the challenges are significant enough to require more than a half-hearted effort. To meet these challenges, agency acquisition strategies will need to define a targeted, relevant contribution to non-interest income. The bank will need to be sufficiently well-capitalized to meet the requirements of the acquisition strategy. And bank management will need to bridge its knowledge gap in order to provide effective leadership.
For many community banks that are contemplating entry into insurance brokerage, both the need and the opportunity are evident. But the time for dabbling has passed. •
The electronic version of this article available at: http://www.nxtbook.com/nxtbooks/sb/ababj0910/index.php?startid=32
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