BANCASSURANCE

BACKGROUND

• Bank deregulation is changing the face of the financial services in India.

• Deregulation has increased competition thereby creating excessive pressure on the banking system by narrowing the interest spread.

• Commercial banks have expand their activities beyond the traditional functions.

• Bancussrance helps the bankers to venture into insurance avenues.

INSURANCE - FEATURES

• Generates fee based income.• Scope for business

– Large under-served market with relatively less efficient distribution system

• Branch network has high fixed cost.• Banks by utilizing network more productively can venture

into other services such as insurance.• Apply wider range of activities to gain the economies of

scope.

ADVANTAGE TO BANKERS

• The proximity and knowledge about their customers – Depositors and Borrowers

• Bank’s control of insurance business– European countries, between 20% to 40% – US market merely 1%

BANCASSURANCE IN OTHER COUNTRIES

• Restriction on the extent to which banks could engage in domestic life insurance activities curtails US banks.

• Banks capitalize on the long-term savings and pension strength of insurers in European banks.

• Insurers are attracted by bancassurance due to the possibility of gaining short-term deposits.

BANCASSURANCE

• Bancassurance allows banks and insurance companies to hold significant ownership stakes in one another.

• Bancassurance is enforced through a legislation by the Government.

• Bancassurance legislation differs from country to country.

• No country allows the bank and the insurer to combine in a single legal entity and remain controlled by their own respective regulatory agency.

BANKING & INSURANCE: KEY DIFFERENCE

• Core function in insurance is to intermediate risk itself. – The risk in this service must be well managed – Bearing the risk itself is the service provided by the

insurance company• Core function in banking is to intermediate between

lenders and borrowers – Banks acquire risk as a consequence of conducting

the banking function rather than being intrinsically the same as that function

– Banking function is to be managed well because it is risky

INSURANCE COMPANY

• Insurer’s liabilities: Capital adequacy in relation to the proportion of risk assumed by the insurance company

RISK IN INSURANCE SECTOR

• Adaptive control cycle

• Gather data, make assumptions, set appropriate terms and conditions for policies

• Classify and rate risks

• Assess experience against expectation and adapt practices and rates accordingly

RISK IN INSURANCE SECTOR

• Principle of risk diversification: Insurance companies charge premiums that spread the number of expected claims across a large number of policy holders commensurate with their contribution to the overall exposure and draw upon the collective pool of premiums to meet actual claims.

• The number of independent risks increases.

• The overall risk becomes more stable when considered as a proportion of expected number of claims.

RISK IN INSURANCE SECTOR

• Claim Risk: The fundamental risk in insurance is not being able to meet claims because of the variability of the number of claims. It is necessary for insurers to hold capital adequately for the risk they face.

• Insurers set premiums that reflect not only the expected risk but also a margin to accommodate contingencies and to provide an economic return on the capital.

RISK IN INSURANCE SECTOR

• Diverse nature of risks that are insured give rise to the need for appropriate risk classification.

• Insurance market consists of two kinds of customers – Low risk – High risk

• Risk differential do not result in pooling equilibrium when both the risk classes pay the same premium for the same coverage.

• Equilibrium can only be reached by separating these two kinds of risks.

PRICING COMPARISON

• A bank sets rates on its lending and deposit products by taking into account its cost of funds and expense margins and fees without any distinction between acquisition and service activities.

• Life insurance, by contrast, involves looking at and separately keeping track of each group of business for each investment and insurance product type. It distinguishes between the acquisition and other costs.

RISKS IN BANCASSURANCE

• Credit Risk• Concentration Risk• Liquidity Risk • Realization Risk• Operational Risk• Market Risk

– Interest Rate Risk (Re-pricing, Yield Curve, Basis and Options)

REGULATION AND CAPITAL ADEQUACY

• Difficulty in regulation and supervision arises primarily because despite the complementary nature of the two types of products, the nature of business and risk that banks and insurance companies face are very different.

• Bank and insurance supervisors have different definitions of capital and different solvency and liquidity requirements.

REGULATION AND CAPITAL ADEQUACY

• Solvency in insurance is concerned with meeting obligations and capital adequacy is concerned with the ongoing business of the insurer and its ability to fulfill policy holders’ expectations.

• Capital adequacy standard in insurance is less prescriptive and reflects actuarial judgment more than that for solvency.

REGULATION AND CAPITAL ADEQUACY

• In 1999 a tripartite group of banking, insurance and security regulators from G-10 countries produced a report ‘The supervision of Financial Conglomerates’

• The main issue addressed is that it is possible for the entities in a group to fulfill their capital requirements on an individual basis, but for the group as a whole to have less own funds than the sum of its parts.

REGULATION AND CAPITAL ADEQUACY

• The group suggested four quantitative techniques to assess capital adequacy– Building Block Prudential Approach– Risk Based Aggregation– Total Deduction– Risk Based Deduction

BUILDING BLOCK PRUDENTIAL APPROACH

• In building block approach, the consolidated balance sheet of the group is split according to type of business.

• Capital requirements are calculated by each supervisor and added together.

• This is then compared with the aggregated own funds of the group.

• If the consolidated balance sheet is not available, capital requirements of individual companies are computed and added up and then compared with group capital.

BUILDING BLOCK PRUDENTIAL APPROACH

• As the intra-group exposures are not automatically netted out, this method can produce stricter capital requirement.

BUILDING BLOCK PRUDENTIAL METHOD

• Consolidated balance sheet separated down into its major firms

• Specific capital requirement is calculated for each firm• Requirements are deducted from each firm’s actual

capital to calculate surplus / deficit• Items deemed non-transferrable are deducted• Specific capital requirements are aggregated and

compared to actual firm’s capital to identify the surplus or deficit.

EXAMPLE

Division of Balance Sheet

Banking Insurance Securities Unregulated

(Parent) (60% ownership)

Full Consolidation

Banking Insurance Securities Unregulated Total

Capital required

42 12 20 12 86

Actual capital 50 15 25 10 100 Surplus (Deficiency)

8 3 5 -2 14

EXAMPLE

Pro Rata Consolidation

  Banking InsuranceSecurities

(60%) Unregulated Total

Capital required

42 12 12 12 78

Actual capital

50 15 15 10 90

Surplus (Deficiency)

 8 3 3 -2 12

TOTAL DEDUCTION & RISK-BASED DEDUCTION

• In total deduction method, the book value of the investment in subsidiaries is deducted from the parent’s own capital.

• In risk-based deduction method, the capital requirements of each subsidiary is matched directly against the own funds of that subsidiary. Surplus, if any, can be used to augment group capital base.

RISK BASED DEDUCTION METHOD

• Dependant’s investments are fully segregated from parent capital

• Specific capital deficits may also be considered• Adjusted capital is compared to the parent’s specific

capital requirement

EXAMPLE

Parent Bank

  Insurance Securities Unregulated    (60% owned)  

Capital investment 15 12 5

Bank Capital70

EXAMPLE

  Insurance Securities Unregulated BankSpecific capital required 15 15 14 32Actual capital 18 20 10 70

Surplus (Deficiency)  3 5 -4 38

EXAMPLE  Bank capital 70

Deduction of capital investment in dependants      Insurance -15  Securities -12  Unregulated -5     Additional dependants deficit      Unregulated -4     Adjusted Bank capital   34

Bank specific capital requirement   32Bank surplus capital   2

RISK BASED AGGREGATION

• Add specific capital requirement of parent and dependants

• Add actual capital held by parent and dependants• Deduct any upstream or downstream capital• Deduct any non-transferrable items• Compare aggregate requirements to aggregated group

capital of surplus or deficit

EXAMPLE

Parent Bank

  Insurance Securities UnregulatedDown streamed capital

    (60% owned)    Capital investment

15 12 5 32

Bank Capital70

EXAMPLE

Full Consolidated

  Insurance Securities Unregulated BankDown streamed capital

Group capital

Specific capital required

15 15 14 32   76

Actual capital 18 20 10 70 -32 86

 Surplus (Deficiency)

3 5 -4 38 -32 10

Example

Pro Rate Consolidation

  Insurance Securities Unregulated BankDown

streamed capital

Group capital

Specific capital required

15 9 14 32   70

Actual capital 18 12 10 70 -32 78Surplus

(Deficiency) 3 3 -4 38 -32 8