The insurance underwriting industry won a sweeping victory when a panel of the 11th U.S. Circuit Court of Appeals, based in Atlanta, said insurance regulators have the sole authority to determine whether a hybrid bank or insurance product is banking or insurance.

Banking lawyers cautioned that the ruling conflicts with other recent court decisions, including two by the Supreme Court. Efforts to contact the Washington offices of American Deposit Corp., which has a pending patent on the product, were unsuccessful. It would be the only entity able to appeal the decision to the Supreme Court. Michael Crotty, deputy general counsel for litigation for the American Bankers Association, reacted to the decision by saying, "These guys just missed it. It is flat wrong.

"It flies in the face of several recent unanimous Supreme Court decisions, including Barnett, decided in 1996, and Valic II, which was handed down in 1995," he said. It also is contradicted by Valic I, handed down in 1959, which says annuities are securities and not insurance, Crotty said.

The court held that the National Bank Act is a minor law and is "trumped" by the McCarran-Ferguson Act when an analysis is made whether a product is banking or insurance. The case deals with a Montana bank’s effort to sell a fixed annuity as a bank product. The product, called a "Retirement CD," was advertised as providing tax-deferred treatment on earnings inside a bank’s federally-insured certificate of deposit. Upon maturity, the accumulated value of the product would be distributed to the owner in periodic payments, like an annuity.

"The Retirement CD was an annuity, an insurance product," said Gary Hughes, vice president and general counsel of the American Council of Life Insurance. "Equally important, the court noted that the Office of the Comptroller of the Currency overstepped his authority in 1994 by giving the product the green light. What this shows is that Congress, not the OCC, will decide whether banks or their affiliates will be allowed in the future to underwrite annuities and other insurance products," he added.

With his eye on pending legislation that would bar banks from underwriting annuities in operating subsidiaries, Hughes added, "If any banker had considered sidestepping Congress and underwriting annuities in a bank’s operating subsidiary, this should significantly dampen those plans."

But David Roderer, a banking lawyer in Washington, called the decision "backward-looking, static and simplistic." He explained that the court looked at the issue as if there were no hybrid products, only banking, insurance and securities products. He added that the National Bank Act, and the Supreme Court’s interpretation of that law "clearly indicate that the agency has the authority to adjust banking products to the times."

A federal court decision that limits national bank sales of insurance outside of small towns to credit-related products is "troublesome," but could set the stage for the reversal of two long-standing appeals court decisions contrary to existing precedent that the industry has wanted to attack for some time, sources said.

The decision Judge June Green handed down March 23 says national bank insurance sales are limited to small towns unless they are credit-related, and also says the Comptroller of the Currency exceeded its authority in declaring crop insurance a "credit-related" product.

Staffers at the OCC said the agency would appeal the ruling.

The decision was based on two precedents, set in 1968 and 1989. The courts held that Sec. 92 of the National Bank Act, which says that, "in addition to all other powers" banks are allowed to sell all types of insurance from offices in places of 5,000 or fewer, is an implied bar on national bank insurance sales outside of small towns.

Acting Comptroller Julie Williams had based her interpretation allowing Iowa national banks to sell crop insurance on another provision of the National Bank Act, Sec. 24(7th), the incidental powers clause. In approving the Iowa banks’ application, Williams had ruled that sale of such insurance is part of, or incidental, to the business of banking. But, in her decision, Green said that ruling "appears limited to a certain type of insurance known as ‘credit life’ and does not purport to stand for the notion that Sec. 24 (7th) can be used to authorize the sale of all insurance by national banks everywhere." But, she said, "crop insurance protects the farmer, not the lender, and is therefore not credit-related."

But David Roderer, a Washington banking lawyer, calls the decision "troublesome," and contrary to the Supreme Court’s 1995 ruling that the Comptroller has the authority under the incidental powers clause to reinterpret the National Bank Act to fit changing market conditions affecting national banks.

While troublesome, Roderer said, the Green decision allows banks and the Comptroller an opportunity to have appeals courts revisit the two older decisions, which the banking industry universally believes are contrary to the 1995 precedent.

In another sign of the converging financial services industry, a New Yorkbased life insurance company has won approval to provide trust services to its customers nationwide through a unitary thrift.

However, a banking industry lawyer said that in approving the application by Guardian Life Insurance Co., the Office of Thrift Supervision (OTS) has imposed new, "intrusive" restrictions on non-banks using unitary thrift charters to conduct parts of their financial services businesses. Institutions planning to apply for this type of thrift charter should be aware that the agency is now imposing new restrictions between broker/dealers and trust companies operated out of thrifts.

In its application, Guardian Life said a number of insurance, securities and investment companies, which operate mutual funds, are finding that the thrift charter is the ideal vehicle to provide nationwide trust services to customers. The new institution will be known as Guardian Trust Co. FSB, and will employ eight to 10 trust professionals.

The president of the newly-chartered institution, Francis Quinn, said Guardian, a $26-billion-asset life insurance and reinsurance firm, will likely launch its new service in June, after meeting several preconditions imposed by the OTS when it approved the new charter March 26.

Guardian will use its new unitary thrift to provide such nationwide services as trusts and individual retirement accounts through Guardian’s existing 5,000 employees and 3,000 agents, Quinn said. Most agents work through general insurance agencies; Guardian, a mutual institution, and its officials have said that it plans to remain one.

Guardian will feature multiple money managers, tax-sensitive investing and superior reporting capabilities to its trust customers, Quinn said. "Our options include separate account management, directed portfolios and mutual fund asset allocation services," he said. "We will not offer annuities as a product of the trust company. But, if an annuity is in the portfolio, we can manage it at the trust company.

"We see our role as providing sophisticated services our field associates can offer to their clients," Quinn said. "We don’t see ourselves as competing with the banks. There is a whole industry of nontraditional providers of trust services," he said. They are affiliated with securities firms, insurance companies and investment management firms, which include mutual funds companies.

However, a lawyer in Washington said the OTS’s approval "is unusually intrusive both as to what has to be done immediately and what must be done going forward, particularly as to the relationship between the trust and the securities dealing activities of Guardian."

The lawyer said the approval "imposes certain restrictions and arrangements we haven’t seen in the past. That seems to suggest that the agency is still grappling with issues as to the level of regulation that is appropriate and the level of freedom that should be enjoyed by trust operations in a diversified financial institution structure."

He said that one of the provisions that concerns him is language designed to "ensure that neither the broker nor the holding company dominates the federal savings bank to the extent that one is treated as a mere department of the other." The agency is clearly "seeking to ensure that there is adequate corporate independence so that the thrift is not just a department of the insurance company operations." The agency appears especially concerned with the independence of the thrift from Guardian’s securities brokerage unit, Guardian Investors Services, a registered broker/dealer.

Certain disclosures regarding trust operations, particularly in conjunction with securities brokerage, that must be made by Guardian Trust are new, the lawyer said.

But Quinn said Guardian is "comfortable with the terms of the order the OTS has issued. We were able to meet all the requirements that we understood were presented to us."

Despite banks’ apparent fervor to enter new financial services arenas, such as brokerage products and insurance, they have dropped the ball and now must scramble to avoid getting left permanently behind, according to a report released last week by the Bank Administration Institute and the Boston Consulting Group. The report adds, however, that a quick reversal of the current trend could send bank retail revenues skyrocketing.

The report, Putting It Together: Convergence Strategies For Banking, Insurance and Investments, issues the industry a stern warning, citing woeful statistics of its rapidly falling "share of wallet." It proceeds to offer specific advice to turn the bleak situation around, including quickly increasing banks’ commitment to insurance and other mass market products.

The study asserts that the European system of bancassurance, in which banks have fully integrated insurance and investment products with traditional retail banking, should be used as a model by American bankers. The report cites statistics of the 50% share of the life and pension market in France held by banks, and the 30% share in Spain. By comparison, U.S. banks have 1% of the market. The European banks’ costs are 50%-70% lower than independent insurance agencies in Europe, and the branch sales system sells three to five times as many insurance policies as the conventional sales system, the report said.

John Garabedian, a vice president at the Boston Consulting Group who oversaw the study, said banks have fallen down and let business go to other more aggressive financial service firms by only making "halfhearted" commitments to the new markets.

"Banks need to make a commitment to improving the consumer insurance experience and leveraging elements of their existing administrative, marketing and distribution infrastructure to provide these products at a lower cost and with wider margins. By using their own networks efficiently, banks have the potential to double their profit per customer," Garabedian said.

The study cited statistics showing banks’ share of the retail financial services wallet has slid to 34% in the late 1990s from 50% in 1981, and that banks are paying even more to garner new customers, the majority of whom do not turn out to be profitable. The study counters that woeful picture with the assertion that banks are "well positioned" to reverse the trend by getting into the mass market with insurance and investment products.

Like their more successful European counterparts, U.S. banks are more suited to the sale of insurance than traditional insurance agents, the report says, because of their existing administrative infrastructures and customer base, trusted brand and a lower-cost sales force. The report asserts that if banks made a major commitment to insurance and "a more narrowly targeted commitment to investments," retail revenues could jump by almost 50%.

Other strategies the report touts include selling more aggressively to women and members of Generation X, who have traditionally been under-tapped by traditional insurers and financial advisors. Also, the report advises bankers to market more aggressively cash management products that bundle checking accounts with investment products and offer limited investment guidance to first time and young investors, to maintain market share.

Banks selling insurance are running into a problem with what should be a slam dunk: selling homeowners’ insurance to customers who have just taken out a mortgage. Solving the quandary is one of the main goals for the industry, sources said.

The problem arises when a bank turns to its insurance carrier to underwrite a policy and the underwriter cannot write any more policies for a particular area. Similar to a quota system, insurers do not want more than a certain amount of coverage in specific geographical areas, because significant coverage could mean financial ruin in the case of a natural disaster. The industry learned this lesson back in the early 1990s after Hurricane Andrew ripped through South Florida, causing hundreds of millions of dollars worth of damage.

To ask an insurer to write more policies in an area than it deems inappropriate, a bank would have to be able to balance the insurer’s exposure in danger-prone areas by bringing more production in non-danger areas. Today, the party who is protecting the primary insurer, the reinsurer, charges the insurer more than it would be worth to take on the extra business. Because the primary insurer has committed to the secondary insurer to fix the concentration of losses, the primary insurer must pay a hefty fee to go over the limit. So, in this situation, the bank’s insurance agency must find another underwriter to write the policy–and it may also be at capacity for that area.

Sources said now the only thing to do is work to appease insurance carriers by bringing more business in other areas. But that has not proved easy.

"That is the one thing banks hope to be able to do, especially ones that operate in many states. They can help insurance companies keep their ratio limits in line to help balance out coverage in less attractive areas. I haven’t seen many cases where they can make that work. It’s very early in these programs and they haven’t generated performance to show how much volume they’ll be able to generate. It’s hard to convince (insurance carriers) you can bring value," said bank consultant Frank Caccione, of the Mitchell Madison Group.

Jeff Huff, manager in sales for property and casualty for one of the bank-in-insurance industry leaders, BB&T, said the problem of insurance companies struggling to make the homeowners’ insurance line profitable is a tricky one. If a bank’s insurance unit has enough contractual relationships with enough carriers, he said, a policy can usually be found; it’s just that it will not be at a sellable price in the market. This is because some giant carriers that distribute only to their own agents, such as State Farm or Allstate, will probably have lower prices. But, at the same time, Huff said, "The bigger the bank and the more spread they have, the harder it is to have the right company for all the opportunities that it would have to provide insurance. Most banks are having some heartburn over this. How do you be all things to all people, but do it efficiently with as few carriers as possible? This is getting a lot of tension now as the industry consolidates."

He said BB&T has tackled the problem by trying to work with all of its carriers to understand their strategies, weaknesses and strengths. "We try to direct business to companies’ strengths as best we can. We hope they’ll look favorably on us and allow us to carry the banner into new territories for them. You just feel your way through the thing," he said.

A group of insurers has moved the ball forward on the important issue of onshore securitization of catastrophic risk, which banks may soon be interested in as investments. But important hurdles remain to be negotiated.

The new instrument may also help banks hedge risk stemming from concentrations of loans that could be adversely affected by a hurricane or other natural disaster.

While approving a draft of a model act designed to allow insurance companies to securitize their risk within the United States, the NAIC Working Group on Securitization stalled on further efforts to bring the concept into reality.

The life insurance industry and other institutions are looking at investing in such arrangements as soon as property and casualty companies get state regulatory approval to do so.

The exposure draft of the model, approved last week at the NAIC’s spring meeting in Washington, D.C., calls for assets to be carried at fair value. It will also require fully active cells and funded dollar-for-dollar transactions within the protective cells, and will ban derivative-based deals–for now.

Jeffrey Alton, chief accountant for CNA Insurance Company, said that under the proposal, insurers will have to file a plan of operation with each insurance department. "It should be very clear to a regulator what exposures preside in those cells." Alton said he did not support the concept that the protected cell should have a separate risk based on a capital charge of 10% that stems from concerns of potential tax liabilities.

CNA has pushed the hardest for quick approval of the catastrophe model so it will be in place by the next hurricane season.

Questions continue to arise over whether the assets contained in the protective cells will be enough to sustain the liabilities. Mike McCarter, vice president of accounting for American International Group, isn’t worried. "These are high quality securities," he said.

He said that within the month, he hoped to be able to hook customers up to the bank’s brokerage unit, Midwest Capital Management, Inc., so they can execute trades on-line. A little bit of that is making sure Gold Banc "gets in front of the money," he said, adding that banks should get more aggressive in the securities area. "We have been letting investment strategy go to Wall Street as opposed to letting that money go to the market through the bank." The securities unit finished 1998 with 27% of net interest income for the bank up from 16% in 1997. Gullion said the bank’s goal for the brokerage unit is to be in the 30% range within a year. Part of the expansion of the firm, bought in March 1998 for $4.25 million, will come from the ongoing project of putting investment centers in each of the 28 locations.

The company also provides wholesale services to banks throughout the Midwest. Gullion said that, typically, Gold Banc wants its service companies, which include The Trust Company and Gold Banc Insurance Agency, to shoot for a 20% return on revenue. "We are looking for not just 8-10% growth a year, but 30%–not just in terms of earnings-per-share growth, but income. That is a factor of improving efficiencies and income streams and growing the company in terms of acquisitions," he said.

The insurance agency, while centralized, is a work in progress, as management evaluates how best to deliver the product in the future. The goal is to have an agent in 75% of the branches. The company sells property and casualty, life and health insurance. Gullion said the bank is not interested in getting involved in bond underwriting, professional insurance, or any areas "requiring a high degree of expertise."

The company is at work on a business plan for The Trust Company, acquired at the end of last year. The idea is to bring the service to all banks by mid-year, with officers in the larger branches full-time and videoconferencing to the smaller branches. Now, the firm has full-time trust officers at two banks, insurance agents at five banks, and investment retail brokers at four banks.

Gullion said the bank is always looking for new acquisitions, the criteria being number one or two market share and strong leadership by bankers who believe in the community banking model.

The acquisition of multiple insurance agencies, pioneered by the likes of Norwest and BB&T, is on the cusp of spreading widely among banks as they become more comfortable with their first acquisitions. Now they’re seeking to expand that line of business, not just cross sell products to bank customers.

Union Bank in Ottawa, Ill., for example, is getting comfortable with the integration of the insurance agency it bought last year, and is now looking around to buy another.

Scott Grigsby, president and CEO of Union Bank, said the October purchase of the Mercier Agency was actually two agencies in one. Just before Union’s acquisition of privately-held Mercier, Mercier had acquired the Bryan Agency. The agency has been rechristened Union Financial Services, and has both insurance and brokerage services.

"We are looking at expanding," said Grigsby. "We’re in quite a few markets right now throughout Illinois and we think that acquiring different books of business in those markets might be an advantage." He added that the $625-million-asset bank took a year-and-a-half to two years to buy an agency because it took that long to find one it really wanted.

"You don’t just buy one insurance agency and be satisfied you’re in the insurance business. You grow it and get economies of scale. Get the initial base and build on that," said John Pottridge, who heads up his own bank consulting firm in Alexandria, Va. Pottridge has one bank client which is nearing the close of a deal to buy its fourth agency.

Pottridge said that the new movement is to buy the first agency and let it continue to run without immediately handing over the bank’s biggest asset: its customer base. The key to making the insurance business really work and meet profitability expectations is in developing a strategic plan to acquire insurance agencies over time in a way that makes sense for the bank, he said. The agencies should be chosen on the basis of what kind of insurance business the agency has and how well that blends in with or adds to the bank’s customer base. Another consideration is the location in the bank’s market. As the agencies are chosen and acquired, an integrated and fully developed sales and marketing plan must be implemented. Part of the plan is to have provisions for how the bank’s customer base will be used for the entire insurance organization as it develops. Too often, a bank will buy its first agency, and turn over the entire customer base to the single agency, which probably will not have the entire range of products the bank aims to offer, and that can be a mistake.

Pottridge explained that the downfall of many banks which bought an agency, and were disappointed when it did not prove to be the cash cow they envisioned, was a lack of coordination. Customers with auto loans were pitched auto insurance. Later, if they bought a house, they were pitched mortgage insurance. Pottridge said they should have been approached with a package of products that could be offered from the entire insurance organization, which might have been the merged entity of several agencies. "You can’t seesaw your bank customers. You’ll confuse them," he said.

Ken Reynolds, executive director of the Association of Banks in Insurance (ABI), agreed, saying Pottridge is "forecasting the next wave." But he cautioned bankers to make sure they had their first acquisition under their belt. "I would agree it makes sense once you’ve created the first successful model, figure out how to integrate it into your program. As your base of business supports additional agencies, it makes sense to expand," he said.

Norwest, the granddaddy of insurance-agency-owning banks, has been in the business of expanding for so long it has grandfathered abilities many other banks don’t. But an official at the Minneapolis-based bank recently merged with Wells Fargo said no matter how big you get, the strategy is the same: get a new insurance agency to get into a new market.

"A community we don’t have a presence in–a quick way to get in, better than a de novo, is to buy a good agency, well-run with top-notch talent. Otherwise, we’re not interested," said Charlie Hendrickson, executive vice president of Norwest Insurance Inc., soon to be called Wells Fargo Insurance.

In the debate over who should pay more to bail out the decade-old thrift debacle, recently revived by the American Bankers Association, America’s Community Bankers is fighting back.

ACB, which represents thrifts, is lobbying Congress heavily to stick to the original payment schedule for the Bank Insurance Fund and the Savings Association Insurance Fund. The issue was decided in 1996 when a deal was cut to have each industry pay a certain amount into the funds to cover the cost of the bailout. Those amounts o 6.25 basis points for thrifts and 1.25 basis points for banks–are weighted more heavily on the thrift side now, but amount to more money being paid by the bankers because that industry is larger.

Starting in 2010, each industry would pay 2.3 basis points, an increase for the bankers and a decrease for thrifts. Part of the deal was that the thrift and bank charters would be melded into one when the payments were equalized. The ABA cried foul recently when it learned that there is a possibility that may not happen, because new financial modernization legislation would not eliminate the unitary thrift charter.

The ACB’s message last week was that the 1996 solution was the correct one and it would be a futile "reopening of wounds" to rejigger the deal now. In a document entitled "FICO Obligation: The Real Story," obtained by Financial Modernization Report, the group outlined why it believes the deal did not "squeeze" banks and why it should stay in force. The document said ending the requirement that SAIF members pay higher premiums than BIF members would "risk heightening the premium disparity it averted in 1996" and "pull the rug from under the typical SAIF-insured institution that has paid at least 33 times more in premiums to the FDIC since 1996 than an equivalently sized BIF-insured institution."

Mike Krimminger is a Senior Policy Analyst with the Federal Deposit Insurance Corporation. The views expressed in this article are solely those of the author and should not be construed as representing the policies or views of the FDIC or other governmental entities. Part one of two. The second portion will run next week. A clear understanding of legal and contractual rights if your counterparty defaults on a derivative contract and becomes insolvent is critical to effective risk management, creditor strategies, and market responses in today’s turbulent financial environment. The importance of clear rules is illustrated by the questions surrounding the recent near collapse of Long Term Capital Management and the roiling of Asian and Latin American markets. Currently, while American rules for financial market bankruptcies are sound, there are variations between the bankruptcy laws for banks and non-banks and ambiguities in how those laws apply to some newer transactions. Clarifying and updating those laws is an important step to maintain American leadership in the financial markets.

The President’s Working Group on Financial Markets, chaired by Treasury Secretary Robert Rubin, and with representatives of the Treasury Department, the Federal Reserve, the Office of the Comptroller of the Currency, the Commodities Future Trading Commission, the Securities and Exchange Commission, the Federal Reserve Bank of New York, and the FDIC has crafted statutory proposals that update and harmonize insolvency laws while reducing the risk of a system-wide disruption in the financial markets.

One year ago, Rubin submitted the proposals to Congress, where they won general agreement from the industry and key committees. A version of the Working Group’s proposal was included in the Financial Contract Netting Improvement Act of 1998, which was introduced by Rep. James Leach. Sen. Charles Grassley introduced similar legislation in the Senate. Although Congress adjourned before final action on the legislation could be completed, it is expected that the legislation will be reintroduced shortly. Discussion drafts of the bill are circulating on Capitol Hill now.