Last Updated 17 Jun 2020

Diversifying into insurance business

Category Insurance
Essay type Research
Words 1008 (4 pages)
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Diversification has been a prevailing trend in financial institutions especially by banks spreading deposits and loans across a broader range of economic activities so as to avoid concentration of their personal sector funds in a single aspect of economic activity. This has been largely as a response to deregulation, rising competition and financial innovation in the finance sector. In particular, banks have been diversifying into insurance on a larger scale and for a longer period than in securities. 'The Bancassurer's market share rose from .

2% in 1989 to around 20% in 1995'1. Banks have also revolutionised their involvement in insurance companies from agency diversification whereby it sells insurance products produced by the insurance companies, to purchasing insurance companies and more recently to developing own diversification where the bank manufactures its own insurance products. A good and probably the earliest example of a bank diversifying into manufacturing insurance products and services in the UK, is the TSB Trust Company, established in 19671.

A more recent example is National Westminster Bank establishing its own life assurance subsidiary in 1992. While some argue that banks are abandoning their traditional duty as a deposit-taking institution to engage in unrelated business, others argue that the act of banks providing insurance services or products should not be considered as 'diversification' but as engaging in a strategic capital requirement; Lewis, M (1990) describes banking as a form of insurance (liquidity insurance).

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Llewellyn (1991) however stated that the 'central strategic issue' of any financial system is that of separation versus integration. Based on this realisation, in the subsequent paragraphs the arguments for and against banks diversifying into insurance business will be discussed with the aim of reaching a conclusion as to whether this venture should be enhanced or curtailed. As banks diversify into insurance business they enhance the competitive environment in which insurance products and services are provided.

This is also the case for any type of diversification in the financial sector; as more institutions provide similar services, the price offered to consumers is less, there is increased convenience in terms of availability and choice for customers and as the specialist nature of insurance companies is eroded through diversification, they tend to be relatively more efficient in providing their services.

However, it is somewhat paradoxical that one of the reasons for banks diversifying into insurance business is as a strategic response to their traditional services being eroded by other financial and non-financial institutions including insurance companies. Therefore, because of increased competition in the financial sector, banks diversify and thereby further intensify the competition.

This has been the 'prevailing political orthodoxy'2 of the 1980s in the UK as well as in many countries. Banks perceive diversification into insurance business as a way of broadening the relationship with personal customers thereby extending their source of income and profits. Extensive diversification by major clearing banks into the distribution and subsequently, manufacturing of life insurance products occurred mainly during the 1980s and early 1990s.

This was partly because at the time, insurance products offered by insurance companies were gaining sizeable market share as the personal sector invested heavily in these products and with financial innovation, the previously rigid demarcations between banking and insurance products were reduced3. Since this served as a prospective loss to banks, they viewed diversification into insurance as an opportunity to recapture personal sector funds and increase their profits. 'By 1988, 40% of life assurance products were distributed via banks'3.

This case for banks diversifying into insurance can be argued as mainly an advantage to the financial firm (depending on how the profits are spent) whereas the former case can be seen more from the perspective of customers and regulatory bodies. Another argument for banks diversifying into insurance is the probability of this venture improving the systemic risk-return trade off in the diversifying firm. This however depends on the type and correlation of risks involved, (negatively correlated risks tend to improve overall risk-return trade off and vice versa).

The figure below shows how diversification can improve a firm's risk-return opportunities: Assuming without diversification the diversifying bank chose point X, with diversification the curve shifts out and the bank now has more risk-return options. At point B the bank earns a higher return for the same risk, at C; a higher return and lower risk, at D; the same return for a lower risk and E depicts a lower return and risk. However, at point A, the bank earns a higher return for more risk, implying that diversification does not necessarily reduce risk but this will be discussed in a later section.

Most empirical studies on the correlation between diversification and risk prove to be rather inconclusive and ambiguous. Nonetheless, 4 'Saunders and Walter (1994) found that banks could have reduced risk had they been permitted by regulation to diversify into investment and insurance activities' also Boyd & Graham (1988) found evidence of risk-reduction in banks diversifying into life assurance. A by far important case for banks diversifying into insurance business is the supposed potential for economies of scale and scope.

In theory, the perception is that because of synergies (the idea that 2 + 2 = 5 or more), a diversified business can supply more services combined, cheaper than by separate companies. This is a major argument by banks attempting to diversify into insurance business, in that banks are thought to have significant cost advantages over insurance companies (through their delivery system for instance), information advantages attained through managing customers' accounts, economies of scale in portfolio management resulting from the 'law of large numbers', and a good reputation compared with most insurance companies, etc.

Based on this argument, banks find it much easier to diversify into insurance business than insurance companies diversifying into banking (asymmetric advantage). Empirical evidence supporting the existence of economies of scale and scope is limited and somewhat ambiguous which however will be discussed later. Nevertheless, some research indicates economies of scope with large banks especially through the use of information technology. Giddy (1985) and Baumol, Panzar and Willig (1982) observed economies of scope through offering a wide range of products and through shared inputs respectively5.

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Diversifying into insurance business. (2018, Feb 27). Retrieved from https://phdessay.com/diversifying-into-insurance-business/

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