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The Geneva Papers on and Vol. 26 No. 3 (July 2001) 311±322

Integrated ± A Framework for Success: Synergies in Insurance, Banking, and

by Ewald KistÃ

1. Introduction Financial conglomerates, formed by combining , insurers, and asset managers, were virtually unknown when ING was formed ten years ago. They have gained some attention in the intervening ten years with the combination of Travelers and Citicorp in 1998, consolidation within the ®nancial services sector in the U.K. and Australia, and the recently announced deal between and Dresdner . The premise for creating such conglomerates is to create value for all stakeholders, i.e. shareholders, employees, and, most important, their clients. Creating -term relationships with customers and serving them with products that meet their needs through the channels of their choice that create shareholder value is ING's mission and indeed the likely mission of other ®nancial conglomerates. This strategy, which we call ``global management and ®nancial protecion'', has served ING well for ten years, yet there remains much we can still do. Opportunities remain to realize the full potential from our ever-expanding customer base, employee base, and platforms. Synergies continue to be identi®ed and implemented with respect to back-of®ce and front- of®ce operations. And, we expect that the further pursuit of our strategy to operate as an integrated ®nancial services company will continue to create shareholder value. There are currently only a limited number of companies within the ®nancial services sector built upon the model of integrating banking, insurance, and operations. Consequently, ®nancial conglomerates are all too often perceived as complex and thus more risky. Indeed many parties raise the essential question: ``Are they worth more together than they would be as separate companies?''From a ®nancial perspective, the answer is yes if the combination produces relatively higher earnings and/or a reduction in risk. From a strategic perspective, the answer is yes if the combination produces greater ef®ciency and better means of serving customers. This paper discusses the synergies that can be achieved by integrating the of insurance, banking, and asset management into one integrated ®nancial services company. These synergies relate to programs directed toward clients, employees, and distribution channels. They take advantage of the power of global awareness and worldwide purchasing programs. The latter is particularly true in the area of where synergies relate to hardware and software systems for the businesses and indeed to the management of the businesses. And, the outcome is that these synergies translate into signi®cant advantages with respect to earnings and risk for the shareholders.

à Chairman of the Executive Board, ING Group. The author wishes to acknowledge the contribution to this paper from Patrick Dwyer, Francis Ruygt, and Richard Wofford.

# 2001 The International Association for the Study of Insurance . Published by Blackwell Publishers, 108 Cowley , Oxford OX4 1JF, UK. 312 KIST

The ®rst part of this paper sets forth a de®nition of an integrated ®nancial services (IFS) company and summarizes key elements for success. It then explores the ability and value of an IFS company to attract and retain customers throughout their lifetime. Lastly, and perhaps most importantly, it explores an IFS company from a ®nancial perspective, e.g. the impact on earnings and earnings volatility, , and risk as an IFS company compared to a stand- alone bank, insurer, or asset manager.

2. De®nition of integrated ®nancial services An integrated ®nancial services company is an that provides insurance, banking, and asset management products to its customers through a variety of distribution channels. A decade ago, this concept was largely limited to the concept of cross-selling products between banking and insurance channels. Today the IFS concept has evolved to encompass all aspects of the organization. A graphical representation for an IFS company is given in Figure 1. With respect to the segment of the , the starting point is to form a view on ®nancial services from the customer perspective. At various stages of life a customer needs products that focus on asset protection, asset accumulation, and asset distribution. Neither a stand-alone bank nor a stand-alone insurer can meet all these needs, but an IFS company has the ability to develop products across the entire spectrum. (More will be said on this topic later.) Similarly for corporate and global clients, an IFS company can provide an integrated approach to the evolving requirement of ``being in business'' (from simple lending to more structured lending products to an Initial Public Offering or IPO, provision of employee bene®ts, etc.).

Customers Retail Corporate Institutional

d Direct Career Indep. Adv. Banks - Distribution Regional n e-comm. agents agents mkt & wire network site

a houses r IFS/CRM platform

Products Third Variable Fixed Fixed Variable Funds/ Banking life life annuities annuities products A.M. party

Shared services:

Figure 1: Integrated ®nancial services

# 2001 The International Association for the Study of Insurance Economics. INTEGRATED FINANCIAL SERVICES ± A FRAMEWORK FOR SUCCESS 313

An IFS company has the unique ability to develop -made banking, insurance, and asset management products for its customer base. Synergies can develop across a broad spectrum within the segment of the business. An obvious one is the cross- fertilization of ideas among those with different backgrounds. Some ways to gain maximum advantage with an IFS company are to integrate activites across the group, develop consistent ®nancial reporting performance measures across all business types, and implement shared services for technology, , and human resources. A great source of synergy is the ability to combine the previously separate asset management functions across the company into a single management structure. Another key aspect of an IFS company is the ability to have multiple distribution channels that have the means to approach customers in a variety of ways, i.e. click, call, and face. The importance of this is obvious ± not all customers want or need the same type of interaction or level of . Multiple channels and multiple delivery mechanisms can ensure that all customers receive what they want in the way they want it.

3. Key elements of success for an IFS company The key elements to build a successful IFS company can be split into two broad categories: those that are essential, i.e. needed to play; and those that will result in competitive advantage for all stakeholders, i.e. shareholders, employees, and customers. This second category is often described as the criteria that are needed to win. These criteria are depicted in Figure 2 and described below.

3.1 Minimum criteria for success The minimum criteria for success can be inferred from the de®nition of an IFS company as given in the previous section. An IFS company must manufacture an extensive array of

Seven elements critical to a successful IFS organization

Essential elements of IFS 1. Broad array of product offerings 2. Multiple distribution channels Product 3. Scale

Technology Distribution Elements to create competitive advantage Superior 4. Strong ALM/risk management capabilities People customer 5. Powerful proposition

6. Efficient technology Brand Scale

7. Performance-oriented people and ALM/risk management

Figure 2: Keys to success for an IFS company

# 2001 The International Association for the Study of Insurance Economics. 314 KIST products to meet all of its customers' ®nancial service needs. This calls for ¯exible, product- focused factories. Second, it must have the capacity to distribute these products through multiple channels. Customers will have different preferences in how they acquire products, ranging from ®nancial advisors to the . Additionally, while many customers prefer one-stop shopping, they may desire to make choices among the products or management services of several companies. So the concept of ``shelf space'', and in fact having access to lots of shelf space, becomes important in the delivery of products and services. This is easier if you own the shelf space, which may be an Internet ®nancial portal, a bank , or a network of ®nancial advisors. Each distribution channel and product factory must achieve economies of scale. Economies of scale are not limited to achieving competitive advantage with respect to the expense structure of the IFS company and distribution channels. The product plant must be able to identify changing customer needs in terms of product quickly. It must have the necessary resources to , price, and introduce new products to the market in a timely and ef®cient manner. With respect to distribution, the IFS company must own or have access to all forms of distribution and in suf®cient numbers to make the channel ef®cient from an expense point of view. Additionally, the IFS company must have appropriate processes in place to minimize, if not eliminate, unhealthy channel con¯icts that could result in insuf®cient or dissatis®ed customers.

3.2 Criteria that result in competitive advantage Four additional criteria can be used to create competitive advantage in an IFS organization. First, strong risk management capabilities (at head of®ce and within each business unit) can lead to the identi®cation, measurement, pricing, and control of all to which any company is subject. Additionally, this information can be used to determine the required levels of economic capital within each business unit and at the group level. This process also will disclose the tangible and intangible bene®ts of diversi®cation and its impact on required capital levels. (More will be said on this later.) IFS companies are well positioned to make substantial gains here due to the in-depth, state-of-the-art risk management tools that have traditionally resided in the banking business, and the longer-term perspective of risk managers on the insurance side. The successful leveraging of professionals between the banking and insurance businesses can create much synergy in this area. The existence of a powerful brand or multiple brands also is a key element in creating a distinguishing feature for an IFS company. The bene®ts of being able to move into new customer or market segments off the back of a strong brand are well known. An IFS company must have an ef®cient technology infrastructure. This has an enormous impact on all aspects of the business. It will be the difference between timely and untimely product introductions. It will be the difference between the ability to use state-of-the-art risk management and ®nancial performance measurement techniques and those that can be gleaned from legacy systems. It will impact the IFS company's ability to build an all- important customer database that can be used to product purchases, anticipate product needs, and determine customer pro®tability across all businesses. It also has a signi®cant impact on providing quality and timely service to customers.

# 2001 The International Association for the Study of Insurance Economics. INTEGRATED FINANCIAL SERVICES ± A FRAMEWORK FOR SUCCESS 315

Lastly, another key element in building a strong IFS company is the ability to attract and retain performance-oriented employees and build a culture that rewards such performance. Any discussion of success factors is not complete without reference to mandatory synergies. Synergy will not happen immediately or on its own upon the formation of a , because of regulations, structural differences, and cultural differences. Few if any companies have yet reached the goal of fully integrated ®nancial services. Synergy has to be required, not just encouraged.

4. Customer value management Perhaps the clearest advantage that an IFS company has over a stand-alone bank or a stand-alone insurer, especially on the retail side of the business, is the ability to offer products and services over the course of a customer's entire lifetime. In fact, since an IFS company brings to the customer a broad and diverse knowledge of the ®nanical markets it can more easily recognize the diversity of customers' ®nancial needs. Rather than seeing the customer relationship as supplying banking, insurance, or asset management products, an IFS company and the customer can build ®nancial solutions that adapt with changing situations and thereby create an environment for a long-term . Of course, for this to work best the IFS company needs to be in a to offer good value for money, timely service, appropriate products based on fact-based needs analyses, etc. But for now, the assumption is that the company meets these criteria. So let'sturn our attention to the advantages an IFS company has with respect to customer management and product offerings. This discussion starts with an identi®cation of the likely product needs of an individual over the course of his or her lifetime with respect to ®nancial service products. A place to start is by examining Figure 3. Although the graph is based on U.S. population data and focuses on the retail client, the message is relevant in ®nancial services markets across the globe. As individuals leave home and enter the work force, their needs are likely to be more related to death protection, car , mortgages, homeowner'sand automobile insurance, and perhaps a . Before their earning power maximizes, they may have needs

Financial needs by life stage, U.S. Current population, 1997

25,000 Death protection Accumulation Asset protection / distribution Baby Boomer generation

Consumers are living longer, raising concerns Current about outliving . population 12,500 (thousands)

0 25–29 30–34 35–39 40–44 45–49 50–54 55–59 60–64 65–69 70–74 75–79 80–84 Age Cohort Figure 3: Changing ®nancial needs of customers through their lifetimes (source: Insurance )

# 2001 The International Association for the Study of Insurance Economics. 316 KIST related to ®nancing for children. As they get a bit older, their needs will gradually shift to wealth accumulation. As they head toward , their needs will shift yet again to asset protection and distribution. Another way of looking at the advantage an IFS company has with respect to customers is to review not only their product needs but also other requirements they may have with respect to the delivery of ®nancial service products. Some of these requirements are given in Figure 4 along with a view of how well they can be met by each type of ®nancial service organization. The conclusion is that an IFS company has the ability to partner with the customers to meet their ®nancial needs using appropriate products and distribution. Individually, such needs can be met neither by a bank, nor by an insurer, nor by an asset manager. This should translate to competitive advantage for an IFS company, lower costs and better service for the customer and increased return to the shareholder. The key to realizing these bene®ts is tied to customer value management ± a process by which the company uses certain data that it has available to anticipate and solicit existing customers with respect to the next product to be purchased and to retain the business that is already in force. The company'scustomer database would generally contain the following types of data: key demographic information about the customer (age, sex, marital status, , income level); products that the customer has previously purchased across the company's lines of business (subject to regulatory constraints); and contacts with the company, e.g. change of address, change of bene®ciary, etc. The competitive advantage to all parties (especially customers and shareholders) is a direct result of the company'slower distribution costs on new sales as it increases the number of products per customer and higher pro®tability on existing business due to higher retention rates. By successfully establishing a long-term relationship with its clients, an IFS company gets and keeps a larger share of the clients' business on an economical and effective basis.

Insurance Asset Customer demands Bank company manager IFS Protection against interest-rate risk   Protection against personal risks   Safekeeping of assets     Asset portfolio management   Information on financial markets   Informed, trustworthy advice    Financial solutions for reducing   for monetary needs   Convenient financial transactions  

Figure 4: Institutions that can meet customer ®nancial services needs

# 2001 The International Association for the Study of Insurance Economics. INTEGRATED FINANCIAL SERVICES ± A FRAMEWORK FOR SUCCESS 317

5. Financial perspective versus a stand-alone bank, insurer, or asset manager Is a ®nancial conglomerate simply a bank plus an insurance company, or is the whole different from the sum of the parts? This is an important question for ®nancial regulators because insurance, banking, and investment/asset management services have traditionally been separately regulated; most current regulations re¯ect the traditional differences of the industries that existed prior to ®nancial convergence. It is also important to , who traditionally may estimate the value of a company by examining historical earnings, estimating earnings growth, and comparing price/earnings ratios among peers; for ®nancial conglomerates, there are few peers, and little history. Simply adding a bank and an insurance company together under a group , without subsequent integration, would add little value. Financial conglomerates are not intended to be worth only the sum of the parts; they are intended to be worth more. Accomplishing this means ®nding synergies and exploiting them by reconstructing the ®nancial services value chain around the customer. This involves creative destruction: carefully removing the redundant differences that do not add value (improving ef®ciency) while learning from and enhancing those differences that do not add value (improving effectiveness). Many activities that were historically separate become one and the same. To judge the value or risk pro®le of a ®nancial conglomerate, you have to look to fundamentals. The perspective of this paper is that a ®nancial conglomerate that becomes an IFS company can offer more to the customers and shareholders than a collection of separate banks, insurers, and asset managers. This advantage appears in the form of higher earnings, the stability of earnings, and more ef®cient use of capital.

5.1 IFS leads to higher earnings The integration of a bank, insurer, and asset manager gives economies of scale and scope in infrastructure and administration, information technology, and . The resulting revenue and cost synergies produce higher earnings. Furthermore, a company can repeat its successes internationally by exporting systems, products, and the required management skills and knowledge. Insurance, banking, and asset management have common characteristics, including the management of assets, risk transfer/pooling, the same customers, the importance of information, the need for capital, and the importance of trust, brand name, and reputation. But there are also differences in the nature of long-term , distribution channels, customer knowledge, sales compensation, , product sophistication, product taxation, and accounting. Synergy comes from both differences and similarities. Differences provide economies of scope ± illustrated in risk management, where the banking and insurance professionals are learning from each other to improve the measurement of , risk, and . Similarities provide economies of scale: technology, corporate control, risk management expertise, accounting, payroll, and information can be exploited for cost ef®ciency. Meador et al. (1997), in a study of the insurance , give evidence that ``managers of multi-product ®rms are able to achieve greater cost ef®ciencies than their counterparts in more focused ®rms by sharing inputs and ef®ciently allocating resources across product lines in response to changing industry conditions.'' The key to this cost ef®ciency is ¯exibility and

# 2001 The International Association for the Study of Insurance Economics. 318 KIST the ability of the company to share inputs between separate but related product lines. Furthermore, sharing inputs not only reduces complexity, but also increases the company's bargaining power with the suppliers of those inputs. Synergy can sometimes mean doing less of one activity in order to make it possible to do more of another, more pro®table activity. For example, a ``tailor-made'' style of product design might add value in the case of a stand-alone company; but a simple standardized product is repeatable, enabling economies of scale to be realized across the group. Likewise, it may be best to exit non-core businesses to avoid management distraction. It comes down to leveraging knowledge and expertise, not squandering it on activities that add little potential for large-scale repeated success.

5.2 IFS leads to more stable earnings A common understanding in the ®nancial markets is that companies have more stable earnings than banks, justifying a lower cost of capital and a higher price/earnings ratio. This is partly the result of stable accounting methods that recognize life insurance pro®ts over the lifetime of the . Consequently, a life insurer's current reported earnings are a more reliable base for measuring its future earnings capacity. In addition, because of the long-term nature of life insurance, this means that a block of existing life insurance business is a store of earnings capacity, or embedded value. This stored up value produces a core of stable earnings. The volatility of earnings of a ®nancial conglomerate, when the size of the bank and the life insurer are about the same, should be lower than the earnings volatility for a stand-alone bank and more consistent with that of a stand-alone insurer. Why is this? First, as has been mentioned, the life insurer will contribute to the stability of earnings. This effect could be achieved by combining a bank and an insurer in the same portfolio. Second, there is a diversi®cation of risk in respect of economic cycles between a bank and an insurance operation. As discussed in the next section, a ®nancial conglomerate has greater ¯exibility and greater opportunity for diversi®cation than a simple combination. Last, IFS creates a stronger link to the client. The relationship is a partnership focused on the client's needs. Consequently, the IFS company uses its client and market knowledge to build mutually bene®cial solutions for the client that persist through changes in the economic environment and over time.

5.3 IFS uses capital ef®ciently A ®nancial conglomerate can use capital ef®ciently. Internal capital ¯ows are simpler and less expensive to execute than external ones. Furthermore, a conglomerate is better able to achieve regulatory capital or ef®ciencies. However, more important than regulatory capital is economic capital speci®c to the risk. Providing ®nancial services virtually always involves providing guarantees; so ®nancial conglomerates are in the business of risk. Banks and insurance companies have exposures to many of the same categories of risks. These exposures may be additive, independent, or offsetting. All companies are exposed to operational risks and business risks. The most important common environmental sources of risk in ®nancial services are market (equity and ) risks and credit risks. In addition, insurance companies have some unique risk categories (mortality, morbidity, and ) that are largely independent of the common risk categories.

# 2001 The International Association for the Study of Insurance Economics. INTEGRATED FINANCIAL SERVICES ± A FRAMEWORK FOR SUCCESS 319

If its promises are to be , a ®nancial services company has to hold suf®cient risk capital to pay for unlikely but extreme adverse results. An IFS company has signi®cant risk advantages that justify a lower requirement for risk capital. These advantages include greater diversi®cation opportunities, offsetting exposures to common risks, and greater ¯exibility to respond to changes in each customer's demands and in the economic environment.

Diversi®cation Diversi®cation means not putting all of one's eggs in the same basket, so that all the bad things that could happen do not happen simultaneously. Diversi®cation is sometimes viewed as the only ``free lunch''in the ®nancial world. However, in order to achieve the full bene®ts of diversi®cation, insurers, banks, and asset managers must have suf®cient scale. The unique insurance risks are only partially correlated with market and , implying that there should be some diversi®cation bene®t. Assuming that at least part of the economic capital required is for diversi®able risk, this would imply some reduction in the capital requirement from simply adding an insurance company and a bank together in the same portfolio. A current question being discussed among ®nancial regulators is ``How much top-level diversi®cation is there between banking and insurance in a ®nancial conglomerate?'' The use of the term ``top-level'' implies that the question is phrased in the context of a global ®nancial conglomerate consisting of separate insurance and banking , combined at the top of the hierarachy of legal entities. Diversi®cation at lower levels (geographic and within bank or insurance businesses) is not what is considered in that question, only the impact of combining insurance and banking. This question is not straightforward, however, and a generalized answer would not be useful. In fact, it may be fallacious to assume that geographic, market, company, and risk-type diversi®cation effects can be considered in separate ``levels''. The amount of any top-level diversi®cation bene®t depends upon product mix, relative sizes and signs of the exposures in the risk categories, and the degree of integration in each geographic market, as well as the relationships between the various markets in which the ®nancial conglomerate operates. The goal for an IFS company has to be more than just a ``top-level''combination. Truly integrating insurance, banking, and asset management fundamentally changes and improves the risk/ return pro®le of the business.

Offsetting common risks Typical exposures to some risks are sometimes offsetting between banking and insurance, as in the case of interest-rate risk. Being intermediaries between depositors and borrowers, banks by nature have a mismatched position with respect to interest rates; they tend to have long-term assets (loans) and -term liabilities (demand deposits). Conse- quently, banks have developed considerable skill in managing short-term interest-rate risk, and in pro®ting from it. Conversely, insurance companies generally issue long-term liabilities in connection with life insurance and for retirement and income products. Available assets are often shorter in duration than the liabilities, creating an exposure to long-term interest-rate risk, or reinvestment risk. In contrast with banks, insurance companies traditionally have seen the interest risk as something to be eliminated by matching rather than as a source of pro®t, so they have developed expertise in hedging the risk. Banks and insurance companies can provide each other a partial of their natural

# 2001 The International Association for the Study of Insurance Economics. 320 KIST mismatch positions. More important, though, is that their combined interest-rate manage- ment expertise in an IFS company can be turned into value.

Dynamic view of risk Diversi®cation is a passive concept. It does not take into account the intangible value of a company's ``real options'', meaning its ability to respond to sudden changes. This ¯exibility has value, albeit not on the balance sheet. It comes ``in the money'' when the economic environment changes. Succeeding in IFS requires creating more real options. You can create real options in- house or buy them. This includes developing human capital, such as skills in setting up new companies in emerging markets, technological skill to capitalize on new developments in the Internet, ®nancial know-how to create innovative new products, and marketing know-how to introduce effective ways of reaching the customers. Often, this means buying or investing in non-®nancial businesses, especially in the area of technology, and in innovative marketing channels. Non-®nancial businesses inside ®nancial conglomerates have received attention from regulators, who are concerned that failures in one of these could have contagion effects on the ®nancial businesses in the same group through damage to the brand. Another view, though, is that sometimes relatively small can be made with limited downside risk, much , but large payoffs to those who arrive ®rst. This is all about being ¯exible and ready to do integrated ®nancial services for the customer in the most effective way, whatever the future brings. Being a ®nancial conglomerate increases the number of opportunities to diversify. For example, it enables greater geographic diversi®cation. In many countries it has been or is the case that entry into one of the banking or insurance markets is either not permitted or not economically attractive for foreign-based companies. Being able to participate in the part of the country'smarket that is open gives the possibility of greater geographic diversi®cation. In this case it is not only the spread of geographic risk that provides a diversi®cation bene®t, but the ability to conduct both insurance and banking. Figure 5 illustrates this point. This also works at the individual customer level. The degree of openness of a country's various markets can change over time and a ®nancial conglomerate is in a better position to preserve and build on existing customer relationships as this occurs. IFS companies are more able to respond to changes in customer demands and the economic environment. They can be ¯exible with respect to products and distribution

Geographic Bank Insurance Asset Financial presence company manager conglomerate Country A     Country B   Country C    Country D  

Figure 5: Financial conglomerates are more capable of bene®ting from geographic diversi®cation

# 2001 The International Association for the Study of Insurance Economics. INTEGRATED FINANCIAL SERVICES ± A FRAMEWORK FOR SUCCESS 321 channels. For example, a change in in a particular country may cause funds to ¯ow from insurance to mutual funds. An IFS company is capable of keeping the ¯ow internal, using and enhancing the customer relationship. When the economic environment changes or the playing ®eld tilts, a ®nancial conglomerate can shift gears. Two recent examples related to tax law changes are: · In Australia, the new tax system reversed a tax advantage of insurance unit-linked funds, causing investors to prefer mutual funds; · Likewise in the Netherlands, tax law changes reduced some of the tax advantages of investment-oriented life insurance. However, the money has to go somewhere; if a company is well positioned in all the other ®nancial services to capture that business, the client does not have to change brands, and long-term relationships can be preserved.

6. Conclusion An IFS strategy can de®nitely add value for customers and shareholders. A successful IFS company will have distinct advantages in customer relationships, in the use of knowledge and expertise, in risk and ¯exibility, and in operational ef®ciency. The advantage is in the integration, not just from passive diversi®cation that could be achieved by putting different businesses in the same portfolio. Many of the important considerations in a view on the risk and return of a ®nancial conglomerate are not shown on the accounting statements. Comparisons to traditional banks, insurers, and assets managers become more dif®cult precisely because of these advantages. True IFS has yet to be achieved on a large scale, but some ®nancial conglomerates are well on their way. Analysis of a ®nancial conglomerate thus has to be based on fundamentals. In response to the convergence across the ®nancial services sector and the emergence of ®nancial conglomerates, we expect some changes, including: · Greater transparency and disclosure from all ®nancial institutions, including both non- ®nancial disclosures and ®nancial performance measures (e.g. embedded value and RAROC) that cross the traditional boundaries between banking, insurance, and asset management; · An integrated approach to managing risks within the ®nancial services sector. In connection with this, more credibility will need to be given to internal company models for risk management and ; · Investors will rely less on relative valuation against ``peer'' companies, and more on analysis of fundamentals, supported by additional disclosure.

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# 2001 The International Association for the Study of Insurance Economics.