INSURANCE REGULATION AND SUPERVISION IN THE OECD COUNTRIES

Policy Issues in Insurance INSURANCE REGULATION AND SUPERVISION IN THE OECD COUNTRIES No. 3

ORGANISATION FOR ECONOMIC CO-OPERATION AND DEVELOPMENT

ORGANISATION FOR ECONOMIC CO-OPERATION AND DEVELOPMENT Pursuant to Article 1 of the Convention signed in Paris on 14th December 1960, and which came into force on 30th September 1961, the Organisation for Economic Co-operation and Development (OECD) shall promote policies designed: – to achieve the highest sustainable economic growth and employment and a rising standard of living in Member countries, while maintaining financial stability, and thus to contribute to the development of the world economy; – to contribute to sound economic expansion in Member as well as non-member countries in the process of economic development; and – to contribute to the expansion of world trade on a multilateral, non-discriminatory basis in accordance with international obligations. The original Member countries of the OECD are Austria, Belgium, Canada, Denmark, France, Germany, Greece, Iceland, Ireland, Italy, Luxembourg, the Netherlands, Norway, Portugal, Spain, Sweden, Switzerland, Turkey, the United Kingdom and the United States. The following countries became Members subsequently through accession at the dates indicated hereafter: Japan (28th April 1964), Finland (28th January 1969), Australia (7th June 1971), New Zealand (29th May 1973), Mexico (18th May 1994), the Czech Republic (21st December 1995), Hungary (7th May 1996), Poland (22nd November 1996), Korea (12th December 1996) and the Slovak Republic (14h December 2000). The Commission of the European Communities takes part in the work of the OECD (Article 13 of the OECD Convention).

OECD CENTRE FOR CO-OPERATION WITH NON-MEMBERS The OECD Centre for Co-operation with Non-Members (CCNM) promotes and co-ordinates OECD’s policy dialogue and co-operation with economies outside the OECD area. The OECD currently maintains policy co-operation with approximately 70 non-Member economies. The essence of CCNM co-operative programmes with non-Members is to make the rich and varied assets of the OECD available beyond its current Membership to interested non-Members. For example, the OECD’s unique co-operative working methods that have been developed over many years; a stock of best practices across all areas of public policy experiences among Members; on-going policy dialogue among senior representatives from capitals, reinforced by reciprocal peer pressure; and the capacity to address interdisciplinary issues. All of this is supported by a rich historical database and strong analytical capacity within the Secretariat. Likewise, Member countries benefit from the exchange of experience with experts and officials from non-Member economies. The CCNM’s programmes cover the major policy areas of OECD expertise that are of mutual interest to non-Members. These include: economic monitoring, structural adjustment through sectoral policies, trade policy, international investment, financial sector reform, international taxation, environment, agriculture, labour market, education and social policy, as well as innovation and technological policy development

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FOREWORD

The five studies in this volume present an in-depth analysis of the main features of insurance regulation and supervision in OECD countries. The works, which focus on three major aspects of insurance markets and regulation: liberalisation, financial convergence and establishment of policyholder protection funds, were initiated by the OECD Insurance Committee and presented at various international conferences. The volume opens with a comparison of national insurance regulatory and supervisory frameworks, allowing readers to understand the main features and trends in insurance regulation, and provides lessons from the experiences of OECD Member countries, which represent 95% of the world insurance market. The paper on “Liberalisation of Insurance Markets: Issues and Concerns” highlights the benefits from market liberalisation, as well as the main concerns that have to be addressed by policy makers. Since its inception, the OECD Insurance Committee has worked to develop international co-operation in the insurance field and, above all, the liberalisation of the establishment and cross border operations of insurance companies. Liberalisation is not simply deregulation: an open market must be governed by adequate regulation in order to protect policyholders from the potential drawbacks of competition. “Financial Services Integration Worldwide: Promises and Pitfalls” and “Convergence in the Financial Services Industry” continue work begun 10 years ago by the Insurance Committee on bancassurance1, at a time when this phenomenon was still isolated. Financial convergence is now a major concern for most OECD member countries. Over the past few years, consolidated supervision of financial services has become a vital issue. While some OECD Member countries have already moved towards consolidated supervision, others are still considering the issue. These reports analyse the multiple meanings and

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See Insurance and other financial services, OECD, 1992

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forms of financial services convergence, as well the the treatments it receives from regulators and supervisors in OECD countries. The protection of policyholders against insolvency of insurance companies has always been an important objective of insurance regulation. To supplement insurance solvency regulation and supervision, many Member countries have established policyholder protection funds. Nonetheless, the majority of these funds focus on specific types of insurance, such as compulsory insurance, while only a limited number of Member countries have introduced policyholder protection funds that provide protection to all policyholders of the company in the event of bankruptcy. In recent years, however, there appears to be a trend to address this issue as well. The final paper in this volume examines this trend. This publication contains documents prepared by J. Vollbrecht, H.D. Skipper, L.A.A Van Den Berghe and T. Yasui. The views expressed here are the sole responsibility of the authors and do not necessarily reflect those of the Insurance Committee, the Secretariat or the Member countries. This volume is prepared under the aegis of the Centre for Co-operation with Non-Members and is published on the responsibility of the Secretary-General of the OECD.

Eric Burgeat Director Centre for Co-operation with Non-Members

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TABLE OF CONTENTS

Insurance Regulation and Supervision by Jörg Vollbrecht ................................................................................................7

Liberalization of Insurance Markets: Issues and Concerns by Harold D. Skipper, Jr.....................................................................................69

Financial Services Integration Worldwide: Promises and Pitfalls by Harold d. Skipper, Jr......................................................................................99

Convergence in the Financial Services Industry by L.A.A. Van den Berghe...............................................................................173

Policyholder Protection Funds: Rationale and Structure by Takahiro Yasui ............................................................................................303

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INSURANCE REGULATION AND SUPERVISION by Jörg Vollbrecht

I.

Introduction

In 1963, the OECD issued the first set of comparative tables on the “Control of Private Insurance in Europe”, known as the “Paratte Report”. The Paratte Report was created from a study dating from 1963; the study consisted of 33 tables classified into five parts summarising the information derived from the contributions of eighteen OECD Member countries geographically belonging to Europe. The objective was to make available in summary form the basic information on the scope and modalities of the regulation and supervision of private insurance. This information would be available to ministries and the supervisory authorities, insurers and insurance associations, as well as to the public. The report covered general legal framework and scope of supervision, conditions for licensing, investment rules, information on suspension and cessation of business and specifics on compulsory insurance. Furthermore, the original report also provided information on the insurance contract law and taxation rules. With that report the foundation was laid for the OECD work directed at co-operation and liberalisation. After the report was updated 1988, original set of 33 tables of the report expanded to encompass information from 21 OECD Member countries. In 1994, the Member countries decided to issue a new version of the report which was intended to be not only an update as the former one report but a reflection of the considerable changes that have occurred in the regulatory and supervisory framework since the launch of the report in the 1960’s. The Insurance Committee, in response to the creation of the new report, decided to

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send a questionnaire to all OECD Member countries consisting of two sets of tables, one set requiring only “yes/no “answers and the second set asking for further details on the main features of insurance regulation. A draft of the tables was approved in December 1996 by the Committee A task force, consisting of five delegates from OECD Member countries and the Secretariat, met several times to discuss the content of the new OECD Report on insurance regulation. In 1997, during the Second East-West Conference, the 17 participating economies in transition were invited to approve the proposal of such a collection of information on their insurance regulatory systems; the participating economies in transition agreed to join the project. The new “Comparative Tables on Insurance Regulation and Supervision in OECD Countries” now consists of three parts. Part I gives an analytical summary of the information contained in the tables in Part II. Part II contains two sets of tables: Part II A with only “yes/no” responses and Part II B with more detailed but still concise information. Those tables are available on the Insurance and Pensions section of OECD's web site http://www.oecd.org. In Part II A, the reader will find information provided by 24 countries of the 29 OECD Member countries, including 12 of the 15 Member countries of the European Union (EU), as well as, Iceland for the European Economic Area (EEA) and Switzerland. Part II B contains information from 19 countries. In both sets, there is a line on common EU regulations. Given that not all OECD Member countries have answered the questionnaire, “all Member countries” in the following analysis means all Member countries that have responded. Not only issues of regulation and supervision of insurance in a strict sense are covered by this report, but also the regulation and supervision of intermediaries and pension funds, issues relating to the insurance contract law and taxation rules. On the other hand, harmonisation within the European Union has removed many differences among its members. Moreover, the EU rules have become models for other countries as, e.g., for European economies in transition.

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The following analysis of the responses given to the above mentioned questionnaire, Part I of the OECD report on insurance regulation, includes not only the information given for this purpose by the Member countries but also still valid information from the introductory part of the former Paratte Report by Prof. Dr. Angerer (Germany) as well as information deriving from several other OECD publications (e.g. a document by Professor Dickinson on insurance company investments, see Policy issues in insurance, 1996) documents on insurance issues and a paper by Dr. Werner Pfennigstorf. The objective of this analysis is to provide an analytical background and source of information for countries interested in the lessons learned by the experiences of OECD Member countries within the scope of regulation and supervision of insurance. Where appropriate, recommendations accompany the presentation of regulations existing in OECD Member countries. The analysis reflects the situation up to the end of 1998. This report is intended to provide a useful tool in understanding the insurance regulatory structures prevailing in OECD Member countries. This analytical part has been prepared by Jörg Vollbrecht, Consultant to the Insurance and Private Pensions Unit. The opinions expressed in this report do not necessarily represent the views of the Delegates to the Insurance Committee. The report will be published under the responsibility of the Secretary-General of the OECD. II.

Analysis

1.

Basic Principles and Objectives

The insurance sector plays an essential role in a market economy. The insurance industry provides various kinds of coverage against almost every risk and unexpected loss incurred by individuals and entities. Insurance companies are steadily accumulating resources that account for a significant part of a country’s structural investment. Life insurance is part of the social security system. Policyholders and insured are relying on the security of their insurance companies having to trust them to be in a position to meet their commitments over the considerable time lag between the payment of premiums and the receipt of benefits. Given this background, it is not surprising that state supervision of private insurance is existent in all OECD Member countries. The common objective of insurance supervision is to protect the policyholder, the insured, the beneficiary of an insurance contract as well as third parties who may have a right of direct

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claim against an insurer under certain insurance agreements by making sure that an insurance company is in the position to meet its obligations at any time. In former times, countries such as France, Germany, Iceland and Sweden considered it another task of insurance supervision to ensure the compliance of insurance contracts with provisions regarding the nature of the products (e.g. control of tariffs) and that there is an adequate relationship between premium rates and insurance benefits. Other countries (e.g. Australia, the Netherlands, and the United Kingdom) did not share this opinion. Finally, according to the Insurance Directives, the former position had to be given up by the European countries because the drafting of contracts and the fixing of premium rates were no longer subject to approval. At present, within the OECD, one may speak of a prevailing attitude favouring freedom of innovation and expansion for the insurers by defining the insured as mature market participants who will critically compare the products offered on the deregulated markets. Depending on the objectives, some member countries formerly focused more on the financial supervision while others were in favour of the so-called material supervision that covered the entire business of the insurance company, including the control of products and tariffs. These countries as members of the EU had to shift to a system where solvency control was considerably extended and material supervision reduced. However, even in times of deregulation, the interests of the insured are protected by way of insurance supervision as well as via general consumer protection regulations. 2.

Regulatory and Supervisory Authorities

2.1.

General Remarks

In all OECD Member countries, insurance supervision is part of the executive power. It usually comes within the competence of the Ministry of Finance or Economy, but also at times the Ministry of Justice or other ministries. As a rule, insurance supervision is carried out by a special institution. This may be either a special department in the relevant ministry or a separate subordinate authority of the ministry. Very often, certain basic political decisions are left to the relevant ministry while the supervisory authority carries out the current supervision of insurance companies.

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The insurance supervisory authority should be independent of both political influences and the supervised insurance companies. Supervisors should have legally defined objectives, tasks and rights. Personally, supervisors should be professionally independent and impartial and should have a wide knowledge and experience. The relevant authorities should have the power to license insurance companies, suspend or withdraw authorisation, apply prudential regulations and invoke sanctions in cases of non-compliance with legal rules or ordinances of the supervisory body. Ongoing supervision, in particular financial supervision, depends greatly on the quality of the financial statements and returns by the insurance companies. The supervisory body must have the right to obtain and verify information on the companies at any time. Only the right information enables the supervisory body to face the real problems of the insurance companies and to intervene with the correct remedial action in case the management alone is not able to react accordingly. However, with the exception of cases stipulated in law, supervisors may not interfere in the management of the insurance company. Generally, only the management is liable for business decisions. In most countries, at least as a complement to the public supervisory structure, self-regulatory institutions are entrusted with certain supervisory functions in the broad sense of the term. These range from drawing up business guidelines and codes of conduct to licensing and registration of intermediaries. In many Member countries (e.g., Austria, Belgium, France, Germany, Ireland, Luxembourg, Mexico, the Netherlands, Portugal, Spain, Switzerland, and the United Kingdom), the insurance supervisory authority may seek the advice of external experts as auditors or actuaries. Presently, the use of ratings from rating agencies is under discussion. However, for the time being, among the OECD Member countries, the use of ratings by private rating agencies for the monitoring of the insurers’ financial soundness is reported only for New Zealand. In almost all Member countries, the decisions of the supervisory authority may be appealed with the competent ministry or the government. Moreover, in almost all countries it is possible to have the recourse of the courts. 2.2.

Organisation of the Regulatory and Supervisory Authorities

In all OECD Member countries except Luxembourg and Portugal, the regulatory body is a ministry; in most Member countries it is the Ministry of

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Finance. Depending of the size of the country and the amount of insurance companies carrying on business in the respective country, the number of staff varies enormously (between ten and a few hundred persons) among countries. In several Member countries (Belgium, Finland, Iceland, Italy, Japan, Korea, the Netherlands, Switzerland, Turkey, and the United Kingdom), at least partly, i.e., in certain cases such as for implementing regulations or ordinances, regulatory functions are not only with the ministry (or better said a department within the ministry) but also with the supervisory body. In the majority of countries, the regulatory and supervisory body (in case of being another administration than the ministry) is financed by the insurance industry (to less than 100 per cent in Germany, Korea, and United Kingdom). Only in Spain are the bodies financed solely by the state. In principle, within the member countries of the OECD, the Ministry as well as the insurance supervisory body (as an independent body) have licensing functions. Very often, the Ministry is responsible for granting licenses to foreign companies, which is seen as a political decision. For example, in Germany, the Federal Office for the supervision of insurance companies is responsible for granting licenses to domestic companies as well as EU/EEA insurers, whereas the Federal Ministry of Finance is responsible for licensing non-EU insurers. In Iceland, the Ministry of Commerce gives domestic insurance companies the license to operate in this country and it gives non-EU insurers the authorisation to open branches in this country, whereas the Insurance Supervisory Authority grants the authorisation to expand the activities of licensed companies and it gives the authorisation for EU insurers to either provide services in this country without an establishment or open a branch. In all OECD Member countries, the other important task of the supervisory body, apart from licensing, is the on-going supervision. So far as Member countries in the field of insurance have provisions regarding customer mediation (reported as not existing by Czech Republic, Finland, France, Hungary, Japan, the Netherlands and Turkey), those functions are taken over by the insurance supervisory body (with the exception of Denmark, Poland, Sweden and United Kingdom, where there is another authority entrusted with). In Canada and Sweden integrated supervisory bodies for financial services have been created. However, the legal rules for the respective service remain separate due to the different risks involved in banking and insurance and the different requirements regarding capital and solvency.

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3.

Scope of Regulation and Supervision

3.1.

General remarks

In all OECD Member countries, there are legal provisions regulating the insurance business. As the insurance industry is part of the overall economy in a given country and depending on the macroeconomic and structural policies, basic financial and legal infrastructure, insurance legislation and regulation are part of the overall legal environment and depending on other legislation as by civil law, commercial codes, and company law and tax law. Although all developed insurance markets endorse the concept that a competitive market with as less government intervention as possible enhances national welfare most, in the majority of Member countries, the insurance industry is under close supervision. Reasons therefore are easily found. Insurance companies are exposed to various technical and non-technical risks. There is the − risk of miscalculated and insufficient tariffs due to lack of expertise or mismanagement, − the risk of deviation of the actual development of claims frequency and extent, interest income and administration costs from the calculation bases due to changes in mortality, medical progress, legislation or interest rates, − the risk of the technical provisions being insufficient to meet the liabilities under the insurance contracts, − the risk of non-payment by reinsurers, − the risk of excessive operating expenses, − the risk of an unexpected accumulation of losses, − risk connected with investment decisions as e.g. the matching risk, interest rate risk, liquidity risk, evaluation risk ,and the specific risks related to the use of derivatives,

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and - as non-technical risks - risk related to the management being incompetent or having criminal intentions. The majority of these risks can be reduced by taking preventive measures, i.e. measures taken not only by the respective insurance company but also by the responsible regulatory and/or supervisory body. With regard to miscalculation, the regulation should contain requirements for calculation as well as for fit and proper managers, and the supervisory body should monitor calculations closely by e.g. asking for the bases applied to be submitted periodically. On the insurance contract side premium adjustment clauses could be used. The monitoring of bases for calculating premiums and technical provisions as well as the inclusion of special contract clauses, such as premium or benefit adjustment clauses, will also serve to minimise the deviation risk. The risk of non-payment of reinsurers can be limited by deposits and the placing of reinsurance with several reinsurers. The establishment of separate technical provisions as, for instance, the equalisation reserve can limit the dangers of unforeseen high operating expenses and accumulated losses. Suitable measures to prevent risks connected with investments are mainly diversification and spread. To prevent the risk of different due dates of liabilities and the assets covering them, a so-called resilience test or stress test can be applied as a means of control. It provides information as to whether there exist a certain balance of technical liabilities and adequate assets in a changed investment situation (e.g. in a worst case scenario of a crash in the stock market). In general, regulations should be adequate, objective, consistent, transparent and comprehensible for by those to whom they apply. Over-regulation should be avoided. In order to maintain enough flexibility to react to changes in the economic environment and the insurance market, regulators decided it would be more appropriate to incorporate certain provisions not in the law itself but rather in the implementation of regulations that are easier to amend.

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3.2.

Regulation of Direct Insurance

Insurance companies carrying on direct insurance are subject to regulation and supervision in all OECD Member countries. As a rule, the supervisory authority decides whether the activities of a company may be classified as insurance business. Only in a few countries, the term insurance business is legally defined (e.g., in the Netherlands and the United States). The other countries use definitions provided by science, jurisdiction and general practice. For the Member countries of the EU, the term insurance business has been “defined” by a list of the classes whose operation is considered as operation of insurance business in an annex of the respective European Insurance Directives. There also is a classification by the OECD. With a few exceptions (Australia regarding friendly societies, Switzerland regarding provident funds providing unemployment and sickness insurance, Canada and the Netherlands with regard to certain specific sectors) the OECD Member countries supervise all classes of private direct insurance. If a direct insurance company also carries on reinsurance, in most cases, the latter will also be supervised. The regulation and supervision of insurance companies which only carry on reinsurance, so-called professional or specialised reinsurers, differs among the countries. But, even if not under direct supervision, reinsurance companies are at least under indirect supervision through the rules relating to ceding direct insurers. 3.3.

Regulation of Reinsurance

The information collected on reinsurance reflects the increasing problems and increasing supervisory attention among the OECD Member countries. Several countries require reinsurers to be licensed and subject them to some extent of ongoing supervision, often limited to the submission of accounts. There are two aspects of regulation of reinsurance business: the supervision of the reinsurance arrangements of ceding companies and the supervision of reinsurance and direct insurance companies accepting reinsurance business.

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Accepted reinsurance business activities generally should be supervised but not necessarily in the same way as direct insurance business. However, there are OECD countries requiring specific authorisation, minimum capital, solvency and other conditions similar as for direct insurance companies. Most OECD countries supervise accepted reinsurance business of domestic direct insurance companies. Accepted reinsurance activities are not at all supervised in Australia, Czech Republic, Greece, Hungary, Japan, New Zealand and Poland. In principle, reinsurance business accepted by foreign insurance companies is supervised if the direct insurance companies have an establishment in the respective country (e.g., in Portugal and Turkey). Reinsurance business accepted by foreign direct insurance companies is not supervised in Australia, Belgium, Czech Republic, Denmark, Finland, Hungary, Ireland, Japan, Sweden and Spain. Domestic professional reinsurers are not supervised in Belgium, Czech Republic, the Netherlands and Switzerland. In Germany, professional reinsurers in the legal form of a mutual are subject to full supervision while other reinsurers are subject only to restricted (financial) supervision. The United States has steadily expanded its control over reinsurers. Many states require reinsurers to be licensed, to deposit assets in a specific amount, and to submit accounts. Foreign professional reinsurers are not supervised in Belgium, Czech Republic, Denmark, Finland, France, Germany, the Netherlands, Poland, Sweden and Switzerland. Ceded reinsurance is, in general, supervised through the supervision of direct insurance business. The supervisory body will ask for reinsurance arrangements during the authorisation procedure. It will check the proposed reinsurance arrangements in relation to the company’s capitalisation, proposed classes of business and retentions. Ceded reinsurance of domestic direct insurance companies is not regulated and supervised in Hungary. Ceded reinsurance of foreign direct insurance companies notably is not regulated and supervised in Denmark, Finland and Hungary.

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The supervision mainly focuses on financial supervision (e.g., examinations of accounts and submission of annual reports) and on-the-spot examinations (e.g. in Austria, Canada, Portugal, Sweden, United Kingdom). Only France, Italy and Switzerland appear to control technical provisions and investments. In some countries, the requirements regarding the qualification of managers are applicable, as are the rules on shareholder control. As part of the ongoing supervision, very often there will be an annual review of existing reinsurance arrangements. Most often, the supervisory authority reviews the reinsurance treaties (e.g. Germany and Ireland) and examines the risk exposure. Special rules regarding financial reinsurance and other special forms of reinsurance as well as reinsurance offered by offshore companies are only exceptionally reported. The OECD has undertaken efforts to facilitate the control of reinsurers soundness by improving the flow of information. Even if all claims are met in full, a reinsurer in financial difficulties may unduly delay the payment. Therefore, it is an insurer’s responsibility to try to evaluate any prospective reinsurer. In this respect, a recommendation adopted in March 1998 suggests that Member countries invite direct insurers to take appropriate steps to determine the financial soundness of its reinsurers. Information on the reinsurers market reputation and history, including any recent change in its ownership, the qualification and reputation of its management, the composition of its underwriting and investment portfolio, its financial standing shown in the balance sheet and profit and loss accounts, its solvency margin and technical provisions as well as ratings by different rating agencies may help to assess the security of a reinsurer. Reinsurance companies in turn are to be encouraged to supply the required information. 3.4.

Regulation of Cross- Border Business

With respect to cross-border business, it can be stated that liberalisation has considerably progressed among the OECD Member countries. In principle,

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foreign insurance companies which, without having an establishment in the country concerned, are authorised in their home country to write certain direct “international” insurance classes (e.g. very often marine, aviation, or transport insurance), are not subject to supervision of the host country where they carry on their activities, as far as the authorised business is concerned. Within the EU, this is true for other classes, too. In the case of EU Member States, this liberalisation goes back to the implementation of the Third Insurance Directives. Under the provision of the freedom of establishment, according to the European Insurance Directives, the branch of an insurance company having its head office in another EU/EEA Member country is not licensed or supervised by the supervisory authority of the state where the branch is established. The companies are entitled to establish a branch after having informed the competent authority of their head office country of their intention. They have to submit documents indicating the Member country in which the branch is to be established, the name and address of the authorised agent of the branch, a scheme of operations, and a statement that the insurance company if it intends to transact motor third party liability insurance, has become a member of the national Bureau or guarantee fund of the Member country of the branch. Due to the provisions on the freedom of services, insurance companies having their head office in an EU/EEA Member country may carry on any class of insurance without having to establish a branch. The only requirement is that they inform the competent authority of their head office country of the Member country in which they intend to carry on business and of the risks they intend to cover. This insurance business is not supervised by the supervisory authority of the host country but by that of the home country. The supervisory authority of the host country only has the right to ensure that the national legal provisions are observed. Apart from the above EU regulation, in several Member countries, the crossborder trade is allowed provided the resident proposer initiates the transaction (Austria) or takes out the contract by correspondence (Denmark, Germany). In most Member countries (Australia for non-life), Germany, Greece, Korea, Luxembourg, the Netherlands, Poland, Sweden, Turkey, United Kingdom, United States; France, Italy, Japan, Mexico, Portugal and Spain (only with authorisation), resident proposers can enter into an insurance contract on their own initiative with an insurer neither established nor authorised in their

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respective countries, provided it is not possible to cover the risk in their countries. In other Member countries as in Australia for life insurance, in Ireland for nonEEA insurers and in Switzerland (with exceptions), cross-border transactions are not allowed even under such circumstances. 4.

Other Regulation

In some OECD Member countries (Australia, Germany, Luxembourg, the Netherlands, Norway, Portugal, Sweden, Switzerland), certain entities are not subject to insurance supervision. Those are e.g.: − institutions granting assistance without legal entitlement, − societies granting mutual aid, − trade unions paying indemnities during a strike, − smaller societies which write agricultural insurance in a restricted geographical area, − societies writing export credit insurance for the account of the government or with a government guarantee. Some OECD Member countries have introduced specific regulations regarding Financial Conglomerates and/or insurance groups (e.g., Australia, Denmark, Finland, Iceland, Italy, Mexico the Netherlands, Norway, Spain, Sweden, United Kingdom and the United States). Others have specific regulations concerning licensing and supervision of pension funds in a broader sense, i.e., including the so-called Pensionskassen in Germany and the caisses de retraite in France. So, for domestic pension funds, regulations are reported by all OECD Member countries but Poland and Turkey. For foreign pension funds, all countries but Belgium, France, Germany, Hungary, Iceland, Mexico, Norway, Poland, Sweden, Switzerland and Turkey appear to have specific regulations.

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5.

Licensing

Licensing is the main means of preventing unsound insurance companies from entering the market. Thus, in all OECD Member countries, there are legal provisions regarding the licensing of insurance companies (domestic and branches of foreign companies). At least in some cases (e.g., the licensing of foreign companies) if not all cases, the competent authority is a ministry, respectively a part of the competent ministry which is called then “supervisory body”. In several countries, there is an independent administrative body in charge of licensing. It appears that only in Denmark, Hungary, Italy and the Netherlands, the ministries do not have licensing functions. The supervisory body is licensing domestic and foreign direct insurance companies as well as domestic (with the exception of France, Germany, Hungary, Iceland, the Netherlands, Poland and Turkey) and foreign (not in Finland, France, Germany, Hungary, Iceland, Luxembourg, the Netherlands, Poland, Sweden, Switzerland and Turkey) reinsurance companies. Companies being denied a license have a right to appeal. In most countries, the appellate authority is the competent court; only in Korea, Norway, Poland, Portugal, Spain and the United States, it also is the supervisory body. 5.1.

Pre-application Procedures

Pre-application procedures, whichever formal or informal, can be observed in many OECD Member countries (e.g. in Australia, Austria, Belgium, Canada, Finland, Hungary, Iceland, Japan, Luxembourg, Norway, Portugal, Switzerland, United Kingdom, Sweden, Turkey). In Korea, it appears that application documents for pre-approval as well as for the main approval have to be submitted. These procedures are applicable to domestic companies as well as branches and agencies of foreign insurers. In Member countries, where pre-application procedures exist, contacts with the insurance supervisory authority prior to the formal application are reported to have proved useful for potential applicants because they can be informed at an early stage of all information needed by the authority for the licensing procedure.

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5.2.

Licensing Procedures

Usually, the authorisation is granted on application by way of an administrative act. In most OECD Member countries it is granted by the competent minister (Austria, Belgium, Canada, Finland, France, Iceland, Ireland, Japan, Luxembourg, Norway, Portugal, Spain, Switzerland, Turkey), in others by a special supervisory authority (Australia, Denmark, Germany, the Netherlands, United Kingdom). If the insurance company meets the requirements, it is, in most Member countries, legally entitled to authorisation. The decision must be taken within a certain time period (in almost all countries in a period of six months from the date of application). As a rule, a list of insurance companies that have been granted an authorisation is officially published. If the authorisation is denied, the insurance company may have recourse to the court that will decide whether the company has to be authorised or not. 5.3.

Licensing Principles

In all OECD Member countries, the underwriting of insurance risks is restricted to insurance companies which may only transact insurance business. In former times, insurance companies have been allowed only to do business other than insurance business if such business was closely related to insurance business. Such close relationship is considered to exist if an insurance company assists another insurance company in carrying on its insurance business by, e.g., making available technical equipment or staff. Nowadays, in many countries, this is not seen that strict anymore and insurance companies may distribute other financial products than insurance products, or may take over pension business. However, there are still good reasons speaking against a mixture with noninsurance activities: The funds to be set aside and to be preserved under strict supervision for paying insurance claims are not to be placed at risk by the unknown risks of uncontrolled unrelated business. In the United States, where specialisation has been traditionally very strict, insurers may now own at least “ancillary” subsidiaries.

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There are different opinions as to whether an insurance company may hold shares in another non-insurance company (limitations are reported by Czech Republic, Hungary, Japan, Korea and the United States). Inside the EU the shareholding is accepted. Holding of shares is not seen as carrying on the business of the respective company. This even applies in the case of majority holdings. OECD Member countries where the European Insurance Directives are not applied, permit insurance companies to hold a participation in a non-insurance company either to an unlimited (e.g. Canada) or only to a limited extent (e.g. Austria and Switzerland). Against the background of the increasing importance of co-operation between banks and insurance companies - the so-called bancassurance -, it is interesting to learn about the opinion of the Member countries in this respect. The creation of a banking subsidiary by an insurance company only is prohibited in Finland, Iceland, Japan and Mexico. It is limited in Canada, Germany, Korea, the Netherlands, Norway, Sweden, Switzerland and the United States. In many Member countries, the shareholding of an insurance company in a bank is allowed (with limitations in Australia, Canada, Germany, Greece, Hungary, Ireland, Iceland, Japan, Korea, the Netherlands, Norway, Portugal, Sweden, Switzerland and the United States and prohibited in Mexico). The shareholding of a bank in an insurance company is also often limited (in Australia, Canada, Iceland, Japan, the Netherlands, Norway, Sweden and the United States and prohibited in Mexico). The banks are more often free to distribute insurance products while insurance companies only in a limited way may sell bank products. In some OECD Member countries, limitations to take part in a Financial Conglomerate for insurance companies exist. There are exceptions provided in the regulations of Hungary, Iceland, Spain, Switzerland, Turkey and the United States. In accordance with the so-called BCCI-Directive, Member States of the European Union can object to an insurance company being part of an intransparent financial conglomerate. In all OECD Member countries, life and non-life insurance business are to be separated, so that one activity can not be used to support the other. Especially reserves in life insurance have to be protected. But the authorisation to take up life insurance business includes the permission to write supplementary insurance to life insurance (e.g. in all EU Member countries and Switzerland).

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If a company wants to write accident and health insurance together with life insurance, it is required to establish a separate management for life insurance and the other classes. The simultaneous pursuit of life and non-life insurance is only permitted in a few countries (e.g. Mexico). As regards health insurance, there are different regulations among the OECD Member countries solely already because of the different structures of health service in the countries. While in some countries health insurance is written by life insurance companies, in others it is written by non-life insurance companies (e.g., in almost all EU Member countries) or by specialised insurance companies as in Germany. Regarding the treatment of composite insurers, in Switzerland, an insurer which writes both life and non-life insurance in its home country is not authorised to write life insurance in Switzerland. In EU/EEA countries, a composite insurer with its head office outside the EU carrying on non-life insurance in these countries must establish a subsidiary if it wishes to carry on life insurance business, and vice versa. In Canada, composite insurers authorised in their home jurisdiction to write both life and non-life insurance may not write both in this country through the same entity. In most OECD Member countries, separate licenses are issued for each class of insurance or for several classes grouped under a common denomination. Usually the authorisation is granted for an unlimited period of time. However, in some Member countries it is possible to grant authorisation for particular classes of insurance for a limited period of time. After expiry of this time, the authorisation may be renewed. In many Member countries, the authorisation can be withdrawn if the insurance company did not take up business within a certain period of time (mostly one year), i.e. did not make use of the authorisation. 5.4.

Licensing with regard to Reinsurance Business

In all OECD Member countries, the authorisation to do direct insurance business includes reinsurance business in the same classes of insurance.

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Among OECD Member countries, practices on the control of reinsurance activity are widely divergent. However, the majority of Member countries require authorisation specific to reinsurance activities of domestic and foreign direct insurers (including Canada, Italy, Japan and the United Kingdom). In Germany, a separate authorisation is not necessary but direct insurance companies only may write reinsurance business if it is expressively mentioned in their operating plan. Several countries (Australia, Austria, Denmark, France, Iceland, Ireland, the Netherlands, Norway, Spain, Switzerland and the United States) require from domestic as well as foreign (with the exception of Denmark) direct insurers a single authorisation for both direct and reinsurance business. On the other hand, Belgium, Finland and Greece do not require any authorisation. Domestic professional reinsurance companies being subject to authorisation requirements in almost all OECD Member countries (except in Belgium, France, Germany and the Netherlands) are granted the authorisation for all classes of insurance. Foreign professional reinsurers are licensed in Australia, Czech Republic, Italy, Japan, Korea, Norway, Spain (in case of branches), Turkey, United Kingdom and the United States. Mexico registers professional reinsurers depending of the ratings they have. In those countries, the authorisation process mainly is the same for domestic and foreign direct insurers and professional reinsurers. 5.5.

Licensing Requirements

In all OECD Member countries, an insurance company does not obtain the authorisation unless it meets certain requirements. Besides to the financial requirements being of paramount importance, there are other criteria which concern legal requirements as, e.g., conformity of the legal form, filing of bylaws and general terms as well as conditions of policies, accounting requirements as filing of an opening balance sheet, proof of the required minimum capital, technical requirements as filing of premium rates and technical bases for information and/or approval, and managerial requirements (e.g., fit and proper requirement) .

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5.5.1.

Legal Requirements

In all OECD Member countries, only certain legal forms are permitted for insurance companies. Generally, the insurer must be a legal person. All Member countries permit insurance companies in the form of companies limited by shares and mutual societies (with the exception of Luxembourg for companies limited by shares and Australia and the Czech Republic for mutual societies), but the structure of these company forms is not the same in all countries. In the United States, there are many “town mutuals” or “county mutuals”, covering agricultural property risks. Mutual or co-operative insurance companies are also common within the EU for livestock, for small vessels, and for providing burial benefits. Co-operative societies are admitted in Belgium, Czech Republic, Hungary, Iceland, Italy, Luxembourg, Spain, Switzerland, United Kingdom and the United States. Publicly owned companies are allowed in Australia, Belgium, Czech Republic, Finland, France, Germany, Hungary, Iceland, Mexico, Poland, Portugal, Spain, Turkey, United Kingdom and the United States. In almost all Member countries, insurance companies have to submit the articles of incorporation including information on the legal form, the head office of the company, the purpose of the business, the geographic area of business operations and the executive bodies of the company. In some Member countries (Australia, Canada, Denmark, France, the Netherlands, Spain) this information only has to be submitted for information. In other countries it must be approved. Most countries, are asking for submission of a so-called business plan or operating plan. This scheme of operations specifies, in particular, the risks which the insurance company intends to cover, the proposed reinsurance, information on expenses of the first years and the financial resources available. Only a few Member countries require domestic as well as foreign direct insurance companies to submit for approval the general policy conditions (Czech Republic, Hungary (only domestic), Japan, Korea, Mexico, Poland, Switzerland, and the United States).

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In the EU Member countries, neither the approval nor the systematic submission of general policy conditions may be requested. Exceptions are the general policy conditions for compulsory insurance. Member countries may demand their submission prior to their application. But this does not imply any approval. The submission of the policy forms for approval of domestic and foreign direct insurance companies only is requested by Hungary, Iceland, Japan, Korea, Mexico and the United States. In the EU, the submission of those documents must not be required. In various Member countries, domestic and foreign direct insurance companies are required to submit information on the qualification of the management - the so-called fit & proper requirement. The managers must be reliable and must have sufficient professional knowledge and experience. In the EEC (with the exception of Denmark as regards domestic companies, and additionally with the exception of Belgium, Italy, the Netherlands and Sweden as regards foreign companies), insurance companies have to notify the competent authority of the identity of the direct and indirect shareholders - both legal and natural persons - and members holding qualified participations of the company as well as the amount of these participations. A qualified participation is given in the case at least 10 per cent of the insurance company’s capital or voting rights are held or when there is another possibility of exerting a decisive influence on the management. The competent authority may object if it is of the opinion that the person concerned is not meeting the necessary requirements. The reason of the notification is to make sure, that shareholders and natural or legal persons holding participations meet the demand in the interest of a sound and prudent management of the insurance company. The shareholder identification is also asked for in other than EU Member countries (but not - as it appears - in Australia, Hungary, Switzerland and Turkey). Reinsurance arrangements have to be submitted in Australia, Belgium, the Czech Republic, Finland, France, Germany, Iceland, Italy, Japan, Luxembourg, Mexico, Norway, Poland, Portugal, Spain, Sweden, Switzerland, Turkey, the United Kingdom and the United States.

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The reasons therefore are that whichever method is used to place reinsurance, by way of treaty reinsurance contracts, facultative reinsurance, or pools, contract terms must be checked very carefully by the insurers. Financial or finite reinsurance, reinsurance futures and options as well as catastrophe bonds used by insurance companies in industrialised countries are risky and, e.g., seem not to be currently appropriate for insurance companies in economies in transition. They not only bear risks in itself but also cause difficulties in accounting and taxation as well as for the supervision. From the tables, it appears that no country imposes special conditions on subsidiaries. As regards branches of foreign companies, there are specific requirements concerning the proof of business in the country of the head office (in all OECD Member countries but Australia), the duration of the establishment of the registered office (only in France, Iceland, Japan, Norway, Poland, Portugal, Spain, Switzerland, United Kingdom and United States) and the establishment of a business address in the state of operations (all OECD Member countries). In Portugal, the opening of branches of companies whose head offices are outside the EU/EEA have been in existence for at least five years. In Spain, an applicant must have been authorised for at least five years in its home country to write the classes of insurance for which it seeks a licence in Spain. 5.5.2.

Financial Requirements

Financial licensing requirements have to be strong enough to make sure that the company has set up a sufficiently high minimum capital. Very often, capital shortage is a major problem in insurance markets in economies in transition. The main reasons for it are the unstable economic situation, limited savings and the underdeveloped state of capital markets. One of the important factors in expanding the capital base is to increase foreign investments, a measure that is not always supported by governments of the concerned countries. As another side effect of capital shortage is companies with a low capital base that are forced to cede a large proportion of their risks to other, often to foreign companies.

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In all OECD Member countries but Japan, there are rules concerning paid-up share capital of companies limited by shares. In most countries, it is sufficient to pay in an amount between 20 per cent and 50 per cent. Almost all OECD Member countries (except Korea) require that insurance companies possess a certain minimum capital as a condition for authorisation. Besides equity capital or equivalent funds, in particular, many EU Member countries ask for an organisation fund. The equity or equivalent funds must be permanently at the disposal of the company while the organisation fund is used to set up the organisation and therefore will be kept only for the first few years. In most cases, no specific amount is fixed with regard to the organisation fund because the starting costs depend on the structure of the company and the classes written. The amount of the minimum capital varies among the Member countries. As in the EU, it usually depends on the insurance class. In life insurance, according to the First Life Insurance Directive of 1979, at least 800,000 ECU are required. In non-life insurance, the largest amount is required for credit insurance (1 400 000 ECU). The amounts are under consideration and will be substantially increased in the near future due to inflation and market developments. In other OECD Member countries, these amounts are already above those required within the EU. In some countries, a deposit, either of a fixed (for domestic companies: Czech Republic, Korea, Mexico; for foreign companies: Belgium, Czech Republic, Denmark, Finland, France, Germany, Iceland, Italy, Japan, Korea, Luxembourg, the Netherlands, Norway, Sweden and United Kingdom) or variable (for domestic companies: Turkey and some states of the United States; for foreign companies: Denmark, France, Germany, Luxembourg, Norway, Portugal, Spain, Sweden, Switzerland, Turkey and the United States) amount, is required in addition to the minimum capital requirement. The amounts largely depend on the type of the classes written. In the EU, the fixed amount equals 25 per cent of the minimum guarantee fund. The deposit must be made before the authorisation can be granted.

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In Czech Republic, Korea, Mexico and the United States, the deposits (by domestic companies) must be located in the country of the head office (same for foreign companies in Korea and the United States). Exemptions of the obligation to make a deposit are possible in Germany (for foreign companies), Japan (for foreign companies), Portugal (for foreign companies), United Kingdom and United States. Mostly, the consequences in case of insufficient deposits are the denial of granting a licence or the withdrawal of the licence. Specific provisions for foreign companies only are known in Denmark, Finland, Italy, Japan, Norway, Portugal, Sweden, and United Kingdom). 5.5.3.

Accounting Requirements

Traditionally, insurance supervisors have required insurers to submit accounts different from those prepared under the law for the purpose to inform shareholders or the public. Insurance supervisors, in particular, are interested in information on technical provisions, liabilities and assets. The reason is, that, e.g., the valuation of liabilities has been a popular field for “creative accounting”. An insurer can make large amounts of surplus disappear by strengthening reserves as he can create surplus out of reserves by adjusting estimates of future liabilities downward. Independent audits can help to minimise abuse. Such a requirement has been introduced in the United States, where it did not exist before. Together with the operation scheme, domestic direct insurers in most OECD Member countries have to submit for approval an initial balance sheet and a statement of prospective income. Foreign companies have to submit those documents in less Member countries (initial balance sheet: Belgium, Czech Republic, Italy, Japan, Korea, Poland, Spain, Sweden, Switzerland, United Kingdom, United States; statement of prospective income: Belgium, Czech Republic, Germany, Hungary, Italy, Japan, Korea, Poland, Spain, Switzerland, United Kingdom, United States). In view of the fact that premiums and liabilities are commonly reported net of reinsurance, insurers are asked to report on their reinsurance arrangements.

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In some countries, the company not only has to submit the balance sheets but the profit and loss accounts for the past three years as well. The harmonisation within the EU, so far, has not yet achieved more than a set of general guidelines. Each insurer reports to its home country as required there. The supervisors of the host countries may not require more than copies. In other countries as, for example, in Denmark and Norway, an applicant has to submit copies of the company’s accounts and annual reports for the last three financial years. Insurance companies in EU Member countries also have to submit for the first three years information on the expected liquidity position and estimates on the financial means to cover the solvency margin and the technical provisions. In the United States, uniform reporting forms have existed for long time and still exist, but the states may, and frequently do, require additional information. 5.5.4.

Technical Requirements

In many OECD Member countries, premium rates have to be submitted for information or even for approval. The adequacy of premium rates is a fundamental issue. If they are not set at an appropriate level even adequately calculated technical provisions would not prevent the company from making losses. But tariff calculation depends of the availability of reliable data. Insurance premiums are calculated on the basis of the “law of large numbers”. Data on loss frequency and loss severity are indispensable for calculation. In states with monopolistic structures, only the state monopoly possessed of e.g. historical insurance claims data. If the state monopoly had been replaced by a marketoriented system, these data were no longer reliable. The Insurance companies in those economies in transition for the purpose of setting technical provisions had to co-operate to establish new databases by first using probable assumptions. In this regard, the supervisory authorities in some countries (e.g., in Czech Republic and Hungary) have been well advised, to ask for submission of the premium rates and products for approval even if the prevailing trend goes away from such controls; tariffs and products have to be submitted in Japan.

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In this respect it has to be mentioned, that never, in any country, has tariff control been exercised universally in all classes of insurance. It has tended to be strictest in “politically sensible” classes as motor insurance. In the United States, it has also been strict for workers compensation insurance. In the EU, where in former times there were countries (United Kingdom and the Netherlands) with no or insignificant control in this field and countries with a strong control (Belgium, France, Germany, Italy), along with the single authorisation came the almost complete abolition of the prior approval of policy conditions, premiums and tariffs. That means, that under the third generation of the Insurance Directives, systems of prior approval and systematic communication of contractual conditions are prohibited with the only exemptions for compulsory insurance and supplementary health insurance (e.g., in Germany). In life insurance, some EU supervisory authorities made use of the provision in article 29, sub-section 2 of the Third Life Insurance Directive to ask for the bases for calculation to be submitted systematically to verify compliance with the actuarial principles. In the United States, besides the control of contract terms, tariff control presents a pattern of different rules, ranging from no control to a requirement of advanced approval. A move is under way to exempt commercial insurance generally from tariff controls. In the EU, the bases for the calculation of premiums and technical provisions have to be submitted but not for approval by domestic as well as foreign companies. In other Member countries (Australia, Belgium (for life assurance only), Denmark, Luxembourg, Mexico, Norway and Turkey) they have to be submitted for approval. 5.5. 5.

Specific Requirements for Branches

In respect of licensing for branches or agencies of foreign insurers, no OECD Member country has reported the application of the Market Need Test to examine whether there is a need for any additional insurer in the national market. In Australia, new approvals of non-resident life insurers have been restricted to domestically incorporated entities.

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In the United States, 17 States have no mechanism for licensing initial entry of a non-US insurance company as a branch, unless that company is already licensed in some other US-State. In general, branches of foreign insurance companies have to submit the same documents as national insurance companies. In all OECD Member countries, the foreign company has to submit a certificate specifying the classes of insurance it is authorised to transact in its home country. As regards authorisation to carry on business in another EU/EEA Member country, the situation for direct insurance companies with their head office in an EU/EEA Member country was the following. From 24 July 1973 with the adoption of the First Directive on non-life insurance (73/239/EEC) and from 9 March 1979 with the adoption of the First Directive on life insurance (79/267/EEC), the European insurance market started to take shape. These two Directives harmonised the conditions relating to the taking up and pursuit of insurance business of insurance companies of the Common market and of branches of third countries. Although insurance companies wishing to operate outside their home countries still had to obtain authorisation in each Member country, there were comparable legal and financial conditions (as the solvency margin and the minimum guarantee fund) and a uniform procedure. Branches continued to be subject to supervision of both their home country and the host country. With the second generation of Directives, the Second Directive on non-life insurance from 22 June 1988 (80/357/EEC) and the Second Directive on life insurance from 8 November 1990 (90/619/EEC), the freedom to provide services in relation to so-called large risks (e.g., aircraft, ships, and the liabilities for them) or industrial and commercial risks in non-life as well as for services provided on the initiative of the policyholder was introduced. The freedom to provide services in relation to mass risks in non-life as well as the active freedom to provide services on the initiative of the insurer in life still remained dependent of an authorisation by the country of risk.

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Moreover, certain classes of insurance (motor third party liability, builder’s risk insurance, nuclear liability insurance, etc.) were excluded from the scope of the Directive on non-life insurance. The single market in insurance of today was achieved by implementation of the provisions of the third generation of Directives (92/49/EEC on non-life, 92/96/EEC on life insurance). The system of the single authorisation (European passport) permits any insurance company with its head office in one of the EEA member countries and authorised in that country to offer its products through agencies or branches or under the freedom of services provision without having to apply for an authorisation in the host country while being supervised only by its state of origin (home country control). The principle of the single license relies on co-ordination of essential rules concerning the prudential and financial supervision of insurance companies. As regards the procedure, the notification process, under the provision of the freedom to provide services, the insurer must inform the supervisory body of its home country of the commitments it wishes to cover. The following documents must be supplied: − a scheme of operations describing the types of business envisaged, − the structural organisation of the branch, − the address of the branch, − the name of the branch’s authorised agent, and − a solvency certificate. The home Member country communicates to the country in which the insurer wishes to carry on business the above documents. If the home supervisory bodies have doubts about the financial health of the company or the qualifications of the managers, they may decide not to notify the country concerned.

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The Member country of the branch must, in return, inform it of the conditions governing the pursuit of business deriving from the interest of the “general good” with which the branch will have to comply. The concept of the interest of the “general good” is a product of case law which has not been specified in the Directives. According to a definition commonly accepted in Community law, the national measures may only be adopted in a field which has not been harmonised and may not lead to discrimination. The measures must be objectively necessary and relevant to the objective without being disproportionate and without duplicating a regulation which is already safeguarding the respective interest. Companies operating under either freedom to provide services or the freedom of establishment must supply the same information to the host country as that transmitted by its local competitors. The companies have to inform the country of the registered office of the amount of the premiums, claims and commissions obtained in each host country. A representative (also called authorised agent) has to be appointed who is entitled to represent the branch in the host country. In some Member countries, the supervisory body has to be asked for approval of the appointed representative (e.g., Austria, Germany, Iceland, Luxembourg, Spain, Sweden, and United Kingdom). It is generally required that the representative resides in the country where the activities are carried on. All Member countries require that the branch of a foreign company have its own capital resources. Most Member countries have provisions regarding deposits from foreign insurers. However, insurers from EU/EEA countries do no longer need to constitute and maintain deposits and solvency margins in their respective host countries. Insurers outside the EU/EEA (with the exception of Swiss non-life insurers because of the agreement between the EEC and Switzerland on direct insurance other than life insurance from 10 October 1989) must possess in a host country an amount equal to at least one half of the minimum guarantee fund imposed on EU/EEA insurers and deposit one fourth of the said fund as security. For these branches, the guarantee fund is defined as the highest of one third of the solvency margin or one half of the minimum guarantee fund imposed on EU/EEA insurers.

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The initial deposit lodged (one fourth of the minimum guarantee fund imposed on EU/EEA insurers) is considered as forming part of the guarantee fund. Assets representing the solvency margin must be kept within the host country where activities are carried on up to the amount of the guarantee fund and the excess within the EU/EEA. In France, companies from third countries (not being signatories of the GATS) can be required to provide deposits or guarantees if their home country imposes similar requirements on French companies. 6.

Ongoing Supervision

In all OECD Member countries, insurance companies are subject to current supervision. The conditions under which the license was granted must be observed the whole time the insurance company is carrying on business. It is one of the tasks of the insurance supervisory body to ensure that all requirements are met all the time. In this respect, even Member countries with supervisory authorities not having the right to ask for premium rates and tariffs for approval during the licensing procedures, allow their authorities to ask for information on the products, business transactions, the financial situation and mergers and acquisitions while performing the ongoing supervision. The other side of supervision, its repressive nature, is the power of the supervisors to interfere with business management and to impose sanctions if the directors, managers, or other persons in charge violate legal requirements or endanger the interests of the insured. 6.1.

Powers of the Supervisory Authority

To be able to perform its tasks, the insurance supervisory authorities in all Member countries have the right to obtain detailed information about the insurance company and its business activities. One source of information are reports by the insurance companies. All Member countries ask for annual reports, the majority for quarterly reports (even of branches).

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For the examination of reports and other financial documents, in the majority of countries, the supervisory authorities co-operate more or less with the appointed actuaries and auditors (even if this is not legally regulated). As another source, ratings are used for supervisory purposes in Japan, Korea and Mexico. If the supervisory body detects any irregularity it is entitled to take the necessary remedy. For example, legal requirements having been a condition for licensing have to be met in any case of a change during the course of business operations. If necessary, documents have to be submitted anew. Usually, the supervisory body is free in the choice of its means, ranging from a simple reminder over the dismissal of managers or the demand to cancel a certain business operation to the withdrawal of the license. In some Member countries, the supervisory body may impose administrative fines to enforce compliance with its orders. In other Member countries, the supervisory body may send representatives to meetings of the executive bodies of the insurance companies (e.g., Canada, Finland, Germany, Iceland, Italy, Spain and Sweden) or appoint a special commissioner, who will assume special functions on behalf of individual executive bodies for a limited period of time. If foreign insurance companies having their head office in an EU Member country carry on business under the freedom of services provision and violate any legal rule, the applicable procedure inside the EU is as follows: First the supervisory body of the host country requests the insurance company to remedy the irregularity. If the insurance company does not comply, the supervisory body of the host country informs the supervisory body of the home country. The latter then takes the necessary measures in accordance with the national regulations. If these measures still do not show any result, the supervisory body of the host country may prohibit the foreign insurer from writing insurance under the freedom of services in its territory. All OECD Member countries provide their supervisory authorities with the right to periodically or on a case-by-case basis perform on-site inspections at the head office of domestic insurance companies; the majority of countries allow these inspections at establishments of branches of foreign companies - with regard to their domestic business - as well (with the exception of Australia).

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The insurance companies are obliged to give all the information available and to enable the inspectors to look into all business documents so long as justified by the purpose of insurance supervision. The inspectors are bound to secrecy. Some Member countries have very extensive on-site inspections covering all business activities (e.g., including the observation of the legal requirements and compliance with the business plan, the financial standing, the allocations of the technical provisions, the investments, the calculation of tariffs, the internal and external organisation, the reinsurance relations, etc.), while others only inspect certain areas. But first of all, the financial soundness of an insurance company is of the main concern of the supervisors. In this respect, the supervisors have an close eye on the capital resources (solvency), the formation of technical provisions and the existence of assets (investments) necessary to meet the insured liabilities. 6.2.

Solvency

In all OECD Member countries, the minimum capital required as condition for licensing must also be available in the future. The EU Member countries require that capital of the insurance companies be adapted to the development of the business. Where OECD Member countries outside the EU require that the capital has to be permanently adapted to the development of the business, in most cases this adaptation is made by allocations to a statutory reserve or by increasing the nonimputable deposit. Part of the annual profit has to be allocated to these items until the required amount is reached. In some Member countries, the supervisory body may require to restore or make available an organisation fund if the insurance company writes losses (e.g., Germany, Switzerland). Solvency as referred to by the EU Insurance Directives means the financial resources of an insurance company, i.e. the difference between the assets and the liabilities. This kind of safety capital is necessary in order to absorb discrepancies between the anticipated and the actual expenses and profits. At the time of the first Paratte Report, 1963, the standards were generally simple and modest in relation to the amount of the risks carried on by the

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insurers. In most countries, all that was required was a fixed amount of capital, subscribed or paid in, with the amount depending on the class of insurance. Over the past several decades, there has been a trend toward expanding both the amounts and the variety of financial requirements. One reason for strengthening the solvency standards has been the move towards freer markets and - particularly in the European Member countries - the need to compensate for the loss in security that resulted from the elimination of the control of tariffs and contract terms. The solvency margin established in the European Insurance Directives is an important step in the direction of more risk-oriented financial resources. The current solvency regulations within the EU are mainly based on the provisions of the first Directives 73/239/EEC (non-life insurance) and 79/267/EEC (life insurance). The provisions regarding the required solvency in credit insurance and the actual solvency both in life and non-life insurance were amended by the Credit Insurance Directive 87/343/EEC and the Third Directives 92/49/EEC and 92/96/EEC. The directives provide that insurers must have sufficient safety capital in form of the so called minimum guarantee fund at the moment of taking up business activities as well as own funds for the ongoing business serving as a buffer to ensure that the obligations under the contract can be met at any time - the solvency margin. Hence, the purpose of establishing a solvency margin is only to absorb remaining risks which may occur even if concrete risk preventing measures by prudent management or specific supervisory provisions have been taken. Such a solvency margin is known in all other OECD Member countries outside the EU (except the United States). According to the Directives, the solvency margin of insurance companies with their head offices in an EU Member country consists of the companies assets free of any foreseeable liabilities and less any intangible items (i.e., uncommitted assets). There is an open-ended list of admitted assets. The uncommitted assets may comprise of the following: − the paid -up share capital, − one half of the unpaid-up share capital once 25 per cent of such capital are paid in,

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− the statutory and free reserves, − any carry-.forward of profits, − hidden reserves resulting from the under-estimation of assets, − securities with a fixed maturity which are subject to special conditions up to 50 per cent, − in non-life insurance additionally 50 per cent of the supplementary contributions which mutual societies may require their members to pay in a particular financial year, − in life insurance additionally the part of the provisions for bonuses and rebates which has not yet been made available for distribution to policyholders, 50 per cent of the company’s future profits, to a certain extent the acquisition coats included in the premiums as far as they have not been taken into account in the mathematical provision. By requiring insurers to maintain uncommitted funds in an amount equal to a set percentage, this not only creates a safety cushion to hold back insolvency but at the same time it serves as a warning signal to supervisors. If these funds fall below a required amount, i.e., are not sufficient to cover the guarantee fund defined as one third of the solvency margin, the supervisory body has the right to prescribe measures to restore a sound financial situation. Several other OECD Member countries than EU Member countries prescribe measures or ask for restoration plans if the share capital or equivalent fund has been considerably reduced by losses. Within the EU, in Non-life insurance, the amount of the solvency margin can be expressed as the higher of two results: 16 per cent of the annual premiums written by the insurance company or 23 per cent of the average annual claims costs incurred by the insurance company. The result then is multiplied by a factor equal to the ratio of claims costs remaining for the insurance company after taking account of reinsurance ceded to gross claims costs, as resulting from the last financial year up to 50 per cent. Reinsurance is not taken into account for the calculation of the solvency margin in Australia (in life) and the United States, while countries like Hungary, Korea,

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the Netherlands, Portugal, Spain and Sweden allow up to 100 per cent in nonlife as well as in life insurance. In Life, in the EU, the solvency margin requirement may be summarised as the sum of two results: 4 per cent of the mathematical provisions of the insurance company plus 0.3 per cent of the capital at risk, i.e. an amount equal to the difference between the maximum payments under the policies underwritten and the mathematical provision. In respect of health insurance, the solvency margin is calculated in an equal way to non-life insurance. It is, however, reduced to one third. No OECD Member country has different rules regarding the solvency margin of branches and of domestic insurance companies. The EU claims-based solvency margin does not take the inflation rate into consideration. It is based on the average burden of claims for the past three financial years. Economies in transition should be aware of this. Some EU countries already use stricter criteria than prescribed in the EU directives. However, too high a margin might cause negative effects. It could create or reinforce a tendency to establish imprudent premiums and technical provisions to compensate for the rise in the solvency margin requirement, given that these parameters are components of the basis on which the requirement is calculated. On the other hand, too low a solvency margin very often is the reason for the increasing volume of the purchase of reinsurance in economies of transition. The method of the risk-based capital (RBC), introduced in the United States quite recently, is one method to take account of the various risks in connection with the determination of the solvency margin. With respect to the main principle that the capital should be related to the risks inherent in the respective insurance operation, the concept seeks to evaluate a great number of different risks as underwriting risks, assets risks, and credit risks. Using data and procedures specified in voluminous instructions, insurers are required to calculate the amounts of assets that they must have to avoid special supervisory attention, stricter reporting, rehabilitation, or winding up. To determine an insurers RBC, its business data are compared to industry averages for the different classes of insurance. Under the RBC approach, thresholds above 100 per cent of the solvency margin are introduced to enable the supervisory body to intervene at an early stage.

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A point in favour of the RBC is that the assets are looked at considering the investments being actual risk carriers. Besides, under this approach, the experience of European supervisors is avoided that companies having calculated the mathematical provision in life insurance prudently have to present a higher solvency than a less prudent competitor. On the other hand, quantitative financial requirements as known in other OECD Member countries have the advantage of being expressed in simple figures and standardised. With RBC, the standards make complex calculations and evaluations on both the sides of the insurer and supervisor necessary; therefore, assuring correct and equal application of the rules requires special controls. Moreover, despite the fact that the existence of an universally true ratio is disputable, fulfilling a certain ratio can give the insurance management as well as the supervisors the wrong feeling about having done everything possible instead of allowing flexible reactions depending of the necessities of the single insurance product. In some OECD countries (Australia, Austria, Canada, Denmark, Finland, Iceland, Luxembourg, Mexico, Norway, Sweden, Turkey, United Kingdom, United States) requirements for minimum solvency for professional reinsurance companies are known. The requirements often are the same as for direct insurers. 6.3.

Technical Provisions

Technical provisions ensure that the company is in the position to meet at all times the commitments towards the insured. Insurance companies tend to adopt short-term assumptions that often result in under-priced products. Then in the way of cross-subsidisation over reserved products are used to offset the losses on those under-priced products. Economies in transition often made the experience of inadequate technical provisions. The reasons were the lack of historical data for calculation, economic conditions such as an unstable rate of inflation and the underdevelopment of actuarial systems. What technical provisions have to be established and in what amounts depends on the national regulations in each Member country.

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Technical provisions which can be found in almost all OECD Member countries are the: − mathematical provision in life insurance, − provisions for claims outstanding (corresponding to the total estimated ultimate cost of settling all claims reported arising from events which have occurred up to the end of the financial year less amounts already paid in respect of such claims), − provision for unearned premiums ( to defer to the next or to subsequent periods the proportions of gross premiums and risk premiums that are unearned at the end of the financial year), and the − provision for claims incurred but not reported (IBNR) for liabilities estimated on the basis of loss experience over several years, including future claim-settlement expenses. An equalisation reserve as a valuation adjustment in non-life insurance as it is common among some of the EU Member countries is not prescribed in Australia, Mexico, Turkey and United States, because the volatile nature of certain risks. It is seen as an inherent risk of insurance that should be taken into account accordingly when fixing the price for the cover of such risks. A special provisions for the risk connected with the use of derivatives is only known in the United States. In all Member countries those provisions are calculated based on actuarial formulae on statistical bases (e.g. the mathematical provision in life insurance using mortality tables and the technical interest rate) as well as „ case by case“. Within the EU, according to the Third Insurance Directives, only the home country is responsible for setting the rules and supervising the compliance with the rules concerning technical provisions and their investment in representative assets. The Directive on the Annual Accounts and Consolidated Accounts of Insurance Undertakings from 19 December 1991 (91/674/EEC) introduced a harmonised regulation in force since January 1, 1995. The Directive harmonises the layout of the balance sheet and thereby lists and defines the technical provisions and describes how they are to be evaluated.

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Thereafter, the amount of technical provisions must at all times be such that an insurance company is able to meet any liability arising out of insurance contracts as far as can reasonably be foreseen. As a rule, the technical provisions have to be established at the head office of the company. Some Member countries require special deposits to cover technical provisions. Such deposits have to be located in the country of the head office, too (in Czech Republic, Hungary, Mexico, Switzerland and the United States). In almost all OECD Member countries (with the exception of Iceland, Japan, Portugal and Switzerland), branches of foreign companies (in case of EU Member countries, such with their head office outside the EU) have to establish technical provisions in line with the same principles applying to national insurance companies. Within the EU, branches of foreign companies having their head office inside the EU do not have to establish separate technical provisions. The technical provisions required for the insurance business of the branch are only established at the head office of the insurance company in accordance with the regulations which apply in the Member country of the head office. 6.4.

Investments

Historically, the aims of investment regulation are first to protect policyholders, second to direct the flow of investable funds towards what governments perceive as desirable, and third to prevent insurance companies from exercising undue influence within the financial markets as a whole. In the interest of furthering the development of the national economy, some countries, in particular economies in transition, might think of encouraging insurers to give preference to investments in domestic companies. Thereby, the paramount principle of security should not be lost out of sight. Although transfers of capital to other countries are not generally in the interest of the national economy, it may be necessary sometimes, in particular with view to inflation risks, to permit insurers to conclude contracts in foreign (stable) currencies and to invest the funds covering future liabilities from such contracts in the respective currencies. In most OECD countries, the investment regulations do not extend to the investment of the capital base of insurance companies. They only relate to the

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investment of the funds that constitute the contractual liabilities to policyholders, and sometimes to equalisation or claim fluctuation reserves. The reason for this is that the capital base plays a longer-term risk absorption role, as well as allowing insurance companies to finance their future growth. Moreover, for an insurance company a major part of the capital base, excluding mutual companies, belongs to shareholders and they would not wish management to hold too much capital, it were not earning an acceptable rate of return on their invested capital. Therefore, if investment regulations restricts the investment of the capital base unduly, this prove to be a deincentive to hold a high level of capital within the insurance companies, i.e. well above the statutory minimum level. This would thus tend to weaken rather than strengthen the overall financial security of insurance companies. A distinction between the treatment of the assets representing the technical provisions which are the basis for satisfying the claims of the insured and the assets covering the other liabilities which serve to satisfy the other creditors is, e.g., reported by all EU Member countries, Japan, Mexico and Switzerland. It is also recommended for other countries like economies in transition to have such distinction between the minimum required capital and the free capital. In general, one can say that in order to ensure the safety, profitability and liquidity of its investments, in particular regarding the assets covering the technical provisions, the insurance company must ensure that its investments are sufficiently diversified and spread. Thus, in many OECD Member countries prudential investment rules with respect to diversification by type, limits or restrictions on the amount that may be held in certain assets, matching of assets and liability, and liquidity are known. At least for assets representing technical provisions, the majority of OECD Member countries have established certain rules. In the United States, compliance with investment rules for all assets is required. The principles of diversification (the proportion of the total investment in particular classes of investments) spread (the proportion of total investments in one particular class of investments) and liquidity (with the exception of Korea) is common in almost all OECD Member countries. Ceilings may be set on admitted investments, by type of investment and in percentage terms rather than in absolute value, so as to reduce the risk of default or of liquidity shortage. Hence, it is common to find maxima on unquoted

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securities, on low quality corporate bonds and on certain classes of foreign investments. Maximum percentages on classes of investments have a double purpose in risk reduction: − to restrict holdings in classes which are deemed to be risky, and − to ensure adequate diversification of the investment portfolio as a whole. That is why, beyond the general principles of security, yield and liquidity, the EU Insurance Directives instead of harmonising investment rules, drew up a list of ceilings intended to ensure diversification and an adequate spread of the investments representing the technical provisions. The list is exhaustive in order to give maximum flexibility to the EU Member countries as well as to the insurance companies. Moreover, in certain countries, such as United Kingdom, Ireland and Australia, the insurance companies can invest above the maxima, but they cannot count these assets which are held above this level as admissible assets representing technical provisions. Although OECD countries today very seldom set floor limits (EU Member countries are prohibited from requiring insurance companies to invest a minimum amount in specific assets or categories of assets), such practices were possibly used in the past to encourage investments with a low risk of loss or lack of liquidity or in pursuit of macro-economic objectives. In recent years, there has been a general move away from detailed quantitative restrictions on investment choice towards more general guidelines known as prudent-man-rules. Two different approaches seem to confront each other: the so-called “prudent man” management and the quantitative requirements. Prudent-man rules are more qualitative in nature. The principle of the prudent man management means that it is up to the manager and not to national or community statutory provisions to determine the investment policy for assets representing technical provisions. Thereby one is trusting in the manager’s expertise in financial strategy and his prudence. This approach is in favour, e.g., in the United Kingdom and the United States. Prudent-man rules are less constraining on financial asset choice thus allowing investment policy to change with changing liabilities and changing market conditions, but on the other hand they are open to differences in interpretation making their enforceability more difficult. Moreover, prudent-man rules demand closer liaison between the supervisory body and the insurance company being regulated, including more detailed disclosure on investments. Investment regulations in OECD countries 45

do not always neatly divide between prudent-man rules and quantitative restrictions. One finds both in operation in some countries. Prudent-man rules provide the general guidelines, but they are reinforced with quantitative restrictions as an additional safeguard. Such a mixed system can be found in life insurance directives within the EU. However, if used, prudent-man rules should be applied on both asset and liability elements. Countries following the approach of quantitative requirements and having fixed certain percentages (the above ceilings) for the individual types of investments, in general allow the same kind of investments but with different limits. Assets representing technical provisions may be invested in: − bonds (in all Member countries; no minimum floors reported; maximum percentages between 2 per cent as in Turkey and 5 per cent ( Poland) up to 100 per cent); − shares (all Member countries; no minimum floor reported; maximum percentages between 25 per cent and 100 per cent); − mortgages (not allowed in Turkey) , − real estate (all Member countries; percentages of 10 per cent as in the Netherlands to 100 per cent); − loans (all Member countries except Poland); − advances against policies in life insurance (except for Japan and the United Kingdom);and − cash (all Member countries except Mexico). There are regulations on the use of financial derivatives in asset management. With the development of fixed interest, equity and currency derivatives, most regulatory systems have recently been adapted to accommodate their use, but under close guidelines. It is recognised that derivatives are a useful way of hedging investment risks, both in respect of hedging against a rising stock or bond market when investing new funds or by hedging against falling market prices for assets already held. Strict restrictions are placed on insurance companies in their use of derivatives for trading or more speculative purposes. The writing of options contracts is especially restricted because there is no limit on potential losses. There is also justified supervisory concern with the credit worthiness of suppliers of over-the-counter derivatives and to ensure that the sources of supply are also adequately diversified. Investments in derivatives are 46

not permitted in France, Hungary, Luxembourg, Norway, Poland and Turkey, and for hedging purposes exclusively in Belgium, Denmark, Germany, Iceland, Korea, Mexico, the Netherlands, Norway and United Kingdom. Ceilings or restrictions for investments abroad (representing technical provisions) exist in Belgium, Germany, Iceland, Italy, Japan, Korea, Luxembourg, Norway, Poland, Portugal, Spain, Sweden and United Kingdom which range from 5 per cent (Poland) to 100 per cent (Germany, Italy, Luxembourg and Norway). Australia, Czech Republic, Hungary, Mexico and Turkey are not permitting investments abroad for cover of technical provisions. Investments in (strong) foreign currencies seem to be advisable especially in case of inflationary and weak economies. Strict restrictions on foreign investments may cause problems within the domestic capital markets which cannot take in all investments. In connection with investment decisions the risk of evaluating the investment at too high a value occurs. Therefore, standards for valuation of assets are set and the admissibility of the value placed on assets for the calculation of technical provisions or solvency margin requirements are specified. Those standards should be consistent, i.e. they should be the same for liabilities and assets. In all OECD Member countries, the valuation of assets is performed in accordance with provisions and principles of accounting applicable to all undertakings in the country concerned. Within the EU, detailed evaluation rules based on article 17 of the First Life Insurance Directive and article 15 of the First Non-Life Insurance Directive as well as articles 56 to 62 of the Accounting Directive (91/674/EEC) serve to prevent the evaluation risk in connection with the technical provisions. The investments may be valued at market value or historical costs. Furthermore, in some countries the prudent evaluation is supported by accounting the assets in the balance sheet at their acquisition costs in connection with the principle of lower-of-cost-or-market-value (e.g., Austria, Belgium, Denmark (life), Finland, Germany (life), Iceland, Italy (life), Norway). In countries, where investments are valued at cost or current market price, whichever is less, insurers tend to accumulate substantial amounts of undisclosed (embedded) reserves. In response to EU rules, which permit such reserves to be counted for the calculation of the solvency margin, insurers have begun to publish the amount and nature of their excess investments. Insurers

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valuing their assets on the basis of market costs have to show the historical value and vice versa. A majority of OECD countries have no specific rules regarding accepted reinsurance business. In some countries accepted reinsurance is taken into account for the calculation of assets corresponding to technical provisions and technical provisions may be represented in assets by debts on ceding companies (Denmark, France, Italy, Spain, United Kingdom and United States). In other countries like Ireland, Switzerland and Portugal this is not allowed. In EU Member countries, if assets have to be available in the amount of gross provisions, as a rule, the share of reinsurance shall be considered as permissible asset. They may be openly disclosed on the liability side or shown on the asset side. The domestic localisation and/or physical custody of certificates of investments corresponding to technical reserves can be of considerable importance. It makes it possible to ward off difficulties in establishing proof of ownership and the possibility of deceptive practices by companies. The insurance company itself can undertake this custody role but it is more common for the securities and associated ownership documentation to be required and held in trust by an approved bank or other service providers. Traditionally, national insurance regulation has required that investment documentation be physically held in an approved institution within the country in which the business is transacted; however, with technological advances in computer and telecommunication technologies there is a trend towards less rigid local custody requirements. However, the wish to keep investments in the country because of a concern for the domestic economic growth should not constitute a barrier to entry to foreign insurance companies. With respect to localisation of assets, the EU Insurance Directives provide that the document of title, the debtor or the collateral of a loan and the real estate must be situated in a country within the EU/EEA in the case that these assets are employed for covering the solvency margin of the branch of a non-EEA insurance company established in the EU area. In case of branches and agencies whose head office is outside the EU/EEA, the assets representing the solvency margin must be kept within the country where the business is carried on up to the amount of the guarantee fund, and the excess must be kept within the EU/EEA. In Canada, the foreign companies are required to maintain in this country assets vested in trust, which cover their policy and other liabilities in Canada plus a

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margin. In Korea, branches of foreign insurers are required to hold their assets in Korea, which are equivalent to the sum of technical reserves and contingency reserve. In some countries (Austria, Belgium, Finland, Germany, Iceland, Sweden, Switzerland), assets representing the mathematical provisions in life insurance have to be kept separately from the other assets. They have to be entered in a special list that is regularly updated. The assets secured in this way serve to satisfy the claims of the insured in life insurance ranking before those of other creditors. In Germany, assets that serve as a security for the mathematical provision in life insurance are monitored by a specially appointed person, called the “Treuhänder”. This person is authorised by the supervisory body to make sure that always-suitable assets are available in sufficient quantities; assets may only be sold with his approval. In most OECD Member countries (with the exception of Japan and Korea), the investment regulations stipulate that the assets must be denominated in the same currency as the liabilities. The principle of currency matching helps to protect against exchange rate risks. Investments ought to be in the same currency as commitments. The assets must with respect to their performance and due dates as well as their returns guarantee at any time that the technical liabilities are covered. External influences as changes in the capital market or exchange rates are constantly jeopardising the adequate cover. Companies with their head office in EU Member countries may hold nonmatching assets denominated or payable in a currency other than that of the commitment due to cover an amount of up to 20 per cent of their commitments in a particular currency. Moreover, with the introduction of the Euro, there is now even greater investment flexibility in respect of countries within the Eurozone, whereby 100 per cent of investments, whether in the Euro or in other Euro-zone national currencies, can be held against liabilities in a national currency. One of the primary objectives of insurance companies in managing their assets is to ensure that the maturity (or duration) of those assets matches that of their commitments to reduce the risk of changes in interest rates. It is rare to find within insurance regulation any detailed requirements for such matching of assets and liabilities. This is because it is difficult to specify within legislation

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such a complex requirement. Nevertheless, even though it is not specified formally, it is a recognised duty of supervisors to monitor any significant mismatching of assets and liabilities, since these cross balance-sheet exposures are key aspects of the investment risks faced by life insurance companies. There is no regulation regarding the maturity matching in the EU Member countries, Switzerland, Japan, Korea and Turkey. In almost all OECD Member countries (with the exception of Iceland, Italy, Japan, Norway and Turkey), there is no regulation regarding free assets. The EU Member countries expressly committed themselves not to draw up any such regulation. In most Member countries, the companies must periodically inform the supervisory authorities about their newly acquired assets and about the composition of their total investment portfolio. In all OECD Member countries, the same investment rules apply to both national insurance companies and branches of foreign insurance companies. 6.5.

Control of Accounting

In all OECD Member countries, insurance companies have to submit annual accounts comprising the balance sheet, profit and loss accounts and additional notes. In principle, direct insurance companies have to report separately and in detail the amount of direct business as well as of reinsurance business accepted and ceded in both balance sheet and profit-and-loss accounts. The EU Member countries follow the Insurance Accounting Directive (91/674/EEC) from 1991. Insurance companies in EU Member countries have to establish their balance sheets and profit and loss accounts in the same form. An annex has to be attached to both documents listing the items that need not to be included in the accounts as well as items requiring special explanations. An annual report has to describe the development of the business and the present situation of the insurance company. With respect to reinsurance, the asset side of the balance sheet includes debtors arising out of reinsurance operations and deposits with ceding companies. The liability side shows the technical provisions (both gross amount and the amount of the reinsurance share), the deposits received from reinsurance and creditors arising out of reinsurance operations. The option to require or permit the reinsurance shares to be shown as assets is not taken by all countries. In the technical accounts of the profitand-loss accounts, the earned premiums and the reinsurance amount have to be shown (likewise in Canada, Japan and the United States).

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In all OECD Member countries, branches of foreign companies have to submit accounts in respect of their business in the host country. Within the EU, this does not apply to branches of insurance companies having their head office in an EU Member country because they are not subject to the insurance supervision of the country of activity. Insurance companies having their head office within the EU have to submit to the supervisory body of their home country a report on their insurance business written in another EU Member country. They have to give separate information on business written through a branch establishment and on a basis by country and by class of insurance. In each case the written premium income and gross expenditure in respect to claims and amounts set aside for provisions have to be disclosed. In all OECD countries, professional reinsurers have to record their activities in their balance sheets and profit-and-loss accounts in the same way as the direct insurers. There are no specific requirements. In most Member countries (e.g., all EU Member countries), the annual accounts have to be audited by an auditor. The profession of the auditor is recognised and regulated in all OECD Member countries. There is an obligation to appoint an auditor as well as legal provisions with respect to the professional education and qualification of auditors. The auditor has to be independent of insurance companies. He has to check whether both bookkeeping and annual accounts are in line with the provisions of the Member country concerned and has to give his view of the actual financial situation of the company. After the audit, the correctness of the documents has to be certified. Auditors are supervised by state only in Belgium, Germany, Iceland, Italy, Japan, Korea, Mexico, Norway, Spain, Turkey, and the United States. 7.

Suspension and Termination of Business Operations

Suspension or termination of business operations may affect all or only parts of the classes of insurance which insurance companies are authorised to transact. The suspension or termination may be voluntarily or compulsory by order of the supervisory authority. In all OECD Member countries, insurance companies may suspend business in one or several classes for any reason, but not in all countries the total or partial voluntary suspension is specially regulated (e.g., not in Canada, Germany, Finland, Iceland, Switzerland).

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In some Member countries, the supervisory body is entitled to order the compulsory suspension (e.g., Austria, Belgium, Finland, Italy, Japan, Spain and Switzerland). In these countries, the suspension is used as a means of restoration of a sound financial situation in case of business difficulties. In some countries without a special regulation concerning suspension (e.g., Austria, Germany, Switzerland) the supervisory body may by order temporarily suspend the effectiveness of the contracts by dispensing the policyholders from the payment of premiums and the insurers from the payment of benefits or indemnities. In life insurance, it is also possible to reduce benefits. A suspension does not necessarily result in a withdrawal of the license for the insurance class concerned. In many Member countries (e.g., Austria, France, Italy, Portugal, Spain), there are, however, provisions stipulating a maximum period (6 months to 3 years) after which the company should have resumed business not to loose authorisation. Usually, insurance policies written prior to the suspension will stay in force. If business operations are not terminated temporarily but definitive, one speaks of total or partial voluntary or compulsory termination. In all OECD Member countries, termination results in the expiry or withdrawal of the license. The existing insurance policies have to be wound up or transferred to another insurance company (portfolio transfer). In all Member countries, the termination is made public. Insurance policies written prior to termination stay valid. The withdrawal of a license is not only a consequence of termination but it can be the consequence in other cases as well. In all OECD Member countries, there is a regulation regarding the withdrawal of the license of direct insurance companies. On the other hand, in some countries such as France, Germany, and the Netherlands, there are no rules for the withdrawal of the license of a reinsurance company. The license of a direct insurance company may be withdrawn in OECD Member countries except for Japan if the insurance company is not making any use of the license for a certain duration of time, if the company does no longer fulfil the conditions for licensing or fails to meet any obligation (all OECD Member countries except the United Kingdom).

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The validity of existing contracts is not affected. However, there might be a transfer of the contracts to another company (regulated in all Member countries but the United Kingdom). In some Member countries (Czech Republic, Denmark, Finland, Hungary, Iceland, Italy, Japan, Mexico, Norway, Switzerland, Turkey and the United States), the insured have an extraordinary right to terminate their insurance contracts. The expiration of the contracts or the reduction of benefits is other possible consequence for the insured (e.g., in Czech Republic, Denmark, Finland, France, Germany, Hungary, Iceland, Japan, Korea, Mexico, Norway, Portugal and the United States). In almost all Member countries, the decision of suspension, termination or withdrawal of the license may be appealed in the courts (appeal to supervisory body in Czech Republic, Korea and Portugal). The appeal has to be filed within a certain period of time (one day in Denmark, Iceland, Luxembourg and Portugal and 60 days in Italy). Almost all OECD Member countries grant the right of portfolio transfer, but only with the previous authorisation by the insurance supervisory body (except in Turkey and United Kingdom). The EU Member countries have to make sure that the accepting insurance company possesses the necessary solvency margin after having taken the transfer into account. In case of a voluntary transfer of insurance policies written abroad by a branch or under the freedom of service provision, this has to be certified by the supervisory body of the country of the accepting company. The certificate is the necessary condition for the supervisory body of the transferring company to approve of the transfer. As a rule, if total or partial voluntary transfers involve future policies corresponding assets and liabilities have to be transferred. Only in a few countries (e.g., Austria, Italy, Japan) are transfers without the assets and liabilities allowed. Because a portfolio transfer is touching the interests of the insured, they have to be informed and have the right to object to a portfolio transfer (in Denmark, France, Iceland, Japan, Mexico, the Netherlands, Norway, Portugal, Spain, Sweden, Switzerland, Turkey, United Kingdom and United States) or even the right to cancel the contract (all Member countries except for Denmark, Germany, Japan, Korea, Spain, Sweden, United Kingdom).

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8.

Insurance Companies in Difficulties

A crisis in a key company of the local market could lead to instability for the entire insurance market. Therefore, in most OECD countries, it is generally accepted that supervisory authorities should do everything to prevent an insurance company from defaulting. Even the difficulties of a small insurer can affect many policyholders and insured. It is for this reason, that safety net systems are designed to protect policyholders against losses from insolvent insurers. Some countries have introduced guarantee funds or policyholder protection funds that are designed to pay the claims of insolvent companies up to a certain limit. It is general practice for general compensation funds to co-exist with compulsory third party liability insurance in motor insurance for the benefit of motor accident victims, either in case the responsible driver cannot be identified, or in the case, that the responsible driver is not insured or in the case of the insurer of the driver being insolvent (known in all EU Member countries). Under these funds, claims normally are paid in full without any reduction. Those funds very often are established by the state with the exception of Belgium, Finland, Norway, Switzerland and United Kingdom where private associations are in charge) supervised by the insurance supervisory bodies in Belgium, Finland, Korea, Luxembourg, Norway, Poland, Portugal, Spain, Switzerland, Turkey, United States) and financed by the insurers operating the classes of business protected under the respective fund (all Member countries except for Hungary, Japan, Mexico, Portugal and Spain). In life insurance, policyholder protection funds can be found in Korea, United Kingdom and United States. All states of the United States have insolvency guarantee funds for property and casualty insurance. Usually, the insured (and the injured) have the right to directly claim payment from the fund (in all EU Member countries Switzerland and the United States). A disadvantage of such funds is that in covering insolvency losses it is often noted that costs can weaken participating companies. There is also the possible aggravation of moral hazard that the establishment of such a fund may cause. The day-to day management undertaken with less rigour and prudence could increase the risk of failure. As another „safety net“, other countries have introduced so-called early warning systems. But even if almost all OECD Member countries (with the

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exception of Japan, Luxembourg and Poland) have reported to have such a system, they only referred to warnings provided by their systems of on-going supervision, examinations of accounts, etc., but not, as it appears, specific early warning systems. Recovery plans, established either by the insurer or by the supervisory body (in all Member countries but Denmark, Poland, Portugal, Spain, United Kingdom), are used everywhere, besides being standard in the EU. Before it comes to liquidation, the supervisory authorities try every other measure to solve the financial problems of the company in difficulties. The authorities have the right to intervene by adjusting contracts (France, Germany, Iceland, Japan, Korea, the Netherlands, Spain, Switzerland, Turkey, United States) or policy conditions (Australia, Belgium, and the above countries), to replace the management (EU Member countries, Japan, Korea, Mexico, Poland, Turkey, United States), or to appoint a special auditor (all Member countries but Australia, Czech Republic, Poland, Sweden, Switzerland, United Kingdom). The authorities have the right to prohibit the conclusion of new contracts or the payment of benefits or the free disposal of assets (almost all Member countries). In respect of liquidation, the laws of the OECD Member countries differ in many ways. The conditions of rehabilitation and liquidation procedures are defined differently. There is also a difference in regard of the order of priorities among creditors (ranking). It is often difficult to reconcile the conflicting interests, specifically if a state where assets are located claims a priority right for its residents to be satisfied from such assets. In general, liquidation is the winding up of the entire business of a company. It may be carried out on a voluntary or compulsory basis. The insurance company remains under supervision until the liquidation is terminated. Entitled to file for liquidation are the insurance companies (all Member countries but Turkey) and the supervisory authorities (all Member countries but Switzerland).

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In several countries (Australia, Belgium, Denmark, Finland, France, Hungary, Iceland, Italy, the Netherlands, Portugal, Spain, Sweden, Switzerland, Turkey, United Kingdom) even other creditors are allowed to do so. In most OECD Member countries, the decision to wind up the company is with the competent court and a liquidator is appointed (in some countries by the supervisory body). The liquidation is terminated when the company has met all claims, or if the existing means are not sufficient to satisfy all creditors’ claims. In this case, the company is declared insolvent. If bankruptcy is declared (in Austria, Germany and Switzerland, only the insurance supervisory body may file a petition in bankruptcy), the winding up is performed in accordance with the general regulations. The rules are usually the same for branches of foreign companies (special rules reported by Austria, France, Sweden). However, within the EU, the decisions on behalf of the insurance company are generally taken by the competent executive bodies at the head office of the company. In most Member countries, in particular in respect to assets representing technical provisions, there are privileges for the liquidator (in all Member countries but Czech Republic, Denmark, Finland, Iceland, Korea, Poland, Portugal, Spain, Sweden, Switzerland) and the policyholders (in all Member countries but Czech Republic, Denmark, Iceland, Sweden, United Kingdom where privileges on the assets in general may be provided). Insured holding claims under a life insurance are always given priority in the distribution of the assets representing the mathematical provision which have been specially secured for them. In all Member countries, the insured of a branch of a foreign company enjoy the same rights as the insured of a national insurance company. Within the EU, a new Directive on Winding-up is under way. The directive is based on a mutual recognition approach inspired by the principles of unity, publicity, co-ordination, and non-discrimination, ensuring a minimum harmonisation of the privileges for insurance claims. With respect to the privileges to be granted to insurance claims, the Member countries might choose between firstly either granting insurance claims absolute precedence over any other claim with respect to assets representing technical

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provisions or, secondly granting insurance claims a special rank (i.e., they only might be preceded by claims on salaries, social security, taxes and rights in rem) over the whole assets of the insurance company. 9.

Other Supervision

9.1.

Financial Conglomerates and Insurance Groups

The ownership of insurance companies by non-insurers and insurers being part of a financial conglomerate is a known and accepted matter of fact in several OECD Member countries and a special challenge and subject of concern for all supervisory authorities. From the time when the first big conglomerates appeared, in the late 1960s, supervisors and regulators have sought to devise more effective methods for protecting the interests of the insured. One of the dangers is the raiding of the insurer’s assets by an outside owner. In this respect, the laws of various states of the United States require supervisory approval before extraordinary dividends may be paid out. But all in all, special rules concerning, e.g., adequate financial resources and a sufficiently knowledgeable and experienced management still appear to be the exception. The existence of specific requirements concerning capital are reported by Australia, Denmark, Luxembourg, Mexico, the Netherlands and Spain, those concerning the management by Finland, Mexico and Spain, and those concerning accounting by Australia, Finland, Iceland, Mexico, Norway and Spain. Supervisory authorities in Denmark, Germany, Iceland, the Netherlands, Spain and United Kingdom have the power to prohibit the participation of an insurer in a financial conglomerate. In the EU, a directive is drafted to expand supervisory powers and to authorise supervisory interventions against non-insurers. Already today, there is some kind of co-operation among at least the insurance and banking supervisory authorities in most OECD Member countries.

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As regards insurance groups, more countries have reported the existence of special rules: capital requirements are existing in Australia, Denmark, Germany, Iceland, Luxembourg, Spain and the United States, management requirements are existing in Finland, Germany, Iceland, Spain and the United States, and provisions regarding accounting are established in Australia, Belgium, Denmark, Finland, France, Germany, Iceland, Italy, Luxembourg, Norway, Spain, United Kingdom and United States. Where provisions specific for insurance groups exist, there often measures against double gearing (for the prevention of the multiple use of the same assets for satisfying solvency standards of parent company and subsidiary) and contagion are found, as well as rules ensuring a certain transparency of business operations (e.g., in Australia, Belgium, Denmark, the Netherlands, Norway, Spain, United Kingdom). Within the EU, in the Council, there was a new directive on insurance groups (98/78/EEC) adopted on 13 October 1998. 9.2.

Supervision of Intermediaries

Regulation regarding the supervision of domestic insurance intermediaries can be found in almost all OECD Member countries but Czech Republic, Denmark (with a bill in Parliament), and Germany. Special legal provisions for foreign intermediaries are not existing in Denmark (but likely from 1999 on), Germany and Switzerland and neither in countries not yet allowing branches of foreign companies. Regulation regarding reinsurance intermediaries exist in France (but only concerning fit & proper testing), Italy, Mexico, Norway, Turkey and United States. Some countries have regulations regarding the licensing of intermediaries but not regarding the supervision of them (e.g., Norway and the Netherlands) and vice versa (e.g., France and Switzerland). In the United States, where insurance markets were long dominated by independent agents who worked for more than one insurance company, agents must obtain a licence. In some Member countries, the amount of the remunerations paid to insurance intermediaries is limited. These limits are partly fixed by law and partly by order of the supervisory body. These mainly apply to remunerations paid for the

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conclusion of life insurance contracts or motor third party liability insurance. They are thought to prevent an increase in insurance premiums. In other countries (e.g., Finland, Germany, Japan, Sweden, Switzerland), it is forbidden by law to favour certain potential policyholders by granting them premium reductions. This prohibition is intended for both insurance companies and intermediaries. In most countries, in respect to regulation, a distinction is made between the supervision of agents and brokers. This due to the fact, that in most cases agents are directly employed by supervised insurers. The direct supervision of the insurers means an indirect supervision of the agents. Furthermore, almost as a rule, insurers are held legally responsible for the activities of their agents which means that the policyholders are fully protected. Regulation containing rules regarding the management of premiums exist in Australia, Germany (for agents), Iceland (for broker), Japan (for agents), Korea (for agents), the Netherlands, Norway (for brokers), Spain, Sweden (for brokers) and Turkey (for agents). Agents as well as brokers have the legal obligation to disclose certain information regarding the insurance company, the contract and the policy conditions in almost all OECD Member countries. Requirements concerning the professional qualification of agents exist in Belgium, France, Italy, Japan, Korea, Luxembourg, Mexico, and Turkey, and for brokers in almost all OECD Member countries. In most Member countries, especially broker and multi-company agents (if recognised) have to establish financial guarantees. For example, the guarantee in form of a liability insurance is required from agents being intermediaries for more than one company in Australia, Hungary, Korea, Mexico and Portugal, while broker have to contribute to a guarantee fund in Italy, Korea and United Kingdom. In countries where intermediaries are supervised, the supervision is carried on by the insurance supervisory body (e.g., in Australia, Belgium, Finland, France, Hungary, Iceland, Italy and Mexico). Otherwise, in a few countries, only the insurers themselves have been held responsible for controlling the qualification and conduct of their agents.

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In the EU, the status of insurance intermediaries has so far been subject of a Directive in 1976 (77/92/EEC) and a Recommendation in 1991 (92/48/EEC). The Directive is based on the principle of mutual recognition and has as an objective the liberalisation of cross-border activities for intermediaries. There is no system of a single license for intermediaries as for the insurance companies. The intermediary wishing to establish a branch in another Member country or to operate under the freedom to provide services must obtain certificates on his professional experience, good repute and absence of earlier bankruptcy from his home country to forward them to the host Member country authorities. The Recommendation only encourages to take account of certain points as the distinction between dependent and independent intermediaries, the determination of a minimum level of professional competence, good reputation, the fixing of cover for professional liability, and the creation of a registration system. However, in principle, still each EU Member country is free to regulate insurance intermediation. The registration of agents (in Belgium, Iceland, Italy, Japan, Korea, Luxembourg, Mexico, Portugal, Spain (by the insurers under supervision of a special body), Turkey, United Kingdom) is less common among the OECD Member countries than the registration of broker (all countries having legal requirements regarding broker) because of the fact that usually the insurer is legally responsible for the conduct of agents intermediating for him. The admissibility of insurance intermediaries in respect of cross-border transactions varies from one Member country to the other. In more than one third of OECD countries (Australia (for non-life), Greece, Finland (broker only), Japan (for reinsurance), Netherlands, United Kingdom, Switzerland), resident proposers can enter into an insurance contract with an insurer neither established nor authorised in the respective countries by using the service of an insurance intermediary which is resident in the country. In other countries (Austria, Belgium, Denmark, Germany, France, Luxembourg, Portugal), this is allowed only for the intermediary acting on behalf of an EEAinsurer. In the Czech Republic and Turkey, it is generally not allowed.

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In the United States, 19 States have restrictions related to brokerage licenses. Higher license fees for non-residents may be charged in 24 states. In all OECD Member countries but Japan and Korea, professional associations for intermediaries are existing. 9.3.

Actuaries

In almost all OECD countries but Czech Republic, France and Switzerland, life insurance companies are required by law to appoint actuaries. This precaution seems all the more relevant for economies in transition at an initial stage, in order for this profession to be recognised. Only a few countries have such a requirement for the appointment of actuaries in the non-life sector. Actuaries are supervised by state in Belgium, Denmark, Germany, Italy, Japan, Korea, Mexico, Norway, Poland and Turkey. In the majority of Member countries, they have to be professionally qualified. At least in Australia, Iceland, Italy, Mexico, Norway, Turkey and the United States, they appear to be legally obliged to be independent of an insurance company. The compatibility with a function as a manager of an insurance company is denied in Belgium, Czech Republic, Italy, Mexico, Portugal, Switzerland and the United States. No country requires third party liability insurance. The tasks of an actuary, as, e.g., to advise the management (not regulated in Czech Republic, Luxembourg, Poland, Spain, Switzerland), to attest and monitor the solvency, or to calculate the technical provisions (not regulated in Czech Republic, France, Germany, Switzerland) as well as to co-operate with the supervisory authorities (not regulated in Czech Republic, Luxembourg, Poland, Sweden, Switzerland), are the same in almost all OECD Member countries. 9.4.

Compulsory Insurance

Insurance is made compulsory out of a desire to protect all or part of the public.

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Compulsory insurance enables the state to cease being financially responsible for certain losses which they otherwise would have to compensate. With the exception of automobile liability, the need for certain types of compulsory insurance differs from country to country. Compulsory insurance seems advisable in branches which are more closely related to the social sector than to private insurance, in areas where the risk exposure is extremely high, and in areas where premium payments should be divided on an equitable basis among the public. In the majority of OECD Member countries, there exist special regulations which restrict or exclude the possibility of concluding compulsory insurance contracts with non-established insurers (e.g., in Czech Republic, Finland, Iceland, Korea, Poland, Switzerland, United Kingdom; in Australia for compulsory third party motor vehicle insurance, workers compensation, etc.; in Austria, Belgium (workers compensation), Spain and Portugal only for non EU/EEA insurers; in Germany for liability insurance for hunters, owners of motor vehicles registered in that country, operators of nuclear plants, etc.; in Greece and Sweden for motor third party; in Japan for compulsory automobile liability; in the Netherlands for liability insurance for hunters) .In the Czech Republic, foreign insurers cannot underwrite compulsory classes of insurance such as motor third party liability insurance and employers liability insurance. In Finland, only Finnish insurers may be granted a license to carry on statutory pension insurance being social insurance and constituting an integral part of the Finnish social security scheme. Only in a few Member countries, compulsory accident insurance is known (e.g. Australia, Belgium, Denmark, Finland, Norway, Switzerland and Turkey. For health insurance only Czech Republic and Switzerland seem to have compulsory insurance. All OECD Member countries have introduced compulsory motor insurance. Related to that insurance class, one also finds practically everywhere a direct action for third parties. Tariffs in compulsory insurance are controlled in about one half of the countries (e.g., Australia, Czech Republic, Japan, Switzerland, Turkey).

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10.

Other Items

10.1.

Pension Funds

Pension funds or pension schemes in a broader sense are existing and regulated in the majority of OECD Member countries. In recent years, the sector has expanded considerably. Private pension schemes are more and more considered a potential answer to the problems of government pension systems. They will play a complementary role to governmental schemes if not partially substituting them. Thus, private systems will pay out benefits above and beyond basic assistance and their purpose will be to provide retirement income enabling recipients to maintain a minimum standard of living or one comparable to that which they enjoyed before retirement. In countries as, e.g., Portugal (100 per cent), Hungary (98 per cent), Norway (81 per cent) and France (71 per cent), the importance of pension funds for the „first pillar“, measured in percent of contribution to retirement schemes, is enormous. In half of the countries, an remarkable importance for the „second pillar“ (between 30 per cent and 60 per cent) is reported, while for the „third pillar“ the pension funds loose importance (only between 10 per cent and 30 per cent of contributions) against life insurance contracts or pure investment funds. Almost all OECD Member countries promote pension funds by having established tax incentives on contributions as well as on benefits (in some countries as, e.g., Australia, Belgium, Finland, Germany, Hungary, Italy, Korea, Portugal, Spain and United Kingdom). The tax treatment of pensions generally allows the deduction of employer and employee contributions, while income from pension fund investments is exempted and taxes are only paid on benefits. This form of deferred taxation is considered an essential incentive for providing retirement income. Pension schemes come in various forms. As group insurance contracts, they play an very important role for retirement financing in Australia, Belgium, Denmark, Germany, Mexico, and Sweden, while in Hungary, Iceland, and Japan, such contracts are not relevant at all.

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More widespread among the OECD Member countries are self-managed pension funds (in Australia, Belgium, Czech Republic, Denmark, Finland, Iceland, Japan, the Netherlands, Norway, Sweden and United Kingdom) or pension funds managed by an external insurance company (Australia, Denmark, Germany, Japan, Norway, Portugal, Sweden, Spain, United Kingdom). The difference, whether a scheme is managed in-house or externally, has consequences in case of bankruptcy by the employer. In the event of bankruptcy by the sponsor, vested rights are protected if the fund is a separate legal entity and has sufficient assets. Rights can be fully protected, even in the case of insufficient funding, if the seniority of the fund’s claims in event of liquidation of the company is high or if the fund is insured. If the fund is not separated from the employer, it should be backed by guarantees such as reinsurance or insolvency insurance. The growth of private pensions exposes individuals and institutions to a number of risks. Some of the risks, in particular those concerning eligibility, vesting and the adequacy of benefits, are common with government schemes. Others as financial risks, such as insolvency by the employer, underfunding, investment risks, inflation, changes in interest rates, or even fraud are typical for the private systems. Thus, all Member countries with regulation regarding pension funds have set prudential standards. However, pension funds are seldom subject to close supervision. Where pension funds are supervised, the authority therefore is different from the insurance supervisory authorities (e.g. in Czech Republic, Hungary, Iceland, Italy, Japan, Korea, Mexico, Sweden, Switzerland, United Kingdom and United States). In any event, supervision is essentially based on a review of accounting and financial statements. There can also be on-site inspections. The role of the supervisory body may focus on: − ensuring compliance with legal obligations − financial controls investments, etc.

concerning

equity,

technical

reserves,

− actuarial examination of premiums and contribution rates, and technical or mathematical provisions, and 64

− management qualifications and reputation in short, almost the same points which concern insurance supervisors. 10.2.

Contract Law

Insurance contract law regulates legal relations between insured parties, policyholders and insurers. The purpose of insurance contract law is to establish a proportionate relationship between contracting parties, which in turn prevents insured and policyholders from being placed at a disadvantage. In most OECD countries, the parties who enter into insurance contracts covering risks situated in a Member country must comply with compulsory provisions such as those related to general good, public order, etc. stipulated by the contract law of that country, even if the parties are allowed to make their own choice of the applicable contract law. If the parties have not chosen the domestic contract law, this in general does not mean that they are not entitled to bring dispute before the civil courts of this country. Within the EU, substantial differences in legal developments and court rulings obstructed a harmonisation in the field of insurance contract law. However, the EU adopted the Second Casualty Directive which has compensated for this lack of harmonisation by introducing regulations which govern conflicting legislation. Under these regulations, precedence is generally given to the law in the contracting state where the risk is located, such as in the country where the policyholder resides. In most OECD countries, with an exception of Poland and the United States, insurance contracts can be expressed in foreign currency. However, in several countries (e.g., in Portugal, Spain and Switzerland with respect to life insurance), there are certain restrictions. Without to present the contract law of the various kinds existing in the OECD Member countries in detail, it can be said, that in all Member countries, there are rules regarding − the conclusion of insurance contracts, − the policy conditions ( with the exception of Czech Republic and United Kingdom),

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− the disclosure (except Czech Republic, France and Switzerland), − the payment of premiums ( except Australia, Czech Republic, the Netherlands, Switzerland, United Kingdom), − the claim settlement ( except Australia, Czech Republic, the Netherlands and Poland) and with respect to − the rights and duties of the policyholders and the insurers as contracting parties. In general, additionally, the parties are subject to domestic regulations of a general nature such as those on consumer protection. For the protection of the consumer, in the near past, a popular demand aiming at more useful consumer information by insurers was heard. For example, the laws of several states of the United States today not only require that contract documents are printed legibly but also that they conform to a certain predefined standard. Requirements regarding the so-called „fine print" are also known in European countries. Moreover, the European Insurance Directives prescribe the information that must be furnished by insurers prior to the conclusion of the contract and during the term of the contract. A special need for information has been recognised in life insurance which includes a saving element. In the United States, at a time when interest rates temporarily rose to unusually high levels, rules were introduced that required life insurers to supply detailed information on the composition of the premium. The objective was to enable policyholder to make an intelligent choice among the various forms of life insurance and alternative investments. Within the EU, similar ideas are thought over in the Member countries. 10.3.

Taxation

Taxation is to broad an issue to be presented in this report in an adequate way. The tables in part II containing some information on tax rules, however, have the purpose to show the very existence of special tax regulation in the field of

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insurance. Moreover, in some OECD Member countries (France, Germany, Hungary, Japan, Korea, Mexico, Norway, Poland, Switzerland, United Kingdom) the same tax rules are applicable for insurance companies as for other companies. This would make necessary to present the complete tax system of a country to achieve a certain comparability. This cannot be done by a report like this. Even in the EU, despite the harmonisation of a certain kind by the Insurance Directives, insurance companies do not benefit equally throughout the EU from the harmonisation because of differences in taxation. The Third Directives provide that any insurance contract is subject to the indirect taxes on insurance premiums in the Member country in which the risk is situated. An insurer operating under the freedom to provide services is required to appoint a tax representative within the host country or to communicate an exhaustive list of contracts issued locally. Due to the complexity, the tables in part II only include a list of applicable taxes with their rates and information whether policyholder may deduct premiums from their income for tax purposes. In almost all OECD Member countries (with the exception of Czech Republic and Poland), there exist provisions for such a tax deductibility for the benefit of the policyholder. Tax deductibility for the benefit of insurers only is reported for a few Member countries (Australia, Belgium, Czech Republic, Denmark, France, Germany, Iceland, Japan, Turkey, United Kingdom and United States).

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LIBERALIZATION OF INSURANCE MARKETS: ISSUES AND CONCERNS by Harold D. Skipper, Jr.

This paper addresses several issues that may be relevant to insurance markets and governments in connection with liberalization. This paper approaches liberalization issues from several perspectives. First, I set out the role and importance of government policy in insurance. The essential point here is that government intervention into insurance markets is essential but should be carefully targeted to minimize undue interference. To some, this discourse might appear a bit academic, but it is the most important in this treatise because it lays the foundation for the circumstances under which government should and should not intervene into insurance markets. Next, I discuss the role of foreign insurers, with particular emphasis on the concerns that have historically been expressed about their roles in national insurance markets of emerging economies. The essential point here is that such insurers should be expected to play an important role in market evolution and development. Finally, I present a set of principles around which governments should craft their regulation of insurance. A market regulated in accordance with these principles will be one in which consumers enjoy a wide range of fairly priced insurance from financially sound insurers. The Meaning of Liberalization I should first note that liberalization cannot be separated from regulation – hence, I cover both. By liberalization, I mean the process by which government takes actions to move toward liberal markets. A liberal insurance market is one in which the market, subject only to economically justifiable government restrictions, determines:

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1. who should be allowed to sell insurance, 2. what products should be sold, 3. how products should be sold, and 4. the prices at which products should be sold. The first item, therefore, deals with issues such as market access and equality of competitive opportunity, including national treatment. In turn, market access issues encompass prudential regulation. Items 2 through 4 commonly deal with issues such as product, price, and market conduct regulation. All four items subsume competition regulation. The Role and Importance of Government Policy Competitive insurance markets are in the national interest because they generally offer businesses and individuals greater choice and better value than alternative approaches.1 Formerly restrictive markets are made competitive through a combination of liberalization and deregulation. Of course, many governments have undertaken liberalization and deregulation efforts. At the same time, some seem tentative — facially endorsing competitive markets while retaining elements of restrictive regulatory systems. Thus, many governments continue to deny their citizens and businesses access to low-priced, high-quality insurance policies and services. These actions suggest either that (1) regulation exists more to protect established private interests than the overall national interest or (2) policy makers remain skeptical that competitive markets will deliver the benefits to the national economy as suggested above. I analyze both issues below. Different Regulatory Approaches Reflect Different Interests Government intervention into insurance markets takes many forms; some direct, some indirect. Its stated purposes are always noble — to protect consumers, to raise revenue to support worthwhile social objectives, or to ensure orderly, well functioning markets. However, in reality, regulation does not always serve noble purposes. Various factors influence regulatory policies and behavior. These factors include market problems that regulators are seeking to rectify, ideology, special

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interests, and regulatory resources. Other factors sometimes distort regulation. Often, private interests or special interest groups exert undue influence on regulation to serve their own interests at the expense of consumers and the overall national welfare. For example, established insurers might support government action that bars entry and diminishes competition from new insurers — both national and foreign. The resulting restrictions might be cloaked in the guise of “consumer protection,” but consumers are actually hurt by such restrictions. Special interest groups typically are better informed, financed, and organized than consumers. Regulation unduly influenced by such special interests is characterized by: − restrictions on entry of new national and especially foreign insurers − suppression of price and product competition − control of interindustry competition from those selling similar or complementary products Insurance regulation that exhibits these characteristics is likely subject to “capture” by the local industry, with the result that both individual and commercial insureds are penalized through high prices, lack of product innovation, and poor product choice. I can but point out the obvious fact that private interests sometimes take precedent over the greater national good — to great harm to the overall national interest. Citizens and businesses — through dedicated government representatives and through publicity — must be ever vigilant in exposing such abuses of the public trust and should support measures that expose and thwart such abuses. The glaring light of truth coupled with transparency in all relevant government decisions and processes provide the strongest, most effective means of preventing and detecting abuse. I return to this important point later. Competition Enhances Choice and Value Some policy makers seem skeptical about the benefits of competition. I address this concern here, fully aware that this presentation is unnecessary for most of readers, for which I apologize. Nonetheless, the case for liberal insurance markets, while clear to those schooled in economics, can be a confused array of conflicting claims to those charged with making policy decisions.

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Empirical Evidence in Favor of Liberalization Until recently, we have had scant empirical evidence about the practical effects of insurance liberalization within emerging markets. A recent doctoral dissertation at Georgia State University might be the first to explore this important issue empirically. In her research, Dr. Thitivadee Boonyasiai – now a professor at Chulalongkron University in Thailand – examined the effects on life insurer efficiency of insurance market opening (defined as liberalization in her study) and deregulation efforts undertaken by Korea, the Philippines, Taiwan, and Thailand.2 All four countries undertook some market opening during the past decade, with Korea and the Philippines undertaking modest deregulation as well. In neither instance could these deregulation efforts be characterized as substantial. Nonetheless, these two markets can be contrasted with those of Taiwan and Thailand, which undertook virtually no deregulation during the study period. Dr. Boonyasai found that liberalization and deregulation of the Korean and Philippine life insurance industries seem to have stimulated increases and improvements in productivity. In addition, liberalization and deregulation of these markets created more competitive markets as witnessed by life insurers’ improving efficiency; e.g., achieving cost savings and adjusting their scale of operations. Merely allowing greater market access without dismantling restrictive regulatory regimes – as was the situation with Taiwan and Thailand – seems to have had little effect on increases and improvements in productivity. Thus, study findings are consistent with the view that market access is a necessary but not a sufficient condition for contestable markets. Study findings also are consistent with the view that, in a restrictive regulatory environment, welfare gains will be minimal if deregulation does not closely follow market opening. Dr. Booyasai’s rigorous research speaks eloquently in favor of liberal insurance markets. The Case for Liberal Insurance Markets Of course, the objective that a market-oriented economy has for its insurance industry is the same as that which it has for other industries — an efficient allocation of society’s scarce resources. Furthermore, society desires an economic system that leads to continuous innovation and improvement. These objectives are most likely to be achieved through reliance on competitive markets.

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Competition not only leads to economic efficiency, it provides an automatic mechanism for fulfilling consumer needs and wants and for creating a greater variety of choices. Additionally, competition compels insurers to improve their products and services, thus further benefiting buyers. A perfectly competitive market – one in which new entrants enter and exit the market with ease, buyers and sellers are perfectly informed, and all sellers offer identical products at the same prices – requires no government direction or oversight to accomplish these desirable social goals. Perfect competition, however, is an ideal that cannot be realized in practice. Even so, this economic ideal provides a useful construct against which we can compare actual market functioning. We know that the closer a market is to this competitive ideal, the more efficiently it functions. Indeed, a market that is workably competitive functions well and provides most of the benefits of perfect competition. Markets characterized by workable competition generally have low entry and exit barriers, numerous buyers and sellers, good information, governmental transparency, and the absence of artificial restrictions on competition. The markets for numerous products satisfy these conditions sufficiently such that little government intervention is required for the market to function well. For an insurance market to be workably competitive, however, rather substantial government intervention ordinarily is necessary because of important imperfections that exist in such markets. Because of these market imperfections (also called market failures), government intervention into key areas is required to ensure healthy competition and good performance. Competition has Limitations The two major types of market imperfections in insurance relate to information problems and market power, each of which is discussed below. The efficiency of government intervention to address a particular market imperfection must be evaluated from a cost-benefit standpoint. Information Problems A critically important assumption of the competitive model is that both buyers and sellers are well informed. As a practical matter, we know otherwise regarding insurance. Information problems abound in insurance, and arguably are the industry’s most important market imperfection. Insurance is a complex business, with buyers having superior information to sellers in certain instances (e.g., buyers have better information about their relative risk when they apply for insurance) and vice versa in others (e.g., the

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insurer knows more about its financial condition than does the buyer). Asymmetric information problems exist when one party to a transaction has relevant information that the other does not have. The nature of the insurance transaction involves a contract that makes a present promise of future performance upon the occurrence of stipulated events. Individuals and businesses purchase policies in good faith, relying on the integrity of the insurance company and its representatives. Even assuming that insureds could be induced to take an interest in the financial condition of their insurers, few are sufficiently knowledgeable to do so without some assistance. Insurance is necessarily a technical, complicated subject, and the true financial condition of an insurance company can be determined only by expert examination. Also, some individuals may have difficulty understanding the complex nature of insurance contracts. These statements are less applicable for sophisticated buyers, such as large businesses, than for persons. Information problems for insurance customers provide the rationale for the great majority of insurance regulation. Insurers and their representatives have little incentive to disclose adverse information to potential customers. Doing so hurts sales. Governments seek to rectify the unequal positions between insurance buyer and seller by mandating certain disclosures for insurers, by monitoring insurer financial condition, by regulating insurer’s marketing practices, and through other means.3 Because insurance is a financial future-delivery product tied closely to the public interest, governments judge this information imbalance between buyers and sellers to warrant substantial oversight of the financial condition of insurers. The widely accepted view is that the public, especially poorly informed consumers, must be protected. In many aspects of insurance processes, neither the buyer nor the seller has complete information because the desired information simply does not exist. Insurers cannot know the future. Environmental factors — such as the economy, inflation, new laws and regulations, and changing consumer attitudes and preferences — present great uncertainty to both insurance buyers and sellers. Asymmetric information and other factors can lead to principal-agent problems in insurance markets. Such problems arise, for instance, when policyholders have difficulty in monitoring and controlling the behavior of their insurer. The insurer might incur additional financial risk that is hazardous to its policyholders’ interests or fail to meet its obligations to policyholders. If the insurer becomes insolvent or refuses to pay claims, policyholders may find it

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very costly or impossible to recover funds or force the insurer to fulfill its obligations. Unequal resources and bargaining power between the insurer and an individual policyholder can exacerbate the problem. Because of these problems and other market imperfections, private insurers will not supply every type of insurance that consumers demand. Insurers may perceive excessive adverse selection or moral hazard problems or they may be unable to diversify their loss exposures. Thus, the private insurance mechanism generally offers little unemployment insurance and faces some difficulty in insuring catastrophic events such as earthquakes and nuclear disasters that could cause huge, concentrated losses in a particular area. In each instance, insurers perceive too much uncertainty occasioned by a change in the state of nature or state of the world, coupled with prospects for severe adverse selection. Information problems also are responsible for individuals being so completely ill-informed that they are unable to know their own best interests. One of the premises for social insurance programs is that individuals will not or cannot fully arrange for their own financial security, so government must do it for them. Arguably, elements of social security programs could be privatized over time for individuals with sufficient financial resources to provide for their own security through the purchase of appropriate insurance and financial products. Government programs could be targeted more to low-income individuals who lack such resources. Market Power Insurers also can acquire market power, under some circumstances, which permits them to limit competition. Market power is the ability of one or a few sellers (or buyers) to influence the price of a product or service. Under the competitive model, sellers and buyers are price takers — meaning that they are so small compared with their market that they cannot exercise any meaningful influence over the price and quantity of a good or service, either individually or collectively. If some players in the market can affect price and quantity significantly to serve their interests, the allocation of resources generally will be inefficient. In most cases, in the absence of government restrictions, insurance markets are structurally competitive. Entry and exit barriers and economies of scale and scope are not of a nature that would allow a small number of insurers to acquire meaningful market power. Even in highly concentrated markets, the everpresent threat of new entry can impose competitive discipline, i.e., the concept of “contestable markets.” If insurers enjoy meaningful market power within a

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country, the cause usually can be traced to restrictive government control over entry and competition. The solution in such instances is not more regulation, but rather the removal of the government restrictions on entry and competition. Several countries have monopolistic markets (e.g., Iran and India), and many others are oligopolistic (e.g., Japan and South Korea), because of government policies. Explicit or implicit collusion historically has been common in many insurance markets internationally, especially concerning pricing. Tariff markets, in which all sellers charge similar or identical prices, remain common in many developing countries and for certain insurance lines in some OECD countries. National tax regimes can create market power. Some countries assess higher premium taxes on the local business of foreign insurers than they do on the local business of national insurers. Such practices are analogous to trade tariffs and have similar adverse economic consequences. National licensing requirements technically are entry barriers, although they are justified on consumer protection grounds. Some entry restrictions are appropriate to ensure that insurers are financially sound and their owners and managers are honest and competent. However, some governments go beyond this legitimate objective and will not grant a new license unless a market need to do so is established. Other countries will not grant new licenses under any circumstances or require local equity participation. Transparency in the licensing process is less than desired in many markets, with numerous unwritten rules. Reasonable freedom of entry does not exist in many of the world’s insurance markets. Several countries prohibit or severely limit the creation of new national insurers, and many erect substantial entry barriers to foreign insurers, although the trend is toward more liberal markets. Ultimately, consumers should be the judge of whether an insurer responds to their needs, not government. Insurance Regulation Should Rectify Market Imperfections Other imperfections exist in insurance markets but the above are the most obvious and common. Government’s role in crafting insurance regulation should be limited to rectifying imperfections that can cause significant harm. A pro-competitive approach, therefore, would witness governmental intervention into the insurance market only with respect to matters that meet three conditions:

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− an actual or potential market imperfection exists, − the market imperfection causes or can reasonably be believed to cause meaningful consumer or public harm, and − government action can ameliorate the harm. Conversely, if any one of the three conditions is not met, no government intervention is warranted. Thus, no government intervention is justified with respect to any insurer operation that does not cause demonstrable or reasonably expected harm. Even if some aspect of insurer operations might adversely affect some individuals, no intervention is warranted if the intervention would be ineffectual or might actually exacerbate the problem. Just as there is no perfectly competitive market, so too is there no perfect government regulation. All existing and proposed insurance regulations should be tested against these three conditions. Some existing and proposed regulations will meet all three conditions. Others will not and should be abandoned. The likelihood of consumer abuse because of market imperfections will vary from country to country. Thus, countries with a long history of competitive insurance markets will have already resolved many of the complex issues concerning appropriate government intervention. Countries moving from monopolistic and other restrictive regimes, on the other hand, must exercise a certain degree of caution to ensure that abusive practices do not undermine confidence in an embryonic, competitive insurance market. Justifiable government intervention should be minimally intrusive and as efficient as possible. For example, one way to minimize consumer harm occasioned by insurer insolvencies is to allow insurers to collude to set prices so high that even the most inefficiently operated insurer is guaranteed a profit and, therefore, survival. Such an approach, however, results in high priced insurance and excessive profits for insurers — all at the expense of consumers and businesses and, therefore, at the expense of the national interest. The superior approach is to allow price competition but to establish reasonable capital standards while closely monitoring insurer financial condition. This approach yields lower priced insurance — thus benefiting the national economy — while minimizing the possibility of consumer harm that would otherwise arise from excessive insurer financial risk and insolvencies.

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The Appropriate Role of Foreign Insurers Concern persists that certain dimensions of liberalization may carry unacceptable risks and drawbacks. One such concern relates to the appropriate role of foreigners in the provision of financial services generally and insurance in particular.4 How Insurance Aids Economic Development Insurance companies are financial intermediaries. As such, they perform the same types of functions and provide the similar generic benefits to a national economy as other financial intermediaries. At the same time, their role in individual and corporate risk management means that their contributions to economic development will not precisely overlap with other financial intermediaries. Financial services generally and insurance in particular, of course, are of primordial importance to economic development. Another recent doctoral dissertation at Georgia State University established this importance in a way that no one has done before. In his research, Dr. Ian P. Webb investigated the mechanisms by which insurance and banking jointly stimulate economic growth.5 At first, economists considered that economic growth was driven mainly by labor and capital inputs. When it was found that, in fact, these two factors alone left much of economic growth unexplained, economists added technology to their equations, thereby increasing their explanatory power but with troubling gaps remaining. Dr. Webb asked whether banking and insurance, when added to existing economic growth models, might further explain economic growth. His research showed that nonlife insurance, life insurance, and banking all have significant roles in explaining national productivity gains. The results indicated that the exogenous components of banking, life insurance, and nonlife insurance are important predictors of economic productivity. Additionally, he found evidence of synergies among financial intermediaries. Thus, each sector fuels economic growth independently but they collectively provide greater growth impetus than suggested by merely summing their component contributions. Dr. Webb’s research provides tangible support for what has been to date largely reasoned economic suppositions. Thus, the more developed and efficient a country’s financial market, the greater will be its contribution to economic prosperity. It is for this reason that

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governments should foster greater competition among financial service providers, while ensuring that the market is financially sound. It is wrong to view insurers as simple pass-through mechanisms for diversifying risk under which the unfortunate few who suffer losses are indemnified from the funds collected from many insureds. Laudable though it is, this function masks other fundamental contributions that insurance makes to prosperity. Countries that are best at harnessing these contributions give their citizens and businesses greater economic opportunities. Insurance provides seven categories of services that collectively constitute the mechanisms by which insurance contributes to economic growth, as found in Dr. Webb’s research. Insurance Can Promote Financial Stability Insurance helps stabilize the financial situation of individuals, families, and organizations. It accomplishes this task by indemnifying those who suffer loss or harm. Without insurance, individuals and families could become financially destitute and forced to seek assistance from relatives, friends, or the government. Businesses that incur significant uninsured losses may suffer major financial reverses or even fail. Besides the loss in value of the owners’ stake in the business occasioned by an uninsured loss, the firm’s future contribution to the economy is foregone. Employees lose jobs, suppliers lose business, customers forgo the opportunity to buy from the firm, and government loses tax revenues. The stability provided by insurance encourages individuals and firms to create wealth with the assurance that their resources can be protected. Insurance Can Substitute for and Complement Government Security Programs Insurance, especially life insurance, can substitute for government security programs. Private insurance also complements public security programs. It, thus, can relieve pressure on social welfare systems, reserving government resources for essential social security and other worthwhile purposes, and allowing individuals to tailor their security programs to their own preferences. Studies have confirmed that greater private expenditures on life insurance are associated with a reduction in government expenditures on social insurance programs. This substitution role is especially important because of the growing financial challenges faced by national social insurance systems.

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Insurance Can Facilitate Trade and Commerce Many products and services are produced and sold only if adequate insurance is available. Insurance coverage is a condition for engaging in some activities. Because of the high risk of new business failure, venture capitalists often make funds available only if tangible assets and the entrepreneurs’ lives are adequately insured. Entrepreneurs are more likely to create and expand their business ventures if they can secure adequate insurance protection. Insurance underpins much of the world’s trade, commerce, and entrepreneurial activity. This fact is unsurprising. Modern economies are built on specialization and its inherent productivity improvements. Greater trade and commercial specialization demand, in turn, greater financial specialization and flexibility. Without a wide insurance product choice and constant service and pricing innovations, insurance inadequacies could stifle both trade and commerce. It is in these ways that insurance serves as “a lubricant of commerce.” Insurance Can Help Mobilize Savings Studies have shown that, on average, countries that save more tend to grow faster.6 Insurers play an important role in channeling savings into domestic investment. Insurers enhance financial system efficiency in three ways. First, insurers reduce transaction costs associated with bringing together savers and borrowers. Thousands of individuals each pay relatively small premiums, and insurers then invest these amassed funds as loans to businesses and other ventures. In performing this intermediation function, direct lending and investing by individual policyholders, which would be time consuming and costly, is avoided. It is more efficient for insurers to acquire the information necessary to make sound investments than requiring individuals to acquire the same information. In turn, the efficiencies and higher returns achieved by insurers are passed to policyholders as lower premiums. Second, insurers create liquidity. Insurers invest the funds entrusted to them by their customers to make long-term loans and other investments. Policyholders, however, have immediate access to loss payments and savings while borrowers need not repay their loans immediately. If all individuals instead undertook equivalent direct lending, the proportion of their personal wealth held in longterm, illiquid assets would be unacceptably high. Insurers and other financial intermediaries thereby reduce the illiquidity inherent in direct lending. Third, insurers facilitate economies of scale in investment. Many investment projects are quite large, especially in relation to available financial capital in

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many emerging markets. Such large projects often enjoy economies of scale, promote specialization, and stimulate technological innovations and therefore can be particularly important to economic development. By amassing large sums from thousands of smaller premium payers, insurers often can meet the financing needs of such large projects, thereby helping the national economy by enlarging the set of feasible investment projects and encouraging economic efficiency. For example, in the US, insurers provide financing for fully onethird of all corporate debt. A well-developed financial system will have a myriad of financial institutions and instruments. Other things being the same, the greater the variety of financial institutions and products, the more efficient the system and the greater its contribution to economic development. Contractual savings institutions, such as life insurers and private pension funds, can be especially important financial intermediaries in emerging markets. In contrast with commercial banks, which often specialize in collecting short-term deposits and extending short-term credit, contractual saving institutions usually take a longer-term view. Their longer-term liabilities and stable cash flows are ideal sources of long-term finance for government and business. Insurance Can Enable Risk to be Managed More Efficiently Financial systems and intermediaries price risk and provide for risk transformation, pooling, and reduction. The better a nation’s financial system provides these various risk management services, the greater the saving and investment stimulation and the more efficiently resources are allocated. Risk Pricing A competitive market’s success depends on pricing. The pricing of risk is fundamental to all financial intermediaries and is no less important to their resource allocation than to any other supplier of goods or services. Insurers price risk at two levels. First, through their insurance activities, insurers evaluate the loss potential of businesses, persons, and property for which they might provide insurance. The greater the expected loss potential, the higher the price. In pricing loss potential, insurers cause insureds to quantify the consequences of their risk-causing and risk-reduction activities and, thus, more rationally deal with risk. Investors in projects judged too risky for insurance at any price are put on notice and should rationally expect returns commensurate with the risk. When governments interfere with accurate

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insurance pricing, their actions can distort the allocation of insurance and, therefore, other resources. Second, through their investment activities, insurers evaluate the creditworthiness of those to whom they extend loans and the likely business success of those in whom they invest. By these activities, business owners, potential investors, customers, creditors, employees, and other stakeholders can be better informed about the firm’s overall risk characteristics and thereby make better informed decisions. Risk Transformation Insurance permits businesses and individuals to transform their risk exposures to suit their own needs better. Many property, liability, loss of income, and other risk exposures can be transferred to an insurer for a price and, in the process, the insured’s risk profile changed. Moreover, life insurers, by tailoring contracts to the needs of different clients, help individuals and businesses transform the characteristics of their savings to the liquidity, security, and other risk profile desired. Risk Pooling and Reduction Risk pooling and reduction lie at the heart of insurance and, as with risk pricing, occur at two levels. First, in aggregating many individual risk exposures, insurers can make reasonably accurate estimates as to the pool’s overall losses. The larger the number of insureds, the more stable and predictable is the insurer’s experience. This fact leads to a reduction in volatility and, by that, permits insurers to charge smaller risk premiums for uncertainty and maintain more stable premiums. Second, insurers benefit from pooling through their investment activities. In providing funds to a broad range of enterprises, individuals, and others, insurers diversify their investment portfolios. The default of a few borrowers is likely to be offset by the many sound investments. The more stable and predictable an insurer’s investment experience, the less it can charge for loans. Insurance Can Encourage Loss Mitigation Insurance companies have economic incentives to help insureds prevent and reduce losses. Moreover, their detailed knowledge about loss-causing events,

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activities, and processes affords them a competitive advantage over many other firms in loss assessment and control. If pricing or availability is tied to loss experience and risky behavior, insureds, in turn, have economic incentives to control losses. Insurers support many loss control programs, typical of which are fire prevention; occupational health and safety activities; industrial loss prevention; reduction in automobile property damage, theft, and injury; and literally dozens of other loss control activities and programs. These programs and activities reduce losses to businesses and individuals and complement good risk management. Society as a whole benefits from the reduction of such losses. Insurance Can Foster Capital Allocation Efficiency Insurers gather substantial information to conduct their evaluations of firms, projects, and managers both in deciding whether and at what price to issue insurance and in their roles as lenders and investors. While individual savers and investors may not have the time, resources, or ability to undertake this information gathering and processing, insurers have an advantage in this regard and are better at allocating financial capital and insurance risk-bearing capacity. Insurers will choose to insure and to provide funds to the soundest and most efficient firms, projects, and managers. Insurers have a continuing interest in and monitor the firms, projects, and managers to whom they provide financial capital and risk bearing capacity. They encourage managers and entrepreneurs to act in the best interests of their various stakeholders (customers, stockholders, creditors, etc.). By doing so, insurers tangibly signal the market’s approval of promising, well-managed firms and foster a more efficient allocation of a country’s scarce financial capital and risk bearing capacity. National financial systems that impose minimum constraints on insurers’ abilities to gather and evaluate information in this way should realize a more efficient allocation of capital and therefore stronger economic growth. The Costs of Insurance Insurance indeed offers societies great social and economic benefits. However, it also carries certain costs. Government, insurers, and insureds have an interest in minimizing these costs. First, insurers incur sales, servicing, administration, and investment management expenses. These expenses are an indispensable part of doing business, but increase the cost of insurance. Such expenses may

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account for 10 to 40 percent or more of a policy’s premium, with the loss payment portion accounting for the balance. Second, the existence of insurance encourages moral hazard – the propensity of insureds to seek to gain unfairly from their insurance.7 Some insureds inflate otherwise legitimate claim payment requests. Moral hazard can manifest itself in mere carelessness, with attendant higher losses than otherwise. Occasionally, individuals deliberately cause the destruction of or damage to property to collect insurance proceeds. From 5 to 15 percent of all nonlife claims are believed to be fraudulent in Germany, Spain, Italy, Austria, Finland, and the US. Each year, some insureds are murdered for life insurance proceeds. All such behavior causes premiums to be higher than they would be otherwise, represents a deadweight loss to society, can lead to disruptions in otherwise well functioning markets, and truly is a cost of insurance. Arguments Favoring Greater Foreign Insurer Involvement Briefly, the specific arguments favoring greater foreign insurer participation are that countries could realize one or more of the following benefits: − improvements in customer service and value − increased domestic savings − transfers of technological and managerial know-how − additional external financial capital − improvements in the quality of insurance regulation − creation of beneficial domestic spillovers, including the addition of more and higher quality jobs, quality enhancing backward and forward linkages, and societal loss reductions. I examined each of these items in detail in a study that I conducted in 1997. I concluded that each is potentially relevant. Concerns About Foreign Insurer Involvement Policy makers have expressed numerous reservations about foreign insurer participation in their domestic markets. In my 1997 study, such reservations

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were classified around seven common themes, five of which were found to have little or no justification or the associated issues can be addressed more adequately and with less welfare loss through alternative means. The validity and importance of a sixth theme cannot be established a priori. The seventh reservation theme was judged to warrant policy-maker concern. The five classes of reservations either lacking factual justification or for which more efficient, viable alternatives exist are as follows: First, foreign insurers might dominate the domestic market and thereby precipitate adverse microeconomic (less consumer choice and value) or macroeconomic (failure to contribute adequately to economic development) effects. If a market offers great potential and if domestic insurers are inadequate and unsophisticated, market liberalization could lead to foreign domination. In such a case, however, no rational basis exists to support a parallel belief that the nation’s consumers and businesses will suffer harm or that the national economy will be harmed. On the contrary, that the market offered great potential, was unsophisticated, and had an inadequate capacity suggests that the status quo was stifling microeconomic and macroeconomic improvements. Of great political importance, as a practical matter, the likelihood of “foreign domination” seems slight in any event. The second reservation class for which factual justification is lacking or for which more efficient means exist to address the concern than denial of market access is that foreign insurers might market insurance selectively, thereby leading to adverse microeconomic or macroeconomic effects. (This selectivity may be because of concern that foreign insurers will market insurance only to the most profitable segments, to multinational corporations or to the commercial sector, ignoring the retail market.) Governmental efforts to discourage selective marketing can be harmful. Specialization and market segmentation lead to efficiency improvements, as suggested earlier. It is true that segmentation could cause some market segments to be under served. If it does and if these under served segments are judged critical, policy makers would be wise first to examine whether repressive regulation (such as price suppression) is at fault. If not, insurers can be enticed into neglected segments through less distorting subsidies or other positive means. The third class of reservations is that foreign insurers might fail to make lasting contributions to the local economy. In my study, I could find no reasonable factual basis to support this belief. The fourth class of arguments for limiting foreign insurer market access is that the domestic market is already well served by locally owned insurers or through

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reinsurance. Again, no reasonable factual basis to support this belief could be established. The fifth reservation category is that the national industry should remain locally owned for strategic reasons, such as national security concerns or because of the desire for economic diversification. To the extent that these goals are valid and not driven by special interests, less market-distorting means exist for accomplishing them than limits on foreign insurer participation. The sixth reservation class is that foreign insurers may provoke a greater foreign exchange outflow. The validity of this concern cannot be ascertained a priori. Over the short-term, of course, foreign exchange would flow into the country. More importantly, as an UNCTAD study noted: “(any) loss of foreign exchange may not be substantial enough to justify the opportunity cost involved in running and upgrading national insurance corporations.” The final reservation relates to the belief that full market liberalization should await insurance and possible macroeconomic regulatory reforms so as to minimize the chances of micro- or macroeconomic disruptions. This concern is valid in certain situations, particularly regarding adequate prudential supervision, competition regulation, and market conduct oversight. Reasonable insurance laws and regulation are essential. Ideally, they should exist prior to full market liberalization to avoid abuse by the unscrupulous. The study concludes that opening insurance markets to appropriate foreign insurers is likely to aid economic development, enhance overall social welfare, and carry few unresolvable negative possibilities. Countries that maintain unjustifiable market access barriers and that fail to extend national treatment to foreign-owned insurers likely are doing their citizens, businesses and national economies a disservice. The Path Towards Competitive, Solvent Insurance Markets In today’s globally competitive financial services world, the nature and specific features of each government’s intervention into its insurance market should be reassessed to ensure that every aspect is essential and is accomplishing its goal at minimum market disruption in light of the country’s economic, political, and social situation.8 The most common rationale for government intervention into insurance markets is to protect buyers — in economic terms, to rectify market imperfections. To do this, insurance regulation should seek to ensure that quality, reasonably-priced products are available from reliable insurers.

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A well-structured competitive market will ensure that the quality, reasonablepriced, and availability goals are attained. Hence, an important role of government is to promote fair competition to achieve these goals, while protecting buyers from misleading, collusive, and other anti-competitive practices. At the same time, arguably the most important governmental role is to ensure that insurers are reliable. To promote these twin goals of having a competitive and solvent insurance market, insurance regulation should have the following traits: − adequacy − impartiality − minimal intrusiveness − transparency In structuring insurance markets that better serve each country’s interest, regulatory reform should reflect certain principles that are designed to ensure competitive, solvent, and fair markets. Such a set of principles are summarized and discussed briefly below. The principles should help move a national insurance market toward the competitive ideal. They are not an argument for elimination of regulation. In fact, as made clear below, pro-competitive regulation requires a greater — not lesser — emphasis on competition law, prudential matters, and market conduct. Regulation Should be Adequate Regulation should be adequate, meaning that it should be sufficient to rectify meaningful market failures and, thereby, protect the public. Several principles of adequacy follow. Competition Law To establish an adequate system of regulation, government must, first, have necessary laws and regulations in place that create the framework for a competitive market. The first principle, therefore, is that:

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Government should enact and enforce laws that provide an effective framework for competitive insurance markets. Competition law is a vitally important component of competitive markets. Competition law regulates the nature of competition in the marketplace rather than individual competitors. As markets move from restrictive to liberal regulatory approaches, competition law becomes more important as some firms will have motives to try to engage in anti-competitive practices. The law should give regulators clear and strong authority to prevent or punish collective behavior that lessens competition, such as collusive price setting, market sharing arrangements, and other anti-competitive collective actions. Prudential Regulation Insurance laws and regulations also should address all relevant aspects of insurer operations, from creation to liquidation. The most essential component relates to prudential regulation and supervision, which brings us to the next principle related to adequacy of regulation: Government should enact and enforce laws that establish reasonable solvency standards and regulation as the primary means of protecting the public. The more competitive a market, the more important is prudential regulation and accompanying supervision. The insurance regulator in a deregulated market faces more complex and difficult issues than his or her counterpart in a strictly regulated market. Indeed, prudential regulation and supervision can be deceptively simple in a market in which all insurers charge the same or similar prices such that the least efficient insurer can enjoy reasonable profitability. Insolvencies in such markets are diminished by overcharging – a form of preinsolvency assessment. Not all insolvencies can or should be prevented. In a competitive market, some insolvencies are inevitable. Government’s delicate task is to minimize consumer harm occasioned by such difficulties but without signaling other insurers that mismanagement or other unsound business practices will be tolerated. Rigorous but fair enforcement of well-crafted prudential regulation is called for. The emphasis of prudential regulation and supervision should be to prevent insurers from incurring excessive levels of financial risk and on timely intervention when an insurer’s financial condition becomes hazardous. This can be accomplished by reasonable minimum financial standards and effective

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monitoring of insurers’ financial conditions. Such a strategy should include frequent informal consultations with insurer executives to keep regulators well informed about potentially adverse developments and enable them to steer insurers away from actions that threaten their policyholders’ interests. Resolving the problems of financial difficulties for existing insurers should be a priority. Thus, the next principle would lead to the creation of appropriate and consistent ways of dealing with insurers that incur financial difficulties. As a part of reasonable solvency regulation, government should establish, make public, and enforce appropriate and consistent rules and procedures for identifying and dealing with financially troubled insurers. An objective of insurance regulation should be to establish proper incentives for efficient and safe insurer operation and institute safeguards to keep the number of insurer insolvencies to an acceptable minimum. A marketplace with no insurer failures likely is one in which insurance is expensive and consumer choice limited. Government’s responsibility is to establish rules and procedures for identifying and dealing with financially troubled insurers. A key element in the identification process is the establishment of appropriate accounting, reporting, and auditing standards and requirements. Government would be wise to borrow freely from international best practices standards. The rules and procedures for dealing with troubled insurers should be sufficient to address the particular difficulty and should be consistently applied across all competitors. The rules and procedures should be made public and any changes subject to transparent regulatory processes (see below). Regulatory Effectiveness The next step to ensure adequate regulation in a competitive market involves creating an independent regulatory agency with sufficient resources to enforce laws and regulations efficiently, effectively, and impartially. Government should establish an insurance regulatory agency that operates in society’s interest and has sufficient resources to efficiently, effectively, and impartially enforce the nation’s insurance laws and regulations. If the agency is to function in society’s interests, as opposed to private interests, it should operate independently of undue insurance industry and other special

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interest influence. It is insufficient that the regulatory body be established as an agency of the government. The means by which industry input is secured must be transparent, impartial, and consistent. Rules may be necessary to limit undue influence over regulatory decisions, such as not allowing former heads of the regulatory agency to lobby the agency for a certain period of time after vacating the office. Due process and transparency (see below) are critically important to ensuring that the regulator deals at arms length with the regulated. The regulatory body must be provided sufficient financial and other resources, including information technology, to carry out its regulatory function. A critically important resource issue relates to the quality and integrity of supervisory personnel. Regulation in competitive markets is more complex and difficult than regulation in restrictive markets. Because of this fact, more competent, highly skilled, and technical employees are required for effective regulation in a competitive market. Regulatory efficiency means that responsibilities are carried out expeditiously, with prudent use of the agency’s resources. Regulatory effectiveness means that responsibilities are carried out in ways that genuinely ameliorate the identified market failure, but using approaches that are minimally intrusive (see below). Regulatory impartiality means that responsibilities are carried out with fairness to all market participants and without favoritism toward any. Impartiality is of such great importance that it warrants separate treatment (see below). Phased-In Liberalization Observers correctly note that insurance regulatory oversight in many transition market-economy countries may not be sufficiently attuned to protecting consumers in a liberalized, competitive market. They may need to enhance prudential, competition, and market-conduct regulation and supervision as they re-regulate and liberalize their insurance markets. At the same time, the movement from a restrictive to a competitive market does not take place overnight, which brings us to our next principle. Government should develop and implement pro-competitive insurance regulation in a way and at a pace that ensures adequate protection of the public but that proceeds without undue delay and is subject to a reasonable implementation timetable. Certainly, new insurer entry and operations into formerly restrictive markets should not be allowed to overwhelm government’s ability to protect consumers and the stability of the national insurance industry. On the other hand,

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experience suggests that consumer protection concerns are often asserted as a justification for unreasonable delays in liberalizing and deregulating. Policy makers should recognize that entrenched interests will always urge slowness in reform. Yet, the road to reform should be traveled at the maximum possible safe speed, not the minimum. Moreover, reform should follow a reasoned, carefully crafted route, which means that an implementation timetable, with clear deadlines, is essential. Regulation Should be Impartial The principle of impartiality is fundamental to a competitive market. Impartially means that government should accord no competitor or group of competitors more favorable treatment than that extended to other competitors or groups of competitors. Thus, the next pro-competitive regulatory principle is that: Government should ensure that insurance regulation and enforcement are applied with consistency and impartiality between competitors, irrespective of the nationality. Historically, the fair trade principle of national treatment has been the standard for impartiality and, in minimally intrusive regulatory regimes, this standard is a reasonable test of impartiality. It is intended to ensure equality of competitive opportunity for foreign entrants. National treatment problems exist for foreign insurers in some markets. Thus, some countries have different deposit or capital requirements for foreign insurers than for national ones. Many countries assess higher taxes on foreign than on national insurers. Some countries deny or restrict foreign insurer membership in local trade associations, thus denying them equivalent access to national statistics, research, and lobbying. The national treatment standard is insufficient to ensure effective market access under certain circumstances. Other government actions that can distort the competitive balance include exchange controls, deposit and lending rate ceilings, privileged access to credit, and unnecessarily strict controls with respect to investments and business powers. Such strict regulation affords already established firms a competitive advantage over new entrants.

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Regulation Should be Minimally Intrusive The Limits of Regulation As noted earlier, all insurance regulation should be based on the goal of rectifying meaningful market imperfection — that is, to protect the public interest. A government will have multiple ways of rectifying each imperfection that it identifies. All of the ways might meet the adequacy test in the sense that they are sufficient to accomplish the purpose. Some means, however, will prove less disruptive to the competitive market than others, while still accomplishing their purpose. In selecting among its many alternatives, government should select those that accomplish the purpose at minimal disruption to the smooth functioning of their insurance markets; in trade terms, government should select among those that are the least trade restrictive (i.e., that meet a “necessity test”). Thus, an important pro-competitive regulatory principle is that: Insurance regulation should be limited to that which is (1) justified as providing meaningful protection and (2) minimally intrusive to accomplish its purpose. Thus, government should avoid any regulatory intervention with respect to transactions and matters that have little or no possibility of harm to the public. Moreover, in selecting among alternative regulatory approaches to address problems that involve the possibility of meaningful public harm, government should always opt for those approaches that solve the problems with minimal interference with or imposition on insurance transactions. This is the principle embedded in the GATS Article VI requirement that measures should be no more burdensome than necessary to ensure the quality of the service. This philosophy implies that insurers should be allowed to offer an array of insurance products at prices that they deem appropriate, without being subject to severe restrictions or cumbersome pre-approval process, unless meaningful consumer harm could result from doing so. Market forces should prevent insurers from sustaining prices above a competitive level. Insurers that charge inadequate prices or incur excessive financial risk can be removed from the market. Products that do not serve consumer needs also will not be viable. Through effective monitoring and actions, regulators should move decisively against insurers that attempt to defraud consumers or treat them unfairly. The threat of timely regulatory enforcement actions and appropriate penalties will help to discourage insurers and intermediaries from engaging in abusive practices. This approach conserves regulatory resources by directing them toward the small number of insurers and intermediaries that treat consumers

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unfairly, without subjecting all market participants to unnecessary constraints or burdensome oversight. An important element of the minimally intrusive principle is government undertaking actions that can increase corporate accountability but without government itself being responsible for the details of oversight. Thus, requiring audits and certifications by independent actuaries and accountants can both relieve government of these tasks and create positive incentives for insurers. Placing more responsibility on management and boards of directors can have similar effects. The importance of “fit and proper” standards for key management grows with greater market competition. It must be stressed that the standard of minimal intrusion does not imply a policy of laissez faire or no regulatory oversight. Rather, it implies that regulation should be confined to interventions that are truly needed and can meaningfully benefit consumers. Effective regulatory monitoring can help to ensure that regulators are alerted to problems that require action on a timely basis. In determining appropriate regulatory restrictions, policy makers and regulators must consider the frequency and severity of market abuses and problems. It is not feasible to prevent consumers from ever making poor choices. In designing regulatory policies, government should focus on areas where there is a pattern of abuse or practices harmful to consumers, reflecting fundamental gaps in consumers’ abilities to protect themselves. Distribution and Product Regulation Restrictive markets usually adopt a philosophy that insurers may do only that which is expressly authorized. Regulation tends to rely on an ex ante system of detailed oversight and approval. Such regulation can ensure a stable market, but such markets are rarely innovative, typically offer high-priced insurance, and provide comparatively limited consumer choice and value. Thus, consistent with the minimally intrusive standard, the next principle is: Subject only to that regulatory oversight essential to protect the public, government should allow the market to determine (1) what financial services products should be developed and sold, (2) the methods by which they will be sold, and (3) the prices at which they will be sold. Deregulation connotes a lessening of national regulation with the goal of retaining only that which is adequate and minimally intrusive. The most critical

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first step along the path toward reasoned deregulation is to adopt the philosophy that insurers should have the flexibility to respond to consumer needs in ways that they deem appropriate, subject, of course, to regulatory oversight to deal with solvency matters and to minimize misleading or abusive practices. Market forces will encourage insurers to develop and sell products on terms that are in the best interest of consumers. This philosophy argues for greater reliance on an ex post system of oversight wherever it is most efficient. Ex ante regulation will remain appropriate for some areas, such as insurer licensing and solvency oversight, where certain market failures are best addressed by imposing minimum standards and prohibiting activities that could harm consumers. These will include situations where lack of information and unequal bargaining power between consumers and insurers can lead to abuses that should and can be prevented by regulators. Many countries have shifted more to the philosophy of ex post regulation. Even so, remnants of earlier restrictive philosophies persist, if not strictly de jure then at least de facto. The product approval process in many countries is at best sluggish and at worst erratic, arbitrary, and opaque. The benefits of competition are blunted when regulation is slow, unpredictable, or inconsistent. Prior approval and other restrictive approval approaches tend to retard adjustment of prices and product innovation. Such actions should be unnecessary in a competitively structured market. A competitive insurance market will have numerous channels for insurance distribution. New products and services require channels attuned to the buyer’s needs and wishes. Brokers and other marketing intermediaries can help insurance buyers make better informed decisions. Government-imposed limitations on distribution channels that could serve the market more efficiently are inconsistent with a market-driven regulatory philosophy. They are examples of governmentally created barriers to entry. Disclosure and Consumer Information When a government moves from a restrictive regulatory system to greater reliance on competition, some consumer protection functions shift from the government to consumers themselves. Government should ensure that insurance buyers understand that such a fundamental shift has taken place. Buyers will need to become more active in evaluating insurers and their products.

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Government should ensure customers have access to sufficient information to be able to make good purchase decisions and protect their own interests. This brings us to the next principle: Government should ensure that insurance customers have access to information sufficient to enable them to make informed, independent judgments as to (1) an insurer’s financial condition and (2) the benefits and value of its products. This principle goes directly to the information asymmetry problems of insurance buyers. Regulation may be necessary to compel insurers to make certain disclosures in connection with their sales efforts. In other instances, it may prove most efficient and effective for government itself to be the source of needed unbiased information. This approach will require additional governmental efforts to facilitate informed and prudent customer choices. Rating agencies and other independent information sources can greatly assist customers as a source of unbiased information. Unfortunately, some governments discourage or prohibit entry by rating agencies and other such independent financial service information firms. Such actions hinder competition in the national interest by denying local businesses and citizens information beneficial to their decisions regarding the purchase and maintenance of insurance and other financial service products. The Regulatory Process Should be Transparent Transparency in the regulatory process is fundamental to ensuring a competitive market. This brings us to two of the most important pro-competitive regulatory principles. The first is: Government should make existing insurance laws and regulations easily available to the public, including to consumers and businesses and to insurers and other financial services providers. The fair trade principle of transparency, as embedded in GATS Article III, requires that regulatory and other legal requirements regarding market access and national operation should be clearly and fully set out and easily available. Transparency problems are too common in insurance markets. Many governments’ laws and regulations are incompletely set out and not readily available. Foreign firms, in particular, encounter transparency problems in countries that grant their insurance regulatory authorities broad discretionary powers, as the foreign insurer may have no clear understanding of the market access or operational requirements.

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Many countries, especially those that historically have been relatively closed, may have unclear or nonexistent due process standards. In such instances, foreign (and national) insurers may not fully understand either their rights to appeal regulatory decisions or the process by which an appeal is undertaken. The second dimension of the transparency principle applies to proposed laws and regulations. This dimension requires that all interested parties have the opportunity to know about and to comment on proposed regulations and that methods to challenge regulatory decisions be available. In crafting proposed insurance laws and regulations, government should (1) make such proposals easily available to the public, including to consumers and businesses and to insurers and other financial service providers; (2) invite comment on the proposals; (3) allow sufficient time for interested parties to provide comment; (4) provide justifications for decisions to accept and reject comments; and (5) establish and communicate a fair process by which decisions considered arbitrary or unjust can be challenged. Although impressive gains in transparency have been made in many markets, others continue to draw criticism internationally. Close relationships between government and established insurers are inconsistent with the ideal of transparency. Transparency implies that regulators maintain an arms-length relationship with all insurers and that some insurers do not gain an unfair advantage through privileged associations with regulators. Conclusion The internationalization of financial services promises to continue. Some observers express concern about the competitive model, given the recent economic turmoil experienced in several countries. Competition itself did not cause the difficulties. Rather, the lack of certain government rules and policies inhibited truly transparent, competitive markets, making a bad situation much worse. It has been argued that greater market access and involvement by foreign financial services firms would have lessened the adverse economic effects. The lesson for governments is to craft laws and enforce regulations that promote more transparent markets supported by fair competition unfettered by government direction, favoritism, and unwarranted interference. Competitive insurance markets serve each country’s interest. Governments that deny their citizens and businesses such markets lessen consumer choice and value and needlessly hinder national economic development.

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NOTES

1

This section draws in parts from Harold D. Skipper, Jr. and Robert W. Klein, Insurance Regulation in the Public Interest: The Path Towards Solvent, Competitive Markets, Working Paper no. 99-4, Center for Risk Management and Insurance Research, Georgia State University.

2

Thitivadee Boonyasai, The Effect of Liberalization and Deregulation on Life Insurer Efficiency, unpublished Ph.D. dissertation, Georgia State University, 1999.

3

Another way government may address this problem is by providing consumer information and education. Private for-profit and non-profit organizations also can provide consumer information and education, but government may play a valuable role in this area as well.

4

This section draws from Harold D. Skipper, Jr., Foreign Insurers in Emerging Markets: Issues and Concerns (Washington, D.C.; International Insurance Foundation, 1997).

5

Ian P. Webb, The Effect of Banking and Insurance on the Growth of Capital and Output, unpublished Ph.D. dissertation, Georgia State University, May 2000.

6

IMF (1995). World Economic Outlook, May, pp. 69-70. Of course, this finding does not suggest that every country with a high savings rate will have a high growth rate. Countries whose financial systems are inefficient are less likely to achieve high growth rates even with high savings rates.

7

One of the chief purposes of underwriting is to discourage and detect moral hazard and adverse selection. Insurance contract terms also attempt to limit moral hazard, as do insurable interest and anti-fraud statutes.

8

This section draws from Skipper and Klein, op. cit.

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FINANCIAL SERVICES INTEGRATION WORLDWIDE: PROMISES AND PITFALLS by Harold d. Skipper, Jr.

Introduction Will financial services integration lead us straight away to a brave new financial world in which operational and marketing efficiencies and innovation ensure ever greater consumer value and choice and a safer financial system? Or will it result in a handful of financial giants exercising their market power to sell high priced, unsuitable products to all but their wealthiest customers, while abusing their privacy and exposing the entire financial system to greater risk? This paper attempts to summarize and synthesize the current knowledge and opinions on these and related issues. We begin with a discussion of the many meanings ascribed to the phrase financial services integration. We then offer a brief summary of the existing economic literature on the subject and of the key issues that managers of integrated firms face. To provide context, especially for our U.S. audience, there follows an overview of financial services integration in selected countries. Next we attempt to classify and summarize the numerous public policy concerns that have been raised with integration. The paper closes with some speculations about the future of financial services integration. The Multiple Meanings and Forms of Financial Services Integration Because the term “financial services integration” is subject to multiple meanings, we need to be clear about how it is used.1 Additionally, because firms offering integrated financial services can be structured in multiple ways, we also should understand these different structural possibilities.

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The Meaning of Financial Services Integration Perhaps the most familiar definition of financial services integration is that it occurs whenever production or distribution of a financial service traditionally associated with one of the three major financial sectors is by actors from another sector. Terms such as bancassurance, allfinanz, universal banking, and financial conglomerates are all used to convey some notion of integration. Terminology, however, is not yet standard, so these terms carry different meanings for different people. The above definition embraces either or both production and distribution of financial services. The degree of integration may range from shallow to deep. The definition is not completely satisfactory, however, unless production is understood to include two dimensions: product and management. To understand this importance, it will be useful, first, to consider a financial conglomerate – commonly defined as any group of companies under common control whose exclusive or predominant activities consist of providing significant services in at least two of the three major financial sectors. The three sectors are commercial banking, investment banking, and insurance. Consider two financial conglomerates that, from a legal point of view, are identical. Each is composed of a non-operating holding company that owns a commercial bank and an insurer. In one conglomerate, the bank and insurance company are managed as separate profit centers, with no effort made to integrate overall management and operations. Activities are aligned precisely with legal form. The other conglomerate, by contrast, has global control functions allowing management and operations at the group level. Activities align with target markets, not legal form. Profit centers cut across sectoral lines. Both conglomerates might sell the same portfolio of products, so this dimension of production is indistinguishable. They are, however, managed quite differently. The latter group is more integrated, believing that economies can be secured through operational integration. The French term bancassurance most commonly refers to banks selling insurance products (and usually vice versa2). The German term allfinanz usually is synonymous with bancassurance, although it sometimes suggests integration via distribution across all three major sectors, as does bancassurance at times. Universal banks usually are thought of as representing a greater degree of integration. According to many scholars, a theoretical definition of a universal bank allows it to manufacture and distribute all financial services within a single

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corporate structure (Saunders and Walter, 1994). As a practical matter, perhaps the most common concept of a universal bank is that of a financial institution that combines the production and distribution of commercial and investment banking within a single firm. Some universal banks distribute insurance but through a separate subsidiary.3 The term financial conglomerate probably connotes the greatest degree of integration. Under the earlier definition, a conglomerate must involve firms under common control, suggesting the possibility of integration at the level of production (both product and management). Note, however, that the definition does not specify the structure of the conglomerate, insisting only on common control. Thus, two conglomerates may each contain a commercial bank, life and nonlife insurers, and an investment bank, yet they may exhibit vastly different degrees of integration if one has global controls and integrated management and the other does not. The business of a conglomerate consists exclusively or predominantly of providing services in at least two financial sectors. Thus, a universal bank ordinarily meets the definition, as would a bancassurance arrangement involving affiliated firms. A conglomerate that contains one or more financial services firms, but which is predominantly commercially or industrially oriented, does not meet this definition. Such a conglomerate is commonly referred to as a mixed conglomerate. Financial services integration also occurs when firms in one sector create and sell products containing significant elements traditionally associated with products of another sector. Thus, variable (unit linked) annuities and life insurance combine elements of insurance and securities. The securitization of banks’ asset cash flows (e.g., mortgages, credit card balances, and other debt portfolios) combine important elements of investment and commercial banking. Alternative risk transfer techniques such as catastrophe options, bonds, and equity puts; standby letters of credit; and finite risk transfer mechanisms offer other examples. Money market mutual funds, offered by investment banking firms, are effectively demand deposit accounts. This product convergence trend can be expected to be an important force toward operational integration among commercial banks, securities firms, and insurers. Finally, financial services integration can occur at the level of the advisor, without necessarily any supply-side integration or even cooperation. Thus, personal financial planners, accountants, attorneys, risk management consultants, agents, brokers, and other personal and corporate advisors often effectively integrate financial services for their clients. They may sell products themselves or direct the client’s purchasing behaviour based on an integrated 101

financial or risk management plan. Integration also occurs when employers or affinity groups offer a range of financial products to employees or group members, as, for example, when an employer offers a “cafeteria” of employee benefits that may be self-funded or not. For purposes of this paper, we focus on integration at the supplier level. Thus, product and advisory integration receive scant attention here, although we recognize the importance of this type of integration. Structures for Delivering Integrated Financial Services Integrated financial services may be delivered through several structural forms. In general, however, they fall into one of five classifications.4 Full Integration. The most fully integrated operational form is one wherein all financial services are produced (underwritten) within and distributed by a single corporation, with all activities supported by a single capital base. Figure 1 illustrates this form which probably exists presently only in theory as no financial institution actually is structured in this way legally. The form, nonetheless, is important as it might represent a future structure of such firms, and provides a schema for thinking about the issues associated with regulation and management of financial conglomerates that, while sectorally separate for legal and regulatory purposes, might be operationally integrated. Figure 1 Full Financial Services Integration

Commercial Banking Activities

Investment Banking Activities

Insurance Activities

Other Financial Activities

Universal Bank – German Variant. German universal banks, a step removed from the fully integrated firm above, represent the next structural form of integration. As illustrated in Figure 2, such firms combine commercial and investment banking within a single corporation but conduct other financial activities through separately capitalized subsidiaries owned by the universal bank. The German grossbanken (“big banks”), including Deutsche Bank, Dresdner Bank, and Commerzbank, are organized in this way as are many regional banks. The large Swiss banks also are structured in this fashion, as are many other continental European financial institutions.

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Figure 2 Partial Financial Services Integration (Universal Bank – German Variant) Commercial Banking Activities Banking Activities

Insurance Activities

Investment

Other Financial Services

Bank or Insurer Parent. The third structural variation of financial conglomerates is one in which the parent company is a bank or an insurer. The parent owns one or more subsidiaries that produce other financial services and are separately capitalized. Figure 3 illustrates this approach, with the bank as the parent. This structure is common in the U.K., with Barclays and Lloyds TBS being examples.

Figure 3 Financial Services Integration via Bank Ownership

Commercial Banking Activities

Investment Banking Activities

Insurance Activities

Other Financial Services

Holding Company Arrangement. The fourth principal form of financial conglomerate is via a holding company arrangement. Typically, a nonoperational holding company owns all or most of the shares in separately incorporated and capitalized sectoral subsidiaries, as illustrated in Figure 4. This arrangement is the evolving model for the U.S.

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Figure 4 Integrated Financial Services via a Holding Company Arrangement

Financial Services Holding Company

Commercial Banking Activities

Investment Banking Activities

Insurance Activities

Other Financial Services

Joint Venture and Other Arrangements. The final form through which integrated financial services are provided involves joint venture and other arrangements between unaffiliated financial services firms. In such structures, two financial intermediaries – such as a bank and an insurer – form a joint venture firm, strategic alliance, or other formal arrangement through which one or both firms’ products are sold. Figure 5-a illustrates a joint venture and 5-b illustrates a simple marketing arrangement whereby a bank markets the products of an unaffiliated insurer, such as found commonly in the U.S. Less formal marketing arrangements are also common.

Figure 5-a: Financial Services Integration via Joint Venture Arrangement

Commercial Bank

Insurance Company

Joint Venture Marketing Firm

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Financial Services Integration via Marketing Arrangement (Bancassurance) Insurance Company

Commercial Bank

The structure adopted in delivering integrated financial services is influenced by a myriad of factors. Besides the historical context of a country’s financial services market, its regulation is critically important in this respect. But so too are issues such as market power, economies of scale and scope, operating efficiencies, and how best to address conflicts of interest. These and other issues are discussed later in this paper. The Economics of Financial Services Integration Having set out definitions and structures for integrated financial services firms, we now explore our existing understanding of the economics of integration. Does integration bring about efficiencies? Integration is economically logical if it results in a reduction in operating costs, an increase in revenues, or both. Cost Effects Financial services conglomerates could enjoy cost advantages through realizing economies of scale, economies of scope in production, or operational efficiencies. Economies of Scale. Economies of scale exist if the average cost of production falls with increased output, holding product mix constant. Economies of scale, in themselves, would not seem to justify the formation of multi-sectoral financial firms, although they may justify existing conglomerates growing larger through organic growth or mergers or acquisitions. The majority of studies on economies of scale of financial institutions have been conducted on U.S. firms, and, therefore, hold less relevance for scale economies with financial conglomerates, given the U.S. practice of having segregated financial institutions. Saunders and Walter (1994) studied the world’s largest banks, among which were included several universal banks, and found economies of scale only in the middle range of big banks. 105

The few other studies on economies of scale for universal banks find somewhat similar results. Growing from $1 billion to $10 billion in assets seems to gain scale, but growing from $10 billion to $100 billion seems to gain little.5 Thus, we have some evidence for scale economies for financial conglomerates, but not for very large institutions. Walter (1997, p. 348) summarizes results as follows: “Overall, the consensus seems to be that scale economies and diseconomies do not result in more than about 5 per cent difference in unit costs.” Economies of Scope in Production. Economies of scope in production exist if multiple products can be produced at less cost than the sum of the costs of producing each separately. Economies of scope are likely to be important in financial services because of the ability to share overhead, technology, and other fixed costs across a range of products. Thus, the fixed costs of managing a client relationship would seem to lend themselves to sharing across a broad range of financial services (Herring and Santomero, 1990, p. 474). Economies of scope could come about from investment operations (having a single investment unit for all sectors), information technology (having customer information consolidated and available for multiple uses), distribution (using distribution channels established for one sector to sell other products), and reputation (having the good reputation of one firm, e.g., a commercial bank, enhance the sale of other conglomerate products). As with studies on economies of scale, most scope studies are on U.S. single-sector financial firms, finding that, where they exist, they are exhausted at fairly low levels of output. However, most studies were conducted over periods during which financial firms were undergoing great change, perhaps incurring substantial sunk costs that may have distorted results. Diseconomies of scope are not unlikely. Financial conglomerates are large firms with substantial bureaucracies. They may suffer from inertia and an inability to respond quickly to changing markets and customer demand. They may lack creativity, experience “turf” battles, realize internal compensation conflicts that erode synergy, and suffer from serious internal cultural differences across sectors that inhibit cooperation and coordination necessary for synergy (Walter, 1997). Also, not all customers will want to purchase financial products from a single conglomerate. They may be concerned about being treated impersonally, about a large firm not passing lower costs of operation to its smaller customers, about having their financial purchases concentrated within a single group (and foregoing diversification), or about use of personally identifiable information within the conglomerate family to the customer’s detriment.

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Operational Efficiencies. Economies of scale and scope are static efficiency concepts, with studies focusing on size and product mix cost effects for a given time frame. Dynamic efficiency, involving product and process innovations and other operational efficiencies (also called X-efficiencies), might be even more important. Financial conglomerates might have an informational advantage over specialized firms in that they can more quickly develop products in response to changing technological or market conditions, especially products carrying attributes of multiple sectors. Indeed, several studies have found that technical inefficiencies (excess use of inputs) and allocative inefficiencies (suboptimal input mix) are large and dominate scale and scope economies.6 Considerable effort has gone into the measurement of X-efficiency of financial institutions. Berger and Humphery (1997) survey 130 studies on efficiency that covered 21 countries and used various efficiency and measurement methods. These studies included multiple time periods and all major financial intermediaries. It appears that the average unit costs in banking ranges from 20 to 25 percent above the costs of best practice firms. Revenue Effects Two aspects of financial integration could give rise to important revenue effects: economies of scope in consumption and market power. Economies of Scope in Consumption. Integration may enhance the earnings potential of a financial conglomerate through distribution of a greater product range. These economies of scope in consumption (demand-side economies of scope) could follow from the cross-marketing of investment, savings, credit, and insurance products. Many financial products are complements: mortgage loans and mortgage protection life insurance policies; auto loans and auto insurance; and wrap accounts and investment products. Customers could realize lower search, information, monitoring, and transactions costs by purchasing products from a conglomerate than by purchasing the same array of products from specialty firms. Private banking has always been designed to exploit such economies. These economies may not entail lower priced products. In fact, if such consumption economies exist, customers presumably would be willing to pay more for products offered in this convenient way. Evidence of such economies exists, although the literature is thin. Berger, Hancock, and Humphrey (1993) found that gains inherent in universal banking may lie more on the revenue than the cost side. Canals (1993) found that bank

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performance was improved from the increased revenues from new business units. Mutual fund activities were found to increase bank profitability (Gallo, Apilado, and Kolari, 1996). Various risk-simulation studies conducted by Saunders and Walter (1994) suggest that combinations of banking, insurance, and securities activities may lead to a more stable profit stream, as each sector’s cash flows are usually imperfectly correlated. Boyd, Graham, and Hewitt (1993) found that simulated mergers of U.S. bank holding companies (BHCs) with life insurance and property/casualty insurance firms may reduce risk, but that mergers with securities firms would likely increase risk. Kwan (1997) found that U.S. BHCs gain potential diversification benefits from having securities subsidiaries because of low correlations between their returns and those of the other operating units of the BHC. Benston (1989) reports that returns for combined commercial and investment banking would be significantly higher, but without an increase in overall risk. Vander Vennet (1998) found that European financial conglomerates were more revenue efficient and enjoyed higher profits than specialized financial firms. Further, Walter (1997) observes that network economies, a special type of economies of scope in consumption, are associated with some elements of universal banking. With network economies (positive externalities), relationships with end users represent a network structure wherein additional client linkages add value to existing clients by increasing the feasibility or reducing the cost of accessing them. These externalities tend to increase with the absolute size of the network itself and are characteristics of activities such as securities clearance and settlement, global custody, funds transfer and international cash management, foreign exchange and securities dealing, and the like. Market Power. Large size can convey market power; i.e., the ability to affect price. To the extent that barriers to entry exist and a country’s financial services market tends toward oligopoly, financial conglomerates may be able to charge higher prices, at least to some market segments, than would be charged in a less concentrated, integrated market. In exercising their market power, such conglomerates would enhance their revenue (or at least profit) stream. Until the mid-1990s, many countries strictly limited access to their financial services markets, especially to foreign firms, and sheltered a highly concentrated market. Government-sanctioned market power flows naturally in such markets. With the deregulation and liberalization trend worldwide, such markets seem likely to be the exception rather than the rule for the future. With fewer barriers to entry, more competitive markets with fewer opportunities to gain market power should evolve.

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Relationship between Effects and Operational Structure If integration yields positive microeconomic cost effects, i.e., through economies of scale or scope or through operational efficiencies, one would expect to find conglomerates moving toward production and operational integration. Back-office operations such as investment, accounting, information technology, risk management, and the like would more likely be the basis for realizing economic gains. Synergies would likely relate to both the corporate and retail markets. If integration yields positive microeconomic revenue effects, i.e., through economies of scope in consumption, one would expect to find financial integration more toward distribution. It may be that little or nothing is gained by production and operational integration. In such instances, bancassurance arrangements, with or without affiliation, would be sufficient. Synergies would likely relate more to the retail than to the corporate market. Management Issues in Integration The preceding discussion highlighted several management challenges associated with financial services integration but did so in the terminology of the economist. This section translates some of those economic concepts into practical management concerns. Group Structure After establishing the group’s mission and strategy, management must decide on the most desirable operational structure. We can distinguish between de jure and de facto structures. Whereas the formal structure must comply with legal requirement (e.g., conduct insurance operations in an insurance subsidiary), this should not necessarily dictate the operational structure. In fact, adopting the legal structure as the operational basis could fail to capture hoped-for economies, as alluded to earlier. Group structure decisions relate also to whether the necessary manufacturing platforms for financial services will be acquired or created de novo. Of course, such decisions need not be the same from market to market or over time. In general, organic (“greenfield”) growth leads to fewer cultural difficulties and allows operations to be oriented more quickly and efficiently toward the group’s

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mission. Many observers believe that organic growth has been more successful than growth through acquisition. On the other hand, organic growth means that the group is unlikely to be a major player within a country’s financial services market in the near term. If, as many financial conglomerates believe, being among the five or so largest financial institutions in the market is important for operational efficiency and profitability, organic growth may not be the best choice. This is especially true for mature markets, where consolidation is already well under way and opportunities for acquisitions abound. Organic growth tends to be more common in emerging markets than in mature markets. Complexity Integrated financial services firms are complex operations. This observation seems especially relevant when integration is accomplished via merger or acquisition. As noted in a recent issue of The Economist, “Managers are finding that, in practice, consolidation brings such nightmarish complexity that it often threatens to undo any costs savings or revenue synergies that the mergers might have achieved in the first place.”7 Such complexity, however, is not associated solely with consolidation. For example, it has been observed that long-established European universal banks consistently subsidize unprofitable activities, seem reluctant to out-source nonessential operations, and rarely excel or become innovative in any one sector. Many are said to operate with a “silo” mentality. These observations may explain why they achieve a lower return on equity than U.S. commercial banks, with some observers contending that no European investment banks are capable of competing with U.S institutions such as Morgan Stanley Dean Witter, Goldman Sachs, Bankers Trust, or J. P. Morgan (Kraus, 1998). The problem of complexity seems largely to be ignored at present. As reported in European Banker (1999), it is as if consolidation and being big were not just necessary but sufficient conditions for success in financial services. Again, this seems particularly true for Europe’s universal banks. In an examination of the annual reports of Europe’s 50 largest banks, Lafferty Business Research found only one bank that questioned whether merger and consolidation were the appropriate answers to the advent of the European Monetary Union. Banco Popular, perhaps prophetically, noted: “It is, to say the least, surprising that there should be such widespread and critical [sic] acceptance of this need, with no precise distinction between types of business and without meticulous

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analysis of the many drawbacks that these processes may involve and of the problematic nature of their purported advantages” (European Banker, 1999). Complexity (or perhaps just poor management) is evident in problems experienced by some of the world’s leading financial institutions. Consider the “rogue trader” at Barings, the world’s oldest and one of the most respected private banks; trading losses at Bankers Trust (which spurred its sale to Deutsche Bank), one of the world’s most respected banks; multi-million dollar market conduct settlements by Prudential, New York Life, Metropolitan, and many other U.S. life insurers, all highly respected firms; and property losses at Yamaichi, one of Tokyo’s largest stockbrokers. Corporate Cultures Corporate cultures vary across firms and across financial sectors and can lead to potentially crippling management problems. The investment bank corporate culture is one of entrepreneurship, risk taking, and incentive compensation. The commercial banking culture is one of relationship building, little risk, stability, and compensation schemes less related to performance. The insurance culture is bi-polar. Life insurance is associated with aggressiveness, marketing innovation, consultative selling, and incentive compensation. The nonlife insurance culture falls between that of life insurance and commercial banking. Nonlife products are largely demand pull, not demand push products like life insurance. These cultural differences pose challenges for management of financial conglomerates, especially those resulting from merger and acquisition (M&A). Indeed, one-half of all mergers and acquisitions are unsuccessful, with the most frequently cited reason for failure being cultural differences (Tuohy, 1999). Cultural differences seem less of an obstacle when integration is organic. Thus, a frequently reported difficulty with bancassurance is indifference by bank employees to insurance. They treat such products as sidelines or as too complex to sell within the traditional banking relationship (Higgins, 1999). Another dimension of corporate culture seems to be related to national differences in management dedication to shareholder value. Economists classify this as an agency problem. In a study touching on this issue, Lafferty Business Research found that European banks clustered around two distinct business approaches: focused banks and universal banks (European Banker, 1999). Lafferty concluded that focused banks operated within a culture of shareholder value, used internationally acceptable accounting standards, had a sharper focus

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on retail banking operations, and were consistently more profitable than the European average. Universal banks, in contrast, operated within a managerial culture, followed inferior accounting practices which prevented shareholders from gaining an accurate picture of the business, believed in universal banking as a concept, and were consistently less profitable than the focused banks. Focused banks tended to be found in the Netherlands, the Nordic countries, the U.K., and Ireland. Universal banks tended to be found in Austria, Finland, France, Germany, Italy, and Spain. The study noted that the boundary between the two groups was blurred, in constant movement, and rapidly losing its geographic consistency. For example, several banks in Spain were highly focused and the leading Swiss banks, formerly strong advocates of the universal concept, were moving to a more focused approach. The study further noted that virtually every bank in the study had formerly subscribed to the universal concept (European Banker, 1999). Inexperience/Lack of Expertise Admittedly not a problem for the long run, the lack of experience in managing an integrated financial services group can pose vexing short-term problems. This issue is particularly relevant in markets where financial integration has not existed formerly, either because of practice or regulatory prohibitions, such as in the U.S. and in many Asian countries. Financial conglomerates from other countries, particularly Europe, may have a competitive advantage over domestic financial institutions in such markets. Joint ventures and strategic alliances between domestic and experienced foreign firms may prove most appealing to both domestic and foreign entrants. Although foreign financial conglomerates have greater knowledge and insights into how to make integration work, local firms have a competitive advantage in understanding the local culture and in local relationships. Marketing/Distribution Issues Distribution issues can be among the most challenging for management of integrated financial institutions. Among the most troubling for financial conglomerates created via M&A has been how to deal with channel conflict. The concern, of course, is that marketing intermediaries, especially agents and brokers, that have been the primary distribution outlet for one of the formerly independent institutions face the possibility of disintermediation by new channels, such as a bank branches, direct response, or the internet.

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The situation of ING – the first large-scale merger of a bank and an insurer – offers an example. ING was formed in 1991 by the merger of the insurance group Nationale-Nederlanden (NN) and the banking group NMB-Postbank which was itself a result of a 1989 merger between two important Dutch banks. At the time, NN was the largest insurance group and NMB-Postbank was the third largest banking group in the Netherlands. In announcing the merger, NN indicated that it would design special insurance products to be sold through Postbank. Such products would compete with and be less expensive than those sold by NN’s army of independent agents, which accounted for some 85 percent of NN’s sales. Their agents promised a boycott. Only after agreeing to limit Postbank distribution to very simple products, such as travel accident insurance and certain types of annuities, was the boycott cancelled (Van den Berghe and Verweire, 1998). The channel conflict for ING has since eased, but remains a challenge for the group in the Dutch market, arguably causing the group to forgo some demand-side economies of scope. Channel conflict seems to be less of a management challenge for (1) de novo bancassurance operations (e.g., the creation of Deutsche Lebensversicherungs AG by Deutsche Bank and the creation of Predica by Credit Agricole), (2) integration that does not involve agents or brokers (e.g., USAA Life and USAA and Maybank Life and Maybank in Malaysia), and (3) integration in countries with less mature financial markets (e.g., the Philippines and Poland). Marketing issues are associated largely with demand-side economies of scope. As such, they usually are of greater concern with bancassurance integration than others, especially those related to investment, risk management, and other back office integration possibilities. Target Market Clarity Management must be clear about the group’s target market. History is littered with attempts at financial services integration that were unsuccessful largely because of ambiguity in this regard. For example, when Prudential acquired Bache many years ago, it was expected that Prudential – with its largely blue collar, lower middle-income target market – and Bache – with its largely white collar, upper income target market – would cross-market each other’s products. That the experiment failed is unsurprising, in retrospect. To date, most success in financial services integration has been in the retail market. Within the retail sector, greatest success has been with middle and lower-income markets.

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The affluent market seems largely to be the province of financial planners and independent agents and brokers. Indeed, some years ago it was predicted that bancassurers would capture one-third of the U.K life insurance market. Their share today is about one-eighth. Independent financial advisors, by contrast, now control more than one-half of the market, up from less than one-third a few years ago (O’Conner, 1999). These advisors have expanded their own product offerings; in effect, offering integration at the advisory level and blunting bank distribution. In selecting the target market, management will simultaneously be determining the classes of products to be offered. The emphasis might be on the retail market, the corporate market, or both. Different demographic, economic, and geographic emphasis will be taken with each broad market segment. Management will decide which asset accumulation, debt management, and asset protection products to manufacture and through which channels to distribute them. In this connection, an issue confronting all financial conglomerates is the extent to which it is better to manufacture the desired product or to market other institutions’ products through their distribution channels. Management of some financial conglomerates seemingly is concerned that some financial products carry the easy potential for creating diseconomies for scope. Property/casualty insurance is perhaps the most commonly discussed product line in this regard. An insightful story making the rounds is that of a superb banking customer taking her entire account elsewhere because the group’s insurer denied automobile insurance to her 17-year old son who had two speeding tickets. What is the anticipated effect on a good securities customer of being dissatisfied with a property insurance claim settlement? Many conglomerates have chosen to avoid the manufacture of property/casualty insurance for reasons of this type, with some not even making it available via marketing arrangements. Financial Management Issues For financial institutions and conglomerates interested in manufacturing their own products, financial management should be a core competency. Two areas of financial management seem to be particularly important: risk management and performance appraisal. Only in the past few years have risk management issues been addressed in anything resembling an integrated way by financial institutions. Even then, this has occurred chiefly within individual financial institutions, not across

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institutions within a group, with some notable exceptions. Moreover, the focus of risk management differs considerably based on sector and product line. Credit risk, interest rate risk, liquidity risk, operating risk, and foreign exchange risk vary greatly from line to line and even product to product within the same line.8 For example, interest rate risk for an investment bank ordinarily is far less important than it is for a life insurer. A challenge for management of financial conglomerates is, first, understanding the risk profile of the group as a whole rather than its parts in isolation. Second, management must develop risk management policies and techniques appropriate for the entirety of the group. If synergies are to be realized through integration, one would fully expect them to arise, among other places, through a holistic approach to measuring and managing risk. Related to holistic risk management is the issue of how best to appraise the financial performance of the entire group. Banks, insurers, and securities firms have used different techniques. Banks historically have focused on interest spread, with return on equity of more recent importance. Life insurers increasingly use embedded value analysis. Property/casualty insurers use combined ratios and return on equity. How are these diverse techniques to be reconciled (if at all) for the benefit of management and ultimately shareholders? Conflicts of Interest The potential for internal conflicts of interest (agency problems to the economist) is endemic to financial services integration.9 Conflicts of interest exist when incentives within the group do not align with the customer’s best interest. The major classes of conflicts of interest include the following: − Salesperson’s stake. It has been argued that when one financial institution within a conglomerate has the power to sell affiliates’ products, salespeople and managers are less likely to offer objective product advice to customers. Rather they will have a stake in pushing the conglomerate’s products, possibly to the disadvantage of the customer. − Stuffing fiduciary accounts. In underwriting securities, the investment operation of a financial conglomerate may seek to minimize a potential loss by “stuffing” the unwanted securities into customers’ accounts over which it has discretionary authority.

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− Bankruptcy-risk transfer. Because of its relationship with its commercial loan or commercial insurance customers, the group may secure private information that a customer’s bankruptcy risk has increased. The group may have an incentive to induce the firm to issue bonds or equities – underwritten by its securities operation – to an unsuspecting public. Proceeds could be used to reduce the bank loan, thus effectively transferring the bank’s credit risk outside the group, and earning fees or underwriting spreads. − Third-party loans. A conglomerate may have an incentive to make below-market loans to customers of its securities operation on the condition that the proceeds are used to purchase products sold by other units, such as securities or life insurance. − Tie-in sales. A bank could use the threat of withholding or rationing credit to coerce a customer into purchasing other conglomerate products, such as insurance or securities. − Internal information transfer. One unit of the conglomerate may secure material, private information about a customer that enables other units to charge higher prices than otherwise to that customer. (The result also could be lower prices.) For example, in underwriting a life insurance policy, the insurer might discover that the proposed insured had a substantial health problem. Information about this problem might influence a mortgage loan decision by the group’s bank. Irrespective of whether the customer might suffer harm, the important issue of the extent to which he or she should be able to control the flow of personally identifiable information within a financial conglomerate remains an important public policy (and, therefore, management) concern. Incentive conflicts are managed by rearranging the incentives to be more compatible with the desired result (a market solution) or through regulation. Most universal banking systems are said to rely on market incentives (Walter, 1997). The U.S. historically has relied more heavily on regulation, including “firewalls” between activities potentially giving rise to incentive conflicts. In general, conglomerates deal with potential conflicts of interest by seeking to instill a sense of professionalism and ethical conduct within salespeople and employees. Training, close supervision, and internal monitoring are essential. Further, the group’s reputation and competition act as disciplinary mechanisms. The value of future business (goodwill) is greatly affected by the group’s 116

market reputation (franchise), as recent market conduct and trading scandals have demonstrated. Preventing or mitigating the adverse effects of internal conflicts of interest is expensive. Training and monitoring systems are costly. Building internal firewalls or creating other substantial limitations on information sharing within the group can defeat the very reason for integration. Financial Services Integration Internationally It will prove insightful to compare and contrast markets in some of the major financial center. The focus will be on the national regulatory and political environments and on the extent and nature of financial services integration in each center. Overview of Regulation of Financial Conglomerates Internationally The regulation of financial institutions varies greatly in detail from country to country. This observation applies particularly to prudential regulation, although some harmonization has been achieved in banking through the Basle Accord. Some generalizations can be drawn, however, in the extent of financial activities that countries permit within a financial conglomerate and the overall mode of regulation. Permissible Activities. In a survey of 52 of the world’s major financial centers, the Institute of International Bankers (1999) found that the majority, especially the largest centers, permit financial conglomerates to undertake banking, insurance, and security activities. The survey does not speak to the important issue of consistency of prudential oversight across sectors. Also, it does not include the recent reforms in the U.S. Table 1 is a summary of the survey. It shows that the overwhelming majority of countries allow joint banking and securities activities, with many permitting banks to undertake securities activities within the bank itself. Several others require some or all securities activities to be undertaken through subsidiaries or affiliates. Of the countries surveyed, only China prohibits any joint undertakings.

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Table 1 Permissible Activities for Banking Organizations in Various Centers (1998)

Permitted Through the Same Legal Entity Argentina Australia Austria Bahrain 1 Belgium Bermuda Bolivia Cayman Islands Chile Czech Republic Denmark Estonia Finland France Germany Hong Kong 1 Italy Latvia Luxembourg The Netherlands Nigeria Norway Pakistan 1 Portugal Russia Singapore South Africa Spain Sweden Switzerland Turkey

Securities Insurance Permitted Through Not Permitted Not Permitted Subsidiaries or Permitted Affiliates Only Brazil China Argentina 2 Bahrain 2 Canada Australia China Colombia Austria 2 Colombia Egypt Belgium 2 India Greece Bermuda 2 Israel India Bolivia 2 Japan 2 Indonesia Brazil Pakistan Ireland Canada 2 Panama Israel Cayman Islands Peru Japan Chile 3 Russia 2 Korea Czech Republic United States1 Mexico Denmark 2 New Zealand Egypt 2 Panama Estonia 2 Peru Finland 3 Philippines France 2 Poland Germany 2 Romania Greece 1 United Kingdom Hong Kong 1 United States Indonesia 2 Ireland 2 Italy 1 Korea 2 Latvia 2 Luxembourg 2 Mexico 2 The Netherlands 2 New Zealand 2 Nigeria 2 Norway 2 Philippines 2 Poland Portugal 2 Romania 1 Singapore2

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Securities Permitted Through Permitted Through Not the Same Legal Subsidiaries or Permitted Entity Affiliates Only

Insurance Permitted Not Permitted

South Africa 1 Spain 2 Sweden Switzerland 2 Turkey 1 United Kingdom 2 1 With limits. 2 Through subsidiaries or affiliates only. 3

Brokerage or agency only.

The situation with regards to insurance is somewhat different. Although the information source is not completely clear, it appears that few, if any, countries generally permit insurance underwriting within a bank. The majority allows joint arrangements, but through subsidiaries or affiliates. Several countries prohibit any affiliation between insurance and banking, with a few others prohibiting banks from owning insurers but allowing them to act as agents or brokers for unaffiliated insurers. Structure of Regulatory Authority. The majority of countries regulate financial conglomerates on a functional basis; that is, banking and insurance (and often securities also) oversight are separate, with each sector having its own regulator. Several countries with functional regulation, however, establish a lead regulator for conglomerates, based on its principal activity. Thus, if a conglomerate’s main activity is commercial banking, the bank regulator is the lead regulator. He or she is responsible for overseeing the entire group’s operation and ensuring coordination of responses among functional supervisors. This does not mean that the lead regulator usurps the power of other regulators, however. An important trend during the past few years is the implementation of consolidated financial services regulation within several countries. For example, new regulatory agencies with responsibilities for consolidated oversight of banks and other financial institutions have recently been established in Australia, Korea, Japan, Singapore, and the U.K. Canada, Denmark, Norway, and Sweden have had consolidated regulation for several years. Plans for the creation of such an agency are underway in Estonia, and the Netherlands has decided to establish a Council of Financial Supervisors consisting of supervisors of the banking, insurance, and securities sectors. There is as yet no international consensus on consolidated or some variation of functional regulation. Table 2 summarizes the regulatory approaches of several major financial centers (Institute of International Bankers, 1999). 119

Table 2 Regulation of Financial Conglomerates (1998) Single Regulator Oversees Activities of Financial Conglomerates as a Whole Australia Bolivia Canada1 Cayman Islands Columbia Denmark Japan Norway Peru Singapore Sweden United Kingdom

Identity of the Lead Regulator for a Financial Conglomerate Determined on the Basis of the Financial Conglomerate’s Principal Activity Argentina2 Austria Belgium Chile Estonia3 Greece Ireland Israel Latvia4 Philippines5 Spain United States6 Venezuela

Financial Conglomerates Operate without a Single or Lead Regulator

Czech Republic Finland France Germany Hong Kong Italy Luxembourg Netherlands Panama7 Poland Portugal Romania South Africa Switzerland Turkey Uruguay8

1. The Office of the Superintendent of Financial Services oversees the operations of financial conglomerates at the federal level. Certain companies within a financial conglomerate (e.g., securities firms and insurance companies) may also be subject to supervision by provincial authorities. 2. Only financial conglomerates headed by banks are subject to consolidated regulation. 3. The Central Bank is the lead regulator of financial conglomerates that include banks. Financial conglomerates that do not include banks do not have a lead regulator. 4. Effective January l, l999, but only with respect to conglomerates headed by credit institutions. 5. The Central Bank has supervisory authority over banks and their subsidiaries and affiliates, as well as nonbank financial institutions with quasi-banking or trust authority. The Office of the Insurance Commissioner supervises insurance companies that are subsidiaries or affiliates of banks. Nonbank financial institutions that are subsidiaries and affiliates of banks and other financial institutions where their charter provides that they will be under the Central Bank’s supervision are regulated jointly by the Central Bank and the Securities and Exchange Commission (SEC). The SEC regulates other nonbank financial institutions that do not fall under these classifications. 6. Financial conglomerates that include banks are regulated at the holding company level by the Federal Reserve. Nonbank financial conglomerates (i.e., those comprised of only nonbank financial institutions such as securities firms, insurance companies, and commercial finance companies) are not regulated at the group level, although the Securities and Exchange Commission requires registered broker-dealers to file with it quarterly risk assessment reports regarding their material affiliates. Banks may affiliate with securities firms and insurance companies. 7. Only financial conglomerates that include banks are regulated on a group-wide basis. 8 . The Central Bank regulates separate companies within a financial conglomerate (e.g. banks, insurance companies, investment fund managers, and pension fund managers) but not the group as a whole.

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Other Governmental Actions Affecting Financial Services Integration. Other governmental actions, not explicitly aimed at financial services integration are, nonetheless, having or promise to have potentially important effects on integration. Thus, the trend towards allowing mutual insurers and banks to convert to shareholder-owned firms opens up new opportunities for financial conglomeration. Demutualization has been particularly important in Australia, Canada, South Africa, the U.K., and the U.S. Privatization of banks and insurers in several countries continues similarly to create opportunities. Privatizations have recently occurred or are occurring in Belgium, the Czech Republic, Finland, France, Israel, Norway, Peru, Poland, Turkey, and Venezuela. Significant combinations of banks and insurance companies occurred recently in Denmark, Norway, Switzerland, and the U.S., while consolidation of domestic banks, insurers, and securities firms continues in many countries. Foreign financial institutions developed, expanded, or were given new authority to develop or expand their presence in other countries such as Canada, China, Poland, and Singapore, with the most significant recent cross-border transaction being Deutsche Bank’s acquisition of Bankers Trust in the U.S. Asia-Pacific Region Except for Australia, financial services integration in the Asia-Pacific region is at an early stage. With recent liberalization and deregulation efforts, many spurred by the Asian economic crisis, we can expect accelerated integration in several markets, particularly in Japan, Korea, and Singapore. Here we examine briefly two of the region’s most important markets. Australia. The Australian financial services market, in some ways, might offer other markets a glimpse into the future of financial services integration. The Australian market is comparatively small but sophisticated. It is dominated by financial conglomerates. The Regulatory and Political Environment. Australian experience with financial integration and, thus, regulation dates back several decades. The government has never prohibited the creation of financial conglomerates. Its approach to their regulation, however, has changed dramatically. Until 1998, financial institutions were regulated on a functional basis. The Reserve Bank of Australia (RBA) was responsible for banking supervision, the Insurance and Superannuation Commission (ISC) was responsible for

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supervision of insurance and superannuation (retirement) firms, the Australian Financial Institutions Commission (AFIC) regulated various non-bank depository institutions, and the Australian Securities Commission oversaw securities firms, mutual funds, and finance companies. In 1992, in response to concern about appropriate oversight of financial conglomerates, the Council of Financial Supervisors, composed of the four major regulators, was established. The Council was to facilitate informal cooperation among the functional regulators, but with no one regulator having a lead role. As the market witnessed continued product innovation and integration, perceived shortcomings of functional regulation emerged as firms engaged in regulatory arbitrage. In response, in 1998, the functional regulatory system was abandoned in favor of consolidated regulation under the auspices of the Australian Prudential Regulation Authority (APRA). Prudential supervision formerly handled by the RBA, ISC, and the AFIC became the APRA’s responsibility. The APRA regulates both solo financial institutions and financial conglomerates, Separate from the APRA, the Australian Securities and Investment Commission is responsible for corporate and securities regulation, consumer protection, and market integrity issues. It combines the functions of the former Australian Securities Commission with consumer protection functions of other regulators. The Council continues in a modified role to facilitate regulatory coordination. Extent and Nature of Financial Services Integration. Bain and Harper (1999) observe that “the decades of the 1980s and 1990s have been amongst the most eventful in Australian financial history – rivaled only by the financial crises of the 1890s and the Great Depression of the 1930s.” Australia began aggressively deregulating its financial services market in the 1980s, and continued throughout the 1990s. As is often the situation, the market led; financial services integration pushed governmental reform. The Australian financial services market today is among the world’s most sophisticated. Financial conglomerates account for 80 percent of total financial system assets. The 10 largest conglomerates hold one-half of Australian financial system assets. Financial conglomerates typically offer a full range of financial services and products. For example, the four major banks in Australia operate as conglomerates in all areas of commercial and investment banking, in life and nonlife insurance, and in pensions (Bain and Harper, 1999).

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Financial integration is deeper than an examination of market shares might suggest. Several conglomerates have moved aggressively to acquire or create firms to be able to offer a wide range of financial products and advice and to offer them through multiple distribution channels. Integration via distribution might be among the most advanced in the world. At the same time, with ever more sophisticated customers, competition has driven down distribution costs substantially, especially in life insurance. Traditional life insurance products continue to fade from the market, replaced by variable (unit linked) products with low sales loads. Less visible is the integration occurring at the operational and production level. Managerial orientation and control functions increasingly are at the group rather than the sectoral level. Business operations and activities increasingly deviate from a pure alignment with legal structure. Both trends are consistent with the fully integrated model. Japan. Japan is home to many of the world’s largest financial institutions, a deliberate result of past government policy to create a small number of very large financial firms. These firms, unfortunately, are today among the developed world’s least profitable and most poorly capitalized. The Political and Regulatory Environment. The Japanese government’s position on the regulation and structure of its financial services market has undergone a major shift over the past few years. Formerly, the view was that market access should be limited, competition should be circumscribed, and administrative guidance offered by government officials should be welcomed (and followed) by businesses. Additionally, the keiretsu system of cross shareholdings and other inter-corporate linkages was considered stabilizing and good for the national economy. It is now generally believed that these market-constricting views and practices contributed to overvalued stock and land prices, the former plummeting 10 years ago and the latter eight years ago. Economic recession and stagnation ensured. Neither the Japanese economy nor its financial institutions have yet recovered fully, although some encouraging signs have recently emerged.10 Market Reforms. In 1997, the government undertook several deregulation initiatives in response to recommendations from its Financial System Research Council and others. The most significant changes, however, occurred in 1998 when Japan moved to consolidated regulation. Formerly, Japan’s regulation of financial institutions was on a functional basis within the Ministry of Finance

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(MOF). Effective June l998, the bank and securities supervisory functions of the MOF were transferred to a new Financial Supervisory Agency (FSA). Additionally, in March l998, a law lifting the ban on the establishment of holding companies took effect. Under this law, two different types of financial conglomerates are possible: (1) banks, securities companies, and insurance companies may own subsidiaries engaged in other financial services or affiliated businesses and (2) financial holding companies. Although bank holding companies are not allowed to own commercial entities, the other forms of holding companies can be affiliated with non-financial companies. Also in 1998, other financial reform laws were enacted. This legislation included the comprehensive Financial System Reform Law that provided a means of moving forward with earlier enacted reforms. Some of the important features of the Law are as follows: − introduced mutual funds and privately-placed investment trusts − permitted sales of investment trusts directly by banks − allowed securities companies to undertake other activities − eliminated restrictions on the permissible activities of bankaffiliated securities subsidiaries − allowed affiliations insurance businesses

among

banking,

securities,

and

− established a framework for consolidated disclosure − formulated and expanded fair trading rules − expanded regulations on the conducts of securities companies and other institutions − expanded disclosure requirements of financial institutions. Financial Failures and Scandals. Japan has seen a series of financial institution failures. Four major firms failed in 1997. Sanyo Securities, one of the secondtier brokerage firms, suspended part of its operations and filed for protection under the Corporate Reorganization Law. The Hokkaido Takushoku Bank, one of the smallest “city banks,” failed because of cash-flow problems. Nissan 124

Mutual, a life insurer within the Nissan keiretsu, became the first insurer in modern Japanese history to fail. Finally, Yamaichi Securities, one of Japan’s big four brokerage firms, decided to undergo voluntary liquidation after suffering during the long stock market slump and investigation for illegal payoffs and illegally concealed losses. During 1998, the government took action against several firms. Long Term Credit Bank of Japan and the Nippon Credit Bank were found to be insolvent and taken over by the government. The Kokumin Bank, the Kofuku Bank, and the Tokyo Sowa Bank were taken over by the government for reorganization. The latter two banks were also subject to the first-ever order for prompt corrective actions. The problems experienced in the financial sector prompted legislation to amend the Deposit Insurance Act, as well as additional legislation regarding emergency actions for financial system stabilization. The law enables the use of up to ¥30 trillion in public funds for the protection of depositors and the stabilization of the financial system. To date, some ¥7.46 trillion has been injected into 15 large banks, a sum equivalent to one-half of their equity (Survey of International Banking, 1999). In applying for public funds, the financial institutions submit plans to streamline their businesses. Japan has also suffered from several financial scandals. In 1997, the MOF imposed administrative punishments on Nomura Securities and Daiichi Kangyo Bank for making illegal payoffs. The Ministry also imposed administrative punishments on Nikko Securities and Daiwa Securities for related payoff scandals. Further administrative sanctions were imposed on Nikko for additional violations in 1998. Additional scandals hit the government itself within the MOF and the Bank of Japan. Extent and Nature of Financial Services Integration. Before the recent reforms, financial conglomerates were illegal in Japan. Consequently, Japan has one of the least integrated financial sectors of any developed country. In light of the comparatively weak financial condition of so many Japanese financial institutions, consolidation would have been the expected reaction, yet Japan has only recently begun to experience consolidation. This delayed reaction is attributable to several factors. The complexity and inherent conflicts of interest in trying to deal with the numerous interconnections in kieretsu relationships are enormous. Virtually every major bank and insurer is involved in such a relationship. Additionally, requirements for consolidation run counter to the Japanese cultural propensity to avoid direct conflict, including the termination of employees. 125

Even so, the pressures for action seem at last to have become too great. Consolidation seems to be a 1999 hallmark. In response to recent spate of merger announcements, The Economist (November 6, 1999, p. 71) remarked: Besides the odd bankruptcy, nothing had changed in Japan’s financial industry for so long that the big firms seemed like fixed constellations: 20 “major” banks, 20 fullservice life insurers, [and] four big securities brokers. Suddenly, a handful of groups remain – and the mergers are not over yet. The mergers announced in 1999 and 2000 include the following: − Dai-Ichi Kangyo, Fuji, and Industrial Bank of Japan (IBJ) – forming the world’s largest banking group with combined assets of ¥141 trillion. IBJ would focus primarily an investment banking, with the other two partners bringing strong retail banking expertise, making the first Japanese universal bank. − Sanwa Bank, Tokai Bank, and Asahi Bank with combined assets of more than ¥100 trillion, creating the world’s third largest bank. − Sumitomo Bank and Sakura Bank with combined assets of ¥98.7 trillion. − Mitsui Trust and Chuo Trust with combined assets of ¥14.7 trillion. − Mitsui Marine and Fire, Nippon Fire and Marine, and Koa Fire and Marine with combined assets of ¥6.1 trillion (The Economist, November 6, 1999, p. 71) Other consolidation has occurred among smaller trust companies and banks, usually at the insistence of the FSA. The above announcements make an important statement to other Japanese financial institutions – and no doubt pose a competitive threat. Consolidation is occurring also via joint ventures. Nikko Securities and the Travelers Group established a joint venture brokerage firm, Nikko Salomon Smith Barney, Inc. as of March 1, 1999. This firm will specialize in wholesale securities, while Nikko itself concentrates in the domestic retail market.

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Additionally, on April 5, 1999, Daiwa Securities SB Capital Markets Co. Ltd., a wholesale brokerage collaboration between Sumitomo Bank and Daiwa Securities, opened it doors for business. Shortly thereafter, Daiwa spun off its business divisions as independent companies and reorganized itself to become Daiwa Securities Group, Inc., Japan’s first financial holding company. Neither consolidation nor integration will come easy for Japan’s big life insurers. The largest Japanese insurers are mutual life companies. M&A discussions are purportedly taking place among some of them and between them and banks and trust companies. Mergers of the life companies with other life insurers and with firms from other sectors would require demutualization. No Japanese insurer has initiated demutualization, although several are said to have it under active consideration. Most trust companies in Japan are in financial trouble. Their investment management business, however, makes them attractive M&A targets given the rapidly growing private pensions business in Japan. The Japanese financial services market is not renown for financial or product innovation, exceptional service to customers, low prices, or great product choice. In short, the market offers much room for improvement and, therefore, great opportunities, especially for foreign firms more accustomed to competitive markets. On balance, therefore, Japanese financial institutions seem to be at the very beginning of meaningful change and integration. Neither bancassurance nor universal banks exist at present, but opportunities for financial conglomeration seem abundant. Unlike U.S. and U.K. or even continental European structural reform, true structural reform of Japan’s financial services sector likely will prove painful and perhaps slow, given its cultural and historical traditions. Success will depend to a greater degree than in other markets on the extent to which the new FSA is able to maintain its arms-length position as independent regulator while ensuring the existence of a competitive environment. Europe The observations on the European financial services scene will be limited to the 15- member European Union and, within the EU, to selected countries. Of course, the EU single market in financial services continues to evolve, built on the principles of minimum regulatory harmonization of essential elements, home country control, and mutual recognition. Directives issued by the European Commission (EC) are the mechanism by which the single market is created. These directives are implemented through enactment of equivalent national law.

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No directives oriented explicitly toward financial conglomerates have been issued, although some have dealt with various combinations (e.g., securities and banking). Financial conglomeration has been identified as a priority for the Commission (Thom, 1999). This failure to promulgate broadly applicable directives, however, has not impaired European financial services integration, as no EU country’s laws or regulations prohibit integration. Moreover, those directives addressing consolidated supervision and capital adequacy of combined securities and banking activities effectively address the majority of European conglomerates, as most do not include insurance activities. The EC’s series of directives dealing with banking, insurance, investment services, information sharing, and cross-border mutual funds collectively have provided a framework for integration. Thus, the Second Banking Directive permits an EU-based bank to engage in securities activities anywhere in the EU to the extent permitted by the institution’s home country. All EU member states permit both banking and securities activities within a financial conglomerate and most permit them within a single legal entity. Life and non-life insurance generally must be undertaken within separate corporations, although this can be within a single financial group. The mature EU financial services markets are experiencing the same types of competitive pressures as found in the other mature markets. As a consequence, we see considerable consolidation, along with integration. Integration is advanced in Europe. The creation of the European Monetary Union has provided additional impetus. We now examine five EU markets in more detail. They are France, Germany, the Netherlands, Spain, and the U.K.11 France. Several French financial service institutions are among the most integrated in the world. France, as with other mature European financial markets, continues to witness substantial consolidation. The Regulatory and Political Environment. The introduction of the single market program has had a profound effect on French financial services regulation. Formerly, the French regulatory scene could be characterized as one of gentle competition, protected by a paternal state. State-owned institutions dominated the financial services market. All have now been privatized. Price and product competition is now encouraged. The 1996 acquisition of UAP by AXA and the more recent hostile takeover of the investment bank Paribas by Banque Nationale de Paris (BNP) and the failure of BNP to secure a majority in Société Générale highlight a changed

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competitive environment in France. Financial institutions believe that they must be large if they are to compete successfully in the European single market and internationally. Consolidation also reflects a desire of the major banking institutions to cross-sell products. At the same time, the difficulties in achieving a single market in financial services in Europe are highlighted by these actions. That non-French interests were unwelcome in this play was clear.12 France permits securities activities within commercial banks but requires separately capitalized legal entities for insurers. Regulation is on a functional basis. There are no specific regulations on supervision of financial conglomerates, although recent proposals would strengthen cooperation between supervisors. If the parent company within a conglomerate is not a bank or an insurer, there is no specific authority to supervise the group on the basis of the holding company. Extent and Nature of Financial Services Integration. The securities business in France is growing but remains below that found in several other mature economies. Some French banks specialize in merchant banking, competing with the subsidiaries of foreign banks. Some commercial banks offer investment banking services, either internally or through subsidiaries. Banks’ share of the life insurance market has grown dramatically since the 1980s, and some banks have recently begun selling nonlife insurance. Most French banks have either marketing agreements with unaffiliated life insurers or cross shareholdings with life insurers. The French star of bancassurance, Predica, was established in 1986 by Crédit Agricole. Predica and other bank-owned insurers specialized in sales of bons de capitalisation contracts. These tax-favored life policies contain little pure life insurance protection, being mostly savings contracts. (They would not qualify for life insurance under U.S. tax law.) As simple contracts, they were easy for bank employees to understand and to explain to customers. The most striking aspect of French bancassurance is the substantial market share banks achieved in a relatively short period. By 1998, banks accounted for 61 percent of total life premiums and 63 percent of new premium production in France (Daniel, 1999). A major factor for French bancassurance success has been the substantial savings in distribution expense in comparison with those insurers using traditional distribution channels.

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This success is said to stem also from inherent weaknesses in the insurance industry (Genetay and Molyneux, 1998, p. 79). The French insurance industry has been characterized as relying too heavily on compulsory insurance and suffering from a lack of competition. General agents are said to have exerted a virtual monopoly on the distribution of insurance products until the 1980s. The dispersion and generally low level of qualifications of agents contributed to the uncompetitive nature of the industry. Agents lobbying to protect their privileged position met with little success. As a result of the entry of banks into the insurance market, the number of agents has fallen by about 50 percent. Although the trend towards savings-oriented life assurance products is observable within other European countries such as the U.K. (with the development of endowment and unit-linked policies), it has been most significant in France. The tax-advantageous feature of these endowment policies has made the product attractive to customers and their simplicity has necessitated little training of bank staff. In addition to selling simple, tax-favored contracts, another factor in French bancassurance development has been the authorities’ implicit encouragement of the strategy. Formerly, the state had a substantial stake in leading French banks and insurance companies. The state encouraged bank entry into insurance because, among other reasons, banks were in need of new sources of cash flows to boost low capital bases and poor performance. Finally, competition has driven financial integration in France. The French insurance market’s past lack of competitiveness played a significant role in promoting integration by allowing banks to capture unprotected market shares. Banks, by contrast, operated in a more competitive environment. This meant that, as more banks embarked on insurance linkages, insurers and other banks believed that they too had to offer a wider range of financial products if they were to compete successfully. Ease of entry into the life insurance market convinced banks that insurance distribution was an effective way to utilize expensive branch networks to cross-sell a variety of products. Germany. The German financial services market is recognized for its financial soundness and is reasonably well developed. Although changing because of the EU single market program, competition historically been circumscribed in favor of “stability.” The Regulatory and Political Environment. Germany has long permitted the conduct of commercial and investment banking activities within a single legal entity. Indeed, this joint production more or less defines a German universal

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bank. Banks may also produce insurance but only through separately capitalized insurance subsidiaries. Banks are subject to regulatory oversight by the Bundesaufsichtsamt für das Kreditwesen – the Federal Bank Supervisory Office (FBSO) – in cooperation with the Deutsche Bundesbank. – the central bank. Before the creation of the European Central Bank, the Bundesbank was responsible for national monetary policy. Its focus today is more on systemic risks. The FBSO is responsible for regulation of commercial and investment banking activities. Insurance is subject to regulation by the Bundesaufsichtsamt für das Versicherungswesen – the Federal Supervisory Authority for Private Insurance (BAV). Financial conglomerates with non-financial holding companies are permitted. There is no consolidated regulation in Germany and no sectoral supervisor is charged with a lead role. A nonbank which, as a holding company, owns a bank or investment firm is required, however, to report to the FBSO. The FBSO can prevent the parent from exercising its voting rights if regulatory violations are found. Three important characteristics of the German financial services sector should be noted. First, under the Hausbank system, German businesses place heavy reliance on one main bank to be the prime supplier of all forms of financing (Saunders and Walter, 1994, p. 91). The bank is deeply involved in such customers’ business affairs, with the relationship expected to last for many years. With deregulation and liberalization, this system of mutual loyalties, however, is eroding. Second, German banks and insurers often hold substantial ownership interest in non-bank businesses. As a corollary, they also often hold positions on the supervisory boards of these companies. This too is eroding. Third, German banks hold proxies to vote the large portfolios of shares held through their trust operations. This gives German banks a degree of control over industrial enterprises that is several times larger than their proportionate share ownership (Saunders and Walter, 1994, p. 92). These characteristics give large German financial institutions and large German industrial corporations a type of alliance. Universal banking has fostered these alliances, but not without important public policy questions having been raised. Three issues have been identified:

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Banks are perceived to possess excessive economic power, which they can potentially use for their own gain at the expense of the public interest. Domestic capital markets are perceived to be relatively inefficient. German financial technology has been viewed as uncreative and poorly developed, especially in relation to the U.K. and U.S. A discussion of these issues is beyond the scope of this paper, but the market itself seems to be rectifying these concerns. Already, German financial institutions have reduced their ownership of shares in industrial firms. German capital markets, not well developed in comparison to those of the U.S., the U.K., the Netherlands, or France, have begun to liberalize. The EU single market program perhaps gets credit for bringing about greater competition and fewer inter-corporate linkages. Extent and Nature of Financial Services Integration. Germany’s four largest banking groups are Deutsche Bank, Hypo Vereinsbank, Westdeutsche Landesbank, and Dresdner Bank. Until last year, Dresdner was second largest, being displaced when two Bavarian banks merged. Allianz is easily the largest German insurer, with the Munich Reinsurance Company second. Deutsche Bank’s securities operations represent the largest German play in that market. The German financial services market is in a state of flux. As reported by The Economist (October 16, 1999), “these are uncomfortable times for Germany’s banking behemoths.” They have lagged behind other markets in consolidating, with the recently failed takeover of Dresdner Bank by Deutsche Bank seeming to confirm market difficulties. Low profitability continues to plague German financial firms, although the acquisition of Bankers Trust by Deutsche Bank is seem by many observers as an important move by Germany’s largest financial institution. The recent sale by Deutsche Bank of almost a quarter of its holdings in Allianz is further evidence of change in the German market. As suggested above, investment and commercial banking in Germany has been integrated for many years. Allfinanz is of more recent origin and is considerably less developed than in other European countries, although the concept dates back to the beginning of the century (Genetay and Molyneux, 1998, p. 80.) Most German ventures in allfinanz have been via cooperative arrangements such as strategic alliances rather than acquisition or de novo entry. In most

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instances, the bank is the senior partner but not invariably so. Deutsche Bank was the first German bank to establish a life insurance company on a significant scale when it launched DB Leben in 1989. Prior to the launch, 4,000 employees underwent extensive training. DB Leben is now among the top 15 insurers. Despite claims that Deutsche Bank’s management was committed to a go-alone strategy in insurance, it bought 65 percent of Deutsche Herold in 1993 and transferred its insurance operations to Herold. Deutsche Bank now relies on bank branch sales as well as Herold’s 15,000-strong sales force, and its wide range of life and nonlife insurance products. Dresdner Bank has long operated a strategy of marketing insurance products of selected insurers. Its entry strategy has been one of regional cooperation with the insurance sector, a fact that perhaps can be explained by the 25 percent stake of Allianz in the bank. The privileged relationship between the bank and the insurer has meant that Allianz is one of the principal partners of the bank The German financial services market has not experienced the same degree of integration as in other European countries, with the exception of commercial and investment banking. Even here, operations cannot always be regarded as fully integrated, with complaints of inefficient cross subsidization and management conflicts. While most banks have marketing agreements with insurers (and possibly some cross-shareholdings with them), it is said that the conservative nature of the German insurance market and regulation has hindered full integration (Genetay and Molyneux, 1998, p. 82). This conservatism made it difficult for German banks to profitably distribute insurance products. Moreover, the tradition of extensive cross-shareholdings within the financial industry has meant that banks chose to collaborate with insurance companies rather than develop their own in-house expertise. The Netherlands. Consistent with the long Dutch tradition of promoting international trade, the Netherlands is home to some of the most international and most integrated financial firms in the world. The Regulatory and Political Environment. The Netherlands has a history of offering a political and regulatory environment in which financial markets and institutions could flourish and prosper. Changes in the law in 1989 permitted full cross ownership within the financial services sectors. Supervisory responsibility for banks is held by De Nederlandsche Bank, the central bank. Insurance is regulated by the Verzekeringskamer – the InsuranceSupervisory Authority – and the securities sector (including the stock exchange and the derivatives exchanges) is subject to oversight by theStichting

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Toezicht Effectenverkeer – the Securities Board. Thus, the Netherlands has functional regulation but with oversight ofsome cross sectoral aspects of financial supervision being coordinated by the recently established Council of Financial Supervisors. The Council is composed of supervisors from the banking sector, the insurance sector, and the securities sector. The Council deals primarily with cross sectoral supervisory issues such as conglomerates, fitness and propriety of managers of financial “Chinese walls” within conglomerates and electronic commerce within the financial sector. Dutch banks may offer commercial and investment banking services within a single entity, and most do so. Insurance may also be offered, but it must be through a separately capitalized insurance subsidiary. Extent and Nature of Financial Services Integration. The Netherlands is home to some of the world’s most integrated and international financial services firms. At the same time, the domestic financial services market is quite concentrated, in part because of its relatively small size. Concentration resulted to a great extent from sectoral and cross-sectoral consolidations that have taken place over the past decade. The largest Dutch financial conglomerates market a full range of financial services. These firms include ABN-Amro, ING, Rabobank, and Fortis. All but Rabobank have major international banking and insurance operations. Aegon is the only major Dutch group that has eschewed moving into fully integrated financial services, preferring to focus chiefly in insurance. Rabobank is a cooperative bank that also serves as the central bank for Dutch cooperative banks. Its insurance subsidiary, Interpolis, offers products through its 800 member banks. Both life and nonlife products are offered. Rabobank also has an alliance with Robeco, the largest independent European fund manager. The three entities (Rabobank, Interpolis, and Robeco) have developed joint investment, savings, and insurance products. The Rabobank-Interpolis link in 1989 is said to have marked the beginning of an era of consolidation in the Dutch financial services industry. The next major consolidation took place in 1990 with the merger of savings bank VSB and AMEV, a large insurer that soon thereafter merged with the Belgian insurer AG, forming the Fortis Group. In 1996, the group acquired MeesPierson, an investment banking firm. The ING Group resulted from the merger in 1991 between the then largest insurer, Nationale-Nederlanden, and the third largest bank, NMB Postbank.

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Despite the high publicity surrounding this merger, the process was not smooth, as noted earlier. Only after agreeing to sell only specialized products through the bank was an agent boycott lifted. Since then, the group has announced plans to offer insurance through multiple distribution channels, including its Dutch banking operations. Early difficulties apart, ING has become the largest financial services provider in the Netherlands. In 1994, it reorganized its operations to further integration. One of the most important moves was to create a single Executive Board, rather than separate ones for the banking and insurance activities. The new structure involved creation of four business units: ING Financial Services International, ING Asset Management, ING Corporate and Capital Markets, and ING Nederland. The corporate legal structure, because of regulatory requirements, was unchanged. Other factors in ING’s development include its acquisition of the Belgium banking firm Banque Bruxelles Lambert, its perhaps most famous acquisition of the failed U.K. merchant bank, Barings and several insurance companies in the US. ABN Amro is the result of the merger of the two largest banks in the country, in 1990. It launched a subsidiary insurer, ABN Amro Levensverzekering, in 1993. ABN Amro’s strategy has been to expand abroad. Today, a handful of large financial conglomerates controls virtually the entire national market. Nonetheless, the market seems reasonably well served. For example, mutual fund and equity purchases are among the highest and the fees among the lowest in Europe. Spain. The Spanish financial services market is evolving rapidly. While not as sophisticated as many other EU markets, it is considered to be among the most promising and interesting. The Regulatory and Political Environment. Spain has functional regulation, but with provision for a lead regulator in the case of financial conglomerates. Banks are supervised by the Bank of Spain and securities dealers are supervised by the Spanish Securities and Exchange Commission. Insurance oversight is by the Directorate-General of Insurance. Nothing in Spanish law prohibits a financial group from being composed of firms in each of the three major sectors. Banks may engage in both commercial and investment banking within the same or separate legal entities. Insurance operations must be conducted in a separately capitalized subsidiary.

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The law provides that a financial conglomerate’s lead regulator will be determined by the group’s dominant entity. Thus, if the dominant entity is a bank, the supervisory body is the Bank of Spain; if the dominant entity is a securities dealer, the supervisory body is the Spanish Securities and Exchange Commission. If the dominant entity belongs to neither of these two sectors, the supervisory body will be that which corresponds to the group’s leading activity. Extent and Nature of Financial Integration. The investment banking business is growing but remains small in comparison with its relative importance in more advanced European economies. Nonlife insurance has historically been more prominent than life insurance but this is changing, especially as banks have moved aggressively into life insurance marketing. For 1998, banks accounted for an estimated 75 percent of new life premiums. The rapid growth of the Spanish life and pensions markets was due in part to the introduction during the mid-1980s of single-premium policies that were free of withholding tax and structured as bearer instruments. Euroseguros, the wholly owned insurance subsidiary of Banco Bilbao Vizcaya (BBV), benefited from this activity, but the eventual demise of the instruments did not halt the growth of the company or bank marketed insurance generally. In 1992, BBV joined with AXA Seguros which accounts for about 4 percent of Spain’s life premiums. La Caixa, Spain’s largest savings bank, set up an insurance subsidiary Vida Caixa in 1988. The venture experienced strong growth. A holding company, CALIFOR, was formed jointly by La Caixa and Fortis (the Dutch group) in 1992. CALIFOR holds 80 percent of Vida Caixa with La Caixa retaining the balance. Vida Caixa distributes policies through La Caixa’s branch network and two agency networks, accounting for somewhat less than 4 percent of the total life market in Spain. Corporation Mapfre, Spain’s largest insurer, offers an example of an insurer acquiring a bank, rather than the more common reverse approach. In 1989, Mapfre acquired Inverbank, the next year using it to create Banco Mapfre. Banco Mapfre contributes only modestly to Mapfre’s overall profits, but growth is reported to be strong. The Spanish financial services market has achieved impressive growth and development, mainly because it was relatively underdeveloped. This low level of development, coupled with an orderly deregulation and liberalization process associated with Spain’s membership in the EU, provided unique opportunities for financial institutional growth and integration. That Spanish banks already

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had long-standing ties with insurance companies facilitated product crossselling. Banks have recently been the prime movers in introducing variable products, thus combining insurance and securities. Another feature of the market has been the entry of foreign companies, including Met Life, Generali, Allianz, and Winterthur. The net result of these forces is that the Spanish financial services market has become quite competitive. United Kingdom. The U.K. is one of the world’s most sophisticated, competitive financial services markets. It is known for its financial innovations, facilitated by a historically liberal economic and political environment. The Regulatory and Political Environment. The U.K. regulatory environment has been described as “ . . . among the world’s most well structured and carefully thought through, in a serious and relatively unpoliticized effort to balance safety and soundness with static and dynamic efficiency as a matter of the national interest” (Saunders and Walter, 1994, p. 117). Regulation in the U.K. has historically been heavily focused on prudential measures. Many observers attribute the great success of U.K. banks and insurers internationally to the government’s regulatory approach that permitted innovation and entrepreneurship. The U.K. has long permitted financial conglomerates, although with functional regulation and some limitations on ownership interests, especially for building societies. Securities and insurance activities must be conducted in separately capitalized subsidiaries. The U.K. has moved to consolidated regulation of its financial services institutions.13 The process was initiated in May 1997. In October 1997, the Securities and Investment Board, the U.K.’s then leading financial services regulator, changed its name to the Financial Services Authority (FSA) in preparation for the consolidation. Responsibility for banking regulation was transferred from the Bank of England to the FSA in 1998. Oversight for other financial institutions and activities, including insurance, was transferred in 1999. With the expected enactment in 2000 of the Financial Services and Markets Bill (FSMB), the transition to a single regulator will be complete. The FSMB will give considerable powers to the FSA to regulate, investigate, and discipline regulated firms and individuals.

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Important regulatory changes in 1986 set the stage for the above developments. First, the U.K. capital market experienced unprecedented deregulation that year under the so-called Big Bang. Among other things, it allowed 100 percent foreign ownership of U.K. investment banks and deregulated commissions. Lower fees and commissions followed, as did lower profitability, but an enhancement of the reputation of London as a financial center. As a consequence of this deregulation, several commercial banks acquired U.K. investment banking firms. Second, the regulation of the investment industry was changed, including the management and marketing of investment products. Legislation placed reliance on self regulatory organizations (SROs) in insurance and securities. Three important principles adopted by the SROs were (1) disclosure to customers, (2) the best advice principle, and (3) the polarization principle. The first principle meant that customers had the right to disclosure of commissions and expenses. The second principle meant that salespeople were required to give the customer their “best advice” as to product and product suitability. For independent salespeople, this meant that they were obliged to search the market for the best product. The third principle forced salespeople to work either exclusively for one financial firm or as independents. A tied intermediary had no obligations to include a market survey within his or her recommendations. An independent intermediary was effectively required to present an array of competing products to his or her clients. In combination, these requirements drove most insurers and other financial firms toward the tied approach to distribution. The other important 1986 law was the Building Societies Act. It greatly expanded the powers of building societies, providing them with a level playing field vis-à-vis commercial banks. Among other items, the act and later amendments authorized building societies to own insurers and securities firms and, if they desired, to convert to commercial banks. Much of the faith in the market and in SROs was shaken with the scandal in personal pension selling in the U.K. Under a 1988 law, employees could opt out of the State Earnings Related Pension Schemes sponsored by employers and invest their funds in private plans. Private pension plans became a high growth area, especially for life insurers. Misleading sales and other market conduct breaches, however, resulted in insurers having to pay millions of pounds in redress. Prudential (U.K.) was particularly hard hit. More importantly, the scandal led to enactment in 1995 of disclosure requirements that led to massive declines in the number of insurance agents. This issue, now the FSA’s responsibility, continues to be contentious. 138

Extent and Nature of Financial Integration. The big four clearing (“high street”) banks in the U.K. – Barclays, National Westminster, Midland, and Lloyds TSB – are financial conglomerates, with most investment banking activities conducted through subsidiaries. Each is involved in insurance. U.K. investment (merchant) banks are among the best known in the world. Banks’ entry into insurance has been primarily through de novo subsidiaries or joint venture corporations with insurers. The joint-venture route has been followed chiefly because of the perceived need to secure insurer’s expertise, although, after some time, some banks (e.g., Midland) have increased their proportionate ownership of the joint venture operation. More recently, the market has witnessed some acquisitions but without always attempting to fully integrate the banking and insurance activities. Life insurance subsidiaries of banks have relied on various distribution channels. The main objective remains selling insurance products to bank customers. Barclays Life provides an example of a subsidiary that relies on a variety of channels. It has three main aspects in its distribution strategy: direct sales, a regional force composed of brokers and representatives, and bank branches. The latter represents more than 90 percent of sales and relies on two forces: the branch staff and Barclays Life representatives who are allocated to branches. This scheme is common among bank-insurer linkages. This system requires the cooperation of bank employees to pass leads to the insurance specialists. The specialists are likely to be assisted by a database that includes customer attributes. A problem associated with bank employees who sell insurance products is the possible lack of skill and qualifications. This has become a significant source of concern for regulators as well as insurance and pensions intermediaries in recent years (Genetay and Molyneux, 1998, p. 69). Perhaps the most successful and profitable U.K. financial group is Lloyds TBS.14 It was formed in 1995 by the merger between Lloyds Bank and Trustee Savings Bank (TBS). The former TBS Group had been involved in bancassurance since it created its own insurer in 1972. Lloyds acquired an insurer in 1984. Neither bank took a broad view of insurance, however, until the late 1980s. Unlike their major competitors, neither bank moved aggressively into the investment banking field post-Big Bang. In 1999, Lloyds TBS acquired the Scottish Widows, a major insurer, for $11 billion, adding substantially to its insurance portfolio. With this acquisition, Lloyds TBS holds a 9 percent share of the U.K. life and pensions market, second only to the Prudential at 11 percent.

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Lloyds TBS offers a full range of life and nonlife insurance products for individuals principally through three distribution channels. Not all products sold by Lloyds TBS are manufactured by its insurance operations. In fact, only about one-half of its sales are of its own products. About 20 percent of total insurance sales is via direct response. The expectation is that electronic commerce will further enhance this channel. Lloyds TBS Insurance unit offers products through bank branches, following a low-key approach, and often as complements to banking services such as mortgage loans. No products sold in this manner are subject to the strenuous regulatory requirements discussed above. Lloyds TSB Life Assurance sells investment, pensions, and life policies through 3,300 tied agents. These products are subject to full regulatory disclosure and other requirements mentioned above. The sales force relies on referrals from Lloyds TBS’s 2,400 U.K. branches. Within U.K. bancassurance generally, the main difficulty faced by bank managers is to motivate branches to make insurance sales. The first response of managers to this difficulty has been to integrate insurance specialists into the branch networks. By doing so, they ensure the contacts between the two parties are frequent and increase the feeling of belonging to the same entity. For example, Lloyds integrated sales consultants to the branches in 1991 to increase this type of co-operation. The second response has been the initiative by some banks to integrate insurance sales into the assessment of branch performance. This is the case at all the main banks – it encourages branch managers to motivate their staff to sell insurance. At the Royal Bank of Scotland, commissions of sales referrals and completion are fed into the branch account. The third response to avoid conflict between insurance specialists and branch staff is to base the remuneration of the specialists in line with that of bank employees rather than traditional insurance agents. Several banks in the U.K. have opted for a salary-based remuneration for branch-based agents. At Lloyds TBS, sales consultants at branches receive a salary that is based on reaching a target level of sales. At Abbey National, the Bank of Scotland, and National Westminster, the emphasis is also on a salaried insurance sales staff. Bonuses are also common. A major factor in promoting U.K. bank/insurer linkages was the high costs associated with traditional insurance distribution. While the U.K. is home to highly competitive insurance companies, their long-standing reliance on

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expensive independent financial intermediaries gave banks the opportunity to develop less expensive alternative channels of distribution. Another factor stems from the nature of the banking relationship in the U.K. Unlike in the U.S., British citizens must qualify with the bank to be a customer. Once an individual chooses and is accepted by a bank, he or she tends to be quite loyal to that institution, buying a wide range of services. Relationships, therefore, tend to be long term, although, with competition, this is changing (O’Connor, 1999). North America The North American financial services market is the world’s largest. The Canadian market is sophisticated, having had consolidated regulation for more than 10 years. Mexico continues to evolve, with the North American Free Trade Agreement having a profound effect on its financial services market. The United States is among the world’s most sophisticated markets in terms of sectoral financial products and innovation, distribution expertise, and risk management, but integration is not as advanced as that which we find in Europe and Australia. Canada. The Canadian financial services market is sophisticated, offering both depth and breadth. Similar to Australia, it is a comparatively small market that has undergone important structural change during the previous two decades, with more change promised. The Regulatory and Political Environment. Canada was among the first countries to adopt a consolidated system of prudential regulation with the creation of the Office of the Superintendent of Financial Institutions (OSFI) in 1987. Until comparatively recent times, however, banking and insurance were overseen within the OSFI by separate areas, and one could not assert that the government truly practiced consolidated regulation. While the OSFI retains sectoral specialists today, it new organizational structure promises greater consolidation and cross-sector consistency (Thompson, 1999). Financial conglomerates generally were not permitted until 1992 at which time changes allowed any federally chartered financial institution to provide a broad range of financial services, mostly via subsidiaries. This legislation effectively eliminated what historically had been called the “four pillars” (banks, insurers, trust companies, and investment dealers). Further legislative changes were made in 1997.

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These changes, however, went only part way to allowing integrated financial services, as important limitations on information sharing, holding company arrangements, and ownership, among others, were retained. These limitations are believed by many observers to have hindered the orderly evolution of the Canadian financial services industry. For example, depository institutions cannot use their extensive branch networks or customer databases to support insurance marketing. The government has tabled a set of reform proposals that would soften or eliminate some of these and other constraints. Extent and Nature of Financial Services Integration. Canada has moved toward greater financial services integration since the 1992 changes, with banks owning insurers and vice versa. Even so, the market cannot be regarded as far along the integration continuum, except for commercial and investment banking. The great majority of life insurance continues to be marketed by independent life insurers, and independent mutual fund operations dominate that sector. Most of Canada’s largest investment dealers have been acquired by the commercial banks over the past decade, with the big six banks controlling 70 percent of the investment market. Few independent securities firms survive, and none is the lead firm within financial conglomerates. The Canadian financial services business is concentrated and becoming more so with consolidation and demutualization, driven by competition. The largest six banks control about 85 percent of the Canadian bank assets and the largest six insurers, most mutuals, control 70 percent of insurer assets. The life sector, in particular, promises great change as the four largest insurers are in the process of demutualization. The market is reasonably competitive, although performance is not strong. Both the financial services bought and the way that they are distributed have changed greatly from that just a few years ago, as ING Direct, Citizens Bank, MBNA, Wells Fargo, and others continue to introduce innovative marketing and products. During the preceding two decades, the percentage of household financial assets in banking deposits declined from 31 to 25 percent, while the percentage held in mutual funds increased from 1 to 14 percent. Banking deposits and traditional cash value life insurance sales are stagnant or declining. These shifts have been mirrored by changes in financial institutions. United States. The U.S. is home to many of the world’s largest and most profitable financial institutions. A mature market, the U.S. has witnessed considerable consolidation, with more anticipated because of recent reforms. The Regulatory and Political Environment. The 1999 enactment of the Financial Services Modernization Act (known also as the Gramm-Leach-Bliley 142

Act) promises the most fundamental reform in U.S. financial services regulation in more than 60 years. Even with this reform, however, U.S. financial services regulation remains highly fragmented. Insurance. Insurance companies are authorized and regulated primarily at the level of the individual states. This system evolved from an 1869 U.S. Supreme Court case that held that insurance was not interstate commerce and, therefore, was not the proper subject of federal government oversight. After a 1944 Supreme Court case held otherwise, the U.S. Congress passed in 1945 the McCarran-Ferguson Act that reestablished the states as the venue for insurance regulation. An insurer wishing to do business as an authorized insurer in each of the 50 states must secure a separate license from each state. Unlike in the EU, there is no mutual recognition and no single passport. Besides general employment and tax laws, insurers may also be subject to other federal regulations. Thus, insurers selling variable life and annuity products are subject to regulations of the Securities and Exchange Commission (SEC). Federal law greatly influences the design and sales of many types of employee benefit plans. Life insurer marketing and product design is influenced greatly by the favorable tax treatment of policy values and definitions of life insurance for tax compliance purposes. Commercial Banking. U.S. commercial banks are subject to multiple oversight. First, state chartered banks are subject to regulation by state banking authorities. The U.S. has a dual banking system under which banks may be either federally (national banks) or state chartered. Most large banks are national banks. Second, the Federal Deposit Insurance Corporation (FDIC), established in 1933 through the National Bank Act (see below), insures the deposits of and examines member banks. The FDIC also is responsible for ensuring the orderly closure of insolvent banks. National banks are required to be FDIC members, and state banks may be members. Third, the U.S. Treasury’s Office of the Comptroller of the Currency (OCC), established in 1863, charters national banks. It also has authority to examine them, to close them, and to oversee merger applications. Fourth, the U.S. central bank, the Federal Reserve, is not only responsible for U.S. monetary policy but also establishes reserve requirements for state and national banks. Membership in the Federal Reserve System (FRS) is mandatory for national banks and optional for state banks. The primary advantages of FRS

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membership are direct access to the federal funds wire transfer network for nationwide lending and borrowing of reserves and access to the discount window. The Fed also has regulatory responsibility for bank holding companies and, as discussed below, will be primarily responsible for newly allowed financial holding companies. Securities. The regulation of the U.S. securities business has been shaped by three laws. The Securities Act of 1933 applies to the new issues market, mandating disclosure to prospective purchasers of all material and relevant information about the security. Severe penalties apply for fraud or misrepresentation. The Securities Exchange Act of 1934 extends similar requirements to the secondary markets. It also requires registration of national exchanges, brokers, and dealers. Both Acts are administered by the Securities and Exchange Commission (SEC), established in 1934, which is the primary regulatory body for the U.S. securities markets. The emphasis of U.S. securities regulation has been on consumer protection via disclosure. The third important law shaping U.S. securities regulation is the Glass-Steagall Act. This law is discussed below. Financial Conglomerates – Pre-reform. Until the recent reform, the formation of financial conglomerates was greatly hindered by two federal statutes: the Banking Act of 1933 and the Bank Holding Company Act (1956). The Banking Act of 1933 has been a fundamental part of U.S. banking and securities regulation for 66 years. Sections 16, 20, 21, and 22 of the Act collectively are referred to as the Glass-Steagall Act. The Act stemmed from a belief in the early 1930s that banks’ errant recommendations for and investments in stocks helped precipitate the Great Depression.15 To rectify this perceived abuse, the Glass-Steagall Act effectively erected a wall between commercial and investment banking. Over the decades, banks argued futilely for the Act’s repeal, contending that such limitations harmed bank competitiveness and profitability and limited consumer choice. The intensity of their reform fervor grew in the 1970s and 1980s, with new arguments that U.S. financial institutions were at a competitive disadvantage internationally because of U.S. restrictiveness.

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By the 1990s, banking regulators had done through regulatory interpretation much of that which the banks had been unable to convince the Congress to do. Regulators had interpreted the law to allow banks to trade and underwrite securities through subsidiaries, provided their activities accounted for no more than 10 percent of the group’s revenues. This limit was raised to 25 percent in 1996, thus effectively allowing the largest banks to acquire the largest brokerage firms, while Glass-Steagall continued to bar brokerage firms from acquiring banks. The other major impediment to integration has been the Bank Holding Company Act (1956) and its 1970 amendments. They limited the ability of bank holding companies to engage in commercial, insurance, and other non-bank financial services activities. Bank holding companies are corporations that own banks and non-bank subsidiaries. They are regulated under the Bank Holding Company Act by the Federal Reserve. The Bank Holding Company Act generally prohibited bank holding companies and their subsidiaries from marketing insurance. Other legislation allowed bank marketing of insurance but only from a “place of 5,000 or less” or for other “bank related” activities. Under the OCC interpretation, subsidiaries or branches of national banks, located in small towns, did not have to limit their insurance marketing activities to those small towns. State chartered banks historically had been similarly limited by their states’ laws. However, almost all states now grant their banks some insurance sales powers, with more than one-half of the states granting their state banks broad powers to sell virtually any type of insurance. For decades, the insurance industry, led by insurance agents, had been successful in limiting banks’ insurance marketing. Two U.S. Supreme Court cases had a profound effect in the debate. In NationsBank v. Variable Annuity Life Insurance Company (1995),16 the Court held that the sale of annuities, which had been authorized by the OCC as the sale of investment products, was allowable under the National Bank Act. The Court held that annuities were investments and not “insurance.” As such, banks would be permitted to both manufacture and sell annuities. Under state insurance law, however, banks can manufacture annuities only if they obtain a Certificate of Authority from the insurance regulator – which seems unlikely as banks are not “life insurance companies.” To date, therefore, banks have been unsuccessful in manufacturing annuities but quite successful in marketing annuities underwritten by life insurers.

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In the second case, Barnett Bank v. Nelson, Florida Insurance Commissioner (1996),17 the Supreme Court held that a national bank with a branch and insurance agency in a “place of 5,000” may sell insurance as an agent despite state law prohibiting bank and insurance agency affiliations. Further, the court held that preemption of state law applies to any law that “prevents or significantly interferes” with the authority of national banks provided by the National Bank Act. The practical effect of (1) liberal interpretations of federal limitations by bank regulators, (2) states allowing banks to sell insurance, and (3) Supreme Court decisions favorable to banks were that regulators and the courts had greatly diminished the constraints on financial integration inherent in Glass-Steagall and the Bank Holding Company Act. But diminished constraints are not the same as no constraints. Financial Conglomerates – Post Reform. After more than two decades of trying to reform U.S. financial services regulation, success was achieved with Congressional passage of the Financial Services Modernization Act. The Act effectively eliminates restrictions on financial services integration in the U.S. Highlights of the Act follow. Title I repeals Glass-Steagall and Bank Holding Company restrictions on affiliations among banks, securities firms, and insurers. It allows the creation under the Bank Holding Company Act of “financial holding companies” and authorizes them to engage in a range of financial activities, including insurance underwriting and distribution, securities underwriting, trading, and merchant banking activities, and banking. The Federal Reserve may not allow the creation of a financial holding company if any of its depository institutions’ subsidiaries are not well capitalized and well managed or do not receive a satisfactory community reinvestment rating. This title provides for state regulation of insurance subject to prohibitions on discriminating against persons affiliated with banks. It also clarifies the role of the Federal Reserve as the umbrella holding company supervisor, with functional state or federal regulation for affiliates and subsidiaries. Title II provides for functional regulation of banks’ securities activities. Title III affirms state regulation of insurance and provides for functional regulation of insurance activities. This title also contains a provision allowing mutual insurance companies to redomesticate to another state and reorganize into a mutual holding company or stock company. This provision applies only to insurers located in states not allowing creation of mutual holding companies.

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Title III also preempts state laws prohibiting affiliation between insurers and banks and provides for consultation and sharing of confidential information between the Federal Reserve and state insurance regulators. Finally, this title encourages states to establish uniform or reciprocal agent licensing requirements. If a majority of the states fails to do so within three years, the National Association of Registered Agents and Brokers (NARAB), a private, non-profit entity, would be established and supervised by the NAIC. Agents and brokers could then join NARAB. Certain state laws that discriminate against NARAB members would be preempted. Title V requires both initial and ongoing disclosure by all financial institutions of their privacy policies and an opportunity for consumers to “opt-out” of sharing of non-public personal information with nonaffiliated third parties. No prohibitions are included or affirmative actions required for the sharing of personal information among affiliated companies. Several consumerists have taken strong exception to this treatment. Extent and Nature of Financial Services Integration. On September 23, 1998, the Federal Reserve approved the application by the Travelers Group to acquire Citicorp. By this action, the Federal Reserve for the first time permitted a bank holding company to engage in substantial insurance underwriting activities, notwithstanding the restrictions of the Bank Holding Company Act. Citigroup, one of the world’s largest financial conglomerates, was thus born. In the process, it arguably signalled a new, elevated stage of financial services integration in the U.S. As a mature market with an aging population, but in the face of a surprisingly strong and stable economy and booming stock market, the U.S. financial services market is competitive and becoming more so. Consumers are increasingly comfortable with equity investments. Almost one-half of U.S. households own common stocks or mutual funds, up from 19 percent in 1983. Consumers expect to deal with financial institutions in ways most convenient with them and not necessarily through those means dictated by the institution. As they become more sophisticated and have more money to save and invest, they expect greater financial institution efficiency and better product performance. Thus, the high costs associated with typical insurance distribution make insurance an attractive prize for banks and other depository institutions. The experience in European countries suggests that banks may be able to distribute insurance at lower costs than traditional insurance distribution channels. If true, this would be great news for depository institutions, especially as their share of total financial assets continues it decline – from about 60 percent in 1977 to less one-fourth in 1999. 147

With anemic bank asset growth, others enjoyed strong rates of growth. Figure 6, which shows growth rates for major U.S. financial intermediaries over the period 1986 through 1996, illustrates this point. Many of the problems for U.S. banks stemmed from regulatory restrictions and their relatively small size, limited geographical orientation, and poor management practices.

Figure 6: U.S. Asset Growth: 1986-1996 18.6%

Mutual Funds

13.0%

Securities Firms Insurers

9.5%

Pension Funds

9.3% 7.9%

Finance Companies

7.2%

Credit Unions

2.8%

Banks

0

0.05

0.1

0.15

0.2

Average Annual Growth Rate

The situation has changed. Substantial consolidation has ensued, with U.S. banks again occupying the top tiers among the world’s largest and most profitable financial institutions. Recent important mergers include Chemical Bank, Manufacturers Hanover, and Chase Manhattan to create Chase Manhattan; NationsBank and BankAmerica to form BankAmerica; and Bank One and First Chicago to form Bank One. The number of banks in the U.S. has declined from approximately 14,500 in the mid-1980s to less than 9,000 today. Similar consolidation is occurring in insurance. More consolidation both within sector and across sectors is expected.

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Financial services integration in the U.S. is surprisingly advanced given the obstacles that many financial institutions had to address. Banks have been important marketers of individual annuities, typically for unaffiliated insurers. They write perhaps 15 percent of new annuity considerations. They have long been able to sell insurance products judged closely related to banking, including credit life and health insurance, although aggregate premiums written have been small. Their writings of nonlife insurance remain comparatively small. Banks are not prominent in securities activities, although this too is changing. Securities firms write relatively large shares of the variable annuity business and small but increasing shares of life insurance. Schabb, Merrill Lynch, and Morgan Stanley Dean Witter are important distribution channels. Mutual funds, such as Vanguard and Fidelity, increasingly offer insurance to their customers. The Prudential, John Hancock, USAA, and several other insurers already offer banking, securities, and insurance services. Numerous insurers are establishing or have acquired thrift charters recently. Potentially among the most important is State Farm, which plans to offer comprehensive consumer banking services. Several insurers have either created their own mutual funds or have formed alliances to offer nonproprietary mutual funds through their own distribution channels. Simultaneously, many financial institutions have become more specialized. This trend is not necessarily incompatible with the integration trends in the U.S. For example, First Union bank, with about 3 percent of U.S. bank deposits, is concentrating on the individual and small business market, Bank One (with 3 percent also) on credit cards, and J. P. Morgan on wholesale business. Each, however, offers its target market an array of financial products and services. USAA Insurance Group’s target market is former military officers, but it offers them a full array of financial services. The insurance demutualization trend in the U.S. promises to enhance consolidation and integration, as it is in Canada. Already, the Prudential, Metropolitan, MONY, UNUM, the Equitable, and several other large insurers have demutualized or are in the process. The integration trend is being fostered by the activities of non-financial institutions. Certainly, Microsoft, Quicken, AOL, and other internet-focussed businesses have the potential for fundamentally altering financial service distribution and servicing. Diversified firms such as Ford, General Electric, and American Express already offer a full array of financial products, including banking services, credit cards, securities, and insurance.

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Public Policy Concerns in Integration Many individuals and government policy makers express concern about certain aspects of the financial services integration trends observed above. The question is whether new or additional regulation is needed to protect consumers or the financial system. Categories of Market Imperfections In considering this question, we should first be clear about the generic types of market imperfections of concerns to financial services regulators. These market imperfections fall into three broad categories: information problems, market power, and negative externalities. Information problems exist when the information that buyers or sellers have is deficient in some way, such as being incomplete or inaccurate. Thus, insurance buyers typically have incomplete information about the policies that they purchase and the insurer’s financial solidity. This information asymmetry – the “lemons” problem – means that customers are at an information imbalance vis-à-vis the insurer and its agents, which could lead them unknowingly to purchase poor-value insurance or purchase it from financially unsound insurers. Hence, government intervention is justified to minimize the chances of consumers being harmed because of insurer insolvency or misleading or incomplete marketing information. As noted earlier, market power exists when the seller (or buyer) can exercise meaningful control over prices. If a market were reasonably competitive, all sellers would be forced by competition to charge more or less the same prices. Firms seek to create market power and thus enhance profitability through market segmentation and product differentiation strategies. Market power can result also from increasing returns to scale and from concerted practices among competitors that restrain competition, such as market sharing arrangements, pricing collusion, or exclusive dealings. In many instances, regulation is the source of market power for companies, as when government creates unreasonable barriers to entry for new competitors or mandates price controls (as in mandating interest rates on demand deposits or premiums for insurance policies). Negative externalities exist when a firm’s activities impose uncompensated costs on others. Ordinarily, costs of production reflect the prices of inputs. If they do not, as when a firm pollutes and “gets away with it,” costs of production are understated and, therefore, the price of the good or service produced is

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lower than it should be. In turn, consumers buy more of the good or service than otherwise. The most important negative externality in financial services stems from the possibility of systemic risks. Systemic risks exist because the difficulties of financial intermediaries can cause harm elsewhere within an economy. We can identify two types of systemic risks. The first – dubbed cascading failures – exists when the failure of one financial institution is the proximate cause of the failure of others. This can occur, for example, if a bank’s default on its shortterm credit obligations to other banks precipitates other bank failures – ultimately causing harm to the real economy. The second type of systemic risk is a run in which many depositors (or other creditors) demand their money at once. Runs are caused by a loss of confidence in the financial institution, often precipitated by a real or imagined fear of insolvency. The failure of one or more banks can then precipitate runs on otherwise solvent banks, causing their failure. Similar runs in securities markets can lead to crashes. Categories of Regulation Government regulation of financial intermediaries is justified when market imperfections could cause substantial economic harm to consumers or the economy and, importantly, government intervention can ameliorate the harm. Governments are not always capable of ameliorating harm. (Just as there are market imperfections, so too are there government imperfections.) Generally, regulatory intervention falls into three categories: prudential, market conduct, and competition policy. Prudential regulation is concerned with the financial condition of the financial intermediary. Market conduct regulation addresses the marketing behaviour of the intermediary and its agents. Competition policy (antitrust) regulation is concerned with actions of the intermediary that have the effect of substantially lessening competition. Prudential regulation evolved primarily because of information problems and negative externalities (especially for banking). Market conduct regulation evolved primarily because of information problems. Competition policy regulation evolved because of market power concerns. Historically, prudential regulation has been the most critical element in government oversight of financial intermediaries.

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Multinational Public Policy Initiatives Financial services integration raises questions whether it introduces additional or more complex market imperfections and, therefore, whether different or additional regulation is needed. These questions are not limited by national boundaries. With the continued internationalization of financial services, it was recognized that an international approach was desirable. Thus, at the initiative of the Basle Committee on Banking Supervision (the Basle Committee), an informal group of banking, securities, and insurance regulators was formed in 1993 to examine issues relating to supervision of financial conglomerates. The report (The Tripartite Group, 1995) was the first to address cross-sectoral issues associated with integration on an international level. A more formal approach emerged in 1996 with the creation of the Joint Forum on Financial Conglomerates (Joint Forum), which was charged with taking forward the work of the Tripartite Group. The Joint Forum is comprised of an equal number of senior bank, securities, and insurance supervisors representing the Basle Committee, the International Organization of Securities Commissions (IOSCO), and the International Association of Insurance Supervisors (IAIS). Thirteen countries are represented in the Joint Forum, with the EU attending in an observer capacity. The Joint Forum’s 1999 report contains papers addressing the following topics: − capital adequacy – these papers outline measurement techniques and principles to facilitate the assessment of capital adequacy on a group-wide basis − fit and proper requirements – this paper provides guidance to ensure that supervisors of entities within financial conglomerates are able to exercise their responsibilities to assess whether those entities are soundly and prudently managed − sharing of information by supervisors – these papers set out general principles and a framework for facilitating information sharing between sector supervisors − coordination of activities by supervisors – this paper provides supervisors guidance on cooperation and selection of a coordinator (lead) regulator in emergency and non-emergency situation.

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Recently, papers setting our proposed principles on risk concentration and intragroup transactions and exposures have been released for comment, with further work continuing on transparency issues. Consideration is being made to renaming the Joint Forum and to an expanded mandate. Additional but, to date, limited work on issues related to financial integration is also being carried out by the G-7 Stability Forum in the area of encouraging implementation of core regulatory principles. Finally, the Multidisciplinary Working Group on Enhanced Disclosure, created in mid-1999, has begun to study enhanced disclosure by financial institutions and how to promote market discipline in financial risk management. Public Policy Issues in Integration The discussion below draws from the above and other sources. Our focus is on only those public policy issues that arise from integration, not on issues of the type ordinarily dealt with by sectoral regulation alone.18 The discussion is framed around the three classes of market imperfections and associated typical regulatory responses. Information Problems. This area addresses potential information problems that could accompany integration. The problems are clustered around prudential and market conduct regulation. As will be seen, prudential issues dominate. •

Prudential Issues. At least six prudential issues have been mentioned as flowing from financial integration. These issues are presented and discussed below as if they were distinct from each other, for ease of exposition. Of course, they relate to each other, often intimately so. They include the following: − Transparency − Contagion − Double and multiple gearing − Unregulated group entities − Fit and proper requirements − Regulatory arbitrage 153

Transparency. Overarching all public policy concerns about financial services integration is the issue of group transparency. As it relates mainly, but not exclusively, to prudential concerns, we cover it here. Transparency concerns the extent to which accurate, complete, timely, and relevant information about the financial group is readily available to regulators. Transparency also is sometimes considered as encompassing the availability of such information to other interested parties, such as customers (especially corporate customers), citizens, rating agencies, and marketing intermediaries. This form of transparency often is classified as disclosure. Using the narrower definition, regulators are concerned about the possibility of opaque management, ownership, and legal structures. If supervisors do not fully understand these structures, they may be unable to assess properly either the totality of the risks faced by the group or the risk that non-regulated members of the group may pose to the regulated members. The structures of financial groups vary greatly because of tax, legal, cultural, regulatory, and historical considerations. Complexity is multiplied with such groups. Regulators are concerned that they be able to understand fully the lines of accountability relevant to their tasks. Large international financial conglomerates can be particularly complex, making effective regulation more difficult, especially with multiple national and international sectoral regulators. There is concern that some groups may choose complex structures to make their operations opaque in order to avoid or impede effective regulation (The Tripartite Group, 1995, p. 29). To avoid these problems, regulators must have the power to secure needed information from the group itself or from other regulators. Contagion. Contagion entails the risk that financial difficulties encountered by one unit in a financial conglomerate could have adverse effects on the financial stability of the group as a whole or possibly on the entire market in which the constituent parts operate (i.e., negative externalities). Close monitoring of the relationships among entities in the group is of paramount importance. Adequate transparency minimizes the risk of contagion. The Tripartite Group (1995, p. 19) identified two types of contagion. The first is psychological in that the market effectively transfers problems associated with one part of a conglomerate to other parts. The financial difficulties of an insurer within the group may be perceived as threatening financial performance of the bank, for example, irrespective of whether the perception comports with reality.

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The second type relates to intra-group exposures. Intra-group exposures are direct or indirect claims of units within a conglomerate that are held by other conglomerate units. Some such exposures include the following: − Credit extentions or lines of credit between affiliates − Cross-shareholdings − Intra-group trading in securities − Insurance or other risk management services provided by one unit for another − Intra-group guarantees and commitments Intra-group exposures can have implications for both liquidity and group solvency. An example is a life insurer placing its premiums on deposit with its parent bank, a practice that might not be obvious to regulators. The Tripartite Group (1995, pp. 20 and 23) said that it was important for regulators to be made aware of all intra-group exposures and their specific purposes. Each sectoral regulator should then ensure that the pattern of activity and aggregate exposure between the regulated entity for which it is responsible and other group companies are not such that the failure of another company will undermine the regulated entity. Close coordination among regulators is essential, especially when uncertainties arise. The Tripartite Group admonished regulators that they must ensure that capital is increased or activities limited if the risk that other companies pose to the regulated entity appear to be unacceptable. Double and Multiple Gearing.19 Double gearing, also called double leverage, occurs whenever one entity holds regulatory capital issued by another entity within the same group and the issuer is allowed to count the capital in its own balance sheet. Multiple gearing (leverage) occurs when the subsidiary firm in the previous instance itself sends regulatory capital downstream to a third-tier affiliate. Double and multiple gearing are special classes of intra-group exposures and ordinarily are associated with parents downstreaming capital to subsidiaries. The flow can be reversed or can be by a sister affiliate. The principal issue raised with double and multiple gearing is less the ownership structure flowing from it and more the proper assessment of a financial conglomerate’s consolidated capital. With double and multiple gearing, group capital derived directly from each entity’s solo capital is likely overstated. For the most part, capital derived only from external sources

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provides support for the group. Consequently, assessments of group capital should exclude intra-group holdings of regulatory capital. The Joint Forum (1999, Annexes 1 and 2) noted three methodologies used for adjusting financial data for double and multiple gearing. These methodologies also accommodate the important issue of capital adequacy assessment for groups containing subsidiaries that are not 100 percent owned by the group. Unregulated Group Entities. Additional information problems stemming from financial services integration can occur when the group contains an unregulated entity; that is, one not subject to oversight by any sectoral regulator. One such issue is excessive leveraging.20 Excessive leveraging, another class of intragroup exposure, can occur when an unregulated parent issues debt or other instruments not acceptable as regulatory capital in a downstream entity and downstreams the proceeds to a subsidiary firm in the form of equity or other regulatory capital. The subsidiary’s effective leverage may be greater than appears on a solo basis. Such leverage is not inherently unsafe but can become so if undue stress is placed on the regulated subsidiary because of the parent’s obligation to service the debt. With an unregulated holding company, an assessment of group-wide capital adequacy should encompass the effect of the holding company’s structure. Regulators will, therefore, need to be able to obtain information about the holding company’s ability to service all external debt. Excessive leveraging as well as double and multiple gearing can also occur when the unregulated entity is an intermediate holding company. The groupwide capital assessment should eliminate the effect of such holding companies. Such intermediate holding companies typically are non-trading entities whose only assets are their investments in subsidiaries or that provide services to other companies. Finally, some unregulated group entities conduct activities similar to those of regulated companies; for example, leasing, factoring, and reinsurance. In such instances, a comparable or notional capital proxy may be estimated by applying to the unregulated entity the capital requirements of the most analogous regulated industry. Unregulated non-financial entities normally would be excluded from the assessment of the group. Fit and Proper Requirements.21 The probity and competence of the top management of banks, securities firms, and insurers are critical to the achievement of regulatory objectives, particularly as relates to prudential aspects. An effective and comprehensive supervisory regime should include

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controls designed to encourage the continued satisfaction of the fitness, propriety, or other qualification tests of supervisors and to allow supervisory intervention where necessary. The application of such tests for managers, directors, and key shareholders is a common regulatory mechanism for supervisors to ensure that the institutions for which they have supervisory responsibility are operated in a sound and prudent manner. The organizational and managerial structure of financial conglomerates adds complexity for supervisors seeking to ensure the fitness, propriety, and other qualifications of the top management of regulated entities. The management of such entities can be influenced by individuals who may not be managers or directors of the regulated entities themselves. Thus, managers and directors of unregulated entities, such as those within an unregulated upstream holding company, can exercise a material influence over many aspects of the regulated entities’ business and can also play a key role in controlling risks in the various entities of the group. Additionally, for multinational financial conglomerates, issues of supervisory jurisdiction arise. A supervisor’s reach may not extend beyond national boundaries. This raises the issue of the sharing of information among supervisors with respect to individuals (and companies, see below). To address these concerns, the Joint Forum (1999, p. 43) recommended that fitness, propriety, or other qualification tests should be applied to managers and directors of other entities in a conglomerate if they exercise a material or controlling influence on the operation of regulated entities. Tests should apply as well to individuals holding substantial ownership or who can exercise material influence on regulated entities within the conglomerate. Regulatory Arbitrage. Financial conglomerates should be expected to undertake their activities in ways that minimize their regulatory burdens and taxes. Of course, tax treatment, accounting standards, investment restrictions, capital adequacy requirements, and other elements of regulation differ between types of financial intermediaries and across countries. To the extent that sectoral regulations and taxation differ, arbitrage possibilities are created. For example, regulations typically limit the maximum exposure that credit institutions may undertake with respect to a single client or group of related clients. Thus, in the EU, loans or other exposures to a single client may not exceed 25 percent of a bank’s free capital. In contrast, limitations on insurers’ counterparty exposures generally are unrelated to their capital. It is possible for an insurer’s exposure to a single client to exceed 100 percent of its capital. Even in countries that subject all major types of financial intermediaries to

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capital-related limitations (e.g., the U.S.), they are rarely the same across different types of intermediaries. Similar examples are found with capital requirements in connection with other investments and products. Arbitrage possibilities influence decisions about the structure of the group. If the parent firm is a regulated financial institution, as is common with banks in the U.K., the group itself could be subject to regulations applicable to that institution. The parent is fully subject to regulatory oversight. If the parent firm is an unregulated entity, as is common in the U.S., many of its activities may pass outside regulatory scrutiny. With continued internationalization and convergence of financial services, the material differences in sectoral and cross-national regulation will gradually disappear, as governments individually and collectively converge toward more common approaches.22 In the interim, however, arbitrage is possible. In some instances, it may result in no meaningful weakening of regulation; in others, the opposite. The Tripartitie Group (1995, p. 35) believed that regulatory arbitrage in relation to core activities in most jurisdictions was rare. That there is scope for arbitrage, however, suggests that it must be considered carefully. The suggested solutions to this issue are to move toward consolidated financial regulation where such differences are eliminated or to ensure that sectoral regulators cooperate fully with each other to identify and, if necessary, address such instances collectively. Market Conduct Issues. Market conduct regulation is the other major regulatory category intended primarily to address information problems. The information asymmetry problems here are conflicts of interest (agency problems). Concern has been expressed that conflicts of interest within integrated financial services groups might lead to deficiencies in market conduct. These conflicts of interest were discussed above in connection with management issues in financial conglomeration. Additionally, there may be greater scope for churning of a customer’s investments within a conglomerate structure. As between commercial and investment banking activities, most authorities seem to doubt its importance, with many noting that financial firms have strong reputational incentives to address these potential problems internally. As between insurance and banking activities, the same reputational incentives should apply, plus there have been comparatively few instances of bank/insurance tie-in sales (Kelley, 1985; Diamond, 1989; Bank Powers, 1990; Benston, 1990 and 1994).

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To the extent that proper private incentives and appropriate management control are insufficient to address conflicts of interest, a regulatory response may be called for. Already, most potential conflicts are illegal. Market Power. The second major classification of market imperfections addressed by regulation is market power. Market power could arise through economies of scale or scope, but available evidence, as noted earlier, suggests that such economies are unlikely. Market power could, in theory, arise from size alone if barriers to entry are great. It also could evolve through predatory pricing. An established, large conglomerate could sell at less than the cost of production if it wished to drive out smaller competitors or to discourage new entrants. As a practical matter, this option seems remote, provided there are not substantial barriers to entry (Skipper, 1997). For every large national or multinational financial conglomerate that might attempt such practices, there are several others with the financial capacity to weather the storm. Existing competition law would seem to be sufficient, if enforced reasonably, to prohibit or punish concerted anti-competitive behaviour by conglomerates. An exception could occur if the collusion occurred outside of a national market but with respect to that national market, such as by large international financial conglomerates. Negative Externalities. The third major classification of market imperfection addressed by financial services regulation is negative externalities. The principal negative externality is systemic risk, most commonly associated with commercial banking. The public policy question is whether financial service conglomerates pose a greater risk to system-wide financial stability than do solo institutions. If they do, their failure could both create greater harm to the real economy and impose greater costs on taxpayers. Are Financial Conglomerates Riskier? In an examination of the studies on the effects on risk and return of combining banking and non-bank financial activities, Kwan and Laderman (1999) conclude that the studies generally show that both securities activities and insurance (agency and underwriting) are riskier and more profitable than banking. The literature also suggests, however, that such activities provide diversification benefits, with the result that they offer the potential to reduce bankruptcy risk.23 Hence, it appears that financial services integration could lead to a reduction in systemic risk. This hoped-for benefit, however, might not materialize if the smaller likelihood of failure (because of diversification) is accompanied by a much higher severity associated with those failures that do occur. That is, if financial firms are larger because of integration (a likely result), their now-less159

frequent failure might cause greater harm to the financial system. In turn, government authorities presumably would be more likely to take a “too-big-tofail” (TBTF) position. The moral hazard problems of a TBTF policy are well known. If customers (depositors, insureds, creditors, etc.) believe that they will be made whole financially were the financial institution to fail, they have much less incentive to monitor the institution and to cease doing business with it if it takes on more risk. In turn, managers (with shareholder approval) might take on greater risk than they would otherwise (Boyd and Gertler, 1993). Thus, it is possible that large financial conglomerates, contrary to the findings of the literature, could be riskier even in the face of diversification benefits. This increased riskiness would have stemmed, however, from an increase in the risk appetite of managers and shareholders, brought about because of a TBTF policy or other reasons. Safety Net Issues. Governments build so-called safety nets into financial systems to minimize systemic risks. The safety net includes deposit insurance or other guarantee arrangements, the discount window, and payment system guarantees.24 Does financial service integration pose additional burdens on the safety net, with resultant taxpayer exposure? As with a TBTF policy, safety nets create moral hazard problems. Customer incentives to monitor the condition of financial institutions with which they do business is diminished, so managers are prone to take on more risk than they otherwise would. An expansion of banking activities through integration, thus, could lead to excessive risk taking that could weaken the fabric of the financial system (Mishkin, 1999). Neither the TBTF nor the safety net issue is new. Suggested reform proposals include the following: − eliminate deposit insurance (Edwards, 1996) − price deposit insurance premiums to reflect institutional risk25 − limit deposit insurance protection to narrow banking26 − increase capital requirements and enact stricter closure rules (Benston and Kaufman, 1988) − more vigilant supervision − impose a program of “constructive ambiguity” onto the safety net (Mishkin, 1999)

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These and other proposals to address the moral hazard issue seem as applicable in an integrated financial services world as in a segregated one. Supervision admittedly will be more complex as will problems of regulatory arbitrage such as moving the underwriting of products from units not within the safety net to units enjoying safety net protection. To the extent that these problems prove valid, however, they are not caused by integration but by government failure. As such, the solution is governmental reform, not limitations on integration. The Relationship between Integration and Regulatory Structure A final public policy concern is whether existing regulatory structures are appropriate in an integrated financial world. If financial sectors are integrating, shouldn’t supervisors do the same? The underlying issue is what regulatory structure minimizes the chances of government failure in ameliorating market imperfections and does so most efficiently. The case for consolidated regulation is both compelling and obvious. To have true consolidated regulation, it would seem that the single regulator should: − have oversight responsibilities for all or most types of financial intermediaries, especially banks and insurers − work under laws that are not inconsistent across types of intermediaties − apply comparable (although not necessarily identical) regulation to all intermediaries and cross-sectoral competing products, ensuring equality of competitive opportunity between types of intermediaries Having a single supervisory body could minimize the problems of information sharing and coordination associated with sectoral supervisors, at least at the national level. In concept, it would permit a less complex approach for addressing issues such as transparency, multiple and excessive gearing, fit and proper requirements, and contagion. Needed harmonization of accounting and capital adequacy requirements across financial intermediaries would, in theory, be facilitated. Opportunities for regulatory arbitrage should be lessened. On the other hand, it is argued that existing solo regulatory approaches, augmented by information sharing and agreement on coordination issues, are adequate and involve less disruption. There is something to be said for building on existing structures.

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Moreover, the objectives of regulation vary by sector. Banking supervision is oriented more toward stability of the financial system as a whole, rather than the solidity of individual banks or efficiency, and relies on consolidated regulation. Systemic risks are not as important in insurance as they are in banking or even securities (Skipper, 1996). Securities regulation is oriented more toward consumer protection through disclosure and market efficiency than toward system stability. Insurance regulation is oriented more toward financial soundness of individual insurers and fairness, with less focus on systemic risks and efficiency. Additionally, arguments have been made that product differences justify solo regulatory approaches. Insurance products tend to be more complex and often involve much longer guarantees than banking and securities products. As a consequence, risk and risk management practices differ by sector and regulatory specialization offers greater efficiency. This debate might be moot to some extent. Already many banking regulators have captured the “high ground” of consolidated regulation because of their charge to protect the financial system against systemic risks and because they already focus their regulatory efforts at the group level. Thus, so the argument goes, if a financial conglomerate contains a commercial bank, the banking supervisor should have an important voice in the supervision of the group. No international consensus has yet emerged on this issue. Some countries already have consolidated supervision, including the U.K., Australia, Denmark, Sweden, Singapore, Japan, and Korea. Most countries retain sectoral regulation for banking, securities, and insurance, although some include investment banking within the overall banking function; for example, Germany and Switzerland. According to Thompson (1999), Deputy Superintendent of Canada’s consolidated regulator, the case for consolidated regulation is strongest in a market that exhibits the following characteristics: − similar products and services are offered by different types of intermediaries in the same market segments − institutions in competing sectors have similar strategies for growth and development in home and/or international markets − institutions in one sector create systemic risk exposure for another sector − competing sectors are at a similar and advanced stage of development

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− institutions are combining in ways that make it difficult to distinguish a bank and an insurance company − the financial services industry is pushing for reform to meet competitive pressures Clearly, the larger the financial services market of a country, the greater the complexity and difficulty in moving to consolidated regulation. Thus, for example, substantial regulatory change in the U.S. financial regulatory system would seem problematical, even though, according to The Economist (October 30, 1999, p. 19), “[U.S. regulation] is hopelessly fragmented and costly.” In contrast, the more modest in size is a country’s financial sector, the easier it should be to move to consolidated approaches. The Future of Financial Services Integration Services in general and financial services in particular lie at the center of all developed economies. Financial services innovation and production efficiency are essential to continued economic development. The question is how integrated financial services fits into this evolution and whether it poses unacceptable risks to consumers and the financial system. Whether integration leads to economies of scale or scope or greater efficiencies cannot be answered with confidence at this time. In one sense, however, the answers are irrelevant. The pressures for integration seem both unrelenting and irreversible. Financial firms are battling for customers and understand that they must allow potential and present customers to conduct their financial affairs in ways most convenient to them. This translates into figuring out how to make available a range of financial products and services through multiple distribution channels and how to offer multiple service points. Our poor understanding of the possibilities for technology to assist in making integration work hinders the making of sound forecasts. With time being the currency of the future, the opportunities for economies of scope in consumption seem to loom large. Securing these economies does not require financial conglomeration, however. It requires integration only at the interface of the customer and the distributor (advisor), and that distributor can as easily be Microsoft as Citigroup representatives. The market will determine whether financial conglomeration makes good business sense and, if so, the optimum operational structure. One can imagine different outcomes in different markets, depending on cultural, historical, and

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economic factors, such as stage of development. Additionally, even for markets in which some financial firms move aggressively to integrate, we will find many that decide that specialization offers greater opportunities. These trends seem contradictory, but they need not be. Important market segments will prefer specialized service providers, in part because their needs will themselves be highly specialized (e.g., large businesses and wealthy individuals). Additionally, we should not be surprised to find that specialized financial institutions are able to develop a better understanding of their narrower target markets and corresponding core competencies, allowing them to compete effectively with conglomerates. The globalization of business in particular and financial services specifically fosters integration. One has but to consider whether the recent U.S. reforms would have been enacted or as sweeping without the compelling arguments from U.S. financial institutions that they were at a competitive disadvantage internationally under former U.S. law. A byproduct of globalization and liberalization, especially for mature markets, is consolidation aided by demutualization, both of which seem destined to continue. Look particularly for greater consolidation activity in Japan, Germany, the U.S. in the commercial banking and insurance sectors, and in France. Demutualization in Japan has yet to bloom, but it will. In all instances, important transparency and fairness issues must be addressed. Integration seems to be further advanced in Australia and the Netherlands than other countries, with France and the U.K. not far removed. Each of these and other countries with reasonably advanced integration offer a wealth of experiences for countries, such as the U.S. and especially Japan, that are not as far along. At the same time, however, care must be taken to recognize those situations or elements that do not travel well. As noted in this paper, for example, some unique circumstances aiding integration in Australia, France, the Netherlands, Spain, and the U.K. may not exist in the U.S. or Japan. The public policy concerns accompanying financial services integration are rational but manageable with reasonable and timely governmental responses. The question is whether governments will adjust fast enough to minimize possibilities of systemic and substantial consumer harm and whether their adjustments will be no more burdensome on business than necessary. Both the management and regulation of conflicts of interest might pose the greatest challenges. Within the U.S. and between the U.S. and the EU, however, the privacy issue stands out. Lowering the costs of gathering, storing, and using (including sharing) information lies at the heart of integration. Network externalities might

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also accompany integration. An unresolved issue is how to achieve the appropriate balance between an individual’s right to control the flow of personally identifiable information about him- or herself and a business’s (and ultimately, customers’) desire for information efficiencies. A reasonable approach would seem to be to allow explicit consumer consent to share sensitive personal information between affiliated companies. Providing consent to disclose information and being notified of prospective disclosures do not provide comparable confidentially safeguards (Skipper, 1979, 1980a, 1980b). The integration trend will push regulatory convergence in two dimensions. First, with integration and product convergence, those aspects of national regulation and taxation that are specific to one financial sector or its products can be expected to cause increasing distortion. Firms will offer products and structure themselves in ways that minimize their regulatory burdens and taxes; i.e., regulatory and tax arbitrage will ensue. This will continue to drive governments to seek greater horizontal equity in financial institution and product regulation and in taxation. In turn, this will lead to national regulatory and tax convergence. This could facilitate the move by more nations toward consolidated regulation. Second, international differences in regulation and taxation of financial institutions and products increasingly will afford opportunities for international regulatory and tax arbitrage. This is especially true as markets continue to liberalize and as the cross-border provision of financial services grows, facilitated by the internet. Again, it is logical that firms will take advantage of these differences. Pressure will mount for governments to harmonize key elements of tax and regulation. A danger is that governments will succumb to the sirens’ song of de jure harmonization and harmonize the wrong things or harmonize at the wrong level, thereby stifling innovation and efficiency. The superior approach is gradual convergence through mutual recognition and establishment of regulatory principles (Skipper, 1998). In this process, the importance of some meaningful degree of accounting harmonization internationally cannot be overemphasized. Many knowledgeable observers believe that the financial world of the future will be dominated by a dozen or so financial conglomerates. Even if accurate, oligopolistic markets can remain competitive and innovative if barriers to entry remain low, especially to foreign financial service suppliers. And certainly, specialist suppliers, even if small, will provoke continuous improvement by the giants. Irrespective of the “correct” view, changing demographics and economic prosperity ensure a growing role for financial service providers and distributors.

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NOTES

1

In a 1982 article on this subject (Skipper, 1982), I referred to the “homogenization” of the financial services community. While the word seems odd today, it perhaps conveys a clearer sense of the integration trend.

2

Van den Berghe and Verweire (1998) use assurfinance to signify banking products being marketed through traditional insurance distribution channels.

3

Some scholars, following the German model, further distinguish universal banks from other financial institutions through their holding of important equity positions and voting power in non-financial companies.

4

This classification scheme is a variation of that of Saunders and Walter (1994), p. 85.

5

See, generally, studies cited in Berger (1999).

6

See Berger, Hunter and Timme (1993), for a review of the literature.

7

“Complex Equations,” The Economist (June 5, 1999), p. 69.

8

For an overview of the risk profiles of different financial intermediaries, see Santomero and Babbel (1997), chap. 25.

9

This section draws heavily from Walter (1997).

10

The sections that follow draw from Institute of International Business (1998 and 1999).

11

The insurance-banking elements of these discussions rely heavily on Genetay and Molyneux (1998).

12

“Yes, but who won?” The Economist (August 21, 1999), p. 63.

13

This discussion draws on Institute of International Bankers (1998 and 1999) and Genetay and Molyneux (1998).

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14

This discussion of Lloyds TBS relies heavily on O’Connor (1999) and “A Restless Quest for Perfection” (1999).

15

Most economists and historians now dispute this view, noting that the more substantial causes were mistakes in Federal Reserve policy, the SmootHawley Tariff, and a tax increase. The Act did, however, restore confidence in the banking system.

16

115 S.Ct. 810 (1995).

17

116 S.Ct. 1103 (1996).

18

Thus, we ignore the important issue of whether financial institutions should be permitted extensive equity investments in or other control of commercial businesses and vice versa, as this issue applies equally to isolated financial institutions.

19

This discussion draws from The Joint Forum (1999), pp. 8-9.

20

This discussion draws from The Joint Forum (1999), pp. 9-10.

21

This discussion draws from The Joint Forum (1999), pp. 41-44.

22

For a discussion of these issues, see Barfield (1996).

23

Exceptions occur in certain securities activities. According to Kwan and Laderman (1999), the literature suggests that, while securities trading tends to be more profitable and riskier than banking, it may not provide diversification benefits because of its high stand-alone risk.

24

For an examination of the elements of the U.S. and other countries’ safety nets and of the need for reform associated with universal banking, see Saunders and Walter (1994), chap. 7.

25

For a discussion of this proposal, see Saunders (1997), chap. 18.

26

For a discussion of this proposal, see Mishkin (1999).

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REFERENCES

“A Restless Quest for Perfection.” 1999. Euromoney. October. Allen, F. and Santomero, A.M. 1998. “The Theory of Financial Risk Intermediation,” Journal of Banking & Finance 21, 1461-1485. Bain, E.A. and Harper, I.R. 1999. “Integration of Financial Services: Evidence from Australia,” paper presented at the 1999 Thomas P. Bowles Symposium on Financial Services Integration. Georgia State University. Bank Powers: Issues Relating to Banks Selling Insurance. 1990. Washington, D.C. General Accounting Office. Barfield, C.E., ed. 1996. International Financial Markets: Harmonization versus Competition. Washington, D.C. AEI Press. Benston, G.J. 1989. “The Federal Safety Net and the Repeal of the GlassSteagall Act’s Separation of Commercial and Investment Banking,” Journal of Financial Services Research. October, 2, 287-306. Benston, G.J. 1990. The Evidence on the Passage and Continuation of the Glass-Steagall Act’s Separation of Commercial and Investment Banking: Analysis of a Hoax. New York. Oxford University Press. Benston, G.J. 1994. “Universal Banking,” Journal of Economic Perspectives. Summer, 3, 121-143. Benston, G.J. and Kaufman, G.G. 1988. in W. S. Haraf and R. M. Kushmeider, eds., Restructuring Banking and Financial Services in America. Washington, D.C. American Enterprise Institute. Berger, A.N. 1999. “The Integration of the Financial Services Industry: Where are the Efficiencies?” paper presented at the 1999 Thomas P. Bowles Symposium on Financial Services Integration. Georgia State University.

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Berger, A.N., Hunter, W.C., and Timme, S.G. 1993. “The Efficiency of Financial Institutions: A review of Research Past, Present, and Future,” Journal of Banking and Finance, 17, 221-249. Berger, A.N. and Humphrey, D.B. 1997. “Efficiency of Financial Institutions: International Survey and Directions for Future Research,” Working Paper 97-05, Financial Institutions Center, The Wharton School, University of Pennsylvania. Berger, A.N., Hancock, D. and Humphrey, D.B. 1993. “Bank Efficiency Derived from the Profit Function,” Journal of Banking and Finance, 17, 317-347. Boyd, J.H. and Gertler, M. 1993. “US Commercial Banking: Trends, Cycles, and Policy,” NBER Macroeconomics Annual. Boyd, J.H., Graham, S.L., and Hewitt, R.S. 1993. “Banking Holding Company Mergers with Nonbank Financial Firms: Effects on the Risk of Failure,” Journal of Banking and Finance, Feb., 43-63. Canals, J. 1993. Competitive Strategies in European Banking. Oxford. Oxford University Press. Daniel, J-P. 1999. “The Integration of Financial Services in Europe,” paper presented at the 1999 Thomas P. Bowles Symposium on Financial Services Integration. Georgia State University. Diamond, D. 1984. “Financial Intermediation and Delegated Monitoring,” Review of Economic Studies, 51, July. Edwards, F.R. 1996. The New Finance: Regulation and Financial Stability. Washington, D.C. American Enterprise Institute. European Banker. 1999. “Bigger Size Fits All,” January 1. Gallo, J.G., Apilado, V.P., and Kolari, J.W. 1996. “Commercial Bank Mutual Fund Activities: Implications for Bank Risk and Profitability,” Journal of Banking and Finance, Dec., 1775-1791. Genetay, N. and Molyneux, P. 1998. Bancassurance. New York. St. Martin’s Press, Inc.

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Herring, R.J. and Santomero, A.M. 1990. “The Corporate Structure of Financial Conglomerates,” Journal of Financial Services Research, Dec., 471-497. Higgins, M. 1999. “Breaking Tradition: Creating Tomorrow’s Leading Retail Bank,” Bank News. September 1. Hilliard, G. 1999. “The ING North American Scene: Opportunities and Challenges,” presentation at ING Business School, October 14. Institute of International Bankers. 1998. Global Survey 1998. Institute of International Bankers. 1999. Global Survey 1999. Jarvis, D.B. 1998. “Bancassurance: Easier to Justify than Execute.” Reinsurance Reporter. Third Quarter, 14-17. Joint Forum on Financial Conglomerates. 1999. Supervision of Financial Conglomerates. Kelley, E.J., III. 1985. “Conflicts of Interest: A Legal View,” in Deregulating Wall Street; Commercial Bank Penetration of the Securities Market, New York. John Wiley and Sons. Kraus, J.R. 1998. “Europe’s Universal Banks: Flawed Models,” American Banker, June 8. Kwan, S.H. 1997. “Securities Activities by Commercial Banking Firms’ Section 20 Subsidiaries: Risk, Return, and Diversification Benefits,” Federal Reserve Bank of San Francisco Economic Review, October. Kwan, S.H. and Laderman, E.S. 1999. “On the Portfolio Effects of Financial Convergence – A Review of the Literature,” Federal Reserve Bank of San Francisco Economic Review, January 1. Mishkin, F.S. 1999. “Financial Consolidation: Dangers and Opportunities,” Journal of Banking and Finance, 23, 675-691. O’Connor, R. 1999. “UK Bancassurance: Will it Play in Peoria?” Banking Strategies, Sept./Oct.

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Santomero, A.M. 1993. “Banking and Insurance: A Banking Industry Perspective,” in J. D. Cummins and J. Lamm-Tennant, eds., Financial Management of Life Insurance Companies. Boston. Kluwer Academic Publishers. Santomero, A.M. and Babbel D.F. 1997. Financial Markets, Instruments, and Institutions. Chicago. Irwin. Saunders, A. and Walter, I. 1994. Universal Banking in The United States. New York. Oxford University Press. Shirriff, P.A. 1999. “Integrated Financial Services in ING,” presentation at ING Business School, October 14. Skipper, Jr., H.D. 1980a. "An Analysis of the NAIC Model Privacy Act," Best’s Review, Life/Health ed., 80, pp. 12, 14, 99, 102-105. Skipper, Jr., H.D. 1980b. "An Analysis of the NAIC Model Privacy Act - Part II," Best’s Review, Life/Health ed., 81, pp. 24, 26, 28, 100-102. Skipper, Jr., H.D. 1997. Foreign Insurers in Emerging Markets: Issues and Concerns. Washington, D.C. International Insurance Foundation. Skipper, Jr., H.D. 1982. “The Homogenization of the Financial Services Community,” The Journal of the American Society of CLU. January, 3040. Skipper, Jr., H.D. forthcoming. “Insurance in the General Agreement on Trade in Services: Successes and Prospects,” American Enterprise Institute. Skipper, Jr., H.D. 1996. “International Trade in Insurance,” in Claude E. Barfield, ed., International Financial Markets: Harmonization versus Competition. Washington, D.C. AEI Press. 151-223. Skipper, Jr., H.D. 1979. "The Privacy Implications of Insurers' Information Practices," Journal of Risk and Insurance, 46, 9-32. Skipper, H.D., Jr. 1998. “Regulatory Harmonization and Mutual Recognition in Insurance,” in H.D. Skipper, Jr., ed., International Risk and Insurance: An Environmental/Managerial Approach. Boston. Irwin McGraw Hill. Survey of International Banking. 1999. The Economist. April 17.

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Thom, M. 1999. “The Prudential Supervision of Financial Conglomerates in the EU,” paper presented at the 1999 Thomas P. Bowles Symposium on Financial Services Integration. Georgia State University. Thompson, J. 1999. “Financial Services Reform: Basic Components, Position and Prognosis,” presented at the Conference on Insurance and Financial Services Regulation. Hartford. The Tripartite Group of Bank, Securities, and Insurance Regulators. 1995. The Supervision of Financial Conglomerates. Tuohy, M.R. 1999. “Financial Services: What Lies Ahead?” Emphasis, 3, 32. Van den Berghe, L.A.A. and Verweire, K. 1998. Creating the Future with All Finance and Financial Conglomerates. Boston. Kluwer Academic Publishers. Vander Vennet, R. 1998. “Cost and Profit Dynamics in Financial Conglomerates and Universal Banks in Europe,” Working paper, University of Ghent. December. Walter, I. 1997. “Universal Banking: A Shareholder Value Perspective,” European Management Journal, 15, August.

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CONVERGENCE IN THE FINANCIAL SERVICES INDUSTRY by L.A.A. Van den Berghe

Part A Convergence in the Financial Services Industry A Business Economic Perspective

Before we can outline the impact of the growing convergence within the financial sector, it is important to have an overview of what is really happening in that industry. This supposes a view on the actual situation and the historical background. Of even greater importance is the analysis of the underlying driving forces and of the different strategies that have been adopted by insurance companies, pension funds and other financial institutions. This is all the more true, since the convergence within the financial sector is developed in a very heterogeneous way, not only from a geographical perspective, but also within a given country and even within a given financial group. This section analyses these different dimensions of the convergence between the banking, the insurance, the investment and the pension industry. The emphasis is more on the business economic perspective. The first four chapters deal with the convergence within the financial sector. In chapter 5, we will pay attention to the convergence between insurers and pension funds. As will be shown there, banks also are (becoming) important partners in the pension market. Quite a number of financial firms act as true financial supermarkets, offering a very broad range of products (covering credit, insurance, savings and investment aspects). Due to deregulation, financial institutions are allowed more and more to offer complimentary or competing products, that were originally the closed privilege of neighbouring financial sectors. This leads to a blurring of the boundaries between the different sub-sectors of the financial system and to

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the formation of financial conglomerates. We will try to prove that financial conglomerates are the most prominent institutionalisation of the convergence within the financial services industry. Since the terms "financial convergence" and "financial conglomerates" are central in this report, we will outline briefly what we mean by these two terms. We refer to "financial convergence" as the general term, relating to all types of interfaces between financial suppliers and the demand of all types of financial products and services. Part of the interface is of an institutional nature, and this is where the term "financial conglomerates" pops up. More particularly, we consider a financial conglomerate as a group of enterprises that is formed by different types of financial institutions (banks, insurance companies and investment institutions). Most of the time, the term financial conglomerates is used to denominate groups with both banking and insurance subsidiaries. But in principle, a financial conglomerate can consist of a bank and an investment company (without having an insurance subsidiary). These types of groups are often referred to as "universal banks". One of the most striking observations in this convergence process is the huge heterogeneity in structures and strategies that have been adopted by these financial institutions. Unless we accept a rather approximate and rough overview by comparing apples and oranges, we will need to develop a clear understanding of the differences in approaches and strategies of financial firms. This will be the subject of chapter 1. The general framework developed there is called the financial conglomerates control board. This instrument can also be used to describe the convergence of the insurance and pension industry as well as make the inventory of potential synergies and potential risks. We will use this framework to show that the convergence in the financial services industry is taking place on different levels. The most familiar or well known is the convergence at the distribution level (cross selling). This is discussed in chapter 2. However, more and more financial institutions realise that there is more than cross selling. Put differently, in order to gain a lasting competitive advantage, firms will have to do more than merely cross-sell the different products of companies within the group (or from an allied partner). This is shown in chapter 3. In chapter 4, we will go one step further and have a look at back-office operations of financial institutions and investigate whether there are opportunities for "integrating" banks, insurance companies and investment institutions.

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In chapter 5, we will turn our attention to the convergence of the insurance and the pension industry. Insurance companies not only broaden their scope in the direction of financial services, but there is also an increasing competition with pension funds. We will show that some of the trends that are occurring here are quite similar to the trends of financial conglomeration. This part of the report should give the reader some insights into how the convergence in the financial services industry is taking place. Where possible, we will try to highlight some important trends or give some concrete examples (by means of case studies, statistics or product examples). A warning is however necessary in this respect. We have been collecting data for more than 15 years now and although our database has grown over the years, the quality of the statistics is rather poor. This becomes very clear when one compares statistics that relate to the same market: there is a great lack of reliable market information and the different sources of statistics use different definitions and measure different samples so that comparison is hard to make. This is all the more striking since supervisors, business firms as well as researchers, are all in great need of reliable statistics and benchmarks. A joint venture to establish such a reliable database between supra-national organisations, market supervisors and academic circles could perhaps tackle this worldwide need. 1.

A framework for the analysis of the convergence in the financial services industry: The Financial Conglomerates Control Board

1.1.

Introduction

The growing convergence in the financial services industry, and more particularly, the convergence between the banking and the insurance industry, has received widespread attention in both academic as well as in business literature. Most articles focused on: − the drivers of this trend; − the main strategies followed and the organisational forms used; − the potential advantages and the risks associated with convergence mainly between banking and insurance. In the beginning of the nineties, the OECD issued two important and still relevant studies in this respect: “Insurance and other financial services: structural trends” (1992) and “Financial conglomerates” (1993).

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Especially relevant for our purpose are the studies that analysed the main strategies and the different organisational forms adopted. What is striking is the huge heterogeneity in this development process. It would be a mistake to consider the convergence of financial firms as being a homogeneous trend with similar characteristics worldwide. Some researchers have acknowledged this heterogeneity and have developed a typology of financial conglomeration. 1.2.

Link with the corporate diversification literature

Before we discuss these studies, we think it is appropriate to establish a link with the corporate diversification literature. One could argue that the convergence in the financial sector could be considered as an example of diversification. The breaking down of the boundaries between banking, insurance and investment markets is strongly associated with the creation of financial holdings (conglomerates), with business units in the respective industries. Therefore, it seems not illogical to apply the literature of corporate diversification (which has most of the time focused on the industrial environment) to the financial services industry. The critical results of these studies certainly influenced the rather sceptical evaluation of a number of diversification ventures in the financial services market. It is therefore of interest to point to some of the main results of this general diversification literature. Although applying the general literature to the financial services industry is extremely dangerous, we could "borrow" some of the more general frameworks developed in this literature. Diversification has been one of the most extensively researched topics in the strategic literature. Some of the seminal works were written in the early 1960s, but "diversification" was put on the top of the academic agenda after Rumelt published one of the most influential books in 1974, "Strategy, structure and economic performance"1. In this book, Rumelt showed that related diversifiers outperformed unrelated diversifiers. That is, diversifiers who concentrated on some central skills or competencies outperformed all other categories of firms (i.e. specialised firms, unrelated diversifiers, vertically-integrated firms). This study was the start of a huge stream of literature which refined and redefined the tools used by Rumelt. It is impossible to comment on all these studies here, but we can easily summarise these studies in the following, somewhat disappointing, conclusion: “The use of alternative approaches for measuring diversity has not led to greater insights into the impact of diversification on performance. The results of most studies have merely extended or marginally modified Rumelt's (1974) 2 original findings" (Ramanujam and Varadarajan, 1989) .

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Although this statement is 10 years old, it is still very up-to-date. Researchers have tried to come up with answers as to why no conclusive relationships could be detected. And more and more, they acknowledge that diversification is a multidimensional concept. There is scientific evidence that each of these different dimensions is important in explaining the degree of success of a diversification strategy3: − Diversity status - which gives an indication of how diversified a company is. It is clear that the larger financial conglomerates with substantial banking and insurance (and investment) activities, like ING, Crédit Suisse-Winterthur, Fortis, are more diversified than banks with a small insurance subsidiary (or vice versa). The idea is that more diversified firms have more potential to exploit synergies, and therefore should be more successful. A large number of empirical results do not support this hypothesis for non-financial firms. Recent research of financial conglomerates4 has shown that the main performance driver is certainly not the diversity status. The reason being that potential synergies are often hard to realise. Other factors seem to be more relevant (e.g. implementation). − Degree of relatedness - which indicates how related the new business is compared to the existing business. If this is the case, we call this related diversification. If the different businesses have no marketing or other forms of relatedness, the diversification is labelled unrelated. The common idea is that related diversifiers should outperform unrelated diversifiers because they have more opportunities to exploit synergies. The empirical results have not always confirmed this hypothesis. − Mode of diversification - researchers have examined whether startups were more successful than mergers and acquisitions (and joint ventures). No conclusive answers were obtained in this respect. − Implementation aspects of diversification - researchers focus on different aspects, e.g. which organisation structures have been set up, do managers share the same "culture", etc. In these discussions the concept of integration is central. Because of the importance of this factor for realising the potential synergies and benefits of financial conglomeration, we will come back to this point later in this chapter.

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In what follows, we will show that academicians who have described the convergence process in the financial services industry have implicitly used these dimensions the backbone of their typologies. 1.3.

Making an inventory of the types of interfaces between the banking and the insurance companies

Some researchers have acknowledged that the formation of financial conglomerates is not a homogeneous process and that different forms of financial conglomeration exist. We refer to appendix A.1 for a more detailed overview of the three different typologies we found in the literature. The three typologies each focus on a particular dimension of the diversification decision. 1. The typology of Herring and Santomero (1990)5 is based on the corporate structure of the financial conglomerates and is based on differences in the legal and operational separateness. This typology, which is based on implementation aspects of diversification, distinguishes between 4 different financial conglomerate models: − complete integration − bank parent - non-bank subsidiaries − holding company parent - complete legal separateness − holding company parent - complete legal and operational separateness. 2. The second typology was developed by the Verzekeringskamer, the supervisor of the Dutch insurance companies and pension funds, and was used to effectively control financial conglomerates. This classification used the diversity status as a criterion to distinguish between the different alternatives. 3. Some early publications (e.g. Lafferty Business Research, 1991 and 19946; Hoschka, 19947) have used a typology based on the entry strategies of banks into the insurance industry (i.e. the mode of diversification). Of course, this methodology may also be

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applied to insurance companies entering the banking industry. A distinction was made between: − de novo entry (start-ups) − mergers and acquisitions − joint ventures − distribution alliances. The typologies focusing on the implementation aspects of diversification and the mode of diversification have implicitly tried to provide arguments for the relative success of some diversification strategies. For example, the studies which used the typology based on the mode of diversification, found that de novo entries and mergers and acquisitions (M&As) were more successful than distribution alliances and joint ventures. One of the main explanations was that the degree of integration was higher in the start-ups and M&As, as is shown in Figure 1.

Figure 1 - Alternative entry vehicles for banks entering insurance De novo entry = greenfield entry with own underwriting of insurance

Level of Integration

Merger/acquisition = combination and integration of two separate corporations either through merger or control acquisition

Joint venture = jointly owned separate legal entity underwriting insurance

Distribution alliance = co-operation agreement, concerning distribution area possibly supported by mutual shareholding

Source: Hoschka (1994)

8

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1.4.

Towards a new theoretical framework: Conglomerates Control Board (FCCB)

The

Financial

We are convinced that the degree of integration is a key concept in explaining differences in financial convergence strategies. However, the typologies we just described only consider part of the problem [see e.g. Hoschka (1994)] or consider this level of integration on a too theoretical level [see e.g. Herring and Santomero (1990)]9. We have tried to elaborate a useful theoretical framework, by combining the concept of the value chain with the service operations system (the servuction system). This standard reference base, called the financial conglomerates control board makes it possible to gain a better understanding of the types of financial conglomerates, their structure and strategy, their potential synergies as well as the types of potential risks. Figure 2 - The Financial Conglomerates Control Board Environmental Factors Lega

l Stru

Corporate Governance & Management

ructu r

e

Orga nisa Struc tional ture

Capital policy Technology

Distribution

a l St

Market Development

Product Development

Infrastructure Capit

Operations Management

cture

M.I.S. : Accounting & Reporting

Source: Van den Berghe and Verweire (1998)

10

The concept of the value chain has been developed by Porter. The value chain highlights the different activities to create added value for the customer. Every step costs money and creates value. The higher the total added value, the better the perspective for a competitive advantage and a profitable margin. This tool is mainly used for an industrial firm. In order to be able to integrate this concept into the analysis of financial conglomerates a fundamental adaptation is necessary. Such a translation can best be based on the structure of the service operation system, which pictures the banking and insurance firms. The details of this framework must be so that they make it possible to test for:

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− the drivers for and the different types of synergies within financial conglomerates, and the degree to which they are realised; − the drivers for and the different types of risks within financial conglomerates, their size and possible consequences; − the classification of financial conglomerates and possible correlation with the performance level. In the future we hope to classify conglomerates according to differences in this reference framework. In addition the specific macro/market environment is also relevant and should be considered as well. This reference scheme is divided into three main parts. The arrow on the front side (containing the boxes Corporate Governance & Management to Distribution) is comparable to the value chain. It depicts all primary and support activities where synergies can be found and which determine the risk level of the conglomerate. At the back side of the instrument, we find some structural aspects (such as the legal structure, the capital structure and the organisational structure) which also influence the potential for synergies and the risk level. At the upper front, we take along some environmental factors. These are control variables that could also be important in the comparative study of financial conglomeration and financial convergence. We refer to appendix A.2 for a more detailed explanation of this financial conglomerates control board. In the remainder of this first part, we will analyse the convergence in the financial services industry based on this reference framework. More particularly, in chapter 2 attention is paid to the convergence in the financial services industry at the distribution level. We will, however, show that pure cross-selling of banking, insurance and investment products through the same outlet is only a first step, and perhaps even a minor step, in creating a competitive advantage. In order to build a lasting competitive advantage for their clients, financial institutions will probably have to go one step further by developing all finance solutions. That means that they will have to examine the whole marketing cycle of their financial products (product development, market development and to some extent the operations management). This is the subject of chapter 3.

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In chapter 4, we will show that the convergence between different types of financial institutions is taking place on other levels as well, namely more and more in the back-office and the rest of the organisation. In chapter 5, we will describe the convergence between the insurance industry and the pension industry. 2.

Convergence in the financial services industry (bankinginsurance): convergence at the distribution level

2.1.

Introduction

In countries where the boundaries between the different sub-sectors have broken down, the majority of the banks and the insurance companies have engaged in cross-selling each other’s products. Even in countries where deregulation hasn’t proceeded that fast (the most notable example being the US), distribution alliances between banks and insurance companies are very common. In this chapter, we will first create some definitional clarity. The different terms that have been used throughout all the studies and reports may have completely different meanings for different countries, companies and individuals. We proceed by outlining some historical trends, which show that the convergence at the distribution level has been going on for decades (long before the concepts of "bancassurance" and "assurfinance" or "assurbanque" were invented). We will then give you an idea of the current situation and we end with describing some new developments in this respect. 2.2.

Some definitional clarity

Banks and insurance companies have been joining forces in the provision of a complete range of financial services for quite some time. Most researchers have referred to this phenomenon by the term "bancassurance", but other terms like "assurfinance", "assurbanque", "allfinanz", "all finance" and "financial conglomerates" have been used to identify the phenomenon of financial convergence. Little uniformity can be found, however, in the definition they attach to each of these terms. Therefore, we want to clearly define what we mean with the different terms.

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For what concerns the collaboration on the distribution level11, there is considerable agreement regarding the definition of bancassurance and assurfinance (sometimes the term assurbanque is used): − Bancassurance is the strategy of a bank to cross-sell insurance products through its own distribution channels, usually branches. − Assurfinance can be defined similarly and is used to designate the strategy where an insurance company and/or an insurance intermediary cross-sells financial products. The banks and the insurance companies can opt for different ways to realise these strategies. If we take the example of the bank, the following approaches have been used in practice: − The bank can produce the product itself (through an insurance subsidiary or sister company) and become the risk bearer through its own insurance company. The risk-taker is always an insurance company. − Banks can offer insurance products with the help of an insurance partner through an own (creative) joint venture. − The bank can limit herself to a pure agent or brokerage role (respectively with one insurance partner or as an independent intermediary). It is worth noting that some recent studies [e.g. the LOMA study, 199712] define bancassurance as the sale of insurance -manufactured by the bank’s own insurance company- through the bank’s distribution channels. In such a definition, the researchers explicitly exclude those cases in which joint ventures or distribution agreements are the approach used. This alternative was popular in the beginning but in the last couple of years, mergers and acquisitions have been used more frequently (see the current merger and acquisition wave in the financial services industry). Sometimes, the term "allfinanz" has been used to indicate both bancassurance and assurfinance strategies. For example, Lafferty Business Research (1991)13 used the term "allfinanz" (which some people have translated into "all finance") because it better conveys the dissolution of barriers that has been taking place, not just between banks and insurance companies, but among all types of financial service providers. We will come back to the term all finance in the next chapter. 183

2.3.

Historical background

2.3.1.

From a co-operative interface between banking and insurance

The analysis of bancassurance (and assurfinance) to a large extent coincides with the analysis of financial conglomerates, because the banking and insurance groups mainly focused on distribution synergies (at least in the beginning). The formation of financial conglomerates does however not coincide completely with the growing market interface between insurance companies, banks and investment firms. Belgium for instance has been a country of financial holdings which did not operate in the market as financial conglomerates for quite a long time. On the other hand, even before such large financial groups were formed there were important operational relations between different players in the financial market. The financial conglomerate movement mainly started with banks who elaborated separate subsidiaries for a wide range of financial services such as leasing, consumer finance, mortgage, financial engineering, unit trust management, insurance brokerage and consulting services. The diversification strategies within the banking sector were driven by different forces. One of the most significant forces has been the desintermediation in commercial banking. The traditional function of a credit institution is to act as an intermediary between economic agents with financial surpluses and agents with financial shortages. During the former decade, some structural trends have evolved both on the assets as well as on the liabilities side of the bank balance sheet. On the assets side, credit institutions are confronted with the replacement of straight bank loans with market-determined sources of financing. For example, large corporations with a good rating prefer the issuance of bonds and other securities to get the necessary capital. On the liabilities side, there is a substantial outflow of deposits to a wide range of new financial products offered by companies of different sectors. In addition, banks faced new capital adequacy rules which put further pressure on banks’ profitability. Examples of significant moves in this respect are the increase of off-balance sheet transactions (e.g. securitisation) and increased feebased business (e.g. financial engineering, investment advice and insurance selling). Therefore, banks have looked for new sources of profit, preferably without increasing their necessary solvency level. All fee income was therefore a welcome source of diversification. By acting as agents (or brokers) for

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insurance companies, banks could increase their fee income and enlarge their service assortment with some high touch products. To a certain extent, also insurance companies benefited from this development: they disposed of an additional distribution channel. The agency role that was played by banks (for insurance companies) has a long history. It partly arose because of the complementary nature of banking and insurance products. Another explanation lies in the fact that both banks and insurance companies can reduce the search costs for their customers, if these wish to extend the range of financial products purchased. It is remarkable that insurance companies, at that time, did not show the same intensity to diversify into non-core business activities. 2.3.2.

Towards a competitive interface

The situation changed when banks decided to set up their own insurance companies, from this moment on banks were considered as competitors for insurance companies. We will show that it is not surprising that banks tried to recapture their cheap ways of funding by diversifying primarily into the life insurance industry. Lafferty Business Research (1991)14 sums up the factors that have prompted banks to do so, and which have created an entirely new environment for the financial services sector: − a dramatic alternation in demographic patterns; − a shift in the emphasis of consumer demands; − corresponding changing savings trends. In the 1980s the population growth rates significantly slowed down whereas the average lifetime increased significantly. The combination of these two trends leads to a greying population. This demographic pattern has serious consequences on the overall economic environment, and especially on the provision of social security. The increasing proportion of the elderly relative to the working population is placing a strain on public pension systems. As these systems generally work through a redistribution scheme, the financing base comes under pressure (a decreasing number of contributors) while at the same time the financing needs increase drastically (a growing number of beneficiaries who live longer and have earned higher wages). This tendency is putting more

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severe pressure on governments trying to maintain state pension levels. For the higher-income groups the public provisions are generally not enough to ensure the same standard of living. As a consequence, people try to set up their own additional pension scheme. Given the financial pressure on the state pension systems and the drive towards decreasing the government deficits the level of public pension could well decrease in the (near) future. Consequently also the lower income levels feel more and more the need for extra private pension savings. Thanks to the growth in prosperity and the expectations of a higher standard of living the budgetary margin for pension savings increased creating a growing emphasis on long-term, high-yield financial savings. This partly explains the success of alternative investment vehicles such as unit-linked and universal life products, but also investment or mutual funds. This evolution shows the link between the financial conglomeration at the one hand and the converging trends with the pension market at the other hand. Life insurance in general has been a booming industry since the eighties. Of course the just mentioned retirement issue has certainly had a positive impact on growth in the life insurance sector, but other factors have been at work as well. The level of inflation is another determining factor for the economic potential of life insurance. Due to the discipline imposed by the European exchange rate mechanism, inflation was relatively low during the last decade. As inflation was low and real interest was relatively high, the consumers had a stimulus to invest in long-term oriented savings. Moreover the life insurance product became a very attractive long-term saving instrument because the average long-term interest rate offered by insurers (actuarial interest rate) was more competitive than in a high inflationary environment. Thus, life insurance accounted for an increasing share of total savings in some EC countries which underlines its rising significance and the successful inroads in which insurers were able to make into the savings pool that traditionally was monopolised by banks. This strategic move of banks into insurance was further stimulated by other factors such as the growth perspective in the insurance industry, the support of an advantageous tax regime, and the gradual regulatory liberalisation within the financial services industry. The regulators realised it was not necessary to rely on direct interference by imposing restrictions on activities of banks and insurance companies. In the Netherlands, the liberalisation of the Structure Policy in 1990 has been one of the main causes of the accelerating pace of takeovers in the financial services sector.

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2.4.

The current situation: facts and figures

Time has shown that the bancasssurance and assurfinance are more than just a fashion and that these trends are here to stay. After years of regulatory battle over whether banks should be allowed to sell insurance, banks and insurance companies are recognising that bancassurance (and assurfinance) is finally becoming reality. Moreover also the most fervent specialist insurers (like AXA or AEGON) acknowledge these trends and use the bancassurance potential in their own way. 2.4.1.

Bancassurance

Most attention has been paid to bancassurance. This can also be deducted from the numerous articles, written about the (successful) inroad of banks as distribution channel for insurance products. A distinction is however necessary between the life and the non-life business. The statistics given below show that distribution via the bank branches is most successful in the life insurance industry. The life insurance business An overview of some international statistics of the penetration of banks in the life insurance market is given in Figure 3. Figure 3 - Bank penetration into life insurance market (new life insurance contracts)

Source: Flur, Huston & Lowie (1997)

16

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More recent data are available for some European countries. We collected them from different sources. It must be mentioned that different sources have come up with figures, which might differ significantly. The reasons behind these differences are multiple: − the definitions of the relevant variables differ, − the sample differs, − it is often more approximate evaluations than hard statistics, − banks rarely reveal the penetration rates of their own customer base with life products, whereas conglomerate insurers mostly hide the division of their insurance premiums over the different types of distribution outlets. We must limit ourselves to those cases where the bank owns the insurance company so that it is nearly impossible to have a global view of the total impact of banks in the insurance business. Taking these remarks into consideration, Table 1 gives an overview of the penetration of banks in the life insurance market. The figures exclude bancassurance arrangements in which the bank acts as the agent or broker of the insurance company. Stated in another way, in order to be included in these statistics, the premiums sold through the banking network have to be paid to an insurance company that forms part of the financial conglomerate to which the bank belongs or the insurer must be owned by the bank. We therefore must warn that the real impact of banks selling insurance products is probably substantially higher than the statistics given below. Table 1 – Penetration of life insurance markets by banks Belgium The Netherlands United Kingdom Germany Spain Italy France Sweden Finland

1992 16% 20% 20% 8% 8%

1994 19% 18% 15% 7% 32% 20% 55% 10%

1995(*)/96(°) 23%° 15%* 17%° 15%* 32%* 56%* 26%° 44%°

Note: penetration is measured as the bancassurer’s share of new annual gross premiums or new premiums written.

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These statistics reveal that the bancassurance movement shows considerable geographical differences. France is the clear leader: almost 60 per cent of new life insurance contracts is estimated to be written by banks. Banks have been very successful in Finland, Italy and Spain. But also in the other countries, bancassurance has proven to be more than a marginal phenomenon. Holsboer (1998)17 explained the differences in penetration between the different countries along developments at the demand side. In a country like France, vast middleclass segments had been underserved, and banks were in a better position than insurers to reach these segments. In countries with mature private pension markets, such as the Netherlands, the success of bancassurance has been less pronounced, due to a stronger market position of local insurers. In the German market, which is less developed in terms of private life and pension plans, bancassurance in the strict sense (banks entering insurance for their own account) has gained less ground. This is attributed to a market structure that is characterised by longstanding close links and cross-shareholdings between insurers and banks [Holsboer, 1998: 28]. But Holsboer expects some changes, due to the growing competition from direct writers and other European insurers. Table 1 also shows that for most countries the share of the banks as distribution channel for life insurance products is still increasing. This trend is expected to continue, at least for most countries. At the same time, we must say that the move of banks into the life insurance business is more a defensive reaction to the trend that took place during the 1980s and 1990s, when a substantial part of the banking deposits has moved to the (life) insurance industry. In fact, the increasing market share of the banks can lead to some form of cannibalisation. Indeed, the banks are in fact reshuffling their portfolio and substitute (out of sheer necessity) traditional banking products with new forms of savings products. The success of bancassurance in the life insurance industry has been explained by a number of factors. − Banks disposed of an extensive branch network which can be used to sell insurance products. − Banks had more frequent contact with their clients. This advantage is rapidly decreasing due to technology-driven banking services. Insurance selling can therefore be seen as a hedge against this leakage of client contact. − Banks could use a much more detailed database to approach the customer and deliver tailor-made products with a one-stopshopping convenience. 189

− Banks mostly had a better reputation: banks were rather seen as trust persons, as opposed to insurers who were thought to be sellers. − Bancassurance is considered to be much more cost efficient compared to the traditional insurance selling. − A final reason for the success of bancassurance can be attributed to the fresh look banks have given to the insurance business, developing a strong customer focus, resulting in simpler and more transparent products, mostly designed for the large middle classes. The non-life business Table 2 gives the comparable figures for the non-life insurance market. Table 2 – Penetration of non-life insurance markets by banks 1994 3% 15% 1% 2% 3% 5%

Belgium The Netherlands United Kingdom Germany Spain France

These figures show that bancassurance has been less successful in the non-life market. The main argument is that non-life insurance is much more different from the banking products, while the life insurance products have more similarities. Since non-life products have different features, it is more difficult for the bank branch staff to sell these products. However, there are financial conglomerates that indicated to put more pressure on selling non-life insurance products through the bank branches. Some of these non-life products (e.g. car insurance) have a "trigger function": if banks are able to sell these products, there is a higher probability that they can sell other insurance and financial products. Although banks have long been afraid of the claim settlement and the potentially negative effect on their image there are some signals that also this trend is turning now (cf. EFMA conference on claim settlement). Are the US and Canada lagging behind in this bancassurance trend?

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The LOMA report by Brooks Groca (1997) paid special attention towards the bancassurance situation in the US and Canada. Operating in a restrictive regulatory environment, US banks have found a number of ways to enter the insurance business. Normally, national banks and subsidiaries of bank holding companies are excluded from providing insurance as principal, agent or broker (through the Bank Holding Company Act, amended in 1982). There are, however, some exceptions where banks are allowed to sell insurance: − where the insurance is limited to assuring repayment of the outstanding balance due on a specific extension of credit in the event of death, disability, or involuntary unemployment (this provision permits banks bank holding companies to own credit insurance subsidiaries); − where the bank owned the insurance company prior to 1982 (which was the case for 16 banks: "the sweet 16"); − where the bank is located in a town with a population of not over 5000; − where the bank assets are only $50 million or less. Given the legal limitations on insurance activities by banks, US banks have to take more indirect routes to bancassurance. Their involvement is still restricted, as compared to the European financial conglomerates, but has to some degree educated them about the business. Some of them are likely to apply this education aggressively when allowed to do so. According to the LOMA study, banks’ involvement in insurance business has taken five main forms. − Distribution alliances: which is the most significant route into bancassurance by US banks. Of banks with more than $10 billion in assets, 84 per cent market insurance. Savings institutions and credit unions are also distributors of insurance. − Credit insurance: under US law, banks have long had the ability to manufacture credit insurance, but only few of them have exercised this authority. − The bank-owned reinsurance company: some banks have the right to own captive reinsurance companies, which have been used to reinsure their credit insurance business and to reinsure directors’ and officers’ liabilities.

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− Investments in insurance companies through venture capital subsidiaries: e.g. JP Morgan has an equity investment subsidiary (JP Morgan Capital Financing Corp.), which made a $200 mln investment in Travelers/Aetna Property/Casualty Comp. − Credit relationships: banks are providers of credit and cash management services (to insurance companies). And some banks have played major roles in financing insurance acquisitions. Credit relationships have played on occasion an important role in bank distribution alliances with insurance companies. In Canada, banks face a particular situation. Under Canada’s 1992 Bank Act, banks and insurance companies can own one another. However, banks are barred from selling most kinds of insurance through their branches. The only exceptions are credit and travel insurance. Furthermore, strict limitations are placed on the use of bank customer data by affiliated insurance companies. These restrictions severely reduce the economies that can be obtained by integrating some activities (which are open to the European competitors). 2.4.2

Assurfinance

Insurers have reacted to the rise of bancassurance by strengthening and improving their existing distribution network. Serious efforts have been made to make the whole selling process more efficient or to focus towards more advice and service-oriented types of products. Furthermore, insurance companies have upgraded their new products with financial components. This is, however, restricted to the life insurance industry (except for Japan, where non-life insurance products sometimes have financial components as well). As a more offensive response, insurers have also started cross-selling simple banking products to their customers. Some insurers decided to set up their own banking company from scratch (or by acquiring a small bank). According to Holsboer, this strategy has worked to some degree of success, e.g. for some Dutch insurers, which started quasi-banks, working from a direct marketing approach. But this approach has generally been confined to niches and simple products. For broader scale banking activities, acquiring or merging with existing banks seemed to be a better alternative. Generally, one could say that the moves of insurers into the retail banking business were less noticed and didn’t always seem very successful. In Germany, the rapidly expanding insurance group Aachener und Münchener really bought a problem with a former trade union bank, Bank für Gemeinwirtschaft (BfG). 192

The problems had become too heavy and therefore, they reduced their participation in the bank to 25 per cent. Other problems originated in France where GAN, one of the largest insurers, had problems with its subsidiary CIC, because the latter one was too heavily exposed to the collapse in the French property market. Other nightmares were found in Australia (Chase-Australian Mutual Provident’s) and New Zealand (General Accident and NZI Bank). It’s remarkable that insurance companies played a less important role as agents for banking products. Possible explanations are: − regulatory restrictions: banks could sell insurance products without great regulatory barriers, whereas insurance companies could not easily attract public savings (deposits, term accounts, etc.) or operate as a monetary institution; − distribution facilities: most banks (except the savings banks) operated through their own distribution network. This gives them the facilities to implement whatever marketing strategy they prefer. Insurers on the contrary operate in many countries through independent brokers so that they do not reach their final clients directly. We may naturally not forget that insurers have always been important players in the financial market. Their institutional investor function made insurers important players in the investment field as well as in the field of mortgage loans. Another aspect in the assurfinance trend is the fact that independent intermediaries themselves have to a certain extent been involved in the distribution of financial services. For a long time already they not only offered mortgage loans (coupled with life insurance and eventually with fire insurance) but many of them operated also as agents for a savings bank. Research in Belgium18 has shown that 65 per cent of the independent small and mediumsized intermediaries also offered financial services. However, the contribution of these financial products towards the turnover is much smaller: financial products represented only 17 per cent of the total commission earned by the interviewed intermediaries. The market percentage of profits attributable to the financial products can even be lower because it is frequently heard that the commissions on these products are (very) small compared to those of insurance products. More recently, a number of insurance companies have made well-noticed inroads into the banking industry. For example, in the UK, Prudential, Scottish 193

Widows, Sun Life of Canada, Friends Provident, Direct Line and Legal & General had all moved into banking by July 1997. The trend has become quite prominent in Scandinavia. According to Sorcha Corcoran19, the new breed of banks was designed, at least in part, to stem the outward flow of funds when policies mature. These latter moves seem to be more successful than the assurfinance strategies of the earlier days. 2.5.

Beyond bancassurance and assurfinance

More and more financial conglomerates now have the disposal of different distribution channels. In these companies, managers believe that it is not a question of bancassurance or assurfinance. But managers of financial institutions believe that the best distribution strategy encompasses all different distribution alternatives. The purpose is to develop an integrated distribution system, where customers are free to select the distribution channel they want. In some instances, this might be the bank (e.g. for financial or simpler insurance products), in other cases this might be the insurance broker, and in still other cases, the customer might contact the financial services provider more directly. Although this might still be wishful thinking for most financial companies, we believe that this distribution model will become the model of the future. It is worth noting that less traditional distribution channels will gain in importance. The volume of sales and service transactions conducted through lower-cost remote channels (e.g. telephone or internet) is growing dramatically. And in many sectors of personal financial planning, remote channels are already widely used. A study by McKinsey20 revealed that in 1996, 65per cent of consumers claimed to have used their bank’s telephone service, and 1000 banks had web sites, up from only 20 in 1994. Roughly 1.2 mln households currently use PC banking. These new trends will force financial institutions to reinvent but not eliminate- the traditional face-to-face channels. For the McKinsey analysts, it is, however, clear that the role of traditional insurance agents or bank branches may shift. At the same time, financial institutions face competition from non-traditional competitors. The UK shows us some interesting examples in this respect. Food retailers such as J Sainsbury and Tesco have successfully set up a joint venture with Bank of Scotland and Royal Bank of Scotland. But in these cases, the banks are behind the scenes, and the retailer owns the customer. Furthermore, it is the retailers’ brand names that have been used. Other (UK) examples of successful inroads from non-traditional competitors include Marks & Spencer Financial Services, and Virgin Direct.

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2.6.

What about the corporate market?

So far, we concentrated ourselves on the retail market. Indeed, bancassurance and assurfinance have largely been confined to retail segments and products. But leaders from the "all finance movement" movement proclaim that the actual focus on the retail market co-operation between banks and insurance companies is only the tip of the iceberg. Also the corporate market could offer many opportunities for joint and integrated projects. For example, Holsboer (1998)21 showed that extending pension plans for individuals to small businesses is only a logical step further. "Especially in countries with emerging private pension markets, such as Spain and Italy, there will be significant opportunities for corporate life insurance. In these countries, insurers have no traditional relations with corporate customers, while banks can easily leverage their existing corporate client relationships. A similar reasoning is true for non-life insurance. Bancassurers have entered into individual lines insurance with increasing success. Commercial lines is a more specialised field, making entry more difficult. Yet we expect that banks will increasingly seek to acquire this expertise and that they are well positioned to compete in the corporate segments (p. 30)" At the same time, there is a growing convergence trend underway in US financial markets involving commercial insurance companies, reinsurance companies and leading investment banks. Certainly, this trend is not unique to the US. It is, however, beginning to change significantly the very nature of risk management and the methods of financing risk. This trend is driven largely by corporate needs and demands for more effective types of financial protection for a broad range of financial and non-financial risks. For example, In the US, providing financing arrangements for corporate risks is becoming big business in the investment banking industry. Virtually all large investment banks in the US have now developed large risk management divisions that focus on new products that utilise capital market tools for financing a broad array of corporate financial risks. Investments banks, insurance companies, reinsurers and insurance brokers are also coming together to jointly form catastrophic property and liability insurance companies to write high limits of traditional insurance. Some examples include significant capitalisations from J.P. Morgan for the formation of Bermuda-based EXEL, Limited and Mid-Ocean Reinsurance, and Morgan Stanley’s investment in ACE, Limited. The opposite trend can also be observed:

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a number of large insurers companies and insurance brokers develop capital management companies. For example, American International Group established AIG Capital Management, a division focusing on global investment banking. In 1992, Marsh & McLennan established a new division, Marsh & McLennan Risk Capital, to focus specifically on investment activities, primarily in the insurance industry. From these examples, it is clear that investments and risk are considered to be complementary. This can also be seen in the redefinition of Swiss Re’s mission and core business: "the mission of Swiss Re Group is to be the authority on managing capital and risk, based on the core competencies risk transfer, risk financing and asset management". More and more examples can be given of the growing convergence between these different types of financial institutions. In conclusion, many new developments are underway in the convergence of commercial insurance, reinsurance and investment banking. While it remains uncertain just how extensive this trend will become, we will probably see more and more innovative blending of the products, services and operations of the different sectors. This convergence provides compelling evidence that commercial insurance market will not remain the sole province of traditional insurers and reinsurers.

3.

Convergence between banking and insurance: there is more

than cross-selling 3.1.

Introduction

In the previous chapter, we have extensively described the bancassurance and assurfinance development. The main conclusion was that banks and insurance companies have been working together on the distribution level for quite some time, but only from the middle of the 1980s on, a real convergence in the financial services industry has taken place. In this chapter, we try to show you that more fundamental forces are at work. We will argue that the growing convergence in the financial services industry is taking place because financial institutions reconsider their core business and come up with appropriate strategic answers. One of these answers, is what we call "all finance". This discussion is also very relevant with respect to the discussion on the convergence between the insurance and the pension market. We will come back to this point in chapter 5. 196

3.2.

Redefining the core business of financial institutions: from a technical (product) to a client-oriented (functional) approach

The current changes that take place in the financial services industry make that today’s and tomorrow’s financial sector will look very different from the financial sector of 10 years ago. Strategists often agree that in most markets, and in particular the financial services market, the definition of the core business has traditionally focused on the kind of products offered. Typically, this is reflected in the words used to denominate the different types of financial institutions: life insurance companies, mortgage companies, pension funds, car insurance companies, etc. But as the product and geographic boundaries disappear, this traditional definition of the core business might not work well anymore. Managers of financial institutions should rather adopt a client-oriented (functional) approach, instead of the traditional technical, product-oriented approach. This is also acknowledged by the managers of insurance companies. For example, we cite Dean O’Hare, CEO of the Chubb Corporation: "Our industry [the insurance industry] is constantly assessing the regulatory, economic and financial landscapes. We spend precious little time assessing the landscape of our customers and the economic, social and political problems they are facing. We need to redirect our efforts, because these problems define their protection needs and therefore our future opportunities […] The insurance industry historically has been product driven. We have done an excellent job of developing new products, coverages and packages of coverages, which we have taken to our customers and told them, "you need this." Much of the time, they agreed with us […] This relationship is changing, however. In an uncertain economy -and a soft insurance market- many customers have seen fit to re-evaluate the way they interact with their insurer. The smart insurers have picked up on this change. They are listening to their customers. They then are finding ways to address customers' problems and to identify new customer needs. It may sound simplistic, but listening to customers and understanding their problems in detail will prove to be our most important strategic activity" [O'Hare, 1995]. Such a redefinition of the core business by means of a more functional approach will enable financial firms to:

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− better join in with the real needs and wants of the customer; − face all different forms of non-traditional competition; this was already noticed in 1987 by Prof. Matthias Haller, who stated: "With which products and services can our competitor solve the problems of our clients better and pick in part of our current market share? And how can we protect our core product and services by filling in our scope of activities with broader functions and services? [Haller, M. (1987)]. − exploit opportunities which have come up, due to changes in society (e.g. changes in the welfare state). Defining the core business from the perspective of the customer can open a far broader field of services than when one sticks to the pure technical approach or product focus. The following figure, based on our own market research (Van den Berghe & Baeten, 1996) shows clearly that the traditional insurers focus their core business on a very small part of the whole risk management spectrum. Figure 4 - Insurers’ core business from a broader perspective RISK MANAGEMENT

Safety

Financial security (1) All finance direction Personal Financial Planning

Physical security Psychological security Prevention

(3) All care direction

(2) Traditional core business of insurance companies

Although the tendencies are not yet completely clear in practice, we see two main options for further integration: − All finance, into the direction of personal financial planning (for the retail market) and employee benefits (for the commercial market). This is an option followed by a large number of insurance

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companies. However, it is not always clear whether insurance companies are in the best position to offer such solutions. For example, in case of employee benefits, it might be that human resources consultants have developed more competencies than the traditional insurance companies in this respect. − All care, into the direction of family risk management (retail market) and integrated or holistic risk management (commercial market). Here too, we see a broadening of the scope of the insurance company, e.g. by offering laundry, catering and home care services. Similar arguments can be forwarded with regard to the banking industry. Robert Merton (1990)22 published an article where he suggested that a functional approach may provide a more useful organising perspective than an institutional approach, especially in an environment of rapid technological changes and movements towards increasingly global connections among financial markets. Applied to the banking industry, Crane and Bodie (1996)23 elaborated on the Merton article and described the transformation of banking. They argue that the functional view of the financial system will provide a valuable framework to understand how the future of financial institutions might evolve. The point of departure is the underlying functions that all financial systems must provide, in order to make an economic system work. Specifically, the financial system serves six core needs: − payment methods in order to facilitate the exchange of goods and services; − resource pooling mechanisms to fund large scale enterprises; − ways to transfer economic resources over time and across distances, as in lending and investing; − methods of managing risk, such as insuring, diversifying, and hedging; − price information, such as interest rates and securities prices, to help co-ordinate decentralised decision making in various sectors of the economy; − ways to handle incentive problems that interfere with efficient business transactions. 199

This set of functions does not change, although there are large differences between the different countries. Crane and Bodie believe that the search for higher performance and efficiency increases direct competition between banks, insurance companies, securities companies, mutual fund companies and other finance companies. With these authors we believe that this fragmentation of traditional institutions is part of a transition to more efficient arrangements. This whole development is definitely not an end point. Although some niche companies will continue to be successful, other companies will recombine functions to meet the needs of customers better and to take advantage of new technology to produce and deliver products at lower cost. The insurance and the banking industry will change dramatically: "In the short run, banks will continue to compete by cutting costs and striving to be more efficient […] But in the long run, there are important and legitimate reasons for functions to be combined into new packages […] The winners of the future will be those who best package functions to meet customers' needs, not those who cling to old institutional arrangements" [Crane and Bodie, 1996: 111]. 3.3.

From bancassurance and assurfinance towards "all finance": bundling and rebundling of financial services

The traditional definitions of most financial and insurance services are based on technical criteria and institutional sectoral barriers. The discussion regarding the core business of financial institutions reveals, however, that the real market needs are often not in accordance with the traditional product concepts. It is our firm belief that the combination of banking and insurance products, as is now done through bancassurance and assurfinance, is just the first step of a more profound development. The complementarity in time and space between different financial and insurance products not only creates natural incentives for cross-selling and packaging but also for innovative product integration. Through unbundling (old traditional products) and rebundling (in accordance with the real market needs) new service bundles are created. Bundling can mean different things to different suppliers or customers. It is therefore necessary to analyse into more detail the elements that differentiate the many forms of bundling that exist in practice. This analysis will help to make the distinction between bancassurance (resp. assurfinance) and what we call "all finance".

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The many forms of bundled services can be differentiated with the help of the following criteria: − the level of customisation and integration between the different products and services involved; − the underlying degree of expertise with the service provider for each of the products and services involved; − the value added for the customer, which finally is the ultimate goal of this bundling. These three elements can be combined in one graph to give a visual picture of the different types of bundling.

Figure 5 - The different forms of bundling Value added

Fully integrated services Packaging Cross-selling Level of integration and customisation

Degree of expertise

Source: Van den Berghe & Verweire (1998)

24

Two extreme cases can be observed and in-between a whole bunch of variations are possible. On the one hand stands cross-selling with the lowest degree of integration and customisation, with a limited scope of different expertise involved and a relative lower level of value added. Here the accent of the supplier’s strategy is more on the volume of business and this from a perspective of transactional marketing.

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At the other extreme we find the fully integrated services with a high degree of integration and customisation, many experts involved and a high value-added for the customer. Here the supplier is looking for a competitive edge in tailoring different complementary products and services, personalised from a lifetime perspective or built around specific needs or events. This is a typical approach for relationship marketing and builds on customer loyalty. In-between all types of packaging can be found with intermediate positions on the level of integration, customisation, expertise and value added. Our argumentation is that bancassurance and assurfinance are nothing more than cross-selling strategies. Nevertheless, there are firms that have adopted a more integrated product development strategy, which we call "all finance". We define all finance as a more product and market-oriented approach, whereby products produced in different ’factories’ are unbundled and rebundled to tailor them to the needs of specific client segments in order to offer them an integrated personalised solution. Recall that this is different from the traditional definition given to the concept of "allfinanz", which is merely the same as bancassurance and assurfinance. In the next paragraph, we will give some examples of cross-selling, packaging and fully integrated solutions in the financial services industry. 3.4.

Examples of cross-selling, packaging and integrated solutions

Many types of bundled services are developed at great speed in the market for financial services. Although it is not always easy for an outside observer (and a supervisor?) to evaluate the degree of integration and customisation as well as the level of expertise of the service providers and consequently the value added for the customer, some broad lines are clearly observable. 3.4.1.

Cross-selling - bancassurance and assurfinance

Historically, cross-selling was defined within one sector such as the supply of life insurance products by an insurance intermediary, specialised in non-life products (e.g. car insurance and family liability covers) or the offering of saving accounts as well as current income accounts by bank tellers. Diversification of financial firms and the blurring of the boundaries between the different sectors enlarge the scope of cross-selling to an assortment that contains insurance products as well as banking and other financial services. The most prominent

202

example being today the cross-selling of life insurance products by the banks (see previous chapter). 3.4.2.

Packaged products

The insurance sector as well as the banking sector more and more realise that customers are better served if they offer them a more fine-tuned offer of packaged services. Some of the frequently sold banking and insurance products are then put together in a standard package bank and insurance product. There are numerous opportunities for bancassurers to integrate insurance and credit. Credit insurance products are a staple of bancassurance in many countries. Similarly banks have numerous opportunities to market auto insurance in conjunction with auto loans and homeowners insurance in conjunction with mortgage loans. The LOMA study25 has summed up a number of alternatives commonly sold in the US and the UK. − Credit insurance: credit insurance products guarantee repayment of a loan if the borrower dies, becomes incapacitated or in some cases loses a job. The credit insurance can be linked to many consumer loans such as mortgages, automobile loans, personal loans, revolving lines of credit and credit cards. In the US, credit insurance is the one form of insurance that banks have traditionally been allowed to underwrite. Many banks do not take advantage of this power but instead have long-standing credit insurance relationships with US insurance companies. Banks have a big incentive to offer their customers credit insurance because it increases the likelihood that borrowers will repay their loans. In Europe this type of packaged product has been sold as well through banks as through insurance companies. In the bancassurance model the mortgage is mostly of the annuity type linked with a pure risk cover (in case of death or disability). In the assurfinance case the mortgage is mostly repaid through a mixed life insurance contract. − Life insurance enhancements to traditional mortgages: in the UK, one of the most popular bancassurance products is the endowment mortgage, which is an endowment life insurance policy linked to a traditional mortgage. Although this product is not simple, until recently it offered tax advantages that made consumers willing to tolerate its complexity. The same holds for other European countries (e.g. Belgium). 203

− Auto and homeowners insurance: auto and homeowners insurance have close relationships to auto loans and mortgage loans and, therefore, also represent useful bancassurance products. For example, the Bank of Scotland offers a GAP insurance product that covers gaps in a customer’s automobile insurance. This product is designed primarily for customers of the bank’s automobile loans. It pays the difference between the market value of a car and the remaining balance due on the automobile loan if the car must be written off in the event of a total loss or theft. − Medical savings accounts (MSAs): are new US bank products that integrate with health insurance. These products allow individuals to obtain health insurance coverage with high deductibles. They use the funds accumulated in the savings account to pay for outof-pocked medical expenses that fall within the deductible. According to the LOMA study, this product has a promising future given the difficulties many countries are likely to have funding medical care for ageing populations. − Asset management accounts: asset management accounts are traditional stock brokerage accounts that incorporate moneymarket funds (mutual funds that invest in short-term instruments). Account holders can use the money-market funds as the functional equivalent of interest-bearing checking accounts. This product was first introduced by Merill Lynch, a decade ago. The success of packaged products can also be deducted from the following list. In a Dutch magazine intended for the insurance intermediaries an overview was given of personal insurance packages. Besides the name of the insurer and the insurance package, we also have mentioned the year of introduction and the percentage of the new production coming from these packages.

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Table 3 - Packaged insurance products Aegon De Amersfoortse AMEV Particulieren Avéro De Noordhollandsche Delta Lloyd ELVIA Verzekeringen Erasmus FORUM General Accident GENERALI Goudse Guardian Hooge Huys Interpolis Klaverblad Levob

1995 1994 1993 1993 1989 1986 1974 1996 1996 1993 1976 1996 1990 1997 1997 1997

1983 1983 Nationale-Nederlanden 1992 Nieuwe Hollandse Lloyd 1995 NOG 1997 Reaal 1993 Royal Nederland 1985 1985 Stad Rotterdam 1995 1995 Tiel Utrecht 1995 UAP-Nieuw Rotterdam 1994 1993 Unigarant 1994 Zevenwouden 1992 Zürich 1996 Zwolsche Algemeene 1985 1970

Woonpakket-plus Domino Pakket Plus Combinatiepakket Comfort Plan Combipolis Particulieren Het Verzekeringspakket Alles-onder-één-dak polis Vier Sterren Polis Multi Polis Voordeelpakketpolis Pakketpolis Eén-Gezins-Polis Privé Woon Polis Comforta Polis Totaalplan Alles in één polis Verzekeringspakket voor Particulieren Privé CombiPlan Auto CombiPlan ZekerheidsCombinatie Particulieren Odeon Verzamelpolis Totaal Plan Wel-Thuis Pakket Weg-Wijs Pakket Autopakket Huispakket Privé Pakket Gezinspakket Uit & Thuis Combinatieplan Pakket Verzekering Particuliere Pakketverzekering Rubriekenpolis rondom het huis Modulair Privé Pakket Auto Pakket Verzekering

60% 40% 35% 50% 50% 40-50% 35% 50% 50%

30-40% Almost 100%

45% 77% 60% 25%

40% 40% 50% 50% 75% 50% 85% 85%

Source: Het Verzekeringsblad (VB), April 24th, 1997.

3.4.3. Fully integrated solutions More integrated services can be found in the directions of personal financial planning, personal or family risk management and flexible employee benefits

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and cafeteria plans. This supposes a pro-active research of the service provider into the formal and informal needs, attitudes and customer behaviour. Integrated customised service bundles not only need such an up-front analysis but also a dynamic and flexible perspective that goes hand in hand with a long-term client relationship. The degree of personalisation and flexibility can differ quite a lot as well as the type of products and services involved. The list is long of potential combinations: − banking accounts and payment services; − savings and investment instruments; − different types of loans and credit formulas; − all types of private life and non-life insurance; − risk management instruments other than insurance; − social insurance covers and partly privatised categories; − legal aspects (family, succession, contracts); − etc. Such an approach supposes a great deal of individual information per client, a long-term planning in relation to the life cycle of the client with different event scenarios and a dynamic approach for flexible updating and adaptation. It is clear that most financial institutions have only started working on this type of solutions, so it is quite difficult to point to the current success or problem factors. It is clear that these newly integrated products are -for the moment- more exception than the rule. Nevertheless we found the following examples. − Employee Access Accounts: the Employee Access Account is a product, recently developed by Merill Lynch, and is based on the asset management account (we described when discussing packaged products). Merill Lynch distributes the account through large employers to their employees, who can have their pay directly deposited in it. The Employee Access Accounts provides a comprehensive menu of banking, securities, and insurance products and services. Holders of the account can use it for check writing and bill payment, investment (money-market funds, 206

mutual funds, and securities trading), credit cards, other loans, insurance, and financial planning -in sum, for their total financial activity. This product allows full integration of an individual’s financial relationship. This example gives an idea how a modern "employee benefits" solution could look like. − "Proveniersplan": certainty for the elderly: The Proveniersplan is a product, developed in the Dutch financial market by the Achmea Group, one of the larger financial conglomerates in the Netherlands, and focuses on servicing the segment of the older people. The opinion of Achmea is that products and services towards this segment not always meet the needs of these people. The purpose of this Proveniersplan is to provide the elderly with products and services tailored to their needs so that they can stay as long as possible in their actual way of living. This product also is the appropriate answer for the more general economic problems in the social security. More and more there is made appeal on the responsibility of the individual and contributions are asked for provisions made by the government. − The Proveniersplan consists of different elements and is about integral home care: the provision of an alarm system, help at home, security systems and meal preparation are all forms of servicing in kind. All the products of the Proveniersplan can be considered as variations or complements of existing products such as pensions, annuities, mortgages, general insurance, etc. The products will be adapted to the wishes and the needs of the elderly and are composed modularly so that everyone can make up his own product. − The success of the Proveniersplan was still limited. The spokesmen of the different parts of the Achmea Group acknowledged that the new product was nothing more than a package of existing financial products and that for the products in kinds the Group is still in a testing phase. Furthermore the reactions on the new product are relatively modest so there is also a need for more promotion and publicity. − The capital care concept of OHRA: OHRA is a Dutch direct writer and now part of the Delta Lloyd Bank and Insurance Group, with a clear customer-oriented strategy. The creation of the capital care service has the purpose to provide full financial advice. In this

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way OHRA strives for a lasting relationship with its clients by providing the client with professional help for banking, insurance, investment services. The financial group does this on a continual basis taking into account the particular situation and some characteristics of the client (such as the risk profile). The starting point is the capital position of the client. This capital position is formed by an inflow, a capital position, and an outflow. If there is something left after the flows are taken into account then there is room for financial planning. A financial target is proposed based on the current capital position and on the risk profile of the client. All these factors determine which actions are taken and which products will be used. It’s clear this is a very customer-oriented approach, as this is the basis for further actions. This is certainly not comparable with the selling process of a lot of other financial institutions. 3.4.4.

The future of financial products: the modular approach

The main idea for the future is to work with modular concepts. These modules form the building blocks around which new financial products will be built. This new approach allows for some standardisation (there are only a few modules) but on the other hand the combination of different modules and other features makes it possible for a financial firm to develop products tailored to the specific needs of a customer. For the moment this is at best in the planning phase: a small number of companies are thinking of applying this idea in practice shortly. 4.

Convergence between banking and insurance: integration on other levels

4.1.

Introduction

In the preceding chapters, we outlined the integration of the financial services industry on the distribution level. Indeed, the convergence mainly between banking, insurance and investment started with the development of bancassurance and assurfinance. But in the previous chapter, we showed that the convergence at the distribution level is only a small dimension of a much broader trend. More particularly, we believe that financial institutions (will have to) reconsider their core business. Only if firms can give an adequate answer to the changing customers’ needs, they will be able to be successful. We showed

208

that all finance, which is here defined more from a customer-oriented perspective (as opposed to the pure cross-selling strategies: bancassurance and assurfinance) could be such an answer. 4.2.

Integration of support activities

If we recall the financial conglomerates control board, as presented in the chapter, we see that up until now, we focused on distribution, product market development and to a lesser extent operations management. integration of these primary activities has indeed received most attention, in the academic and business articles.

first and The also

Figure 6 – The Financial Conglomerates Control Board Environmental Factors Lega

l Stru

Corporate Governance & Management

ructu r

e

Orga nisa Struc tional ture

Capital policy Technology

Distribution

a l St

Market Development

Product Development

Infrastructure Capit

Operations Management

cture

M.I.S. : Accounting & Reporting

Source: Van den Berghe and Verweire (1998)

26

During the last couple of years, we also notice more integration between banking and insurance at the support activities (which can to some extent be considered as more back-office activities). This is especially the case for the asset management activities, which we put under the heading "capital policy". In this chapter, we will show that substantial benefits of integration come from a combined asset management. But we will show that despite the legal prohibition of integrating banks and insurance companies, some financial conglomerates try to integrate on other levels as well.

209

4.2.1.

Management and corporate governance

The corporate governance and management level consists of different activities: the governance and management itself, including also strategy development, human resource management, and initiatives to manage the different cultures. These activities all have in common that they are involved with the way the strategy is implemented. An increasing number of financial conglomerates opt for tight management structures and strive for an integrated group approach (two notable examples are ING and Fortis). The whole group is then led by an integrated management team (of bankers and insurers) who mostly have the strategic control over the business units. The business unit managers have operating autonomy. In order to create the necessary flexibility these groups make use of a quite integrated human resource management. Mostly the personnel department is centralised. Furthermore these groups make use of job rotation and cross-overs, i.e. techniques whereby managers and other personnel are rotated through the whole company, once in a banking subsidiary, once in an insurance company. Sometimes these companies have created collective agreements per industry for all companies of the group (within a particular country). Attention is paid to prevent culture clashes and to stimulate synergies. 4.2.2.

Capital policy

Under this heading, we group all activities associated with funding and investing the funds collected by the banks and the insurance companies. We will focus on two main activities where considerable efforts have been made regarding the integration: (1) asset management and (2) risk management. Asset management. Financial conglomerates often cite the opportunities of combining their asset management capabilities as a major benefit of the deal. Asset management as a business in its own right is increasing in importance, and massive growth in the area is expected in the coming years, mainly due declining state pension provisions and the changing savings needs of individuals and households. Managers of financial conglomerates believe that larger asset management companies will be in a stronger position to compete on a wider geographic scale and more likely to attract higher skilled staff. Furthermore, substantial economies of scale can be achieved through combining the back office

210

operations and in eliminating excess offices and staff. In addition to the economies of scale, there exist economies of scope, e.g. through the combination of investment management skills of banks and insurance companies. It is, however, difficult to get reliable and accurate data on the cost savings in this respect. In practice, we see that an increasing number of financial conglomerates have integrated their asset management departments. ING and Fortis were among the first to integrate the asset departments of their banks and insurance companies. But in more recent mergers, increasing the asset management business and exploiting the economies of scale and scope seems to be key motivation as well. Examples include SEB Asset Management (asset management department of merged SE Banken and Trygg-Hansa) and SSB Citi Asset Management Group (which is a combination of three existing asset management business within the newly formed Citigroup, namely Salomon Brothers Asset Management, Smith Barney Asset Management and Citibank Global Asset Management). In the US, banks and insurance companies are also heavily involved in the pension fund management business (in contrast to Europe). In fact, both banks and insurance companies have very similar kinds of expertise in the areas of pension funds and mutual fund management. It is therefore expected that, when the legal barriers are removed, the similarities in these areas are likely to affect partner selection and the ultimate structure of the bancassurance and assurfinance ventures (Crooks Gora, 199727). It is worth mentioning that not only financial conglomerates have integrated their asset management department. Independent banks and insurance companies have set up joint ventures in order to benefit from an integrated asset management. Examples here are the joint venture between Allianz and Dresdner Bank, Allianz Dresdner Asset Management, set up during 1998. Risk management. Financial conglomerates not only try to benefit from an integrated asset management, they also try to link their risk management techniques. Risk is a central element in banking and insuring. More specifically, financial firms are fundamentally different from all other businesses because they must seek out and attract risk in order to make money. Where other businesses try to avoid and pass off risk, financial firms absorb, intermediate and advise on risk.

211

In the previous chapter, we already indicated that the core business of banks and insurance companies might converge. This is highlighted once again by the following statement: "In their traditional roles, both banks and insurance companies operate as intermediaries. As financial intermediaries, they obtain funds by issuing claims against themselves to market participants, and then investing those funds. Banks invest these funds in loans. Insurance companies invest them in securities, mortgage loans, and mortgagebacked securities. Both try to make money from the spread between their assets and liabilities. Both intermediate maturities (when their liabilities have one maturity and their assets another). Both reduce risk for their liability holders by diversifying their assets. Both reduce their liability holders’ costs of gathering information about assets and contracting with asset holders" (Crooks Gora, 199728). Perhaps these statements might somewhat simplify the differences between banks and insurance companies; however, people agree that banks and insurance companies now employ many similar approaches to risk management and that there is a complementarity between the risk management techniques of the different partners. Some empirical evidence for this statement was forwarded by Verweire (1999)29, who found that the overall risk profile of financial conglomerates was better than the risk profile of specialised banks or specialised insurance companies. From an historical perspective, banks have been more aggressive than insurance companies in applying their risk management skills to financial engineering. The example in this respect is securitisation. As such, securitisation is one of the main trends in the banking and the insurance sector which could have serious consequences for the definition of the core business of financial firms. What is it all about? For the past 20 years, mostly US banks and their investment banking counterparts have been pooling large numbers of similar loans and issuing securities against them in the capital markets. This process started in the residential mortgage area and has since been extended to other forms of credit including short-term commercial loans, trade and credit card receivables, auto loans, etc. Some of the US insurance companies (with mortgage banking subsidiaries) also participated in asset securitisation. The last couple of years, securitisation has become an instrument, increasingly used by insurance companies. The insurance industry has been seriously hit by a record number of natural catastrophes. Potential losses from these catastrophes exceed (ed) the available capacity in the insurance and reinsurance markets and the insurance sector faced a capacity problem. Due to this problem, the idea was 212

raised of trading insurance risks not only within the insurance system but also transferring them to the more liquid financial markets (Swiss Re, 199630). Although, securitisation of insurance risks is -for the moment- only rarely accomplished, the size of the capital markets that securitisation seeks to tap and the apparent success of some recent securitisation deals confirm that a risk securitisation growth can be expected. The expected increase in the importance of securitisation in the insurance sector is just part of a broader trend in risk management and insurance. The shortage of traditional insurance capacity in some specific areas has led to the emergence of alternative risk financing techniques, where capital markets serve as ultimate bearers of risk. As such, we might expect an increased convergence between traditional insurance markets and the capital markets. 4.2.3.

(Information) Technology

The costs of (information) technology are increasing rapidly. The merger wave in the financial services industry is often explained in terms of creating the necessary scale to bear these immense (information) technology costs. It is often argued that the creation of financial conglomerates can result in substantial economies of scale. But it is difficult to test whether these economies are effectively materialised. There are only a limited number of examples where the use of IT was really a source of process improvement with regard to the bancassurance process. Some financial conglomerates make use of an integrated front-office system. In most banks there is an electronic acceptation system so that the personnel of the bank branch can handle the insurance contract. In this way there is only one input procedure which decreases potential mistakes. In some cases there is a direct link with the insurer’s back office so that the necessary documents can be printed in the bank’s outlet. There are examples where the green card of the car insurance rolls out of the bank’s printer some minutes after the insurance contract was signed. This certainly opens up opportunities for large productivity gains. Another example is the electronic handling of securities. We have already mentioned that at the investment level banks and insurance companies work together for the administration of securities. Banks have a range of funds to which the insurance product can be directly linked (unit linked products) or indirectly invested (investment of the technical reserves). As more and more consumers are interested in these kinds of savings vehicles the electronic handling of these securities may rise in importance, and thus IT may be an important means to control efficiency.

213

Finally, it is often mentioned that both the banking and the insurance partner can have access to each other’s customer base. In Norway, several banks have adopted particular front-office support software that allows a full integration with existing office support products. The system, supplied by market leader Fellesdata, consists of four independent modules -sales, lending, everyday banking, and teller services- which are brought together in a customer information module. In this way, the customer consultant in the bank branch (or call centre) has access to a complete overview of customers, products, contracts, completed and planned activities, customer rating, customer profitability and cross-selling opportunities. We know that there are at least a number of financial conglomerates from different European countries that have developed such software for at least part of these functions. 4.2.4.

MIS: Accounting and reporting

The challenge for financial conglomerates is to build up a comprehensive accounting and reporting system necessary for monitoring and managing the financial conglomerate. This is not always easy: banks and insurance companies have their own reporting and valuation methods so that a comparison of the banking with the insurance activities is not always easy. The creation of an integrated Management Information System is not merely intended to achieve substantial cost economies. Rather, it should allow managers to better monitor the financial conglomerate. Since this is very strategic information, we have no clear view on how well financial conglomerates are integrated yet. 4.3.

Creating new organisational structures

The quest for integration has made some financial conglomerates to set up new organisational structures, which have hardly anything to do with the traditional legal structures. We already mentioned that legal restrictions prohibit banks and insurance companies to fully integrate. Because of supervisory reasons, most financial conglomerates group their insurance subsidiaries in an insurance holding, while the banking subsidiaries are brought into a banking holding. Either the insurance holding or the banking holding may act as the holding company for the whole group. In some cases, however, a new holding company is created which has controlling stakes in both the banking and the insurance holding. The most notable example in this respect is ING Group.

214

Figure 7 – ING's former organisation structure ING Group Nationale-Nederlanden Insurance Company

ING Bank (former NMB Postbank Group)

DUTCH ACTIVITIES

Steering Committee

INTERNATIONAL OPERATIONS

Steering Committee

INTERNATIONAL OPERATIONS

SECURITIES & LOANS

Steering Committee

TR & TR/ I.B. CAPITAL MARKETS

Steering Committee

PROJECT DEVELOPM. & FINANCING

ASSET MANAGEMENT & INVESTMENTS

DOMESTIC OPERATIONS

From 1991 on, the moment the ING Group was formed, it had always considered banking and insurance as part of the same market for financial services. ING considered the traditional separation between banking, investment and insurance out-of-time. Moreover they believed that developments at the demand side created the need for a more integrated approach. The first three years after the merger, ING retained the legal structure as its main organisational structure, but tried to establish links (by means of steering committees) between the banking and insurance subsidiaries, at several levels. However, in 1994 a new corporate structure was created. The management of ING felt that in order to create a more flexible and integrated group, fundamental changes were necessary. A major decision was to create a new organisation structure, which went beyond the traditional separation within the financial services industry. The following business units were created: − ING Nederland, which comprises the financial services to personal and corporate customers in the Netherlands; − ING Financial Services International, which encompasses all the insurance activities outside the Netherlands in combination with the banking activities for private customers and small and medium-sized enterprises in local markets; − ING Corporate & Capital Markets, which includes the operations in the money and capital markets as well as the international banking activities for corporate clients;

215

− ING Asset Management, which acts as the property and the relation manager (both for the clients as well as for ING itself): in this way it unites the asset management, real estate and private equity operations. After the take-over of the Belgian bank BBL, the management created a fifth administrative centre: ING Belgium, which comprises the financial services to personal and corporate customers in Belgium. This new organisation structure is presented in the following figure.

Figure 8 - ING’s new organisation structure

ING Group

Administrative centers

ING Nederland

DIRECT MARKETING Postbank Particulieren Postbank Verzekeringen Operations betalingsverkeer

ING Financial Services International

INTERMEDIARIES NN Leven NN Hypotheken NN Schade & Zorg NNFD/ Vola NMS, NVB/ Welvaert Tiel Utrecht Nationale Borg

ING Corporate & Investment banking

OFFICES ING Bank NL Westland/ Utrecht CenE Bank ING Lease

ING Asset Management

ING Belgium

AGENTS RVS

Of particular interest is the way ING Netherlands is structured. The structure is based on the different distribution channels used: (1) direct marketing, (2) intermediaries, (3) agents, and (4) bank branches (offices). In each of the four parts, both banks and insurance companies are included, as can be deducted from the figure. Although the ING case is quite innovative, we think that the more the different parts of the financial services industry converge, the more integrated organisational structures will be developed, which might differ substantially

216

from the traditional legal structures. Interesting in this respect, is that ING has just announced that, given the need for the realisation of potential synergies, the actual structure will be changed further in order to gain additional synergies. This might be an important lesson for supervisors and regulatory authorities. 5.

Convergence between the insurance and the pension markets

5.1.

Introduction

In the chapters 2 to 4, we have extensively described the growing convergence between the banking, the insurance and the investment industry. We have outlined the major drivers of the financial conglomeration trend. We showed that the financial conglomeration trend was initiated by the banks looking for an appropriate answer to the desintermediation problem. From the moment the regulators removed the barriers that existed between the different sub-sectors, the number of financial conglomerates increased rapidly. We also showed that more fundamental forces are at work: the different types of financial institutions reconsider their core business due to the changed financial and economic environment. This redefinition of the core business can lead to a further convergence of the financial services industry. This was also proven by the fact that banks and insurance companies try to integrate not only the primary activities, but are looking for synergies in the support activities. Of particular interest, are the efforts by banks and insurance companies to integrate asset management and risk management techniques. In this chapter, we argue that the convergence between the insurance and the pension industry follows the same pattern. More particularly, we will show that deregulation will only be the first step in a more comprehensive process, where insurers and pension funds need to reconsider their core business (due to the changed financial and economic environment). This will be demonstrated by the case of the Dutch pension market. 5.2.

The pension system: three pillars

Traditionally, the pension system is composed of three pillars, as presented in the following figure.

217

Figure 9 - The pension system - the three pillars 3rd Pillar

2nd Pillar

Insurance companies

Other financial institutions

Insurance companies

Pension funds

1st Pillar Public sector

− The first pillar is the public pension system, which is usually characterised by pay-as-you-go, mandatory and defined benefit. − The second pillar comprises the occupational provision of pensions, which is usually pre-funded31, often mandatory but sometimes voluntary, and either of the defined-benefit or the defined-contribution type. Pensions are managed by either affiliated or independent pension funds, group life insurance contracts, or enterprises themselves that built up their own book reserves. − The third pillar consists of voluntary individual savings managed by life insurers, mutual funds, investment companies, or by individuals themselves. In general, it is of the defined-contribution type and most often enjoys tax privileges. Since the three pillars differ considerably there has been a heated discussion as to which pillar is best suited for pension provision. There is however no obvious answer: as a rule, a balanced mixture of all three pillars serves as a good solution and makes it possible to reap advantages of all three pension systems and, in addition to spread the risks. An international comparison demonstrates that there exist considerable differences between countries. Some countries primarily rely on the first pillar (e.g. Italy, France, and Germany), while in the Anglo-Saxon countries, the second and the third pillar are far more developed. This is graphically represented in Figure 10.

218

Figure 10 - Size of financial asset stock managed by institutional investors and public pension expenditures 180

US UK

Financial assets, % of GDP

160 140 120 100 Canada Japan

80

France

60 Germany 40 Italy 20 2

4

6

8

10

12

14

16

18

20

Public Pension expenditures, % of GDP

Source: Swiss Re (1998)

32

In this figure, for each G7 country, we have shown the importance of the first pillar (by means of public pension expenditure as per cent of GDP) and the importance of the second and third pillar (by means of financial assets as per cent of GDP). The importance of the second and third pillar can best be seen from the size of accumulated assets managed by institutional investors. Swiss Re acknowledges that private savings can also be used for retirement provision, but for the scope of this investigation, they only considered savings via institutional investors. The differences between the countries are very large. The main observation is that institutional investors’ assets are especially high in countries with lower public pension expenditures and vice versa. This may reflect that in countries, with lower burdens imposed by public pension schemes, households are more inclined to make private provisions. (For more detailed information regarding the importance of public and private pension schemes, we refer to the Swiss Re study.)

219

5.3.

Public provision under pressure and implications for the financial services industry

The demographic changes taking place in the Western industrialised countries are likely to lead to a dramatic increase in the proportion of elderly relative to the working population, which is likely to place a strain on public pension systems which finance themselves through contributions of the working population. In these pay-as-you-go systems, total pension payments must in principle equal total contribution payments at every point in time. The missing gap can be filled in different ways : − by government subsidies, which probably will have to be financed by taxes or through the creation of government debt and hereby transferring the problems to future generations; − by increasing the contributions to the social security system (increasing the pension premiums); − by decreasing the level of the actual and/or future pension benefits; − or by a combination of some or all of the above methods. The pay-as-you-go system is thus particularly vulnerable to the ageing process. As a result, reforms of public pension systems seem to be inevitable in many countries. We thought it might be interesting to briefly show the funding burden of current public pension schemes the G7 countries face. The study of Swiss Re (1998) made some preliminary calculations and came to the following figures. Note that the figures reflect the potential funding burdens if current public pension systems remain unreformed and the underlying assumptions regarding demographic change prove to be true. Considering the long-term horizon and the resulting high degree of uncertainty, the figures should be taken with care. Nevertheless, we believe that they can be taken as a good proxy for the funding problems.

220

Figure 11 - Net public debt and net pension liabilities (% of GDP) Net public debt and net pension liabilities, % of GDP Canada France Germany Italy Japan UK US 20

40

60

80

Net public debt at end 1994

100

120

140

160

180

200

Net pension liabilities, 1995-2050

Source: Swiss Re (1998)

Different solutions have been proposed, e.g. the building up of a significant fully-funded pension pillar inside or outside the public pension system. Everyone is convinced that in the field of pensions, the transition from an unfunded to a funded pension scheme creates an enormous potential for (life) insurance companies and can make an important contribution to financial market developments. Holsboer (1998)33 believes that the reform of social security and pension systems may prove the most significant trend to affect the insurance industry. The changes in social security systems will bring opportunities for new businesses on both the retail and wholesale side. That is why the concept of employee benefits has received very much attention the last couple of years. Employee benefits is a two-speared concept: it can be divided into group benefits (such as group pension plans, group medical insurance and disability) as well as group-related benefits (additional products offered to the employee through the employer whereby the employee participates voluntarily). In other words: employee benefits can turn into personal benefits, and then we have a situation in which the boundaries between 2nd (group pensions, collective life insurance) and 3rd (individual savings vehicles) pillar provision start to blur. Moreover this new movement can give rise to a converging trend between the pension providers and other financial firms.

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Thus, the shift from "government benefits" to "employee benefits" provides insurers with new opportunities to market growth. As governments continue to cut back social security provision (including pensions), the provision of many benefits is shifting more to the employer, either on a mandatory or incentive basis. In some European countries, like the Netherlands and Ireland, employee benefits packages are already widespread, but expected to grow further. In other countries, like Spain and Portugal, the employee benefits markets are underdeveloped, but expected to grow quickly. Some countries, like Belgium, are blocked by the government. The study of Swiss Re (1998) tried to estimate the potential market volume for life insurers. The simulations showed that life insurance penetration (life premiums per GDP) would increase to 5per cent in Italy and the US, 6 per cent in Canada, 7 per cent in the UK, 8 per cent in Germany, 11 per cent in France, and 15 per cent in Japan. This is tantamount to life insurer’s premium income tripling in Italy and Germany and doubling in Canada and France. The increase would be only moderate in the US and particularly small in the UK. One might conclude that, in theory, the life insurance industry has the strength to step in and shoulder part of the financial burden carried by the public pension schemes. We believe that this trend will affect the competitive position of all market players from banks, life insurers, pension funds to asset managers, since all these different types of institutions are in some way involved in this market, as is shown in the figure below.

Figure 12 - The main players in the pension market

Bank

Customer

Asset Manager

Intermediary

Insurance Company

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Pension Fund

Pension Consultant

Trust office

5.4.

The Dutch pension market: an example of what could happen

5.4.1.

Expansion of product scope thanks to the partial withdrawal of the government

The pension system and market in the Netherlands can be described as a mature one because government intervention is limited while, at the same time, private pension and life insurance contributions are important. The table below illustrates that a rather limited social security pension provision in most of the cases implies high private contributions, and that The Netherlands are trendsetter in this area:

Table 4 - Comparison between public pension expenditure and private pension contributions Public pension expenditure (in % GDP - 1995) 5.2% 8% 10.1% 9.9% 15.5% 13.7%

The Netherlands United Kingdom Germany Spain Italy Sweden

Per capita private pension contributions (Euro, 1994) 24.1 18.8 7.1 1.1 2.5 1.1

The important role of the private sector in the Dutch pension provision is also made clear by the fact that pension fund assets represent 89 per cent of GDP. This is a huge amount compared to the European Union average (20 per cent). Because of that mature character of the Dutch pensions market, nowadays’ supplementary provisions have more than just a pension character. A modern disability provision for instance, is much more than just an insurance product; also prevention and reintegration play an important role. This integrated approach with regard to pensions, disability, financial planning, etc., gives a new meaning to the concept of "Employee Benefits". In the second tier of pension provision (pension plans provided by the employer), the market is divided among insurance companies (counting for 20 223

per cent of the participants) and pension funds (80 per cent). This picture, and also the legal environment make clear that the core business of pension funds consists of executing pension arrangements caused by pension promises made by the employer, or pension obligations concerning an industry branch. The labour relation is the central aspect. Insurers on the other hand, mainly take care of individually arranged old-age provisions. So far, the playing field of insurers and pension funds was clearly defined. Problems began to occur at the moment the government started its withdrawal in the early 1990s, changing the welfare state into an insurance state. Pension funds wanted to service their participants by offering insurance products to fill up the gap created by the partial withdrawal of the government in the field of social security. In two cases the government withdrew through decreasing the social allowances and through the establishment of stricter criteria: disability compensation (1993) and surviving relatives compensation (1996). Nearly at the same time some social changes came up that that can be summarised by the trend towards individualisation and flexibilisation. In reply to all these movements, pension funds started to offer products belonging to insurers’ monopoly in earlier times: the Dutch pension providers also offered pension products with an individual premium settlement. This was possible because employers and employees agreed on this in the collective labour conditions, although the employer’s contribution was a very small one. Due to these developments, the core business of pension funds was changing. While they had only been offering collective, standardised pension schemes in the past, new product lines were emerging: − insurance products supplementary to social security, hereby filling up the gaps in social security; − flexible and more tailor-made products: because of the changing life styles and working patterns, there are more and more doubleincome families; because of this double income, partners might prefer to have a higher pension instead of the surviving relatives benefits; − some people also prefer to have a higher pension provision and are willing to pay for that on an individual basis without decreasing other provisions; − others want to retire earlier and are willing to pay for a preretirement arrangement. 224

Insurers became very embarrassed because they felt they were loosing market share and potential. This became even more dramatic because pension funds have some important advantages in comparison to insurers: − they aren’t liable to corporate tax: because of their solidary character, Dutch pension funds have the legal form of a foundation, characterised by a very advantageous tax regime; − insurers have to incorporate a profit margin in their prices, while pension funds have no profit aim; − pension funds have access to a broad database of participants while insurers face huge acquisition costs; − less supervision: pension funds have no solvency margins. Because of these important differences, it is stated that competition was falsified and that pension funds should limit their activities to their former core business, collective pension arrangements. Pension funds from their side argued that their profits are used to increase their participants’ benefits, while insurers distribute these profits to their shareholders. Another argument is that also pension funds have to adapt their offer to the changes in society, and that the new market created through the government withdrawal isn’t the monopoly of the insurers. This discussion also got the attention of the political scene and the supervisory authority, "De Verzekeringskamer". One of the points of action was to define the term "pension promise", the core business of the pension funds. De Verzekeringskamer stated that the employer has to pay at least 50 per cent of the premium for the pension plan in order to be categorised as a pension promise. Because the solution for the problems was not yet found, the decision was taken that the concerned parties should work out an agreement in consultation, so that direct legislative action wasn’t needed. Only in November 1998, pension funds, insurers and the other involved parties reached that agreement: pension funds can continue to offer products supplementary to the collective pension plans insofar the employer carries at least 10 per cent of the costs. It is stipulated in the agreement that there should be enough solidarity in the arrangement. Because pension and policy distribution war has come to an end, the government wants to take initiative in order to give a legal framework to the agreement. A specific point of attention here will be the fit with the view of the European Union’s competition rules.

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5.4.2.

Expansion of the product scope beyond the traditional pension business

The core business of pension funds is not only changing due to the abovementioned government withdrawal and the need towards flexibility, but also because of the growing importance of communication and personal advice, e.g. towards financial planning. Consequently, pension funds are becoming service providers and they have to fulfil much more tasks than they did in the past when they were just administrators and investors of contributions within largely standardised pension schemes. Some pension funds even want to go further and want to offer private non-life insurance with the aim of becoming a total market player, specialised in the sector they have been servicing all the time. Because the pension fund can’t and may not offer these products itself, an insurance company is set up. There are already some examples of big pension funds setting up insurance companies. This leads to some important advantages and makes it possible to realise synergies because of their notoriety and clientknowledge. Specific points of attention are knowledge of these new markets and commercial attitude. Pension funds have never been confronted with these things and consequently, they have almost no experience in these fields. Very recently, the newspapers announced that two Dutch pension funds, ABP and PGGM, have acquired Nationale Investeringsbank. For the moment, the main aim of this take-over is to combine the asset management and investment activities of the three financial institutions. It could also be a first step of these pension funds in the direction of the banking industry and a further extension of the scope of activities. To conclude, we can say that the pension war in The Netherlands has come to a provisional end, but that legal initiatives still have to be taken. In the past and still at this moment, the government, nor the supervisory authority, nor the insurers wanted the pension funds to move in the direction of private and individual products, complementary to social security. This might be surprising because one of the specific points of attention and aims of the whole deregulation and privatisation movement set up by the government was to create more market functioning. The whole discussion concerning the playing field of pension funds seems to be contrary to this. 5.5.

The US situation

The Dutch case is just one example. Although quite different, the US example shows that we might expect increased convergence as well between mutual funds, insurance companies and banks.

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We cite a well-documented overview of the US situation from the Lafferty report (1999: 20-22)34. In the US, the state has traditionally provided for a much lower level of pension provision than in Europe. A social security pension has been in place since the 1930s, but like in Europe, there are fears that it is unsustainable considering the demographic changes that are expected [...] If the Democrats do not manage to save pension provision, such as it is, demand for private provision is likely to rise, which will present opportunities of financial service providers. Total pension fund reserves in the US have grown steadily from $2.4 trillion in 1987 to $7.3 trillion in 1997, according to the Federal Reserve. This includes private and public pensions. Employees in the US have the option of participating in a 401(k) plan, which allows them to contribute part of their salary to a tax-sheltered plan. These plans were first permitted under federal tax law in 1980. Participation in 401(k) plans has grown steadily from 62 per cent of all US employees in 1985 to 78 per cent in 1997. The plans’ assets are estimated to grow from around $1 trillion in 1997 to more than $2 trillion in 2003, according to research organisation Spectrem Group. The emergence of 401(k) plans has resulted in welcome additional revenue for financial service providers. But it is the mutual fund companies that are dominating the business, rather than the traditional life insurers, who might have expected to be the main beneficiaries because of their expertise with longterm savings products. This is a result of a greater awareness of mutual fund brand names, and a perception among the general public that mutual fund companies are better at managing money than insurance companies. Mutual fund companies’ share of 401(k) assets under management has been growing steadily at the expense of insurance companies and banks. In 1997, their share stood at 42 per cent, compared to 22 per cent held by insurance companies and 21 per cent by banks. The figures for 1991 indicated that at that time mutual funds had 21 per cent of the market, insurance companies 37 per cent, and banks 28 per cent. As already indicated before, legislation in the US currently prevents bank-insurance mergers, but change is expected. To combat the threat from mutual fund companies in the 401(k) field, banks and life insurers could merge to pool their investment management expertise and generate scale. With larger asset management divisions, they would be in a stronger position and be able to attract high calibre fund managers.

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In addition, the market for 401(k) plans for the larger corporations and companies has reached effective saturation, and most of the future growth will occur among small and mid-sized companies. Smaller companies should be easier to target on a local level through the bank branch. A merged bank-insurer company could target small companies with financial services packages that could include 401(k) plans.

Part B

Convergence in the Financial Services Industry Possible Consequences and Challenges

In part A of the research project, we aimed at outlining the general trend towards convergence and integration in the financial services sector (and the pension market). We demonstrated that this growing interface takes many different forms and concerns many different types of players. Consequently, it is not possible to refer to this movement as a uniform, well-defined type of diversification. Of course, this will pose more challenges to supervisors and regulators. In the remainder of this research report, we will consider the consequences of this financial convergence for: − the regulatory environment and the level of competition (chapter 6); − the consumers (chapter 7); − the adaptations (chapter 8).

to

prudential

regulation

and

supervision

These different areas are of main interest to regulators and supervisors. Regulators and supervisors have a responsibility to preserve a sound financial system and to provide the basis for a stable financial environment for all economic actors. As such, they need to establish a regulatory framework that aims at maintaining a strong and stable financial system that meets the needs of its constituents. The framework should consider three areas35, i.e.

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− prudential regulation, which dictates that financial services providers operate in a safe and sound manner; − competition regulation, which ensures that providers of financial services observe proper market conduct, and; − consumer protection, which sets out the rules that protect the (retail) customer. 6.

Financial convergence, the regulatory environment and the level of competition

6.1.

Introduction

In this chapter, we examine the implications financial convergence has on the level of competition in the different sub-sectors of the financial system. It must be mentioned that the impact of the financial convergence on the level of competition cannot be analysed without taking into consideration the effect of the changed regulatory environment. In fact there is a continuous interaction between regulation, market conduct and competition and vice versa. Although we will analyse the impact of the financial convergence for regulators and supervisors more in detail in chapter 8, we think that it is necessary to outline some major points already in this chapter. We will pay attention to some more general issues of regulation in this chapter. In particular, we will briefly discuss the role of regulation in respect to competition and market conduct and give a short overview of the current trends towards deregulation and re-regulation. Then we will analyse in greater detail the impact of the changes in the regulatory environment, both in the banking as well as in the insurance industry. Special attention will be paid to issues concerning competition in each of these industries. 6.2.

The regulatory environment: regulation and deregulation

Everybody agrees that the regulatory environment has (had) an important impact on the outlook of the financial services industry. It is clear that the current trend towards more competition cannot be seen without referring to the changes that have taken place in this respect.

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It is useful to keep in mind that the financial market is in such a hectic change that regulators are continuously confronted with structural and operational changes in the financial services industry. Therefore, we can say that much of the public policy enacted in the area of financial services was merely catching up to developments which then continued apace [Harris, 199836]. 6.2.1.

Finding the right balance: some general remarks

Before we can outline the effects of regulation and deregulation, we have to consider the potential advantages and disadvantages and the role of regulation in the financial services industry. Regulation has always received more attention in the financial services industry than in most other economic sectors, because of the special character of banks and insurance companies: they both have the attributes of public goods. Therefore, preserving the systemic stability of the financial system is of major concern, since confidence in the institutions that hold these liabilities is a public policy necessity. Financial regulation is also necessary because of the existence of externalities (i.e. disparities between private and social costs or benefits, in conformity with the analytical framework of welfare economics). The most illustrative example in this respect is the issue of asymmetrical information. Investors’ lack of information on the range of opportunities available in all sectors of financial markets is one important reason for installing regulatory control. The market power of financial service providers represents a second motive for regulation. It is however clear that regulation creates also costs and can have quite a number of negative (side-)effects. For this reason every new regulation has to be analysed with care and a cost-benefit analysis should be made. On a periodic base, it is good to evaluate all existing regulations and supervision. In order to optimalise the economic benefits, deregulation can be necessary. This trend was prevailing clearly in the financial sector, especially under the stimulus of the globalisation of capital markets. In the EU, the creation of the single European Market, mainly focused on deregulations and free competition. One must however be aware that these deregulation trends cannot be copied throughout the world. Depending upon the maturity of the market, the emphasis of the cost-benefit analysis can shift considerably. We therefore suggest that this analysis be done on a market by market base, and this from a geographical as well as from a sector or even product perspective. The following schemes can help in highlighting the potential benefits and disadvantages of regulation and deregulation.

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The main merits of free competition which disappear in a highly regulated market are: Table 5 – The merits of free competition Free competition • Market-oriented products that relate to real needs of clients • •

Product innovation competitive driver Competitive prices

as

a

main

High regulation • Standardised products with bureaucratic and technical development process • Pressures to restrict product innovation • Profitable and safe prices; competition mainly on service

The highly regulated environment has also some advantages over the competitive market: Table 6 – The merits of high regulation Free competition • no standardisation and tendency to over-segmentation ⇒ considerable information gap37 • Danger for destructive (price) competition and instability

High regulation • Market transparency •

Highly stable market

Given the potential benefits and costs of regulation, the optimal solution will often lay in a combination of regulation, deregulation, self-regulation and free competition. Such a combination is however a difficult and dynamic exercise, that can be best illustrated by referring to it as a magic triangle between stability - (de)regulation - efficiency. Figure 13 - The magic triangle regulation

free competition

STABILITY

EFFICIENCY

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6.2.2.

Regulation and deregulation and financial services

In summary, we can state that the objectives of financial services regulation are: − maintaining a safe and sound financial system; − correcting market failures and enhancing competition; − providing an environment for effective implementation of financial policies; − achieving redistributive and social goals. Financial industry regulation in the U.S. (but also in other major countries) prior to the 1980s can be traced back to the Great Depression. It was intended to prevent such an event ever happening again. But the 1980s witnessed a great change in attitudes towards the government regulation of business in general, and regulation of the financial services industry in particular [Barron e.a., 199838]. The ultimate liberalisation, that did take place, occurred as countries and their financial industries found themselves at a competitive disadvantage as the momentum of globalisation proceeded. Authorities responsible for financial regulation wanted to ensure that their financial hubs would not become backwaters because of a failure to respond to international competitive pressures. Furthermore, uncertainties created by inflationary pressures in a number of countries and the associated boom and bust cycles in economic activity (which originated in the early 1970s) made clear to macro-economic policy managers (e.g. central banks) the need for more flexible financial market processes. However, at the same time, it became clear that deregulation had to be accompanied by re-regulation. "Rapid growth and diversification of financial transactions, technological change, new market dimensions, securitisation and financial innovation proper, all required new approaches to ’market design’. Innovative regulation was -and is- required to create efficient market structures. Operative rules on intermediaries; methods, techniques and transparency of brokerage, dealing and settlement in securities and money markets; rules of conduct and definition of standard products and qualities in markets for financial futures, options and swaps: all these are instances which require specific, innovative and mutually consistent regulatory frameworks." 232

In summary, we can say that liberalisation is a process which originated a number of decades ago, due to − some global phenomena: e.g. emergence of multinational corporations, information and communication technologies; − the reactions of the government: to liberalise certain elements of their financial services industry, especially a global capital market, free trade in financial services, etc.; − and this all stimulated by overarching framework policies: such as the creation of the European Union’s single passport, the creation of the EMU and the EURO, initiatives by the General Agreement on Trade in Services (GTS) and the OECD. According to Stephen Harris39, it seems that most of the major impediments that would seriously interfere with market efficiencies have been eliminated although in some countries the opacity of the regulatory system interferes with market efficiency. That is to say, obstacles that were formerly tied to prudential factors and which have outlived their usefulness have been eliminated. Most of the barriers to trade in financial services have disappeared and where countries displayed some reluctance, the overarching international agreements pushed those stragglers into action. Where prudential oversight seemed lax, countries have taken steps to tighten-up prohibitions. This is especially true, for example, in securities market trading, institutional capital adequacy requirements, and the risk-proofing of clearing and settlement systems. Some countries have reviewed or are in the process of reviewing the question what powers financial and market intermediaries ought to have -notably in the US, Japan, Canada, Australia and Korea. Other regulatory issues lingering on the horizon relate to uses and abuses of communication technology, derivatives and other financial engineering constructs, early warning systems and early response capabilities of banking supervisors and securities regulators. 6.3.

Implications of the changes in the regulatory environment on the financial services industry in general

6.3.1.

From industry-based competition to product-based competition: the gateway to financial convergence

In part A, we stressed that financial convergence coincides with the changing view on the core business of financial intermediaries from a product oriented

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towards a functionality and needs oriented perspective. The fulfilment of the different financial core needs, as mentioned in part A section 3.2, has made the financial institutions rethink their core businesses. Consequently, there is an accelerating transformation of the financial services industry towards productbased competition (e.g., several types of firms offering similar financial products), rather than competition within traditional industry segments. In the United States, the House of Representatives have recently passed legislation that would eliminate regulatory barriers and allow federal regulators to engage in product-based rather than industry-based regulation. As the FTC states: "One of the implications of product-based competition is that, while there is a trend toward greater consolidation within the traditional financial services industry, there has been growth in the number of firms outside that industry that provide financial services and products. Opening up markets to new firms has the potential to result in increased competition, but it may also lead to competitive scenarios that are unfamiliar to traditional regulators" [Federal Trade Commission (1999)40]. In this particular case, anti-trust authorities play a significant role in assisting the financial regulatory and supervisory authorities to ensure the two functional requirements for a free market free competition, i.e. competitors provide a range of options for consumers and consumers have the ability to make informed decisions from among those options. Anti-trust legislation protects the range of options in the market, preventing firms from engaging in illegal price fixing, restricting entry, or limiting the choices available to consumers. 6.3.2.

The scope of competition: national and international competitive pressures

The economy of many countries is becoming increasingly internationalised, or as it is sometimes called, globalised. Thomas Hatzichronoglou, a researcher at the OECD, considers globalisation as a more complex stage in the process of internationalisation. According to Hatzichronoglou, internationalisation is a phenomenon of the 1950s-1960s and a large part of the 1970s, whereas globalisation refers to changes that took place during the 1980s. Worldwide competition has led to the emergence of a new type of corporate organisation, which is often labelled the global firm. This trend has profound consequences for financial firms and financial markets, in the sense that financial institutions and financial markets are striving to become more internationalised themselves. This trend has potential increased competitive

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implications, but not uniformly for all types of customers. New "foreign" financial players enter the markets that bring extra competition in the "national" financial services industries. The effects of internationalisation and globalisation on competition are quite different. As long as a firm internationalises its operations and operates as a multinational, the competition is organised per market and local rules and guidelines will prevail. From the moment the firm shifts gear to launch a globalisation strategy, the competitive game changes drastically. Although local elements will always affect the competitive position, the global players organise their competition strategy with the broader global position in mind. Once deregulation allows global competition, protection of local markets will become much more difficult. This has become extremely relevant in the financial services market for the following reasons. − Competitors increasingly approach the competitive game from a global perspective. − Also the client base becomes increasingly globalised. The larger clients are more and more looking for globally integrated risk management solutions. Small and medium-sized enterprises as well as a growing number of private customers will get access to worldwide shopping around, especially through the Internet. − The competitive struggle forces national and regional players to cope with these global competitors. This often leads to a "me-too" strategy, whereby most of the market partners realise that they need to expand their scope to stay competitive in this tough market environment. Consequently many opt for both national and international expansion, hereby looking for economies of scale and economies of scope to increase their competitive edge. Another feasible strategy for companies who only work in the local market is to take advantage of being embedded in the local roots. As we just said, the rules of the game in a global competitive environment are quite different from those in a multinational competition. Although the Michelin-Goodyear case is from outside the financial services industry, it perfectly illustrates what could happen.

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Michelin vs. Goodyear The famous competitive struggle between Michelin and Goodyear gives an excellent idea of the difference between multinational and global competition. At the beginning of the seventies, Michelin -producer of tires- had a strong position in Europe, while Goodyear was especially active in the US market. Michelin decided to expand internationally and started attacking the US market with an aggressive marketing policy. Goodyear felt that his strong competitive position in the US was being threatened by a multinational competitor, entering his market. Two possibilities of counterattack were studied: the multinational and the global approach. The multinational competitive strategy of Goodyear would have been to react

6.4.

immediately to Michelin’s attack by countering the aggressive marketing approach in the US by an even more aggressive marketing. Such a solution would have harmed Goodyear, because the US was its main market. The second option, namely the global competitive strategy, was chosen. Because Michelin was more vulnerable in its European home market, where Goodyear was a marginal player, they decided to attack Michelin in Europe with the same aggressive strategy used by Michelin in the US This global approach proved to be successful, since Michelin shifted gear to a more moderate approach in the American market.

Implications of the changes in the regulatory environment on the banking industry

Financial deregulation has led to considerable benefits analogous to those flowing from deregulation of other sectors. Deregulation, both directly and through the increased competition it has spurred, has raised productivity and quality and lowered prices for the services provided by the financial sector itself. The allocation of resources throughout the economy, and therefore overall economic efficiency, have been improved by the removal of regulation-imposed distortions in the allocation and pricing of credit. In addition to these improvements, financial deregulation has had important broader consequences for financial and macro-economic behaviour that reflect the central role of the financial system in economic decisions and which enter into overall assessments of the efficacy of deregulation. While clearly beneficial in important respects these changes have complicated the functioning of key economic policies, at least temporarily. The changes have also been associated with a number of economic problems that raise questions about the risks of the financial deregulation process.

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Before we outline the main consequences of deregulation and financial convergence, two points should be kept in mind in evaluating the benefits of financial deregulation. − Because the benefits and the costs of financial deregulation are multi-faceted and very widespread, they are more difficult to quantify than for most other sectors. The effects of deregulation on resource allocation, or on financial volatility, for example, are diffuse and almost impossible to disentangle from the impact of other factors. Gains from introduction of new products, or the extent of productivity gains in service sectors generally, are notoriously difficult to measure. Largely for these reasons, very few studies have attempted to provide quantitative measures of the effects of deregulation and then only of certain aspects. Much of the evidence for the benefits of deregulation therefore comes from historical studies of experiences with financial reform as well as inferences drawn from economic theory. Nevertheless this body of evidence make a very persuasive case that deregulation has brought considerable benefits. − Many of the benefits and other effects of explicit deregulation are virtually impossible to distinguish from the changes resulting from financial innovation or other changes in market practices not directly related to regulation. Deregulation clearly has been an important stimulus to financial innovation, while, as noted earlier, innovation has served to spur and force the process of deregulation. Comparisons of the benefits of the present financial environment with those offered by the previous regulated environment to some degree tend to overstate benefits from deregulation to the extent they arise from changes that would have occurred in any event. However, those changes also make reimposition of many of the old regulatory policies either not feasible or much more costly than before; in this respect comparisons with the past tend to understate the benefits of a deregulated versus a regulated economy. 6.4.1.

Increased competition in banking

Increased competition has been an issue in banking for years. As a consequence, bankers all over the world have focused strongly on attempts to improve their cost/income ratios.

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But banks did not only experience competition from industry peers, they more and more face increasing competition from unregulated "non-banks". For example, many large corporations are increasingly carrying out their banking business “in-house” (e.g. Volvo, BP and Renault). In the United States, General Electric and Ford are now two of the largest financial services companies, and the former is expanding vigorously into Europe (and Japan) in direct competition with local providers of financial services. We already described the examples in the United Kingdom: Sainsbury, Marks and Spencer and Tesco, which are all now taking deposits as well as making loans to their retail customers. Specialised companies are also targeting the markets for credit cards, mortgages and the leasing of certain kinds of equipment. Here again, increasing inroads are being made into European markets. The central point is that the fixed costs of entering these markets have come down with advances in technology and many financial services can now be produced by specialised providers very efficiently and at low cost. The fact that many of these companies have extremely well-known brand names gives them a further competitive advantage. Whether unregulated entities have a competitive advantage simply because they are unregulated is moot given that regulation of banks in the past was often directed to maintaining the rents associated with cartel-like behaviour. It is the case, moreover, that the costs of regulation are to some degree offset by certain benefits (e.g. access to lender of last resort facilities) [White, 199841]. Another area where competition seems set to increase is electronic payments processing and the provision of services over the Internet. This is a global phenomenon that will certainly affect continental Europe. Non-financial firms that control communications networks, and the gateways to them, could set themselves up as "brokers" directing customers to the most suitable product for them. The loyalty of the customer would increasingly be to the broker rather than the ultimate producer of the product. At the very least, this process will squeeze margins of traditional financial service providers. At most, these nonfinancial firms could use the information made available to them through datamining technology to design new products themselves to compete with products from traditional financial service providers. Moreover, in this virtual world where concerns about security are naturally heightened, the possession of a brand name inspiring confidence will become ever more important as a marketing tool. This may further encourage non-banks to contemplate new forms of competition against European banks whose brand recognition does not tend to be very high [White, 1998].

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6.4.2.

Efficiency improvements in the provision of financial services

Deregulation and financial convergence has not only increased competition but at the same time raised efficiency and lowered costs considerably. Indeed, the removal of regulatory restrictions gave financial firms more freedom to adopt the most efficient practices available and to develop new products and services than in the past. The increased competition in turn has spurred reductions in margins in financial services and raised efficiency by forcing the exit or consolidation of relatively inefficient firms and by encouraging innovation. The need to compete on a global basis arising from the development and integration of international financial markets has been particularly important in this respect. These effects of deregulation are manifest in declining relative prices for financial services and productivity growth well in excess of that for the economy as a whole. Transactions costs in stock, money and capital markets have declined considerably since the 1970s. Productivity gains in financial services are partly reflected in lower costs required for processing financial transactions. In particular, staff costs, and in many countries overall operating expenses, have also fallen in relation to total income. Users of financial services have benefited not only from lower prices for traditional services but, perhaps even more, from the considerable improvements in the quality, variety, and access to new financial instruments and services that have resulted from liberalisation. 6.4.3.

Gains from more efficient resource allocation

The improved ability of consumers and private businesses to allocate their spending over time constitutes one of the most important resource allocation gains from deregulation in industrialised economies. Significant improvements in the capacity of financial markets to direct funds to their most efficient uses have come from the dramatic increase in the mobility of international capital flows over the last three decades arising (in large parts) from reduction in official barriers to international capital flows. Increased capital mobility has also brought significant benefits to industrial countries. Returns to their savings have increased beyond what would be available from domestic outlets alone; the ability to diversify individual risks, and thereby lower overall risk, has increased; and, improved access to external financing has become an important buffer against disturbances to the domestic economy.

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6.4.4.

Broader consequences for the macro economy and macro-economic policy

Financial deregulation also has led to extensive changes in the financial and macro-economic environment. Some of these changes have been clearly beneficial, others have considerably altered the implementation and functioning of key economic policies but without obviously greatly increasing or decreasing their overall effectiveness. Changes in financial markets resulting from deregulation have had pervasive consequences for monetary and fiscal policies, some beneficial, others more problematic. Particularly in Japan and a number of European countries, the broadening of securities markets -due to the combined effects of deregulation, innovation, and increasing government budget deficits- has helped in the management of public debt by improving the marketability of government securities and increasing the variety of instruments that can be issued. In other respects, however, financial liberalisation has to some degree complicated macro-economic policies, at least for a time. The relations between traditional credit and other indicators and monetary policy objectives have broken down in many cases, and can no longer be used as reliable indicators for policy to the degree they were in the past. 6.4.5.

Problems arising in conjunction with financial deregulation

Financial deregulation in many OECD countries has been accompanied by several economic developments that have either been problematic themselves or raises concerns about the potential risks or other drawbacks from financial deregulation. These developments include: − wide swings in financial market prices that have given rise to concerns that markets have become more unstable and excessively volatile; there is, however, little evidence that there has been any lasting increase in the volatility of stock or bond prices (as measured in terms of their variability on a daily or monthly basis); exchange rate volatility did rise during the first part of the 1980s over the prior decade but fell back during the 1990s;

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− credit market booms leading to build-ups in private sector debt to historically unprecedented levels in relation to income and, in some cases, boom and bust cycles in real estate and stock markets; − the international debt crises experienced by Mexico and several other countries that emerged in the mid-1990s in the wake of very large inflows of private capital over the previous several years. However, the problems do not seem to be an inherent feature of the liberalisation process, but more the result of its interactions with other economic problems and distortions present as liberalisation was occurring. The experiences do underscore the importance of key linkages between macroeconomic, financial and other policies for the relative success of the financial deregulation process. 6.5.

Implications of the changes in the regulatory environment on the insurance industry

A similar analysis can be made concerning the impact of deregulation on the insurance industry. But the same elements should be taken into account when evaluating the benefits and drawbacks of financial deregulation. For example, for the European insurance industry, the impact of deregulation is to a large extent interlinked with the consequences of the creation of the EMU. Changes will take place in market structure, market behaviour and market result. 6.5.1.

Changes in market structure

The changing regulatory environment has one of the most profound effects on the contestability of the insurance markets. New entrants wanting to take advantage of the additional entrepreneurial freedoms will be specialist suppliers, banks and foreign insurers (through direct sales or some form of cooperation). In some cases, market shares are being completely redistributed and dominant insurance companies of today are confronted with a weakening market presence. Focused specialist insurance suppliers and direct writers are likely to use the deregulation of rates and conditions to consolidate their market position. According to Jan Holsboer (1998)42, the rise of non-industry competitors is most prominent in the personal lines business, although the success of companies like Virgin demonstrates that there is a distinct segment that is willing to purchase life and pensions from non-industry competitors and through direct distribution. New entrants like Virgin have prospered not only from a powerful brand name, but convenience of access and a sharper customer

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focus have also stripped the insurance industry of its jargon, creating more transparency for consumers. Sector specialists expect that the insurance companies will face more difficult periods. Since the European Central Bank is sure to conduct a deflationary policy, interest rates will fall and probably lead to stagnant market volume of insurance companies as a result of falling premium rates and (structural) economic problems. It will also become increasingly difficult to rely on national government-decreed price increases, because transparency and pan-European comparability of insurance products will eventually prevail over temporary discretionary government aid. These things make it virtually inevitable that restructuring, mergers, cooperations (particularly in the field of sales) and insolvencies (i.e. an increase in supplier concentration) will occur -particularly in fragmented markets. However, from the Sigma Report (1991)43, we can tell that in the insurance industry, growth through economies of scale is not necessarily synonymous with commercial success. From their study, economies of scale have only a noticeable effect up to a premium volume of $400 to 500 million. Foreign branches will become more important. The "Home Country Control" principal gives foreign business opportunities to operate under the supervisory legislation of their home country, together with the benefit of a local presence in the target country. Countries having a higher number of independent agents and brokers should be easier to enter. Notwithstanding this unprecedented opportunity, barriers of entry like customer loyalty, insurance customers’ attitudes to alternative sales methods (e.g. via the telephone or over the counter in banks) and a well-developed sales force structure of local insurers will complicate foreign entrance. Insurance products will tend to be more similar and global insurers will have an advantage against local insurers. In the industrial market, small or local insurers will have less and less opportunities when companies will prefer pan-European industrial risk insurance. 6.5.2.

Changes in market behaviour

In regulated markets, government-guaranteed minimum prices made it logical to pursue a strategy of turnover maximisation, and sales played a key role. In deregulated markets, as the EMU increasingly will be, competition takes place

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via prices, products, underwriting criteria, innovative sales methods services and credit worthiness. Cross-subsidisation of industrial business by bulk business is likely to decline. The increasing competitive environment will put pressure on profits and hence the development of new organisational structures (i.e. profit centres) will be promoted thereby. The "spirit of cooperation", which frequently manifested itself in the form of cartel-like agreements, will be replaced by more competition. In the deregulated and liberalised environment, price and product competition will prevail over these "gentlemen’s agreements". The increased competitive environment will shift the attention more and more to shareholder value. Narrower profit margins and more volatile results increasingly put higher demands on the insurance companies’ capital management. The trend will be promoted by increasingly demanding, globallylinked financial markets and the increasingly important rating agencies. The survival of insurance companies will depend on their ability to attain the corresponding return on equity and pay greater attention to capital productivity. 6.5.3.

Changes in market result

Prices will become increasingly flexible, which will result in more volatile technical results and probably more volatile corporate results. The causes for this trend can be found in: − deregulation of premium rates; − competition for "good" risks; − the development of alternative sales methods; − greater competition from new (foreign) suppliers and financial markets (e.g. risk securitisation); − increased downward pressure on interest rates resulting from deflationary monetary policy of the European Central Bank; − the cost of adapting the accounting, management and information systems will temporarily affect the overall corporate results.

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7.

Financial convergence and the consumer

7.1.

Introduction

To what extent do consumers benefit from the convergence between the different sub-sectors in the financial services industry (and eventually the pension industry)? It is clear that the financial convergence will inevitably have a profound impact on both financial services providers and on consumers. This can be discussed from a more general perspective, as well as from a consumer point of view. We will start this chapter with some general remarks on financial convergence and the consumer. A number of more general issues have been raised in the papers of the Joint Forum and of the European Community. We will discuss the most frequently cited comments in this chapter. When we talk about financial convergence from a customer point of view, we will present a theoretical framework which can be used to evaluate the value added of integrated financial services solutions (which are the ultimate outcome of the financial convergence). 7.2.

Financial convergence and the consumer: a general perspective

The question whether convergence in the financial services industry is beneficial to consumers is a central element in the whole discussion of financial convergence. The main idea behind deregulation is that it leads to greater competition, greater efficiency, increased economies of scale and scope, and greater consumer choice. In the previous chapter, the main conclusion was that a number of benefits brought about by deregulation (and financial convergence) have been materialised: increased competition, increased efficiency, lower costs, more efficient resource allocation. 7.2.1.

Risks associated with increased deregulation and financial convergence

One must, however, not forget that the role of regulation was to protect the consumer. Recall that we showed in the previous chapter that financial regulation is necessary because of the existence of externalities (see the example of asymmetrical information). The trend towards deregulation (and

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financial convergence) can have negative effects for the consumer to the extent that no appropriate actions have been taken to guarantee consumer protection. Furthermore, the large financial conglomerates might exploit the market power they have. Since (large) financial conglomerates are also (large) institutional investors, they might have substantial shareholdings in a number of companies. A comparison can be made to the German situation where the "universal banks" not only grant credits and loans, but also have equity participations in the German industrial companies. Finally, one could point to the risk of potential conflicts of interest. Such conflicts can exist if a supplier has the choice between two or more options, and this choice is not neutral for himself or for his enterprise. In this case the interests of the client and of the supplier can be opposite. Another example of conflicts of interest can be found in the potential opposition between the best choice for one client and the repercussions on another one. Research of the European Commission revealed that the risk of conflicts of interest increases with the number of activities or products offered. Nevertheless we want to stress that the risk of conflicts of interest is not only relevant for financial conglomerates, but does exist in all types of enterprises that offer substitutable products or services. 7.2.2.

Consumer protection

Furthermore, the financial institutions themselves are well aware that a reputation for honesty and good customer service are among the most effective marketing tools in an increasingly competitive market. In addition, consumer protection has remained a major issue in national financial legislations. For example, various aspects of consumer protection in the field of financial services have been addressed -directly or indirectly- by the existing texts of the European Union law. We will present a brief overview of some issues, as they were forwarded by John Mogg, Director-General of DG XV44 in his Green Paper (May 1996). − Consumer information: financial services directives contain a number of provisions requiring financial institutions to provide their clients with appropriate information (for banking, this is e.g. information on credit limits, termination procedures etc.; for insurance, the policy-holder must be informed about the duration, right of cancellation, applicable law, etc.; for the securities and

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stock exchange, directives seek to ensure investor protection by means of maximum transparency). − Legal protection: certain provisions in a number of directives strengthen the consumer's position vis-à-vis the financial institution and protect the consumers' legal interests should something go wrong. According to Mogg, in all three sectors, host countries may impose rules they have adopted to protect the interest of the general good. − Systems of redress: both in banking as well as in insurance, the existing union law has addressed some aspects that indirectly affect consumer protection. For example, in banking, Member States must ensure that the depositor's rights to compensation may be subject of an action by the depositor against the depositguarantee scheme. In legal expenses insurance, the policy-holder must be explicitly informed in the event of a conflict of interest with the insurer, about his or her rights to have the free choice of a lawyer, and to have recourse, if necessary, to an arbitration procedure. − Trustworthy financial services industry: one of the main objectives of the financial services directives is to maintain the stability and the trustworthiness of the financial sector and all directives contribute to this goal. Examples include the fit and proper regulations (for staff and major shareholders), regulations concerning the transparent structure of financial firms, etc. − Strong financial institutions: in all three sectors providers of the relevant financial services are subject to a formal authorisation procedure and to detailed and strict minimum capital requirements both initially and on an on-going basis. Firms that are not authorised may not provide the core services covered by the directives. − A wider choice of financial services and products: deregulation has led to a wider scope of financial services and products offered. This has also been one of the main objectives of creating a single market in financial services. Any financial service benefiting from mutual recognition may, if it is legally provided in the home country, be offered in the host country, via a branch or on a crossborder basis, even if the service in question does not exist in the

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latter country or even if domestic institutions may not offer it. As a result, savings and insurance products are already being offered on markets where they were previously unavailable. − Pricing of financial services: in the previous chapter, we indicated that deregulation and financial convergence has led to lowered costs and increased efficiency. It is a question whether this also implies lower prices. The financial services directives do not seek to interfere with the free determination of prices. Indeed, the only direct intervention in this area has been in the insurance sector, where imposed and approved tariffs have been abandoned. Having removed this obstacle, the insurance directives have opened the way for more competition. 7.3.

A theoretical framework for the evaluation of integrated financial services

We think it is worth analysing the impact of financial convergence from the customer’s point of view as well. The previous chapter was based on the general idea that customers are a homogeneous group of people with the same needs and expectations. It is clear that this is not the case. Before we present the theoretical framework, it is good to bring you back to chapter 3, where we argued that the cross-selling of banks and insurance products is only a first step in the growing convergence of the financial services industry. We argued that the complementarity in time and space between different financial and insurance products not only creates natural incentives for cross-selling and packaging but also for innovative product integration. Through unbundling (old traditional products) and rebundling (in accordance with the real market needs) new service bundles are created. Recall that in chapter 3, we distinguished between three main bundling approaches: − cross-selling; − packaging; − fully integrated financial services.

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Figure 14 - The different forms of bundling Value added

Fully integrated services Packaging Cross-selling Level of integration and customisation

Degree of expertise

Source: Van den Berghe & Verweire (1998)

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In what follows, we will show that - from a customer’s perspective- each approach has its benefits and drawbacks. This evaluation is based on the approach developed by J. Heskett e.a. (1997)46. It allows us to identify in greater detail where potential value added is situated, and where possible negative side effects can prevail. In this framework, the value-added for the client depends upon the following elements: result (3) + process quality (4) price (1) + non - monetary costs (2)

1. Thanks to economies of scale as well as economies of scope the price of bundled services can be lower than for services bought separately. In practice most bundled services are sold at a price discount. It can however be more difficult to compare the respective prices because bundled services are often less comparable than the standard ones. Critical customers can evaluate this lower transparency as a negative side-effect of bundling. 2. The non-monetary costs consists of different sub-elements:

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− The search costs will decrease drastically if a supplier offers bundled services, especially less-informed customers can find it very difficult and are even afraid to shop around and look for the most convenient supply in the market. This is even the case for more informed customers when it relates to complicated products and complex determinants of the best needs. Quite a number of financial products are rather complex. − On the contrary the switch costs or the cost of changing suppliers will increase the higher the integration of the services involved. Moreover suppliers often expect that customers sign more longerterm contracts in case of customised or personalised integrated service bundles. These factors can be an argument favouring the supply of bundled services: the suppliers -in fact- buy more loyalty because of the longer-term of the contracts and the higher switch costs for the customers. However they can entail a disadvantage, especially for critical customers and shoppers. These observations are very useful for applying such theoretical concepts in practice: our market research (Van den Berghe and Baeten, 1995)47 clearly showed that some customers are considering this non-monetary cost as the main hurdle to accept the one-stop shopping idea of bundled services or the integrated approach of all-finance. Fortunate for these suppliers that not all customers are approaching this factor with the same attitude: some customers do not consider these non-monetary costs that important because they attach more value to the higher quality and result. Our research also revealed that even critical customers can be convinced of the net surplus-value of integrated services as far as they see the advantage on the price level being more important than the disadvantage on the level of the switch cost. − Another element of the non-monetary costs is related to the fact that bundling leads more or less to the principle of all eggs in one basket; especially critical customers can see different potential disadvantages in this respect. They fear that one institution knows too much about them: this is a real fear in relation to financial services. Some also see a potential danger of concentration of power within the hands of the service provider. These dangers are often expressed by informed or critical customers, whereas less eloquent customers often feel more comfortable when they do not have to detail to every service provider the personal needs, situation and problems. A familiar intermediary is often best

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situated to become the thrust person for the personal financial diagnosis and recipes. 3. The more the services will be bundled and integrated the higher the result for the customer and this from different perspectives. − Suppliers of integrated services often offer a result commitment, thereby working more solution-driven than volume- or productdriven. In the case of a pure cross-selling approach it is very well possible that over-selling goes hand in hand with white spots or failing covers of service components. Eliminating these over- and undersupply through integration and customisation creates a higher value-added for the customer and a better competitive position for the supplier. − The integration also supposes a considerable degree of individualisation or at least customisation. This certainly improves the value for the customer who receives solutions fine-tuned to his specific needs and expectations. − The components of the bundled services can be produced by different specialists as far as it is offered by a large conglomerate or an integrated network of specialist service providers. According to many management experts, the networking road looks promising, but potential dangers remain. First, are all partners in the network delivering the same quality? The chain is as strong as its weakest link: therefore bundled services suppose an integrated management of the whole service supply-chain. Secondly, how strong is the network? Will the collaboration last? This question is especially relevant in sectors like insurance, where a customer buys a promise that will have to be honoured in the future, which sometimes can be as far away from the signing of the contract as 30 to 40 years (e.g. long-term care contracts or pension provisions). 4. The process quality will be improved from different perspectives: − The one-stop shopping leads to more convenience. − The customisation supposes a relationship marketing whereby the client receives a personalised approach instead of a standard client approach of the transactional marketing type inherent in crossselling. 250

This theoretical framework shows that there is not a univocal answer to the question whether integrated financial solutions are better than separate banking and insurance products. We saw that much depends on the type of consumer and what he/she thinks is important. Similar conclusions were reached in the Lafferty study by Sorcha Corcoran (1997)48: customer segmentation is necessary. According to Corcoran, the more sophisticated customers want to shop around for the best deal and spread their assets around to more than one institution. They do not want their bank or (life) company to know too much about them. By contrast, there may be a customer segment that likes the idea of one organisation looking after all of its financial needs. All these arguments show that one of the most important tasks of financial services companies is to gain an in-depth knowledge of the needs and profitability of each of its customers. The Lafferty Study showed that many providers are still a long way from reaching this goal. Corcoran mentioned a Deloitte Consulting survey, which indicated that few executives are very confident that their current approach is meeting the evolving needs of their customers. The survey showed that a mere 19 per cent said they were highly confident that they were successfully locking-in customers across a range of products, and only 20 per cent were highly confident that they could customise products as required. According to the Lafferty study, one of the main problems in this respect is to integrate the various databases in order to gain a view of the total relationship with each customer. Here, financial institutions are also hampered by privacy issues. Indeed, they are not allowed to use information they gathered in the banking side for the insurance part of their businesses. It is clear that this will remain a major issue for financial services providers. 8.

Financial convergence and prudential regulation

8.1.

Introduction

Although financial convergence and in particular financial conglomerates are well under way, up to now few regulatory initiatives are taken towards legislation on financial conglomerates. Indeed, most national regulatory and supervisory systems are structured in view of the traditional boundaries between banks, insurance companies, pension funds and investment firms (the so-called vertical division of activities). The market evolution in the direction of financial

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conglomerates, all finance, packaged solutions, integrated product development etc. leads to the further blurring of the traditional boundaries (the so-called horizontal integration and product clustering). This raises the question whether the actual legal solutions and structures are adapted to the new wave in the financial sector. To come to a number of regulatory issues on financial convergence, we start with identifying the differences and parallels in the philosophy behind the current regulation of the different types of financial institutions. The headlines behind the regulation on financial services have been highlighted in chapter 6. In this chapter the emphasis will mainly lay on the specific differences between the institutions involved and on the concrete measures taken to regulate and supervise the financial institutions. For simplicity, we will limit this comparison to the EU rules and we will not enter into the details of the national applications of these EU rules49. The main goal with this analysis is to identify potential domains for discussion and improvement. 8.2.

Parallels and differences in approach of regulation and supervision within the financial sector

The financial convergence and the creation of financial conglomerates with substantial banking and insurance activities necessitates that more attention is paid to the supervision of these financial groups. In most countries, there is still a fragmentary supervision. As the boundaries between the banking, the insurance and the investment industry slowly disappear, we might expect that changes in regulation and supervision will occur. This was also acknowledged in the Joint Forum paper of February 1999: "The solo capital adequacy requirements of each of the banking, securities and insurance sectors are different with varying definitions of the elements of capital, and varying approaches to asset and liability valuations. Each sector’s capital adequacy requirements reflect the nature of the different businesses undertaken by each sector, the differing risks to which they are exposed, and the different ways in which risk is managed by the firms and assessed (and/or constrained) by supervisors [...] The requirements within each sector are not in all cases uniform, but the trend is towards convergence of capital adequacy requirements in

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the insurance sector is however desirable, including for insurance groups" (Joint Forum on Financial Conglomerates, 1999: 6-750). Any difference in regulation and supervision in each of these industries could either cause a (competitive) advantage or a disadvantage for the particular financial institutions. Therefore, we think it is necessary that both regulators and supervisors must be aware that -in a financial system where the companies from the different sub-sectors are becoming more direct competitors- it is necessary to create a level playing field. 8.2.1.

Parallels and differences in the philosophy behind regulation and supervision

A necessary precondition, however, is that we understand the parallels and differences in the regulation and supervision of credit institutions and insurance companies51. The philosophy behind these different types of regulation has to be analysed at three different levels: the micro-, the market- and the macro-level. The philosophy behind the regulation at the micro-level is quite parallel for banks and insurance companies. The main aim of the supervision of both sectors is to protect the clients that own "financial assets" or "receivables" that are the "liability" of the banks or insurance companies. Especially the solvency regulations have to cover these needs for protection of the clients. In the case of credit institutions these liabilities relate to banking accounts, term deposits, saving accounts, etc. For life insurers it can be "contractual savings" and for all other types of insurance this relates to "non-individualised liabilities" of insurers against their policyholders and other parties concerned, whom they promised to refund eventual losses. Other types of regulations, such as the accounting and disclosure rules are set up to cope with the problem of asymmetric information. In fact most of the mass clients suffer from an information gap, when they have to value the reliability of the institutions in general, and of their promises more specifically. The philosophy behind the regulation at the market-level is also quite parallel between banks and insurance companies. The third generation directives try to install the free competition, since that would be at the advantage of all clients: greater choice, innovation and better conditions (see also chapter 6). The philosophy behind the regulation at the macro-level is however quite different. The credit institutions are not only performing a function as "financial intermediary" but they also are crucial to the monetary system. Consequently the volume of their transactions and the remuneration of the different types of

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deposits and credits do influence the monetary system to a great extent. Therefore, the supervision of credit institutions is a fundamental instrument for the development of monetary policy (e.g. interest rate structures, monetary mass, inflation rate, etc.). Here insurance companies only play a minor role, and are certainly not the leading institutions to develop the necessary monetary policy instruments. The regulation of the financial sector should procure the necessary macrostability. In this respect there exists a greater parallel, but not a complete comparable situation between the banking and the insurance sector. Although "stability" and "thrust" are important ingredients of the "products" sold by both sectors, it is clear that these characteristics have more far reaching consequences in the banking sector. This again has to do with their "monetary" function; by transforming "banking accounts" into "credits" they influence the buying power, but this transformation process is built upon the premises of stability and thrust. Although the national banks can perform their function of "lender of the last resort", the financial payment system could become under great pressure when all clients ask simultaneously to cash their receivables (cf. the liquidity crisis of the thirties). This is certainly not comparable to the insurance business, where the largest amount of the "technical" liabilities is not "liquid". In fact, life insurance companies even transform a financial intermediation function in an opposite direction: they invest long term capital (even up to 40 years) into shorter term instruments (and consequently they suffer from a problem of matching assets with liabilities). That this duration mismatch can create extra problems has been observed lately with the negative effects of the low interest rates on life insurance companies. The discussion on the need and magnitude of an increase of their mathematical reserve has been on the agenda of all supervisory authorities and board meetings of life insurance companies. 8.2.2.

Consolidated and solo-regulation and supervision

There do not only exist differences in the philosophy at the macro level between the banking and insurance industry, another important distinctive feature is the approach used to supervise the financial institutions. In principle, regulatory authorities have a choice between two "extreme" basic models: − They can apply a consolidated regulation (and supervision), where regulation is applied from the top, to all members of the group engaged in financial activities, or;

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− they can apply a separate or solo regulation (and supervision), which attempts to insulate or ring-fence the regulated entity from other group members. Bank regulators and supervisors have opted for the first alternative, whereas the insurance sector opted for a separate control per legal entity (whether an independent company or a partner within a larger group or conglomerate). However, for a number of years, there is an open debate on whether the supervision of the insurance sector should be focused on the group level or rather on the level of the individual companies. Moreover the financial converge in general and the growth of financial conglomerates more specifically forced the insurance sector to reach a consensus on the way towards an extra level of supervision on top of the solosupervision, which is the so-called solo-plus approach. Since financial groups are characterised by more integration and since intra-group relationships are becoming more important, a fragmented (solo) approach will have to incorporate an increasing amount of extra supervision (supervision plus) if sufficient information is obtained about the complex reality of these relationships. Traditionally, the supervisors of the banking and the insurance sector of some countries established a sort of mutual information procedure. In as far as this movement is, however, becoming more important, the cooperation between the respective supervisors will have to become more prominent. This is probably why more and more people suggest that one integrated supervisor should be established (see e.g. the UK and Japan). It is worth mentioning that in this respect, the insurance sector is often more on the defensive side, while the banking supervisors are mostly more offensive in this respect. In our opinion, it is necessary that the insurance sector develops a more pro-active approach! Even the different supervisory systems do not change, it will become necessary to compare the different rules and guidelines that govern the respective "sectors" involved. In as far as the regulatory philosophy and the regulatory instruments differ, a competitive level playing field will not be possible. The more the financial world integrates, the more these differences will become unacceptable. Again, this pressure could easily lead to a more integrated and consolidated supervision on insurance groups, credit institutions, securities businesses and financial conglomerates. And again the question is to what extent insurers are pro-active in forcing adaptations or are merely trying to prevent changes.

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Finally, we would like to point to an important aspect regarding the supervision of financial conglomerates. As long as one uniform supervisor is not in place, the division of duties between the respective supervisory authorities remains an important question. The nomination of a lead-supervisor can, however, be based on questionable criteria. − For example, the division of duties in the Netherlands has been based on the "required" solvency level. But, the calculation of the required solvency level is based on completely different assumptions for the different types of financial institutions. Moreover these criteria do not take into consideration the degree of integration, nor the type of collaboration. E.g. many, if not all joint ventures between banks and insurance companies have an important element of distribution networking; these interfaces can never be measured in terms of solvency requirements. − Most players in the insurance sector accept that the solvency requirements, as prescribed, e.g. by the European directives, are (by far) too low, so that regulators themselves demand levels that are 200 per cent and more of these regulatory measures. By consequence the major insurance companies have by far more solvency capital than the required level. In the banking sector the opposite evolution can be noticed. A first observation is that many major banks do not have large "overweight" in the level of own funds vis-à-vis the required solvency level. Moreover, banking regulators accept more and more types of "near" capital and allow individualised calculations of required solvency levels. Consequently the definition of the type of financial conglomerate (insurance, banking or mixed) can be totally different whether the definition is based on the required versus the actual solvency level. 8.2.3.

Differences in solvency regulation and the supervision of products

In addition to differences in the philosophy (at the macro level) and the unit of supervision, there exist considerable differences between the solvency regulations of the banking and the insurance industry, and the supervision of products. Since these differences are quite important and fundamental, we come back to this issue in the next paragraph.

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8.3.

Differences in the reference base to supervise the stability and confidence of banks and insurance companies

We already argued in the introduction of part B that it is of utmost importance to have a sound and stable financial system. In order to guarantee the soundness and stability of the financial institutions involved, careful attention is paid to the solvency of the financial institutions. The calculation of the required level of solvency as well as the definition of the components forming the solvency fund and the supplementary buffers to guarantee confidence in the financial system differ to a great extent between credit institutions and insurance companies. This will be further explained in the following paragraphs. In addition to solvency issues, there are other elements that must guarantee the stability and confidence in the financial and insurance sector. These different elements differ considerable between the banking (credit institutions) and the insurance industry. − Credit institutions. Besides the solvency fund (which is discussed in section 8.3.2), the confidence in the financial system is also guaranteed through the existence of a deposit insurance system. Such a system creates a safety net for clients (saving, depositing their money) within certain limits and certain conditions, against the risk of failure of their credit institution. Most industrial countries have a deposit insurance system but the institutional form and coverage differ markedly across countries. However, the EU has issued a directive, implying that all member states will have to adapt their deposit insurance schemes in such a way that certain minimum requirements are met. − Insurance companies. The EU rules do not require the insurance companies to set up a guarantee system or a "deposit insurance mechanism". This does not mean that clients of insurers can only rely on their solvency fund held by an insurer. On the contrary, quite a diverse set of instruments must guarantee the stability and reliability of the insurance sector: − the technical provisions form the first buffer; in the case of life insurance with an important saving element, these liabilities are the individual claims of the clients, comparable to any deposit or saving account with credit institutions; but for pure risk insurance these liabilities are the collective claim of the insured;

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− for insured losses that have occurred, but for which the insurer has not yet received any concrete claim, an extra reserve is formed (the so-called IBNR reserve); − for cyclical risks an extra reservation is made (legalisation reserve); this reservation has quite a great resemblance with the "general banking fund"; contrary to the credit institutions this fund is not considered as an element of the solvency fund of insurance companies, whereas for banks it is a component of the tier 1 funds; − besides these "obligations to reserve" for liabilities, also numerous aspects of the investment of these reserves are regulated: − obligation to diversify the investments; − requirement of congruency and localisation of assets; − rules for the evaluation of these representative values. 8.3.1.

Calculation of the required level of solvency

In this section, we will briefly describe the headlines for the calculation of the required level of solvency, both for credit institutions (banks) and for insurance companies. A more detailed analysis is presented in appendix A.3. This analysis gives neither a complete overview of all actual regulations, nor is it aimed at evaluating the different aspects of these regulations. The only aim is to be able to better observe the parallels and differences between the approaches for respectively banks and insurance companies. Credit institutions The determination of the required solvency level of banks has been broadened from a capital-to-assets ratio to a risk-assets ratio. According to the capital-toassets ratio the required level of the solvency fund is proportional to the volume of assets. Important evolutions in the international banking activity necessitated the introduction of a new "risk assets" ratio, based on the credit risk of the assets of the credit institution.

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The introduction of all types of off-balance sheet transactions (securitisation, derivatives) increased the risks run by credit institutions. This development was (partly) a method to circumvent the solvency requirements, previously based on the balance total. Supervisors have taken appropriate actions and now, offbalance sheet components are also taken into account to calculate the solvency margin (by means of a credit conversion ratio). Besides this credit risk, the important interest rate risks and exchange risks must eventually be taken into account. The introduction of the new rules on investment activities will also lead to the integration of other market risks. It has been decided recently that also "large exposures" must lead to higher solvency requirements. It can be argued that new instruments, developed recently within the banking sector like RAROC and RORAC, do offer a far better method for risk analysis than the methods used up to now. Although it is not the aim of this report to discuss these issues, it must be stated that these new risk management instruments for banks could well help to solve the supervision of financial conglomerates. By adapting these rules to the insurance activities, it must be possible to come up with an integrated risk analysis for financial conglomerates. This could well solve the actual problems of so different regulations that endanger a true level playing field within a converging financial sector. Insurance companies For insurance companies, a distinction must be made between life and non-life companies. For the life companies, the reference base is partly the liabilities (mathematical provisions) and partly the insurance risk (capital under risk). For the non-life companies no balance sheet elements at all are taken into account. There, the reference base differs according to the profitability of the business. We refer to appendix A.3 for more detailed information in this respect. 8.3.2.

Calculation of the solvency fund for credit institutions and insurance companies

Once the required level of the solvency margin has been calculated, one must analyse whether the institution involved has enough "free" funds to cover these solvency requirements. This means that we have to look at what types of funds can be taken into account to represent the solvency needed, but also at the degree to which these funds can be integrated as "representative values".

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Neither of these elements are defined in the same way for credit and insurance institutions. Although the differences between the banking and the insurance sector decreased since the last EU-directives became into force52, a separate analysis of the respective regulations is still necessary. Like in the previous section, we summarise the main headlines, more detailed information can be found in appendix A.4. Credit institutions The calculation of the solvency fund for credit institutions distinguishes different types of funds: the tier 1 capital, tier 2 capital and tier 3 capital. Besides these factors, also some correction factors have to be taken into account. Insurance companies For the insurance industry, the definition of "free funds" that can constitute the solvency fund, has been adapted to include quite a number of new elements. Most of these elements are in fact copied from the definition of solvency components for credit institutions, such as subordinated loans and cumulative preferential share capital. These new regulations bring the definitions of solvency for both sectors more in line with each other. There remain however some important differences, which are described in greater detail in appendix A.4. 8.3.3.

Philosophy behind the solvency regulations

As a summary, we briefly outline the major differences in (1) the calculation of the required level of solvency, as well as in (2) the definition of the components forming the solvency fund. 1.

Solvency level.

The calculation of the necessary level of solvency is based on the insights into the risks, from which the institutions under consideration can potentially suffer. Comparing the minimum solvency requirements, it must be observed that the banking risks need more solvency than the insurance risks; within the insurance sector the credit insurance is considered the most risky business, while the other non-life insurance branches consume less capital.

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For credit institutions no attention is given to potential liability risks; the only reference base is asset risks and "off-balance" risks. These risks are mainly credit risks, although also interest rate risks and exchange risks can be taken into account. These risks are measured on an institutional level; if a group structure exists, it will be the holding company that has to fulfil the solvency requirements. Insurance companies on the contrary, are less supervised on an institutional level; it is more the technical working level that is taken into account. This is logical in as far as the measures of the risks carried by insurers are mainly of a technical nature and differ according to the type of insurance branch. Moreover, the EU directives oblige the insurance companies to specialise in either life, non-life, credit insurance etc.53. Due to the inversion of the exploitation cycle the insurers’ risks are first of all "liability risks". These are measured on the basis of certain liability components (for life insurers) but especially on the basis of underwriting risk indicators (premiums, claims, capital under risk). For non-life insurers even sanctions are foreseen if they do not use sufficient profitable tarification schemes. Asset risks are more supervised through specific prescriptions for investments and their valuation than through risk based solvency requirements. For life insurers however there is an important solvency requirement in relation to the investment risks carried by the insurer: three quarters of the solvency requirements (based on the specific liabilities - mathematical reserves) can in fact be considered as a buffer against these investment risks54. For the moment no attention is paid to potential off-balance risks. This was certainly justified in the past, since not many insurers used these instruments. There is however an increasing tendency that (larger) insurance companies try to sophisticate their financial management and integration of certain off-balance instruments is becoming more and more popular. 2.

Components of the solvency fund.

The difference in the definition of the components, forming the solvency fund are decreased to a considerable degree since the third generation directives. Nevertheless there remains quite a substantial number of differences: − integration of non paid-up capital for insurance companies;

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− integration of general banking fund (for credit institutions) and no integration of legalisation reserves (for insurers); − difference in the degree of integration of revaluation reserves (50 per cent for banks and 100 per cent for insurance companies) and value corrections (for banks); − difference in the degree of integration of subordinated loans and cumulative preferential shares; integration of hidden reserves and future profits for life insurance companies; − under-estimation of assets for non-life insurance companies; − penalties for concentration of holdings of credit institutions in other credit institutions. In relation to this last factor, a discussion has been going on whether the same rules should not be applied to insurance companies. It is not possible to go into detail on this important question. The only remark we want to make here is the following: although it is reasonable to overcome also double gearing in the insurance sector, it is clear that insurers as institutional investors can have considerable holdings in other companies and enterprises with pure investment perspectives. 3.

Extra buffers.

The extra instruments that guarantee the solvency, stability and confidence in the financial sector are completely different. The banking sector is relying on an extra deposit insurance that insures clients -within certain limits- against unfortunate or bad choices of their suppliers of financial services. The insurance sector is more relying on extra supervision and extra reservations. Another difference that should be mentioned is the fact that all banks are supervised while there is in principle no supervision of reinsurance companies (although there is an indirect control through the cession in reinsurance of the supervised direct insurers, but this does not relate to the so-called spiral effect of retrocessions). 8.3.4.

What about financial conglomerates?

The calculation of the required level of solvency as well as the definition of the components forming the solvency fund and the supplementary buffers to guarantee confidence in the financial system differ to a great extent between 262

credit institutions and insurance companies. This brings us to the question which global approach of the solvency requirements for financial conglomerates is necessary and what is feasible? We have dissected this general question into a number of subquestions: − Should the solvency requirements for banks and insurance companies be more in line with each other, and is a global approach for financial conglomerates feasible? − Should the solvency norm for insurance companies also include a risk asset ratio? − Should the risks of using derivatives and other off-balance sheet activities by insurers be monitored more carefully? − Does the minimum solvency or guarantee fund for insurance firms need to be updated? From the previous discussion, it is clear that a global approach for the calculation of the solvency requirements for financial conglomerates is not straightforward. Due to large differences in the activities involved, the accounting principles used and the legal requirements, it is not easy to develop a common measure for all risks involved. It is often stated that the calculation of such a global solvency can easily be solved, by stating that the group should have the combined solvency of the constituting enterprises. Although this may be a solution in the short run, it is certainly not a sufficient one from a conceptual perspective. In order to give an adequate and well-developed answer to this question, we need to have more insights into the risk-increasing or risk-decreasing aspects in financial conglomerates. Are there synergies (in the form of economies of scale and scope) or are the combination effects negative? Today, academic researchers have not found an appropriate answer to this question. The second question is whether the solvency calculation for insurance companies should not be amended to take into consideration the "increased" investment risks, run by insurance companies55. It was already explained that the solvency calculation for insurance companies mainly focuses on the underwriting risk. The risks involved with the investments of their technical provisions are monitored through a double regulation: namely (1) the regulation of the investment policy, and (2) the accounting rules and prescriptions for the evaluation of the "representative" assets. 263

For life insurance companies also the investment risk is taken into account in the calculation of the required solvency level. The evolution towards unit linked products and innovative combinations of investment, saving and life insurance products does not lead automatically to more investment risk for the insurer. In fact two opposing trends can be observed in this respect. Increased competition stresses the need for more competitive guaranteed returns, which ultimately lead to an increased investment risk for the (life) insurer. On the other hand, modern life insurance products give a substantial part or even the complete investment return to the clients, so that the investment risk is no longer carried by the insurer himself. A comparison was made between the solvency level required for banks and for insurance companies. In order to come up with some well-founded answers, it was decided to use a simulation study56. Because of methodological difficulties, it was only possible to apply the banking rules to the insurance companies (4 Dutch insurance companies: life/non-life; large/smaller companies). Comparing the different companies studied, we can conclude that the impact of applying the banking rules to the insurance sector has rather different effects whether the company under consideration is a life or a non-life company. A non-life company is not a "financial intermediary" in the strict sense of the word, but the function of institutional investor is only induced through the insurance "capitalisation" technique and the "inversion of the exploitation cycle". Due to the relative "shorter term" of their commitments, the investment policy primarily focuses on liquidity; their assets have a lower risk profile and consequently need less solvency capital. Life insurers, on the contrary, focus more on return in the long term; a higher return is often associated with higher risks, so that their solvency needs, calculated on the basis of the "weighted assets" is considerably higher. If we compare this observation with the underwriting experience, than it becomes clear that the banking rules are not very useful for non-life companies. From a pure insurance perspective, the nonlife business is far more risky than the life business. The difference between larger and smaller companies is also important to mention. The larger the groups are the more sophisticated their financial management is. Consequently their assets tend to contain more risky elements, but at the same time the diversification degree is also quite larger. The application of the banking rules leads to a relatively higher solvency need for larger companies. This is again in contrast with the solvency measures, based on the underwriting risks. It can be proven, on the basis of the law of large numbers, that the underwriting risks of larger portfolios can be estimated more accurately than for smaller portfolios. Consequently, the solvency requirements

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for non-life companies are degressive, which means that larger companies have proportionally less solvency needs than smaller ones. We already observed that the question is sometimes raised whether the solvency requirements for insurance companies should not be upgraded to incorporate also the "asset risks". We therefore calculated also the solvency level for insurance companies combining the requirements of the "insurance" regulations with those of the "banking" sector. Such a combination, however, is "overshooting" the required solvency level, certainly in the case of life insurance companies. We can prove this hypothesis on the following grounds. − The life insurance regulations already integrate considerable solvency requirements to cover the "investment risk". The investment risk included in the solvency calculation, can be deducted from the comparison of the requirements for "classical" life insurance products with those for "unit linked" products (with no investment risk for the insurer); the first category needs 4 per cent of the mathematical reserves, while the latter only needs 1 per cent. Consequently the difference (3 per cent) represents the investment risks. The solvency needs, calculated on the basis of the "weighted" asset risks, should therefore be corrected for the investment risk already integrated in the "insurance solvency calculations". − The application of the "corrected" banking rules to the life insurance companies of our sample must start from certain hypotheses in relation to the "risk indicators". It is therefore not possible to make absolute statements on the level of solvency required. From our calculation it is however clear that in most cases the insurance solvency calculations take more investment risk into consideration than the corresponding measures for the banking sector. It is therefore clear that the life insurance measures are probably not underestimating the investment risk. A last question relates to the discussion whether the minimum solvency or guarantee fund for insurance companies need to be updated (because of the depreciation of the monetary value). This is especially questioned for the "older" definitions, such as non-life insurance (dates back to 1973) or life insurance (1979). The directives for credit institutions are from a more recent date (1989). The simulation also provided a first answer to this question. On the European level, it could be argued that the minimum solvency requirements must be corrected to take into account the "EU-inflation". 265

According to the difference in reference year, the correction must be the largest for the non-life branches (more than 3 times the actual level), followed by the life branches (more than the double of the actual level); only minor changes will be needed for the banking sector. The impact of these changes will be different in each member state, according to the evolution of their currency rate against the ECU and to their specific inflationary experience. For the Netherlands the impact would be lower than the average EU adaptations, mentioned before. This can be explained by the fact that the Dutch economy performed better than the EU average and had a lower inflation rate over the period under consideration. The potential correction would be the following: − for the non-life branches: x 2.25; − for the life branches: x 1.5; − for the credit institutions: x 1.13. 8.3.5.

Differences in the supervision of banking and insurance products

Since most of the regulations and supervision is done on an institutional base the analysis of the differences at the product level can only be deducted by comparing the indirect effect of different regulations at the level of the producer or intermediary offering the products under discussion. This analysis is most relevant for products that are (nearly) identical, like mortgages. But the same analysis is also relevant for products that do differentiate but are competing one against the other. This is especially important given that the financial convergence is leading to an intensified competition between banking, insurance and pension products. In this report we will limit the analysis to the mortgage product. Although banks and insurance companies can built different emphasis in their mortgage offers (e.g. with the focus respectively on annuities with death risk cover versus repayment of the loan by a mixed life insurance product), they are competing with a comparable product assortment. Nevertheless the solvency burden on mortgages is rather important for banks (on average 8 per cent solvency capital is needed), whereas insurers can offer an identical product without any extra solvency capital needed. This difference can easily be explained by referring to the analysis of (the difference within) the calculation of the necessary solvency capital. This can not only lead to a considerable disturbance of the level playing field between banks and insurance companies, but could well lead to regulatory 266

arbitrage especially within financial conglomerates that house banks as well as insurance companies. 8.4.

Other regulatory issues with regard to financial convergence and financial conglomerates

Besides the solvency issue, there might be other issues regarding financial convergence and financial conglomerates that deserve special interest. Indeed, it is sometimes argued that financial convergence, and in particular financial conglomerates, can bring about additional risks. We will summarise these risks very briefly. − Risk of contagion. Supervisors are very concerned with the risk of instability and insolvency. They think that, with the creation of large financial groups, problems in one part of the organisation could infect another (healthy) part of the group (risk of contagion). This risk is comparable to a certain extent to the risk of large financial exposures; however, also important psychological effects on the image, reputation and credibility can increase the risk involved. It is however questionable to what extent the total risk of the conglomerate is larger than the sum of the individual risks involved. Verweire (1999)57 showed that for a sample of Dutch and Belgian financial institutions, the risk profile of the financial conglomerates was better (thus less risky) than the pure banking and insurance groups. − The risk of double gearing. Another aspect, related to the problem of insolvency and instability, is the risk of double gearing. Supervisors are afraid that capital will be used several times in determining the adequate capital coverage for the group as well as for the different parts of the conglomerate. The supervisors are unanimous that this danger should be prevented. − The creation of opaque structures. It is argued that financial conglomerates could be set up in such a complex way that the structure becomes opaque. In the first place this would lead to problems for supervisors, wanting to assess the real risks of the conglomerate or to control the activities in an effective way. An even more dubious practice could be feared whereby some activities are transferred to those entities which are subject to less prudential supervision or which are not subject to any control at 267

all, thereby searching for the way of the least resistance. The opaque structure could even be used to hide doubtful activities. − External conflicts of interest. We already argued in chapter 7 that one of the risks associated with financial convergence and financial conglomerates is the risk of potential conflicts of interest. For example, what will happen when a firm gets in trouble and the bank arm has a credit exposure, while the insurance part has an equity stake in that same firm? At this moment, the interests of the two parties are flatly opposed to each other. These potential conflicts of interest are, however, not restricted to the consumer, but can also harm investors and supervisors. To overcome these conflicts of interest Chinese walls will have to be built. It is our firm believe that more than any Chinese walls, it is a conduct of ethical behaviour that will be necessary. Whatever Chinese walls may be established within an integrated firm, there will always be inside information, certainly at the top level. Only strict ethical behaviour with a firm top-down control will lead to a good risk management in this respect. − Internal conflicts of interest. Besides the external effects, conflicts of interest may also lead to a number of internal problems such as, which might (or might not have) consequences for the outside world: struggle between business units to get market share, danger of cannibalisation, cross-subsidisation, cultural conflicts, ... − Quality downgrading. The overall quality level can be downgraded because some parts of the diversified scope of businesses are not well under control. The service chain will be as strong as the weakest of its elements. The number of products a distributor or selling representative or agent can tackle successfully is not unlimited! The limitation of the optimal scope of the product portfolio is not so much dictated by the consumers but by the operational limits and the limits of professional capacities. The Joint Forum on Financial Conglomerates has addressed some of these risks in "Supervision of Financial Conglomerates", which formulates some guidelines on some of these issues. For example, considerable attention is paid to capital adequacy principles. The main objective of these principles is to provide banking, securities and insurance supervisors with principles and measurement techniques to: 268

− facilitate the assessment of capital adequacy on a group-wide basis for heterogeneous financial conglomerates, and; − identify situations such as double or multiple gearing which can result in an overstatement of group capital and which can have a material adverse effect on the regulated financial entities. Furthermore, the Joint Forum has also formulated "fit and proper" principles for managers and key shareholders, and developed a framework for supervisory information sharing. 8.5.

The regulation and supervision of financial conglomerates: main recommendations

The regulation and supervision of financial conglomerates raises difficult issues with respect to: − theory (what should be the appropriate regulatory approach and what is the precise nature of the special risks faced in financial conglomerates?); − conceptual approaches (what should the broad regulatory strategy be in addressing the special risk characteristics of these complex firms, and how should these risks be addressed by regulation, e.g. prohibition of certain types of business, fire walls, consolidation, dedicated capital); − practicality (how, in detail, regulation is to be framed once the first two dimensions have been settled). These are problems being addressed by all countries and a series of official international study groups have addressed the difficult issues involved and have made recommendations. Our main conclusion is that it is extremely difficult to create and apply one set of regulatory and supervisory rules for banks, insurance companies and financial conglomerates. Therefore, we argue that regulation and supervision should be diversified according to the different sectors. There are, however, a number of elements which should be taken into account. The focus of regulation and supervision should not only relate to the legal entities. Financial conglomerates are the institutionalisation of a wider trend

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towards financial convergence. Convergence also takes place through joint ventures and networking, which is not captured by financial conglomeration. Furthermore, we are convinced that in the future new competitors, coming from outside the traditional domains, will come into play. And consequently, the focus will be much more on functional aspects than on institutional aspects. No double supervision is necessary. It is important that the new regulation and supervision do not hamper the strategic development of financial firms. All in all, regulators and supervisors should try to create a regulatory framework that helps to establish a level playing field, without limiting and hampering the innovation and expansion of the financial services industry.

Part C 9. Financial Convergence: Some Conclusions and Recommendations

This part wants to summarise the most important conclusions of the analyses done in part A and B. Moreover, it is the goal of this report to look for a number of recommendations; these recommendations must foster innovation and prosperity, without neglecting the important conditions of a stable and reliable financial sector. 9.1.

Financial convergence is here to stay and supervisors must and cannot prevent this

In the eighties we started scientific research to investigate the drivers behind the financial convergence trends. The hypothesis analysed started from the idea that this trend was only beneficial for the suppliers and that in fact, it was for them, a fancy way of selling their diversification strategy to the public. The main conclusions of this research were that the financial convergence offered a number of advantages but disadvantages as well. For some consumer segments the balance was towards the advantages so that they favoured this movement. Others were more pessimistic about the outcome of this evolution in the

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financial sector. In follow-up research in the nineties it became clear that the camp of the believers had grown and that more integration into the direction of all finance and all care could shift the balance considerably in favour of this financial convergence. Looking at the market scenery today, we can state that one or other form of financial convergence can be witnessed in many, if not all developed markets. It is striking to observe that even the strongest opponents of financial convergence do accept that this trend is irreversible. An even harder proof of the fact that financial convergence has gained tantamount acceptance is that specialist insurers start applying the formerly damned bancassurance in their own business. Other manifestations of the growing market acceptance can be found in the "neighbouring" markets: − the sectoral agreements on labour conditions are shifting more and more into the direction of convergence (to an integrated base either per sector or per company); − the sectoral education organisations are more and more collaborating or even integrating; our own MBA in Financial Services and Insurance is an example in this respect, but convergence is also taking place with great speed at other universities58 and technical education institutes59. This convergence trend is not the propriety of the financial sector alone. In fact one can state that this financial convergence is embedded in a much wider trend towards integrated services; in an effort to offer convenience and switch from mass production to customisation and individualisation, bundling and unbundling becomes necessary. The reaction of many of the supervisory authorities has been very marketfriendly in that they allowed this convergence to happen. Notable exceptions that tried to restrict the playing field of the financial firms, like the US, show that market innovation always finds a way around strict regulations: − look e.g. at the establishment of "near-banks" to cope with the strict limitations on interest payments by banks in the US; − it is clear that the same circumventing movement could well evolve in other directions as well: e.g. in regulating intermediaries one will always have to cope with the famous Internet; the same could be the case by strictly regulating insurers or pension funds,

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whereby self-insurance or alternative risk transfer could offer a way around; − a number of examples in part A showed how the strict limitations in the US on financial convergence have been bypassed (to a certain extent). This does not mean however that there is no further need for regulation or supervision, even on the contrary, as will be shown in the next point. 9.2.

Financial convergence creates many opportunities and advantages but can also create extra risks and disadvantages

It has already been stated in the previous point that financial convergence hides advantages as well as disadvantages. At the outset, the general feeling of critique against diversification of business firms, certainly influenced the sceptical evaluation of many types of financial convergence. Nowadays a more positive attitude is prevailing. On the consumer level, it will depend on the personal needs and attitudes of the customers, whether the balance will strike in positive or negative sense. Some customer segments do prefer comfort and convenience and accept that this raises the need for detailed private information to be given to one supplier or that this can lead to tied-in sales. Other customers will sympathise with financial convergence because cross-selling can lead to price discounts, which they prefer above all. Other customers will be convinced that they do not need the patronage of a one-stop seller or an integrated service provider, but rather prefer shopping around themselves. Consumer protection arguments must therefore be treated with care. Not all consumers have the same attitude towards financial convergence nor have they the same needs of protection. Supervisors will have to address the potential disadvantages in a flexible way. Risks that will have to be tackled by the supervisors are e.g. conflicts of interests, abuse of power, tied-in sales etc. On the market level financial convergence will certainly need to be tested against competitive criteria. On the macro level it is clear that the growing accent of insurers on financial products will bring them more into the picture when setting monetary policy as

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well. On the other hand the banking business is shifting much of its attention from the traditional intermediation to the more fee-based services, consulting and financial engineering. This certainly influences the role of the financial market versus the one of the financial intermediaries. The new role played by financial conglomerates is another aspect that deserves attention, because this evolution is certainly not neutral from a risk perspective. Although the supervisors have feared that conglomerates created extra risk (e.g. risk of contagion), our research showed that the risk profile of financial conglomerates is better than that of specialised suppliers. 9.3.

Financial convergence takes many different forms

9.3.1.

It is (very) dangerous to categorise this whole evolution as one standard practice

In part A of the research project, we outlined the general trend towards convergence and integration in the financial services sector (and the pension market). We demonstrated that this growing interface takes many different forms and concerns many different types of players. Consequently, it is not possible to refer to this movement as a uniform, well-defined type of diversification. In fact diversification is a multidimensional concept and financial converge will have to be analysed from all relevant angles, such as: − the types of institutions involved (banks, insurance companies, pension funds, other financial institutions); − the structure used (networking, distribution agreements, crossshareholding, parent/subsidiary, holding structure, etc.) and the mode of diversification (de novo start-up, merger, acquisition, joint venture); − the level of integration for all relevant steps in the value chain (cf. analysis on the base of the financial conglomerates control board); − the diversity status, which gives an indication of the level of diversification per business unit (and sub-unit).

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9.3.2.

Supervisors should not focus their attention on the "distribution" or "cross-selling" nor on the "financial conglomerates" alone

In part A we made the distinction between cross-selling, packaging and integrated financial services at the one hand and bancassurance and assurfinance at the other hand. We showed in part A that it is our firm belief that the combination of banking and insurance products as is now done through bancassurance and assufinance is just the first step of a more profound development. Bancassurance The majority of the financial players do practice one or other type of crossselling. The most popular, being the bancassurance trend, is where banks sell insurance products. Especially the life insurance products have proven to be a great success for bancassurance. From a statistical perspective it will certainly be necessary to make the distinction between distribution for own account (manufactured by the own insurance subsidiary or sister company within a financial conglomerate) and the pure cross-selling, whereby the bank acts as a distributor for another insurance company. Reliable information is completely lacking for this last type of financial convergence. Assurfinance The opposite trend of insurers selling financial products was referred to as assurfinance. Although the insurers have been successful in launching more financially-oriented (life) insurance products, it seems that their success in selling pure banking products has been less progressive and successful. Whereas bankers proved to be successful in establishing an insurance company from scratch, this seems a far more difficult route for assurfinance; the only (successful) route in this respect is buying an existing bank. However the effect of this financial convergence on the traditional distribution outlets of insurance has been tremendous. A number of important consequences are: − a generalised trend towards multi-channel and multi-distribution has gained a difficult but a certain acceptance; this trend goes beyond the bancassurance movement, because many nontraditional competitors are entering the arena (the same holds for the distribution of bank products);

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− quite a substantial number of these traditional insurance intermediaries, that survived this though competition, developed a new, innovative and offensive strategy in order to create their own competitive advantage. More than the retail market alone Much of the attention has been given to the financial convergence in the retail market. In part A we have shown that much more potential is laying in the corporate market. Here, it seems that insurance intermediaries, reinsurers and investment bankers are taking the lead. Integrated services In part A we have shown that the supply of integrated services can be seen as a special application of the more general shift from product-oriented supply to a more client-oriented focus. Although the tendencies are not yet completely clear in practice, we suggested, based on market research, the following options for further integration: − all finance, into the direction of personal financial planning (retail market) and employee benefits (commercial market); − all care, into the direction of family risk management (retail market) and integrated or holistic risk management (commercial market). Based on the fact that this integration can lead to a net advantage for customers and suppliers (economies of scope) we stated that far more integration can and will probably be fostered (realised?) in the financial sector. In this respect we do believe the following expression: "l’appetit vient en mangeant" or "appetite comes with eating". We believe that the fragmentation of traditional financial suppliers is part of a transition to more efficient arrangements. A functional approach may provide a more useful organising perspective than an institutional approach, especially in an environment of rapid technological changes and movements towards increasingly global connections among financial markets. Examples of potentially far reaching integration are to be found in the following directions: − asset liability management

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− integrated (holistic) risk management − alternative risk transfer − personal financial planning − employee benefits − back-office integration and ICT. Financial conglomerates and integrated financial services Although the formation of financial conglomerates can lead to better conditions for integration, it is certainly no guarantee that (only) this route leads to the supply of integrated financial services. Pension funds and financial convergence Almost all of the previous analyses and conclusions also hold for the increasing interface between pension funds, insurance companies and other financial institutions. Two opposing converging trends occur: the pension funds entering the insurance and other financial markets at the one hand, and the insurers and other financial institutions entering the pension market. − The inroad of the pension funds into the financial sector is based on the same principles of the financial convergence trend: shifting to a functional and client-oriented approach, whereby the bundling and unbundling must lead to integrated employee benefits (collective base) and even personal benefits (individual base). In fact they look for service bundles, starting to integrate the socalled first, second and third pillar of the pension system. The core business of pension funds is however also changing because of other factors: the need for flexibility, clear communication on future pension benefits, etc. Instead of being pure administrators of collective pension provisions, modern pension funds want to position themselves as competitive financial service firms. − The most important difference being that most pension funds, and especially the largest ones, are not private companies, but do operate in a somewhat different (protected?) market environment.

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− As governments cut back on social security provisions, the provision of many benefits shifts to the employer (either on a mandatory or incentive base), or even to the individual. The transition from an unfunded to a funded pension scheme creates an enormous potential for (life) insurance companies, ranging from a doubling or tripling of the market volume (according to the degree of accumulated savings). This can lead to new financial developments. We believe that this trend will affect the competitive position of all market players not only pension funds and insurers, but also banks and asset managers. 9.4.

Given the diversity of the sectoral regulation and supervision it is hard to create a level playing field

The main question in this respect is: "what rules help to create a level playing field without limiting the innovation and expansion of the financial sector?" In the modern financial markets of today, the main difficulties the supervisors face can be summarised as follows: − the supervision and most of the regulation is based on a sectoral focus; this can be observed when analysing the solvency rules (different approaches for defining the required solvency capital and the solvency fund) and the institutions under supervision (consolidated group level versus business unit level); but also the philosophy towards regulation and supervision differs quite substantially; − this institutional approach proved to be a good solution as long as the sectoral barriers remained stable; once the barriers started to blur, the supervisors had to collaborate more intensively; the solution was mainly searched into the direction of solo-plus supervision; − this solution supposed a clear division of tasks; such a division was (sometimes) based on the typology in mixed financial conglomerates, besides banking and insurance conglomerates. Such an approach supposes that a clear distinction can be made between these three types of conglomerates. We tried to prove that the actual approach is certainly disputable in a number of respects (e.g. reference base for this typology).

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A number of specific critiques will be dealt with in more detail in the next points. 9.4.1.

The solo-plus supervision is probably only a temporary solution

Up to now, most attention has been devoted to the question of reconciling the sectoral regulatory and supervisory approach with the creation of financial conglomerates. The solution has mainly been searched in the direction of the solo-plus supervision. For a number of reasons this solution seems in need of revision: − the more financial convergence is evolving into the direction of integrated services, the more important the "plus" will have to be, creating the danger of double supervision; − trying to solve the issue by establishing a separate regulatory system and supervision for financial conglomerates is not only a tough issue to solve, moreover it is only part of the potential answer to this challenge; − the supervision is oriented mainly at the legal entities; business innovation leads more and more to a shift away from these legal entities into networks and joint venture agreements; the shift from product-oriented competition to customer orientation needs bundling and unbundling and leads to the creation of ‘supplychain management’ where the emphasis is no longer on legal entities but on organisational and strategic networks; this general trend affects the supervisors in the financial sector more than in any other sector, because it is mainly in the financial sector that business regulation and supervision exists to such an extent; − the new competition is certainly not restricted to the traditional suppliers in the financial market; the toughest competition often comes from outsiders; in part A we showed that quite a number of new, alternative suppliers and distributors are competing in the modern financial arena; extending control over these alternative suppliers will be a tough job, not only because they often work in other –more free- business environments, but especially because the innovation and imagination is great in challenging the traditional market players.

278

9.4.2.

The magic triangle of regulation/deregulation and market competition will probably shift in more mature markets

As has been highlighted in part B, the advantages and disadvantages of regulation and market competition lead to a search for an optimal welfare level by combining market freedom with regulation and supervision. The less markets are developed, the more the balance will shift towards regulations and a priori supervision. The more markets become mature, the more a-priori supervision is replaced with a posteriori control and disclosure. In an information age disclosure must be the cornerstone of all supervisory mechanisms. Such a system is only viable if sufficient and clear information is available. Today, this is certainly lacking in many respects; this will be highlighted in the next point. 9.5.

There is a tremendous need for reliable and comparable statistics

As long as the market is strictly regulated and the supervisory authorities operate with a priori control, the need for information can be achieved on a oneto-one base. In stable market environments this information need, can be organised quite well. Once markets become more open, innovation starts, thus leading to an explosion in the number and types of market suppliers as well as in the services they offer. In such a market environment there is a great need for clear information. Especially when financial convergence becomes important and all types of financial conglomerates are created, it will become important to prevent that opaque structures are created (which can lead to regulatory arbitrage); in such circumstances even information is not always a guarantee for effective disclosure. Given the many dimensions of financial convergence, a better view on the types of convergence, the degree of integration and the products involved is more than necessary. Unfortunately this is completely lacking today. Part A showed how difficult it is to get an overall view on simple statistics like bancassurance. This is harmful for a better understanding of the financial sector from a supervisory perspective as well as from a research perspective. We therefore hope to convince the regulatory authorities and supra-national organisations to collaborate together to find a way to realise a better disclosure of this financial convergence in all its aspects. We are certainly willing to help in this direction.

279

NOTES

1

Rumelt, R.P. (1974) "Strategy, structure and economic performance", Graduate School of Business, Harvard University, Boston, MA.

2

Ramanujam, V. and Varadarajan, P. (1989) "Research on corporate diversification: a synthesis", Strategic Management Journal, 10, 6, November-December, 523-551.

3

Consequently all of these dimensions are relevant variables when analysing the convergence in the financial sector. By lack of reliable statistics this report will not be able to provide this in-depth analysis.

4

Verweire, K. (1999) "Performance consequences of financial conglomeration with an empirical analysis in Belgium and the Netherlands", Thela Thesis Publishers, Amsterdam.

5

Herring, R.J. and Santomero, A.M. (1990) "The corporate structure of financial conglomerates", Journal of Financial Services Research, 471-497.

6

Lafferty Business Research (1991) "The Allfinanz revolution: winning strategies for the 1990s", Lafferty Publications Ltd., Dublin. Lafferty Business Research (1994) "Allfinanz 2000: how retail financial institutions worldwide organise to provide total financial services", Lafferty Publications Ltd., Dublin.

7

Hoschka, T.C. (1994) "Bancassurance in Europe", The MacMillan Press Ltd., Houndmills.

8

Hoschka, T.C. (1994) "Bancassurance in Europe", The MacMillan Press, Ltd., Houndmills.

9

See appendix A for a more detailed comments on the different typologies.

280

10

Van den Berghe, L.A.A. and Verweire, K. (1998) "Creating the Future with All Finance and Financial Conglomerates", Kluwer Academic Publishers, Dordrecht.

11

The other concepts will be further detailed in the next chapter.

12

Crooks Gora, J. (1997) "Bancassurance: positioning for affiliations - lessons from Europe, Canada, and the United States", Loma Publications, Atlanta.

13

Lafferty Business Research (1991) "The Allfinanz revolution: winning strategies for the 1990s", Lafferty Publications, Dublin.

14

Lafferty Business Research (1991) "The Allfinanz revolution: winning strategies for the 1990s", Lafferty Publications, Dublin.

15

We would like to refer here to the remark made (in the introduction of this report) in relation to the quality of the statistics available.

16

Flur, D.K., Huston, D. & Lowie, L.Y. (1997) "Bancassurance", The McKinsey Quarterly, 3, 126-132.

17

Holsboer, J.H. (1998) "Repositioning of the insurance industry in the financial sector and its economic role", Paper presented to the Geneva Association, Dresden, June 25-27.

18

Van den Berghe, L.A.A. & Baeten, X. (1996) “Risico, beleggen, sparen, verzekeren, zorg”, (a survey of the Dutch market), Research project, Vlerick School voor Management, Gent.

19

Corcoran, S. (1999) "Bank-insurance mergers: synergies or sham?", Lafferty Publications Ltd., Dublin.

20

Flur, D.K., Mendonca, L.T. & Nakache, P. (1997) "Personal Financial Services: a question of channels", McKinsey Quarterly, 3,

21

ibid.

22

Merton, R.C. (1990) "The financial system and economic performance", Journal of Financial Services Research, 263-300.

23

Crane, D.B. & Bodie, Z. (1996) "The transformation of banking: for follows function", Harvard Business Review, March-April, 109-117.

281

24

Van den Berghe, L.A.A. and Verweire, K. (1998) "Creating the Future with All Finance and Financial Conglomerates", Kluwer Academic Publishers, Dordrecht.

25

Crooks Gora, J. (1997) "Bancassurance: positioning for affiliations - lessons from Europe, Canada, and the United States", Loma Publications, Atlanta.

26

Van den Berghe, L.A.A. and Verweire, K. (1998) "Creating the Future with All Finance and Financial Conglomerates", Kluwer Academic Publishers, Dordrecht.

27

Crooks Gora, J. (1997) "Bancassurance: positioning for affiliations - lessons from Europe, Canada, and the United States", Loma Publications, Atlanta.

28

Ibid.

29

Verweire, K. (1999) "Performance consequences of financial conglomeration with an empirical analysis in Belgium and the Netherlands", Thela Thesis Publishers, Amsterdam.

30

Swiss Re (1996) "Insurance derivatives and securitisation: new hedging perspectives for the US catastrophe insurance market?" Sigma, No. 5.

31

A notable exception is France.

32

Swiss Re (1998) "Financial difficulties of public pension schemes: market potential for life insurers", Sigma, No. 8.

33

Holsboer, J.H. (1998) "Repositioning of the insurance industry in the financial sector and its economic role", Paper presented to the Geneva Association, Dresden, June 25-27.

34

Corcoran, S. (1999) "Bank-insurance mergers: synergies or sham?", Lafferty Publications Ltd., Dublin.

35

McKinsey & Company (1998) "The changing landscape for Canadian financial services: New forces, new competition, new choices", Research Paper prepared for the Task Force on the Future of the Canadian Financial Services Sector.

36

Harris, S.L. (1998) "Regulatory reform in the financial services industry: where have we been? Where are we going?", OECD - Financial Market Trends, January.

282

37

According to Uwe Haasen [1987] the explanation for this information gap lies in the following points: − −

limited possibilities of the consumer to understand the insurance policy and the insurance technique; limited interest for and involvement in their insurance contracts.

38

Barron, D.N., West, E. & Hannan, M.T. (1998) "Deregulation and competition in the financial industry", Industrial and Corporate Change, Vol. 7, No. 1, 1-32.

39

Harris, S.L. (1998) "Regulatory reform in the financial services industry: where have we been? Where are we going?", OECD - Financial Market Trends, January.

40

Federal Trade Commission (June 3, 1998) "The effect of Consolidation on the State of Competition in the Financial Services Industry, 9 p.

41

White, W.R. (1998) "The coming transformation of continental European banking?", Bank for International Settlements (Monetary and Economic Department), Working Papers No. 54.

42

Holsboer, J.H. (1998) "Repositioning of the insurance industry in the financial sector and its economic role", Paper presented to the Geneva Association, Dresden, June 25-27.

43

Swiss Re (1991) "Economies of scale in the insurance industry", Sigma, No. 4.

44

Mogg, J. (1996) "Financial services: meeting consumers’ expectations", Green Paper, May 1996.

45

Van den Berghe, L.A.A. and Verweire, K. (1998) "Creating the Future with All Finance and Financial Conglomerates", Kluwer Academic Publishers, Dordrecht.

46

Heskett, J.L., Sasser, W.E. Jr. & Schlesinger, L.A. (1997) "The service profit chain: how leading companies link profit and growth to loyalty, satisfaction, and value", The Free Press, New York.

47

Van den Berghe, L.A.A. & Baeten, X. (1995) "Survey with regard to the management of an insurance broker’s office, Research project Vlerick Leuven Gent Management School, Gent.

48

Corcoran, S. (1999) "Bank-insurance mergers: synergies or sham?", Lafferty Publications Ltd., Dublin.

283

49

This does not mean that these differences are of no importance, but our research focuses on the potential EU regulation of financial conglomerates and not on national adaptations to these EU directives. Moreover the national differences tend to decrease due to the home country control, the single licence and the harmonisation of supervisory approaches.

50

Joint Forum on Financial Conglomerates (1999) "Supervision of financial conglomerates", Paper prepared by the Joint Forum on Financial Conglomerates, February.

51

It is essential that attention is paid to the rules for investment firms. This regulation, which has to be applied before January 1996 is not included in this document.

52

Think for instance at the integration of "subordinated loans" in the calculation of solvency funds for the insurance sector.

53

Exceptions to this generalised specialisation requirement are possible for "existing" multi-branch companies.

54

This is deducted from the comparison of the rules for life insurance with and without investment risk (respectively 4 per cent and 1 per cent of the mathematical reserve).

55

The reverse remark, that banks should also integrate "insurance risks" into their solvency calculation has not been made, to our opinion. This can certainly be explained by the fact that banks must always set up a separate company to carry their "insurance risks", whereas insurance companies can offer certain saving products within their insurance corporation.

56

For a more detailed explanation, we refer the reader to Van den Berghe, L.A.A. (ed.) (1995) "Financial conglomerates: New rules for new players?", Kluwer Academic Publishers, Dordrecht.

57

Verweire, K. (1999) "Performance consequences of financial conglomeration with an empirical analysis in Belgium and the Netherlands", Thela Thesis Publishers, Amsterdam.

58

In most Dutch universities this is already the case.

59

See e.g. NIBE & SVV in the Netherlands.

284

A. APPENDICES

A.1.

Making an inventory of the types of interfaces between banking and insurance companies

Researchers who analysed the convergence in the financial sector have developed classification schemes, based on one of the dimensions of diversification. In what follows, we will discuss three typologies, aiming at classifying financial conglomerates (and implicitly trying to find an explanation for the varying degree of success of the financial conglomeration strategies). A.1.1.

Typology based on the corporate structure of the financial conglomerate (implementation aspects of diversification)

Herring and Santomero (1990)1, merely looking at the diversification of banks, have proposed a theoretical model to evaluate the alternative corporate structures of financial conglomerates. They distinguished between four basic models for organising a financial conglomerate, based on the degree of legal and operational separateness. According to Herring and Santomero (1990), legal separateness implies that different products are provided by separate corporate entities, each of which has its own management structure, set of accounts, board of directors, and capital. Operational separateness implies regulatory or self-imposed restrictions (which are generally called firewalls and/or Chinese walls) that inhibit the integrated production of different financial services. Herring and Santomero distinguished between four models: − Model 1: complete integration (German model)

1

Herring, R.J. and Santomero, A.M. (1990) "The corporate structure of financial conglomerates", Journal of Financial Services Research, 471-497.

285

In this model, managers are allowed to conduct all activities within a single corporate entity. In this case, there is no legal nor operational separateness, although the financial conglomerate may choose to establish Chinese walls in order to enhance the perceived value of its services to potential customers. In principle, the completely integrated conglomerate should be able to produce any given output at the theoretically lowest cost because it can exploit economies of scope. However, from the viewpoint of public policies, there might be strong concerns over such a form because of the potential for anti-competitive behaviour, conflicts of interest and the potential risk of contagion [see also Koguchi (1993)1]. Furthermore, the costs of supervision might be much higher than in the other cases. For the moment, there is no country that permits complete integration for the production of financial services. − Model 2: bank parent - non-bank subsidiaries (British model) In the British model, there is a legal separateness in that the banking function is conducted in the corporate parent and nonbank functions are conducted in separately incorporated subsidiaries. Compared to the German model, operational efficiency will be inevitably reduced. On the other hand, this organisational form has several merits: the loss in a business can be of limited nature2, tax benefits can be exploited, and the costs of regulatory oversight are reduced. − Model 3: holding company parent - complete legal separateness The US model is comparable to the British model, but here the company shell is the sole owner of the banking subsidiary and its non-banking counterparts. According to Herring and Santomero, the legal separateness is more extensive than in the former model, and consequently there is less potential for economies of scope. But like in model 2, the social benefits might be higher than in the German model: the legal separateness simplifies regulation 1

Koguchi, K. (1993) "Financial conglomeration", Financial Market Trends, (4), October, 7-62.

2

In practice, it is unlikely that the bank will allow a subsidiary to go bankrupt (due to reputation costs, loss of operational synergies, …). Therefore, the advantages of limited liability may be somewhat illusory.

286

and supervision of the different activities. Furthermore, there is less risk that the safety net is used to distort the cost of funds to non-bank subsidiaries. − Model 4: holding company parent - complete legal and operational separateness In this last model, the holding company operates as an investment company and no operational synergies between the different parts are exploited. Herring and Santomero conclude that this model should not be considered as an integrated financial corporation, since this structure only benefits from financial synergies. Of course, this model yields only limited supervisory problems. This classification is interesting because it points out that differences in corporate structure may have implications for the conglomerate’s performance, its profit potential and risk level. However, the classification is too theoretical to be used in practice and focuses too much on the banking side of the financial conglomerate. For example, Herring and Santomero use the term "German model" to nominate the category of financial conglomerates with complete integration. It is clear that this model more reflects the universal banking model, which is a common organisation structure in German banking, but to our opinion, this model can hardly be used when insurance activities are included. Furthermore, the authors focus on legal separateness as the main determinant for potential synergies and risks. However, practice shows us that some financial conglomerates have set up organisational structures which might be totally different from the legal structure, and which might be a more important determinant of the economies of scope and the risk level within a financial conglomerate (Van den Berghe and Verweire, 19981). A.1.2. Typology based on the diversity status A second typology has been developed by the Verzekeringskamer, the supervisor of the Dutch insurance companies and pension funds. This classification is used to effectively control financial conglomerates and as such has practical relevance (for the supervisors). A distinction is made between: 1

Van den Berghe, L.A.A. and Verweire, K. (1998) "Creating the Future with All Finance and Financial Conglomerates", Kluwer Academic Publishers, Dordrecht.

287

− primarily banking financial conglomerates; − primarily insurance financial conglomerates; − mixed financial conglomerates. Financial conglomerates are classified on the base of the relative proportion of their banking and insurance activities. The Verzekeringskamer proposed to use the balance sheet total as a criterion to distinguish between these categories. Other criteria had to be used because the balance sheet total distorts the results in favour of the credit institutions: − in the banks balance sheet, all monetary transactions with clients as well as in relation to inter-bank funding are included − the insurance balance only lists the technical reserves and their investment, while the monetary transactions with clients (premiums & claims) are included in the profit-and-loss account. Therefore criteria must be developed that do not suffer from such a bias. The Dutch supervisors actually use the measure of the necessary solvency capital and define the mixed conglomerate on the base of the 80/100 limit. The great variety between the solvency calculations of banks and insurance companies is no guarantee that this measure is the best criterion either. A.1.3.

Typology based on the mode of diversification (method of entry)

Some early publications have set up a typology based on the entry strategies of banks into the insurance industry. Of course, this typology may also be applied to insurance companies who enter the banking industry. Indirectly this typology also helps to explain the differences in the degree of integration.

288

Figure 15 - Alternative entry vehicles for banks entering insurance De novo entry = greenfield entry with own underwriting of insurance

Merger/acquisition = combination and integration of two separate corporations either through merger or control acquisition

Level of Integration

Joint venture = jointly owned separate legal entity underwriting insurance

Distribution alliance = co-operation agreement, concerning distribution area possibly supported by mutual shareholding

Source: Hoschka (1994)

1

− De novo entry (start-ups): As we can deduct from the figure, a de novo entry is characterised by the highest degree of integration. As a matter of fact, there are some examples such as TSB in England, Crédit Agricole in France and Deutsche Bank in Germany, who proved that their de novo entry in insurance has been successful. The relative success of this method of entry is often explained by the fact that with a de novo entry, the strong cultural differences can be overcome more easily. The banks (c.q. the insurance companies) have a higher degree of control over the whole startup process and they don't have to take into account an insurance (c.q. bank) partner with diverging ideas and a totally different culture. − Mergers/acquisitions: According to the earlier publications, mergers and acquisitions were seen as the next best option for banks and insurance companies. Several arguments have been forwarded as to why M&As can be successful: (1) both a merger and an acquisition have the advantage that it's easier to follow the same direction in the all finance approach, 1

Hoschka, T.C. (1994) "Bancassurance in Europe", The MacMillan Press, Ltd., Houndmills.

289

(2) the expertise and experience for both the banking and the insurance domain is available in the group from the start, and (3) M&As are suited when a quick entry is necessary. − Joint ventures: A joint venture is defined here as a kind of a cooperation agreement between two or more independent companies, setting up a legally independent entity, owned and controlled by the parent companies (here a bank and an insurance company). A joint venture is considered to be a more formalised way of co-operation. It is commonly accepted that joint ventures are rather short-term solutions because nearly 80 per cent ends up in sale. Nevertheless this was a frequently used entry vehicle, especially in cross-border alliances. − Distribution alliances: it’s a loose form compared to the other approaches and therefore it is at the bottom of Hoschka’s figure. However, marketing agreements can be completed with substantial cross-shareholdings. Anyway, this method of entry gives two (or more) companies the highest degree of freedom. This is, however, rather perceived as a disadvantage because they probably don’t get the most out of this relation. The combined offering of insurance and credit services requires a lot of involvement to resolve the bottlenecks that surely will appear. With this method, the two parties will give up efforts more quickly and will pay attention to other priorities. This typology is interesting because it also tries to provide an explanation for success of some financial conglomerates. More particularly, Hoschka argued that: "A comparative analysis of the different entry vehicles shows that of the four different entry routes, de novo entry (start-ups) seems to be most successful. This stems primarily from the organisational and strategic flexibility which de novo entry offers, allowing a tailored solution to the idiosyncratic internal structure and organisational environment of the bank" (Hoschka, 1994: 137). Furthermore, a link is established with implementation aspects of diversification, e.g. the degree of integration. However, a recent study by

290

Verweire (1999)1 found hardly any significant differences in the degree of integration and centralisation between start-ups and M&As. Therefore, the explanation as to why some start-ups might be more successful than the other types of entry strategies is only tentative. However one must not forget that this typology is only relevant in as far as the diversification strategies are analysed within a limited time frame and geographic scope. In practice these techniques are combined, either geographically within one firm or over the lifetime of a firm. It can become rather difficult after a while to distinguish the effects from each of the different approaches used.

1

Verweire, K. (1999) "Performance consequences of financial conglomeration with an empirical analysis in Belgium and the Netherlands", Thela Thesis Publishers, Amsterdam.

291

A.2.

Detailed description of the financial conglomerates control board

Before we outline the different parts of this financial conglomerates control board, we first give a graphical representation of this instrument. Figure 16 - The Financial Conglomerates Control Board Environmental Factors Lega

l Stru

Corporate Governance & Management

ructu r

e

Orga nisa Struc tional ture

Capital policy Technology

Distribution

a l St

Market Development

Product Development

Infrastructure Capit

Operations Management

cture

M.I.S. : Accounting & Reporting

Source: Van den Berghe and Verweire (1998)

1

This reference scheme is divided into three main parts. The arrow on the front side (containing the boxes Corporate Governance and Management to d. Distribution) is comparable to the value chain. It depicts all activities where synergies can be found and which determine the risk level of the conglomerate. At the back side of the instrument, we find some structural aspects (such as the legal structure, the capital structure and the organisational structure) which also influence the potential for synergies and the risk level. At the upper front, we take along some environmental factors. These are control variables which could also be important in the comparative study of financial conglomerates.

1

Van den Berghe, L.A.A. and Verweire, K. (1998) "Creating the Future with All Finance and Financial Conglomerates", Kluwer Academic Publishers, Dordrecht.

292

Let us start by explaining the structural factors somewhat more in detail. − The legal structure is the way in which two (or more) companies are formed. The early studies on financial conglomerates suspect a relation between the degree of success and what they call the method of entry. We can use the same subdivisions Hoschka and Lafferty Business Research made (see appendix A.1). − The capital structure gives insight into the capital ties between the different companies of the group. One of the most important risks, namely the risk of contagion, is to a large extent of a financial nature. This means that the greater the ties between different companies on the financial level the greater the potential for contagion. − Sometimes financial conglomerates set up a new corporate structure which should facilitate co-operation between the different parts of the group. However, not all financial conglomerates adapt their organisation structure but stick to the legal structure. It would be very interesting to investigate if such an adaptation leads to better results. The activities are the main part of the financial conglomerates control board. As in the value chain of Michael Porter, we have made a distinction between primary activities and support activities. The support activities can be further subdivided into several categories: − Corporate governance and management: we have identified some relevant issues in this respect. As management is a very important aspect to all matters, we try to identify which management structure is best suited to influence the synergy process. Furthermore, we will investigate whether this has consequences on the strategy process and the human resource management. We will also analyse the impact of synergy development and cultural projects on the diversification process. − Infrastructure: it is a question whether a physical integration (infrastructure) is an essential element in achieving synergies. − Capital policy: from our case studies we have seen that financial conglomerates try to achieve synergies in the investment department. The issue consists of different elements: we will look 293

if the investment policy is integrated, if there is an integrated asset liability management, if there is an integrated risk management and if reinsurance activities are grouped together. − Technology: we also want to analyse the technological issue. To what extent are technological systems of the different parts of the group used in other parts of the group and to what extent do they fit? − MIS: Accounting and reporting: when a financial conglomerate is created, it is interesting to see what implications this decision has on the management information system of the two (or more) partners. Is an integrated M.I.S. set up or do they stick to the old system? The primary activities of a financial institution are divided into the following categories: − Product development: we see that some financial conglomerates go beyond cross-selling each other’s products. They depart from the needs of the customers and they integrate different characteristics of different products into a new product. It is interesting to see how important these new kinds of products are related to the whole product portfolio. Market development: when insurance companies are able to use the bank’s database, they can approach those clients in a better way. Banks have entry to the financial transactions of the client and have generally more information than insurance companies. Operations management: there are a lot of examples which prove that synergies can be achieved in this domain as well. One of the most striking examples can be found in the Eureko Group, the joint venture between some financial conglomerates in Europe. The Dutch partner, Centraal Beheer, part of the Achmea Group, disposed of a very good claim handling department with respect to automobile insurance. The Portuguese partner, Ocidental, used this system for their car insurance department. Furthermore, they installed a link with the bank branches so that the green card could be delivered immediately. Distribution: many conglomerates were formed because the partners saw opportunities in distributing each other’s products. It is seen as one of the most important areas where synergies can be achieved. Of course there are many different ways to organise the distribution. The Dutch ING Group has organised 294

the home market according to the main distribution channels. Other groups just cross-sell products and try to fine-tune the selling process. The last category of variables are environmental factors. The main point of the research is oriented towards synergies and risk factors. Furthermore, integration is another important concept in the whole research project. But of course, we should analyse whether there are no other variables that influence the degree of success. For example the country in which a financial conglomerate operates could be a determining element for the conglomerate’s performance. Other important variables could be the size of the conglomerate, the time period of the partnership, etc.

295

A.3.

Calculation of the required level of solvency

In this appendix, we will describe the headlines for the calculation of the required level of solvency, both for credit institutions (banks) and for insurance companies. This analysis gives neither a complete overview of all actual regulations, nor is it aimed at evaluating the different aspects of these regulations. The only aim is to be able to better observe the parallels and differences between the approaches for respectively banks and insurance companies. Credit institutions The determination of the required solvency level of banks has been broadened from a capital-to-assets ratio to a risk-assets ratio. According to the capital-toassets ratio the required level of the solvency fund is proportional to the volume of assets. Important evolutions in the international banking activity necessitated the introduction of a new "risk assets" ratio. Two types of indicators are used to measure the credit risk of the "assets": the type of creditor and the country of the creditor. The creditors are divided into different categories (leading to four levels of risk which require respectively 0, 20, 50 or 100 per cent of solvency capital); the countries are classified into 2 categories (zone A with roughly the OECD countries and zone B with all other countries). The introduction of all types of off-balance sheet transactions (securitisation, derivatives) increased the risks run by credit institutions. This development was (partly) a method to circumvent the solvency requirements, previously based on the "balance" total. Here the credit risk is not only measured on the basis of the former two elements (type of creditor and country of the creditor) but also on the basis of a third element, the "credit conversion degree". Besides this credit risk, the important interest rate risks and exchange risks must eventually be taken into account. The introduction of the new rules on investment activities will also lead to the integration of other market risks. It has been decided recently that also "large exposures" must lead to higher solvency requirements. Large risks are defined as loans which are greater than 10 per cent of the own funds of the credit institutions. Two measures are taken to limit the exposure of those loans: − such large loans are considered as high risks, so that they require a 100 per cent of the solvency capital;

296

− the exposure is restricted on an individual basis (may not be greater than 20 or 25 per cent of the own funds) as well as on a global basis (the total amount of outstanding large loans may not be greater than 8 times the own funds). Insurance companies The most important aspects for calculating the required solvency level of insurance companies are the following. − The solvency margin required is completely different for life and non-life companies. − For the life companies the reference base is partly the liabilities (mathematical provisions) and partly the insurance risk (capital under risk). In calculating the risk, a distinction is made according to the term of the contract and the degree of investment risk carried by the insurer: − short(er) term contracts carry less underwriting risk, so that the solvency needs are lower: 0,1 per cent or 0,15 per cent of the capital under risk instead of 0,3 per cent; − contracts, which do not guarantee a fixed return, transfer the investment risk to the insured (e.g. unit-linked insurance); consequently the level of solvency needed is much lower (1 per cent instead of 4 per cent of the mathematical reserves). − For the non-life companies no balance sheet elements at all are taken into account. The reference base differs according to the profitability of the business. If an insurance company sets her tariffs too low (and has a technical cost ratio of more than ±70 per cent of her premium income) the indicator will be the "average claims due"1; on the contrary if the tarification is set at sufficient

1

The rule is that the average is calculated over the previous three years; only for insurance with a "longer cycle" (credit insurance, storm insurance) is the reference base the average claims due over the previous seven years.

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profitable levels, the premiums will be the reference base on which the solvency requirements will be based1. − The solvency requirements can be decreased through the use of reinsurance. For non-life business a maximum decrease up to 50 per cent of the necessary level is possible. For the life risks a distinction is made between the liability risk (with a potential decreasing effect through reinsurance up to 15 per cent) and the underwriting risk (with the same rule as for the non-life risks, i.e. 50 per cent maximum decrease). − The minimum level of the solvency fund is different according to the line of business. For the life insurance companies the minimum is set at 800.000 ECU. Exceptions are possible (e.g. for mutuals), so that this minimum is decreased to a level between 100.000 and 600.000 ECU. For the non-life business, specialised companies should have the minimum level needed for their speciality branch. Companies with a mixed portfolio of non-life businesses must have the largest of the "relevant" minima. The levels vary between 200.000 and 400.000 ECU (but lower levels can be allowed for mutuals). Only for specialised credit insurance is the minimum much higher (1.400.000 ECU). − These minimum requirements are set to a lower level (50 per cent) for companies which are not incorporated in the EU, but they will have to make a deposit (of 50 per cent of their minimum solvency level) to guarantee their commitments.

1

According to the actual level of profitability of the insurance companies, most companies will have to calculate their solvency requirements on the basis of the claims due.

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A.4.

Calculation of the solvency fund for credit institutions and insurance companies

In this appendix, we will describe the headlines for the calculation of the solvency fund, again for credit institutions (banks) and for insurance companies. Credit institutions The calculation of the solvency fund for credit institutions distinguishes different types of funds: − the tier 1 solvency is composed of the capital, reserves and the general banking fund; in principle, these components are taken for their total value; − the tier 2 solvency is composed of funds with a lower quality or funds which are less secure (e.g. subordinated loans, revaluation reserves, value adjustments); consequently these funds are not taken for their total value but only for 50 or 25 per cent of their book value. − Corrections are eventually needed e.g. for own shares hold, for intangible assets or for subordinated loans or participations1 in other credit institutions; this last correction is intended to overcome the danger of the so-called double gearing2. − the tier 3 solvency is composed of the subordinated loans with an original duration of minimum 2 years. − Besides these factors also some correction factors have to be taken into account. 1

In principle transactions larger than 10 per cent of the capital of the enterprise in question.

2

However, in the context of the discussion about financial conglomerates it might be opportune to outline that there are no time or quantity limits for participations of credit institutions in other financial institutions, but the weight of certain equity participations in the risk assets volume is 100 per cent and the calculation of the capital elements within the groups is subject to certain corrections.

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Insurance companies For the insurance industry, the definition of "free funds" that can constitute the solvency fund, has been adapted to include quite a number of new elements. Most of these elements are in fact copied from the definition of solvency components for credit institutions, such as subordinated loans and cumulative preferential share capital. These new regulations bring the definitions of solvency for both sectors more in line with each other. There remain however some important differences. As was the case with the calculation of the required level of the solvency margin, also the components that can constitute the solvency fund differ between life and non-life insurance companies. For non-life companies the solvency is composed of the capital and reserves for their full value. For non-paid up capital, cumulative preferential share capital, subordinated loans, etc. only part of the book value is taken as "free funds". Although these last two components are new in the definition of the solvency fund, it is clear that the new definition is potentially more severe, because elements of "over-estimation" of liabilities and technical provisions are no longer accepted. This is not completely justified to our opinion in as far as insurers face more and more difficult risks and can measure their "liabilities" less and less accurate (cf. liability crises, problems of reinsurers, etc.). Opposite to credit institutions, it is still allowed for non-life insurers to integrate "hidden reserves" and "under-estimation of assets" as solvency components. Since life insurers face more upfront costs1 and have "contractual" commitments over a much longer period of time, the calculation of their profitability and their solvency is more complicated than it is the case for nonlife companies or for credit institutions. Besides the main solvency components, as defined for the non-life insurers, different types of hidden reserves and future profits can eventually be taken into account. The degree to which such extra solvency components can be integrated in the solvency calculations will differ according to the type of accounting system. In this respect, quite diverging methods exist to account for the high up-front costs.

1

Such as acquisition costs, contractual examinations, contract administration, etc.

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− At one extreme there is the very orthodox method of absorbing all up-front costs in the first year of the contract; this leads to net losses (on these contracts) in the first years and postponement of profits (and taxes) to later years. Consequently these companies have large hidden reserves, and these "implicit" funds can be taken into account for the calculation of the solvency fund. − At the other extreme there are methods that are based on the appraisal value or the embedded value: the profits and reserves that are based on these calculation methods are much more in conformity with "economic" appreciation techniques in so far that the liabilities and the profitability accounted for are much more in line with realistic expectations. In principle, the resulting system doesn’t allow for the existence of hidden reserves. Consequently the solvency calculation will not be based on implicit elements. − In between are methods as for example methods referred to as "Zillmerisation"1. Different "degrees" of Zillmerisation are possible, but they all have in common that the "liabilities" towards clients (mathematical reserve, surrender values) are corrected for the "up-front costs" which have not been repaid (completely) at that moment in time. This method however does not take into account the potential profitability of the written contracts and consequently this goodwill is a source of "hidden reserves". The "implicit funds" can be larger, if the Zillmerisation is only partially applied.

1

The "Zillmer-method" and other methods as the "Höckner-method" and the "release from risk method" are discussed from (among others) an accounting and an actuarial point of view in Oosenbrug (1993).

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POLICYHOLDER PROTECTION FUNDS: RATIONALE AND STRUCTURE by Takahiro Yasui*

I.

Introduction

The protection of policyholders against insolvency of insurance companies is one of the primary objectives of insurance regulation. In order to achieve this goal, a range of regulatory and supervisory measures are normally established to ensure financial and managerial soundness of insurance companies, and supervisory authorities are expected to do their best to avoid the failure of supervised companies. It is sometimes inevitable, however, that some insurance companies will encounter serious financial difficulties. In spite of all possible supervisory measures, insurance companies can become insolvent. In order to protect the interests of policyholders in the event of insolvency of an insurance company, certain special regulatory arrangements are normally established. These arrangements can be divided into two groups: those included in the winding-up procedure and those outside of it. The former type of arrangement is used in most jurisdictions, but typically vary considerably in detail across jurisdictions, largely depending on idiosyncrasies of the judicial insolvency procedures of * Principal Administrator in the Directorate for Financial, Fiscal and Enterprise Affairs, OECD. The author would like to thank the delegates from Japan, Norway, Spain and US for the OECD Insurance Committee and Stephen Lumpkin for their comments on an earlier draft. This paper is also benefited from presentations and comments made at various conferences and information provided by relevant regulators and experts, though not specified in particular. The views expressed in this article are, however, solely those of the author and do not necessarily reflect those of the OECD Insurance Committee or Secretariat or any other organisations with which the author has been associated.

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respective jurisdictions as well as the specificity in the insurance regulatory frameworks. In addition to these measures, in many jurisdictions, policyholder protection funds (or guarantee schemes) have been established to provide certain protection for policyholders outside of the winding-up procedure. The remainder of this document analyses the rationale and structure of policyholder protection funds. It consists of five sections. The next section provides an overview of policyholder protection funds. A distinction is made between a fund for a specific class of insurance and a general fund. The third section reviews the arguments regarding the merits and drawbacks of general funds. The fourth section discusses the key aspects of the structure of such funds. The last section provides concluding remarks. II.

Overview

When an insurance company becomes insolvent, policyholders face potential financial losses as their claims may not be fully met. In order to protect policyholders under such a situation, a fund to compensate their losses is often created. Such schemes may be designed to collect necessary contributions or levies (referred to as “contributions” hereafter, otherwise specified) in the event that an insurance company goes bankrupt. Without building up a fund, these schemes are sometimes called policyholder guarantee schemes. In this paper, however, the phrase “policyholder protection funds” includes such schemes. Policyholder protection funds are fairly common among OECD countries. At least 21 countries have one or more such funds. These funds can be classified into two types. The first type includes the funds that focus on the policyholders of one or a few branches of insurance. In the second type, the funds cover most of the insurance contracts subscribed to by the participating insurance companies. The former type is often referred to as a fund for a specific class of insurance, while the latter is a general fund. A fund for a specific class of insurance is normally established in association with compulsory insurance. The typical example is a fund for compulsory motor vehicle liability insurance. In many OECD Member and non-Member countries, car drivers or owners are legally required to purchase liability insurance, which aims principally at protecting victims of car accidents by ensuring minimum indemnification for any damage or loss of income. The goal of this regulation would not be achieved when the insurer is insolvent and therefore unable to pay the claim. Funds for compulsory motor vehicle liability insurance are established to compensate the losses of the victims under such circumstances. The funds also step in when the driver responsible either cannot

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be identified or is uninsured and thus no insurance protection is available for the victim. This type of policyholder protection fund is considered, therefore, to exist mainly for protection of accident victims. Special protection for the victims may also be rationalised by the fact that they are “involuntary” creditors for the particular insurance companies and, thus, had no prior option to select the insurers. In this context, the funds pay the full amount of the claims in principle. Among Member countries, at least fourteen countries have funds that cover compulsory motor vehicle liability insurance exclusively. Some countries, like Belgium, Finland, France and Spain, have a fund that covers other branches of compulsory insurance (such as workers’ compensation insurance and hunting insurance). In contrast to a fund for a specific class of insurance, a general fund covers a wide range of insurance classes, both compulsory and non-compulsory, including most of the products of an insurance company if not particularly specialised. Such a fund is created to ensure the payment of claims to policyholders when a company becomes insolvent and unable to meet its financial obligations.1 While the benefit of a fund for a specific class of insurance in ensuring the protection of the beneficiaries is widely recognised, the necessity of creating a general fund is not agreed upon internationally. Among Members, nine countries, namely Canada, France, Ireland, Japan, Korea, Norway, Poland, the United Kingdom and the United States, are known to have established such funds to date.2 Hereafter a “policyholder protection fund” means a general fund, otherwise specified. III.

Policyholder protection funds: benefits and drawbacks

1.

Benefits of policyholder protection funds

Protection of non-professional policyholders The primary objective of policyholder protection funds is to protect the interest of policyholders, especially individual or non-professional policyholders in the event of bankruptcy of an insurance company. The funds are expected to serve as the final safety net for policyholders, when, in spite of all possible supervisory measures, bankruptcy occurs. Policyholders are the creditors of insurance companies. Creditors usually extend credit after checking the credibility of a debtor and are responsible for

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their credit decisions; i.e., they have to submit themselves to the negative consequences. However, it is difficult to expect non-professional policyholders, typically individuals, to assume this responsibility in full. This is because there is a considerable amount of information asymmetry between such policyholders and insurers with regard to financial soundness of the insurers. The financial and managerial situation of insurance companies is much more technical and complex than that of ordinary companies. Non-professional policyholders can hardly be expected to verify the credibility of an insurance company sufficiently. Moreover, their financial capacity is usually limited. Therefore, if such policyholders are given to the full responsibility as creditors of insurance companies, they would refrain from getting insurance, which would deter the development of the insurance market. This argument provides a rationale for the establishment of special regulations and supervision for insurance companies, which are essentially intended to provide a monitoring function for policyholders so as to protect them from the negative consequences of their credit decisions. Stringent insurance regulations should be set up and supervisory authorities should take all possible steps to ensure the financial soundness of insurance companies. However, regulation and supervision may not always be perfect in avoiding the bankruptcy of an insurance company. Policyholder protection funds can provide the final safety net for policyholders in such extraordinary cases and, thereby, supplement supervision as a means of protecting the interests of policyholders. Maintenance of public confidence The insurance industry is built on the public’s confidence in the business, which is in fact vulnerable. Policyholder protection funds can help to maintain the public’s confidence in the insurance business and, thereby, help to sustain the sound development of the industry. Non-professional policyholders not only have limited ability to evaluate appropriately the financial soundness of insurance companies, but also they have little incentive to do so. Because of the technical and complex nature of the financial situation of insurance companies, the cost of gathering sufficient information to make a wise decision is significantly high. Under this circumstance, each policyholder is inclined to rely on the efforts of someone else who engages in the same type of transaction. More practically, most nonprofessional policyholders select insurance companies based on a belief in the financial soundness of the company and the industry as a whole, beliefs which do not necessarily have a firm ground.

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Against this backdrop, suppose an insurance company goes bankrupt and its policyholders suffer losses. Without the ability to appropriately assess the risks of individual companies, the general public may lose their confidence in the soundness of other insurers. Knowing the possibility of damages in the event of a company’s insolvency, the public may be discouraged from seeking insurance, which would again affect the industry as a whole and lower the social welfare. More dynamically, the bankruptcy case of a given insurer may cast doubt as to the soundness of other insurers and induce a run on them. Such a run was actually observed in some countries, particularly on companies of poor reputation. A run could put the remaining insurers in a serious liquidity crisis, and possibly force them to go bankrupt. Policyholder protection funds can protect policyholders against damages caused by the insolvency of an insurance company, keep the public’s confidence in the industry at large, prevent a contagion of bankruptcy, and thereby contribute to the sound development of the insurance industry. This line of reasoning is in fact analogous to the argument for the banking sector, which usually has a deposit insurance scheme. It should be noted, however, that the risk of bankruptcy contagion is likely to be smaller for the insurance sector. Bank deposits can be withdrawn in full amounts with minimum losses, if any. Depositors may need to accept some disadvantages, such as earning lower interest or giving up favourable future interest, but are more inclined to withdraw their deposits swiftly when they think the bank might go bankrupt. In contrast, the cancellation of insurance contracts results in a loss of risk transfer. Also policyholders usually incur losses due to cancellation deductions. Eventually, policyholders are more likely to give a second thought before taking an immediate action. Moreover, repayments of insurance products are usually made less quickly than bank deposits. Insurance companies should have more time to build liquidity for repayments so as to meet their obligations. Therefore, this argument probably has weaker grounding for insurance than banking. Development of competitive markets It is also argued that the establishment of policyholder protection funds contributes to the development of competitive markets. Policyholder protection funds prepare a smooth exit mechanism for incompetent insurers from the market, which supports dynamics in the marketplace. Competitive markets experience failures. The failure of an insurance company affects policyholders significantly. They would suddenly face risks they thought had been transferred to a third party. They may be able to get insurance

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from another insurer, but the coverage could be more expensive. They may also suffer financial damage as repayments during the liquidation proceedings could be substantially less than the face value of the claims. Even in the event that policyholders do not suffer financial losses, they are likely to suffer from a shortage of liquidity, as liquidation repayments take time, sometimes years. A policyholder protection fund can alleviate significantly the difficulties that policyholders might face in the event of the failure of an insurance company. Without such a safety net, the supervisory authorities would be inclined to try to prevent the failure of insurance companies at any cost. This is especially true for a larger insurance company because of the huge number of policyholders that would be affected by its failure and the associated enormous social impact. This is sometimes described as the “too big to fail” situation. Insurance authorities would be inclined to place more stringent regulations to minimise such a failure and to mobilise all possible supervisory measures to rehabilitate companies when they are found to be distressed, steps which could work effectively to restrict competition in the market. Policyholder protection funds make it possible to handle bankruptcy cases without exposing policyholders to risks of severe losses. Having the safety net, the supervisory authority may let a financially impaired insurer go bankrupt without taking extraordinary measures that often disturb the efficient functioning of the market. Policyholder protection funds therefore can serve to help develop dynamic and pro-competition insurance markets. A level playing field across sectors Last but not least, policyholder protection funds are an important tool for preparing a level playing field for insurance companies and banks. In recent years, the insurance and banking sectors have converged. Cross-selling is increasingly common in many countries. At the product level, banks sell financial derivatives that effectively provide guaranty against certain risks, and insurance companies, especially life insurance companies, offer products that have significant savings elements. Insurance companies and banks are competing more and more directly. This development in the financial markets creates a momentum towards the convergence of regulation of the two financial industries, though it is not obvious at this moment. Such a movement may be found in the recent trend to create a consolidated financial supervisory authority as well as consolidated supervision. In the same context, it is argued that insurance policyholders should be protected by a safety net system as bank depositors are, and that

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insurance companies should have a similar back-up as deposit insurance in order to compete with banks. 2.

Drawbacks of policyholder protection funds

Moral hazard The most important argument against policyholder protection funds is the moral hazard problem that they may raise for policyholders, insurers and supervisors. When there is a safety net, consumers may be less inclined to assess the financial situation of the insurer that they contract with and to make a prudent selection. Even worse, they may seek the cheapest products regardless of the risk associated with the insurer, because of the belief that they will not suffer from the negative consequences of their choice in the event that the risk materialises, i.e., the insurer goes bankrupt. The lack of risk averse behaviour on the part of consumers is likely to give incentives to insurance companies for increased risk-taking. They may try to expand high risk-high return investments in the use of the funds gathered by quite attractive insurance products. This is the typical behaviour of financial institutions such as insurance companies and banks when they experience financial distress. Moreover, some observers stress the moral hazard in the supervisors. When there is a safety net to protect the interests of policyholders faced with insurance insolvency, the insurance authorities may feel less pressure for strict supervision to avoid any possibility of insolvency. This could lead to a loosening in the financial discipline of the companies and an increase in moral hazard in the industry as a whole, which may cause several insurance bankruptcies at once, resulting in de facto bankruptcy of the protection fund itself. It should be noted, however, that moral hazard may be an endemic nature of the insurance as well as banking sectors, for which the authorities conduct supervision for the benefits of policyholders and depositors. As often discussed, even without a safety net, there could be moral hazard behaviours particularly on the part of insurers when they face financial difficulties and policyholders when they rely on supervision. The issue, therefore, is how much the establishment of a safety net may fortify the incentives for such behaviours.

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Financial burden on soundly managed insurers As seen below, policyholder protection funds are financed by contributions collected from the member companies. Therefore, the establishment of the funds imposes new financial burdens for insurance companies covered by the fund. This raises the following two arguments against setting up such systems: The first argument focuses on the fact that policyholder protection funds intend to subsidise the mismanagement by one member company at the expense of other members that run their business in a prudent manner. Under this mechanism, prudently managed companies, which avoid effectively being in financial distress, need not only to contend with reckless competitors that offer aggressive pricing to attract customers, but also to compensate for the eventual failures of such competitors. This situation could seriously undermine sound and fair competition in the industry. The second argument is that the financial burden to finance policyholder protection funds could weaken the financial soundness of member companies. This weakening could be significant in some cases. In the extreme, a company might become insolvent because of the payment of contributions to the fund. Moreover, one may see that this system contains a structural problem. Insurance insolvency is apt to occur when the economy moves adversely to the interests of the insurance business. As all the companies are more or less financially troubled during such a circumstance, the burden to cover the losses incurred by one bankruptcy case might possibly lead to another insolvency, which could trigger a chain reaction of insurance insolvency because of the safety net system. It can be argued that policyholder protection funds are meaningful only for special cases in which a company goes bankrupt due to particular mismanagement, while other members remain economically sound in the favourable economic environment. Unfair competition across jurisdictions Related to the argument above, some maintain that the burden on member companies to support the safety net system, which should cover not only the cost for compensation paid to policyholders but also various administrative costs to operate the system, would affect their competitiveness relative to the insurers located in jurisdictions that do not have such a system. The recent advancement of telecommunication technology in general, and a growing use of the Internet in consumer service businesses including insurance, has dramatically increased consumers’ direct access to service providers outside of the jurisdiction in which they live, thereby intensifying competition across

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borders. Under this situation, the establishment of policyholder protection funds may create a serious disadvantage to the member insurers. This argument, however, is usually countered by the view that the existence of a safety net should benefit the member companies in attracting consumers. Practically, it seems difficult to determine which effect is more dominant, as these effects are not measurable and likely to differ depending on customers, products and other factors. 3.

Observations

Obviously, it is not possible to conclude decisively whether policyholder protection funds should be established or not. The importance of the benefits and drawbacks mentioned above should differ among jurisdictions, which have different histories, market environments, regulations and cultures. Consequently, there is no one answer that fits all jurisdictions. However, three observations can be made in this regard. First, one should note that a policyholder protection fund constitutes only a part of policyholder protection in the event of insolvency of an insurance company. Therefore, its necessity largely depends on the protection provided for policyholders particularly on the judicial insolvency procedure for insurance companies. Some jurisdictions provide relatively strong protection to policyholders in the liquidation procedure. Countries like Germany and Italy grant policyholders a special claim on the assets of the failed insurance company corresponding to the technical provisions over any claims lodged against the insurance company. Other countries, including Canada, France and Norway grant policyholders a general claim to all the assets of the company over any other claims than those that are given higher priority by bankruptcy provisions of the national law concerned (typically employees’ claims and tax liabilities).3 There are also some countries like the United Kingdom4 that do not grant any particular privileges to policyholders, which are treated equally with other ordinary claimants. Protection of policyholders with policyholder protection funds is more important for jurisdictions that grant weaker privileges to policyholders in the insolvency procedure of insurance companies. In other words, policyholder protection funds may not need to be introduced if the interests of policyholders are well protected in the insolvency procedure of insurance companies. For example, in Spain, the Commission for Winding-Up of Insurance Undertakings (Comision Liquidadora de Entidades Aseguradoras) is expected to act as liquidator in the insurance insolvency proceedings to facilitate the process and protect the interests of policyholders. The

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Commission can also buy up the claims of policyholders at the price equivalent to the estimated dividend to the given claim from the insolvency proceedings. This provides up front liquidity for policyholders and in many instances improves considerably payments to the policyholders, as policyholder protection funds usually intend to do. Second, it is noteworthy that those countries that have recently introduced policyholder protection funds have experienced one or more bankruptcies of larger insurance companies around the time the legislation was introduced. This suggests that such incidents highlighted the limitation of supervisory efforts to prevent insolvency of insurance companies, and urged strongly for the preparation of a contingent safety net system in the event of future cases (or even in order to handle the current cases). Given the difficulty in abolishing a safety net system once introduced, the establishment of policyholder protection funds will probably continue to increase in the long run. Third, increasing attention has recently been given to establishing a level playing field between the insurance and banking sectors, reflecting the deepening convergence of the two segments of the financial industry. For example, in France, the introduction of a policyholder protection fund was explicitly coupled with the reform of the deposit insurance system. These two measures were explained to have one mission: compensate depositors in the case of bankruptcy of the bank or policyholders in the case of bankruptcy of the insurance companies in accordance with the same principles of simplicity, equality and efficiency.5 Given further convergence, establishing a safety net for policyholders, especially of life insurance, equivalent to the one for depositors may have more support. Furthermore, this argument could lead to the establishment of a common safety net system that covers both sectors. Korea has already moved in this direction. With the enactment of a new law in January 1998, the Insurance Guarantee Fund was merged into the Depositor Insurance Fund that is managed by the Korean Deposit Insurance Corporation. Also, in the United Kingdom, the creation of a single Financial Services Compensation Scheme is under public consultation.6 In either case, however, separate accounts are set up for different lines of business to avoid cross subsidisation. IV.

Structure: comparative analysis

As seen above, policyholder protection funds clearly have both benefits and drawbacks. When their establishment is determined, therefore, their structure should be designed carefully to provide protection effectively and efficiently

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and to limit the deficiencies at a possibly minimum level. This section analyses the major aspects of the structure of the funds that require due attention in designing the schemes, referring to the existing funds to the extent possible. These aspects include the coverage, functions, contributions and governance. 1.

Coverage7

Insurance branches covered By definition, policyholder protection funds (i.e., general funds) should cover a wide range of insurance products. Various branches of insurance are normally divided into two sectors: life (and health) insurance and non-life (property and casualty) insurance. Given the difference in the nature between the two sectors (particularly, the former is normally a long-term business while the latter is generally short term) and also reflecting the segregation policy in most countries, the existing funds cover only one of two sectors. In Canada, Japan and the United States8, two funds have been established to cover the respective sectors. France and Poland have created one fund that covers life insurance. The Polish fund also covers compulsory non-life insurance, while France has set up a fund separately from the compensation scheme for compulsory liability insurance. By contrast, Ireland has established only one fund that covers all non-life insurance products, including the compulsory ones. In Norway there have been two funds created -one covering all non-life insurance classes except for credit insurance and the other is for credit insurance only. In Korea and the United Kingdom, there is a single fund for all insurance classes (and other financial products as well in the case of Korea), but it has two separate accounts for life and non-life insurance businesses respectively that are operated in principle independently in order to avoid any cross subsidy between the two sectors.9 Moreover, the existing funds do not necessarily cover all the insurance branches of the sector they cover. In accordance with the objective to protect nonprofessional policyholders, certain insurance products that are designed particularly for corporations are often excluded from the coverage of the funds, as corporations should normally be able to get sufficient information on the products and the companies and assess appropriately the risks involved. Reinsurance and marine insurance are typical examples of the branches that are usually not covered by policyholder protection funds. In the Japanese system, the branches covered by the funds are positively listed to limit the protection to those largely targeted at individual customers such as life, motor vehicle liability, fire and disability insurance. The Policyholders Protection Scheme of the United Kingdom does not cover insurance policies underwritten at Lloyd’s, mainly because Lloyd’s has its own compensation scheme internally.

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Eligibility of claimants In order to limit the protection by policyholder protection funds to those who really need it, some funds do not allow corporations to ask for compensation for their claims. In the United Kingdom scheme, only individuals and partnerships comprised of individuals are eligible for protection, except for compulsory insurance for which corporations are also entitled. This eligibility for compensation is expected to be modified under the Financial Services Compensation Scheme that will integrate various financial service customer protection schemes including the Policyholders Protection Scheme, so as to include small businesses but exclude large partnerships.10 The Irish fund also excludes from its protection claimants who are not natural persons unless they have a liability to a natural person or a natural person has a liability to them. Other funds do not have particular eligibility restrictions according to the nature of the claimants. It may be because the limitations on the insurance branches to be protected and the caps on the compensations should work effectively to limit the benefit that larger corporations can get from the safety net systems and, thereby, to discourage the moral hazard behaviour on their part. Limitations on compensations Most of the existing policyholder protection funds have certain limits on the compensation that the funds guarantee to pay for claimants in the event of insurance insolvency.11 This intends to reduce the moral hazard problem by requiring policyholders to share losses so as to urge them to make prudent decisions in selecting insurers. Actual limitations on compensation vary significantly across the existing funds, as summarised in Table 1. There are largely two types: payment ceilings and partial payments (sometimes called as “co-insurance”). Countries like Canada, France, Korea and the United States have adopted the former method. Many of the funds adopting this method set a fixed amount limitation on a policyholder basis, not on a policy basis. This is probably because a ceiling on a policy basis can easily be overcome by dividing the insurance into pieces. It is noted, however, that the operational cost could be higher for the policyholder-based approach than for the policy-based one, as the former requires all the policies of a policyholder to be added up in determining the amount to be paid. Moreover, dividing insurance into pieces may incur more loss than doing the same for other financial products, which would discourage policyholders from doing so. The table shows that the level of the ceiling differs across jurisdictions and sectors.

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Japan and the United Kingdom do not have a fixed limit on the amounts paid to each policyholder or policy by the funds. Instead, they restrict compensation to 90 percent of the claims. An exception is applied to compulsory insurance for which the claims are guaranteed in full. This is because compulsory insurance schemes normally aim at ensuring a minimum indemnification, which should not be reduced in the event of insolvency of an insurer. As mentioned above, the funds for a certain compulsory insurance usually pay the full amount of the claims.

Table 1 Limitations on compensation

Japan Korea Norway

Fund for life insurance CAD 200,000 (USD 130,000) but CAD 60,000 in cash value1) 70,000 Euro 65% of the claim but not more than IRL 650,000 (825,000 Euro) 90% of the claim 50 million won (USD 39,000) --

Poland

--

Canada France Ireland

UK US

90% of the claim USD 300,000 but USD 100,000 in cash value4)

Fund for non-life insurance CAD 250,000 (USD 160,000)2) --90% of the claim3) 50 million won (USD 39,000) No limit 50% of the claim but not more than 30,000 Euro 90% of the claim3) USD 300,0004)

Note: 1) Death benefits under life insurance policies. 2) For a single event. 3) 100% for compulsory insurance. 4) Quoted from the NAIC model acts

Although a ceiling and partial payment for compensation share the same objective of restricting the moral hazard problem that policyholder protection funds may raise, they have different focuses. The former puts emphasis on prevention of moral hazard behaviour by large policyholders, while providing full protection for small ones. It should also contribute to limiting the cost of handling a case, which alleviates the financial burden for member companies. By contrast, the latter requires all policyholders, including small ones, to share the consequences of their selection of an insurer. It therefore seeks to reduce moral hazard of all consumers, companies and supervisors and to enhance market discipline on the management of insurers. Interestingly, the proposed new scheme in the United Kingdom plans to cover 100 percent of the claims of non-compulsory general insurance up to GBP 2,000 (approximately 3,200

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Euro12), while parts of the claims exceeding that amount and claims of life insurance continue to be subject to 90 percent protection.13 In contrast, Ireland and Poland have both ceilings and partial payment limitations. In spite of the limitations indicated in the table, in Korea, the insurance products were protected in full until December 2000. The Japanese schemes were also expected to compensate 100 percent of the claims against insurers that were found insolvent by March 2001, after which the coverage has reverted to 90 percent. In these countries, the insurance claims, in effect, had been fully protected by supervisory measures to avoid any bankruptcy of insurance companies until recently when one or more large companies went bankrupt. 2.

Functions

Payment of compensations The fundamental objective of policyholder protection funds is to compensate losses of policyholders in the event of insolvency of an insurer. A basic operation of the funds is, therefore, to pay out compensation to the eligible insurance claimants after an insurance company is declared insolvent. Upon payment, the rights of the claimants are automatically assigned to the funds to the extent of the amounts paid. The funds then recover the payments, at least partially, during the judicial insolvency procedure. All or part of the operation is often commissioned to one or more member companies. It may benefit the policyholders, as it is likely to facilitate their ability to obtain similar insurance from the companies carrying out the operation. Continuation of insurance contracts In the case of life insurance, the funds in Canada and the United States may assume the covered insurance contracts of the insolvent company, administer those contracts and pay claims up to the covered amounts. This is because, owing to the long-term nature of the products, policyholders are considered often better off if their contracts are continued rather than having contracts immediately terminated and receiving compensation in cash. In contrast, property and casualty insurance is generally short term. Therefore, the continuation of the contracts is considered less important than the efficient handling of the insolvency cases. The claims for events that occur before the date of the bankruptcy or for a certain period (usually 30 to 45 days) afterward are covered by the funds, but the remaining contracts at the end of the period are terminated and paid off. The policyholders are therefore required to make

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similar insurance arrangements with other companies if they want to be continuously insured. Some countries put more emphasis on the continuation of insurance contracts in protecting policyholders. In Japan, when there is a member company that is willing to receive the transfer of all or part of the insurance portfolio of the insolvent company, the policyholder protection funds, either of life or non-life insurance companies, are expected to give financial aid to the receiving company to ensure or facilitate the transfer. This seems to be based on the belief that portfolio transfer is the most effective and efficient way to protect the interests of policyholders in the event of insurance insolvency. In order to alleviate the moral hazard problem, the insurance contracts to be transferred may be modified to decrease the benefits up to the level protected by the funds and also to lower the implied rates of return if they are too high. In the case where such a receiving company cannot be found, the funds are expected to undertake the insurance contracts of the insolvent company, administer them and pay claims to the extent that they are covered. The United Kingdom scheme may also make payments to the insolvency practitioner or the insurer receiving the portfolio transfer for facilitating the deal. Similar payments can be made by the Canadian life insurance fund and the Korean fund. It is probably desirable to prepare options in carrying out the protection of policyholders in the event of insurance insolvency and select the most appropriate operation according to a given case. However, this selection is likely to be difficult. Generally speaking, portfolio transfer may provide better protection to policyholders, but sometimes requires substantial financial aid to match the assets with the liabilities to be transferred. As applied in the United Kingdom, the principle of selecting the most cost efficient operation may need to be established, though it may then raise another question for what should be included in the “cost”. 3.

Funding

Funding methods Policyholder protection funds are normally financed by the contributions collected from (or levies imposed on) member companies. The contributions of respective member companies must be assessed in a fair manner and collected in such a way as to avoid imposing excessive burden on the companies. There are largely two ways as to raise funds for the schemes: pre-funding and post-funding. In the former case, the contributions are collected regularly from

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member companies to build up a fund in preparation for future insolvency cases. Until disbursed to protect the interests of policyholders of an insolvent company, funds in the schemes are invested in safe and liquid assets, typically government bonds. In the latter case, the contributions are called for only when the fund actually needs to pay for policyholders, and therefore no fund or pool of money is accumulated in the schemes. Pre-funding has some merits. First of all, it serves to handle insolvency cases relatively quickly, as funds for compensations for policyholders are always ready. This is especially important in dealing with the bankruptcy of a larger insurer, for which a considerable amount of funds needs to be mobilised within a short period. Second, the existence of a sufficient amount of funds for policyholder protection ensures the visibility of a safety net and thus contributes to the maintenance of public confidence in the industry. It can be stated, however, that the ready-to-use funds may induce moral hazard behaviour of consumers, companies and supervisors. Moreover, because of its visibility, the lack of sufficient funds may adversely affect public confidence. Third, prefunding can provide better predictability for member companies concerning future financial burdens. Post-financing has different advantages. First, it requires virtually no administration costs (such as fund management costs for pre-funded scheme) until an insolvency case comes out, and thus is less costly. Second, postfinancing allows member companies to retain funds until these funds become of immediate necessity. The companies should be better off using the funds for their business than pooling them in a policyholder protection scheme that principally invests in safe, but less profitable, assets. There is no common practice internationally in this respect. France, Japan and Korea have adopted pre-funded schemes, but Ireland, Poland, the United Kingdom and the United States14 have post-funded arrangements. The Canadian schemes have employed a post-financing method, but have recently introduced a prefund mechanism. The funding mechanism of the Norwegian schemes is in effect a combination of pre-funding and post-funding methods. It is essentially a pre-funded scheme, as member companies are required to set aside the contributions each year until the accumulated sum (labelled as “provision for the guarantee arrangement”) reaches the prescribed level. However, the individual companies retain and manage the funds pooled in them respectively (i.e., the assets corresponding to the provision) until the board of the guarantee scheme calls for payment of the contributions to use for protecting policyholders of failed insurers, as is the case of post-funded schemes. This mechanism is partly introduced in the French scheme, which allows member companies to retain one half of the amount of their contributions until the funds 318

become necessary in actuality. It perhaps aims to incorporate the advantages of post-funding into a pre-funding scheme, though it might also run the risk of a lack of readiness of sufficient funds for policyholder protection. Even with the current diversity, a slight tendency may be observed in favour of pre-funding, because the countries that introduced a policyholder protection fund most recently (i.e., France, Japan and Korea) preferred a pre-funded scheme. Moreover, as stated above, the funds in Canada have recently incorporated a prefund mechanism in their essentially post-funding arrangement. This is explained to intend that the funds become more capable of handling a large insolvency case quickly.15 With such a mechanism, these funds can be viewed as operating effectively on a pre-financing basis. From the viewpoint of contributing companies, however, the difference between the two methods may not be so significant. On the one hand, pre-funded schemes do not require member companies to make contribution, once the fund reaches a predetermined level. After this point, member companies become obliged to pay only when the fund goes below the level due to the payments for policyholders, as they would do under post-funded schemes. On the other hand, under the latter schemes, member companies may also be required to pay contributions for several years because of the cap explained below. They may have to continue to pay more if other cases come out during that period, as they would do under the former schemes. The level of funds needed to accumulate in a pre-funded scheme varies across sectors and countries, largely reflecting the size of companies covered by the respective schemes. The French fund (for life insurance) expects to build up FF 1.8 billion (approximately 270 million Euro; including the parts retained in the member companies), which can normally be reached in three years. In Japan, the level is set at JPY 400 billion (approximately USD 3.3 billion) for the life insurance fund, and JPY 50 billion (approximately USD 410 million) for the nonlife one. These amounts are considered sufficient to cover a few insolvency cases of average-sized companies in each sector. Each non-life insurance company in Norway has to augment the provision for the guarantee arrangement until it amounts to 1.5 percent of the overall earned gross premiums for direct insurance during the last three years. The prefunds set up in the Canadian schemes seem much smaller. A prefund of the non-life insurance fund (PACCIC) amounts to almost CAD 30 million (approximately USD 19 million), which resulted from a special levy collected from member companies during 1998 to 2000. The target level of a prefund of the life insurance fund (CompCorp) is set at CAD 100 million (approximately USD 64 million). The relatively low levels suggest that these funds should only cover the payments at an initial stage in advance of the collection of contributions from member companies on a post-financing basis 319

(i.e., the amount of money necessary to handle an insolvency event is assessed and collected when the event occurs). Especially when a larger company fails, a large amount of funds need to be used to protect the interests of policyholders. In order to deal with the case swiftly, policyholder protection funds are normally able to borrow from member companies or from other credit institutions. This is indispensable particularly for the post-financing schemes, which do not have funds in advance. Member companies are usually required to provide financing up to certain limits that are often prescribed as the equivalent to the maximum amounts of the annual contributions or their multiples. Assessment of contributions The contributions of respective companies are normally calculated based on gross or net premiums.16 This seems reasonable, considering that the burdens of contributions are at least partly passed on to policyholders, the direct beneficiaries of the scheme, in the form of increased premiums. Premiums received are also an adequate indicator of the payment capacity of insurance companies on a flow basis. In Japan, however, the assessment of the contributions takes into account not only premium incomes but also technical reserves, in order to reflect the payment capacity of the companies on a stock basis as well. The French scheme depends only on technical reserves in the assessment of the contributions. Interestingly, the life insurance fund in Canada (CompCorp) has recently changed its formula to calculate contributions. It was previously based on the five-year average premium but it now uses the new base calculated from the required capital that the company with the authority. In a pre-funded scheme, member companies are normally required to pay in the prescribed contributions each year. In contrast, under a post-financing system, the annual contributions vary considerably from year to year, depending on the level of funds needed to deal with bankruptcy cases. Basically, the amount used for the operation of the scheme is shared among member companies based on gross or net premium incomes. However, the existing post-funded schemes have a cap on annual contributions in order to avoid an excessive burden on surviving member companies. The prescribed rates for contribution for the existing pre-funding schemes and the caps for assessments under the postfunding arrangements are indicated in Table 2. In the assessment of the contributions, Korea provides an interesting example. Reportedly, in the Korean system, the assessment takes the risk factor into account. Insurance companies are categorised into three groups according to their respective financial soundness. The companies in the least risky group

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enjoy 5 percent discount in their contributions, while the contributions for those in the most risky category are increased by 5 percent. The risk-based assessment of the contributions is similar to the one for deposit insurance in the United States. It is intended to avoid placing an unfair burden on soundly managed companies and to give incentive to member companies to improve their financial soundness. There are, however, arguments against this approach, which include that it may increase insolvency cases by imposing a heavier burden on less profitable companies. Table 2 Assessment of annual contributions1) Fund for life insurance 0.05% of technical provisions JPY 40 billion (USD 330 million) for all the member companies

JPY 5 billion (USD 41 million) for all the member companies

Korea3)

0.3% of premium income

0.3% of premium income

Norway

--

Canada4)

1.33% of capital required5)

France Japan2) Prefunding

Postfunding (caps)

Fund for non-life insurance

Ireland

--

Poland7)

n.a. 1% of gross premium income 2% of gross premium income

UK US

--

1% of gross premium income 0.75% of premium income6) 2% of gross premium income 1% of net premium income 2% of net premium income

Note: 1) A term “premium income” is not strictly defined below and may differ among jurisdictions. Therefore, it is not appropriate to compare the figures directly across the jurisdictions. 2) Due to a series of insolvencies of both life and non-life insurance companies in the last few years, these figures are increased to JPY 46 billion (for the life insurance fund) and JPY 6.5 billion (for the non-life one) for the time being. 3) The rate was raised from 0.15 percent as of June 2000. 4) With a prefund mechanism, both funds in Canada can also be classified to pre-funding. The figures referred to concern the assessments for the fund to be paid for policyholders. 5) Subject to the floor of a proportionate share of CAD 100 million. Special assessments could also be levied if necessary to replenish the prefund or to prepare for potential future commitments. Capital required is equal to the one filed with the authority after some adjustments for this assessment purpose. 6) Also subject to the floor of a proportionate share of CAD 10 million with a cap of 1% of premium income. 7) The law says that the rate shall be specified by the regulation by the Minister of Finance.

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Government support Although policyholder protection funds are in principle financed by member insurance companies, in some countries, governments may support funding of the funds. For example, the Irish legislation stipulates that the government may advance to the Insurance Compensation Fund proper sums to enable the Fund to make necessary payments for policyholder protection, and such advances have been made in the past.17 Japan and Korea have recently introduced some government support measures in the face of serious crisis in the insurance industry. In order to combat with such a crisis in the last few years, Japan has set up the scheme where the government guarantees borrowing by the policyholder protection corporations to facilitate their fund raising for policyholder protection.18 In addition, responding to a series of failures of life insurance companies, the government declared its intention to support the life insurance fund by providing up to JPY 400 billion (approximately USD 3.3 billion), if the fund needs to pay for dealing with the failures beyond JPY 560 billion (approximately USD 4.6 billion) to be accumulated with the contributions from member companies.19 Similarly, the Korea Deposit Insurance Fund can raise funds to deal with insolvency cases of financial institutions including insurance companies by issuing government guaranteed bonds.20 The experiences in these countries suggest that under such crisis situations, the government may be required to support the safety net, as the industry is probably unable to meet the immediate costs of a series of bankruptcies. It should also be noted that these measures, coupled with explicit blanket guarantees of insurance policies, would be necessary in the process to move from the implicit full guarantee tradition to the new regime of limited coverage safety net.21 Another form of government support for funding of policyholder protection funds is tax deductibility of the contributions that member companies pay into the funds. As these contributions are normally recognised as expenses and thus reduce corporate taxes that the company has to pay, part of the costs for protecting policyholders are effectively passed on to the government and thereby to the taxpayers. Moreover, in the United States, some state laws allow insurance companies to recoup the contributions through the use of premium tax credits, typically amortised over five years, while other state laws provide for recoupment through an increase in rates or a surcharge added to policies. The use of premium tax credits is much more prevalent with regard to life/health insurance companies, where rates for many products are fixed over a long term.

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4.

Governance

Organisation Policyholder protection funds are normally founded by member insurance companies as non-profit legal entities.22 The funds are organised in accordance with specific legal provisions that stipulate basic elements of the funds such as the objective, coverage, functions, funding and governance, though the details are determined by regulations, by-laws, memoranda and so on. The funds are normally administered by a board of directors or governors.23 Members of the board are either elected at the meetings of members or appointed by the authority. The actual composition of the boards differs among jurisdictions and funds. The boards usually consist of the directors who represent member insurance companies. In addition, many boards also include independent directors who are expected to represent public or consumer interests. For example, the board of the Canadian Life and Health Insurance Compensation Fund (CompCorp) comprises independent directors only. Both of the Japanese Policyholders Protection Corporations have a board in which independent directors consist of the majority. In some cases, the insurance commissioner or his representative sits on the board. Some funds establish one or more committees in addition to the board of directors. The function of these committees varies. For example, CompCorp has the Industry Advisory Committee and the Asset Review Committee. The Property and Casualty Insurance Compensation Corporation (PACICC) of Canada forms the Advisory Committee on an ad hoc basis to handle a given insolvency case. The two Policyholder Protection Corporations in Japan have the Steering Committee that provides advice on the critical operations of the Corporation and the Asset Evaluation Committee. The Insurance Guarantee Fund in Poland has the Fund Council that supervises the affairs of the Managing Board. The discretionary power of the funds and their boards also varies across jurisdictions, but is largely limited to operational decisions. The funds are legally obliged to provide protection for policyholders in the event of insolvency of member insurers. In some cases, the funds are authorised to decide whether or not to take actions for protecting the interests of policyholders when a member company is not found insolvent but seriously impaired. When there are multiple options available for handling a case (such as direct payment of compensation or financial aid to portfolio transfer), the funds may have discretion to select one. Moreover, various other decisions as to practical operations are also naturally the responsibility of the funds. When

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necessary to carry out their duties, they may enter into contracts to commission some operations, take legal actions and make concessions to recover their funds, employ staff, borrow money, and so on. Membership Policyholder protection funds can be designed with either compulsory or voluntary membership. One may argue that even under voluntary membership, the insurance companies should have strong incentive to participate in the fund, as it enhances their credibility with the public. In reality, however, the most, if not all, of the existing funds have compulsory membership, under which any insurance company conducting one or more lines of insurance business covered by a fund has to be a member of the fund. In Japan, the Policyholder Protection Funds established in 1996 had voluntary membership. The Funds were, however, abolished by the law in 1998 that has created the Policyholder Protection Corporations which adopted compulsory membership. Two reasons can be pointed out for compulsory membership. The first is to ensure the protection of policyholders of insurance, who may unintentionally choose an uncovered insurance company under voluntary membership. This could happen if the company is allowed to drop out of the fund at any time. Given the cost for policyholders to switch their contracting insurance companies, the policyholders of the company might suddenly be left outside of the safety net due to the company’s arbitrary decision to drop out of the fund. The second reason is to avoid the adverse selection problem. Risky companies have a strong incentive to participate in the safety net scheme as they can enjoy significant enhancement of their credibility. On the contrary, soundly managed companies, which have already established a good reputation in the market, have less incentive to be a member, because they may find the cost of the participation (i.e. contributions) to be heavier than the benefit. As a result, the fund with voluntary membership may attract risky companies only, which is likely to create a serious financial problem to the fund in the end. In consequence, once the decision has been made to introduce policyholder protection funds in spite of their drawbacks mentioned above, there is a strong case for compulsory membership. Co-operation with the supervisory authorities Another important governance issue is the relationship of policyholder protection funds with the insurance authorities. Although normally established as independent entities from governments, the funds need to be operated in close co-ordination with supervisory authorities in order to carry out effective

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policyholder protection. Usually there is a good working relationship between a fund and the supervisor. Besides, some jurisdictions prepare certain formal arrangements to institutionalise effective co-operation between the two. One such arrangement is the involvement of the supervisor in the decision making of the fund on important issues. In the United States, for example, the insurance commissioner may be a member of the board, or have the right to attend all board meetings. In Canada, the insurance regulatory authority is entitled to convene and participate in meetings of the board and the advisory committees of CompCorp. In the Polish scheme, a representative of the supervisory body becomes a member of the Fund Council when bankruptcy of an insurance company is declared. In addition, approval from, or consultation with, the supervisory authority is often legally required for important operational and managerial decisions by the funds. Relation with judicial insolvency procedure Policyholder protection funds function in the wake of insolvency of an insurance company. Although some funds are expected to handle a case regardless of court actions if a company is not insolvent but seriously distressed, the commencement of the judicial liquidation or reorganisation of a member company always triggers the operation of such funds. Conceptually, the operation of the funds to protect the interests of policyholders can be carried out separately from the judicial procedure. It would be desirable when the supply of liquidity for policyholders is highlighted as a benefit of the funds in addition to compensation for losses.24 The funds may pay out compensation to policyholders up front, and then participate in the judicial procedure as a creditor with the rights assigned from policyholders. Practically, however, the operation of the funds needs to be implemented in close coordination with the judicial procedure. For example, insurance claims protected by the funds should also be found eligible in the judicial procedure. In many instances, the supervisory authorities are expected to play a role in coordinating the operation of the funds and the judicial proceedings. In some cases, the two procedures are directly linked. In Ireland, only liquidators appointed by the High Court can apply for and receive from the Insurance Compensation Fund, the funds to be distributed in the liquidation proceedings under the Court.

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V.

Conclusions

The establishment of policyholder protection funds (i.e. general funds) is clearly beneficial in promoting the protection of policyholders, supplementing insurance supervision in the event of insurer insolvency. However, there are also drawbacks that cannot be neglected, which perhaps accounts for the fact that only a limited number of countries have introduced such funds. In recent years, however, there seems to be a trend towards creation of these funds, mostly triggered by the failure of one or more larger insurance companies in the countries. It has probably also driven by the convergence of financial service sectors, especially between insurance and banking that is usually equipped with a deposit insurance scheme. Given the difficulty of abolishing a safety net system and the deepening convergence of financial markets and perhaps of financial regulations, this trend is likely to continue. When established, policyholder protection funds should be designed carefully to minimise any drawbacks, particularly the moral hazard problem and the burden on soundly managed member companies. However, the actual structure of the existing funds can differ considerably in various important aspects such as coverage, functions, funding and governance.

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NOTES

1.

Some funds may also compensate the losses sustained by the beneficiaries of compulsory insurance when no insurance protection is available for reasons other than the insolvency of the relevant insurer.

2.

In addition, the Netherlands is in the process of introducing a policyholder protection fund for life insurance. The relevant law was enacted as of 13 December 2000. It will come into force when a Royal Decree is made. However, details of the scheme are not available at this moment.

3.

In the United States, policyholders have been granted the second priority only after the expenses of administration in the insolvency proceedings of insurance companies since U.S. v. Fabe (1993).

4.

Japan was one of the countries that did not grant any special privileges to the claims of policyholders, but recently amended the Insurance Business Law to grant a general privilege over ordinary claims to policyholders.

5.

Communiqués de presse, 18 juin 1999

6.

UK Financial Services Authority has issued a series of consultation papers on this subject. The most recent and comprehensive one is Consultation Paper 58 “Financial Services Compensation Scheme Draft Rules”, July 2000.

7.

One of the issues related to the coverage of policyholder protection funds is whether a fund should extend its protection to foreign policyholders or domestic policyholders of a foreign insurer. However, this paper does not cover this issue.

8.

Except for the State of Wisconsin, which has established a single fund covering both life and non-life insurance.

9.

Some policyholder protection funds established in other countries also have separate accounts that cover different insurance branches to limit cross subsidy among them. The question of how insurance branches should be segregated is not examined in this paper.

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10.

UK Financial Services Authority Consultation Paper 24 “Consumer compensation: a further consultation”, June 1999

11.

For example, the guarantee arrangement for non-life insurance companies in Norway does not currently have any explicit limitations on the compensations for claimants. The Banking, Insurance and Securities Commission (Kredittilsynet) is now proposing a legislative amendment to put in place the following limitations: −

The guarantee scheme should not include insured risks within blue water hull insurance, energy insurance, aviation insurance and accepted reinsurance. Moreover large commercial risks within non– marine insurance should be excluded given that some specified criteria are fulfilled.

−

Claim amounts exceeding 20 million NOK (approximately 2.4 million Euro) should not be covered by the guarantee scheme.

−

The guarantee scheme should not cover more than 90 per cent of a single claim, except for the claims arising from housing insurance which should be fully covered.

12.

The exchange rates used in this paper referred to those as of 16 March 2001: 1 Euro = GBP 0.626, IRL 0.788, FF 6.56, NOK 8.18, and USD 1 = CAD 1.56, JPY 123, 1288 won.

13.

UK Financial Services Authority Consultation Paper 58 “Financial Services Compensation Scheme Draft Rules”, July 2000

14.

The exception is the New York State fund for property/casualty insurance, which employs a pre-funded structure.

15.

In the case of the non-life insurance fund (PACCIC), the creation of a prefund was linked with its decision to pay out claims for unearned premiums, which it did not do initially, in order to help the policyholders replace their insurance quickly.

16.

The definition of “gross” or “net” premiums varies across jurisdictions. This paper does not analyse the details.

17.

The Irish government provided a grant of IRL 30,000 to establish the Insurance Compensation Fund in 1964. More recently, even after the introduction of a levy on member insurance companies, advances were made of IRL 100 million in 1985 and IRL 32 million in 1993.

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18.

This scheme was introduced as a temporary measure applicable until March 2001, but the deadline has been lifted for the Life Insurance Policyholders Protection Corporation.

19.

This government support arrangement is a temporary measure that is available until March 2003.

20.

By the end of 1999, the Korea Deposit Insurance Fund raised 43.5 trillion won with government guaranteed bonds, all of which has been used to handle the cases of insolvent financial institutions. However, the Fund expects to recover these funds by rehabilitating those institutions under its control and selling them off in due course.

21.

A Background Paper (June 2000) produced by Financial Stability Forum Working Group on Deposit Insurance discusses the issues related to the transition from blanket guarantee to limited-coverage safety net systems in the context of deposit insurance.

22.

An exception is the Insurance Compensation Fund in Ireland, which was established with a grant made by the Minister of Finance.

23.

The exception is the Irish fund, which is administered by the Accountant of the High Court, acting under the control of the President of the High Court.

24.

Up front provision of liquidity is often emphasised as an important merit of deposit insurance systems. In the case of insurance, however, it may be less relevant, as insurance payments or repayments in cancellation of the contracts usually take some time.

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OECD PUBLICATIONS, 2, rue André-Pascal, 75775 PARIS CEDEX 16 PRINTED IN FRANCE (21 2001 12 1 P) ISBN 92-64-18694-8 – No. 51875 2001