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 ar