15463 AID (Summer03) 14 8 03 - PwC · 2015. 6. 3. · Contents EDITOR’S COMMENT • JOHN S. SCHEID 2 REVOLUTION IN REPORTING – INSURANCE ANALYSTS’PERSPECTIVES ON DEVELOPMENTS

Insurancedigest

AMERICAS EDITION • SEPTEMBER 2003

The Americas Insurance Digest is published three times a year, to address the key issues driving the insurance industry.

If you would like to discuss any of the issues raised in more detail,please contact the individual authors or the Editor-in-chief, whose

details are listed at the beginning of each article.

We would also welcome your feedback and comments onInsurance Digest, and as such, we enclose a Feedback Fax Reply

form. Your feedback will help us to ensure that our publications areaddressing the issues that you feel most strongly about.

AMERICAS EDITION • SEPTEMBER 2003

Contents

EDITOR’S COMMENT • JOHN S. SCHEID 2

REVOLUTION IN REPORTING – INSURANCE ANALYSTS’ PERSPECTIVES ON DEVELOPMENTS IN IFRS • MARIE BRAVERMAN AND SAM GUTTERMAN

PricewaterhouseCoopers brought together 20 analysts covering the European insurance sector. This article highlightsthese analysts’ reactions to the recent proposals of the IASB, as well as providing a current status of these proposals.

THE CANADIAN INSURANCE MARKET • BILL BAWDEN AND IRMA FREESE

The Canadian insurance market has experienced rapid change in recent years. This article discusses the impact that the legislative reform, the consolidation of life insurance companies and the intensive competition, has had on insurersoperating in the mature Canadian market.

12

MANAGING RISKS ALONG THE PATH TO TECHNOLOGY-DRIVEN BUSINESS TRANSFORMATION • MARK KEELEY AND CHERYL FLETTERICK

Companies need to develop a comprehensive risk management strategy to help them address risks that threaten the company’s ability to recognize the business benefits, that result from technology-driven business change.

18

THE INSURANCE MARKET IN JAPAN • STEPHEN T. O’HEARN AND MICHAEL S. JOHNSON

The Japanese insurance market is in a state of change. Twelve years of economic malaise depressing solvency reserves, a more transparent regulatory environment, the entry of energetic, well capitalized foreign companies and the desire forincreased scale have led to a series of M&A deals which are changing the face of the Japanese insurance industry. In thisarticle, Stephen O’Hearn and Michael Johnson assess the Japanese insurance landscape today and outline its future prospects.

22

4

2 Insurance Digest • PricewaterhouseCoopers

With the first half results for 2003 now in, the insurance industry continues to face thelingering drag on earnings caused by saggingeconomies and regulatory changes. The lifeand property/casualty industries have beenfaced with declining interest rates for the firstsix months of 2003, increasing corporategovernance and regulatory requirements and tight capital markets.

Although rising property/casualty premiumshave given the industry a shot in the arm,capital constraints caused by the economicslowdown have diminished the capacity ofreinsurers to provide sufficient coverage.

Overall, while the rebound in the economyfrom the end of the Iraq War has been adisappointment, the amount of stimulus put into the ecomonic pipeline should helpgrowth in the second half of 2003. Some reasons for hope include the following. The heavy pace of refinancing over the pastfew months should boost consumer liquidity,which with the tax cuts approved shouldprovide a boost to cash flow in the secondhalf. As for investment returns, consensusopinion seems to indicate that profits and cashflow are expected to improve gradually as wemove further into 2003, although a lack of

pricing power, concerns about over-capacityand efforts to improve liquidity/cash flow willlikely keep capital spending trends modest.

With interest rates at historic lows therebylowering profits from investment returns,insurers will have to become more adept at improving the returns from their corebusinesses. Identifying and exploiting theirsource for financial strength, insurers willrefocus on underwriting, risk managementand claims practices. Some insurers havebegun to hold their businesses to morestringent standards. Perhaps with lessinvestment gains the industry will refocus on underwriting, claims management andcost control. Time will tell.

In this edition of Insurance Digest we havefour articles, covering both marketopportunities and challenges in Canada andJapan, together with articles of topical interest.

With the deadline for implementation ofInternational Financial Reporting Standardsrapidly approaching for many Europeaninsurance groups, Marie Braverman and Sam Gutterman provide a current status onthe IFRS proposals. Their article also providesa perspective from the investment analysts on

Editor’s Comment

JOHN S. SCHEID CHAIRMAN, AMERICAS INSURANCE GROUP

3Insurance Digest • PricewaterhouseCoopers

the recent IASB proposals. IFRS measurement,recognition and presentation standards willhave a fundamental impact on several keyareas for insurance companies.

Continuing the theme of risk management,which has been the subject of a number ofarticles in recent editions of Insurance Digest,Mark Keeley and Cheryl Fletterick discussmanaging risk during business process orinformation technology transformation.

Our next edition of Insurance Digest will bepublished in November. Please continue toprovide us with your feedback and topics youwould like to see addressed in future issues.

John S. Scheid Editor-in-chief

Tel: 1 646 471 5350E-mail: [email protected]

Revolution in reporting –Insurance analysts’ perspectives on developments in IFRS

AUTHORS: MARIE BRAVERMAN AND SAM GUTTERMAN


IFRS for insurance will revolutionize accounting and reporting.Key changes, including the move to fair value, a possible new format for reporting and disclosure requirements and a new definition of whatconstitutes an insurance contract, could transform the way companiesrecognize and communicate value. For analysts, IFRS represents a wholenew basis for judging performance and profitability.

Judging value and performance

While the overall thrust is clear, the details and timing of theproposed International FinancialReporting Standards (IFRS) forinsurance continue to shift.Although we have known that theInternational Accounting StandardsBoard (IASB) decided not toimplement the Phase Two IFRS for insurance contracts until 2007or 2008, this ‘distant date’ is by no means a cue to forget aboutIFRS. All existing standards willapply in Europe and certain otherareas in the world from 2005, including certain US subsidiaries of multi-nationals or US companieswith world-wide operations.Notably an enhanced version ofIAS 39, the standard for financialinstruments, will most likely apply. Financial instruments includebonds, equities derivatives andmost other assets of insurers, aswell as certain products currentlytreated as insurance but treated asinvestment contracts under theIASB’s new contract definition.

Indeed, the so-called ‘interimsolution’ or Phase One, couldprove as much of a headache for the preparers and users ofaccounts as the 2005 European‘big-bang’ faced by other sectors.Potential problems range fromconfusion over the classification of contracts to the effect ofvaluation mismatches betweenassets and insurance liabilities.

In February 2003,PricewaterhouseCoopers broughttogether 20 analysts who coverEuropean insurers, to discuss thelatest developments in IFRS andhow they are likely to work inpractice. The seminar, which was a follow-up to a similar event heldin February 2002, provides anopportunity to gauge analysts’reactions to the current proposalsfrom the IASB, and how theybelieve these could be modified to better meet their needs.

The analysts were asked a series of questions during the seminar.Although the responses revealgrowing support for the principlesof the IASB project, some questionmarks remain. An overall cause forconcern is that none of the analystsfeel that ‘companies are providingthem with appropriate feedback on the impact of the newaccounting standards’. This canonly compound their overall

current dissatisfaction with the‘adequacy of European insurers’financial reporting’, with aroundtwo-thirds regarding it as ‘poor’ or ‘very poor’. None believe it is‘good’ (see Figure 1). Since manyEuropean insurers follow USaccounting standards for insurancecompanies, one has to wonderwhether their views of the financialreporting of US insurers are any better.

The chief implications of the latestdevelopments in IFRS and theanalysts’ perspective are outlined in this paper.

Changes since 2002

At the end of 2002, the IASBresponded to continuing insuranceindustry concerns about thepractical implementation of itsproposed IFRS for insurancecontracts by agreeing to splitimplementation into two separatephases (see Figure 2 overleaf).

IFRS for insurance marks a revolution inaccounting and reporting.

REVOLUTION IN REPORTING – INSURANCE ANALYSTS’ PERSPECTIVES ON DEVELOPMENTS IN IFRS


Very poor

Poor

Average

Good

Very good

14%

53%

33%

0%

0%

Analyst survey results: How would you rank the adequacy of European insurers’ external financial reporting?

FIGURE 1

Phase One – interim solution

Under the current proposal for theinterim phase due to be effectivein 2005 for European listedcompanies, contracts linked to aninsurable ‘event’, including mostforms of life and p&c insurance,will continue to be covered byexisting GAAP standards such as US GAAP if currently permittedin a jurisdiction and used forprimary accounts.

Consistent with US GAAP, suchelements of fair value, such asdiscounting of p&c loss reserves,will not be required at this stage.Insurers will be able to continue todefer acquisition costs as long asthey are recoverable. However,such dispensations appear to betemporary, and unless there is aradical change in direction, areunlikely to survive under the‘finalized’ insurance IFRS.

All other existing IFRS standardswill apply from 2005, including

IAS 32 (recognition) and 39(measurement) of financialinstruments. One reason whythese two standards have been so controversial is that they canintroduce income volatility. Any contract that does not transfersignificant insurance risk will bedesignated as a financial instrumentand come under IAS 39, regardlessof its current legal form (unless the contract’s benefits are suitablyperformance-linked). This will likelysweep in most group pensioncontracts and some variableannuities that do not containsignificant guarantees. Dependingon the final rules, investment and insurance contracts not valuedon a fair value basis that containan embedded derivative may need to be split and valued separately,either in the main accounts or morelikely in the notes. The lack ofclarity and potential volatilityrelated to IAS 32 and 39 haveresulted in considerable oppositionto some of their provisions.

An important part of the proposedPhase One requirement isdisclosure, the most importantaspect being the disclosure of thefair value in the notes beginning atthe end of 2006. Depending onthe progress of Phase Two, thiscould prove problematic.

Phase Two – full implementation

Full implementation of Phase Twofor insurance contracts isprovisionally due in 2007,although depending on howquickly Phase Two moves along,this requirement might slip to2008. The cornerstone of theIASB’s proposals is a move awayfrom ‘deferral-and-matching’ infavor of prospectively determinedinsurance liabilities in line with its conceptual framework.Recently certain Board membershave tentatively concluded that,given the lack of markettransactions and to reduce the possibility of manipulation, an entity should use entry price

values or sufficiently validatedentity-specific assumptions andinformation to be able to use a best estimate.

Insurers will need to calculatetheir ‘best estimate’ of futureliabilities, based on the ‘weightedaverage of all possible outcomes’or mean values. This is likely torequire more sophisticatedactuarial techniques and enhancedmanagement information systemsthan generally used today, possibly including the use ofstochastic and option pricingmodeling to forecast the expectedcost of options/guarantees andclaims payments for p&cinsurance under a broad range of different scenarios.

Companies will also need toincrease their expected futurecosts, including loss reserves, withmarket value margins (MVMs) toreflect the uncertainty in theirfuture cash flows. Although theconcept is reasonable enough,actual evaluations will be far lessstraightforward as the MVMs mayhave to reflect the compensation a prospective buyer would requireto take on these risks. The Boardhas so far provided little or noguidance about how such amarket valuation could beachieved in the absence of aliquid market. A number ofbodies, including the InternationalActuarial Association, are lookinginto how MVMs can bedetermined in practice.

Much of the remaining detail ofthe proposed insurance IFRS is stillthe subject of considerable debate.Key points of issue include how toreflect possible renewal premiums,how to value options andguarantees, the effect of the use of

REVOLUTION IN REPORTING – INSURANCE ANALYSTS’ PERSPECTIVES ON DEVELOPMENTS IN IFRS continued


2003 2004 2005 2006 2007 2008

1st IFRSannual report

(fair valuedisclosure)

YOU AREHERE

1st IFRS B/S on Phase 1?

1st IFRS B/Sfor US-foreignSEC registrants

1st IFRS B/Sfor non-US

SEC registrants

1st quarterlyinterim on IFRS basis

1st IFRS annual reports

(Phase 1)

1st IFRSannual reports(Full Phase 2

implementation)?

Exposuredraft forPhase 2

Exposuredraft forPhase 1

Currently expected IASB timetableFIGURE 2

risk free rates discount, themeasurement of performance-linked contracts and whether toallow up-front profit recognition.On the last issue there wascertainly no consensus among ourpanel of analysts (see Figure 3).With no end to the deliberationsin sight and continuing industryconcerns about the practicalimpact of IFRS, producing anagreed IFRS ready forimplementation in 2007 will be a challenge.

Nevertheless, while the IASB isprepared to allow more time fordialogue with the insuranceindustry and other stakeholders, it has already voted unanimouslyto pursue the ‘asset-and-liability’approach. The move to fair valueliability is consistent with many of the proposals included in theEU’s Solvency II project, whichaims to provide the next generationof solvency management forEuropean insurers. Therefore thekey challenge for both analysts andindustry is not if, or even when,the IFRS is applied, but how toensure that the eventual standardsprovide a coherent and workablebasis for accounting and reporting.

A new way of looking at the business

IFRS measurement, recognitionand presentation standards willhave a fundamental impact in anumber of key areas, includingproduct, investment and possiblytaxation strategies.

The IASB is determined toenhance transparency and ensurethat financial reporting reflects theeconomic realities of the business.From 2005, European insurers arelikely to have to disclose morequantitative and qualitativeinformation about their relativerisk exposures and procedures inplace to mitigate them.Importantly, current IASBproposals include the requirementthat fair values of insuranceliabilities be disclosed at the endof 2006.

Looking ahead to the ‘full’ IFRS,the IASB is in the process ofdeveloping proposals forpotentially radical changes to theformat of the income statementthat are likely to focus on the valuegenerated from both new andexisting business (see Figure 4

overleaf). Our analyst panel clearlyendorsed such a move, with 90%feeling that ‘separate analysis ofnew and existing business in theprofit and loss account wouldenhance the understanding ofinsurance accounts.’

Many product lines withpreviously stable reported profitsmight not look as favorable underthe new valuation and disclosurecriteria. Reported values ofoptions, guarantees andparticipating contracts may beespecially vulnerable to marketfluctuations, resulting in acontinued move to more variabletype contracts that pass the marketrisks to policyholders. IFRS fairvaluation may also have importantimplications for investmentstrategies, such as more carefulattention to the management ofvolatility through betterasset/liability matching. The IFRScould continue the trend inEuropean companies away fromequities and towards more fixed-income securities, as well asgreater use of hedging andreinsurance strategies.

In addition, for European insurerswhose taxes are based upon theirannual accounts, changesresulting from the move to IFRScould have a real tax effect. Even where the tax calculationsare based upon regulatory orseparate tax accounts, companieswill need to consider betteralignment with IFRS values.

Continuing concerns:The insurers’ perspective

Many insurers are concernedabout what they see as theexcessive complexity and lack ofcoherence in the IASB’s proposals.



For all expected future premiums (including non-life renewals)

For all expected future premiums (life only)

Only for future expected contractual premiums

None at all

15%

40%

40%

5%

Analyst survey results: Should any profits be recognized at point of sale?

FIGURE 3

IFRS measurement,recognition andpresentationstandards will havea fundamentalimpact in a numberof key areas.

Based on discussions with life andnon-life companies, it has becomeapparent that there is growingawareness and support for theneed for more credible,comparable and transparentdisclosure, especially at a time ofgrowing market skepticism aboutthe quality and reliability offinancial reporting.

However, these discussions alsohighlighted mounting concernsabout the practical implications ofpossible Phase Two proposals, thatsome believe owe more to rarefiedfinancial theory than the tangiblerealities of their business. In particular, many are concernedthat a system that relies oninconsistent methods ofmeasurement of assets andliabilities, and untestedassumptions and complex modelscould produce unreliable resultsand be difficult to implement dueto data and systems constraints.

A major source of contention hasbeen the recognition of renewalpremiums in the fair valuation ofliabilities. One possible approachthat could be taken is to reflectrenewals only to the extent that theoption to pay premiums is valuableto the policyholder. Many insurerswould counter that in realityrenewal is subject to individualcircumstances such as customerloyalty and after-sales service,rather than being based on a purecontractual-based assessment. It would therefore seem reasonablethat any ‘knowledgeable’ estimationof fair value should draw on theexperience and informedexpectations of management, ratherthan rational expectation theory.

Moreover, at a time when somefeel that corporate reputationsincreasingly depend on reasonablystable or at least predictableresults, many insurers areconcerned that the income

volatility that could result from theuse of fair values could underminemarket confidence and increasetheir cost of capital. Many alsoquestion whether the cost andsystems impact of IFRS outweighsits benefits, especially at a timewhen they are faced with so manyother market and regulatorypressures. Insurers’ misgivings arecompounded by what many see asthe absence of a level playing fieldthat has allowed banks to evade(at least for now) fair valuation formuch of their business.

The IASB is now facingincreasingly coordinated anddetermined lobbying from leadinginsurers. Letters addressed to theIASB regarding Phase One havehighlighted continuing concernfrom some industry sectors aboutthe lack of guidance on contractclassification, liabilitymeasurement and the potential forunstable results arising from

inconsistency in measurement ofassets and liabilities. Fair valuationhas attracted vehement oppositionfrom many powerful voices withinthe US insurance industry,including the American Council ofLife Insurance (ACLI), whichbelieves that it ‘could create havocin the financial statements of lifeinsurers’. The ACLI’s alternativeproposal favors the use of anamortized cost liability model toavoid unexplainable volatility dueto asset/liability mismatches andinconsistent measurement of assetsand liabilities.

On the other hand, some industryassociations including those fromthe UK and Canada haveencouraged the IASB’s efforts. In part, this reflects theirfamiliarity with prospectivevaluation methods, which wouldmake the conceptual move to fairvalue more straightforward. They anticipate that investors willcome to recognize that earningsvolatility reflects inherent marketmovements rather thancompetitive weakness. They haveexpressed the view thattransparent performancemeasurement will do much todecrease the concerns expressed.In the long run, they believe thatinvestors will reward improvedrisk analysis and greatertransparency with a lower cost of capital. Nevertheless, thereremain significant concernsregarding the timescale provided,the consultation process and somekey technical methodology issues.

In the Asia-Pacific region,Australia’s broad support for fairvalue contrasts with the Japaneselife industry’s continued preferencefor deferral-and-matching, much



Net result of new business XX

Net result of existing business:

Experience variances & changes in future cashflow assumptions XX Emergence of Market Value Margins XX Additional investment return on Technical Provisions XX Change in Discount Rates XX

Sub-total net result of existing business XX

Long-term investment return on shareholder funds XX

Operating result XX

Balance of return on invested assets XX

Changes in economic assumptions XX

Exceptional items XX

Profit before tax XX

Possible Income Statement FormatFIGURE 4

of which stems from their in-the-money interest guarantees inmany of their contracts.

In addition, as we mentioned inour last article on this subject(Insurance Digest, February 2003),the goal of convergence betweenIFRS and US GAAP around acommon fair value model isedging closer, having won thesupport, in principle at least, ofthe Securities and ExchangeCommission (SEC) and theFinancial Accounting StandardsBoard (FASB). Some believe thatfull harmonization could beachieved by the end of thedecade. All but one of our analystpanel support plans to develop asingle global standard based onfair value.

Cautious support:The analysts’ perspective

The responses from our panel ofanalysts reveal growing supportfor the principles of IFRS,tempered by some concerns aboutthe way the IASB is handling the project.

Awareness of the implications ofIFRS among industry analysts hasincreased over the past year. Atthe 2002 seminar, only a coupleof the analysts declared any morethan moderate knowledge of theIASB’s proposals. In contrast, three-quarters now say they ‘understandthe proposals for Phase One’.

Many of the overall reservationsabout IFRS expressed at the 2002seminar have been eased. Aroundthree-quarters of the analystsbelieve that ‘financial reporting byinsurers will improve marginallyor considerably as a result of thePhase One proposals’ (see Figure 5).

Although the endorsement is farfrom wholehearted, the interimsolution could help to overcomesome of the dissatisfaction withcurrent insurer disclosure, as two-thirds believe it is ‘poor’ or ‘verypoor’. Looking forward to thefinalized IFRS, all but one of theanalysts feel that ‘the introductionof the Phase Two proposals willimprove the financialmanagement of insurancecompanies’ (see Figure 6).

Among the key issues raised at the2002 seminar were concernsabout the validity and credibilityof IFRS disclosure, especially asany projections would be moredifficult to audit than today’s‘historic’ accounts. Suchmisgivings have not been entirelyovercome, with half of the analystpanel agreeing that ‘there are toomany assumptions in the PhaseTwo proposals and that this willlead to increased manipulation of results’.

When asked what additionaldisclosures would be most useful,30% of the analyst panel chose‘new business profitability’ and40% selected the ‘solvencyposition under stress scenarios’,the first of which featuresprominently in the proposed IFRSdisclosure standards (see Figure 7).Significantly, support forembedded value (EV) appeared tobe far less marked than at lastyear’s event, where most analystsidentified EV as their preferred,and for many the most‘economically realistic’, method of accounting.

Opinions of the IASB werecontrasting, with around two-thirds saying that ‘considering the



Improve considerably

Improve marginally

Stay about the same

Deteriorate marginally

Deteriorate significantly

11%

62%

16%

11%

0%

Analyst survey results: As a result of the Phase One proposals do you think that financial reporting by insurers will:

FIGURE 5

Improve

Stay the same

Deteriorate

94%

6%

0%

Do you think that as a result of the introduction of the Phase Twoproposals the financial management of insurance companies will:

FIGURE 6

Embedded values

New business profitability

Risk-based capital requirements

Solvency position under stress scenarios

15%

30%

15%

40%

Analyst survey results: What additional disclosures would be most useful?

FIGURE 7

developments that have takenplace’, their ‘opinion of the IASBhas deteriorated’ over the pastyear (see Figure 8). There clearlyneeds to be more dialoguebetween the Board and the analystcommunity to ensure that IFRS forinsurance meets the needs ofanalysts, investors and otherprimary users of accounts.

Conclusion:Countdown to IFRS

IFRS is coming up fast, particularlyfor European companies and theirsubsidiaries. While the details ofthe interim solution for insurancestill need to be ironed out, key changes, including therequirement to mark financialinstruments to market from 2005,will have a fundamental impact onthe way returns for thesecompanies are measured andpresented. Phase Two results willlikely affect all insurers even more.

Insurers need to begin to explainto analysts and investors howthese changes could affect theirresults, including any incomevolatility or asset/liability

mismatches. Indeed, they need tounderstand these effectsthemselves. None of our analystpanel felt that insurers areproviding them with ‘appropriatefeedback on the impact of the newaccounting standards’. This lack ofcommunication could underminemarket confidence and put furtherpressure on equity values.

The IASB’s decision to delayimplementation of the full IFRS forinsurance has helped to allay fearsabout what many saw as animpossibly tight timetable forconversion and gives the Boardmore time to reach a consensuswith insurers and the users of their accounts.

As awareness of IFRS increases,many analysts are coming roundto the asset-and-liability approach,believing that it can improvefinancial management and offer a more realistic reflection of theeconomic realities of the business.However, key aspects of theproposals being discussed and theassumptions underpinning themremain deeply contentious.

The Board needs to look carefullyat how to overcome continuingconcerns about the clarity,cohesion, usefulness andpracticality of its proposals.

Appendix – IFRS for insurance:Key points

• Insurance Contracts: IFRS willaffect all aspects of insurancethrough a new commondefinition for life, general andreinsurance contracts. Contractscarrying ‘significant’ insurancerisk qualify as insurance;

• Reserves: The IASB advocates a move away from ‘deferral-and-matching’ for insurancecontracts in favor of theprospective (‘fair-value’)liabilities;

• Volatility: Fair value will affectthe reported profitability ofcertain policies and thebusiness as a whole, especiallythe potential for volatility and earnings surprises whereinitial estimates aren’t met andwhere assets and liabilitiesaren’t matched;

• Guarantees: The value ofguarantees and options will beespecially susceptible to marketfluctuations and asset/liabilitymismatches under fair value;

• Products: Insurers may need tore-engineer certain products toreflect changes in reportedreturns under fair value,especially in the absence ofDAC and the assumption of renewal;

• Solvency: By better reflectingthe economic reality ofrisk/reward, prospective

realistic reserves will impactcapital management;

• Systems: IFRS will demandmore sophisticated systems andanalytical capabilities thangenerally available today,including stochastic modelingto forecast projected claimspayments under a wide rangeof different scenarios; and

• M&A: Companies are alreadylooking to sell businesses thatwill record diminished or morevolatile returns under an IFRSbasis, particularly those holdinga high number of potentiallyuneconomic guarantees.



37%

63%

Improved? Deteriorated?

Over the last year and considering the developments that have taken place, has your opinion of the IASB:

FIGURE 8



AUTHORS

Marie BravermanPartner, Audit Business andAdvisory ServicesTel: 1 212 314 [email protected]

Sam GuttermanDirector, Actuarial and InsuranceManagement Solutions, ChicagoTel: 1 312 298 [email protected]

The Canadian insurance market

AUTHORS: BILL BAWDEN AND IRMA FREESE


The Canadian insurance market has experienced rapid change in recentyears: the life insurance market has undergone a period of demutualizationand both the general and life insurance sectors have seen significantconsolidation. Competition in the mature insurance market has compelledthe large Canadian life insurers to increase their focus on global operations.

Until the early 1990s, the Canadianinsurance market operated in arelatively stable businessenvironment, benefiting from astable economy and favorableinvestment trends. In recent years,however, it has experienced aperiod of unprecedentedtransformation typified by rapidchange and heavy competition.Changes in legislation,consolidation and restructuring ofthe industry have meant insurershave had to overcome steeplearning curves and uncertainty;but their actions have positionedCanadian life insurers to become a well-kept secret of the country’sfinancial services exports.

In Canada, the industry isstructured very differently betweenthe life and the property andcasualty sectors: whereas the lifeinsurance industry is dominated byCanadian companies, the majorplayers in the property and casualtyarena are subsidiaries of foreignfinancial conglomerates.

Strong domestic life insurancemarket has spread its wings

On the home front, Canadians arefrequent users of life insuranceproducts. According to theCanadian Life and Health InsuranceAssociation (CLHIA), approximately22 million Canadians and theirdependents use some form of lifeinsurance – this covers over 80% ofCanadian households. The totalvalue of life insurance held byCanadians is over CAN$2 trillion,

almost double the amount held in1990. With an ageing population,retirement products includingannuities and pension plans havenow become the fastest growingareas of life and health insurance.

Canada’s life insurers had totalassets of CAN$340 billion in 2002,making them an important factor inthe financial services industry inCanada, but ranking them thirdbehind banks and the mutual fundindustry. However, the largestCanadian life insurers rival the bigCanadian banks in size whenlooking at assets undermanagement, and a largepercentage of the assets held andmanaged by the life insuranceindustry are long-term. The industryplays an important role in meetingthe financing needs of all levels ofgovernment in Canada by investingin federal, provincial and municipalsecurities. As well, about 115,900Canadians earn their wages fromthe industry. In addition, 62,200independent agents earn at leastpart of their incomes from the lifeand health insurance business.

The tapestry of the Canadian lifeinsurance market

The global trend of mergers andacquisitions in the 1990spermeated Canada as well; thenumber of life insurers operating inthe country declined from 163 in1990 to 120 in 2002. Although to alarge extent this shrinkage was theresult of foreign insurers exiting themature Canadian market, there was

significant merger and acquisitionactivity among Canadiancompanies as well.

Until the late 1990s, the Canadianlife insurance industry wasdominated by mutual companies,owned by their policyholders,which severely restricted theiraccess to readily available capitalnecessary for mergers andacquisitions. This constraint drew a lot of attention in the mid 1990s,when the publicly-owned Great-West Life stepped in to purchaseLondon Life, one of the then top fivelife insurance companies in Canada.

Commencing in 1999, the fourlargest life insurers, Sun Life,Manulife, Canada Life and Clarica,demutualized, transforming theculture of the industry to a publiccompany environment, focusing onthe stringent reporting requirementsdemanded by shareholders andsecurities regulators. Three of thesecompanies listed shares onexchanges outside Canada,including on the NYSE, Londonand certain Asian exchanges.

Because of the long-standingmaturity level of the Canadian lifeindustry, in addition to being veryinnovative in designing anddeveloping products, companieshave looked beyond Canada togenerate growth. Despite the hang-over of the US recession, whichresulted in part from September 11,the US life insurance industryremained remarkably stable

On the home front,Canadians arefrequent users oflife insuranceproducts.

THE CANADIAN INSURANCE MARKET


through 2002. This benefited the Canadian insurance industry,which increasingly has beenmaking inroads into the US and global markets. Historically,Canadian life insurers have hadmajor roles in selected Asianmarkets, and both Sun Life andManulife were among the earlyentrants to the mammoth Chinamarket. The recent Sun LifeCanada’s purchase of US-basedKeyport Life and ManulifeFinancial Corp’s acquisition ofDaihyaku, a Japanese life insurer,signalled the trend of Canadiancompanies widening their globalpresence. As a result, internationaloperations have becomeincreasingly important to Canadianlife insurers, to the extent thatforeign premium income nowaccounts for over half of theindustry’s total premium income.

This diversification, however, may prove to be a double-edgedsword. As the value of theCanadian dollar declined againstthe US dollar in the last few years,foreign exchange gainscontributed to profits for Canadianinsurers. Recent developments,however, saw the Canadiancurrency strengthen, spawningwarnings from analysts of negativeimpacts on earnings. This potentialimpact must, of course, bebalanced with the growth prospectsof opportunities outside Canada.

A new legislative frameworkintroduced by the Canadiangovernment in June of 2001allowed consolidation of theindustry, with the exception of thelargest life insurers, and prohibitingmergers between large insurersand banks. Even before the firstdeadline expired, in December

2001, Sun Life announced theblockbuster acquisition of Clarica;in November 2002, Manulifefollowed with a hostile takeoverbid for Canada Life. This wasshort-circuited by a friendlytakeover of Canada Life by Great-West Life. This leaves theindustry with only three majorplayers, Great-West Life, Sun Life,and Manulife, followed by adistant Maritime Life (owned byJohn Hancock) and the Quebec-based company, Industrial-Alliance. The top three companiesrepresent about 90% of total assetsheld by life insurers.

Getting a share of the shrinking wallet

The Canadian life insuranceindustry is concentrating onprofitability and efficiency toremain competitive in itsincreasingly crowded and maturingmarket. In addition to theincreased merger and acquisitionactivity, companies havediversified their product lines toappeal to the broader financialservices market – incorporatingsecurities, mutual funds andbrokerage services into theiroperations and moving away froma strict focus on traditionalinsurance products; the industryhas for some time been a verymajor factor in the investmentmanagement segment of financialservices. Companies are using anumber of strategies to takeadvantage of productcapitalization: for instance,strategic partnerships oracquisitions – both in Canada and the US.

While the return on equity (ROE)generated by the life insurers’ post-demutualization is significantly

higher than in the early 1990s, it is paramount to keep themomentum to prevent a flight ofcapital. The increase inprofitability is attributable not onlyto improved efficiencies; it canalso be credited to the continuingpopularity of insurers’ products,particularly wealth managementand retirement products.Achieving and maintainingtargeted levels of ROE is a majorpriority of the industry.

Product developments

As all financial institutions wrestlewith deregulation, traditionalinsurers are pitted against banks,mutual funds and brokerage firms,which offer insurance andinvestment products through theirdistribution networks, even thoughthey are generally not permitted tobecome directly involved in theretailing of insurance through theirbranches. To meet this challenge,life insurance companies havebecome more aggressive indeveloping and marketing newproducts, primarily interest-sensitive products.

The social fabric of Canada, whichhas a publicly funded health caresystem that covers basic physicianand hospital services, shapes theproduct offerings in the healthindustry. In spite of this, life andhealth insurers play an importantrole by providing ‘supplementary’health services that are not coveredunder government programs, oftenthrough employer plans. By thesame token, the ‘critical illness’insurance product, that has been avery successful blockbuster in otherjurisdictions, took off at a muchslower rate, as social programs inCanada temper exposure toeconomic hardship from illness.

In the late 1990s, the staid oldsegregated funds (called ‘separateaccounts’ in the US), which hadbeen in existence for over thirtyyears and were largely used bypension funds, were injected withnew life by offering fund-on-fundinvestments and improvedguarantees. These innovativeproduct developments caught theinterest of the yield-conscious, butrisk-averse, baby-boom investors,to the extent that segregated fundsmake up an increasingly greaterproportion of the industry’s totalassets. At year-end 2002, theyrepresented 35% of the life andhealth insurers’ total assets, upfrom 25% in 1996.

P&C Insurance

With registered sales of almost$25 billion in 2002, andcontrolling assets of about $68billion, the property and casualtyindustry is a major part of thesocial and economic fabric ofCanada. It provides employmentfor about 100,000 people,including independent brokers,adjusters and actuaries.

While certain consolidation hastaken place within the last decade,there are still 230 domestic andforeign companies operating inCanada, with the top companiesbarely reaching a 10% marketshare. While a large number ofcompanies remain, there havebeen significant changes over thelast few years in the companieswith the greatest market share; theglobal merger and restructuringactivities in the property andcasualty industry have had a directimpact on the Canadian industry.

In some provinces, access to theautomobile market is limited for

THE CANADIAN INSURANCE MARKET continued


private insurers, since thecompulsory component of autoinsurance is provided exclusivelyby government-owned autoinsurers in the provinces of BritishColumbia, Saskatchewan andManitoba. A government-ownedinsurer provides the bodily-injuryportion of automobile insurance inthe province of Quebec.

The financial returns in thisindustry have been verydisappointing over the last fewyears, falling from anunsatisfactory 3.1% ROE in 2001to an abysmal 1.6% in 2002. Thiswas triggered by the decline ininvestment returns and was onlymildly mitigated by a slightimprovement in the combinedratio to 105.8% in 2002 from110.4% in 2001. The decline inprofitability is principallyattributable to considerable claimsgrowth, particularly in automobileinsurance, and varies significantlyby province or market areas.

Regulatory framework

Regulation of Canada’s insuranceindustry is shared between thefederal and provincialgovernments. With respect toprudential regulation, the federalgovernment, through the Office ofthe Superintendent of FinancialInstitutions (OSFI), supervises thefederally incorporated firms and isconcerned primarily with thesolvency and stability of insurancecompanies. Provincial authoritiespredominate in the supervision ofthe terms and conditions ofinsurance contracts and thelicensing of companies, agents,brokers and adjusters.

To ensure financial soundness,OSFI requires insurers to regularly

file capital adequacy measures,which calculate the minimumcapital and surplus required by acompany, adjusted for risk factorsof the business and itsinvestments. In addition, a‘Dynamic Capital AdequacyTesting’ (DCAT) report must alsobe filed with OSFI every year.DCAT is a formal approach to testthe financial strength of acompany by projecting its futurefinancial condition under variouspossible sets of adverse scenarios;it enables the systematicquantification of the majorbusiness risks faced by aninsurance company.

Both the life and the property andcasualty industries fund their ownpolicyholder protection schemes,which guarantee contractliabilities up to certain limits inthe case of an insurer’s insolvency.

Financial reporting

Canadian insurers benefit from an excellent relationship betweenregulators, professional bodies andthe industry. In a collaborativeeffort, OSFI, the Canadian Instituteof Actuaries, the CanadianInstitute of Chartered Accountantsand the life industry developedinsurance GAAP, which since1992 has been the basis for bothpublic financial statements andregulatory financial reporting.Certain unique aspects of theCanadian life insuranceaccounting model include the‘moving average market method’for portfolio investments,accounting for annuity premiumsas revenue, and the CanadianAsset Liability Method foractuarial valuations. With theconversion to public companystatus, financial disclosure has

much improved, including thenow common disclosure ofembedded value and earnings bysource. Effective for 2003, propertyand casualty companies arerequired to discount claim reservesin their financial statements.

IASB and SOX

The International AccountingStandards Board (IASB) continuesto work towards its goal ofdeveloping an internationalfinancial reporting standard forinsurance contracts. The inherentfair value concepts proposed inthe IASB methodology are notnew to Canadian life insurers, but there are some significantdifferences. The Canadian AssetLiability valuation method linksthe asset and liability cash flows,whereas the proposedmethodology values assetsseparately from liabilities. A second difference is thevaluation of investment-typecontracts, which are notcategorized as insurance contractsunder IAS. For P&C insurers, thebiggest adjustment will be theproposed valuation of investments.

Canadian life insurers that arelisted directly on US exchangesare finding themselves caught inthe quagmire of interpreting thenew Sarbanes-Oxley (SOX)legislation. Many more Canadiansubsidiaries of US listed insurancecompanies may also be directlyimpacted. Management ofcompanies not listed may alsovoluntarily choose to adopt certainprovisions of SOX; as well, theCanadian professional bodies andsecurities regulators aredeveloping Canadian requirementsand expectations in the area ofgovernance and accountability.



Canadian insurersbenefit from anexcellentrelationshipbetween regulators,professional bodiesand the industry.

Future challenges

Like other financial servicessectors, within Canada and aroundthe world, both the life and theP&C industry face significantchallenges in the future.

Life industry

Consolidation: The recent mergerand acquisition activities leave themarket very concentrated, withminimal opportunity for desirabletargets within Canada. Thisrequires companies to look eitheroutside the country or outside theinsurance sector. The Canadiangovernment is on record to ‘notfavor’ an insurance-bankconglomerate, which leaves onlythe option of a non-Canadianpurchase. All the large life insurershave a great deal of experience inthis area, and a strengtheningCanadian dollar might wellprovide an excellent opportunity.

Demographic shift: A rapidlyaging population, and the risingcost of health care, willundoubtedly mark a subtle shifttowards private health insurers,

giving life insurers the chance todevelop innovative products forthis expanding market.

Technology: Electronic businesshas created new ways for insurersto deepen their product andservice relationships with theircustomers. For some companies,the lower profit margins andincreased demand for returns to shareholders has necessitatedbeing more efficient in gettingtheir products to customers.However, the recent increasedspending on technology will need to be tempered with a well-attuned eye to the actualreturn on investment.

P&C Industry Issues

Return to profitability: TheCanadian P&C industry must beable to generate reasonable ratesof return in the long term toremain viable. While someindicators show a move to a‘harder’ market, both containmentof claims and improvinginvestment returns are necessaryto avoid a flight of capital from the market.

Increased risk of naturalcatastrophes: The increasedfrequency and severity of naturaldisasters is a key issue of concern,as witnessed by the unprecedentedice storm in Quebec and Ontarioin 1998. The main factors leadingto cost escalation are: growingpopulation, increasingurbanization and climate change.Insurers must employ superiorunderwriting modeling todetermine proper pricing for eachrisk, including possible incentivesfor disaster prevention programs.

In their effort to continue toremain important mainstays of theCanadian financial services sector,both the life insurance and theP&C insurance industry must benimble and innovative inanticipating and dealing with themany challenges, both present and future.



AUTHORS

Bill BawdenPartner, Insurance Practice Leader, CanadaTel: 1 416 947 [email protected]

Irma FreeseDirector, Insurance Assurance and BusinessAdvisory ServicesTel: 1 416 365 [email protected]



Managing risks along the path to technology-driven business transformation

AUTHORS: MARK KEELEY AND CHERYL FLETTERICK


Insurance companies should continue to embrace technology-drivenbusiness change, recognizing that new technology should enable newbusiness models and more efficient and effective business processes. But make sure that there is a holistic risk management strategy supportingthese initiatives. Risk management is an integral component of businesstransformation enabled by new and emerging technologies.

Have faith in the benefits of technology

For many insurance companies, the implementation of new andemerging technologies proved to be more challenging thananticipated, because managementwas not prepared to embrace thecultural and business processchanges necessary to transform itsoperations in a meaningful way. As a result, some insurersdeveloped a cynical attitude andbegan to question whether or notcontinued investment ininformation technology wouldcreate long-term value, particularlyin an environment that wascharacterized by economicuncertainty and volatility. Our morerecent experience shows that thisattitude is beginning to change.

Many of our large insurance clientshave begun to move forward inimplementing new technology suchas enterprise resource planningsystems. They have faith in thebenefits that new and emergingtechnology can deliver. The rewardsof a successful technology strategyinclude stronger customer andagent relationships, marketleadership, streamlined and morecost effective business processes,new products and services, andaccess to new markets. Forexample, technology can be usedto automate existing manualprocesses, which will reducetransaction costs and allowemployees to focus on value added

tasks. Additionally, technology canenable insurers to capture betterinformation about their customersand thereby provide a moreresponsive and personalized service.This, in turn, should translate intobetter customer retention andincreased sales opportunities.

Realizing the benefits oftechnology-driven businesstransformation will require thatinsurers not only make targetedinvestments in new technologies,but also maximize the potential ofexisting investments. The first stepin this process is to develop acomprehensive risk managementstrategy that will allow insurers toidentify the areas where theyshould focus their attention, i.e.,the risks that threaten thecompany’s ability to recognize thebusiness benefits that result fromtechnology-driven business change.

Recognize that risk managementis even more necessary today

Although the concept of trust is stillevolving in the digital economy, it will clearly play an instrumentalrole in the success of newtechnology initiatives. Issues of trusthave always been paramount in theinsurance industry, as customersrely upon companies to objectivelyevaluate claims and safeguardconfidential information, amongother things. Fundamentally, an insurance company builds trust by effectively managing risk.The insurer establishes an

infrastructure of policies, proceduresand controls to help ensure that itsbusiness transactions not onlyconform to corporate strategy and regulatory requirements but also meet and exceed itscustomers’ expectations.

As insurers implement onlineoperations to solicit new business,underwrite applications andprocess claims, effective riskmanagement becomes even moreimportant in preserving customers’trust. Research shows that asignificant number of individualconsumers are predisposed todistrust the security of onlinetransactions, particularly when theyinvolve financial servicescompanies. A single mistake on thepart of an insurer has the potentialto destroy the goodwill it may have spent years developing with its customers.

Manage the full spectrum of risks

1. Understand the completespectrum of risk

The first step in an effective riskmanagement strategy is to identifythe complete spectrum of risks thatare relevant to a company, andthen develop a framework toorganize them so that they can bemore easily addressed. An exampleof a risk management framework ispresented in table 1 overleaf.1

Many of our largeinsurance clientshave begun tomove forward inimplementing newtechnology.

MANAGING RISKS ALONG THE PATH TO TECHNOLOGY-DRIVEN BUSINESS TRANSFORMATION


1 This framework is called emm@. It was jointly developed by PricewaterhouseCoopers and Carnegie Mellon University.

Using this or a similar type offramework minimizes thepossibility that an insurer will failto identify and consider keybusiness risks. In addition, the framework makes it easier foran insurer to assess its risk profileon an ongoing basis and, whereappropriate, implement new riskmanagement strategies.

As technological initiativesprogress, different risks candevelop and the importance of recognizing and addressingthem in a timely fashion cannot be ignored. For example, if aninsurance company’s initial use of its website is to simply provideinformation to the public, its riskprofile is relatively low, and itsprimary concern would be to

ensure that the information isaccurate and updated on a timelybasis. However, once the insurerimplements functionality thatallows users to purchase productsfrom its website or submit claims,it needs to consider the risksassociated with maintaining thesecurity of any informationtransmitted in order to preventunauthorized transactions.

2. Identify the value at risk

The next step in the riskmanagement process is to identifythe value at risk. This meansassigning a specific dollar value of worth to a company’s assets. If the assets are stolen ordestroyed, what is the dollar valueof the loss? An insurer’s assetsconsist not only of physicalpossessions but also intangibles,which may include such things as strategic plans, brand namesand trademarks, customer lists and proprietary software.

Due to the inherent difficulty of identifying and evaluatingintangible assets, many insurershave not taken steps to identifytheir value at risk. Today, the stocks of most insurancecompanies trade above theirtangible book values, which is an indication of the premium that investors place on intangibleassets. By conducting anappropriate analysis of theseassets, an insurer can help ensurethat the market values themappropriately and then determinesthe steps it should take,particularly with respect to itstechnological initiatives, to createadditional long-term value.

3. Manage the risk

After determining the value of the assets at risk, an insurer is in a better position to manage it. Does the insurer choose to ignoreit, mitigate it by implementingcontrols, or transfer it? Forexample, an insurer might want to mitigate its risk by investing indata encryption controls to protectcustomer data received via theInternet in order to comply withindustry regulations.

MANAGING RISKS ALONG THE PATH TO TECHNOLOGY-DRIVEN BUSINESS TRANSFORMATION continued


Table 1: The Nine Categories of Risk

The Nine Domains Included in the domain are the following:

1. Strategy Strategic capabilities, including setting strategic direction,analyzing competitors and leveraging information technology

2. Organization and Competencies Organization and competency capabilities, including whether an insurer has the required skills, competencies and relationshipmanagement processes

3. Performance Management Performance management capabilities, including how an insurerplans, measures, monitors and controls the performance of itstechnology and business change capabilities and functions

4. Delivery and Operations Delivery and operations capabilities, including those affecting the day-to-day operations, such as on-line content creation andmanagement, risk management, financial cost management and project management

5. Value Network Processes Value network processes capabilities, including those affecting theprimary value chain processes, such as customer interaction andproduct delivery systems

6. Security and Privacy Security capabilities, including confidentiality, integrity andavailabiliy and privacy capabilities, including the protection of consumer information and proper disclosure of data handling practices

7. Systems and Technology Systems and technology capabilities, including customer supporttechnologies and new data exchange technologies, such as XMLand XBRL

8. Tax Tax capabilities, including an insurer’s ability to maximize taxbenefits stemming from the implementation of new technologiesand minimize its tax exposure

9. Legal Legal capabilities, including whether an insurer knows its rights,obligations, and potential liabilities as it becomes a global presence

Non-compliance with such lawscould result in monetary fines andput the insurer’s reputation at risk.

Another example would bemanaging the risk of downtime fora key business system. In order tomitigate the impact of a keybusiness system being unavailable,an insurer could install aredundant computer system. An insurer might consider this tobe a worthwhile investment if it iscritical that the system needs to beavailable 24 hours a day, sevendays a week. On the other hand, if it is not critical, the insurercould transfer the risk ofdowntime. It could purchase, forexample, insurance that covers thevalue of transactions lost due to asystem failure. Again, cost/benefitanalysis is key. The cost of theinsurance policy should be equalto, or less than, the value of whatis at risk.

Especially in the financial servicesenvironment, be sure to considerthe value of the insurer’sreputation in the equation. We made the point earlier that ifan insurer fails to earn the trust ofits constituents, its reputation willsuffer. The impact may very wellbe financial. With so manyinsurance providers to consider,how many customers willpurchase products from an insurerwith a tarnished reputation?Remember that trust is key to thesuccess of a digital business model.

Used correctly, controls are apowerful risk management tool:

• Controls empower people –they specify how people canaccomplish what needs to bedone; and

• The success of controlsdepends on a positive riskculture. A simple set ofprocedures can make anenormous difference to aninsurance company if peopletake personal responsibility for upholding them.

Controls can be managementcontrols or technical controls.Management controls are basedon people, policies andprocedures. On the other hand,technical controls areaccomplished by implementing an IT solution. The purpose ofboth management and technicalcontrols can be classified asprevention, detection, recovery or avoidance. At the fundamentallevel, controls help insurers ensurethe authentication, integrity,confidentiality, auditability and non-repudiation of electronic transactions.

When establishing and evaluatingcontrols, insurers should leveragethe COSO Framework. This framework defines thecomponents of controls, internalcontrol objectives and the units or activities of an organisation to which internal control relates.The COSO Framework isparticularly valuable to thoseinsurers required to meet theSarbanes-Oxley requirements, as it can guide management in theirassessment of internal controls andprocedures for financial reporting.

Embrace change to realizebusiness benefits

Insurance companies shouldcontinue to embrace technology-driven business change,recognizing that new technologyshould enable new business

models and more efficient andeffective business processes. This translates into significantchanges in operations that shouldnot be underestimated.

Focus on the initiatives that aremost likely to reduce transaction

costs and offer new revenueopportunities, but make sure thatthere is a holistic risk managementstrategy supporting theseinitiatives. Risk management is anintegral component of businesstransformation enabled by newand emerging technologies.


MANAGING RISKS ALONG THE PATH TO TECHNOLOGY-DRIVEN BUSINESS TRANSFORMATION continued

AUTHORS

Mark KeeleyPartner, Global Risk Management SolutionsTel: 1 860 241 [email protected]

Cheryl FletterickManager, Global Risk Management SolutionsTel: 1 415 498 [email protected]

The insurance market in Japan

AUTHORS: STEPHEN T. O’HEARN AND MICHAEL S. JOHNSON


Over a decade of economic stagnation is causing a shakeout of theJapanese insurance industry. What does this mean for Japanese insurers andhow can international companies leverage opportunities as they open up?In this article we discuss the current state of play for both domestic andinternational players as they jostle for competitive position in the largestinsurance market in Asia.

Introduction

The Japanese insurance market isexperiencing its greatest turmoil inthe last 50 years. The prolongedeconomic recession, an ultra lowinterest rate environment anddepressed equity markets havecombined to create an extremelychallenging environment forinsurers. Out of this turmoil,attractive opportunities have arisenfor enterprising insurers.Acquisitions by foreign life insurersand consolidation within thedomestic non-life sector is quicklychanging the face of the Japaneseinsurance industry.

Economic realities

The bursting of the real estate andstock market bubble in 1990 stillhangs heavy over the Japaneseeconomy in 2003. Banks andinsurance companies still havelarge portfolios of bad loans andunderwater real estate buried intheir balance sheets awaitingresolution. The JapaneseGovernment continues to runmassive budget deficits in desperateattempts to stimulate economicgrowth. In recent periods, theGovernment has aimed to stabilizethe financial system by flooding themarkets with money; 10-yearGovernment bonds are currentlypricing less than 1.0% marketyield. Both Japanese life and non-life insurers generally did not matchthe duration of assets and liabilitiesin the 1980s. With life insuranceproducts and non-life maturitysavings contracts often

guaranteeing credit rates of up to6%, due to asset deflation in the1990s, subsequent record lowinterest rates and the Japanese stockmarket currently at 20-year lows,many insurers have a substantialnegative spread. That negativespread has eroded solvency and ledto six life insurer bankruptcies andone non-life insurer bankruptcy inthe last three years.

Market scale

Despite this tale of economic woe,the Japanese insurance marketremains the second largest marketin the world, after the UnitedStates, nearly as large as the UK,French and German insurancemarkets combined (see Figure 1)1.This market size arises from thehistorical dominance of insurance

companies as a savings mechanismin the Japanese economy and, untilrecently, the lack of credible savingsalternatives to insurers and banks.Japanese insurers, with the benefit ofhigh entry barriers until the 1990s,have attained an entrenched positionof dominance (see Figures 2 and 3overleaf). Only now are foreigninsurers beginning to challenge thatposition of dominance in the lifeinsurance market.

But official Japanese statistics onindividual company rankings donot reveal all. A key competitor toinsurers and banks is the JapanesePostal Life Insurance Service(Kampo). With over 23,000branches that sell insurance andsavings products over the counter,there is a huge sales force making

‘... the Japaneseinsurance marketremains the secondlargest market inthe world...’

THE INSURANCE MARKET IN JAPAN


Prem

ium

s (U

SD m

)

0

200,000

400,000

600,000

800,000

1,000,000

FranceUnited States

Japan United Kingdom

Germany

Life and non-life premium volume by countryFIGURE 1

Source: Swiss Re, Economic Research & Consulting, sigma No. 6/2002

1 Swiss Re, Economic Research & Consulting, sigma No. 6/2002

substantial sales direct to theJapanese consumer. While notsubject to the same regulatoryrequirements and supervision asinsurers, Kampo is effectively thelargest life insurer globally withover 2.7 times the assets andpremium volume of its largestJapanese competitor, Nippon Life.Kampo total assets and premiumincome are a truly staggering

126.7 trillion yen (US$1,055.7billion) and 15.2 trillion yen(US$126.7 billion), respectively.2

The Japanese insurer – A new world

For over 40 years, the Japaneseinsurance industry recorded stronggrowth aided substantially by theconservatism of the Japaneseconsumer, their propensity for a

high savings rate and theconsiderable regulatory controlconstricting competition, inparticular, use of the ‘convoy’system, where all marketparticipants evolved along parallellines. The obvious result was thatmost insurers sold a limited arrayof traditional product offeringsthrough identical agentdistribution channels at the sameprice. The absence of alternativesfor risk or savings needs leftconsumers with few options.Generations of Japanese insurancemanagement were comfortablemaintaining the status quo ratherthan being subject to the raw edgeof true competition.

Distribution networks still reflectthis long period of regulatedstability. The majority of insurancesales today still come from so-called ‘sales ladies’. After WorldWar II, the lack of available menled insurers to hire housewiveswith minimal training to sell life

insurance products around theirlocal communities to friends andfamilies. While obviously successfulif viewed in terms of insurancepenetration (see Figure 4), the approach is costly andinefficient as premiums per saleslady are low and turnover is high.

It was with this backdrop ofmarket protection that a series ofreforms were introduced by theJapanese Government beginningin the mid 1990s aimed atprogressively opening up theinsurance sector to the marketforces of competition. Forexample, insurance premiumratings and agent commissionstructures were deregulated; theFinancial Services Agency hasemerged as a more active regulator,working to clean up past practicesand ensure consistent regulationthroughout the industry; sale ofinvestment-type products throughbank channels is now permitted;and the ‘third sector market’

THE INSURANCE MARKET IN JAPAN continued


20% Tokio Marine

17% Mitsui Sumitomo

17% Sompo11% Aioi

10% Nippon Koa

5% Nichido

4% Fuji

4% Nissay Dowa

12% Other

Total premiums 6.97 trillion yen (US$58.1 billion)

Non-life insurance marketFIGURE 2

Source: Statistics of Non-Life Insurance in Japan, Fiscal Year ending March 31, 2002

22% Nippon Life

15% Dai-ichi Life

11% Sumitomo Life9% Meiji Life

5% Yasuda Life

4% Asahi Life

4% Daido Life

4% Mitsui Life

26% Other

Total premiums 26.2 trillion yen (US$218.2 billion)

Life insurance marketFIGURE 3

Source: Statistics of Life Insurance in Japan, Fiscal Year ending March 31, 2002

Dir

ect p

rem

ium

s as

a %

of G

DP

0

2

4

6

8

10

12

%

FranceUnited States

Japan United Kingdom

Germany Italy Spain

Non-life

Life

Insurance market penetrationFIGURE 4

Source: Swiss Re, Economic Research & Consulting, sigma No. 6/2002

2 Postal Life Insurance Service, Annual Report 2002

(medical, cancer, accident & healthproducts), previously solely thedomain of foreign insurers, is nowopen to Japanese insurers.

These reforms have challengedmany Japanese insurers, previouslysheltered by restrictive practicesand unaccustomed to rapidchange, who are now exposed tothe need to rapidly adapt to fiercecompetition at a time whenfinancial strength is slipping.

Foreign insurer opportunities

As the second largest insurancemarket globally, manyinternational insurers have madeJapan an important part of theirglobal ambitions. Some insurers,like AIG and AFLAC, have been in Japan for decades growing theiroperations. However, with thefinancial weaknesses of the 1990s, a significant influx offoreign insurers has entered thelife insurance market to the pointthat foreign insurers now control13% of the market by premiums,

up from an only 2.5% marketshare just three years previously(see Figure 5). This is a trulyremarkable penetration by foreigninsurers in a huge market in ashort period of time.

Major foreign life insureracquisitions include:

• Artemis purchased the bankruptNissan Mutual and renamed itAoba Life;

• GE Capital purchased thebankrupt Toho Life andrenamed it GE Edison Life;

• AXA purchased Nippon Dantai Life;

• Manulife purchased thebankrupt Daihyaku Mutual Life;

• AIG purchased the bankruptChiyoda Mutual Life;

• Prudential US purchased thebankrupt Kyoei Mutual Life andrenamed it Gibraltar Life;

• Prudential PLC purchasedOrico Life and renamed it PCA Life; and

• GE Edison Life acquired Saison Life.

The acquisition of bankrupt lifeinsurers has typically allowed for arestructuring of insurance contractobligations by cutting futurecrediting rates and/or policyholderbenefits. In addition, certainacquisitions have been aided bycontributions from the Japaneseguaranty fund, the PolicyholdersProtection Corporation. Followingsuch bankruptcy restructuring,these operations havedemonstrated healthy profitabilityunder their new owners, despitethe difficult economic conditions.

At the same time, other foreigninsurers have entered the marketin smaller, more niche-focusedways. Hartford Life and SkandiaLife, for example, have begunoperations to sell investment-

linked life and annuity productsthrough the recently permittedbancassurance channels. Theseproducts represent a significantnew choice to Japaneseconsumers long accustomed toguaranteed interest products.Bringing to bear the support of a well-capitalized parent and well-honed skills in productdesign, notable sales success has been seen through thischannel by a number of foreigninsurers in only a short period.

Innovation continues as certainforeign insurers replicate theirhome-country distributionstrategies of using a lesser numberof highly educated salespersonnel, with generouscompensation schemes linked toperformance, to sell up-marketproducts to up-market consumers.Recent statistics suggest per agentprofitability of these companies isnearly double that of the salesladies still used today by manyJapanese insurers.



Vol

ume

(Yen

bn)

GE Edison Life

ING Life Manulife OtherAFLAC AIG AXA Life

Prudential US

0

100

200

300

400

500

600

700

800

Foreign life insurers Market share

731787

588 585

292

126 124

189

Premiums Foreign life insurers 13%

Local life insurers87% Premiums

(Yen M) 26.2 trillion yen (US$218.2 billion)

Foreign life insurers and market shareFIGURE 5

Source: Statistics of Life Insurance in Japan, Fiscal Year ending March 31, 2002

By comparison, the non-lifeindustry has seen less penetrationfrom foreign insurers. A number offoreign insurers have tried to crackthe non-life market on a start-upbasis, but with tight margins,tough competition fromreasonably well-capitalizeddomestic competitors, the inabilityto rapidly develop an agent-baseddistribution network and the toughinvestment market, the resultshave been mixed. AIG recentlyexpanded its non-life presence by purchasing 22% of Fuji Fire, a publicly listed non-life insurer. Will this set off a foreign insurerrace for non-life acquisitions, as forlife insurance? Only time will tell.

Merger frenzy – A responsemechanism

Deregulation, competitivepressures and financial strainshave all acted as catalysts insetting off a frenzy of merger andacquisition activity. M&A deals inthe last 2 years include:

Mergers

• Millea Group – merger of TokioMarine & Fire and Nichido Fire;

• Nippon Koa Group – merger ofNippon Fire and Koa Fire;

• Aioi Group – merger of Dai-Tokyo Fire and Chiyoda Fire;

• Mitsui Sumitomo – merger of Sumitomo Marine and Mitsui Marine;

• Nissay Dowa – merger ofNissay General Insurance andDowa Fire & Marine;

• Sompo Japan – merger ofNissan Fire and Yasuda Fire; and

• Daido Life demutualized andentered into a business alliancewith Taiyo Life.

Acquisitions

• Yamato Life acquired thebankrupt Taisho Life andrenamed it Azami Life; and

• Daido Life and Taiyo Lifeacquired the bankrupt TokyoMutual Life.

It is interesting to note that themajority of domestic mergeractivity has occurred in the non-life industry. The weakenedfinancial state of domestic lifeinsurers has inhibited the domesticacquisition of bankrupt life insurersthereby leaving an open door forthe foreign life competitors.

More subtle, but still expected tohave an impact, is the series ofalliances and affiliations beingentered into between non-life andlife insurers, both foreign anddomestic, to cross-sell each others’products. For example, Dai-ichiMutual Life has entered into cross-sales alliance agreements withSompo Japan and AFLAC. Suchalliances are two-way, allowingaccess to broader distributionnetworks and in return allowingthe distribution network tobroaden product offerings.

Prospects – Where to now?

For much of the industry –domestic and foreign – there willbe a need to digest the recentacquisitions and mergers to bestextract results.

Future prospects for the marketwill be contingent on thefollowing drivers and how theyevolve over time:

• Consolidation of both the lifeand non-life sectors will likelycontinue. Potential acquisitiontargets remain available,although the global downturnmay hinder the resources ofacquisitive foreign insurers;

• Investment market recovery is unlikely if the economycontinues to stagnate.Investment in foreign markets,with hedges on foreignexchange risk, is increasinglyseen as a means to partiallyaddress the challengingdomestic investment market;

• Life insurers will continue tostruggle with negative spreadand solvency erosion if theinvestment markets do notrecover, with furtherbankruptcies consideredpossible. The life insuranceindustry’s portion of thePolicyholder ProtectionCorporation was recently increased;

• The recession has seen anincreased tendency ofconsumers to save more. Adding to this the rapidly agingdemographics of Japanese

society, it is expected by mostinsurers that the need for lifeinsurance products willcontinue to increase;

• Competition in the non-lifeindustry is expected to remain intense; and

• Bancassurance channelpenetration should continue to increase with the shift inbusiness away from thetraditional sales agents. Newinvestment-style products will beincreasingly sold through bankchannels. Inevitably, distributionwill broaden towards multiplechannels as the market evolves.

While it is not certain how thesedrivers will unfold over time, wecan say with confidence that theJapan insurance market will remainhighly competitive and operationallychallenging for all participants.Potentially, the rewards are great,reflecting the risk of operating in thismarket. For all companies, successwill only result from execution ofa finely honed strategy, skilledpeople, good product anddistribution knowledge and thecapital resources to endure in atough economic environment.



AUTHORS

Stephen T. O’HearnPartner, Japan Insurance LeaderTel: 81 3 5532 [email protected]

Michael S. JohnsonSenior Manager, Audit Business & AdvisoryServices, Tokyo JapanTel: 81 3 5532 [email protected]



Further information

INSURANCE DIGEST

For further information about PricewaterhouseCoopers Americas Insurance Group, please call your usual contact atPricewaterhouseCoopers or one of the following:

GLOBAL INSURANCE GROUP

John S. ScheidGlobal Insurance Assurance and Business Advisory Services Leader and Chairman, Americas Insurance GroupTel: 1 646 471 5350 E-mail: [email protected]

BERMUDA

Richard PatchingJoint Bermuda Insurance LeaderTel: 1 441 299 7131 E-mail: [email protected]

CANADA

Bill BawdenCanadian Insurance LeaderTel: 1 416 947 8970 E-mail: [email protected]

SOUTH AMERICA

Leslie HemerySouth Americas Insurance LeaderTel: 56 2 940 0065 E-mail: [email protected]

US INSURANCE GROUP

James ScanlanUS Insurance Leader, Philadelphia, PATel: 1 267 330 2110 E-mail: [email protected]

J. Timothy KellyTax and Legal Services, New York, NYTel: 1 646 471 8184 E-mail: [email protected]

Michael MarkmanFinancial Advisory Services, Chicago, ILTel: 1 312 298 2858 E-mail: [email protected]

Paul L HorganGlobal Risk Management Solutions, New York, NYTel: 1 646 471 8880 E-mail: [email protected]

Richard I FeinActuarial and Insurance Management Solutions, New York, NYTel: 1 646 471 8150 E-mail: [email protected]

INSURANCE DIGEST

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Jeanne SafferTel: 1 646 471 3799 E-mail [email protected]

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Viki KeenTel: 61 3 8603 6125 E-mail [email protected]

EUROPEAN INSURANCE DIGEST

Áine O’ConnorTel: 44 20 7212 8839 E-mail [email protected]

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