Regulation of Insurance Industry

1
Regulation of Insurance Industry
Tsinghua University School of Economics and
Management
Andrew Sheng Adjunct Professor 13 November 2008
2
The Insurance Industry

• Insurance is an arrangement providing individual
  protection against risk of loss through the
  pooling of risks.
• Two fundamental types-
• General Insurance (property, natural disasters
  etc)
• Life Insurance (health, death, pension or annuity
  based)

3
Difference between banking and insurance risks

• Non-financial risks, such as real perils and
  hazards can be insured - these are idiosyncratic
  or nonsystematic and have low degree of
  correlation
• Financial risks - risks of changes in financial
  condition, but these have high degree of
  correlation - systemic or high aggregation risks.
  
• Mixing banking with insurance risks is dangerous.

4
Objectives of Insurance Regulation

• Insurance and banking both suffer from
  information asymmetry and principal-agent problem
  that give rise to-
• Moral Hazard (hidden action of adverse incentive
  from existence of insurance) that manifests in
  private gain at social or contractual loss
• Adverse selection (hidden information), as
  insurer unable to accurately distinguish between
  risks of good and bad customers
• Both are recognized as part of costs of business,
  either through higher premium or lower insurance
  coverage.

5
Three Key Characteristics of Insurance Industry

• High element of selling costs
• Inversion of production cycle - insurance
  products produced and delivered after they are
  sold or paid for by policyholders
• Unequal relationship between many small retail
  customers and collective action or free-rider
  problem ????,????
• These lead to insufficient capitalization, poor
  underwriting and under-reserving

6
Long-term nature of Insurance creates specific
features of asset-liability management

• Insurance companies can easily enter into
  Ponzi-type scheme by financing losses that take
  time to run-off, by under-reserving for current
  years, thus concealing losses.
• Importance of timing of investments to yield
  long-term total returns to match long-term
  run-off of claims.
• Namely, insurance companies should be
  anti-cyclical long-term investors. However,
  danger of insurance companies being pro-cyclical
  (Plantin and Rochet).

7
Insurance Regulation tends to be fragmented at
local level

• US regulation of insurance is at state level
  (plan to consolidate).
• In many emerging markets, insurance still
  regulated by branches of ministries of finance
• Insurance regulation merged into super-regulators
  tend to dilute attention due to management
  focused on banking issues and do not understand
  insurance

8
Recent Cases of Insurance Failure

• Equitable Life (UK 1999) - Reference Equitable
  Lifes lessons for the bank crisis By John Kay,
  Financial Times, November 4 2008, also Report by
  Lord Penrose www.fsa.gov.uk/Pages/Library/Communic
  ation/PR/2004/022.shtml
• HIH Insurance failure (Australia 2001) - see
  Royal Commission Report www.hihroyalcom.gov.au/

9
International Association of Insurance
SupervisorsIAIS Core Principles (ICP)
10
IAIS Core Principles (ICP)

• Conditions for effective insurance supervision
• The supervisory system
• The supervised entity
• On-going supervision
• Prudential requirements
• Markets and consumers
• Anti-money laundering, combating the financing of
  terrorism (AML/CFT)

11
Conditions for Effective Supervision

• ICP 1 Conditions
• A policy, institutional and legal framework for
  financial sector supervision
• A well developed and effective financial market
  infrastructure
• Efficient financial markets.

12
The Supervisory System

• ICP 2 Supervisory objectives
• The principal objectives of insurance supervision
  are clearly defined
• ICP 3 Supervisory authority
• adequate powers, legal protection and financial
  resources
• operationally independent and accountable
• sufficient staff with high professional standards
• treats confidential information appropriately.
• ICP 4 Supervisory process
• conducts its functions in a transparent and
  accountable manner
• ICP 5 Supervisory cooperation and information
  sharing
• cooperation and information-sharing are subject
  to confidentiality requirements.

13
The Supervised Entity

• ICP 6 Licensing
• An insurer must be licensed and the requirements
  are clear, objective and public.
• ICP 7 Suitability of persons
• including significant owners, board members,
  senior management, auditors and actuaries with
  appropriate integrity, competency, experience and
  qualifications
• ICP 8 Changes in control and portfolio transfers
• Advanced approval from supervisory authority to
  acquire significant ownership or any other
  interest in an insurer and transfer or merge the
  portfolio of insurance business
• ICP 9 Corporate governance
• compliance with all applicable corporate
  governance standards
• ICP 10 Internal control
• adequate internal controls adequate for the
  nature and scale of the business and an oversight
  and reporting systems to monitor and control the
  operations

14
On-going Supervision

• ICP 11 Market analysis
• To monitor and analyze all factors having an
  impact on insurers and insurance markets and
  draws conclusions and takes action as
  appropriate.
• ICP 12 Reporting to supervisors and off-site
  monitoring
• To receive necessary information to conduct
  effective off-site monitoring and to evaluate the
  condition of each insurer as well as the
  insurance market
• ICP 13 On-site inspection
• To examine the business of an insurer and its
  compliance with legislation and supervisory
  requirements
• ICP 14 Preventive and corrective measures
• preventive and corrective measures should be
  timely,suitable and necessary.
• ICP 15 Enforcement or sanctions
• To enforce corrective action and, where needed,
  imposes sanctions based on clear and objective
  criteria publicly disclosed
• ICP 16 Winding-up and exit from the market
• Having a range of options for the orderly exit of
  insurers from the marketplace and clear
  definition of insolvency,criteria and procedure
  for dealing with insolvency. In the event of
  winding-up proceedings, the legal framework gives
  priority to the protection of policyholders.
• ICP 17 Group-wide supervision
• The supervisory authority supervises its insurers
  on a solo and a group-wide basis

15
Prudential Requirements

• ICP 18 Risk assessment and management
• To recognize the range of risks and to assess and
  manage them effectively
• ICP 19 Insurance activity
• To use reinsurance and tools to establish an
  adequate level of premiums to better evaluate and
  manage the risks that they underwrite
• ICP 20 Liabilities
• To establish adequate technical provisions and
  other liabilities for insurance activities and
  make allowance for reinsurance recoverables. The
  supervisory authority has both the authority and
  the ability to assess the adequacy of the
  technical provisions and to require that these
  provisions be increased, if necessary.
• ICP 21 Investments
• To comply with standards on investment activities
  including investment policy, asset mix,
  valuation, diversification, asset-liability
  matching, and risk management
• ICP 22 Derivatives and similar commitments
• To comply with standards on the use of
  derivatives and similar commitments including
  restrictions in their use and disclosure
  requirements, internal controls and monitoring of
  the related positions.
• ICP 23 Capital adequacy and solvency
• To comply with the prescribed solvency regime
  including capital adequacy requirements and
  suitable forms of capital that enable the insurer
  to absorb significant unforeseen losses

16
Markets and Consumers

• ICP 24 Intermediaries
• The supervisory authority sets requirements,
  directly or through the supervision of insurers,
  for the conduct of intermediaries
• ICP 25 Consumer protection
• The supervisory authority sets minimum
  requirements for insurers and intermediaries in
  dealing with consumers including foreign insurers
  selling products on a cross-border basis. The
  requirements include provision of timely,
  complete and relevant information to consumers
  both before a contract is entered into through to
  the point at which all obligations under a
  contract have been satisfied
• ICP 26 Information, disclosure transparency
  towards the market
• The supervisory authority requires insurers to
  disclose relevant information on a timely basis
  in order to give stakeholders a clear view of
  their business activities and financial position
  and to facilitate the understanding of the risks
  to which they are exposed.
• ICP 27 Fraud
• The supervisory authority requires that insurers
  and intermediaries take the necessary measures to
  prevent, detect and remedy insurance fraud.

17
AML and CFT

• ICP 28
• Anti-money laundering (AML), combating the
  financing of terrorism (CFT)
• The supervisory authority requires insurers and
  intermediaries, at a minimum those insurers and
  intermediaries offering life insurance products
  or other investment related insurance, to take
  effective measures to deter, detect and report
  money laundering and the financing of terrorism
  consistent with the Recommendations of the
  Financial Action Task Force on Money Laundering
  (FATF).

18
China Insurance Industry
19
Market Profile

• The whole premium income in 2007 reached 703.6 bn
  RMB with property insurance premium 199.8 bn and
  life insurance premium 446.4 bn RMB
• Total assets of the insurance industry at the end
  of 2007 were 2.9 trn RMB
• There were 110 insurance companies,9 insurance
  asset management companies and 2331 professional
  insurance intermediaries at the end of 2007 in
  China
• Specialist and expert in insurance industry
  records 170,000 including actuaries,
  officers,advisers,investment manager,etc
• Insurance sales force has reached 2,010,000
  personnel

20
CIRC Responsibilities

• Major Responsibilities
• Formulates policies about the development of the
  insurance industry
• Drafts relevant laws and regulations
• Approves the establishment of insurance-related
• Approves the merge, split, alteration and
  dissolution of insurance organizations
• Organizes or participates in the bankruptcy and
  liquidation process of insurance companies
• Approves the qualifications of the senior
  managerial personnel in all insurance-related
  organizations
• Establishes the basic qualification standards for
  insurance practitioners
• Approves the clauses and premium rates of
  insurance lines related to the public interests,
  statutory insurance lines and newly developed
  life insurance lines

To be continued
21
CIRC Responsibilities

• Major Responsibilities
• Supervises the solvency and market conduct of
  insurance companies
• Manages the insurance security fund, and monitors
  the insurance guarantee deposits
• Supervises the business operation of
  public-policy-oriented insurance and statutory
  insurance
• Conducts investigation and imposes penalties on
  unfair competition and other irregularities,
• Supervises overseas insurance organizations
  established by domestic insurance and
  non-insurance organizations
• Establishes insurance risk-assessment,
  risk-warning and risk-monitoring systems
• Analyzes and predicts the operation of the
  insurance market
• Compiles and disclose the statistics and report
  forms of the insurance industry

22
State Council Opinion on Reform and Development
of Insurance Industry, Sep 2006

• Rationale to speed up the reform and development
  of the insurance industry.
• Initiatives Pursue aggressively the
  development of general insurance, life insurance,
  reinsurance and insurance intermediary services
  for broader business scope and mature market
  system Press ahead with structural reform for
  sound corporate governance Open up on a
  higher level to increase the industrys
  international competitiveness and its capacity
  for sustainable development Promote
  independent innovation, optimize product mix and
  change the way of growth to improve services
  continuously Upgrade asset management and
  improve returns to support national economy
  Enhance supervision, prevent and mitigate risks
  and better protect the interests of the
  policy-holders Improve the legal framework,
  enhance public education and accelerate the
  establishment of the insurance credit-rating
  system to foster a culture of integrity and
  honesty.

23
State Council Opinion II

• 3.Put in place a comprehensive agriculture
  insurance system with multiple means of delivery
  by actively and prudently pushing forward the
  pilot programmes.
• 4.Seek integrated development of commercial
  pension and health insurance for urban and rural
  residents to improve the multi-tiered social
  security system.
• 5. Accelerate the development of liability
  insurance to improve workplace safety and
  complement the emergency response system.
• 6. Improve insurance services through independent
  innovation.      SEARCH   

24
State Council Opinion ?

• 7. Improve insurance asset management to better
  support national economy.
• 8. Press ahead with the system reform and the
  opening-up of the industry to achieve sustainable
  development. 9. Prevention and mitigation of
  risks through improved insurance supervision.
  10. To create a favourable environment for the
  insurance industry through a sound legal
  framework and policy support.

25
China Life

• Registered in Beijing, China on June 30, 2003
• Successfully listed on New York Stock Exchange
  and Hong Kong Stock Exchange on December 17 and
  18, 2003, respectively
• Largest life insurance company in China's life
  insurance market
• As at 30 June 2008, total assets and equity of
  the Group were RMB 964 billion and RMB 167
  billion respectively
• Most extensive distribution network in China
• It provides individual life insurance, group life
  insurance, accident and health insurance
• Over 70 million individual and group life
  policies and annuities, and long-term health
  insurance policies in force
• Largest insurance asset management company, and
  one of the largest institutional investors in
  China.

26
China Life Annual Results
In Billions RMB
27
China Life Balance Sheet
In Billions RMB
28
Ping An Insurance

• Established in 1988 and headquartered in
  Shenzhen,China
• Ping An is the first integrated financial
  services conglomerate in China that provides
  insurance,securities brokerage, trust and
  investment, commercial banking, asset management
  and corporate pension business
• It was listed on Hong Kong on June 2004 and on
  Shanghai On March 1, 2007
• As at 30 June 2008,total assets and equity of the
  Group were RMB 688 billion and RMB 88 billion
  respectively
• In July 2008, Fortune recognized it as No.462
  among the 500 largest companies in the world and
  ranked No.1 among the Chinese non-SOEs in the
  list
• It has about 40.95 million individual clients and
  about 1.97 million corporate clients.
• It has about 315,000 life insurance sales agents,
  over 70,000 full-time employees, and more than
  3,000 branch- and sub-branch-units and sales
  offices.
• Ping An Life is the second largest life insurance
  company in China, and Ping An Property Casualty
  is the third largest property and casualty
  insurance company in China.

29
Ping An Annual Results
In Billions RMB
In Millions RMB
30
Ping An Balance Sheet
In Billions RMB
31
Case Study AIG Analysis
32
AIG Profile

• A leading international insurance organization
  with operations in more than 130 countries and
  jurisdictions 
• Founded in Shanghai
• Providing the most extensive worldwide
  property-casualty and life insurance networks of
  any insurer 
• Covering commercial, institutional and individual
  customers
• A leading provider of retirement services,
  financial services and asset management to 70
  million clients. 
• Listed on the New York Stock Exchange, as well as
  the stock exchanges in Paris and Tokyo
• AIG (FY 2007) had 1,060 bn in assets, equity of
  96 bn, made 14bn in annual net profits and
  employed 106,000 people.

33
Annual Revenues and Incomes
In Billions USD
34
General Insurance
In Billions USD
35
Life Insurance Retirement Services
In Billions USD
36
Financial Services Asset Mgt
In Billions USD
37
Balance Sheet
In Billions USD
38
AIG Investment Portfolio
As of Jun 30, 2008
39
AIG Financial Products (London)

• A key attribute that differentiates AIGFP from
  its peers is its ability to commit significant
  amounts of its own capital - depending on the
  opportunity arising from a particular
  investmentat different levels of a companys
  debt and equity capital structure. AIGFP has
  demonstrated this capability in its energy and
  infrastructure investments, both as a single
  investor and in partnership with other investors.
  The firm is also a major investor in a wide
  array of debt and equity securities.
• As an innovator in the commodity and commodity
  index markets, AIGFP played an instrumental role
  in attracting the investing publics interest in
  commodities as an alternative asset class. As a
  result of the severe disruption in the U.S.
  residential mortgage and credit markets that
  accelerated during the fourth quarter of 2007,
  AIGFP recognized unrealized market valuation
  losses of more than 11 billion on its credit
  default swap portfolio written principally on the
  super senior tranches of multisector
  collateralized debt obligations.

40
How AIG 2007 Annual Report disclosed CDS exposure

• Included in 2007 net income and adjusted net
  income was a charge of 11.47 billion pretax
  (7.46 billion after tax) for unrealized market
  valuation losses related to the AIG Financial
  Products Corp. (AIGFP) super senior credit
  default swap portfolio.
• Based upon its most current analysis, AIG
  believes any losses that are realized over time
  on the super senior credit default swap portfolio
  of AIGFP will not be material to AIGs overall
  financial condition, although it is possible that
  realized losses could be material to AIGs
  consolidated results of operations for an
  individual reporting period.

41
AIGFPs CDS Commitments

• At December 31, 2007
• Notional Amount Unrealized Market
• Valuation Loss
• (in billions) (in
  millions)
• Corporate loans(a) 230 -
• Prime residential mortgages(a) 149 -
• Corporate Debt/CLOs 70 226
• Multi-sector CDO(b) 78 11,246
• Total 527 11,472
• (a) Predominantly represent transactions written
  to facilitate capital relief
• (b) Approximately 61.4 billion in notional
  amount of the multi-sector pools
• include some exposure to U.S. subprime
  mortgages.
• SOURCE AIG 2007 ANNUAL REPORT, FORM 10-K, PAGE
  122

42
Stock Quote
Sep 16,Fed extended 85 billion credit facility
43
AIG Rescue
44
Why bail out AIG?

• At its peak AIG was the world largest insurer
  with a market value of 239 billion 74 million
  customers, 700,000 agents and 116,000 staff.
• It wrote credit default swaps (CDSs), with a
  notional exposure of 441 billion as of June
  2008. Of this, 58 billion was exposed to
  subprime securities
• It was exposed to 307 billion of contracts
  written on instruments owned by banks in America
  and Europe and designed to guarantee the banks
  asset quality, thereby helping their regulatory
  capital
• With total derivative exposure 441 bn AIG would
  incur massive losses and would require more
  capital.
• Had AIG gone bust, its millions of customers
  would have been left wondering if their car and
  home insurance policies were still valid, at a
  time when consumers are already twitchy about the
  safety of their bank deposits.

45
Why AIG had to be rescued

• The combination of an epochal financial crisis,
  outsized bets on exotic securities, inadequate
  internal controls and poor regulatory supervision
  forced AIG last month to accept an 85bn loan
  from the Federal Reserve that places it in
  government hands
• AIG has more than 4,300 legal entities scattered
  around the world, a set-up that made both
  internal co-ordination and outside scrutiny very
  difficult.
• More than other insurers, AIG has significant
  exposure in real estate and CDS market, both
  crushed in the past year by the overall decline
  in asset prices.
• It plays a central role in the CDS market and in
  structured finance and was one of the first
  institutions to start buying super-senior CDOs
  almost a decade ago.

46
AIG Annual Report 2007 explanation of CDS
exposure pg 121

• Approximately 379 billion (consisting of the
  corporate loans and prime residential mortgages)
  of the 527 billion in notional exposure of
  AIGFPs super senior credit default swap
  portfolio as of December 31, 2007 represents
  derivatives written for financial institutions,
  principally in Europe, for the purpose of
  providing them with regulatory capital relief
  rather than risk mitigation.
• In exchange for a minimum guaranteed fee, the
  counterparties receive credit protection in
  respect of diversified loan portfolios they own,
  thus improving their regulatory capital position.
  These derivatives are generally expected to
  terminate at no additional cost to the
  counterparty upon the counterpartys adoption of
  models compliant with the Basel II Accord.
• AIG expects that the majority of these
  transactions will be terminated within the next
  12 to 18 months by AIGFPs counterparties as they
  implement models compliant with the new Basel II
  Accord. As of February 26, 2008, 54 billion in
  notional exposures have either been terminated or
  are in the process of being terminated.

47
Notional amounts by remaining maturity of AIGFPs
interest rate, credit default and currency swaps
and swaptions derivatives portfolio at December
31, 2007 and 2006 (in millions)

• Notional amount is not representative of either
  market risk or credit risk and is not recorded in
  
• the consolidated balance sheet.

48
Why AIG had to be rescued

• AIG had racked up about 25bn of cumulative
  losses on its credit default protection and had
  taken 18.5bn in losses over the past three
  quarters.
• The Lehman bankruptcy was not the only cause but
  it shredded the remnants of confidence on AIG
• Adjusted fully for mark-to-market losses and
  stripping out goodwill and hybrid capital, even
  at the end of June AIG might have had about 24
  billion less book equity than safely capitalised.
  
• CDS on AIG leapt to record levels that to protect
  10m of AIG bonds for five years would have to
  pay 1.25m per year
• The final blow came when AIG's debt was
  downgraded, meaning counterparties could demand
  14.5bn in collateral

49
Super Senior Credit Derivatives
50
CDS MTM Valuation Losses
As of Jun 30,2008
51
Lessons and Observations

• Core business can be very profitable and can be
  used to finance innovation in new areas of
  business
• However, if top management did not understand
  implication of new innovation, high financial
  leverage ratio gave rise to fragile confidence on
  the companys liquidity and capital
• Insufficient regulation and lack of system-wide
  supervision
• Fair value accounting Valuation of Financial
  instruments,especially Mark to Model,
• Complexity of derivatives led to difficulty of
  pricing and liquidation under market turmoil.
• Senior management underestimated market
  difficulties
• Senior management did not understand that you
  cannot mix banking risks (high correlation) with
  insurance risks (idiosyncratic risks).

52
References

• International Association of Insurance
  Supervisors (www.iais.org)
• Ernst Baltensperger, Peter Buomberger, Alessandro
  Iuppa, Arno Wicki, and Benno Keller, Regulation
  and Intervention in Insurance Industry -
  Fundamental Issues, Zurich Financial Services,
  September 2007
• Plantin G and Rochet, J, 2007, When insurers go
  bust. An Economic Analysis of the Role and Design
  of Prudential Regulation, Princeton University
  Press.

53
Thank You
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