sharing insights on key industry issues* - pwc · piecing the jigsaw considers the drivers, risks...

InsurancedigestAmericas edition • July 2005

Sharing insights on key industry issues*

The Americas Insurance digest is published three times a year, to address the key issues driving the insurance industry. If you wouldlike to discuss any of the issuesraised in more detail, please contactthe individual authors or the Editor-in-chief, whose details arelisted at the end of each article.

We would also welcome yourfeedback and comments onInsurance digest, and as such, we enclose a Feedback Fax Replyform. Your feedback will help us toensure that our publications areaddressing the issues that you feelmost strongly about.

Contents

Editor’s Comment 2John S. Scheid

The evolving definition of ‘compliance’ 4Stephen KoslowThere are several significant drivers behind the increased attention being paid to the governance of compliance operations. This article examines new perspectives on compliance functions and structure and their impact on the governance of a company’s compliance operation.

European regulatory change – Threats or opportunities? 10Tim HarrisThe regulatory and reporting environment for insurers in Europe has begun a process of radical change, and there is little sign of the pace of change relenting. This presents threats but also opportunities to insurers and reinsurers doing business with Europe.

Record retention compliance in a changing regulatory environment 14Jin J. Lee, James Santangelo and Rosalind ConwayRecord retention compliance in a changing regulatory environment examines the regulatory impact on the insurance industry, the approach to mitigating the risk of non-compliance and the approach to an effective records management program.

The CFO Forum’s European Embedded Value – A superior financial reporting framework for life insurers 20Sheryl A. Battit and David C. ScheinermanAs European Embedded Value support among analysts in the European market increases, the concept is likely to spill over into the U.S. insurance market. U.S. adoption of EEV principles could provide an opportunity for improved communication to stakeholders and present an opportunity for U.S. insurers to enhance their internal performance measurement.

China and India – Opportunities too big to ignore? 26Robert Fok and Khushroo PanthakyOur authors examine the current state of affairs and future trends in these two markets, and discuss the life insurance market entry considerations from the perspective of an overseas insurer.

Americas edition • July 2005

2 Insurance digest • PricewaterhouseCoopers

As this edition is released,companies arecompleting theirsecond quarteror half-yearresults, thefinancial marketsare heading into the slower

days of summer and yet the Insuranceindustry remains increasingly challenged by its regulators.

Generally, the content of Insurance digest is based upon reader feedback and inputfrom our clients about the issues that are of most importance to them. Consequently,it is no surprise that given the ongoingdevelopments affecting companies and the concerns expressed by many insuranceexecutives, regulation and compliance aretwo subjects weighing heavily on youragendas. As a result we have a few articlesaddressing these subjects.

The first article looks at some of the moresignificant conditions leading to increasedattention being paid to governance andcompliance by many within the industry.Effective compliance functions aligned withcompany business goals and board/CEOstrategies are increasingly challengingorganizations and their chief complianceofficers. Where is this evolution headed?This will be examined carefully.

While most regulatory discussions over thepast two years have centered on Sarbanes-Oxley requirements in the US, Europeaninsurers have been focusing on increasingregulations and changing reporting standards.Our second article provides a look at changesthat will redefine the reporting and regulatorylandscape for European insurance companies.

As a result of all the increasing regulation,there are numerous tactical challenges thatall businesses are facing. One of thesechallenges is records retention. Our thirdarticle presents some thoughts on effectiverecords management, together withmitigating compliance risk.

Editor’s Comment

JOHN S. SCHEID: CHAIRMAN, AMERICAS INSURANCE GROUP

Welcome to theJuly 2005 edition

of AmericasInsurance digest.

3Insurance digest • PricewaterhouseCoopers

A perennial topic of interest is capitalmanagement. Today, regulators are increasinglyinterested in solvency and capital adequacy.Embedded Value (EV) is an important tool in life insurer evaluations and in certainEuropean markets EV is increasingly utilizedin insurer financial reporting. The launch,therefore, of the European Embedded Valueguidelines by the European Insurance CFO Forum is a major step forward fortransparency and comparability in insurancecompany disclosure. The development is arare example of industry-sponsored reportingguidelines and should enable companies toachieve a degree of consistency of reportingthroughout a period of considerable changebrought about by the move to IFRS. LikeIFRS, these new principles are likely to havean impact in North America, as well as in Asiaand Europe.

Our last article on China and India grew out of a seminar organized and sponsored by theInsurance Institute of the Republic of China(IIROC), which plays a very important andactive role in the insurance industry in Taiwan.The IIROC has traditionally served as the

think tank to the industry and the MOF(Ministry of Finance) and also as a bridgebetween the Government and the Industry.China and India also made up the agenda atPricewaterhouseCoopers’ first Asia InsuranceForum, held in October 2004, aimed atproviding an informal discussion forum forsenior executives. The insights from theseprograms regarding the dynamic markets in China and India are well worth your read.

Finally, PricewaterhouseCoopers justcompleted a white paper focusing on thefuture of the financial services industry overthe next three years. Piecing the Jigsawconsiders the drivers, risks and opportunities,as well as the impact and responses forexisting and potential players in the industry.The study identifies five principal drivers thatwill affect all financial institutions: Politics,Demographics, The Economic Cycle,Regulation and Reporting, and Technology.

Soft copies of this and all of our other FS and sector surveys and reports are available,free of charge from our web site,www.pwc.com/financialservices.

I hope you find this range of articles ofinterest. Please do continue to provide uswith feedback on the topics you would like tosee addressed in future issues. Online copiesof both this publication and the sisterEuropean and Asia Pacific editions areavailable from our website,www.pwc.com/insurance.

John S. ScheidEditor-in-chief

Tel: [email protected]

The evolving definition of ‘compliance’

AUTHOR: STEPHEN KOSLOW


New perspectives on compliance functions and structure and theirimpact on the governance of a company’s compliance operation.

Chief compliance officers areoften asked to identify the currentissues occupying a significantamount of their time and energy.Over the years, responses to thisquestion have closely trackedmatters being played out in themedia and boardrooms across thecountry. In the early to mid-90s,compliance officers of lifeinsurance companies questionedwhether their company hadadequate controls over sales andadvertising materials to meet new standards of fairness anddisclosure. Just a few years ago,compliance officers worried abouthow well their complianceprogram compared to that of peer companies and industrystandards. Today, facing stiffinquiry by boards of directors and senior management teams,compliance officers are intenselyfocused on whether there issufficient governance andoversight over their company’scompliance operation.

There are several significantdrivers behind the increasedattention being paid to thegovernance of complianceoperations. The Sarbanes-OxleyAct of 2002 requires companies to formalize and strengthen thegovernance structure surroundingthe company’s financial reportingand operating structure.1 Morerecently, the Securities and

Exchange Commission (SEC) andthe National Association ofSecurities Dealers (NASD) haveenacted rules requiringcompliance-related certificationsby senior management.2

In addition, the highly publicizedinvestigations and enforcementactions by New York Attorney-General Eliot Spitzer, and therelated inquiries by statedepartments of insurance into the world of brokers andcontingent commissions, has focused attention on thegovernance and oversight ofcompliance operations at bothproperty and casualty, as well as life insurance companies.

Effective governance of acompliance operation occurswhen a company establishes anappropriate structure to facilitatemeaningful oversight over themyriad compliance functionsbeing implemented throughout thecompany. To build an effectivecompliance structure, a companyfirst needs to identify the universeof these compliance functions andthe individuals and business unitsthroughout the company whohave been charged with theirimplementation. With thisinformation, the company isprepared to establish and formalizethe relationships which serve toconnect and link together theseindividuals and business units.

Ultimately, through this structureof relationships and connections,the company is able to maintainthe governance framework formeaningful oversight.

Compliance functions – core,supporting and monitoring

In a broad sense, virtually all functions occurring in the business environment relate to compliance. Essentially, allemployees are directed to performactivities in compliance withcompany policies, procedures and objectives. Unfortunately,such a broad definition becomesmeaningless for purposes ofanalysis and discussion.

Today’s environment requires that the word ‘compliance’ be expanded into a term whichmore clearly articulates thecontextual meaning of theconcept being conveyed. At themost expansive level, the term‘compliance operation’ can beused to define the universe ofcompliance functions andactivities being implemented byindividuals and business unitsthroughout a company, and theorganizational structureestablished to link theseindividuals and business units to each other, as well as tostakeholders inside and outside the company.

There are severalsignificant driversbehind theincreased attentionbeing paid to thegovernance ofcomplianceoperations.

THE EVOLVING DEFINITION OF ‘COMPLIANCE’


1 The Sarbanes-Oxley Act of 2002 (Pub. L. 107-204, 116 Stat. 745 (2002)).2 Securities and Exchange Commission (‘SEC’) rule 38a-1 under the Investment Company Act of 1940 and rule 206(4)-7 under the Investment Advisors

Act of 1940 and the National Association of Securities Dealers (‘NASD’) Rule 3013.

It is helpful to further dividecompliance functions into atleast three groups which exhibitgenerally accepted distinctions:‘core compliance functions’,‘supporting compliancefunctions’ and ‘monitoringcompliance functions’. Corecompliance functions refer tothose activities necessary tomeet specific and definedregulatory and companyrequirements. Traditionally, corecompliance functions includeactivities such as rate and formfiling, complaint handling,licensing and registration, whereregulations enumerate specificactivities that can be objectivelytested during an examination todetermine whether a company is successfully complying withthe requirement. In certaincircumstances, companiesmandate activities that, while notimposed by regulation, become a compliance requirement. For example, certain companiesrequire that replacementdisclosure forms be provided tocustomers in all states, includingthose states which have notregulated this disclosure.

Supporting compliance functionsrefer to those activities that areperformed to help ensure all core compliance functions arebeing implemented as required.These functions might includeactivities such as training, thedocumentation of policies and

procedures, the completion anduse of risk assessments, analysisand communication of emergingregulations, and the applicationof a formalized metrics-basedsupervisory system. Attention tosupporting compliance functionsincreased when regulators begandrafting laws with an embedded‘reasonableness’ standard as thequalitative measure. For example,NASD Rule 30103 and theregulations implementing theUSA PATRIOT Act, Section 3524,utilize a reasonableness standardas the basis for compliance. In effect, ‘reasonableness’regulations prescribe a desiredoutcome and leave it to thecompany to tailor specificcontrols to achieve the outcome.As a result, companies haveneeded to look beyond the realmof technical compliance withspecific regulations and focus onthose compliance-related activitiesnecessary to support thesuccessful implementation of therelated core compliance function.

In addition, companies withleading edge complianceoperations formally monitor theimplementation of both core andsupporting compliance functionsto evaluate and verify that thesefunctions are reasonablydesigned and being effectivelyimplemented. This assessmenttakes many forms, and oftenincludes continual monitoringand analysis of compliance

activities, periodic testing andformal, independent audits. In addition, it is often within thescope of those performingmonitoring functions to provideadvice and counsel on thedesign of core and supportingcompliance controls. Figure 1illustrates the relationshipbetween core, supporting andmonitoring compliance functions.

Emerging core compliancefunctions

Recent regulatory actionsindicate that lawmakers are nowtaking a hybrid approach toenacting relevant legislation.While generally maintainingreasonableness standards, these new regulations addressactivities previously performed in voluntary support of core

THE EVOLVING DEFINITION OF ‘COMPLIANCE’ continued


3 ‘Each member shall establish and maintain a system to supervise the activities of each registered representative and associated person that is reasonably designed to achieve compliance withapplicable laws and regulations, and with the Rules of the Association.’ NASD Rule 3010 (emphasis added).

4 ‘…[E]ach member shall develop and implement a written anti-money laundering program reasonably designed to achieve and monitor the member’s compliance with the requirements of the BankSecrecy Act (31 U.S.C. 5311 et. seq.) and the implementing regulations promulgated thereunder by the Department of the Treasury. …The anti-money laundering program required by this Rule shall, at a minimum, ***(b) Establish and implement policies, procedures and internal controls that can be reasonably expected to detect and cause the reporting of transactions required under 31 U.S.C. 5318(g) and theimplementing regulations thereunder.’ NASD Rule 3011 (emphasis added).

Advice/consulting

Continuousassessment

Periodic

testing

Audi

ting

Certification

Risk

asse

ssm

ent

Emergingregulations

Metric-based

supervisionTra

ining

Policies/

procedures

Monitoring compliance functions

Supporting compliance functions

Core

compliance function

Core, supporting and monitoring functionsFIGURE 1

Source: PricewaterhouseCoopers

functions. For example,certification requirements underSarbanes-Oxley5, NASD Rule30136 and the SEC Rule 38a-17

have made voluntary monitoringby company officers a regulatoryrequirement. Other examplesinclude the training and testingrequired under anti-moneylaundering regulations.8 As such,companies must address thesefunctions from two differentperspectives. In this circumstance,training and testing are now corecompliance functions, as well asremaining vital supporting andmonitoring compliance functions.As a supporting function, trainingwill still be an essential elementfor ensuring compliance withactivities such as reporting largecash transactions and theidentification and reporting ofsuspicious activities. However, in addition, the company willneed to support this trainingactivity with documented policiesand procedures, training of thetrainers, formal supervision andappropriate monitoring to ensurethe training program is reasonablydesigned and being effectivelyimplemented (see Figure 2).

Compliance structure – roles,responsibilities and reporting

The broad array and increasingcomplexity of compliancefunctions being implementedthroughout an organizationplaces new demands oncompany management to assessand determine the appropriatecompliance structure for their

organization, and requires thatmanagement seek answers tothe following: Which operationalbusiness unit or units should becharged with responsibility forimplementing specificcompliance functions? What isthe appropriate role for thecompliance department and thechief compliance officer indeveloping and managing thestructure established to supportthe implementation of thesecompliance functions?

Organizational alignment for the implementation of compliance functions

The establishment of formalcompliance departments cameinto vogue after the marketconduct scandals of the mid-90s,when life insurance companiespulled the implementation ofcertain core compliance functions(e.g. sales material review) out ofline business units and centralizedthese functions into the compliancedepartment. However, companiesthat built large, centralizedcompliance departments for thesepurposes have started to movethese functions back out to linebusiness units in an effort to bettermanage risk. Many companiesstrongly believe that line businessunits should retain responsibilityfor the implementation of thosecore compliance functions whichare central to the line businessunit’s general operation. Today, it is not unusual for marketing ordistribution to have responsibilityfor sales material review, or for

product development to haveresponsibility for rate and formfiling. In addition, legaldepartments often retainresponsibility for the initialidentification and analysis ofemerging regulations, and manycompanies charge customerservice departments withresponsibility for handlingcomplaints. Of course, this is a simplified delineation and nocompany has pure separation of responsibility.

Having a compliance functionimplemented by an organizationalunit other than the compliancedepartment does not address thequestion of whether theimplementation should be handledin a centralized or decentralizedmanner. Centralization of certaincompliance functions has distinct advantages over broaddecentralization of thesefunctions. There are cleareconomic efficiencies and controlbenefits to the centralization



5 The Sarbanes-Oxley Act of 2002 (Pub. L. 107-204, 116 Stat. 745 (2002)) (Section 302). 6 ‘Each member shall have its chief executive officer (or equivalent officer) certify annually, as set forth in IM-3013, that the member has in place processes to establish, maintain, review, test and modify

written compliance policies and written supervisory procedures reasonably designed to achieve compliance with applicable NASD rules, MSRB rules and federal securities laws and regulations…’NASD Rule 3013(b).

7 Under SEC rules 38-a-1 and 205(4)-7 investment companies are required to appoint a chief compliance officer who is responsible for certifying to the adequacy and effectiveness of the company’scompliance policies and procedures.

8 USA PATRIOT Act, Section 352 (c) and (e).

Example of functional alignment

Key – Compliance functionsGovernance and oversightMonitoringEnablingCore

Board of Directors & Exec. Mgmt

CCO/Compliance department• Periodic testing• Assessment• Advice/consultation

Audit department• Auditing

LOB officer• Certification

Business unit management• Risk management• Policies/procedures• Metric-based supervision

Legal department• Emerging regulations

Training department• Training

Business unit staff• Complaint handling

Open communication between all individualsperforming related compliance functions is key to

maintaining an effective compliance operationFIGURE 2


of functions such as licensing,complaint handling and analysisof emerging regulations.However, the complexity of someorganizations requires thedecentralization of even thesefunctions. The primary challengeassociated with decentralizationis managing consistency inimplementation and in allocatingsufficient resources to handle allnecessary support and monitoringfunctions. It should be noted thatassigning responsibility for theimplementation of a compliancefunction to an individual alignedwith the compliance departmentdoes not, necessarily, avoid theconsistency or resource issue.Compliance departments withstaff physically embedded intothe business units are alsochallenged by consistency andresource issues.

There are no universal answersfor which compliance functionsshould be implemented byindividuals aligned with thecompany’s compliancedepartment and by whichindividuals assigned to one of thecompany’s other business units.Similarly, each company needs to decide whether compliancefunctions should be implementedfrom a centralized operation(compliance department orotherwise) or performed bymultiple individuals located indecentralized business unitsacross the enterprise. For acompliance operation to findsuccess, the location ofindividuals responsible for theimplementation of compliancefunctions must be aligned withthe company’s overall culture and operational needs.

Role of the chief complianceofficer and compliancedepartment

Discussions around whichbusiness units should be chargedwith the implementation of specificcompliance functions leads toquestions surrounding the role of the chief compliance officerand compliance department in designing, developing andmaintaining a compliancestructure that is sufficientlystructured to facilitate the effectiveoversight and governance of allcompliance activities.

While there are many identifiableelements evident in the structureof a robust compliance operation,two stand out as being essential:the quality of the individualsassigned responsibility forimplementing the compliancefunctions and the manner inwhich these individuals areconnected to each other. Today, a primary role of the chief compliance officer is tomake certain these elements aresuccessfully addressed.

Individuals assigned a role in the performance of a specificcompliance function must possessthe requisite skills, experience andauthority to effectively implementthe function. The chiefcompliance officer is responsiblefor ensuring that business unitsassign compliance responsibilityto appropriate individuals andthat resource levels are sufficientto meet the compliance needs of the company. In addition,compliance departments are now responsible for makingcertain that compliance-relatedroles and responsibilities are

well-defined and communicatedin a manner that leaves noquestions as to what behaviorsare expected. Well-articulatedresponsibilities lead to clearexpectations that can bemeasured and evaluated (e.g.metric-based supervision, testing).

Second, it is essential thatindividuals implementingcompliance functions areorganizationally linked in amanner that makes sense for the company’s general operatingstyle and culture. It is not unusualfor multiple business units to playkey roles in the support andmonitoring of a specific corefunction. For example, where a core compliance function isbeing implemented by individualsin a specific business unit (e.g. complaints being handledby the customer servicedepartment), the activities ofthese individuals may be directlysupported and monitored byindividuals from the legal,training, auditing and compliancedepartments (see Figure 2).

Consequently, in a robustcompliance operation, thecompliance department mustensure that individuals areconnected in a formal mannerthat goes well beyond traditionaldirect or dotted-line matrixreporting relationships. Forexample, where similarcompliance functions are beingimplemented in a decentralizedenvironment, consistencyrequirements dictate the need forformal communication on aconsistent basis. In addition, therelationship between individualsperforming core or supportingfunctions and individuals

performing related monitoringfunctions requires a degree ofindependence that supersedesdirect line, or even dotted-line,reporting relationships. However,the absence of reporting doesnot diminish the need for aformal relationship to existbetween these individuals. In fact,monitoring relationships oftencall for a high degree of formalitywith specified forms ofcommunication (e.g. reports) anddirect oversight. Ultimately, whatmatters is that individuals whoperform related compliancefunctions remain connected toeach other in a meaningfulmanner, and each companyneeds to find the appropriatelevel of formality and structure tofacilitate these connections.

Based on the above, chiefcompliance officers mustpossess skill sets that are, in many respects, quite differentfrom the skills that may haveserved them well just a few yearsago. It is now incumbent on thechief compliance officer andindividuals organizationallyassigned to the compliancedepartment to facilitate thelinkage between individualsperforming compliance functionsacross the enterprise. Today’seffective chief compliance officermust be a fully integratedmember of the executivemanagement team with fullaccess to all business leadersand the board of directors. In addition, the chief complianceofficer must complement broadtechnical expertise with amastery of organizational skillsand the ability to presentcomplex compliance concepts to all stakeholders.



effective, essentialinformation will flowfrom thoseperforming core and supportingcompliance functionsto those chargedwith monitoring thesefunctions. In turn,this information willbe presented tomembers of seniormanagement and theboard of directorswho are charged withproviding oversightof the complianceoperation. The chiefcompliance officer isgenerally responsiblefor providing timelyreports summarizingrisks, issues andoperationaleffectiveness.

Importantly, wherethe company’scompliance structureeffectively links all ofthe individuals whoare implementingrelated core,supporting andmonitoring

compliance functions across theenterprise, these reports providemuch more than a retrospectivecommunication focused solely onthe number of complaints, resultsof regulatory inquiries or the costof litigation. These reports havethe potential of providing valuableprospective analytical information

confirming the occurrence ofexpected compliance activity.Risks of non-compliance areidentified and escalated to seniormanagement and the board forevaluation and direction beforethey result in an adverseregulatory action or lawsuit. With this type of information,senior management and theboard of directors have the tools necessary to providemeaningful oversight over thecompliance operation.

There is no question that federaland state lawmakers, regulators,and those charged with enforcingthese laws and regulations, expectmeaningful governance of thecompliance operation from acompany’s leadership team. With continually emergingregulations and new corporatedemands, building thecompliance infrastructurenecessary to facilitate thisexpected governance is no simpleundertaking. Chief complianceofficers must structure andmanage a compliance operationthat successfully connectsindividuals from across theenterprise having the responsibilityfor implementing multiple layersof compliance functions.Understanding that the simpleterm ‘compliance’ now requiresan expansive definition helps inbeginning to frame the issuesand questions that will lead tothe development of a successfulcompliance operation.

Compliance governance – senior management and board oversight

In today’s environment, it isexpected, and in certaincircumstances required, thatsenior management and the boardof directors (directly or through a committee) actively provideoversight over the company’scompliance operation. Thecompliance oversight functionsperformed include the review andapproval of significant compliancepolicies and programs, theprovision of strategic direction to

compliance leadership, and thecontinual assessment of whethercompliance functions are beingeffectively implemented inaccordance with the company’srisk management philosophy (see Figure 3).

For this oversight to bemeaningful, sufficient andsignificant information relating tothe effective implementation of allcompliance functions must beprovided to senior managementand the board. If the structure ofthe compliance operation is



Programreview

Monitoring compliance functions

Advice/consulting

Continuousassessment

Periodic

testing

Audi

ting

Certification

Risk

asse

ssm

entCo

ntin

uous

asse

ssm

ent

Emergingregulations

Metric-based

supervision

Policyapproval

Training

Risk

management

Policies/

procedures

Strategic

planning

Enabling compliance functions

Core

compliance function

Governance and oversight compliance functions

Governance and oversight compliance functions provide anoverlay to the core, enabling and monitoring functions being

implemented across the companyFIGURE 3


AUTHOR

Stephen KoslowDirector, Financial Services Compliance Advisory PracticeTel: 1 312 298 [email protected]

European regulatory change –Threats or opportunities?

AUTHOR: TIM HARRIS


Current and future change will redefine the reporting and regulatorylandscape for Europe’s insurers. This article explores these changesand the threats and opportunities they present, and asks the questionwhether reinsurance arrangements could be developed to helpEuropean insurers manage their risks and capital more effectively as the new regimes evolve.

Radical change in reportingand regulation

The regulatory and reportingenvironment for insurers in Europehas begun to change. Radically.And there is little sign of the paceof change relenting, at least forthe next several years.

Take International FinancialReporting Standards (IFRS) forexample. Listed insurancecompanies, along with around7,000 other companies listed onEuropean stock exchanges, arerequired to convert to IFRS fortheir main ‘generally acceptedaccounting principles’ (GAAP)financial reporting this year. For the insurers, this meansimplementing new or revisedaccounting standards for theirassets and liabilities, including the International AccountingStandards Boards ‘interim’standard for insurance contracts,IFRS4. Because GAAP can impactregulatory and tax reporting, thismeans consequential effects onthe ways companies manage theirregulatory capital and tax positions.

Stakeholders want the wholepicture…and the Europeaninsurance industry isresponding

Stakeholders are demanding a more holistic view of theperformance and funding ofinsurance businesses. Capitaladequacy, performance, cashgeneration and risk managementare fundamental to assessing the

financial position of an insurer.New ways of measuring theseattributes are emerging, both by voluntary initiative andregulatory compulsion.

The initiative taken by Europe’slargest life insurers to develop a way of presenting theirperformance in a more comparableand coherent way illustrates this.European insurers responded tothe concerns of stock analyststhat their supplementary reportingof life business performancelacked consistency and credibility.In May 2004, a group of the CFOsof 20 leading insurance groups in Europe (the ‘CFO Forum’)published voluntary guidance toalign their reporting, known as‘European Embedded Value’.

Changes in regulation have alsodriven changes in reporting. In theUK, for example, the FinancialServices Authority (FSA) hasrequired life insurers to measuretheir ‘with-profits’ liabilities on anew ‘realistic’ basis, andcompanies have startedsubmitting their own ‘internalcapital assessment’, a precursorto full risk-based capitalmethodologies, for regulatoryreview. The regulator expectsthese disciplines to be in place,and for companies to refine andimprove their underlying modelsof the business over time.Reinsurers aren’t immune either,with the recent introduction of thereinsurance directive by theEuropean Commission (EC).

The most significantdevelopments are still to come

Changes experienced in Europeover the last two years are onlythe start. Following the initialimplementation of IFRS, insurers,regulators and standards-settersare now turning their minds to thebigger prize of a long-term solutionaddressing the accounting andregulation of the industry. Thesechanges will arise from theimplementation of a ‘Phase II’standard from the InternationalAccounting Standards Board(IASB) on accounting forinsurance contracts and theintroduction of ‘Solvency II’ – a new basis for the prudentialregulation of insurance. These two initiatives are inter-related,because the regulators would like to use IFRS ‘Phase II’ as theunderlying measurement basis forthe ‘Solvency II’ framework.

IASB ‘Phase II’ – current status

The IASB relaunched itsdeliberations on insurancecontract accounting in 2004 byestablishing a working party toconsider the way forward.Following the controversysurrounding some of the earlierproposals, including the ‘DraftStatement of Principles’ publishedunder the supervision of thepredecessor of the IASB, theInternational AccountingStandards Committee, the IASBhas promised to look at the issues anew.

Stakeholders aredemanding a moreholistic view of the performanceand funding ofinsurancebusinesses.

EUROPEAN REGULATORY CHANGE – THREATS OR OPPORTUNITIES?


Unlike ‘Phase I’ (the interimstandard which became IFRS4)there are wider internationalissues to consider. Phase II is a‘modified joint project’ on theIASB’s convergence programwith the US Financial AccountingStandards Board (FASB). So intime, the standard arising from‘Phase II’ could replace USGAAP for insurance. Accordingly,US companies have startedtaking notice, are represented on the IASB working group, and have presented to the IASBin session.

The IASB has not given a firmtimetable for Phase II, but hasindicated that there will be nostandard until at least 2008,which suggests implementationnot before 2010. The first stepwill be a high-level discussionpaper that the IASB is expectedto publish later this year.

‘Solvency II’ – what is thecurrent status?

Despite the apparent dependencyon IFRS Phase II, it is clear theSolvency II timetable is notaligned. Solvency II will beimplemented through a directiveissued by the EC. The EC hasprioritised creating a directive thatwill define Solvency II, and intendsto follow a fast-track procedureto expedite its development.

The EC has asked the body that represents the prudentialregulators across Europe(CEIOPS) to begin work ontechnical aspects of the directive.Initial consultations identifiedstrong support for an approachbased broadly on the ‘Basel II’regulatory framework for banks,using IFRS Phase II as theunderlying measurement basis.

The EC’s desire to issue thedirective in 2006 for 2008implementation clearly doesn’twork with the IASB timetable. It remains to be seen how the EC will respond to this dilemma –the fear is that they may create a new regulatory measurementbasis (as has been seen in theUK with ‘with-profits’ lifebusiness), further adding to thereporting burden of insurers.

Regulatory change – prizes aswell as burdens

The prize of consistent andcomparable regulationthroughout Europe is real, andone the insurance industryeagerly anticipates. Unlike theU.S., the prudential regulation ofinsurers in the European Uniondiffers significantly betweenmember states, and there is nocommon framework similar tothat established by the NAIC.The hope is that consistentregulation will lead to competitionand ultimately sales acrossborders between member states.

Europe’s insurers would like theregulation to be based on theirown assessment of their capitalrequirements, and are busydeveloping their own risk-basedcapital frameworks. It is likelythat this will be a feature of theframework, although the regulatorsmay be more prescriptive aboutthe models used.

Diversification is key, but theregulators need convincing

One of the areas likely to be highly contentious is thedegree to which the regulatorsallow groups to recognizediversification benefits betweentheir operations in the risk-based

capital assessment. Often thisdiversification capital benefit is highly material in the contextof the overall capital required.This is a key element ofcompanies’ own calculations.The regulators want companiesto prove that the diversification is real and that capital is truly‘fungible’ – i.e. it can bemobilised between operations(which may be different legalentities in different territories).While diversification of insurancerisk at the portfolio level is theessence of insurance, in theregulators’ eyes broaderdiversification of insurance,operational, liquidity, investmentand other risks at the group levelis more difficult to demonstrate.And it isn’t just the regulatorswho are taking notice – the ratingagencies are increasinglyinterested in companies’ owncapital assessments, and capitaladequacy has been a recurringtheme of the stock analysts forseveral years.

Diversification is key to whetherthe promised benefits of‘Solvency II’ come with a bitteraftertaste for the insurers.Without regulatory credit fordiversification, insurers may need to look hard at their capitalposition. At one extreme, thepotential consequences of thisare obvious – more capitalrequired to support the business.Even if additional capital isn’tneeded, it is possible that capitalconstraints on insurers could limit their ability to exploit thegrowth opportunities arising from the advent of a commonregulatory framework.

Companies looking forinnovative ways to manage risks

These changes in regulation andreporting, especially unresolvedissues like diversification, makeEurope’s insurers more willingthan ever to consider innovativeways of increasing the flexibilityof their capital. Emerging capitalassessment disciplines enableinsurers to measure and be moreaware of the underlying risks intheir business.

An opportunity for reinsurers?

This represents a significantopportunity for the reinsurancemarkets, which are expert in the diversification of risk.Interestingly, however, Europe’sinsurers appear increasinglydrawn towards solutions from the capital markets, perceivingstructured products such asinnovative debt and securitisationsa potentially more cost-effectivemeans of meeting their capitalneeds. Reinsurance can beperceived as expensivefinancing. Investment banks andcapital houses are investingheavily in the skills and expertiseto exploit this new market.

The challenge and opportunityfor reinsurers is to create orreinvent risk transferarrangements that help insurersmanage their capital positions ina cost-effective way, comparablewith the costs associated withcapital markets products.

One way of doing this might beto take a long hard look at whetherreinsurance arrangements couldbe used as a way of enablinginsurers to take regulatory creditfor the diversification within theiroperations. If a cost-effective

EUROPEAN REGULATORY CHANGE – THREATS OR OPPORTUNITIES? continued


means of crystallizing thediversification benefit through acombination of internal (mixer orcaptive-type arrangements) andexternal reinsurance could befound, this might provide a moretangible way of demonstratingthe value of diversification toregulators and other stakeholders.This might help avoid theprospect of a lengthy academicdebate to seek to prove the

theoretical and practical basis fordiversification – a debate which,at the end of the day, theregulators have the casting vote.

It remains to be seen whether thereinsurers and their clients in theEuropean insurance markets areequal to the challenge. If the recentpositive and proactive responseof the insurers to the first wave ofradical change in reporting and

regulation is anything to go by,the prospects are good, but it’sgoing to be tough.


EUROPEAN REGULATORY CHANGE – THREATS OR OPPORTUNITIES? continued

AUTHOR

Tim HarrisPartner, Global Capital Markets Group, LondonTel: 44 20 7213 [email protected]

Record retention compliance in achanging regulatory environment

AUTHORS: JIN J. LEE, JAMES SANTANGELO AND ROSALIND CONWAY


Evolving regulations require compliance with a staggering variety ofretention periods, storage methods, and other specifics correspondingto the many types of company records generated in the course ofdoing business. With the market’s focus on corporate accountability,the government agencies that put forth these regulations have beenincreasing their scrutiny in the record retention area, especially electronicrecords, elevating the risk of non-compliance and ultimately litigation.

Introduction

Insurance companies are nowfaced with the arduous task ofpromptly updating and modifyingtheir current records managementprograms to reflect recentregulatory requirements for recordretention. United States regulatorsfrom the Securities and ExchangeCommission (SEC) to the Healthand Human Services and theNational Association of SecuritiesDealers (NASD) have implementedand are rigorously enforcingbooks and records regulatoryrequirements, including:

1. The Sarbanes-Oxley Act 2002(SOX), Section 802 (CriminalPenalties for AlteringDocuments) of SOX imposespenalties and/or fines foraltering, destroying, mutilating,concealing, falsifying records,documents, or tangible objectswith the intent to obstruct,impede or influence a legalinvestigation.1

2. The Health InsurancePortability and AccountabilityAct of 1996 (HIPAA) 45 CFRParts 160 and 164 underHIPAA requires healthcareinstitutions to implement acomprehensive informationsecurity plan.2

3. SEC Rule 17a-4 for broker-dealers states the types ofrecords that brokers anddealers are required to create,how long they must be stored,and under what mediarequirements.3

4. NASD 3010 and 3110 requirethat brokers and dealersmonitor and supervise theexternal transactions andcommunications of registeredrepresentatives, including the monitoring, archiving, and retrieval of instant message traffic required by SEC Rule 17a-4.4

Given the number of newregulations, the emphasis oncompliance and enforcement, and the potential financial and reputational impact on non-compliance, insurancecompanies have started to reviewtheir current record retentionpolicies, procedures, andcompliance. Subsequently, theyhave often found themselves withoutdated policies and proceduresand potential exposure to non-compliance. Companies alsofound that they are: 1) notretaining records as required; 2) retaining records longer thannecessary, subjecting their

records to electronic discovery; or 3) more significantly,inadvertently destroying recordsthat the company is legallyobligated to retain. Recordretention becomes even more of a major issue for companies whenthey find themselves immersed inelectronic discovery during litigationand undergo the enormous effortand resource allocation necessaryto produce electronic records,which creates a tremendousburden for the organization.

In 2004, the financial servicesindustry was put on notice aboutthe importance of a robust recordretention program throughregulatory enforcement and court action:

• The SEC brought a ‘documentscase’ against the Banc ofAmerica Securities in March2004. The SEC’s extraordinaryenforcement action againstBanc of America Securities(BAS) resulted in BAS beingcensured and ordered to pay a civil penalty of $10,000,000.During the investigation, theSEC stated that BASrepeatedly failed promptly tofurnish documents that hadbeen requested by the staff.Specifically, BAS failed in a

Insurancecompanies arenow faced with thearduous task ofpromptly updatingand modifying theircurrent records…

RECORD RETENTION COMPLIANCE IN A CHANGING REGULATORY ENVIRONMENT


1 Sarbanes-Oxley Act of 2002, Section 802, §1519.2 Federal Register, Volume 68, No. 34, 45 CFR Parts 160 and 164, February 20, 2003.3 Elizabeth Clark, ‘Data Retention Regulations: Keep It Legal.’ Network Magazine. March 3, 2004, p.1.4 NASD Notice to Members 03-33 (Clarification for Members Regarding Supervisory Obligations and Recordkeeping Requirements for Instant Messaging),

p. 345, July 2003.

timely manner: (i) to produceelectronic mail, including aparticular e-mail exchangerelating to matters that BASknew were underinvestigation; (ii) to producecertain compliance reviewsafter the staff had requestedthem; and (iii) to producecompliance and supervisionrecords concerning thepersonal trading activities of aformer senior employee of thefirm. When BAS ultimately didrespond to the staff’srequests, its responses wereoften incomplete, inaccurateor unreliable.5

• In Zubulake v. UBS Warburg(UBS), the U.S. District Courtfor the Southern District ofNew York entered a motion to sanction UBS on July 20,2004 for destroying e-mailssent or received by UBSpersonnel relevant to thelitigation.6 On April 6, 2005, a federal jury in New Yorkreturned a verdict in thewrongful termination case ofZubulake vs. UBS WarburgLLC, awarding $29.3 million tothe plaintiff where the plaintiffestablished that the defendantfailed to preserve potentiallyrelevant e-mails after learningthat Zubulake was pursuing aclaim. The Court granted an‘adverse inference’ instruction,noting that the jury couldassume that the missing

documents were damaging tothe defendant in light of thedefendant’s failure to fulfill itsduty to preserve and producethose documents;7

• The SEC announced onAugust 23, 2004 that it finedfour firms (Adams Harkness,Inc., Needham & Company,Inc., Janney MontgomeryScott LLC, and MorganKeegan & Co., Inc.) forviolating the record-keepingrequirements of Section 17(a)and Rule 17a-4 of theExchange Act concerningbusiness-related internal e-mail communications duringthe period July 1999 throughJune 2001. Each of the fourfirms consented, withoutadmitting or denying thefindings, to a cease-and-desistorder and to undertakings toensure that they are incompliance with the record-keeping requirements ofSection 17(a) and Rule 17a-4of the Exchange Act;8

• The New York Attorney-General Eliot Spitzer, onOctober 14, 2004, announcedhis office’s filing of bothcriminal and civil lawsuitsagainst Marsh & McLennan,the largest U.S. insurancebrokerage firm, a probe partlybased on a trail of internal e-mails;9 and

• In a legal blow to Wall Streetgiant Morgan Stanley, a Floridajury awarded billionairefinancier Ronald Perelman$604.3 million on his claimsthat the investment bankdefrauded him when he soldcamping-gear maker ColemanInc. to Sunbeam Corp. in1998. The nine jurors foundthat Mr. Perelman, chairmanof cosmetics giant RevlonInc., relied on statementsmade by Morgan Stanleywhen he sold his stake inColeman to the investmentbank’s client, Sunbeam, for$1.5 billion in stock and cash.Not long after the deal,accounting shenanigans atSunbeam were exposed andthe value of Mr. Perelman’sinvestment plummeted.Sunbeam sought bankruptcy-court protection in 2001.Florida State Judge ElizabethMaass, angered by what shecalled Morgan Stanley’s bad-faith actions in turning overdocuments relevant to thecase, entered a so-calleddefault judgment against thefirm, making Mr. Perelman’scase decidedly easier thanestablishing that he had beendefrauded. In most fraudcases, plaintiffs have to provethey actually were defrauded.10

In this unusual trial, the judgetold jurors to accept as factthat Morgan Stanley helpedSunbeam defraud investors.

Federal and state regulatory concerns

Considering the imposition ofrecord retention complianceresponsibilities dictated byfederal and state regulations, it is incumbent upon theinsurance industry to lookbeyond the NAIC MarketConduct Record Retention andProduction Model Regulation11

and state insurance statutes forguidance on complying with themyriad of complex governmentrecord-keeping requirements. For example, SEC Rule 17a-4has become a rightly placedfocal point of concern forinsurance companies and otherplayers in the financial servicesindustry because of increasedregulator enforcement action andthe resulting financial and legalconsequences that come fromnon-compliance. Although therecord retention requirements offederal regulations such as SOXare targeted at public companies,privately owned companiesshould also assess theirinformation and recordsmanagement practices in thespirit of enterprise-wide riskmanagement. In the post-SOX era, all organizations (public companies as well asprivate companies not subject to SOX) should revisit theirrecords management programsto ensure they appropriatelyaddress their business, legal, and compliance needs.12

RECORD RETENTION COMPLIANCE IN A CHANGING REGULATORY ENVIRONMENT continued


5 Securities Litigation Watch. March 2004. ‘Banc of America Hit With $10 Million Penalty For Impeding SEC Investigation’. March 11, 2004.6 Zubulake v. UBS Warburg LLC, et al. 2004 U.S. Dist. LEXIS (SDNY, 20 July 2004).7 David Cohen. ‘Record Retention & E-Discovery: Zubulake Jury Returns E-Discovery: ‘Wake-up Call’.’ K&LNG Alert, April 2005. Accessed June 9, 2005.

<http://www.klng.com/files/tbl_s48News/PDFUpload307/11470/eda0405.pdf>.8 SEC Press Release, 2004-117. Firms Agree to Pay a Total of 3.65 Million; Four Firms Also Fined for Failure To Preserve E-Mail Communications. August 25, 2004. 9 Thor Valdmanis, Adam Shell, and Elliot Blair Smith. ‘Marsh & McLennan Accused of Price Fixing, Collusion.’ USA Today, October 15, 2004.10 Susanne Craig. ‘Perelman Beats Morgan Stanley.’ The Wall Street Journal, May 17, 2005.11 National Association of Insurance Commissioners. ‘2004, Model Laws, Regulations and Guidelines Model Regulation.’ Kansas City, MO.12 Randolph Kahn, Esq. and Barclay T. Blair. ‘The Sarbanes-Oxley Act: Understanding the Implications for Information and Records Management.’

Kahn Consulting Special Report: Sarbanes-Oxley. Accessed January 7, 2005.http://www.kahnconsultinginc.com/library/KCISOXReport.pdf#search=‘Randolph%20Kahn,%20ESQ,%20and%20Barclay%20T.%20Blair.%20%20The%20SarbanesOxley%20Act:%20%20Understanding’>.

Adding to the complexity of themyriad of federal statutoryregulatory requirements, recordretention standards for theinsurance industry vary greatlyfrom state to state, as noted, forexample, by the differences in theinsurance statutes/regulations ofNew York, Missouri, and Florida:

1. New York – Part 243.2(b)(1) of Title 11 of the OfficialCompilation of Codes, Rulesand Regulations of the Stateof New York (Regulation No.152) requires that a policyrecord for each insurancecontract or policy, except as otherwise required by law or regulation, must bemaintained for six calendaryears after the date the policyis no longer in force or untilafter the filing of the report on examination in which therecord was subject to review,whichever is longer.13

2. Missouri – The Missouri Codeof State Regulations (Rules ofthe Missouri Department ofInsurance, Division 300,Chapter 2-Record Retentionfor Market ConductExaminations) require that aMissouri policy record file bemaintained for each Missouripolicy issued, and bemaintained for the duration of the current policy term plus two calendar years.14

3. Florida – Florida’s insurancerecord retention standards aredetailed in the Floridastatutory and administrativecodes, specifying the recordretention standards that applyto recordkeeping for insurancecompanies. The FloridaAdministrative code, however,does not specify the recordretention period for policyissued records as do the NewYork and Missouri statutes for

record retention, an exampleof the lack of consistencyamong the state statutoryrequirements for the sametype of record.15

Mitigating the risk of non-compliance

Evolving regulations requirecompliance with a staggeringvariety of retention periods,storage methods, and otherspecifics corresponding to themany types of company recordsgenerated in the course of doingbusiness. With the market’s focuson corporate accountability, thegovernment agencies that putforth these regulations have beenincreasing their scrutiny in therecord retention area, especiallyelectronic records, elevating therisk of non-compliance andultimately litigation. Suchaggressive investigation ofcorporate wrongdoing and therelated document requests,

expose many companies not onlyto negative publicity, but also tothe possibility of monetarysanctions. For a company’smanagement to navigate themultitude of record retentionvariables in today’s highlyregulated insurance industry and reduce its risk of non-compliance, it mustunderstand the implications of the changing business,technological innovation, andlegal requirements, and howthose changes affect recordretention criteria. Welldocumented and organizedrecords help form a basis ofevidence needed to defend thecompany’s position oncompliance-related matters.

Then how is it possible toimplement an enterprise-widerecords management program in order to mitigate the risk of non-compliance when the



13 Part 243.2(b) (1) of Title 11 of the Official Compilation of Codes, Rules and Regulations of the State of New York (Regulation No. 152).14 Rules of the Missouri Department of Insurance, Division 300, Chapter 2-Record Retention for Market Conduct Examinations.15 Florida Administrative Code, Chapter 4 (Department of Insurance), Section 4-184.004.

requirements are evolving on a number of fronts? If theappropriate policies andprocedures are in place today,what can be done to ensure that they are current and thatemployees comply with thosepolicies and procedures on adaily basis? The answer mustinclude a periodic analysis of:

• The understanding of thecurrent businesses and theregulations affecting them;

• The business processes and the types of informationthey generate;

• The record retention policies governing information management;

• How the information is used and stored as records,including the relatedtechnological infrastructureand systems used to secureand archive it; and

• The records managementorganizational structure andits effectiveness in execution.

The general approach to theeffective records managementprogram is to deploy enterprise-wide policies and procedures,apply technology to capture,archive, and retain theinformation, organize a networkof compliance coordinators tofacilitate the program, and, ofcourse, include general counselin any decisions that are made.But over a short period of time,there are revisions to theregulations, the technologychanges, some of the peoplewith program knowledge areredeployed, business processes

are modified and appropriateresources and processes are notin place to keep up. Therefore,the policy may becomeinsufficient, the technologyinadequate, or programadministration ineffective, butmost importantly, the companymay generate new informationoutside of the current policy dueto additions or changes inbusiness processes (e.g., throughan acquisition of anothercompany or the creation of newproducts or services) and theinformation that needs to bestored for record retentionpurposes is not being retained.This results in an ineffectiveprogram that translates into ahigh exposure to sanctions andpenalties for the company.Essential to reducing the risks isto establish a record retentionmethodology that integratesrecord retention compliance intoan organization’s corporategovernance and riskmanagement structure, whichprovides for periodic programassessments and audits.

What is the most effective approach?

A key driver of an effectiverecords management approach is the integration of a complianceprogram into the company’sbusiness processes. Forexample, an organization thathas the conflicting goals of an e-mail archiving strategy neededfor disaster recovery, but whichalso finds itself attempting tocreate an e-mail retentionstrategy to comply with federaland state regulatory requirements.These archiving and retentionstrategies should be integrated tosatisfy the objectives of disaster

recovery and record retentionutilizing the appropriatetechnology to support thisintegrated strategy. Also, one ofthe biggest challenges inimplementing a recordsmanagement program is theemployees’ compliance with thepolicies and procedures as theyperform their work. Integratingcompliance requirements into thebusiness processes and periodicaudits for their enforcement willmake the records managementprogram effective.

Additionally, periodicassessments and audits thatprovide regular ‘snapshots’ of theeffectiveness of the complianceprogram are essential to ensurethe program’s success. Periodicassessments and audits shouldbe completed to assist inevaluating and monitoring thefollowing areas:

• Company functions andbusiness processes and theinformation they generate –assess areas of the companythat are considered high riskto validate the informationthey produce;

• Regulations affecting thecompany functions and theirrecord retention requirements– review and determineapplicable laws and specificactions needed to comply;

• The company record retentionpolicies, procedures andretention schedules – ensurethey are updated inaccordance with the currentlaws and regulations, changesin business environment, andtechnology innovation;

• The technologicalinfrastructure and systemsused to store, secure andprovide business continuity –evaluate the technicalcapability and the ability toutilize technology to facilitaterecord retention to the fullestextent reasonably possible;

• The records managementorganizational structure –ensure that it is effective andthat people continue tocomply with its policies andprocedures; and

• Communications and trainingto ensure both are conductedperiodically and regularly.

Conclusion

The insurance industry facesmany challenges to keep pacewith the complex changes in thebusiness, legal, and technicalcomponents of the currentregulatory environment withrespect to record retention. Intoday’s regulatory environment,companies must re-examine theirenterprise-wide information anddocument retention policies andpractices to ensure theiradequacy. New and extensivedocument retention regulatoryrequirements, together withgreater regulatory scrutiny andenforcement, have significantlyincreased the risks and costs ofnot retaining documentation andinformation as statutorilyrequired. A records managementprogram that incorporates itscompliance requirement into the business processes, and a periodic assessment and audit, reduces the risk ofnon-compliance and drives itsoverall success.





AUTHORS

Jin J. LeePartner, Information and Document Retention ServicesTel: 1 312 298 [email protected]

Rosalind ConwayManager, Insurance Regulatory ComplianceAdvisory ServicesTel: 1 646 471 [email protected]

James SantangeloDirector, Information and Document Retention Services Tel: 1 203 881 0722

[email protected]

The CFO Forum’s EuropeanEmbedded Value – A superiorfinancial reporting framework for life insurers

AUTHORS: SHERYL A. BATTIT AND DAVID C. SCHEINERMAN


European Embedded Value (EEV) seeks to address certain limitationsassociated with most existing embedded value reporting, and providesa framework for financial measurement and disclosure that can be ofsignificant value to all life insurers, including U.S. insurers who havenot embraced embedded value reporting before.

Introduction

Transparency, consistency andcomparability: key goals of mostfinancial reporting systems, but not yet available acrossinternational borders. InternationalFinancial Reporting Standards(IFRS) are evolving to address thisgap, but in the near term, mostinsurance contract accounting willremain primarily based on localaccounting standards. Althoughmany European companies haveadopted IFRS this year, it willrequire significant experience andtime for the benefits of this newset of standards to be fullyrealized. This gap served as aprime motivator for the EuropeanInsurance Chief Financial Officers(CFO) Forum to develop analternative financial reportingframework: European EmbeddedValue Principles (EEV).

This article describes embeddedvalue reporting, how EEV seeks to address certain limitationsassociated with most existing EV reporting, and how EEV canassist internal and externalstakeholders in evaluating a company’s performance, the value of shareholders’interests and a company’s overallfinancial position. EEV provides a framework for financialmeasurement and disclosure thatthe authors believe can be ofsignificant value to all life insurers,including U.S. insurers who havenot embraced EV reporting before.

What is embedded value?

Mathematically, EV equals thepresent value of future‘distributable’ shareholder cashflows from ‘in-force’ (existing)business (PVIF) and the value ofcapital supporting the business.The value of capital supportingthe business includes requiredcapital (e.g. risk-based capital)and excess surplus (‘free surplus’)over required capital. The valuationof this capital recognizes theeconomic cost of holding therequired surplus to support existingbusiness. Present values aredetermined using a risk-adjusteddiscount rate, generally disclosedto the stakeholders.

EV measurement incorporates and discloses the value of newbusiness (the present value ofdistributable shareholder cashflows from the current year’ssales). EV earnings may also bedetermined as the change in EVduring the year plus dividendsminus capital contributions. EVearnings may be analyzed bycomponents, including the valueadded by the current year’s sales,the earnings from existingbusiness, and the investmentreturn on capital supporting thebusiness. In addition, each ofthese components may be furtheranalyzed in order to identify thesource of the earnings, which canprovide further insight from EV as aperformance measurement basis.

EV measures bridge a gapbetween statutory surplus (often reflecting conservativeassumptions that embed expectedfuture profit in reserves) and GAAPequity (which, although it reflectsa ‘going-concern’ perspective,allows most assets to be reportedat their fair value, while liabilitiesare generally reported at bookvalue). EV earnings may provide a clearer view of current-yearfinancial and managementperformance than either GAAP orstatutory earnings. EV estimatesare designed to reflect the effectof more realistic expectationsabout future performance andexperience, including investmentrisks/rewards, customer behaviorand other factors that influencefuture profitability.

How is EV used?

EV provides an economicvaluation of existing businessthrough a forward-lookingprojection of expected profit, and is used in both external andinternal reporting. In both Europeand Canada, it has generally beenincluded as disclosureaccompanying life insurers’financial statements. Whenavailable, shareholders, ratingagencies and financial analystshave used EV to evaluate aninsurer’s financial performanceand position, as well as to providea more realistic view of currentand likely future return on capital.When viewed over time,

EEV provides a framework for financialmeasurementand disclosure…

THE CFO FORUM’S EUROPEAN EMBEDDED VALUE – A SUPERIOR FINANCIAL REPORTING FRAMEWORK FOR LIFE INSURERS


it provides an indication of thevalue added by management inrunning the business.

EV can be used internally as a basis for establishing andevaluating business strategies,and it has been effectively usedfor performance measurementand incentive compensationprograms. EV is also used byinsurers as a predictive basis forjudging pricing, capital allocationand risk management strategies.

Why did the CFO Forumdevelop ‘European EV’?

Although current industry EVpractice is gaining increasedacceptance internationally, it hashad its detractors and someinherent limitations. Among themhas been a diversity in practicesrelating to the calculation and

disclosure of EV reporting, whichhas resulted in difficulties inmaking valid comparisonsbetween companies. As usage of EV increases within theinvestment community, it isimportant that these measuresbe consistent and comparableamong peer group companies.

Another criticism of conventionalEV techniques is that they fail to take proper account ofchanges in asset mix and thepotential cost of financial options(e.g., guaranteed minimum death benefits) and guarantees(e.g., minimum interest rates).Such concerns have beenheightened in recent years asvolatile equity markets and lowinterest rates have triggeredincreasing expected costsassociated with these obligations

and raised questions concerningthe reliability of the riskassumptions that underpin theEV projections. As a result, inEurope, analysts have sometimesapplied their own, sometimessignificant, risk discount topublished EV numbers.

To address these concerns, inMay 2004, the European ChiefFinancial Officers (CFO) Forumlaunched what they referred to as European Embedded ValuePrinciples (EEV). The CFO Forumbrings together CFOs fromEurope’s leading life insurers to discuss issues relating toaccounting standards anddevelopments and how toenhance transparency of theirfinancial accounts. The Forumhas sought ways to promotestability, credibility and

THE CFO FORUM’S EUROPEAN EMBEDDED VALUE – A SUPERIOR FINANCIAL REPORTING FRAMEWORK FOR LIFE INSURERS continued


comparability in financialreporting. EEV is a set of 12principles that aim to build onthe strengths of existingembedded value methodologies,while addressing the keyconcerns of users of theresulting information.

What are the key elements of EEV?

The 12 principles of EEV, as puttogether by the CFO Forum, aresummarized in Figure 1. Theapplication of these principles isexpected to provide morereliable and risk-responsiveinformation as well as enhancedfinancial disclosure, with a muchgreater degree of consistencyand reliability in the approach.

The EEV principles are designedto account for all significant risksin the covered business. Theyincorporate allowances forfinancial options and guarantees,the prudence of the liabilityvaluations, the cost of holdingthe capital needed to supportany mismatching of assets andliabilities, and a risk discountrate to determine the presentvalue of future cash flows. In their calculations, companiesare required to use stochasticmethods to estimate the futurecost of options and guarantees.Such projections need to reflectthe likelihood of a range ofscenarios and outcomes,including probable variations inlong-term economic assumptionsand possible changes inmanagement/customer behavior.

EEV’s extensive new disclosurerequirements include an analysisof the return on capital, alongwith sensitivity analyses to



The 12 principles of European Embedded ValueFIGURE 1


Principle 1: Embedded value is a measure of the consolidated value of shareholders’ interests in the covered business.

Principle 2: The business covered by the embedded value methodology should be clearly identified and disclosed.

Principle 3: Embedded value is the present value of shareholders’ interests in the earnings distributable from assets allocatedto covered business after sufficient allowance for the aggregate risks in the covered business. The embeddedvalue consists of the free surplus, the required capital and the value of future cash flows.

Principle 4: The free surplus is the market value of any capital and surplus allocated to, but not required to support, coveredbusiness at the valuation date.

Principle 5: Required capital should include any amount of assets attributed to the covered business over and above thatrequired to back the liabilities for covered business whose distribution to shareholders is restricted. The embeddedvalue should allow for the cost of holding the required capital.

Principle 6: The value of future cash flows from in-force covered business is the present value of future shareholder cash flowsprojected to emerge from the assets backing liabilities of the in-force covered business. This value is reduced bythe value of financial options and guarantees as defined in Principle 7.

Principle 7: Allowance must be made in the embedded value for the potential impact of future shareholder cash flows of allfinancial options and guarantees within the in-force covered business. This allowance must include the time valueof financial options and guarantees based on stochastic techniques consistent with the methodology andassumptions used in the underlying embedded value.

Principle 8: New business is defined as that arising from the sale of new contracts during the reporting period. The value ofnew business includes the value of expected renewals on those new contracts and expected future contractualalterations to those new contracts. The embedded value should only reflect in-force business, which excludesfuture new business.

Principle 9: The assessment of appropriate assumptions for future experience should have regard to past, current andexpected future experience and to any other relevant data. Changes in future experience should be allowed for in the value of in-force when sufficient evidence exists and the changes are reasonably certain. The assumptionsshould be actively reviewed.

Principle 10: Economic assumptions must be internally consistent with observable, reliable market data. No smoothing of market or account balance values, unrealized gains or investment return is permitted.

Principle 11: For participating business the method must make assumptions about future bonus rates and the determination of future profit allocation between policyholders and shareholders. These assumptions should be made on a basisconsistent with the projection assumptions, established company practice and local market practice.

Principle 12: Embedded value results should be disclosed at consolidated group level using a business classification consistentwith the primary statements.

Supporting guidance and more details about the thinking behind EEV are available on the CFO Forum website www.cfoforum.nl

enable users of accounts toassess the sustainability of thereported EEV results. Among theother disclosure principles isassurance that segment reportingis consistent with the company’sprimary financial statement,which for the larger Europeanlisted groups would normally be the segments determined in accordance with the new IFRS requirements.

Companies will also need toprovide information on theamount and cost of requiredcapital and the nature andtechniques used to value optionsand guarantees. In keeping withthe latest regulation on seniormanagement ‘ownership’ offinancial disclosure, executiveswill be expected to certifypersonally that the valuesproduced and the disclosuresprovided have been prepared inaccordance with EEV principles.Where this is not the case, theywill need to identify anydepartures and clearly explainwhy they have been used.

Greater consistency in EVreporting will be achieved in twoways. First, companies adoptingEEV need to use the principles intheir entirety. Secondly, theprinciples require the disclosureof key assumptions andsensitivities, which will betterenable the markets to make their

own assessments about howcompanies should be compared.Validation of the approach takenand the assumptions applied by an external review will alsoprove useful in increasing thecredibility of the resultingmeasures to stakeholders.

While life insurance is the keyfocus of EEV, the principles are designed to expand thepossible scope of embeddedvaluation to other long-termbusiness and could be extendedto non-life business.

What are the perceivedlimitations of EEV?

While adherence to the EEVprinciples should improve theconsistency and transparency of EV calculations, certainlimitations remain. For example,the principles do not require a fully ‘market consistent’ EVcalculation and therefore couldcontinue to allow insurersdiscretion over their allowancefor market risk and asset/liabilitymismatch risks. Although theEEV principles aim to addressthe concern that EV can beinflated by using a riskier assetmix with higher anticipatedreturns, it is not yet clear howthis concern is addressed by thenew methodology. Variationcould still exist, relative to thelevel of risk assumed in the

calculations, and in the amount of capital designated as beingnecessary to back the business.

A key practical issue that remainsis how to set risk discount ratesto reflect the aggregate risks not reflected elsewhere. Other practical challengesinclude satisfying the detaileddocumentation and disclosurerequirements involved,developing these values in a timely fashion, given all of theother reporting requirements that insurers are subject to, and developing the data retrievaland scenario modeling systemscapable of generating, calibratingand validating the necessary risk projections.

Finally, firms must consider thegovernance implications of EEV.Not only do they have to ensurethat senior managementunderstands and endorses thenew measures, but they alsohave to effectively embed themin the operations of the companyand explain them effectively tothe markets.

Conclusion: what does thismean to U.S. insurers?

As EEV support among analystsin the European market increases,the concept is likely to spill overinto the U.S. insurance market.Adoption of EEV principles within

the U.S. could provide anopportunity for improvedcommunication to stakeholders.

The use of EEV also presents an opportunity for U.S. insurers to enhance their internalperformance measurement. As public companies seek tomeasure their performancerelative to their peers, a standardapproach to measurement anddisclosure of embedded valuesusing the EEV principles shouldprove to be valuable.

Given the lack of sensitivity ofstatutory accounting measures torealistic current expectations, andthe sensitivity of GAAP earningspatterns to product classificationand its mixed book/market valueapproach, the authors believethat EEV provides a superiorfinancial reporting framework.EEV provides financial informationconsistent with the way insuranceproducts and strategies arepriced and valued, and EEVprovides for standardizeddisclosures that allow for moremeaningful analysis within andamong companies. The authorsbelieve that EEV provides asignificant opportunity to achieveimproved transparency,consistency, and comparabilityamong insurance companieswithin local markets and acrossinternational borders.



AUTHORS

Sheryl A. BattitManager, Actuarial and Insurance Management SolutionsTel: 1 617 530 [email protected]

David C. ScheinermanDirector, Actuarial and Insurance Management SolutionsTel: 1 860 240 [email protected]

China and India – Opportunitiestoo big to ignore?

AUTHORS: ROBERT FOK AND KHUSHROO PANTHAKY


To enter China and India successfully, an overseas insurer must know the markets and carefully consider the options.

Without doubt China and Indiaoffer some of the very largestopportunities for insurersworldwide today. However, they are very different both inregulatory environment and in the potential approaches aninterested investor might take. A comparison of the two isinstructive in deciding on possible market entry strategies.

Where they are similar is inpopulation size. Currently, China is the most populous country inthe world, with a total populationof 1.27 billion, followed by Indiawith 1.06 billion (mid-1999figures). By 2045, it is projectedthat the Indian population willoutstrip that of China – 1.501billion as against 1.496 billion.

Significantly for internationalinsurers, both markets are soon to enter a new phase. This yearChina will remove some of theregulatory restrictions which have held back foreign-investedcompanies in the past. In India,new rules on ownership are likelyto give multinational insurersgreater scope to expand theirlevel of ownership in future.

While non-life companies in Chinamay be wholly foreign-owned,foreign-invested life companies arerequired to take the form of jointventure operations. India restrictsthe maximum foreign holding, in companies writing any class of insurance, to 26%.

However, while the rules onownership may be unattractive,the foreign insurer has, in manycases, effective control of keymanagement positions and hence of company strategy and operation.

Looking at the reality of doingbusiness rather than theregulatory situation, the position is rather different. While thepercentage foreign holding inIndia is half that of China –26% rather than 50% – productinnovation and less restrictiveregulation have enabled foreign-invested life companies to achievea market share of 13%. In contrast,the tight regulatory environment in China, with restrictions onwhere foreign-owned companiescan do business and theirexclusion from the group market(recently relaxed), combined withvigorous competition from localcompanies, has led to foreigncompanies winning only 1.9% oflife business in 2003(see Figure 1 overleaf).

Before considering market entry strategies, it is helpful to take a bird’s eye view of the two markets.

Market background – life assurance

In 2003, the Chinese life insurancemarket totalled US $36bn inpremiums – two and a half timesthe size of the Indian market.

Penetration levels are similar ataround 2.3% of GDP. However,there are sharp differences in themake-up of national savings. InIndia, the proportion of householdsavings accounted for by lifeassurance is about 15%, withpension and provident funds taking up a further 19%. This is in sharp contrast to China, wherelife and pension savings make up only around 5% of retail savingsassets, despite the greater size ofthe market. It is therefore clear thatthere is a considerably greaterpotential for transfers of funds frombank deposits to life assurancepolicies in China than in India (see Figure 2 overleaf).

Both markets have seenimpressive growth in the last few years. In 2003, the Chinese life assurance market grew byover 30% and in India growth was 18% (2002-03). In themedium term, life assurancepremium growth in both countries will increase faster than GDP. In fact, high GDPgrowth rates, combined withpenetration moving towardsmature market levels of 4% ormore, will ensure double digitpremium growth. In the immediatefuture, growth drivers in Chinamay be stronger, since thepopulation is aging much fasterthan in India and recent pensionreforms lay heavy emphasis onthe insurance sector. However,much of the growth of the

Both markets have seenimpressive growth in the last few years.

CHINA AND INDIA – OPPORTUNITIES TOO BIG TO IGNORE?


CHINA AND INDIA – OPPORTUNITIES TOO BIG TO IGNORE? continued


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illio

n

Source: China Insurance Yearbook (2001-2003)

0

3

6

9

12

15

1999 2000 2001 2002 2003

5.7

28.2%

43.5%

10.3%

18%

7.3 10.4 11.5 13.6

US

$ b

illio

n

Source: IRDA Annual Report 2002-03

Ping’An CPIC Other domestic companies

AIA Other foreign companies China Life

10.5

55%

20%

13%

11%

1.2%0.8%

55%

Life market share of year 2003 in ChinaFIGURE 1

Source: China Insurance Yearbook 2004

Foreign companies

Life insurance Corporation of India

10.5

55%

13%

87%

Life market share of year 2003 in India


FIGURE 2 Growth of life premium income in China Growth of life premium income in India

Chinese bancassurance markethas been occasioned by theswitching of savings from bankdeposits to life assurance; aprocess likely to be dampenedby the recent interest rate rise.

While business growth rates have been attractive, margins onbancassurance business in Chinahave been poor. Significantly,management of business mix has been a key factor in theprofit performance of the playersin this market. Foreign jointventures have generally had a lower proportion ofbancassurance business and no group business, resulting in better gross margins (see Figure 3).

Market background: non-life assurance

In 2003, China’s overall non-lifepremiums came to US $10.5 billion, dwarfing the Indian market’s rather smaller total of US $3.6 billion. The relativesizes of the respective non-lifemarkets are explained by theChinese economy’s greaterurbanisation and emphasis onmanufacturing. Growth rates are similar – nearly 12% in China and 13% in India – and they are likely to run a little aheadof GDP growth as penetrationlevels rise from 1% in China and 0.6% in India towards mature market levels of around 2% (see Figure 4).



0

2

4

6

8

10

12

1999 2000 2001 2002 2003

6.3

14.8%

14.5%

13.6%

11.7%

7.2 8.3 9.4 10.5

US

$ b

illio

n

Growth of non-life premium income in ChinaFIGURE 4


0.0

0.5

1.0

1.5

2.0

2.5

3.0

3.5

4.0

1999 2000 2001 2002 2003

2.1

5.9%

25.9%

12.9%

12.5%

2.2 2.8 3.2 3.6

US

$ b

illio

n

Growth of non-life premium income in India


Individual single premium

Individual regular premium

Group

Bancassurance7.214.8%

0 1 2 3 4 5 6 7 8

24.4%

73.2% 23.8%

6%

8%

4%

3%

Profit margins of life insurance products in ChinaFIGURE 3

Source: PricewaterhouseCoopers Estimates

According to published results for the last three years, the Chinese non-lifemarket has been profitable.Although some market segments have relatively lowrates, at market level there hasbeen an underwriting profit. In contrast, recent years haveseen most Indian non-lifecompanies make underwritinglosses – turned into modestprofits only by substantialinvestment returns (see Figure 5).

Regulation has significantlyaffected market make-up in both countries. The Indian non-life market is dividedbetween five public sectorcompanies and a larger number of new, private sectorcompanies, some of which are joint ventures with foreigninsurers. These new companiescurrently have a combinedmarket share of 14% and, in response to recent poorunderwriting conditions, havebeen more selective as to which risks they will accept.

China has around 11 domesticnon-life insurers and 11 foreigncompanies but, currently, foreigncompanies’ market share is small.Past geographical and productrestrictions, not applied todomestic companies, have playeda significant part in holding downthe foreigners’ share. As theserestrictions are about to be lifted,the market may now be moreattractive to foreign companies.Importantly, though, 60% of theChina market is motor business,which is effectively closed toforeign insurers and is expectedto remain so (see Figure 6).

While entry to either market is not without challenges andrisks for a foreign company, the opportunities are large. With restrictions set to loosen in the life sector in China and ownership rules likely to become more attractive in India next year, more foreign insurers are actively considering these two exciting markets. Over the next few pages, we look at life market entryconsiderations from the point of view of overseas insurers.





2001

2002

2003 7.214.8%

0% 20%-20% 40%

Loss ratio

60% 80% 100% 120%

71.9% 24.4%

73.2% 23.8%

68.5% 25.1%

6.4%

3%

3.7%

2%

1.6%

-0.3%

(% of net premiums earned)

Expense ratio

Underwriting profit Investment return

Overall profitability of a leading non-life insurer in China

FIGURE 5

Source: PricewaterhouseCoopers research

-600

-500

-400

-300

-200

-100

100

0

1998-99 1999-00 2000-01 2001-02 2002-03

National New India Oriental United

Royal Sundaram Reliance IFFCO-Tokyo Tata-AID

Bajaj Allianz ICICI Lombard Cholamnadalam HDFC-Chubb

Overall profitability of non-life insurers in India


10.5

55%

11%

15%

60%

13%

1%

Ping An Other domestic

Foreign companies PICC CPIC

Market share of non-life insurer 2004 March in ChinaFIGURE 6


10.5

55%

14%

25%

21%

19%

18%

3%

Others New India National

United India Oriental ECGC

Market share of non-life insurer 2004 March in India


Entering the Chineselife insurance marketEntry strategies

Foreign companies cannotoperate wholly owned subsidiariesor branches, therefore they musteither form a joint venture (JV) or become a strategic investor in a domestic company (with a maximum stake of 24.9%). There are effectively three types of opportunity:

• A joint venture with a Chinese partner;

• A strategic investment in a small or start up domesticinsurer; and

• A strategic investment in a large domestic insurer.

To date, most foreign entrantshave favoured the joint ventureroute. A lack of enthusiasm forjoint ventures back in head officehas generally been offset by thelimited alternatives available andthe scale of the opportunity. For various reasons, there havebeen marked differences in thesuccess of joint ventures.Implementation is key.

Most of the restrictions to whichjoint ventures were subject are in the process of being relaxed.Subject to gaining a license, thereis now no practical limitation onthe locations in which a jointventure can operate. The inabilityto transact group business waslifted in December 2004.However, the JV model posestwo critical challenges:

• The first is to develop brandrecognition and an adequatedistribution infrastructure inthe face of fierce domesticcompetition; and

• The second is to keep theChinese JV partner, whosefamiliarity with life insurancebusiness is likely to be verylimited, comfortable with thegrowth and capital investmentstrategy being pursued.

At the moment, strategicinvestment in one of the smaller,recently-licensed, domesticcompanies amounts to little morethan buying a stake in a license.None of these companies has yet achieved scale and there areseveral who are still in the set-upphase. Of course, being in at thestart of a business offers moreopportunity to influence directionthan would normally beassociated with a minority stake.

It should also offer a faster track to getting into business orgaining regulatory approval forexpansion plans. Additionally,this year’s recent tranche of newdomestic licenses also meansthat the supply of potentialinvestments has increased, whichmay exert some downwardpressure on the prices beingsought for minority stakes.

Making a strategic investment in one of the larger domesticinsurers poses stiff challenges.The three major life insurancecompanies have already eithercompleted deals or are indiscussions with potentialinvestors. Global insurers already

hold strategic investments in thetwo medium-sized life companies– Xinhua and Taikang. Buyinginto an existing operationalstructure and business strategyoffers opportunities, but it alsoholds risks which are not alwayseasy to identify.

JV partner selection

Some foreign companies whohave formed life JVs haveexperienced conflicts with theirChinese partners. Many complainthat their Chinese partner has notdelivered operational advantages.Others have found that the newpartner’s management teamlacks the necessary understandingof the long-term perspectiveneeded to write life business andthat, as a consequence, financialobjectives are not aligned. Thepartner selection process needsto consider issues such as thisvery carefully indeed. It is alsoimportant not to be dazzled bythe names of potential partnersbut to consider carefully what allpotential partners might bring tothe joint venture.

In our view, there are several key steps.

Firstly, it’s prudent to eliminateindustry groups which aregenerally unattractive to foreigninsurers sensitive about theirreputations, such as military-related industries or tobaccocompanies. Secondly, manyforeign companies are adverse tostakes in banks or securitiescompanies, and obviously thosewhich already have an insuranceJV with a foreign company areruled out.

Secondly, you need to develop a set of selection criteria suitablefor the Chinese market. Thesemight include the usual itemssuch as financial strength, brandposition and strength (in China),distribution capability andsynergies. These are questions of fact.

Three further criteria are material.The first is the potential JVpartner’s attitude towards apotential overseas industryinvestor. In addition, the reputationof the company and its keymanagement personnel isabsolutely fundamental. Last, but by no means least, potentialinvestors need to pay closeattention to any possible partner’srelationship with the government.

Only at this stage should thesearch for a partner begin.Careful screening against thecriteria, using publishedinformation but also informalconversations with the potentialpartners, regulators and others,should be carried out. This willyield a short list with whom moredetailed negotiations may beconducted. It is unusual to selecta preferred partner until a relativelylate stage in the discussions.

Business locations

With the restrictions on businesslocations having been lifted atthe end of 2004, the selectionnow needs to be a morestructured process than before.



For the next five years at least, bothgrowth and market opportunitylook likely to remain concentratedin the eastern coastal provinces.The factors below are material tothe successful ranking ofpossible locations.

Growth potential – much of theavailable data on individual cityand provincial markets requiresinformed analysis.

Target market – foreign insurerswho target the affluent marketmay favour Shanghai and Beijing,whereas those who target themass market may lean towardsTianjin, Jiangsu, Zhejiang andGuangdong. Accuratelyestimating the size of the targetmarket in each potential businesslocation is crucial.

Competition – levels ofcompetition vary considerablybetween cities and the mostattractive places to new entrantsnow will not tend to be theexisting hot spots of Beijing,Shanghai and Guangzhou. Those new companies who have blazed a trail in what wereseen as secondary cities havebeen rewarded with significantsuccess, having found thecompetition for distribution andcustomers much less intense.

Branding – the level ofcompetition in many areas issuch that branding is critical.While, in most developedinsurance markets, branding is a national issue, in China, it is local perception of foreignbrands which counts and whichshould play an important part inthe selection of businesslocations. Consumers in somecities are more receptive to

foreign brands than are theircounterparts elsewhere. Forexample, there is a big differencein the values with which Shanghaiconsumers imbue foreign brandsand those of other cities.

Profitability

There is significant variation inprofitability between marketplayers. Some of those heavilyfocussed on bancassurance have seen declining margins as the banks have exploited their control over the distributionchannel to demand a greatershare of the cake. At the sametime, the growth in participatingbusiness means that, overall,newer business has beeninherently less profitable forshareholders than the non-participating business sold in the recent past.

Interestingly, careful managementof business mix has enabledsome companies, both foreignjoint ventures and domesticcompanies, to do considerablybetter than the market generally.

Investment environment

The investment options for lifeinsurers remain limited, both interms of regulatory requirements

and the supply of suitableinvestments. Investments insecurities funds, which typicallyhold 70% in equities, are limitedto a maximum of 15% ofinvested funds. Direct investmentin equities is limited to 5% oftotal assets. Direct investment inproperty is prohibited. At the timeof writing, overseas investment isalso prohibited, except to matchforeign currency policy liabilitiesor in other limited circumstances.

In addition, no more than 20% of assets can be invested in corporate bonds. These must be AA rated and relate to Government-sponsoredinfrastructure projects.(Investment-linked contracts may be wholly backed by bondsor equities.)

The remaining funds effectivelyhave to be invested inGovernment bonds, bondsissued by financial institutions or bank deposits.

Stock market

China’s stock market has a short 13-year history. At the end of 2003, there were 1,287companies listed domestically (A & B shares) with a total

market cap of RMB 4,246 billion.The Chinese government owns the non-tradable portion of the market capitalisation,which is about 70%. The mostrecent bear market started inmid-2001. After two years ofdisappointing performance, the domestic stock market finally ended up in positiveterritory in 2003 (see Figure 7).

Bond market

Compared with more maturecapital markets, China’s bondmarket is underdeveloped. As at the end of 2002 it was RMB 2.67 trillion, only about a third of the size of the stockmarket. Current bond typesinclude treasury bonds,corporate bonds, convertiblecorporate bonds and policybonds. These are bonds issued by the ChinaDevelopment and China Import and Export Banks for purposes of generating funds for infrastructuredevelopment and internationaltrade. Treasury and policy bonds make up 98% of totalbond balances. There are nomortgage or asset-backedsecurities (see Figure 8).



Stock exchange data 2003FIGURE 7

Source: www.research.lipper.wallst.com

Shanghai Shenzhen Total Stock Exchange Stock Exchange

Number of companies 783 504 1,287

Market cap (RMB billion) 3,011 1,235 4,246

Tradable market cap (RMB billion) 835 485 1,320

Money market

Current money marketinstruments include inter-bankloans, government bondrepurchase agreements,accounts receivable, centralbank bills, policy bills and short-term bonds, of which interbankloans and repos are the biggestproportion. As at September2003, their total trading volumewas RMB 14.22 trillion (seeFigure 9).

Funds

The Chinese mutual fund marketsaw a spectacular increase in2003 with the launch of 43 newfunds bringing the total to 114.As at the end of 2002, the greatmajority of funds were closed-end but all 43 new funds wereopen-end – the norm elsewhere.The first five money market fundswere successfully launched inDecember 2003 (see Figure 10).

Regulatory requirements

The reserving treatment to beused for each class of long-termbusiness (annuities, non-annuity

business, with-profits business,unit-linked and universalbusiness) is prescribed by theChina Insurance RegulatoryCommission (CIRC).

The table below summarises the key requirements for long-term life and health products (see Figure 11 overleaf).

Dividend distribution

Dividend distribution must complywith the CIRC’s guidance:

• The contribution method must be used to calculate the dividend;

• The dividend may be paid aseither a cash or reversionarybonus; and

• No less than 70% of profitmust be distributed topolicyholders as dividends.

Most companies limit distributionsto policyholders to the minimum of 70% and only distributeinvestment and mortality profits.




Chinese bond marketFIGURE 8

2002 balance 2003 issues Issue increase (RMB billion) (RMB billion)

Treasury bonds 1,600.00 628.30 10%

Policy bonds 1,000.00 442.00 44%

Corporate bonds 60.00 40.80 10%

Corporate convertible bonds 8.17 18.10 336%

Total 2,668.17 1,129.20 20%

10.5

55%

12%

61%

27%

Interbank loan Interbank repo Exchange repo

Composition of China’s money marketFIGURE 9

Source: People’s Bank of China as of September 2003

Chinese mutual fund data 2003FIGURE 10


2002 2003 TotalNumber Newly launched

Closed-end funds 54 – 54

Open-end funds 17 43 60

Total 71 43 114



Reserve component

4% of reserves

1% of reserves

Net amount at risk component

0.10% of NAR

0.15% of NAR

0.30% of NAR

Long-term products

Insurance products

Investment-related products

• Coverage period: less than three years

• Coverage period: three-five years

• Coverage period: over five years

Short-term business

The following reserves must be established:

• An Outstanding Claims Reserve (in respect of claims reported but not paid) is deemed equal to the estimated losses on claimsoutstanding as at the balance sheet date;

• IBNR is accrued at 4% of claims expenses incurred in the period; and• An Unearned Premium Reserve, i.e. a reserve equal to an amount of net premium written in any year but not yet earned.

Reserving

No more than the lower of

• Valuation interest rate announced by CIRC each year (7.5% currently)

• Corresponding pricing interest rate

• Same as pricing basis

• For whole life annuity, the policy reserve is the larger of that resulting from using the following two loadings:

• 80% of CL annuity mortality table• 120% of CL annuity mortality table

Interest rate

Mortality/morbidity – non-annuity

Mortality/morbidity – non-annuity

Pricing

No more than an equivalent yearlycompound rate of 2.5%

• China life insurance experiencenon-annuity mortality table

• China life insurance experienceannuity mortality table

Actuarial basisFIGURE 11


Life business solvency marginFIGURE 12


Solvency margin

The minimum solvency marginrequirement is calculated byapplying a percentage to a proxy for exposure to risk (see Figure 12).

In addition, there is an InsuranceSecurity Fund which is accrued at1% of retained premium incomefor those policies with terms ofone year to a maximum of 6% of total assets. While currentlyheld as part of the insurer’sassets, we understand that theregulators are considering settingup a formal centralised insolvencyfund (see Figure 12).

Financial reporting and taxation

Financial reporting

Insurers doing business in China must prepare financialstatements in accordance withPRC GAAP. This specifies theaccounting treatment for therecognition and disclosure ofpremium income, claims andbenefits as well as for thedetermination of reserves. The statements must be filed with CIRC. They also have to report specifically onparticipating insurance business,solvency position, otherregulatory indicators and otheroperational and actuarial issues.

Taxation

Insurance companies operatingin China are subject to bothcorporate income tax andbusiness tax. An insurer’seligibility for taxes and the ratespaid varies by type of companyand also by the economic zone in which it is licensed to operate.Certain insurance products are

eligible for business tax exemption(subject to the approval of theState Administration of Taxation). A major review of insurance tax is scheduled for 2006, although nodetails of its likely scope are yetavailable.

Key income tax provisions include:

• Domestic insurers pay nationalincome tax on taxable incomeat 30%. In addition, they alsopay local income tax at 3%;

• Foreign Invested Enterprises(FIEs) which have registered or operational capital of morethan US $10 million and a ten-year-plus business plan, payincome tax at a rate of 15%.In addition:

– No tax is payable in thefirst year of profit;

– For the second and thirdprofitable years of operation,tax is payable at 7.5%;

– If the profit is used toincrease the registered capital,or for other investmentpurposes, and the companyhas been in operation formore than five years, 40% oftax paid can be refunded; and

– The tax rates and rules for FIEs above are onlyapplicable if they have more than 25% overseasinvestment.

Key Business Tax provisionsinclude:

• Business tax is payable at 5%.

• Subject to approval by the State Administration of

Taxation, the following itemsare exempted from businesstax – with-profits policies with terms of one year ormore, annuity business, health insurance policies withterms of one year or more,agricultural insurance andexport credit business.

Entering the Indian life insurance marketAs in China, foreign insurersdoing business in India cannotoperate wholly-owned subsidiariesor branches. In order to begranted a licence to write lifebusiness, a foreign companycannot hold (either directly orindirectly) more than 26% of the paid-up capital.

Until 1999, all the life business had been written by a publicsector company called LifeInsurance Corporation of India(LIC). Currently, there are 13private companies which holdaround 15% of the life insurancemarket share. A joint venture,green field operation is the onlyrealistic entry strategy.

The general issues which needconsideration in selecting a jointventure partner and developingbusiness strategy are similar tothose encountered in China.

Regulatory requirements

Insurance companies doingbusiness in India are primarilyregulated by the ‘InsuranceDevelopment and RegulatoryAuthority’ (IRDA). There areseparate regulators for otherindustries in the financial services sector.

New life companies must pay a deposit of 1% of forecast gross premiums – subject to a minimum of INR 1 million(equiv. US $22,000) – and have at least INR 1 billion (equiv. US $22 million) share capital(after deducting preliminaryexpenses incurred towardsincorporation). Companies mustusually start writing businesswithin 12 months of beinggranted a certificate of approval.Business licenses are renewableannually and must be applied for,and the necessary fees paid,before December 31.

A license to issue policies usuallyallows the company to write allclasses of life business and tooperate across the country. New insurance companies mustadhere to rural and social sectorobligations by ensuring that a certain amount of policies are sold in, and a certain level of premium generated from rural and socially backwardareas. This part of business ismostly unprofitable.

Investment policy

The IRDA (Investments)Regulations 2000, as amendedfrom time to time, specify thetype and amount of permittedinvestments and also thereporting formats. Approvedinvestments are governmentsecurities, approved securities,and approved investments (usually infrastructure or social investments).



Stock market

Around 800 companies from all sectors are listed on theNational Stock Exchange (NSE).Current market capitalisation isUS $220 billion but significantgrowth – at a rate of 15.4% perannum – is expected until 2009,which is likely to see the markettop US $450 billion. NSE listssecurities in both its CapitalMarket (Equities) and WholesaleDebt Market segments.

Smaller, but still significant, is theMumbai exchange, called the‘Bombay Stock Exchange’ (BSE).

Solvency requirements

The rules for the valuation ofassets, norms for the valuation of liabilities and the methodologyfor the calculation of solvencymargins are primarily containedin the IRDA (Assets, Liabilitiesand Solvency Margins ofInsurers) Regulations, 2000.Separate formats (as defined inthe Regulations) need to beprepared and submitted forassets, liabilities and solvencymargins in respect of theinsurer’s total business and thebusiness in India. All the formatsneed to be signed and verified bythe insurer’s appointed actuary.

The Gross Premium Method isrecommended for calculatingmathematical reserves. In respectof linked business, the regulationsprovide for the separate valuationof unit and general fund reserves.Whatever the method used, it must take into account allprospective contingencies (underwhich premiums are paid by thepolicyholders and any benefitspayable to them, as determined

by policy conditions). Liabilitiesmust be valued on a policy bypolicy basis.

In the case of any policy wherethe mathematical reserves arenegative, the company actuarymust set the value of any reserveto nil for the purpose of calculatingthe solvency margin and also forcomputing the surplus available fordividend distribution (Section 49).

Actuarial assumptions are based on the insurer’s ownexperience and generally include an appropriate Margin for Adverse Deviation.

The Solvency regulations requireall insurers to maintain assets of at least US $11 million (US $22 million for reinsurers) in excess of liabilities or anequivalent sum calculated usinga formula given in the regulations. Insurers are required to maintain a solvency ratio of 1.5 times the statutory requirement.

Reinsurance

Government policy on reinsuranceaims to maximise retention withinthe country, develop adequatedomestic capacity, secure bestpossible protection for the costsincurred and simplify theadministration required, and sothere are specific rules onretention of risk, cession,reinsurance and retrocession.

Every insurer is required to submitits reinsurance program for theforthcoming financial year toIRDA at least 45 days in advanceof the start of that year. Subjectto prudent practice, insurersmust maximise their retention.IRDA can require an insurer to

justify its retention policy anddemonstrate that it is not frontingfor a foreign insurer.

At present, the only reinsurer inthe country is General InsuranceCorporation of India, to whom20% of the non-life reinsurancepremiums are mandatorily ceded.

Financial reporting andtaxation

Financial reporting

The rules on financial accountingand reporting are prescribedunder the IRDA (Preparation of Financial Statements andAuditor’s Report on InsuranceCompanies) Regulations, 2002,and Section 11 of the InsuranceAct, 1938.

Separate records are required in respect of life, pensions andunit-linked business. Similarly,separate records must be held on policyholders’ andshareholders’ funds and businesswritten inside and outside India.

Section 11 of the above Actrequires insurers to submit abalance sheet, profit and lossaccount and revenue account for each year of business. The Regulations specify therequired format. The financialstatements must be signed by theChairman (if any), by two directorsand by the Principal Officer.Audited accounts must besubmitted to IRDA within sixmonths of the end of the period towhich they relate.

Taxation

Insurers are liable to both Serviceand Corporate Tax. Service Taxrates have recently increased from

8% to 10%. In addition, servicetax has just been levied on therisk element of life policies.Education cess (a levy towardsensuring development ofeducation in the country) of 2%on all taxes is levied, which impliesthat the services on insurancewould attract an additional 2% on the tax amount. A flat rate of10.2% is levied on premiumreceived for non-life policies.Furthermore, the life insurancepremiums are also subject to thelevy of service tax on the portionwhich can be fully attributedtowards insuring mortality risks.

The Life Insurance Corporation of India (LIC) is the only lifecompany actually declaringprofits and therefore currentlypaying corporate tax.

Until now, there are no insurancecompany-specific taxationarrangements, althoughrecommendations by a reviewcommittee on this issue havebeen given to the Government.New rules are expected in thenear future.

Conclusion

The Chinese and Indian lifeinsurance markets are expectedto see double digit rates ofgrowth in the medium term.

To capitalise on this, potentialentrants need to consider theirentry strategy very carefully. They need to:

• Aim for a corporate structurethat aligns with their businessphilosophy. Areas that needparticular attention aremanagement control and theability to use their relative



advantages such asunderwriting expertise andease of exit;

• Adopt a thorough andstructured approach toidentifying a short list of eligiblepotential JV partners, takingspecific market conditions into account. Preliminary duediligence is essential before any memorandum ofunderstanding is signed;

• Understand the implications of the financial reporting and taxation requirements;

• Thoroughly understand the investment environmentin which life companies must operate and take this into account in theirbusiness planning;

• Select potential businesslocations very carefully, taking into considerationoverall growth potential, size of target market andespecially national and localbrand perceptions; and

• Consciously seek todifferentiate themselves fromlocal companies (who have a dominant market share) by using focussed distributionmethods and differentiatedproduct designs.



AUTHORS

Robert FokDirector, Actuarial Services, AsiaTel: 852 2289 [email protected]

Khushroo Panthaky Associate Director, Insurance Industry Practice, IndiaTel: 91 22 2267 [email protected]

The preceding article was originally printed in PricewaterhouseCoopers Asia Pacific Insurance digest(February 2005), and is reprinted here by permission from our sister publication.

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