Financial Sector Assessment

Key Assessment Experience

The experience of assessments to date indicates that the insurance sector generally shows a weaker level of observance of international standards than does the banking sector.30 Most usually, the reason is reflected in a less well-resourced and less-independent super­visory body and in an insurance law that fails to provide the full range of powers to the supervisor to carry out the task envisioned in the ICPs. It can also reflect, however, a lack of actual soundness in the insurance sector itself. This section considers country experience with individual ICPs and reports the typical difficulties faced in achieving full observance.31

Overall, observance differs across core principles, with several weaknesses and strengths. The area in which insurance supervision is most deficient relates to corporate governance of insurance companies. Less than one-third of countries are observant or broadly observant with this core principle. This low level is mainly a result of unclear jurisdiction of the insurance supervisory bodies over corporate governance issues. In gen­eral, rules on corporate governance are to be found in corporate law. Also, in the field of internal controls, the supervisory authorities seem to have limited jurisdiction, and the system depends on general corporate laws and regulations.

The major areas of assessed weaknesses are organization of the supervisor and asset risk management. The organization of a supervisory agency needs to be improved in broadly one-third of the countries assessed. In a significant number of cases, the insur­ance regulator was incorporated into the Ministry of Finance, but insufficient resources (both in numbers and technical capacity) and unclear budgetary autonomy proved to be problematic in many cases. Although observance with respect to risk management is bet­ter, it is still weakly supervised with respect to asset portfolio in approximately one-third of countries, mostly concentrated in developing and emerging market countries. As in the banking sector, this weakness is an area of serious concern, mainly because adverse developments in asset values would in all likelihood directly affect the financial viability of the institutions. Deficiencies also occur in supervision of off-balance sheet exposures, notably in derivatives in more than half of the countries assessed. The issues arise mainly in developing and emerging market countries and primarily involve the absence of any regulations in this area.

Other areas of concern relate to market conduct. Rules in many cases were limited to rules on registration of brokers and agents and cross-border operations. The most impor­tant issue with respect to this principle relates to deficiencies in the exchange of informa­tion with other supervisors.

Creating all the relevant conditions for effective insurance supervision can be a chal­lenge in less fully developed markets. Statistics that can assist companies in correctly pricing and establishing provisions for insurance products may not be widely studied or reported. Asset markets may suffer from a lack of liquidity or may provide insufficient instruments of a duration necessary to match insurance liabilities. Often, the actuarial profession is particularly limited. In many cases, supervisors are able to take action to alleviate such problems, at least in part. Greater difficulties arise if the jurisdiction faces more widespread challenges, particularly if corruption levels are high and extend to the legal system.

Generally, all supervisors have the obligation to protect the interests of policyhold­ers, and this objective needs to be made more clear and transparent. Opportunities still remain, however, to bring transparency practices into line with best practice by elaborat­ing on the objectives in more detail and with more clarity rather than simply relying on the publication of the law itself. Usually, this stronger transparency practice represents an opportunity for the supervisory authority to take a greater leadership role in their public statements and in commentary in annual reports. An issue that is of concern, although not universal, is that the supervisor in some cases has conflicting objectives, for example, policyholder protection and industry growth.

It is difficult for a supervisory office that remains part of a ministry and subject to generic public service rules to demonstrate full observance of the ICP on adequate super­visory authority. Lack of independence from the Ministry of Finance has been a major issue—mainly in developing countries, where more than half of the sample countries exhibit poor implementation.

Transparency of supervisory process is often inadequate. Many supervisors have inter­nal processes that are well structured and understood within the agency. Nevertheless, the transparency of those processes is often inadequate.

Some supervisors have legal constraints that make supervisory cooperation and exchange of information and cooperation (ICP 5) difficult. Others may be able to cooper­ate in a legal sense, but the effective cooperation among supervisors inside and outside of the jurisdiction may be less than is desirable. In many cases, cooperation was warranted but did not, in fact, occur. Sometimes, in the extreme, cases have been identified in which the local supervisor made every effort to exchange and elicit information, but the counterpart did not respond. This type of case is difficult to assess, given the party that should have participated but did not was outside the jurisdiction. In cases such as these, it is suggested that the authorities’ efforts be congratulated explicitly in the report. Every effort to translate the intent of the standards into practical results by the international associations is to be encouraged in this area.

Weaknesses are found in rules concerning fitness and propriety (ICP 7 on suitability of persons). Frequently, the scope of the persons covered by the rules is limited or legal sup­port (for the otherwise effective moral suasion) to remove unsuitable persons is lacking. Less frequently, the law may not have provisions for testing fitness and propriety.

Usually, changes in control and portfolio transfers (ICP 8) are well covered in law, and transactions, when they arise, are given close attention by supervisors. The one weakness that may arise is the ability to look through the corporate structure beyond the immediate parent and, in particular, to examine transactions that take place outside the jurisdiction (e. g., when two international firms merge with a local operation that does not change direct ownership). The intent of the ICP is to protect policyholders from a change of control whether or not there is an intermediate holding company or other corporate structure, so this possible weakness can present an issue. Often, supervisors do not have the legal power to require local change of ownership of a licensed insurer to require shareholder divestment. That type of power would usually enable any concerns to be addressed by changes to proposed ownership arrangements, by conditions being placed on the approach to the management of the local insurer, or by other solutions. This issue

can also be related to the lack of a full set of sanction powers to facilitate and support the supervisor in its activities.

Corporate governance (ICP 9) and internal control (ICP 10) tend to show strengths or weaknesses together. Where the powers exist, the topics of corporate governance and internal control may have been the subject of recent rules but may not have yet found their way into reliable evidence of effective practice in the institutions; instead, new rules are being formulated on these topics and their robustness remains untested. In addition, where onsite inspections are not carried out, it is difficult for the supervisor to verify the full observance of these requirements.

Ongoing supervision, prudential requirements, and AML-CFT procedures for insur­ance were generally well observed (according to 2000 standards), but weaknesses were evident in implementation despite strong laws being in place. Some of the core principles in this area (e. g., market analysis, risk management, insurance fraud, AML-CFT) are relatively new; implementation experience at the country level is new, and assessment experience remains to be analyzed. Nevertheless, available evidence suggests that nearly one-third of all sample countries (and the majority of developing countries) demonstrated weak regulation of asset quality, and 60 percent of developing countries insufficiently supervised reinsurance practices of insurance companies. Procedures for orderly winding - up of failed insurers (and securities firms) were missing in a significant number of coun­tries sampled. Approximately, only one-third of the countries had adequate insolvency and bankruptcy regimes. Box 5.4 provides additional details on key weaknesses and issues in the ongoing supervision and prudential requirements for insurance.

Development issues related to the insurance sector will need specific attention in the course of ICP assessments. To this end, the assessor will need to consider the factors that affect the contribution of the insurance sector to overall economic development. The usual starting point is the development of the sector itself. The insurance sector, particu­larly the life insurance sector, can play a key role as a mobilizer and manager of savings and as a long-term institutional investor. The sector cannot do so, however, if the custody of policyholder funds is at risk or if the population does not have the capacity to invest in the sector’s products. Over time, it can be expected that this situation will improve as the sector develops, but limitations may exist. In the long run, a sector that is growing, that acts as an effective investor, and that provides long-term capital will be good for the economy and good for the overall well-being of the population—not just for those who are policyholders—as the economy develops.

Systemic risk should also be considered. In the case of insurance, this kind of risk can arise from two main sources and should be—in a reasonably well-run system—limited. First, the sector itself may be weak. Solvency may be in question or the economic envi­ronment may be such that it could reasonably be at risk, which can be serious, particu­larly if resolution measures are inadequate or if supervisory intervention is restricted. The failure of an insurer leads to significant hardship for those immediately affected32 and may lead to a loss of confidence in the sector as a whole that could take a considerable period to restore. The second source of risk rests in the linkages, if any, with the banking sector or with securities markets. For example, where an insurance company is owned by a bank, any potential weakness in the insurer may cause difficulty, or at least an imposition, on the capital of the bank. Insofar as the insurance sector is a significant protection seller
in credit derivatives markets, weaknesses of insurers could have implications for finan­cial stability. Moreover, when insurance companies are major holders of key instruments traded in the capital market, then market volatility may be significantly influenced by portfolio decisions of insurers.