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The Actuary The magazine of the Institute & Faculty of Actuaries

Rebuilding an industry

The Japanese life insurance industry is undergoing significant transformation. Regulatory change, the severe condition of the economy, and increased competition from foreign entrants are leading to change at an ever-increasing pace.

The industry today
The industry today can be segmented into the older, traditional domestic companies, the newer domestic companies, and the foreign players.
Up until around five years ago, the industry was dominated by the traditional domestic insurers, nearly all of them mutuals, offering similar products through large sales-force networks. Premiums were, in effect, fixed across the industry. Products sold provided interest guarantees to policyholders that did not appear onerous at the time. Such guarantees owed their origin largely to the Japanese Postal Service a government-backed insurer roughly three times the size of the next largest domestic insurer, Nippon Life. However, companies were not in the habit of matching asset and liability portfolios, and were consequently exposed to the steady decline in long-term interest rates and the collapse in equity and property prices that occurred in the 1990s.
Many of the newer domestic companies and the foreign players operating at that time focused on niches in product design or distribution. Companies like AFLAC, for example, targeted protection markets that until recently the traditional domestics had been prevented from entering. Companies like Sony and Prudential US marketed to higher net worth individuals through professional financial planners. These companies, with their shorter histories and different strategies, did not build up the same asset-liability mismatching problems of the traditional domestic companies.
The last five years have seen a further wave of foreign companies joining the market some through greenfield operations, some through acquisition; significantly, foreign companies have sponsored most of the restructuring that has so far occurred. They have been able to extend and diversify their customer bases and distribution channels. As a result, these international companies occupy a significant position in the market today.

Financial difficulties
With hindsight, proper asset liability management might have allowed the traditional domestic companies to avoid much of their current financial difficulties. However, after some 30 years of steady growth, no one had imagined returns could fall so far. Today, these companies have liability portfolios with average guaranteed interest rates of 3.2%3.8%. Ten-year government bond yields have fallen to just 1.4%. The difference between the rate companies are earning and the rate they are paying policyholders is commonly known as ‘negative spread’. For example, in the financial year ending 31 March 2001 Nippon Life, the largest company, reported negative spread losses of ¥320bn (approximately US$2.4bn). Companies have funded interest losses from mortality and expense profits, and unrealised gains on equity and property portfolios. However, these unrealised gains have been successively eroded by falls in equity and property values. This year the Nikkei 225 fell to a post-bubble low on 6 February 2002 of just 9,420. Even the modest recovery to 11,024 by the end of the financial year saw the index at over 70% down on its peak.
Japan’s prolonged recession has damaged public confidence and the size of the overall market. Commentators expect that the 31 March 2002 financial year-end will show a net contraction of in-force business for the fifth consecutive year. The traditional domestic companies have suffered the most, with falling new business and increased surrenders. Moreover, with volumes in force declining, expense margins are diminishing too.

The restructuring that has occurred
The combination of these factors has been largely responsible for the seven life insurance restructurings that have occurred since 1997. To give a sense of scale, together these companies had approximately 18 million in-force individual life and annuity policies before restructure.
The regulator instigated the first three restructurings under the Insurance Business Law, because the companies failed to meet the required solvency test. Recognising that more prompt corrective action would be beneficial for all concerned, the government introduced new legislation the Corporate Rehabilitation Law from 30 June 2000. All subsequent restructurings have occurred under this law. The process is more rapid, allows more comprehensive restructuring of liabilities (including general creditors) and the immediate demutualisation of a mutual company. Policyholder benefits are restructured, with reserves and surrender values cut by as much as 10% and future guaranteed interest rates cut.
An important party in the process is the Policyholders’ Protection Corporation (PPC). It is the ‘buyer of last resort’ and also represents the policyholders’ interests when the reorganisation plan comes to the court for approval. Recent restructurings have avoided the need to draw on funding from the PPC, whose net assets are estimated to be close to zero already.

How healthy now?
With consumer spending getting tighter, and confidence in the industry shaken by the failures, consumers are focusing on the financial strength of insurers. This ‘flight to quality’ can lead to an unmanageable downward spiral for weakened insurers, and companies are therefore trying hard to improve published solvency margins and credit ratings.
Some industry analysts question whether the solvency margin itself is an accurate measure of financial strength. Several companies posted apparently healthy solvency margins shortly before failure. Japanese statutory accounting currently does not recognise the full future ‘negative spread’ cost. Liabilities are valued at the rates applicable when policies were sold, rather than the rates being earned at the time of valuation. However, with the imminent adoption of international accounting standards for insurance business in Europe, there is pressure from outside the industry to change the way liabilities are valued.

In search of capital
The financial difficulties of the older mutuals are not over yet. Short of a significant improvement in the economy, companies will require some form of restructuring, additional capital, or both.
A number of companies have capital support arrangements from banks with which they have historical relationships. Life insurers buy shares in banks and in return banks purchase subordinated debt. This process, known as ‘double gearing’, greatly increases the risk of a systemic crisis in the financial services industry.
Clearly, the Corporate Rehabilitation Law process is one of the most severe solutions to companies’ problems. Alternative restructuring measures have been discussed by the regulator, including a revision to the law to allow insurers to cut guarantee rates on existing business. However, the industry resisted these proposals, arguing that they would undermine public confidence and spark a fire of cancellations. Instead, companies are forming alliances and finding alternative ways of raising capital, including demutualisation.

It’s not just capital that is required
These strategies are also enabling improvements in areas such as production, distribution, and operational expense savings. In some cases, Japanese companies are teaming with foreign companies to introduce new management practices. With an appropriate blend of overseas techniques, local expertise and capital support, there is considerable opportunity for change and improvement. Some of the notable developments in the past couple of years include:
– Introducing new products to reduce the guarantees Several companies have successfully launched universal life-type products. These contracts are attractive to the consumer too, as the companies are able to pass back a better return in lieu of lower guarantees. Sales have been buoyant, in stark contrast to the rest of the life insurance savings market. Meanwhile, led by new entrants such as Hartford and Skandia, companies have introduced products similar to unit-linked contracts.
– Enlarging call centres to improve efficiency, cut costs, and give sales agents more time to generate new business Nippon Life plans to expand its call centre from 250 staff to 400 over the course of this year, taking calls now handled by its 51 branch offices.
– Cross-entry with other financial services companies Many of the regulatory barriers separating the operations and marketing of banks, life insurers, and casualty insurers have been removed in the last couple of years. Life and non-life insurers are also now both able to compete in the so-called ‘3rd sector’ cancer and health products.
– Changing corporate structure Two companies have so far successfully demutualised, with several others either in the process of doing so, or at least actively considering its merits. Daido Life listed on the stockmarket on 1 April 2002. It plans to integrate operations and form a joint holding company with Taiyo Life, following that company’s demutualisation next year. Yamato Life took a different route. It first established a joint venture stock company with around 50 non-insurance investors that include an auto-parts retailer, a travel agency, and a consumer finance firm. It was able to demutualise its existing business more rapidly and has successfully merged it into the new joint venture. The strategy provides for an infusion of capital and the opportunity to market insurance products in a range of innovative ways. Meanwhile, Meiji and Yasuda have announced their intention to merge by 2004. Their aims include achieving economies of scale by eliminating duplicated head office functions and integrating marketing.
– Improving operational efficiency Companies are focusing on their core businesses. Asahi is in the process of closing all its overseas subsidiaries, while Nippon Life and Mitsui Life plan cut-backs by the end of this fiscal year. Asahi is also reported to be streamlining its office staff, reducing the workforce by 2,000 people by 1 April 2003.

Continued reform
The transformation of the industry is far from complete. Continued reform is necessary to further improve operational efficiency and enhance risk management practice. Additional capital will also be required to support these strategies. In some cases, restructuring may still be necessary to tackle the remaining unsupportable guarantees and commitments.