Enhancing Life Insurance Regulatory Regimes in Asia

The Australian APEC Study Centre: Melbourne 22 - 23 March 2000

The Demographic Trends and Implications for Life Insurance in Asia-Pacific

Presentation by R. Narasimham Financial Analyst Asian Development Bank

22 March 2000

2 Mr./Madam Chairperson, Ladies and Gentlemen, I. INTRODUCTION

1.

Thank you very much for affording me the opportunity to address this very distinguished

gathering. I heard with keen interest, presentations made by insurers and regulators on the responsibilities of insurance companies and regulators in protecting their customers' interest amid changing demographic and income trends in the Asia-Pacific region. The subject is no doubt very interesting and multi-faceted. Please allow me to share my thoughts on this subject,1 although I am not an insurance expert. When I was asked to speak at the APEC Study Centre, I was very much aware that Asia is more than the western rim of the Pacific Ocean and South Asia. The Asian continent extends from the western shores of the Caspian Sea (i.e. Azerbaijan) to the South Pacific Ocean. It includes the Trans Caucasus and Central Asia (the Former Soviet Republics), South Asia, South East Asia, and North East Asia. The latter two groups are APEC members. This is an amorphous combination of developed countries (OECD members), developing countries, and transitional economies. I have concentrated today on the trends in the APEC and South Asian countries and more so on the developing countries in this group, which I believe will most interest my audience and to keep the presentation brief. The Asian continent is going through a period of rapid demographic change or rather more appropriately, changes. The changes in some geographical areas are different from those in others.2 Even within a geographic region, there are inconsistencies in demographic patterns and/or life insurance businesses. II. LIFE INSURANCE

2.

Life insurance has grown to encompass a wide variety of products. Most obviously and

primarily, in its fundamental form, it is death insurance. It aims to compensate the (insurance) policyholders' dependents (or heirs) from financial losses following the death of the policyholder. It compensates them for the loss of income, helps pay off the insured's personal debts (such as mortgages), meets funeral expenses and (in some countries), estate taxes. Effectively, life insurance policies build up an off-balance sheet fund (in accounting terminology) which the policyholders' heirs tap into on his/her death. Life insurance is fundamentally different from non-life

The views expressed in this paper are entirely my own do not necessarily reflect those of the Asian Development Bank. While the life expectancy has increased in South, South East, and North East Asia, it has decreased in the Former Soviet Republics in Central Asia and the Trans Caucasus following the break up of the USSR. Coupled with hyperinflationary conditions in the early 1990s, these circumstances adversely affected life insurers and their clients.

3 insurance in that the latter is a contract of indemnity to compensate the policyholder against a specific and determinable loss.3 Since it is not considered objectively possible to price human life, life insurance contracts are for a specific amount of money. Life insurance has grown much beyond this basic function.

3.

Life insurance in the present age performs an important function for risk planning and

channels a large flow of savings into investments through financial and capital markets. Life insurance is an important vehicle for encouraging and mobilizing individual savings calculated on an actuarial basis, to provide for a certain sum of money (the policy) in an uncertain future. It is an instrument for contractual savings, based on an anticipated future value (i.e., the policy claim) from a sum of discounted present values (i.e., the premiums). The rate of premium would of course be determined actuarially, based on life expectancy, present and projected inflation and a plethora of other factors. At the micro-level, these premiums (together with the insurer's investment earnings) should be adequate to cover the insurer's claims and other administrative expenses to provide its shareholders adequate returns. The life insurance premiums collected by insurance companies form an important pool of resources. This is a form of capital formation in the economy a priori condition necessary for investment. The profitable investment of such resources is necessary to safeguard the future value of the policyholders' claims. The investment of such funds also provides the necessary capital investment required for economic growth. Life insurance companies therefore play an important financial intermediation function albeit over a longer duration. They accumulate large volumes of assets as premiums are paid oftentimes many years before claims are met. As life insurance companies are universally required to maintain solvency, they can become the largest financial institutions in the country (more on this later). They have evident roles as mobilizers of national savings and venture capital. Their regulation therefore assumes paramount importance.

III.

CHANGING DEMOGRAPHIC PATTERN IN ASIA

4.

Over the 35-year period from 1960 to 1995, life expectancy rose by more than 10 years in

all developing APEC countries (except Papua New Guinea).4 This trend is corroborated by evidence in Appendix 1.5 A definite positive causal correlation has been established between long-

4 5

Typically, non-life insurance for this purpose includes fire, theft, accident, marine, and arson insurance. Health insurance is a borderline area, which will be discussed separately later in this paper. Source: David Stanton and Peter Whiteford. March 1998. Pension Systems and Policy in APEC Economies. Source: 19 November 1999. Asiaweek.

4 term economic development and rising life expectancy.6 Asia has simultaneously witnessed other demographic changes in one generation. These include decline in family size due to declining birth rates, increased female literacy and participation in the workforce, increased urbanization, improvements in preventive and geriatric medicine, and population mobility. Concurrently, Asia has also seen the decline of the extended family, replaced by the nuclear family. The extinction of the extended family has ended a traditional bastion of support of last resort. Coupled with the increasing ratio of dependents to wage earners arising from increased life expectancy, life insurance policies have become important instruments of long-term savings, oftentimes used as collateral for personal debt. Contractual savings policies have replaced the traditional financial support from the extended family. This is attributable to Asia's culture of self-reliance, which the developed world, notably Western Europe and North America, lost after the war. Many of the developing countries of Asia are not burdened with expensive state sponsored social security systems.7 Thus far the developing countries of Asia have generally had phenomenally high saving rates, which has translated into higher premiums collected by life insurance companies. However, with the graying of their populations, their savings rates are also expected to decline. Another significant paradigm shift accompanying demographic changes in Asia is the 1997 East Asian economic crisis and its sequel.8 Countries, notably Korea, saw their culture of job security shattered as the industrial and financial sectors underwent massive restructuring. Increased life expectancy coupled with greater job insecurity, in absence of a state sponsored social safety net should also logically increase the demand for insurance products (more will be discussed on this later in the paper).

5.

The implications of rising life expectancy for life insurance may be seen twofold. For life

insurers providing the traditional types of cover aimed at protecting policyholders and their heirs against the risk of dying in their productive years, rising life expectancy can be beneficial to insurance companies. Mortality rates at each age are lower. Fewer term life policies will result in claims and more permanent ones will survive to maturity. A question nonetheless arises whether additional premiums earned on extra years of contribution fully compensate the insurer for the extra earnings paid out on maturity. This is a question of fund management by the insurers and will
6

There is however no empirical evidence to suggest that a decline in GDP of Asian countries in the aftermath of the 1997 economic crisis has reduced life expectancy. This is in marked contrast to the decline in life expectancy in countries of the FSU, after the break up of the USSR. It is estimated that by contrast in the United Kingdom, nine percent of current wage and salary incomes go in contributions towards the pay-as-you-go pension system. There is empirical evidence to suggest that in Thailand and Indonesia, during the Asian economic crisis, life insurance companies suffered from declining new business and policy cancellations. These adverse effects were caused not only by economic distress, but also waning confidence in the financial stability of life insurers. Both effects resulted in severe liquidity problems for Asian life insurance companies.

5 be addressed later in this paper. It is anticipated that in the 21st century, the principle of life insurance will still retain the importance it did during the 20th. Providing financial protection against the risk of not dying soon enough may become the 21st century's most profitable financial industry.9 Increased life expectancy therefore offers further opportunities for life insurers. The products offered however will be different and more sophisticated (more on that in Chapter 5).

6.

It is an accepted fact that insurance penetration, measured by the level of insurance

premiums to GDP, follows an "S" shaped10 curve. There is empirical evidence to suggest that insurance demand grows faster than GDP until it nears saturation. For life insurance, that saturation level is difficult to determine but in countries with well-developed social security systems, it is lower than in those without. Most countries in the region have life insurance penetration rates between one to four percent.11 Most Asians spend more on life cover than the global average.12 This should not be considered over-insurance. In large parts of Asia, private life insurance forms the main pillar of individual age-old provision reflecting the rudimentary or non-existent character of state-sponsored contractual savings systems. Life insurance business has significant scope for expansion in Asia. In the wake of global pension systems reforms and the gradual demise of the pay-as-you-go system, other markets are likely to catch up with Asia raising the global "S-curve." Another force drawing the high demand for life insurance in Asia is the region's extraordinarily high savings ratio. In many countries, capital markets are not adequately developed to absorb such high savings. This limits the breadth and depth of investment channels. In such an environment life insurance policies are seen as the most promising and safest way of investment. IV. PRICING OF LIFE INSURANCE PRODUCTS

7.

The pricing of life insurance products depends on several factors. Most obviously mortality

is a key feature i.e., the timing of deaths of policyholders. Life insurance companies have traditionally and actuarially believed in punctuality people should be dead on time as anticipated. Simple mathematics shows that an increase in life expectancy has seen a drop in premium rates. An insurance company getting its mortality calculations wrong will experience losses in this regard. In pricing of products however, the insurer will however, have to take into account other facts, in particular the returns on premium until the maturity of the policy or death of the policyholder. If the
9

Peter F. Drucker on Financial Services - Economist, 19 November 1999. "S" curve measures the relationship between economic development (represented by per capita GDP) and insurance market development (based on insurance penetration i.e., share of insurance premiums vs. GDP). 11 See Appendix 2 for Insurance Premium and Penetration Ratios. Source: Swiss Re: Asia's Insurance Markets after the storm May 1999. 12 Asia accounted for 38 percent of global gross life insurance premiums.
10

6 insurer fails to match the risk profile of its assets to that of its liabilities, the results can be disastrous. Efficient risk management is even more necessary in a changing demographic structure of an insurer's market. Increased life expectancy increases the premium contribution period and hence the insurer's earnings. However, intense competition in the market arising from the (i) liberalization in exchange controls on capital (which allow free movement of funds across national boundaries) and (ii) rapid strides in information technology; have given policyholders better knowledge and bargaining powers to shop around for the policies offering them better value for money. It has created a new class of sophisticated customers whose satisfaction would depend on new financially engineered products. A dynamic market provides intense competition that will eat into yesteryear's monopolist or oligopolist insurer's perceived restricted domain.

8.

Not all life insurance products involve payment of premiums for an indeterminate period to

obtain benefits only on death or maturity. A paradigm of such products is an annuity, the inverse of a traditional life insurance policy. A premium is paid once and benefits are paid for an indeterminate period. Increasing life expectancy is obviously bad news for an insurer selling annuities. Paradoxically, a decline in life expectancy should be better news for seller of annuities. These are mathematical deductions. They do not necessarily constitute the main effect which demographic change has on opportunities and threats to life insurers. For one thing, such is the power of compounding mathematics that assumptions as to the timing of cash flows 30 years, hence have to very wrong to have an appreciable impact on present value. Second, analysts could go wrong particularizing from the general. I stated earlier (in paras. 5 to 6), that increase in life expectancy in a country will open more opportunities for insurers. In some APEC developing countries (although this paradigm would be more applicable to some Latin American rather than Asian APEC developing countries), increases in life expectancy have been asymmetrical across different population segments.

9.

Life insurance in developing countries in general tends to be a preserve of those better off,

and who already have a higher life expectancy than the national average. A further increase in life expectancy of this segment may neither necessarily nor drastically increase the elasticity of demand for insurers' traditional products due to market saturation. It would be difficult for insurers to increase their market share for traditional insurance products in such circumstances. This requires the insurers to be market savvy in offering those products that would appeal to this segment of customers. This in economic theory could be considered a Giffen's paradox

7 paradigm.13 On the other hand, it is possible for life expectancy to increase over the board and more evenly (through better preventive medicine or natal care). This would increase the life expectancy of a segment of the population that previously did not have access to insurance. In such a case, the insurers would have to concentrate at the lower segment of the market through the volume route to increasing market share, as a means to greater profitability. V. NEW PRODUCT DEVELOPMENT

10.

It was estimated that in 1990, five to 10 percent of the population of developing APEC

countries was above 60. By 2030, 15 to 20 percent is expected to cross the 60 barrier. In the developed world, presently 15 to 20 percent of the population is already over 60. The ratio is likely to increase to 25 to 35 percent by 2030.14 This graying population's need for traditional life cover may be expected to decline, as they would have probably repaid their mortgage loans during their lifetimes. The need for their heirs to inherit their mortgage debts would be therefore reduced (refer to earlier part in para. 2). The graying of population could also see a decline in savings rate. This calls for better fund management by life insurance companies to offer their policyholders better returns on lower premiums.

11.

The equity and bond market boom of the 1990s saw the development of several savings

based products directly accessing the equity and bond markets. Better returns over a short gestation, less need for risk cover, more need for accumulation, and lower selling costs together with strides in information technology increased their popularity. Most importantly, these products offered high real rates of return to their investors during their lifetime in their old age. With inflation under control through the 1990s, these products definitely pose a challenge to traditional life policies.

12.

The emergence of unit linked equity policies (a new product) combines the characteristics

of both endowment insurance policies and mutual funds. The market in developed countries has changed drastically. Traditional life insurance products have been largely overtaken by new products having more in common with mutual funds. The increased popularity of unit linked (or index linked) policies is directly correlated to the decline in annuities over the past two and half

13

Conventional price theory holds that demand for a particular good or service would increase with an increase in consumers' disposable income. However, for certain categories of goods (example, cheaper goods or services), the demand will fall as incomes increase because the consumer will move up market to buy more expensive goods. This argument was propelled by economist Robert Giffen, hence the name. 14 Source: David Stanton and Peter Whiteford. March 1998. Pension Systems and Policy in the APEC Economies.

8 decades. An essential element of the development of investment-linked products is the existence or development of a stable securities market. This does not yet exist in many developing countries. Insurance companies, like pension funds, are important catalysts for change in this regard but change will not come overnight. This is another reason why new entrants to the industry will still offer traditional products. Where they can compete with old-established companies in developing countries is on service and on efficiency.

13.

From the mid-1970s to the mid-1980s, annuities lost their popularity due to high inflation.

This was followed by tight monetary policy in the developed world in the 1980s with high interest rates as an antidote to inflation. This phenomenon initially benefited insurance companies as their fixed income arising from high nominal interest rates increased rapidly. Declining interest rates reduced insurance companies' income, which they tried passing on to their policyholders through lesser rebates. Some insurance companies trying to maximize their profits by locking into high interest rates sometimes faced a liquidity trap, particularly if their aging customers chose to discount policies at surrender value. Insurance companies learned the lesson during this period for matching their actual and contingent assets and liabilities by both currency and maturity. Increased competition from other contractual savings vehicles reduced life insurers' ability to pass on the decline in their earnings on traditional life policies to the customers either commercially or contractually. We have seen in developed countries, the development of so-called unbundled policies eclipsing the more traditional forms of permanent life insurance. Many commentators foresee a similar development in less developed countries as investors become more sophisticated, and as general levels of wealth increase.

14.

In one Asian developing country, excessive activist and prescriptive regulation of the life

insurance industry has seen the emergence of companies offering products generically similar to life insurance products but technically not under the supervision of the life insurance regulator (more on this topic later). Contrary to possible expectation, increased life expectancy has not increased the gestation period for the pay out of investment by insurance companies offering traditional products. The dynamic market with increased competition has offered policyholders wider choices, reducing the margins of supernormal profits for insurers. At times, it seems that the only two elements of life insurance left in some products are (i) the fact that the value of investment will be paid out on death before maturity of the policy and (ii) the rather high commissions payable to salespeople. Asia has not yet witnessed online internet based sales of insurance products eliminating middle-persons. This phenomenon cannot be entirely unexpected in the future.

9 15. The trend of insurance products in the developed world may also confidently be expected to

repeat in developing countries albeit over a much shorter time frame. Familiarity with existing products coupled with the perception of less regulatory safeguards for newer ones will keep traditional life insurance products popular. Growth of traditional life insurance would also increase institutional demand for investment opportunities. Pressures could also mount for the elimination of obstacles to collective investment activity. At present, the legal framework for regulation and supervision of collective investment products is still in the nascent stage. Fortuitously, the East Asian crisis spotted weakness in prudential regulatory supervision. Consequently, efforts are underway for creation of a more sustainable supervisory infrastructure. VI. HEALTH INSURANCE

16.

Traditionally, health insurance products (such as medical insurance) constituted contracts

of indemnity, whereby the insured could file claims incurred for actual medical expenses. With the growth on the market in size and diversity, several borderline products have emerged which are in reality near life insurance products rather than indemnity contracts. In this borderline category are (i) accident insurance, (ii) permanent disability category, (iii) dread-disease cover, and (iv) guaranteed renewal expenses policies (GREP) with lifetime cover. All these products are basically policies for specific sums of money, (i), (ii), and (iii) above compensate the insured in specific sums of money (rather than his dependents) for loss of future earning capabilities arising from a contingency. The fourth product is a hybrid between medical insurance and endowment. Its emergence is a consequence of the aging of Asia and the need for increased medical expenses by people in their old age. This policy allows the holders to contribute low rate premiums during their younger years (when their claims for medical reimbursement are actuarially estimated to be lower) when they are healthier. This is similar to lower life insurance premiums for younger policyholders. Just as life insurance policies are priced on mortality, GREPS are priced also actuarially on morbidity (i.e. propensity to get ill, which increases with age). As an added incentive, some insurers offer their policyholders rebates in premiums if no claims are made in a particular year (similar to motor insurance). This is beneficial to both the company and policyholder. It provides the company with better cash flow by saving payment of claims. It helps the policyholder the economies of scale over the long-term. From the insurance company's perspective, it allows the insurers to collect premiums and invest them, thereby building up substantial reserves during their policyholders contributing years. Efficient investment decisions by insurers would enable them meet their claims in the later years. In developing Asian countries, the graying of populations coupled with declines in state mandated healthcare has seen the surging popularity of GREPs in almost every market.

10 VII. SUPERVISION AND REGULATION

17.

In various countries, insurance supervisors have concluded from the economic turmoil that

appropriate solvency margins and capital requirements are likely to be more essential to insurers' soundness than fixed rates and conditions. The industry will therefore witness a move towards a more solvency focused supervisory regime (incorporating risk-based solvency standards). In addition, deregulation is considered to be a means of attracting foreign capital since in a deregulated market, foreign insurers generally find it easier to bring their specific competitive edges (client segmentation, product innovation, cost-effective distribution, etc.) in to bear. Over the last two years, some Asian insurance markets have (further) opened up to foreign players. A major driving force behind this trend is the liberalization process under the auspices of the World Trade Organization (WTO), which emerged from the latest (Uruguay) round of multilateral trade negotiations. The General Agreement on Trade in Services (GATS) is an integral part of the WTO. After various delays, GATS negotiations were concluded in December 1997 and 70 countries submitted commitments along the following principles: (i) national treatment ensuring that there is no discrimination between domestic and foreign players, (ii) most favored national principle preventing any discrimination among providers form different WTO member states, (iii) steps towards relaxing or eliminating limitations on foreign ownership of domestic insurers and limitations on the judicial form of commercial presence (branches, subsidiaries, representative offices). Apart from multilateral pressure, some countries undertook unilateral liberalization measures in order to attract foreign capital badly needed for recapitalizing domestic insurance industries. In this respect, Asia's economic downturn acted as a catalyst to the opening-up of markets. Simultaneously, WTO induced liberalization will bring in even more foreign competition which will be market driven. Tariff and other barriers to cross border competition will soon be eliminated. Supervision increasingly will be governed by principles of prudence and solvency rather than product or tariff based prescriptive activism.

18.

Prudential supervision of life insurance encompasses providing policyholders protection

against losses arising from insolvency of and/or fraudulent practices or market abuses by insurance companies. Such supervision is therefore more focussed through its attention to the insurance company's management quality and business performance, particularly its standards of transparency and corporate governance. Amid a growing complexity of a rapidly emerging financial sector, sound corporate governance can be facilitated through better self-regulation, to complement prudential external supervision. In the analysis of an insurer's risk profile, the role of a prudential supervisor is similar to that of an investment advisor, This involves the use of

11 appropriate information technology to analyze the trends from vast volumes of information. Effective prudential supervision also requires close coordination with the insurance company's statutory auditors and actuaries, as also the insurer's accounting standards. The actuarial reserves on the liabilities' side is an important benchmark for assessing an insurer's health.

19.

In risk analysis, oftentimes it is essential for the supervisor to study the insurers' assets side

of the balance sheet (similar to the approach of the Basle Committee for Banking Supervision in the case of banks). This would reveal the quality of the insurer's realizable assets needed to meet the claim liabilities. A Dynamic Capital Adequacy Test15 measuring a company's ability to meet its present and contingent liabilities is a useful analytical tool. The quality of prudential supervision can be enhanced through rigorous training of the supervisors. The supervision function should as far as is practicable be immuned to political interference. A more sophisticated system of prudential supervision may also encompass a dispute resolution mechanism through an out of court settlement. In the ultimate analysis, prudential supervision of insurance aims at striking a balance between the public policy aims at ensuring strong financial institutions and public protection and competitiveness. This is necessary to build public confidence in the insurance industry and the financial sector. As better educated, more efficient, and demanding customers emerge in the market for insurance products prudential supervision standards will also strengthen. VIII. CONCLUSION

20.

It is said that there is nothing more certain in life than old age, and ultimately death.16 No

attempt is being made to redefine metaphysics. However, rational policies on the innovation, supervision, management, and regulation of life insurance and other related contractual savings products could provide some relief to better address the consequences of the above two immutable constants. It is interesting to note that changing demographic trends in Asia are changing traditional markets for life insurance products, which erode some of the original needs for those markets. These trends are also facilitating the creation of new markets for savvy investors who may not have had access to traditional life insurance products before that linked policies and other hybrid products discussed in this paper come to mind immediately in this category of instruments. It is therefore not surprising that life insurers which are prepared to innovate their products in the broader context of convergence of financial services see both opportunities as well

15 16

DCAT measures a company's capital plus actuarial reserve to meet its liabilities. A third constant was said to be taxes. However, the emergence of Reagenomics and the Laffer curve analysis (no laughing matter) has possibly made taxes less uncontrollable.

12 as threats in the new shape of society as it is now forming.

21.

The future scenario is likely to witness retirees in their seventies, sophisticated in their

knowledge of efficient markets and with large financial assets that need efficient management. Life insurers are well placed to both help them build up their assets during their productive years and manage them prudently during their retirement. Life insurers are already facing competition from unexpected sources and will be able to meet this challenge only through efficient intermediation, which comes from better competition and innovation. The need for prudential supervision of all contractual savings products based on their generic character was the theme of a seminar at the Australia APEC Study Centre in November last year. As has been demonstrated in this paper, the changing demographic trends in Asia reiterates the need for enhanced prudential regulation and supervision of generically similar contractual savings products. I therefore regard this seminar as a logical extension of the one conducted last November and wish to thank the Australian APEC Study Centre for the continued focus of this specific sector.

13

Appendix 1 Ranked By Inflation CPI Hong Kong Macau Saudi Arabia Kenya China Thailand New Zealand Japan Taiwan France Germany Britain Singapore South Korea Switzerland Vietnam Indonesia Australia Fiji South Africa Brunei Italy Malaysia Canada US Maldives Cambodia Egypt India Sri Lanka Life Expectancy 79 76 70 59 71 69 77 80 75 78 76 77 77 72 78 68 65 78 73 65 76 78 72 79 77 67 53 65 62 73

14 Ranked By Inflation CPI Pakistan Mongolia Brazil Philippines Bangladesh Nepal Nigeria Bhutan Afghanistan Papua New Guinea Mexico Iran Myanmar Turkey Russia Laos Life Expectancy 63 65 68 67 58 57 53 61 45 57 74 70 60 68 68 53

15 Appendix2. Insurance Premiums and Insurance Penetration 1997 Gross direct premiums, USD Non-life China Hong Kong SAR India Indonesia Japan Malaysia Philippines Singapore South Korea Taiwan Thailand Vietnam 5,872 1,945 2,074 1,384 101,277 2,162 670 1,265 670 1,265 13,935 116 Life 7,557 4,202 5,161 1,248 389,350 2,146 588 3,699 42,738 12,468 1,587 0 Insurance penetration Non-life 0.54% 1.12% 0.56% 0.55% 2.45% 2.19% 0.80% 1.31% 3.79% 1.69% 1.22% 0.46% % Life 0.82% 2.43% 1.39% 0.58% 9.42% 2.18% 0.71% 3.83% 11.63% 4.40% 1.22% 0%