New Zealand Securities Commission

Introduction

1.1

The life insurance industry is an important repository of savings in New Zealand with aggregate assets (including managed funds and superannuation) at 30 June 1997 of some $20.68 billion.1
¹

1.2

The Commission has been statutorily involved with the life insurance industry since our establishment in 1979. However our relationship with the industry has changed over the years as the status of life insurance policies under the Securities Act 1978 ("the Securities Act") has changed.

1.3

We have prepared this paper with the benefit of our experience of the administration of securities law, particularly as that law has related to the life insurance industry since 1989.

Our statutory authority

1.4

We are publishing this paper in terms of one of our primary statutory functions, that of (section 10(c) of the Securities Act) "[keeping] under review practices relating to securities, and [commenting] thereon to any appropriate body."

1.5

The quorum of Members responsible for this paper comprised:

Mr E.H. Abernethy, Chairman
Ms E.M. Hickey
Mr D.J. Stock
Mr M.R.H. Webb.

The purpose and structure of this paper

1.6

On the basis of our experience we believe there are important issues concerning the life insurance industry which need to be discussed more widely and more fully in the community, particularly having regard to the current attention which is being given to the desirability and responsibility of individuals to save for their retirement.

1.7

The purpose of this paper is to identify these issues, and to raise questions concerning the life insurance industry which we believe need to be addressed by the Government, the industry, the accounting profession, the actuarial profession and the investing public. We identify actual or potential issues arising from the current business practices of, and regulatory and financial reporting regimes relating to, the life insurance industry.

1.8

It is not our purpose to provide answers to the questions we identify in this paper, nor does this paper attempt to identify and address all issues relating to life insurance regulation and operations. We think a comprehensive review of the Life Insurance Act 1908 is called for. We believe responses received to the issues identified in this paper will provide a valuable input into such a review.

1.9

We are aware that financial reporting by life insurance companies is already under detailed review with a draft financial reporting standard for life insurance companies2 currently on issue.

Structure

1.10

In Part I of our paper, after an overview of the New Zealand life insurance industry and of the application of the Securities Act to life insurance contracts, we look at the nature of life insurance contracts and the regulatory environment for the selling of life insurance policies.

1.11

In Part II of our paper we review and discuss a number of key areas of life company operations and structure. For each of these subject areas we discuss our experience of the New Zealand life insurance industry, we refer to the existing legislative environment affecting that aspect of life company operations and we summarise the legislative approaches in Australia and the United Kingdom. We make a number of comments concerning each issue.

1.12

We illustrate some of our comments by use of examples drawn from our experience with the "authorisation" of life insurance companies. The examples are drawn from companies both large and small, both New Zealand and overseas owned. In using these examples in relation to particular topics in this paper the Commission is expressing no view as to the appropriateness or merits of those transactions themselves or on the parties involved. In a number of cases those examples are also parts of wider transactions and views as to those transactions may not be able to be based on the examples alone.

1.13

We have chosen to analyse the approaches taken by overseas regulatory regimes, particularly those in Australia and the United Kingdom, to the issues discussed. We have done this because the New Zealand life insurance industry has been dominated, with a few exceptions, by life insurance companies incorporated in, founded in, or directed from, Australia and the United Kingdom. We do not have a view as to whether the approaches followed by the United Kingdom and Australia (or any other jurisdiction) are the models on which future New Zealand life insurance regulation should be based.

1.14

In Part III we discuss various elements of public policy in relation to the regulation of the New Zealand life insurance industry. We raise various questions for consideration about the issues discussed in Part II.

1.15

We are inviting comments on the questions raised in this paper. When these have been considered we will report to the Minister of Commerce.

Brief overview of the New Zealand life insurance industry

1.16

The life insurance industry has been a feature of New Zealand commercial life for well over a century. Life insurance business in this country was originally undertaken by United Kingdom companies, but in the late 1800s the major Australian mutual companies established branches in New Zealand. The Government established its own life insurance office in 1869 to augment the "very inadequate"3 life insurance facilities existing at the time.

1.17

The retail life insurance industry now comprises around 30 companies. The three large Australian mutuals have already converted to, or are in the process of converting to, widely-held proprietary4 companies, with their newly formed parent companies becoming or intended to become listed public companies. With some exceptions New Zealand owned life insurance companies have tended to be fairly small proprietary companies.

1.18

United Kingdom life insurance companies have always had a significant presence in New Zealand, with two of the companies having recently "domesticated" what were formerly branch operations into locally incorporated subsidiaries. More recently life insurance companies from the United States of America and Sweden have commenced operations in New Zealand.

1.19

In addition to aggregate assets under their control of around $20.0 billion (see para 1.1) the life companies operating in New Zealand had "in-force" New Zealand business at 30 June 1997 (including life insurance and superannuation) with annual premiums of $1.565 billion5. This is a measure of the companies' expected annual cash flow from premiums on existing policies without regard to new business or policy surrenders and cancellations. At the same date the companies were obligated to pay annuities in New Zealand at a rate of $28.8 million per annum.

A brief summary of the regulation of the New Zealand life insurance industry prior to 1989

1.20

The first New Zealand legislation directly related to the life insurance industry was the Life Insurance Companies Act 1873.

1.21

The Life Insurance Act 1908 ("the Life Act"), which consolidated the 1873 Act and other life insurance legislation then in force, has been the principal source of statutory authority governing the operation and oversight of the life insurance industry in New Zealand since its enactment.

1.22

Under section 10 of the Life Act the Registrar of Companies may not issue a certificate of incorporation to any company that proposes to carry on the business of insurance upon human life unless that company, before commencing to carry on that business, deposits with the Public Trustee approved securities of an aggregate value of not less than $500,000. There are no other barriers to entry into the New Zealand life insurance industry apart from (for overseas companies) compliance with overseas investment legislation.

1.23

The Life Act includes requirements for the depositing of various annual returns with the Secretary of Commerce (formerly with the Secretary of Justice) and for the undertaking by an actuary of an annual investigation of the financial condition of each company (see para 4.8 onwards). The returns filed with the Secretary are all passed to the Government Actuary for his review.

1.24

When the Securities Act was originally enacted on 20 October 1978 contracts of life or endowment assurance, although "securities", were exempted, by section 5(1)(a), from the provisions of Part II of that Act. This meant that life insurance contracts were exempted from the prospectus, trustee, statutory supervisor and advertising requirements of the Securities Act. This situation changed in 19896

The enactment of sections 7A and 7B of the Securities Act 1978

1.25

With effect from 1 July 19897 section 5(1)(a) of the Securities Act was revoked and sections 7A and 7B inserted. The text of sections 7A and 7B is set out in Appendix One to this paper.

1.26

The effect of the new sections was that life insurance contracts became subject to the normal rules of law relating to the offering of securities to the public, but the Commission was empowered by section 7A(2) to "authorise" life insurance companies, that is, to exempt them from the prospectus and trustee/statutory supervisor provisions, but not the advertising provisions, of the Securities Act. The Commission was also empowered to set terms and conditions of authorisation.

Background to the enactment of sections 7A and 7B

1.27

Enactment of sections 7A and 7B followed closely on the Court of Appeal decision in the Marac case (see para 2.2) which ruled that Marac's life insurance bonds, basically term deposits with an insurance element (covering early repayment in the event of the death of the investor), were life insurance contracts for the purposes of the Securities Act. A particular concern was that in the absence of legislative amendment unsatisfactory business practices would affect the debt security type market of the life companies as well as the more traditional life insurance market.

1.28

The Hon Philip Woollaston, Associate Minister of Justice, in introducing a Supplementary Order Paper to the Securities Law Reform Bill into the House of Representatives on 18 October 1988 said (Hansard p. 7409):
... The Securities Act 1978 exempts life insurance policies from Part II of the Act. In recent times, however, the distinction between investments to which the Act applies and life insurance policies has become blurred and provides a means of avoiding the requirements of the Act. As a result of the Court of Appeal decision in the Marac Life Assurance Ltd case the exemption applies not only to traditional life insurance products but to life insurance products that in legal form are life assurance but in economic substance are ordinary investments. In that case, which also involved taxation matters, the life bonds - as they were called - were indistinguishable from ordinary investment except that they were described in life insurance terms and the investor's death accelerated the repayment of the investment.

In recent times a trend has emerged circumventing the Securities Act requirements by using the life insurance exemption for what would otherwise be ordinary investment. That position is not desirable, and should be stopped. To that end the supplementary order paper repeals the exemption for life insurance policies, and empowers the Securities Commission to grant an exemption from the Act's prospectus requirements by way of designating life insurance companies as authorised life insurance companies issuing policies in accordance with the authorisation. That approach has been taken because of the difficulty, if not the impossibility, of defining in advance the life insurance policies that are regarded as life insurance proper policies and the life insurance policies that are regarded as an investment in substance.
...

1.29

It was recognised by the industry, the Commission and the Government that much needed to be done to improve the business practices of the life insurance industry. Of particular relevance to the Commission was improving the disclosure obligations of life insurance companies.

1.30

It was accepted that the industry was not ready at that time to move to a full prospectus-based issuing regime. Improvement was needed in the procedures for selling life insurance contracts and in the information provided at the time of sale. Financial reporting by life insurance companies, based as it was on the schedules to the Life Act, was inconsistent between companies and generally unsatisfactory. There was no accounting standard applicable to life insurance business at that time.

The general conditions of authorisation under sections 7A and 7B

1.31

Authorisations were subject to a number of general conditions imposed by the Commission under sections 7A(3) and 7B. One of the principal conditions of authorisation, applying throughout the period the two sections were in force, was a limitation of 12 months on each company's period of authorisation. This meant that each company had to apply for renewed authorisation each year.

1.32

The second main condition of authorisation was that life insurance companies agreed to abide by the Code of Business Practices for Life Insurance Companies ("the Code")8. The Code, which was formulated by the industry and approved by the Commission, regulated many aspects of life company selling practice, including information, such as financial statements and policy details, required to be disclosed to policyholders and prospective policyholders.

1.33

A third condition of authorisation, introduced in 1995, related to a "directors' statement". It contained a declaration as to the directors' knowledge of any adverse circumstances which had arisen between the date of the company's last financial statements and the date of signature of the statement. It effectively imposed an obligation on the directors of life insurance companies to affirm in a document provided to investors that they had addressed the financial condition of their companies mid-way through the year. (Life insurers, unlike other continuous issuers of securities at the time, were not required to prepare half-yearly financial statements.)

The Commission's approach to the authorisation of individual life insurance companies under section 7A

1.34

The Commission's approach to the "authorisation" of life insurance companies was to approve authorisation for a period of twelve months where Commission Members were satisfied, on the basis of staff review of each life insurance company's:

that the affairs of the company were reported in an orderly manner in accordance with the law and that there were not aspects of the company's activities or operations which should be drawn to the attention of prospective investors either through requiring the company to issue a prospectus or by some supplementary means of disclosure.

1.35

We required the financial and other information to be supplied to us within four and a half months of balance date (as compared to the nine months allowed under the Life Act for the returns and the five months allowed for the auditing and registration of the financial statements under the Financial Reporting Act 1993 ("the FRA")) in order to ensure that (1) we would be making our authorisation decision on the basis of timely information, (2) prospective policyholders who exercised their rights to request them would be given financial statements which were reasonably current and (3) we could establish an orderly and predictable annual procedure for the authorisation of companies.

1.36

In reviewing the information available to us we paid attention to various factors including:

1.37

Where the Sixth Schedule abstract indicated that there were matters about which the company's actuary was concerned we sought the actuary's full Financial Condition Report9.

1.38

We routinely discussed individual cases with the Government Actuary. In one case the Commission retained an international firm of consulting actuaries to give an expert analysis of an applicant's solvency.

1.39

Where review of a company's financial statements and actuarial reports indicated there could be something about the company's performance, structure or assets which should be brought to the attention of prospective investors we sought further information and invited comment from the company. These indications sometimes lead to the imposition of pre-conditions on the authorisation, generally although not always about the disclosure of additional information, or to an application being declined. Sometimes approval was granted on a short term basis, say three months, to allow a particular situation to be remedied before an application was granted in full.

1.40

In a few instances we believe our interest in requiring a company to disclose information on its financial position may have encouraged that company to increase its level of paid up share capital. However it has not been the Commission's role to prescribe minimum or appropriate levels of capital or solvency.

1.41

The Commission also had the power under section 7A(4) to vary or revoke existing authorisations. For this purpose we reviewed existing authorisations in circumstances where:

An overview of the authorisation process

1.42

In the first year of operation of section 7A (year ended 30 June 1990) the Commission declared 40 companies to be authorised life insurance companies, of which 39 remained authorised at year end. In the year ended 30 June 1991 38 companies were authorised, of which 36 remained in force at year end. The number of authorisations then remained at 35 for several years but dropped to 34 by June 1997.

1.43

All but one authorisation was in respect of all the life insurance policies sold by the authorised company. One company was authorised for several years in respect of life insurance policies other than those policies secured by mortgage securities given over company property and issued in terms of a registered prospectus.

1.44

Since 1990 we have reviewed the existing authorisations of several life companies outside of the routine reauthorisation procedures. These reviews were prompted by a variety of factors, including concerns expressed by the Government Actuary, identification of potential difficulties arising from relationships with related parties, financial statements which did not comply with the FRA, and the pledging of a life company's assets to an external financier. In one case we revoked the authorisation of the company concerned.

Comment on our authorisation role

1.45

Life insurance authorisation was a difficult area for us because it involved our taking a view about the adequacy of information available to prospective investors in individual life insurance companies in the absence of the company being obliged to issue a registered prospectus which would have had to be provided to each prospective investor.

1.46

Our main emphasis was on promoting adequate disclosure of product and institutional information, including financial information, to prospective life insurance policyholders. We believe our approach to authorisation reflected the underlying policy of sections 7A and 7B.

1.47

We did not supplant the important statutory role of the Government Actuary. However he considered that his role in relation to life companies was limited in practice to that of last-resort intervention.

1.48

The Commission had concerns at some of the inherent difficulties of any "authorisation" process. Because of these concerns the Commission advocated the removal of the authorisation process with the advent of the now current investment adviser and product disclosure regime.

The effect of the revocation of sections 7A and 7B

1.49

The position of life insurance policies under securities legislation changed again from 1 October 1997 with the revocation of sections 7A and 7B. Issuers of life insurance policies are now, subject to certain transitional arrangements10, required to comply with the full prospectus, investment statement11 and advertising provisions of the Securities Act, although the trustee/statutory supervisor and trust deed/deed of participation provisions of the Act do not apply. Moreover the Investment Advisers (Disclosure) Act 1996 (which also came into force on 1 October 1997) generally applies to investment advisers promoting life insurance policies.

Comment on the structure of the life insurance industry

1.50

The life insurance companies currently operating in New Zealand include companies incorporated in, or subsidiaries of companies incorporated in, a number of different countries, including New Zealand, Australia, the United Kingdom, the United States of
America, Sweden, and Bermuda.

1.51

The operations of the companies incorporated in New Zealand are regulated primarily by the statutory requirements of New Zealand. However the locally incorporated subsidiaries of overseas life companies, could, we understand, also follow regulatory standards imposed in the home jurisdictions if those standards were imposed by direction of the parent company. Branches of overseas life companies operating in New Zealand are regulated primarily by the statutory requirements of their home countries, although they are also subject to New Zealand law.

1.52

These regulatory differences may have implications for New Zealand resident policyholders as well as for the efficacy or otherwise of New Zealand life insurance regulation

2.1

The Life Act defines a policy of "life insurance" as:

... any contract, so long as such contract remains in force, heretofore or hereafter lawfully entered into by a company, the terms of which are dependent upon the contingencies of human life:

2.2

In the Court of Appeal case Marac Life Assurance Limited v Commissioner of Inland Revenue [1986] 1 NZLR (694) Cooke J cited the definition contained in the opening words of Bunyon on Life Assurance (5th ed, 1914) p. 1:

The contract of insurance has been defined by Tindal CJ to be that in which a sum of money "as a premium is paid in consideration of the insurer's incurring the risk of paying a larger sum upon a given contingency" ... The contract of life insurance may be further defined to be that in which one party agrees to pay a given sum upon the happening of a particular event contingent upon the duration of human life, in consideration of the immediate payment of a smaller sum or certain equivalent periodical payments by another. This consideration in money is termed the premium or premiums, and is paid either in one sum, when it is termed a single premium, or by a succession of periodical instalments.

2.3

In the same case McMullin J noted that the above definition had been cited by Windeyer J in National Mutual Life Association of Australasia Ltd v Federal Commissioner of Taxation (1959) 102 CLR at p 43, who had added:

This description covers the three forms which, historically, life insurance has taken, and which, singly or in combination, are the essence of a life insurance policy. All such policies are basically either term policies, whole of life policies, or endowment policies.

2.4

The essential elements of an insurance policy are risk and uncertainty. In the case of a life insurance policy, the uncertainty element is generally a contingency of human life.

2.5

Life insurance companies offer a wide variety of contracts, some of which involve savings or investment elements along with some risk cover and others of which involve only risk cover.

2.6

The industry classifies life insurance policies as either "conventional" policies, subdivided into "whole of life", "endowment" and "term" assurance, or "unbundled" life policies, subdivided into "capital stable" and "equity linked".12

2.7

The "whole of life" contracts include both insurance cover and a savings element. Many are "with-profits" policies. These contracts could involve payment of premiums for 30 - 40 years with payment of an accumulated capital sum on death or (as an industry practice) on reaching an advanced age.

2.8

"Endowment" policies usually involve payment of regular premiums by the policyholder and then payment by the company of an accumulated sum plus bonuses at a specified age, say 65 or on earlier death. In the event of early death there would be payment of a specified sum, plus accumulated bonuses at that time.

2.9

The conventional contracts are sometimes called "bundled" because the savings and risk components of the contract and the expenses charged to them are not separately identified.

2.10

The "unbundled" policies include fixed-term fixed-interest investments, often called insurance "bonds". The Marac case (see para 2.2) related to insurance bonds. The only insurance element in these contracts may be the provision for early repayment in the event of death during the investment period. Other unbundled policies are similar in nature to unit trusts, with a fixed investment (or single premium) being invested (at the investor's option) into a particular group of assets (for example, property, equities, fixed interest securities, or a mixture) and with the return to the investor being determined by the return on the particular group of assets

2.11

Term or "pure" life insurance contracts provide for a payment during the period of the contract only if the specified contingency occurs during that period. There is no saving or investment element. Such policies are not covered by the Securities Act and Regulations.

2.12

A common feature of the more traditional life insurance contracts is that they are long- or very-long-term contracts frequently with uncertainties as to both the timing and amount of payments to be made to the policyholders. Some life insurance policies are for fixed and generally shorter terms. We are aware that some life policies may be for periods as short as 90 days. In the past some companies have issued call life bonds. These securities differ little from debt securities

Termination of life insurance contracts

2.13

Generally speaking a policyholder is unable to sell his or her interest in a life insurance policy, although we have been aware of a small secondary market being developed in New Zealand for the buying and selling of interests in life policies.

2.14

Where a policyholder wishes to realise an interest in a policy before its termination date the main option available is to surrender the policy back to the company.

2.15

Most life insurance policies have a surrender value, defined in clause 1.9(g) of the Code to mean:

... a policy having a cash sum which may be available to the policyholder in the event the policy is surrendered earlier than expected maturity, or prior to death (but shall exclude the return of any unexpired premium in relation to a pure risk policy).

2.16

Because of the high front-end selling costs of life insurance policies (see para 3.2 onwards for further discussion on this point) the surrender values of most regular premium policies are low or non-existent in the initial years of life of the policy.

2.17

Policy surrender values for each type of policy are determined by the company. We understand the values can depend on a variety of factors including investment performance, claims experience, the level of expenses incurred in the sale and ongoing administration of a policy, the likely pattern of policy discontinuances, and, in the case of proprietary companies, the dividend aspirations of the company's shareholders .

2.18

Surrender values may or may not be expressed as being "assured" by the company, depending on the terms of the contract. The so-called "capital stable" policies generally include a commitment by the company to maintain a minimum surrender value related to the amount of the policyholder's accumulated premium payments.

2.19

Mr James Richardson-Hay, Assistant General Manager (Finance) and chief actuary of Guardian Assurance Limited (incorporated in New Zealand)13 , in a paper "Solvency Issues for Life Offices" prepared for an address given to the New Zealand Society of Actuaries ("the Society") on 3 June 1997, said:

2.20

These observations are equally applicable whether the life company is a proprietary company, with shareholders' funds, or a mutual company, with reserves, as protection against insolvency.

2.21

In future, now that life insurance companies are required to issue investment statements for their products, we expect to see greater transparency in the disclosures to prospective investors at the point of sale of the companies' fees and charges, including those which would apply on ultimate surrender or maturity of the policy.

2.22

The protection afforded to policyholders seeking to surrender their insurance policies in New Zealand differs profoundly from the position in Australia. We discuss this issue in a later section of the paper (see para 8.24 onwards).

Life insurance policies are generally unsecured

2.23

In almost all cases the obligations arising under life insurance policies in New Zealand are unsecured obligations of the companies concerned. In a few cases policyholders have the benefit of a guarantee from a third party.

2.24

The question of security becomes relevant where a life company has borrowed funds and/or given security over its assets to a third party in competition with or in priority to the claims of its policyholders. The giving of such security can affect the position and prospects of both existing and prospective policyholders.

2.25

From the point of view of the prospective investor we think that the disclosure of such borrowings, of the giving of any prior security, and of the company's ability to undertake such borrowing and to give such security are important.

2.26

Issues may also arise with respect to the position of existing policyholders at the time a life company gives security over its assets to a third party. Relevant factors include whether existing policyholders were aware of the company's ability to pledge its assets to outside parties, whether existing policyholders were informed of the giving of the security, and the costs of terminating the policy if the policyholder wishes to surrender it back to the company.

2.27

We have observed that life companies in New Zealand can and do borrow from external parties on security which ranks ahead of or in competition with the claims of policyholders (see para 6.1 onwards). They may do so without the prior knowledge of policyholders.

3.1

Life insurance contracts have traditionally been sold on a commission basis. Companies use both "tied" agents i.e. those who are contracted to sell the products of only one company, and brokers or investment advisers, who might sell products offered by a number of companies. The amount of commission paid to agents varies between companies and products but has been in the range of 60% - 100% of the first year's premium for regular premium contracts14 .

3.2

One of the consequences of commission selling is the strong incentive for the aggressive marketing of life insurance contracts. Another consequence of this form of selling is that there tend to be high front-end costs for most policies sold (sometimes referred to as "new business strain"). This cost pattern has implications for the policyholder who terminates the life insurance contract in its early years.

3.3

We note that life companies have changed their selling practices in recent years to try and reduce selling costs and to give greater rewards to their agents for selling good business ("persistence") as opposed to just any business. Where a policy lapses in its early years a proportion of the commission which had been paid to the agent is "clawed back" by the company15. Alternatively, payments of commission are structured such that initial payments are relatively lower, with further payments spread out over the early years of the policy so long as the policy is maintained by the policyholder. Either way, there are now incentives for the agent to ensure that policies sold meet the needs of the client and are affordable.

3.4

3.4 Some life companies, particularly but not only those operated by banks, also undertake direct selling through the mail. While these policies have low or no commission costs, we are informed that, because of low take-up rates, distribution costs of policies sold by mail can be just as high (proportionately) as the costs for policies sold on commission.

The Code of Business Practices for Life Insurance Companies

3.5

The Code was developed by the Life Office Association of the New Zealand ("the LOA") in the period leading up to and following the enactment of the Securities Amendment Act 1988. The LOA had agreed to develop a suitable code of selling practice for life insurance companies to coincide with the introduction of the section 7A authorisation procedures. Compliance with the Code was to be a condition of authorisation.

3.6

The Code was approved by the Commission in June 1989 and came into force on 1 January 1990. Several amendments have been made to the Code since 1990, with significant changes covering collateral business, benefit projection procedures and establishment of the Insurance and Savings Ombudsman Scheme. The Code no longer has the backing of the authorisation procedure. Its future coverage is uncertain.

3.7

The Code set out the types of information which were to be disclosed to prospective policyholders, either on request (e.g. the company's latest audited financial statements, a specimen of the appropriate life policy, and a copy of the completed life policy) or as of right (a statement of policyholder rights).

3.8

The Code provided for a "free look" period of seven days for single premium policies and fourteen days for policies with periodic premiums. During the free look period the new policyholder was entitled to withdraw from the investment and to receive a full refund of the premium paid without penalty.

3.9

The Code also covered companies' use of benefit projections in the selling process. Life companies would frequently provide a prospective policyholder with a projection of the future benefits likely to arise for a given level of investment and on various yield assumptions. The Code included provisions designed to ensure realism in the projection rates used. Benefit illustrations were to be provided to the client in writing and were not to be misleading nor give unrealistic expectations.

3.10

Where a life insurance company, as a lender, required a borrower to take out life insurance cover in order to comply with a condition of the loan or to provide security for the loan the Code provided that the borrower must be informed that the life policy (a collateral policy) could be taken out with any company of the borrower's choice. It was also a Code requirement that the amount of the policy be no more than was reasonably necessary to protect the prospective interests of the lender and the borrower.

3.11

The Code included a complaints procedure. When the Code was introduced in 1990 the complaints procedure involved referral to the LOA's Business Practices Committee16 if the complainant could not resolve the matter directly with the company. If either party considered that the matter was not satisfactorily dealt with by the Committee there was a right of appeal to the Review Authority, who was retired chief district court judge, Mr Peter Trapski CBE.

3.12

The Review Authority had the power to refer serious or persistent breaches of the Code to us. Mr Trapski reported annually to us on the exercise of his responsibilities. He considered very few cases. He did not refer a case of serious or persistent breaches of the Code to the Commission during his tenure, which ended on the establishment of the Insurance and Savings Ombudsman scheme in early 1995.

3.13

The Code was amended in 1995 so that the primary person handling complaints about life company practices was the Insurance and Savings Ombudsman (or, if the company chose to submit to that jurisdiction, the Banking Ombudsman).

3.14

Generally all complaints relating to life insurance companies, and the administration of the Code more generally, have been undertaken without reference to us, but in the knowledge that we could review the authorised status of any life insurance company if circumstances warranted this. Where complaints were made directly to the Commission we referred them to the company concerned, to the LOA or to the Insurance and Savings Ombudsman for resolution. We undertook detailed analysis of particular circumstances in a very few cases, where there appeared to be evidence of a wider market practice on which we might wish to comment.

3.15

The commitment of life insurance companies to abide by the Code no longer has its present force as a result of the revocation of sections 7A and 7B. Compliance with good selling practices, subject to compliance with the law, is a matter of company policy, agreement between life companies and the Insurance Savings and Investment Association ("the ISI")17 if the Code or something similar continues to apply, and the determinations of the Insurance and Savings Ombudsman. The future of the Code could be influenced by what we understand is some dissatisfaction among life insurers with some of the provisions of the present Code, particularly those relating to benefit projections.

3.16

Under the newly-amended securities law18 where an advertisement for securities includes prospective financial information (including benefit projections) the principal assumptions and methods of calculation for those benefit projections must either be included in the registered prospectus for the product being offered or, if there is no prospectus, in the document containing the benefit projection.

3.17

The new investment statements17 will be required to provide details of the fees and charges imposed on life insurance policies.

3.18

We understand that most if not all life companies will remain members of one or the other of the available ombudsman schemes.

Other Securities Act provisions related to life insurance selling processes

3.19

The Commission's interest in the selling of life insurance products has not been limited to transactions covered by the Code.

3.20

Life insurance advertisements, brochures and other selling material are classified as "advertisements" for the purposes of the Securities Regulations 1983. As such the advertisement is not permitted (regulation 8) to:

... contain any information, sound, image, or other matter that is likely to deceive, mislead, or confuse with regard to any particular that is material to the offer of securities contained or referred to in the advertisement.

3.21

We have powers, under section 38B(1) of the Securities Act20, where, at any time, we :

... [are] of the opinion that an advertisement--

(c) Does not comply with [the] Act and regulations made under [the] Act--

to make an order prohibiting the distribution of that advertisement or any advertisement which relates to the offer of securities.

3.22

Since July 1989 we have, on several occasions, exercised our powers under former section 44A to prohibit the advertisements of life insurance companies. We did not find it necessary to publicise those prohibitions or to issue public warnings concerning investment with any particular life insurance company. Companies have immediately withdrawn or amended advertisements where there was a problem of compliance with the Securities Act or Regulations.

3.23

We have not, however, as a matter of practice, routinely scrutinised life insurance company advertisements. Where matters arise we prefer that they are dealt with in the first instance by the Advertising Standards Complaints Board21 where it has jurisdiction. Most of our formal interventions have related to promotional material other than that appearing in the media.

3.24

In the process of selling life insurance products companies have also been obliged to comply with other statutory provisions including those in the Fair Trading Act 1986 and the Consumer Guarantees Act 1993.

3.25

In addition the Investment Advisers (Disclosure) Act 1996 applies in respect of the offer of life insurance policies to the public.

Footnotes

Our experience of New Zealand life insurance company practice

5.1

Life insurance companies, by their nature, accumulate large sums of money for investment on behalf of their policyholders. These moneys, together with shareholders' funds, are invested in a wide range of investments in accordance with the decisions of the directors of each company (as expressed through investment policies and strategies as well as discrete decisions).

5.2

Some of the investments undertaken by life insurers operating in New Zealand which we have observed32 have included:

Legal provisions relating to the investment of life insurance company assets

5.3

In New Zealand there are no prescribed rules or guidelines for the investment of the policyholders' funds of a life insurance company. Current New Zealand law does not constrain related party exposures by life insurers. As noted earlier (see para 4.25) in some circumstances the law would seem to facilitate related party exposures. We have seen examples of material related party lending by New Zealand life insurance companies. We are aware that the constitutions of some life companies allow them to act in the best interests of their holding companies even if this is not in their own best interests.

5.4

Current law does not prevent the accumulation by life insurance companies of large asset concentrations, whether in single investments or in sectors. Disclosure of such exposures, if any, is usually limited to a company's audited financial statements. However if the life insurer were a listed public company, or the subsidiary of a listed public company, the New Zealand Stock Exchange's Listing Rules (Rule 9.1) would oblige the company to obtain the approval of the members of the company by Ordinary Resolution33 to enter into any transaction where the gross value was in excess of 50% of the value of the shareholders' funds of the listed company. In addition, section 129 of the Companies Act 1993 provides that, where an acquisition (or disposition) of property is valued at more than 50% of the value of the company's total assets before the transaction, the transaction has to be approved by a special resolution of the company34.

5.5

In some cases the types of investment held by a life company may reflect choices made by the investors themselves. Companies offer policies ("investment-linked") which allow the policyholders to nominate the types of investment into which their money is to be invested. The choices available can include fixed interest securities, New Zealand equities, overseas equities, cash and other liquid assets, emerging market securities, etc. The life company, either directly or through contracted managers, decides on the particular assets to be acquired in each asset class. These investments may be said to be divided into units, with a market price per unit available at all times to measure their performance. Under New Zealand law, however, the allocation of assets to units will generally be notional, as there will be no statutory fund or separate trust for the assets, and the allocation will not be effective against competing claims of creditors in the event of financial difficulty.

5.6

The investment-linked types of policies may raise different issues from the traditional participating policies. The investor has made the choice of the type or types of assets into which the funds are to be invested. Managers' performance may be, and sometimes are, measured by prices which are published and are available to potential investors. The exit price will be determined by reference to the market price of the assets allocated to particular securities after taking into account a price spread between buying and selling unit prices to allow for costs and charges.

5.7

As discussed earlier Australian life insurance companies are required to fulfil a number of statutory requirements related to solvency and capital adequacy (see para 4.29 onwards). While these requirements do not include specific prohibitions on life companies making certain types of investment, nor limit the companies' ability to accumulate large concentrations of risk, they effectively achieve these outcomes by the manner in which the statutory requirements are structured.

5.8

To illustrate, the "Solvency Standard" requires the company to create an "Inadmissible Assets Reserve" in relation to related party exposures, investments in companies already subject to prudential ratio requirements, and for various large exposures35. The effect of the reserve is to negate some or all of the value of the company's assets for the purposes of the solvency requirement calculation.

5.9

In the United Kingdom, under the ICA(UK), the solvency requirements have the effect, as in Australia, of imposing de facto constraints on life insurers' investments in particular types of asset.

5.10

Life insurers are able to include within their "admissible" or qualifying assets only those assets which come within the classes of assets prescribed in regulations. Apart from investments in cash and gilt edged securities, which are unrestricted, the admissible level of other assets ranges from around 0.1% of the "long term business amount"36 for debenture options and share options in any one company to 5% of that "amount" for land, mortgages over land and listed shares and debentures. There are prescriptions for valuing the various types of assets.

5.11

The general scheme limits a life insurer's exposure to any particular asset, other than gilt edged securities, to 5% of the long term business amount.

5.12

In addition to the de facto constraints described in the preceding paragraphs, the ICA(UK) also imposes a de jure restriction on transactions with connected persons. In general terms insurance companies (or their subsidiaries) cannot enter into transactions with connected persons (being controllers or directors of the insurance company) if the aggregate of the assets and liabilities attributable to existing transactions with the person concerned exceeds 5% of the amount of the long-term fund, or the proposed transaction would take the aggregate over the 5% limit.

Comment

5.13

It is generally accepted that the riskiness of a financial institution's investment portfolio is likely to be increased37 to the extent the institution has:

5.14

We have observed that some New Zealand life insurance companies have amassed relatively large single exposures, relatively large related party exposures, and relatively large sector exposures.

5.15

There are currently no direct constraints on the size or nature of exposures which may be undertaken by New Zealand life companies. However exposures which are material in the accounting sense should be disclosed in a life company's audited financial statements. The Companies Act, also the New Zealand Stock Exchange Listing Rules, where applicable, provide for shareholder approval for some very large transactions. There is no requirement for approval by policyholders for such transactions.

5.16

We think there are a number of questions which need to be addressed concerning the capacity of life insurance companies to undertake large and related party exposures. We raise these questions in the final section of the paper.

Footnotes

Our experience of life insurance industry practice

6.1

We have seen instances where life companies' policyholder funded assets have been pledged as security to financiers with claims either ranking ahead of, or in competition with, those of the policyholders themselves. In many cases it was not apparent that the policyholders had gained from the pledging of the assets to third parties.

6.2

These instances included:

The legal provisions relating to the pledging of life insurance assets

6.3

There are no specific provisions in the Life Act dealing with the giving of security over policyholder-funded assets. The principal section of relevance is section 15 which states:

LIFE FUNDS SEPARATE--

6.4

Section 15 refers only to those life insurance companies which carry on business other than that of life insurance, and provides that in such cases the company should keep separate account of all moneys received in respect of its life insurance business and these moneys will form a separate Life Insurance Fund which will be "as absolutely the security of the life policy and annuity holders as though it belonged to a company carrying on no other business than that of life insurance...".

6.5

Section 15 does not expressly deal with the giving of security over life fund assets. However there is relevant case law on the subject. Barker J, in ACL Insurance Limited v ACL Insurance Limited (In Liquidation) HC, Auckland M2121/89 6 March 1995, a case involving a company which carried on both life and general business, said:

6.6

In the particular case the company had not maintained a separate fund of assets for the life insurance policyholders, despite carrying on other business. Barker J declined to make an order giving any priority to the life insurance policyholders. They would rank as unsecured creditors along with the company's other creditors (other than a bank, which had security over a property owned by ACL). Barker J commented:

6.7

Two issues arise from the application of section 15 of the Life Act and Barker J's judgment:

6.8

The ACL case was concerned primarily with the claims of policyholders versus the claims of other unsecured creditors, not those of secured creditors. In the absence of a separate "Life Fund" the policyholders lost any protection they might have otherwise had. The question of the purpose of other borrowings did not arise.

Requirements for the segregation of policyholders' funds, and the security position of policyholders more generally, are not clearly stated in the legislation.

The pledging of policyholder assets in Australia and the United Kingdom

6.10

Australian life insurance legislation provides that all life insurance business must be conducted by life insurance companies within separate "statutory funds". Section 30 of the LIA(Aust) states:

6.11

Every Australian life insurance company is required to have at least one statutory fund, but may have more than one fund.

6.12

Under the LIA (Aust) it is not permissible for a life insurer to mortgage or charge any asset of a statutory fund except to secure a bank overdraft or else with the approval of the Insurance and Superannuation Commissioner ("the Commissioner").

6.13

In the United Kingdom the ICA (UK) requires the separation of the "long-term business" (life insurance) assets from the "general business" assets of any company which carries on both life and general insurance. Separate "funds" must be maintained for each type of business. All receipts relating to the respective types of business are paid into the respective funds. In addition, life offices must separate the assets and liabilities relating to their insurance business and their shareholders' funds. We understand that many life offices have at least two long-term funds, one for their with-profit (participating) business and one for their non-profit (linked) business while others have a single fund covering both with-profit and non-profit business.

6.14

The ICA(UK) restricts the uses to which the long-term assets of a company may be put. In general terms they may only be used for the purposes of the long-term business. An exception is provided for the "free reserves" i.e. the extent to which the long-term assets exceed the long-term liabilities as disclosed by an actuarial valuation, which may be used for the purposes of the company's business generally. In addition, long-term assets of the company may be exchanged for other assets of the company provided the exchange is at fair market value. As a further protection no dividend may be declared by any company authorised to conduct long-term business unless it has established, by a valuation, that its long-term assets are at least equal to its long-term liabilities.

6.15

There appear to be no express constraints on the ability of an United Kingdom life office to mortgage or charge its assets. However the requirements in the ICA(UK) for the segregation of business appear to mean that a life company's assets can only be pledged where it is for the purpose of the life business. It would not seem possible for life (long-term) assets to be secured for the benefit of the shareholders. Barker J drew attention to the United Kingdom provisions in the ACL case (see para 6.6).

6.16

Some New Zealand life insurance companies have pledged their assets as security to third parties in priority to or in competition with the claims of policyholders. There are currently no constraints on life companies acting in this manner, except to the extent that section 15 of the Life Act may apply.

6.17

Australia has direct controls over external borrowing by life companies and achieves separation of life company business through the use of statutory funds. The United Kingdom requires segregation of long-term (life insurance) business.

6.18

We think there are a number of questions to be addressed concerning the segregation of policyholders' funds and the capacity of life insurance companies to pledge their assets to third parties in priority to, or in competition with, the claims of policyholders, including the relevance of any perceived direct benefits to policyholders. We identify these questions in the final section of the paper.

Our experience of New Zealand life industry practice

7.1

Over recent years there have been a number of instances in New Zealand where ownership, or effective ownership, of a portfolio of life insurance contracts has changed. Such changes have been effected in a number of different ways with a range of direct and indirect consequences for policyholders.

7.2

A fairly common technique for changing the risks and rewards of an insurance portfolio, without actually changing the legal ownership of the portfolio, is through use of reinsurance. In this method the acquiring company assumes all the risk under a portfolio of policies without any change of obligor. The selling company pays the reinsurer (acquirer) a reinsurance premium by transferring an appropriate amount of the seller's assets to the acquirer. The selling company remains legally liable under each contract but the acquirer takes all or a major part of that risk, and the associated reward, under a reinsurance contract.

7.3

The policyholders' contractual arrangements are undisturbed. Their consent to the reinsurance arrangement is not required even though the strength of their future claims may rest rather more on the viability and business philosophy of the acquiring company than on that of the selling company. Provided the bonus determination processes are not changed by the acquiring company there may be no change in participating policyholders' benefit expectations. However the policyholder's security cover may be improved or worsened depending on the capital position of the company assuming the risks under the reinsurance contract compared with that of the company ceding those risks.

Acquisition by takeover

7.4

We have also observed a few instances in recent years of change of ownership of New Zealand life insurance companies, and thus of their life insurance portfolio of business, effected by acquisition or takeover.

7.5

In such cases the equity participants would be subject to the normal rules of law concerning changes of company ownership. For example:

7.6

There are no special provisions of the Life Act, the Companies Act, the Securities Act or any other New Zealand legislation applying to life insurance companies, whether as target companies or acquiring companies. There is, for example, no requirement that policyholders should be consulted, or their consent obtained, before an acquisition or sale transaction can proceed. There is also no specific requirement that the directors of either an acquiring or of a selling company obtain independent actuarial advice on the effect of any prospective takeover transaction on the policyholders of either company before the transaction is proceeded with.

7.7

With respect to the interests of the policyholders of an acquired life insurance company:

With respect to the interests of the policyholders of an acquiring life insurance company the provisions of existing law appear to mean that such a company is generally free to use its own assets, or indeed the assets of a wholly owned subsidiary, either directly or as security to support borrowings used to finance the purchase of another company, including a life company. Where any such acquisition is made it needs to be questioned whether that acquisition is for the purposes of the "life insurance business" of the acquiring company and if there should be a separation of the life insurance policyholders' funds as provided for in section 15 of the Life Act.

7.9

Examples in the area include where one life insurance company acquired another life insurance company and:

7.10

With respect to any consultation with policyholders we observed that in various instances, including that outlined in the preceding paragraph, the directors of the acquiring company did not seek the views of the policyholders or of any representative on the proposed acquisition.

Instances of changes of obligor

7.11

There were two recent instances where the New Zealand branches of United Kingdom life insurance companies were "domesticated", with the policyholders of the New Zealand branches of the United Kingdom companies becoming policyholders of New Zealand subsidiaries of those companies. These changes were effected through court approved Schemes of Arrangement under section 205 of the Companies Act 1955.

7.12

In both cases the companies requesting court approval to the transfers obtained independent actuarial advice, which was made available to the policyholders and the court, as to the fairness of the arrangements to the policyholders and the effect they would have on the financial security and future prospects of those policyholders.

7.13

These cases involved a change in the entity liable under the life insurance policies from a global United Kingdom-based company to a New Zealand incorporated company. These were arguably rather more fundamental changes to the position of policyholders than would occur with the takeover of one New Zealand life insurance company by another, because of the change in obligor.

7.14

One of the insurance groups involved in the domestication process sought to preserve for its New Zealand policyholders some of the regulatory benefits they were giving up by becoming members of a New Zealand incorporated life company. They achieved this by use of a "Policyholders Protection Guidance Note" which was protected by a Deed of Covenant.

7.15

The Independent Actuary, in an affidavit filed in the Court in support of the application for domestication by the company, said:

7.16

The Policyholders' Protection Guidance Note was designed to address these issues by prescribing the allocation of profits between participating policyholders and shareholders, by obliging the directors of the company to take actuarial advice on a range of matters, and, through the covering Deed of Covenant, to require that the company obtain policyholder approval for any change in profit distribution policy in favour of the shareholders. The Note could only be varied at the request of the directors of the company after taking the advice of the company's actuary and of an independent actuary. The distribution policy in favour of shareholders could not be improved without the approval of 75% of the policyholders.

Changes of ownership of life insurance companies and policies in Australia and the United Kingdom

7.17

Australia has legislative controls relating to changes of ownership of life insurance business, changes in the risks and rewards under life insurance contracts effected through reinsurance and takeovers or acquisitions of insurance (including life) companies.

7.18

Part 9 of the LIA (Aust) covers "Transfers and Amalgamations of Life Insurance Business". This Part (section 189 onwards) provides that no part of the life insurance business of a life insurance company can be transferred to, or amalgamated with the business of, another life insurance company without the approval of the Court44. A copy of the scheme of transfer or amalgamation, and any actuarial report thereon, must be provided to the Commissioner. Appropriate public notification of the intention to seek approval to the scheme must be given. Every affected policy owner must be given a copy of an approved summary of the scheme.

7.19

The Commissioner may arrange for an independent actuary to prepare a report on the scheme and is entitled to be heard in the court proceedings dealing with the application45.

7.20

Any change in the incidence of risks or rewards under life insurance contracts effected through reinsurance requires the approval of the Commissioner.46 Thus changes in the effective ownership of portfolios of life insurance policies cannot take place without consent.

7.21

The "Insurance Acquisitions and Takeovers Act 1991" ("the IAT") covers changes of ownership of both general and life insurance companies in Australia. The objects of the IAT are expressed to be to protect the public interest in a number of ways, including:

7.22

For this purpose any takeover proposal must be notified to the relevant Minister and the proposal is stopped if the Minister makes either a temporary or a permanent restraining order. If a proposal proceeds without the necessary procedures having been followed the Minister may make a divestment order.

7.23

Part 7 of the IAT provides that the Minister may formulate "decision-making principles" to be complied with by him in exercising his powers under that Act. Principles were published in April 1992 and included, among the elements the Minister had to have regard to in considering whether a proposal was "contrary to the public interest":

7.24

In the United Kingdom the ICA (UK) covers transfers of portfolios of life insurance business from one company to another. Sections 49 and 50 enable such transfers to be made with the approval of the High Court. It is necessary for various notices to be published, for the scheme of transfer to be available for prior inspection by policy holders, and for a report on the effects of the scheme to be made by an independent actuary.

7.25

"Controllers", defined as anyone (person or company) entitled to exercise 15% or more of the voting power of an insurance company, as well as the chief executive or managing director of the insurer, are required to satisfy the Secretary of State that they are "fit and proper" persons to control an insurance company.

7.26

Changes of life insurance company ownership are also controlled. Section 61 of the ICA (UK) requires any person seeking to become a controller of an insurance company through acquisition of 15% or more of the shareholding to obtain the approval of the Department of Trade and Industry before the change can become effective. The Department has three months in which to consider the merits and implications of the change in control. If it objects to a proposed change in controller it must give advance notice of this and allow the applicant to appeal.

Comment

7.27

In New Zealand there are no special constraints on either the change of ownership of a life insurance company or the change of effective ownership of the risks and rewards of a portfolio of life insurance business through reinsurance.

7.28

The "major transactions" provisions of the Companies Act and Stock Exchange Listing rules may apply, but these are for the benefit and protection of shareholders not policyholders. There is no requirement for a takeover of a life company or its portfolio of policies to be referred to a representative of policyholders. A life company can give financial assistance for the purchase of its own shares, and where the unanimous consent provisions are available and are used there is no requirement that this assistance be in the best interests of the life company concerned.

7.29

In Australia and the United Kingdom rules of law require court or regulator approval for changes of ownership of a life insurance company or of the risks and rewards under a portfolio of life insurance business.

7.30

Changes of company or portfolio ownership could have implications for policyholders in a number of ways, including in relation to the relative security and yield of their investments and (for participating policyholders) their share of the company's profits (see para 8.11 onwards for further discussion).

7.31

We think there are a number of questions which need to be addressed concerning the takeover of life insurance companies and life insurance business. We set out these questions in the final section of our paper.

Footnotes

DETERMINING THE RETURNS TO POLICYHOLDERS

8.1

There are a number of factors which bear on the returns policyholders are likely to receive from their investments in life insurance policies. These factors include:

8.2

In this section of the paper we will look at life companies' practices for the allocation of profits between shareholders and participating policyholders, and at the extent to which minimum surrender values are protected for the benefit of policyholders.

Our experience of New Zealand life industry practice

8.3

From our observations the practices followed by life insurance companies in determining the allocation of profits between their current policyholders, reserves and (for proprietary companies) shareholders, vary widely.

8.4

As we noted earlier (see para 4.8) the company's actuary is required to state in the Sixth Schedule abstract the principles used to determine the split of profits between shareholders and policyholders, and the source of those principles.

8.5

We have reviewed many Sixth Schedule abstracts. These are usually expressed in the form of a recommendation by the actuary as to the amount of bonus or profit which should be applied to various classes of policy.

8.6

We have seen instances where, in the face of what appeared to be very small profit allocations to policyholders compared to the profit attributed to shareholders, the actuary indicated he would support a higher allocation of profits to policyholders should the company feel disposed to make such an allocation (which it did not).

In one instance a proprietary company reported a significant profit arising from the public flotation of one of its long-held investments. The company subsequently paid a substantial dividend to its parent. In the same year no reversionary bonuses were allocated to with-profit whole of life and endowment policies.

8.8

The particular investment giving rise to the profit was shown in the company's financial statements as an investment of the company without qualification and certain contingent liabilities (guarantees given by the life insurer covering obligations of the floated company) were also shown in the company's financial statements without qualification.

8.9

In effect life insurance companies have the capacity to select after the event which particular profits arising from their business will be for the benefit of policyholders and which profits will be attributed to the shareholders. This is clearly so when the company has not disclosed the "ownership" attribution of the company's assets.

8.10

We are also aware that companies can allocate benefits to policies even though the underlying assets did not earn positive yields. Such allocations may be at the "cost" of other policyholders and/or of the shareholders.

Factors in determining the allocation of profits between policyholders and shareholders

8.11

There are no effective rules of law in New Zealand governing the splitting of profits between current policyholders, shareholders and reserves in a life insurance company with participating policies.

8.12

In mutual companies the issue is one of how much profit to transfer to or from reserves and how much to allocate to policyholders in any given year. In the case of proprietary companies it is also necessary to allocate profits between participating policyholders and shareholders.

8.13

We expect profit allocation decisions are based on a variety of factors including current and expected profitability of the asset portfolio, indications given to policyholders at the time policies were sold, comparable market performance, the interests of the shareholders of the company, and the need to service shareholders' funds.

8.14

The role of the actuary in the profit allocation process is unclear. As we noted earlier (see para 4.8) the actuary is required to prepare a report on the financial condition of the company each year. That report is required to state the principles on which the distribution of profits was made. However the actuary is not required to state, for example, if the distribution appears fair or equitable as between classes of policyholders or as between shareholders and policyholders (although the actuary may choose to do so).

8.15

The actuary is appointed by the company and owes a duty of care to the company. There is not an explicit duty of care towards, or mandate to act for, or in the interests of, a company's policyholders. Many actuaries are employees of the life insurance companies they are reporting on. Some actuaries are directors of the companies they are reporting on. In other instances consulting actuaries are appointed by the directors of the company to report on the company's financial position. There would appear to be important conflict of interest questions for actuaries who undertake section 18 investigations, questions which, as far as we know, are not addressed by formal industry guidance.

8.16

There is no existing opportunity, either in the law or in the conventional policies offered to the general public, for the policyholders themselves to have a say in the distribution of a company's profits between shareholders and policyholders and as between different classes of policyholders.

8.17

Mr Richardson-Hay in his paper (see para 2.19) observed:

Life offices in New Zealand have no restrictions in the following areas:

8.18

Until recently disclosure of the company's approach to profit allocation was a matter for promotional and contractual documentation. However life insurance companies are now49 required to prepare investment statements.These documents have to be provided to all prospective investors andare required to include:

The approach to the allocation of profits between shareholders and policyholders in Australia and the United Kingdom

8.19

As noted earlier, in Australia life insurance legislation requires life insurance business to be conducted within separate "statutory funds"(see para 6.10 onwards).

8.20

The LIA (Aust) contains detailed provisions about many facets of the operation of the statutory funds. With respect to the allocation of operating profit section 60 states that, for a statutory fund representing Australian participating business, at least 80% of the profit (or such higher percentage as may be specified in the company's articles of association) must be added to policy owners' retained profits of the statutory fund. The balance of operating profit must be treated as, or added to, shareholders' retained profits.

8.21

The Australian legislation allows for different treatment for overseas participating business. For example, there is no 80% minimum profit allocation rule. Instead, overseas participating policyholders can have any proportion of the funds' operating profit added to, or treated as, their retained profits provided the allocation would not be inconsistent with the company's articles of association. If a company's articles of association require any part of a profit representing overseas participating business to be treated as overseas policyholders' retained profits then that part of the profits must be treated as, or added to, overseas policyholders' retained profits.

8.22

With respect to the distribution of retained profits, the LIA(Aust) provides that Australian policy owners' retained profits may only be distributed to owners of Australian participating policies. However a similar provision applying to the distribution of the retained profits of overseas participating policyholders is qualified by a further provision which allows overseas policy owners' retained profits, with the approval of the Commissioner, to be transferred to owners of Australian participating policies or to shareholders' funds.

8.23

In the United Kingdom the ICA(UK) (section 30) limits the options available to a company to dispose of profits when the company has with-profits policyholders. The section appears designed to ensure an element of stability in the proportion of profits which can be distributed to policyholders from year to year. Based on the premise that with-profits policies are usually sold by the illustration of the future effects of past bonus declarations, the rule of law means that companies cannot lower the proportion of profits allocated to policyholders from one year to the next by more than 0.5 percentage points without invoking a formal procedure involving notification to the Department of Trade and Industry, publication of the intention in the London, Belfast and Edinburgh Gazettes and in specified newspapers, and delaying the allocation by almost two months from the giving of the public notice.50

Minimum surrender values for life insurance contracts

8.24

The effect of the practices followed in the allocation of profits to participating policies is particularly evident on policy termination.

8.25

Earlier in our paper (see para 2.13 onwards) we discussed the vulnerability of New Zealand life insurance policyholders to the very wide discretion of life insurance companies to determine the surrender value of life insurance contracts. The current position in New Zealand is different from that prevailing in Australia.

Policy termination in Australia

8.26

Under sections 207 and 209 of the LIA(Aust) the LIASB is required to develop an actuarial standard related to Minimum Surrender Values and Paid Up values for life insurance policies.

8.27

In May 1997 the LIASB issued for comment draft standard 4.01 "Minimum Surrender Values and Paid-up Values". It is proposed that the standard, when formally promulgated, will apply to transactions occurring on or after 30 June 1998.

8.28

The purpose of the standard is described in the "Overview" section as being twofold:

8.29

The objectives in prescribing these amounts were described in the "Introduction" to the standard as:

8.30

In outlining the principles underlying the standard the "Overview" included:

8.31

The first part of the standard says:

8.32

The draft standard is quite detailed. It prescribes the methodology to be applied to determine the surrender values of the four major policy types. It requires that Minimum Surrender Values be provided for all policies issued after 1 July 1995 with some exceptions.51

8.33

The standard prevents ongoing charges being levied at a level exceeding that actually applied to the policy. It also provides that charges cannot exceed the level prescribed in the standard. For example, the standard prescribes a maximum administration or transaction charge in respect of a surrendered policy of A$50 (for 1998).

8.34

While the draft standard itself does not prescribe the minimum returns policyholders can expect from their policy, since these returns will obviously vary widely among different types of policy and will depend on the performance of the assets supporting those policies, the standard will require that most policies prescribe a minimum surrender value which includes all returns credited to the policyholder in relation to that policy.

8.35

The minimum surrender values become part of each company's solvency calculation.

Comment

8.36

The processes used by proprietary companies for determining the division of profits between policyholders and shareholders, and between different classes of policyholder, are generally unclear to the outside observer.

8.37

With the significant shift, as a result of demutualisation, towards life insurance business being conducted by proprietary rather than mutual life insurance companies, the issue of profit allocation between shareholders and policyholders is likely to assume greater importance in future years.

8.38

As already noted (see para 2.19), there appear to be a number of ways that a New Zealand life insurance company can adjust the return provided to policyholders, including the levying of expenses against policies, describing the procedures for determining bonuses in imprecise and obscure language in the policy documents to allow flexibility in bonus calculation, adjusting bonus declarations already made and removing expected terminal bonuses.

8.39

Where the ownership of life insurance companies or portfolios change policyholders could be adversely affected if new owners have a different investment philosophy or approach towards benefit allocation.

8.40

The introduction of the new investment statements should go some way to improving the quality of disclosures to prospective policyholders but does not affect the ability of life insurance companies to allocate benefits at their discretion.

8.41

Australia has specific rules of law concerning the allocation of life insurance profits between participating policyholders and shareholders. The United Kingdom has requirements which ensure some stability in profit allocations from year to year. There are no such rules in New Zealand.

8.42

Some New Zealand life insurance policies, generally the "capital stable" policies, have what is akin to a minimum surrender value. Under those policies there could be a promise by the life insurer to pay the policyholder a minimum amount related to the original investment or premiums paid by the policyholder. Otherwise, however, the policyholder may have no assurance as to the value of the investment at any given time.

8.43

We think there are a number of questions which need to be addressed concerning the allocation of profits between policyholders and shareholders and the possible provision of minimum surrender values for life policies. We set out these questions in the final section of the paper.

Footnotes

Our experience of New Zealand life insurance industry practice

9.1

Life insurance companies are "issuers" for the purposes of the FRA. As such they are required to deliver to the Registrar of Companies for registration financial statements which comply with the requirements of that Act, including compliance with applicable financial reporting standards and generally accepted accounting practice. However, as noted earlier (see para 4.17), there is no applicable financial reporting standard for life insurance business and there are number of approaches to life insurance accounting which may be regarded as generally accepted accounting practice. Life companies are also, by Release No 4 issued by the ASRB in August 1994, excused from the application of six SSAPs to their financial statements (see para 4.18).

9.2

We have reviewed each year the financial statements of nearly every life insurance company operating in New Zealand. In our view these financial statements have had many shortcomings. The enactment of the FRA did not significantly remedy these shortcomings because there has been no approved financial reporting standard for life insurance companies available to deal with the peculiarities of life insurance business.

9.3

Among the matters we noted were:

A financial reporting standard for life insurance business

9.4

It has been partly as a result of our awareness of life insurance industry accounting practices that we have been encouraging the Institute of Chartered Accountants of New Zealand ("the Institute") (formerly the New Zealand Society of Accountants ("the NZSA")) to introduce a financial reporting standard for life insurance companies.

9.5

We have been conscious that, with the obligation from October 1997 onwards for life insurance companies to issue prospectuses and investment statements, there should be a satisfactory financial reporting standard for life insurance in place in New Zealand.

9.6

We welcomed the publication of ED-79, Financial Reporting of Life Insurance Business, by the NZSA in July 1996 and we look forward to the exposure draft becoming an approved financial reporting standard as soon as possible.

9.7

It follows from our earlier comments that in our view the new financial reporting standard needs to provide for:

9.8

The ED already addresses a number, but not all, of these issues.

9.9

The Institute has a process underway for considering submissions on the exposure draft, ED-79. It can be expected that the form of the standard will change as a result of the Institute's normal consultation process. Moreover the Institute has committed itself to moving forward with its counterpart organisations in Australia. It is our expectation from discussions in Australia that progress achieved on this joint basis is likely to be slow.

Life insurance financial reporting in Australia and the United Kingdom

9.10

ED-79 is an exposure draft of what is intended to be a joint Australia-New Zealand financial reporting standard for life insurance business. However in Australia the Commissioner, through his rule-making powers, has prescribed financial reporting obligations for life companies, including use of the "margin on services" method of accounting for determining life insurance policy obligations and thus profits. This method is, with some variations, the same as that included in the current draft Australia/New Zealand financial reporting standard. Australian life insurance companies are currently publishing their financial statements on the basis of the Commissioner's rules.

9.11

In the United Kingdom there is no approved financial reporting standard for life insurance business. Companies generally report on a solvency basis. However some life insurers have used, as a supplementary basis of financial reporting, the "achieved profits" method. This is a method put forward by the Association of British Insurers but is one which does not, we understand, have wide acceptance in the UK. (Several companies have used the achieved profits method to report their results in New Zealand.)

Comment

9.12

In general terms we have supported the approach taken in the exposure draft, including its adoption of the "margin on services" method of measuring life insurance company liabilities.

9.13

We do not propose to discuss the various alternative methods of profit determination for life insurance companies in this paper in any detail.53

9.14

We are aware that there are criticisms of the margin on services method of accounting for life insurance profits, particularly as to the predictive value of its reported profit. Mr Richardson-Hay, for example, with respect to the "margin on services" method, said in his paper, "It has a number of fundamental flaws, which make it unusable for any other purpose except as an accounting tool. It will generate a profit figure that may be considered meaningless and misleading. ... If adopted in New Zealand will it replace the current unacceptable system with a meaningless system? ...".

9.15

We think this criticism is too harsh. We understand that the method, despite its shortcomings, is generally accepted by the actuarial profession in Australia, where there is now some experience with using it. Moreover the policy of the FRA is to provide harmonisation of financial reporting standards with Australia and this should be an important consideration particularly as it will facilitate comparisons of the results of companies in the Australasian region.

9.16

The solvency method is generally regarded as too conservative to give a fair recognition of the profitability of a portfolio of life insurance policies. This view is supported by recent experience where the prices paid for life insurance businesses being acquired greatly exceeded the book value of the shareholders' and policyholders' funds.

9.17

We consider there is an urgent need for the adoption of a new financial reporting standard for life insurance business in New Zealand. The regulatory environment under which life companies operate in Australia is fundamentally different from that in place in New Zealand. Because Australian life insurance companies are now reporting publicly under financial reporting rules imposed by the Commissioner there is less urgency in Australia for the introduction of a new financial reporting standard. The basic philosophy in New Zealand is disclosure of information and market scrutiny. That process of scrutiny is hamstrung at present by a lack of coherent financial information.

Footnotes

10.1

In this paper we have set out some of our experiences during the administration of the provisions of section 7A of the Securities Act.

10.2

We have observed that:

10.3

We have noted that Australia and the United Kingdom are examples of regulatory regimes for life insurance which are considerably more extensive than that existing in New Zealand. This is not an argument that such regulatory approaches should necessarily be followed in New Zealand. They are examples, however, of how the various issues have been addressed elsewhere.

10.4

We believe on the basis of our experience that there are a number of questions relating to the operation of life insurance companies, and the laws which govern those operations, which need to be addressed. We believe there is an urgent need to review the provisions of the Life Act.

10.5

In the final Part of our paper we provide further analysis and comment and we set out questions which we believe are relevant. We welcome responses to the questions we have identified. Once these responses have been analysed we will report as appropriate to the Minister of Commerce.

11.1

In this Part of our paper we discuss some of the issues relating to possible forms of regulation of the life insurance industry. We do this to assist readers to respond to the questions set out in section 12. We are not promoting any particular regulatory approach. The Commission at this stage does not have a view as to the appropriate form of regulation, if any, of the life insurance industry.

11.2

A fundamental question in any regulatory review is whether there should be any form of regulation of the subject industry or activity at all. The paper does not address that question. We believe the most useful way to consider life insurance regulatory issues at this time is in the context of already-regulated markets. This brings into consideration some "level playing field" arguments as well as questions of the appropriate degree of regulatory input, if any, into various facets of companies' operations.

11.3

We are aware there is extensive academic literature on the economics of regulation. We would expect any comprehensive review of the Life Act to have proper regard to the literature.

11.4

The existing "regulation" of the life insurance industry is a mix of various inter-dependent components. We discuss the existing components of life insurance regulation, and some possible additional or alternative elements, including the possibility of appointing a trustee or statutory supervisor for life companies, introducing an appointed actuary regime, or introducing a requirement for compulsory rating of life insurance companies' obligations, in the remainder of this section.

The duties of the directors of life insurance companies

11.5

Issues which arise when considering the possible weight to give to reliance on directors' statutory and other duties as means of "regulating" the life insurance industry include:

11.6

Matters which arise in relation to the possible weight which should be given to market scrutiny as a means of "regulating" the life insurance industry include:

Direct role of the Government and its agencies

11.7

Issues which arise in relation to the possible weight which should be given to the role of the central government in the "regulation" of the life insurance industry include:

11.8

Australia and the United Kingdom have rules of law relating to life companies' processes of profit allocation, setting of fees and charges, and determination of policy surrender values. Issues arising as to whether such rules of law should be introduced in this country include:

The segregation of policyholders' funds

11.9

Issues which arise in relation to the segregation of policyholders' funds include:

The change of ownership of life insurance companies and portfolios of life insurance business

11.10

Issues which arise in relation to changes of ownership of life insurance companies and portfolios of life insurance business include:

The appointment of a trustee or statutory supervisor for life insurance companies

11.11

Issues which arise in relation to a possible requirement to appoint a trustee or statutory supervisor to a life insurance company include:

An appointed actuary for life insurance companies

11.12

Issues which arise in regard to possible introduction of an appointed actuary regime in New Zealand include:

A requirement for compulsory rating of life insurance obligations

11.13

Issues which arise concerning possible introduction of a compulsory rating requirement for life insurance companies include:

12.1

Life insurance is an important and complex industry. Contracts of life insurance range from the equivalent of short-term debt securities to whole of life policies which could last for 70 - 80 years. Many life insurance contracts lack portability, and can only be realised prior to maturity at considerable cost to the policyholder. Some life insurance policies give rise to benefits which are in the nature of annuities, on which beneficiaries may be dependent for their livelihood.

12.2

All life insurance contracts are subject to the Life Act. Many life insurance policies are subject to securities law. Some aspects of life insurance companies' business are monitored by government agencies. There are special provisions which provide for the judicial management of failed life insurance companies.

12.3

We think it most likely there will continue to be Government or Crown Agency involvement in the regulation of the life insurance industry, including of the disclosures to be made to policyholders and prospective policyholders, for the foreseeable future. Similarly, the life insurance industry, the actuarial profession, the accounting profession and securities market practitioners generally, all have and will continue to have important roles to play.

12.4

Responses to the questions we set out in this section of the paper should aid the process of deciding what these respective roles should be.

The questions

1.

Do you consider changes should be made to the existing regulatory regime for life insurance companies or products? Why?

2.

Do the particular characteristics of the life insurance industry warrant or justify any different treatment for securities issued by companies operating in that industry compared to other issuers of securities? If so, what are the characteristics which give rise to the need for differential treatment?

3.

What are your views on the relevance and weighting (if any) which should be given to each of the following elements in an overall scheme of regulation of the life insurance industry:

What other options exist and what are your views on them?

Additional comments on reasons for the relative emphasis given to each element would be helpful.

4.

With respect to the statutory duties of directors of life companies:

5.

With respect to takeovers of life insurance companies, or changes of ownership of portfolios of life insurance business:

6.

With respect to the rules of law regulating disclosure of information to prospective and existing policyholders:

7.

With respect to the role of the Government or Crown Agency in the regulation of the life insurance industry:

8.

With respect to the determination of returns on policies:

9.

Should life insurance companies be required to appoint a trustee under a trust deed to represent the interests of policyholders and to monitor the activities of the life companies on policyholders' behalf?

10.

With respect to the separation of life insurance assets:

11.

With respect to the position and role of actuaries:

12.

Should a compulsory rating requirement for life insurance company's claims paying ability be introduced? Should policyholders have any specific rights in the event that a company's rating deteriorated? Would such a rating requirement be an alternative to, or a supplement to, existing or more extensive regulation of the life insurance industry in New Zealand?

Invitation

12.5

The Commission welcomes observations on the questions raised in this paper. We also welcome comment on any other matters covered in the paper. All comments should be forwarded to the Commission by 31 March 1998 at the addresses below.

E H Abernethy
Chairman Securities Commission
12th Floor
Reserve Bank Building
2 The Terrace
WELLINGTON

8 December 1997

Addresses for comments

Postal: P O Box 1179, Wellington
Telephone: (04) 472 9830
Facsimile: (04) 472 8076
Email: seccom@seccom.govt.nz

THE TEXT OF SECTIONS 7A AND 7B OF THE SECURITIES ACT 1978

(b) Requiring the company to publish in such manner and at such times as may be specified by the Commission financial statements, which the Commission may require to be audited, containing such information as the Commission may specify.

APPENDIX TWO

THE REQUIREMENTS OF THE SIXTH SCHEDULE TO THE LIFE INSURANCE ACT 1908

GLOSSARY OF TERMS USED IN THE PAPER

the ACL case

ACL Insurance Limited v ACL Insurance Limited (In Liquidation) HC, Auckland M2121/89 6 March 1995

the ASRB

the Accounting Standards Review Board, a statutory body established under the Financial Reporting Act to approve financial reporting standards

authorisation

declaration concerning a life insurance company made by the Commission under section 7A of the Securities Act 1978

bundled policies

life insurance policies where the savings and risk components of the contract, and the expenses charged to it, are not separately identified

the Code

the Code of Business Practices for Life Insurance Companies, a document issued by the LOA and approved by the Commission

the Commission

the Securities Commission

the Commissioner

the Insurance and Superannuation Commissioner (head of the Insurance and Superannuation Commission, the Australian regulatory body responsible for oversight of the life insurance and superannuation industries)

the Companies Act

the Companies Act 1993 (New Zealand legislation)

ED-79

Exposure Draft 79 Financial Reporting of Life Insurance Business issued by the New Zealand Society of Accountants in July 1996

the FRA

the Financial Reporting Act 1993 (New Zealand legislation)

FRS

Financial Reporting Standard, issued or adopted by the Institute of Chartered Accountants of New Zealand

the IAT

the Insurance Acquisitions and Takeovers Act 1991 (Australian Federal legislation)

the ICA (UK)

the Insurance Companies Act 1982 (United Kingdom legislation)

the Institute

the Institute of Chartered Accountants of New Zealand

investment statement

offer document required for all offerings of securities after 1 October 1997 designed (section 38D Securities Act) to provide key financial information for the prudent but non-expert investor

the ISI

the Investment Savings & Insurance Association of NZ Inc, formed following the merger of the Life Office Association of New Zealand and the Unit Trust Association of New Zealand

the LIA (Aust)

the Life Insurance Act 1995 (Australian Federal legislation)

the LIASB

the Life Insurance Actuarial Standards Board (Australian authority established by section 100 of the Life Insurance Act 1995 with responsibility for making actuarial standards under that Act)

the Life Act

the Life Insurance Act 1908 (New Zealand legislation)

the LOA

the Life Office Association of New Zealand Inc

the Marac case

Marac Life Insurance Limited v Commissioner of Inland Revenue [1986] 1 NZLR (694)

mutual company

life insurance company owned by the policyholders i.e. with no separate shareholders

the NZSA

the New Zealand Society of Accountants

persistence

the maintenance of policies in full force from year to year

proprietary company

life insurance company owned by shareholders

reassurance

a contract of indemnification providing for a third party to accept part or all of the mortality or morbidity risk associated with a particular life assurance or disability policy respectively

the Secretary

the Secretary of Commerce (the chief executive of the Ministry of Commerce)

section 7A

section 7A of the Securities Act 1978

section 7B

section 7B of the Securities Act 1978

the Securities Act

the Securities Act 1978 (New Zealand legislation)

Sixth Schedule return

return required by the Sixth Schedule to the Life Insurance Act 1908, being an abstract from the actuary's annual investigation of a company's financial position

the Society

the New Zealand Society of Actuaries

solvency

the ability of life assurance companies to meet the claims of policyholders as they fall due

SSAP

Statement of Standard Accounting Practice issued by the New Zealand Society of Accountants. Forerunner to Financial Reporting Standards.

statutory fund

term currently used in Australia to define a fund that is established in the records of a life company and relates solely to the life insurance business of the company or a particular part of that business

surrender value

a cash sum available to a policyholder in the event the policy is surrendered earlier than its expected maturity, or prior to death

Twentieth Schedule return

return required by the Twentieth Schedule to the Life Insurance Act 1908, being statistical information of the number, value and types of policies sold by the company during the last twelve month reporting period, and of the policies still in force at balance date.

unbundled policies

those life insurance policies where the cost of life cover and expenses are explicitly separated on an individual policy basis from the amount available for investment