Japan’s Insurance Industry

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Japan’s insurance industry grew like the rest of Japan’s economy during the 1980’s and first half of the 90’s. Japan’s insurance companies began to look abroad for investment because of the sheer volume of their premium income and asset creation, which was sometimes comparable to even the most powerful U.S.A. Analysts around the globe have been examining the industry’s status as a major international investor since the 1980’s.

Global insurance companies tried to establish a foothold in this market, despite the enormous size of the market. In the middle of the 1990s, intense and sometimes bitter negotiations took place between Washington, DC, and Tokyo due to the Japanese insurance laws. These bilateral and multilateral agreements were made in conjunction with Japan’s Big Bang financial reforms.

A series of liberalizations and deregulation has been implemented since 1994, following the conclusion of the US-Japan Insurance talks. However, the process of deregulation was slow and, more often than not selective, it failed to protect the market share and interests of domestic companies. While the Japanese economy was similar in size to its counterpart in the USA, the foundation of an efficient financial market – sound rules and regulations that promote a competitive environment – was absent. Its institutional structure was also different from other developed countries.

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The unique phenomenon of the kieretsu structure, a corporate group that holds cross-holdings in large numbers of companies across different industries, was Japan’s first. The necessary shareholder activism to make companies adopt the best business strategy was not possible. Although Japan was initially viewed as a model in the early days of Japan’s economic prosperity, its vulnerability became more apparent when the bubble burst in 1990. Japan’s inability to keep up with other countries in software development was another factor that worked against it. In the last decade, software was the main engine of global economic growth. Countries that were slow in this area faced the 1990s with stagnant economies.

Japan, the global leader in “brick and mortar” industries, has surprisingly fallen behind in the “New World’ economy following the Internet revolution. Japan now calls the nineties a “lost ten years” for its economy. It lost its shine after three recessions in the past decade. To stop the economy from collapsing, interest rates plunged to historical lows. This was devastating news for insurers whose only source of income is their interest spread investment. A number of large insurance companies were forced to close their doors due to “negative spread” as well as rising non-performing assets. Although Japanese insurers have generally escaped the scandals that afflicted their counterparts in the securities and banking industries, they are still facing unprecedented financial difficulties, including a bankruptcies.

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Institutional Weaknesses

Although the Japanese market is huge, it is only home to a handful of companies. Contrary to the USA, where around 21,000 companies compete in the life sector, Japan’s market only includes 29 domestic companies and a few foreign companies. This same scenario was true for the non-life market, where 26 domestic and 31 foreign companies offered their products. Consumers have far fewer options than American counterparts when it comes to choosing their carrier. The product selection is also less varied. The Japanese life and non-life insurance companies are known for their “plain vanilla” offerings. This is especially evident in automobile insurance where premiums could not reflect differential risk such as gender and driving record. For the purposes of premium determination, drivers were only divided into three age groups. However, US rates have long reflected all of these factors.

Different types of products also have different demand. Japanese insurance products tend to be more savings-oriented. Similar to this, Japanese life insurance companies only offer limited types of variable life policies. These policies, which have benefits that reflect the value of the underlying assets of the insurance company and expose the insured to market risks, are not very popular. The value of Japanese variable life policies as of March 31, 1996 was $7.5 billion. This is only 0.08 percent of total life insurance. The American variable life policies that were in force as of 1995 had a value of $2.7 trillion. This is roughly 5 percent of all life insurance. There are many options such as variable universal, which can be purchased.

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Japanese insurance companies have been less competitive than American counterparts in both sectors of the industry. Implicit price coordination is expected to limit competition in an environment that has only a handful of firms offering limited products to a market with strict regulations. Japan’s unique factors reduce competition.

Lack of price competition and product differentiation means that insurance companies can seize a company’s business and keep it for a long time. American analysts have sometimes noted that keiretsu (corporate groups) ties can be used as an excuse. For example, a member of the Mitsubishi Group might shop around to find the best price on hundreds or thousands of goods or services it purchases. Non-life insurance is a different story. All companies will offer the same product at the same cost. A Mitsubishi Group company will often give business to Tokio Marine & Fire Insurance Co. Ltd. for many decades.

Life insurance premiums are more flexible on paper. The government plays a significant role in this sector of the insurance industry, and it has an impact on the pricing of products. In addition to the huge savings system and the Kampo postal life insurance system, the nation’s postal system is also in operation. Kampo transactions are done at thousands of post offices. Kampo held 84.1 million policies, which is roughly one per household. It also holds nearly 10% of the entire life insurance market as measured by the number of policies in force.

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Kampo funds are invested mainly in the Trust Fund. This fund invests in many government financial institutions and semipublic units involved in various activities related to government such as highways and ports. The Trust Fund is managed by the Ministry of Finance, despite being under the direct control of the Ministry of Posts and Telecommunications. The MOF has theoretically the ability to influence the returns Kampo can earn and the premiums it will likely charge.

Kampo’s interaction with the private sector is influenced by a variety of factors. It is a government-run institution and therefore inherently less efficient. This can lead to higher costs, noncompetitiveness, and a decline in market share. Kampo can’t fail so taxpayers could eventually pay for its high risk tolerance. This means that the postal life insurance system can underprice its products, which could lead to an increase in market share. MPT may prefer growth, but MOF seems to be equally interested in protecting its insurance companies from “excessive competition”.

These conflicting incentives have the net effect that Kampo seems to limit the premiums charged insurers. Kampo will take additional share if their prices rise excessively. Insurers may reduce premiums in response. Kampo may lose market share if private-sector premiums are lower than the underlying insurance.

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The Japanese life insurance industry is also behind the American counterpart when it comes to formulating inter-company cooperative strategies against individual fraud and anti-selection threats. Despite the fact that Japan has fewer companies, disunity and distrust have led to isolated approaches to dealing with these threats. The existence of sector-sponsored entities such as Medical Information Bureau (MIB), in the USA acts as a first line defense against frauds, which in turn saves the entire industry approximately $1 Billion annually in terms of protective value and sentinel effect. Major Japanese carriers have been experimenting with data sharing and data warehouses.

Analysts frequently complain about insurance companies’ inability to comply with prudent international norms regarding disclosures of financial data to policyholders and the investment community. This is especially true when compared to their US counterparts. Nissan Mutual Life Insurance Co. failed in 1997. It reported net assets and profit in recent years, even though its president admitted that the company had been insolvent for many years.

Participation from abroad in life insurance

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15 foreign life insurance companies have been in business since February 1973, when American Life Insurance Company (ALICO), first visited Japan to take part in the market. Companies like American Family Life (AFLAC), however, were initially allowed to operate in the third sector. This was the Medical Supplement Area. It included critical illness plans and cancer plans. Foreign carriers were not allowed to access the mainstream life insurance market. Many domestic companies were left in financial distress by the great turmoil that erupted in the industry in late nineties. Japan offered foreign companies protection by allowing them to purchase the failing ones and keep them afloat in their search for safety.

Japanese operators are still being accessed by foreigners. Japan is considered as a strategic asset as North America and Europe. It is one of the top two global life insurance markets. Global insurers have prime opportunities to expand their Japanese business thanks to the consolidation of the Japanese life market. This is due to the deregulation and collapse of Japanese insurers. Global insurers account for more than 5% of the total market share, and represent over 6% of all business in force. These numbers are nearly two times greater than five years ago.

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The acquisition of Nippon Dantai Life Insurance Co. Ltd., a second-tier Japanese insurer with a poor financial profile, by the AXA Group in Japan in 2000 gave the group a stronger base of operations. AXA was the first Japanese holding company to be established in this sector. Aetna Life Insurance Co. also bought Heiwa Life Insurance Co. Winterthur Group purchased Nicos Life Insurance, and Prudential UK bought Orico Life Insurance. Hartford Life Insurance Co. (a U.S.-based insurance company well-known for its variable insurance business) and France’s Cardiff Vie Assurance are also new to the Japanese market.

Manulife Century, a subsidiary of Manufacturers Life Insurance Company, inherited the assets and operations of Daihyaku Mutual Life Insurance Co. which had collapsed in May 1999. AIG Life Insurance Co. took over operations of Chiyoda Life and Prudential Life Insurance Co. Ltd. absorbed Kyoei Life. Both Japanese companies applied for court protection in October 2001.

Foreign entrants bring strong financial capabilities and a positive global track record, which will help them to build a reputation as part of international insurance companies. They also avoid the negative spreads that have plagued Japanese insurance companies for over a decade. In spite of market turmoil, foreign players are better placed to maximize business opportunities. Although large Japanese insurers still hold a dominant market share, dynamics are shifting as existing business blocks shift away from domestic insurers, including failed ones, to the newcomers, in keeping with policyholders’ flight towards quality. Here is a list of foreign companies:

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INA Himawari LifePrudential Life
Manulife Century Life

Skandia Life
GE Edison Life
Aoba Life

Aetna Heiwa Life
Nichidan Life
Zurich Life

ALICO Japan
American Family Life
AXA Nichidan Life

Prudential Life
ING Life
CARDIFF Assurance Vie

NICOS Life

In terms of innovation and distribution, foreign insurers will likely be able to outperform their domestic counterparts in some ways. They can also draw from a greater experience in global markets. The immediate challenge for foreign insurers is how to establish enough Japanese franchises so they can take advantage of these competitive advantages.

What is the problem with life insurance?

Japan’s life insurance industry is not only a victim to its own inefficiency but also government policies that were intended to save banks from financial crisis. The Bank of Japan encouraged a wide spread between long-term and short-term rates by keeping short-term interest rates low in the mid-1990s. Banks, which pay short-term interest rates on deposits but charge long-term rates for loans, benefited from this.

However, the same policy was harmful to life insurance companies. Customers had locked in high rates for typically long-term investment-type policies. In general, the drop in interest rates meant that insurers’ assets suffered a decline. In 1997, insurance company executives reported that the guaranteed rate of return was 4 percent. However, returns on Japanese government bonds (a preferred asset) hovered around 2 percent.

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Even with an increase in volume, insurance companies can’t make up the negative spread. They tried to solve their problem by reducing yields on pension-type investments in FY 1996, but were met with a huge outflow of money from competitors.

Life insurance companies will also be responsible for part of the cleanup of banks’ non-performing assets. The Finance Ministry allowed banks to issue subordinated debt starting in 1990. These instruments can be counted as part of the bank’s capital. This makes it much easier to meet capital/asset ratio requirements. This is a sensible approach, as equity holders and holders of such debt are almost at the bottom of the list in case of bankruptcy.

Because of the higher risk of default, subordinated debt has high interest rates. In the early 1990s, insurers couldn’t figure out how to prevent bank defaults and were tempted by the high returns. They lent large sums to banks and other financial institutions subordinated. Smaller companies were more likely to participate than their larger counterparts because they wanted to catch up. Tokyo Mutual Life Insurance Co. ranked 16th in Japan’s insurance industry based on assets. Industry leader Nippon Life was at 3 percent.

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Rest is history. In the mid-1990s, banks and securities companies, which were also lent by insurers, started to fail. Sanyo Securities Co., Ltd. collapsed last fall due to the refusal by life insurance companies of the brokerage firm to roll over its subordinated loans. Life insurance companies complained that sometimes they were not paid off, even though the bank’s conditions required them to. Meiji Life Insurance Co. had Y=35billion ($291.7m) in subordinated loans to Hokkaido Takushoku Bank, Ltd., when the bank collapsed in Nov. Meiji Life was not paid from the assets, even though the Hokkaido bank had some good loans which were transferred to North Pacific Bank, Ltd. The entire balance of the loan will be written off, it appears.

The bad-debt story is not complete with subordinated debt. Nearly every major, unsustainable lending scheme collapsed with the bubble economy of the 1990s included insurance companies. They were, for example, lenders to jusen (housing finance firms) and had to contribute to the expensive cleanup of that mess. Insurers, just like banks, relied on the unrealized profits of their equity holdings to bail out any troubled customers. The bubble period saw smaller insurers buy such stock at high prices. As a result, 1997’s stock market crash caused all of the middle-tier life insurance companies (size ranks 9-16) to have unrealized losses.

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What lies ahead

The following are the short-term problems identified by analysts:

New market entrants;
Earnings under pressure
Low asset quality and
Capitalization.

Recent high-profile losses at several life insurance companies have increased the pressure on them to respond quickly and clearly to these problems.

The investment market has performed worse than anticipated. The historically low interest rates have not seen an increase in their value. Since January 2001, the Nikkei index has been declining and it fell to a 9-year low after the terrorist attack on American soil. Although unrealized gains were once a cushion for insurers, due to the insurers’ dependence on these gains, volatility in retained earnings is now impacting capitalization levels and financial flexibility.

Table 1.
Japanese Life Insurance Companies Face Major Risks

Business risks
Financial risks

Weak Japanese economy
High earnings pressures

Flucht to quality because of lack of confidence from policyholders
Low interest rates and exposure to fluctuations in the domestic and overseas investment markets

Deregulation, mounting competition
Poor asset quality

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Inadequate policyholders are the safety net
Capitalization is declining

Consolidating the life sector with other financial sectors is accelerating
Limited financial flexibility

Most analysts would agree that Japan’s life insurance companies face liquidity and solvency problems. The continued viability and sustainability of certain companies is in jeopardy due to heavy contractual obligations to policyholders, declining returns on assets, and little to no protection from unrealized stock portfolio gains. Others, even though they are clearly solvent, run the risk of having to pay uneasy policyholders sooner than they planned. Insurers must decide how they will manage their assets. Japan’s aging population is another factor to consider. Mr. Yasuo Satoh, Program Manager, insurance industry, finance sector at IBM Japan, explains that the industry must change its business model. As the population ages, they must focus on life benefits instead of death benefits. They also need to be more focused on long-term care and Medical Supplement.

Japanese life insurance companies are actively seeking greater segmentation and unique strategies in traditional life and nonlife business. The sector saw the formation of many cross-border partnerships and business partnerships in late 2000. These alliances involved large domestic life insurance companies. Companies are reviewing whether they will be able to participate through subsidiaries in non-life business in order to avoid market consolidation and increased competition. This was allowed for the first time in 1996.

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In the long-term, Japanese insurance companies are likely to form business alliances that are based on demutualization. In the short term, Japan’s financial markets will see a lot of consolidation. This will lead to a major overhaul in the life insurance industry. While domestic life insurance companies announced a variety of business strategies in response to the sea change in Japan’s financial markets, it is not clear what the actual benefits of the various alliances each insurer will bring. Market consolidation will add value to policyholders by providing a wider range and quality of services and products. Life insurers must be sensitive to the needs of diverse customers and create new business models to increase their earnings base. The high savings rate in Japan suggests that the long-term prospects are good. Japan will see a few more insurance companies fail before the sector tightens its belt with radical reforms, prudent investment and disclosure norms.