CZECH REPUBLIC PILOT ASSESSNIENT OF GOVERNANCE OFTHE INSURANCE SECTCIR Private and Financial Sector Development Department Europe and Central Asia Region JANUARY 2006 Financial Sector 1 W O + I I > R A N K ACRONYMS CAP Czech Association of Insurance Companies CAS Czech Accounting Standards CEO Chief Executive Officer CFO Chief Financial Officer CEA Comite EuropCen des Assurances (European Insurance Committee) CESR Committee of European Securities Regulators CNB Czech National Bank CSC Czech Securities Commission CSOB Ceskoslovenska obchodni banka, a. s. COSO Committee of Sponsoring Organizations of the Treadway Commission CP Ceska Pojistovna CZK Czech Koruna (crown) D&O Directors and Officers (liability insurance) EC European Commission EU European Union FSAP Financial Sector Assessment Program GDP Gross Domestic Product IAIS International Association of Insurance Supervisors IFAC International Federation of Accountants IFRS International Financial Reporting Standards ISA International Standards of Auditing MB Management Board MOF Ministry of Finance OECD Organisation for Economic Cooperation and Development OSS Office of Insurance and Pension Fund Supervision PSE Prague Stock Exchange ROSC Report on Observance of Standards and Codes SPV Special Purpose Vehicle us United States This report has been prepared by a team consisting of Marie-Renee Bakker (Lead Financial Sector Specialist, ECSPF), Sue Rutledge (Regional Corporate Governance CoordinatorISenior Private Sector Development Specialist, ECSPF) and Rodney Lester (Head of the Capital and Risk Markets Group and Senior Advisor, OPD). Peer review comments were provided by Craig Thorburn (Senior Financial Sector Specialist of the World Bank) and by Dr. Peter Braumuller (Director of Insurance and Pension Supervision of the Financial Market Authority of Austria.) Valuable assistance was also provided by Zdenek Kudrna of the Charles University in Prague. Table of Contents Methodology ............................................................................................................................................... 2 The Role of Corporate Governance in the Insurance Sector....................................................................... 3 Legal Foundations for Czech Insurance Sector Governance....................................................................... 6 Overview of the Czech Insurance Sector .................................................................................................. 7 Key Findings and Recommendations ........................................................................................................ 11 Related-Party Transactionsand Transparency .................................................................... II Role of the Supervisory Board............................................................................................ 13 Separation of Life and Non-Life Business............................................................................... 15 Tables Table 1.Insurance Penetration and Density Development ........................................................................ 7 Table 2 - Insurance LiabilitiesIBank Deposits Ratio................................................................................... 8 Table 3 - Fixed income securities................................................................................................................ 8 Table 4 - Major Czech Insurance Companies ............................................................................................. 9 Table 5 - Current types of insurance companies ......................................................................................... 9 Table 6 - Permitted types of assets and limits on the structure of the technical provisions ......................10 Annexes Detailed Assessment .................................................................................................................................. 14 List of Recommendations.......................................................................................................................... 34 Confederation Life Case Study................................................................................................................. 40 CZECH REPUBLIC Pilot Assessment of Governance of the Insurance Sector Executive Summary In essence corporate governanceof insurers concerns the management of risk. Risk managementrequires that: (1) sufficientcapital be retained by the business given the insurer's risks and (2) the governance structure take into account the rights and interests of all stakeholderswithin the context of the way a particular country's institutionsand financial infrastructureare organized. Key elements of insurance governanceinclude the regulatory approach,the strength and approachof the supervisor, the role of the professions (actuaries and auditors), the legal structures and financing of institutionsand the roles of boards and managements.A strong system would be characterized by: (1) appropriaterisk management and risk-based capital requirements, (2) effective supervisoryboards, (3) appropriateregulation including accounting standards,(4) corporate structures which inhibit the easy and non-transparenttransfer of assets, (5) a risk-based supervisory approach, and (6) strong protection of policyholders, creditors and minorities in the event of corporatestress or insolvency. At the time of the first World Bank mission in February 2005, the Czech insurance sector fell well short of this ideal, despite its good earnings record and substantial improvementin recent years'. Some of the issues had been resolved but at the time of the second mission eight months later, but many still remained outstanding.The supervisory boards of many insurance companies were ineffective and audit committees were the exceptionrather than the rule. There was (and still is) no mandatory separation of life and non- life business within established insurer^.^ Some auditors accepted actuarial valuations of liabilities without review (still the case). Not all companies were using modem approaches to enterpriserisk management (ERM). The supervisor employed an audit-basedapproach (this should change with the consolidationof supervisors in 2006). The provisions of two key EU Directives had not been fully transposed into national law (since partially rectified). In addition OSS as the coordinating supervisor under the ConglomeratesDirective did not appear to have the resources to cany out full supplementary supervision of a complex cross country group (although this is also expected to change when the various financial sector supervisors are consolidated).The bankruptcy system also remains inadequate to guarantee fair and equitable financial sector resolution3. Introduction In recent years the World Bank has reviewed the corporate governanceof banks and insurance sectors in many countries as part of thejoint IMF-WorldBank Financial SectorAssessment Program (FSAP): governancehas consistentlyproved to be one of the weakest elements identified in the financial sector. 'systems which have suffered unexpected shocks after long periods of stability often see strong and possibly excessive regulation being subsequently introduced under political pressure. Examples include Australia, the UK and Canada. he EU Insurance Directives have introduced permanent grandfathering, allowingexisting companiesto avoid establishing separate life and non-life companies as long as the assets, income and expenditures are clearly separated between the two types of business. 'see Czech Business Week!",October 3-9,2005,page 25 Looking to take a more detailed and structured approach, the World Bank recently developed a template containing a set of best practice benchmarks to assess corporate governance of banks. This template was subsequently adapted to the insurance sector. This insurance governance assessment is one of a series of pilot financial sector governance assessments prepared by the World Bank at the request of the Czech Government, which has taken the lead in supporting this work. The other assessments include those on the banking, collective investment fund and private pension fund sectors. This assessment is the first effort to employ the insurance template. The template has been further refined based on the experience with the Czech assessment and transmitted to the International Association of Insurance Supervisors (IAIS), which is planning to examine this topic. [A copy is available on the World Bank's Financial Sector web site.14 The assessment of governance of the Czech insurance sector has three objectives: (1) develop a set of best practice benchmarks for assessing the governance of insurance sectors in the Europe and Central Asia Region and elsewhere, (2) conduct a trial assessment of the Czech insurance governance framework against these benchmarks, and (3) provide recommendations on ways of further improving the corporate governance of the Czech insurance sector. The benchmarks and the assessment are found in Annex I and a list of recommendations is presented in Annex 11. As this is a pilot assessment, the final report should be seen as no more than a "work-in-progress." Nevertheless, it is expected that it will play a useful role in contributing to guidelines for strong corporate governance of insurers in both developed and emerging markets. It could also lay the basis for further governance-based reforms of the Czech insurance sector and provide a baseline assessment for measurement of the reforms. The report is based on two World Bank missions to the Czech Republic. The mission of January 27- February 3, 2005 was led by Marie-RenCe Bakker (then Finance & Private Sector Program Leader New EU Member StatesILead Financial Sector Specialist, ECSPF) and comprised Sue Rutledge (Regional Corporate Governance CoordinatorISenior Private Sector Development Specialist, ECSPF) and Rodney Lester (Head of the Insurance and Contractual Savings Group and Senior Advisor, OPD). The second mission was conducted October 3-7,2005 and consisted of Sue Rutledge and Rodney Lester, and included a half-day workshop hosted by the Ministry of Finance on the draft assessment. Representatives of the insurance sector and journalists participated in the workshop and provided valuable feedback on the draft report, which was subsequently revised. Valuable assistance was also provided by Zdenek Kudrna of the Charles University in Prague in completing a preparatory questionnaire. The missions met with officials from the Ministry of Finance (MOF), its Office of the State Supervision in Insurance and Pension Fund (MOFIOSS), the Czech National Bank (CNB), the Czech Securities Commission (CSC), the Prague Stock Exchange (PSE), the Czech Insurers Association (CAP), the Czech Association of Registered Investment Intermediaries, and numerous insurance companies, law firms and audit firms. The Team also met several companies: Ceska Pojistovna, Kooperativa Pojistovna, Uniqa, Aviva and Allianz. The World Bank would like to express its gratitude for the efforts of all parties involved to facilitate the preparation of the assessment. Methodology The report draws on earlier financial sector studies prepared by the World Bank for the Czech Republic, including a Capital Market Review in 1999, a Financial Sector Assessment Program (FSAP) Review in 2001, a Corporate Governance Report on Observance of Standards and Codes (ROSC) in 2002, an 'A copy can be downloaded at www.worldbnnk.org Accounting and Auditing ROSC in 2003, a pilot Bank Exit Study in 2004 and also in 2004 pilot Governance Assessments of the Bank and Collective Investment Fund Sectors. The corporate governance benchmarks for insurance companies have been drawn from a wide range of materials including the bank governance template. These include guidance prepared by the IAIS, the various OECD Corporate Governance Principles and various national codes on corporate governance. In addition, the April 2005 OECD guidelines for insurance governance provided valuable input, as did the European Commission's Action Plan to modernize company law and enhance corporate governance in the European Union (EU). In addition, the Commission's February 2005 Recommendations on strengthening the role of non-executive or supervisory directors (20051162lEC) provide useful suggestions on the role of supervisory boards, the independence of non-executive board members, the structure of board committees and minimum training requirements for board members.' One caveat remains in order. The benchmarks are in draft form and should therefore be regarded as no more than a framework for assessing corporate governance in insurance companies and similar financial institutions. It is recognised that there are different approaches to achieving sound corporate governance although some elements, such adequate internal controls apply to all financial institutions. It should also be noted that the benchmarks have some overlap with the OECD principles for corporate governance. In addition the legal and regulatory framework and business environment in the Czech Republic influences the extent of compliance with the proposed benchmarks. Rather than specifying rigid standards, the benchmarks are intended as a general guide highlighting key areas of importance for governance of insurance companies. The Role of Corporate Governance in the Insurance Sector Sound corporate governance ensures that corporate insiders do not use their privileged position to exploit other stakeholders, notably small minority shareholders, creditors such as lenders, and in the case of insurance companies, policy-holders. La Porta et a1have noted that "the empirical evidence rejects the hypothesis that private contracting is sufficient". In addition, La Porta el a1 cite evidence that "insiders in major firms oppose corporate governance reform and the expansion of capital markets. Under the status quo, the existing firms can finance their own investment projects internally or through captive or closely connected banks... Poor corporate governance delivers the insiders not only secure finance, but also secure politics and markets. Thus they have an interest in keeping the system as it is."6 The main weapons in ensuring an equitable distribution of power and rights between the various stakeholders in an enterprise are judicially enforced law and government enforced regulation, supported by adequate levels of disclosure and transparency. The challenge is to set regulation that has sufficient scope but at the same time does not become an excessive cost for business. It is also important that the courts and regulatory/supervising processes cannot be captured by insiders for their own benefit. In the early stages of development, the insurance sector is often seen as a commercial enterprise. The primary insured parties are industrial firms and entrepreneurs. At this stage, relatively light regulation and oversight of the insurance companies is all that is needed. However the situation changes once compulsory classes of insurance are introduced. When motor third party liability insurance is required for all automobile drivers and major liability classes have been introduced, the public at large starts to rely on insurers for significant sums of money in the event of an accident or tort. At this stage, high standards of governance of insurance become necessary. The stakes rise further when life insurance and pensions 'A copy can be downloaded at http://curopa.eu.int/cur-lcx/1ex/LexUriScrv/sitc/cn/o/2OO5/l 05211 05220050225en00510063.pdf 6 ~Porta, Rafael et al., Investor Protection: Origins, Consequences, Reform, World Bank, 1999 a become common and the public invests its long-term savings (including retirement incomes). At this latest stage, the government has an obligation to ensure that insurers and pension providers follow hlgh standards of corporate governance, and risk management in particular. The Czech Republic is currently at this stage. All insurance companies--but particularly life insurers--are obliged to meet long-term obligations. Policy- holders expect that when payments fall due, sometimes 40 years or more after the policy was purchased, the insurance company will have the financial resources to fulfil its obligations. The establishment of adequate technical provisions and the accumulation of sufficient reserves is thus a critical element of sound insurance financial management. The calculations are based on complex assumptions involving mortality rates, allowance for future expenses, lapse and discontinuance rates and future investment yields. As a result, standard corporate accounting and financial reporting make it difficult to gain appropriate insight into the financial position of a life insurer. Insurance policy-holders are thus dependent on the ability and inclination of management (and the oversight board) to take conservative and prudent risks and have sound capital management. In addition policy-holders depend on the willingness and ability of key shareholders to contribute additional capital when needed-and the supervisors to ensure that all key shareholders have such willingness and capacity. Strong governance in the insurance sector requires two lines of defence. The first line of defence consists of the internal organs of the company-its management, risk management system, the company's actuary and the company's supervisory board that should have oversight of them all. More than most financial activities, life insurance requires that management and directors of insurance companies find a trade-off among the rights of various constituencies and stakeholders. In a number of countries, the law makes it clear that life insurance company directors have an overriding responsibility to policy-holders. External measures provide the second line of defence. The external measures cover both the supervising authority that oversees the insurance companies and market mechanisms that monitor and influence the sector. Both lines of defence are needed to ensure a high level of transparency and accountability in the sector. Furthermore the burden on the supervisory authority is reduced if the companies' internal governance arrangements are strong, or where the market provides an effective form of discipline. Corporate governance should therefore be an important part of the formal supervisory framework for insurance sector. The IAIS Core Principles point to the specific governance issues which apply to insurance enterprises: "Inmostjurisdictions corporate governance rules existfor general purpose corporations; these likely also apply to insurers. Often,however, it is necessary to establish additional requirements, through insurance legislation, that deal with the matters of specific concern and importance to insurance supervisors. These matters are described in the criteria below. As the supervisory authority may not have thepower to specifL the details ofgeneral corporate governance rules or to enforce compliance, several criteria under thisprinciple refer to the responsibility of the board of directors rather than requirements from the supervising authority."' Key criteria relevant to the insurance sector are as follows: The supervisory authority requires and verifies that the insurer complies with applicable corporate governance principles. o The supervisoryboard satisfies itself that the insurer is organized in a way that promotes the effective and prudent management of the institution and the board's oversight of that management. The supervisory board has in place and monitors independent risk 'paragraph 9.3. IAIS Core Principles, October 2003 management functions that monitor the risks related to the type of business undertaken. The supervisory board establishes audit functions, actuarial functions, strong internal controls and applicable checks and balances8. o The supervisory board is able to carry out its functions in an objective and equitable manner. The supervisory board has access to information about the insurer, and asks for and receives any additional information and analyses that it needs. o The supervisory board communicates with the supervisory authority as required and meets with the supervisory authority when requested. o The supervisory board identifies officer(s) with responsibility for ensuring compliance with relevant legislation and required standards of business conduct and who reports to the board at regular intervals. o When a "responsible actuary" is part of the supervising process, the actuary has direct access to the supervisory board or a committee of the board. The actuary reports relevant matters to the supervisory board on a timely basis. The IAIS Core Principles make it clear that the supervisory board of directors performs a distinct overview role separately from the responsibilities of senior management of an insurer. The Czech Commercial Code and enhancements in the Insurance Law make it clear that it is the supervisory board which is intended to fill this role. Recent events in countries with similar Civil Code legal systems, Germany and Austria in particular9, support this view. Effective regulation of corporate governance involves finding the right balance. Too many rules will discourage the entrepreneurial spirit that drives a dynamic corporate sector and can result in an unhealthy compliance burden. Too few rules open the door to abuse and corporate fraud. Each country must find the balance appropriate to the level of financial sector development, the local business culture and the agreed objectives for further development. The assessment does not propose more regulation. Rather it proposes better regulation focused on unleashing a healthy competitive and innovative spirit in the insurance sector. The assessment suggests measures that would help to prevent corporate governance abuses in the Czech insurance sector, while minimizing the regulatory burden. In particular the assessment employs a market-based approach to supervision and governance, as epitomized by the Base1I1approach to bank risk management and the insurance Solvency I1model that is currently being developed. Such a market-based approach sees minimal involvement of supervisors in product approvals and pricing. Instead using a market-based system, supervisors should focus on ensuring that insurance companies have adequate economic capital and internal controls, company balance sheets have sufficient transparency, and enlightened market conduct rules are in place and functioning well. he EU hastried to overcome the problem ofapplying this to a bicameral board structure by reference to a functional approach. In this case this would mean that the supervisory board assumes ultimate responsibility and monitors that appropriateaudit functions, actuarial functions, strong internal controls and applicable checks and balances are established. 9 ~ efor example, the 2003 German CorporateGovernance Code (The Cromme Code) and the 2002 Austrian Code of Corporate e Governance. Both can be downloaded 11ttp://www.ecgi.or~codes/r7II codes.php. 5 Legal Foundations for Czech Insurance Sector Governance In the Czech Republic, the Act No. 36311999 Coll. on Insurance as amended (the Insurance Act) regulates the legal form of insurance companies: an insurer may be a joint-stock company or a cooperative. All major insurers arejoint stock companies. Steps have been taken to harmonize the insurance legal framework with the EU standards prior to the Czech Republic's accession in May 2004. Act No. 3912004 Coll. amended the Insurance Act by transposing provisions of the "third-generation" EC directives relating to life and non-life insurances. Among other provisions the Act sets forth the manner in which an insurance company from another Member State or a third country can do business in the Czech Republic (freedom of establishment, freedom to provide services) and imposes upon insurance companies the obligation to have an internal control system. The Act does away with the practice of having insurance terms and conditions approved by the supervising authority, but insurance companies must submit them to the Ministry, upon a written request, for a legal compliance check. The amendment also adds to, expands, and changes the Act's provisions relating to insurance accounting rules. A new Act on Insurance Contracts became effective on January l", 2005. The Act imposes new disclosure obligations on insurers. Another new piece of consumer legislation is the Act on Insurance Intermediaries and Independent Loss Adjusters. This aligns the Czech legal framework with EU Directives aimed to establish a "European Passport" for insurance intermediaries by defining conditions for conduct of this activity including ensuring a degree of consumer protection. Another component of the "package" of insurance laws is Act No. 4712004 Coll. amending Act No. 16811999Coll. on motor third party liability insurance and amending certain related acts (taxes, misdemeanours, Civil Code procedures). The Act implements the Fourth motor insurance Directive, which is aimed at ensuring a higher degree of protection of victims of motor accidents within the EU. Other laws and regulations, which were a part of the overhaul of the insurance industry's legal framework include: o Decree No. 30912004 Coll. implementing the Motor Third Party Liability Insurance Act; and o Decree No. 50212002 Coll. implementing certain provisions of Act No. 56311991 Coll. on accounting of insurance companies. The last major piece of legislation, involving financial conglomerates, was passed shortly before the October 2005 workshop, and is due to become effective in early 2006. The Act on Financial Conglomerates (Act No. 37712005 Coll.) introduced adequate risk management procedures within, and supplementary supervision over conglomerates. The Czech authorities consider this, together with the adoption of the Wind Up ~irective",to be the final steps in the overhaul of the insurance industry's legal framework. Due to the recent adoption of the legislation, the Bank Team was not able to assess the implementation of the Insurance Wind Up Directive (which was introduced as part of the Conglomerates Act). Some additional indirect changes will be introduced by the amendment of the Bankruptcy and Composition Act, which is yet to become law and is proving to be contentious. The amendment will implement the EU directives on the winding up of financial institutions. Further, changes are possible " ~ c No. 37712005 Coll. does not specify which of the two alternative methods of earmarking life insurance assets in a t composite will apply in the Czech Republic (Article 10, 2001117EC) when a completely new Bankruptcy Act is drafted. This will hopefully deal with abuses of receivership provisions which have occurred in the past and which could be relevant to the insurance sector. The Czech Insurance Association, an advocacy group accounting for well over 90 percent of the market premium income in the Czech Republic, is an active member of the CEA (the umbrella association of the Member States' insurance associations), which has called for a moratorium on new rules and a cost- benefit analysis of the existing regulatory framework (see CAP 2003: 11-12). It has been active in introducing risk related technology recommended by CEA. Czech insurance companies are also subject to the following legislation: o The Commercial Code which is the default law mediating the structure of commercial entities and their governance arrangements; o The Civil Code whlch is the default law under the Insurance Contracts Act; and o The Decree implementing the Act on Accountingfor Insurance Companies (No. 502/2002), deriving from the Law on Accounting. Overview of the Czech Insurance Sector The standard penetration and density measures of insurance sector development (premium income divided by GDP and premium per capita respectively) have shown an acceleration as would be expected at this point of the Czech Republic's economic development. Table 1 InsurancePenetration & Density Development - 1993 1996 1999 2003 2004 CR Germany CR Germany CR Germany CR Germany CR Germany Penetration O/O 2.3 6.3 2.7 6.7 3.4 6.7 4.5 7.0 4.2 7.0 Density $US 97 1475 147 1902 176 1718 364 2051 431 2287 Source: SIGMAAnnual Surveys, OECD Consistent rapid growth in the sector can now be expected for an extended period. This should be based largely on the need for long-term savings, and life insurance and pensions" in particular. This trend is borne out by an analysis of the development of the sector in other countries of the European Union. As noted earlier, this will place new and complex pressures on the supervisor and raise the importance of governance in the sector. ensio ion Funds as structured at the time of the workshop had some of the characteristics of pension insurers. Figure 1:Premium Income & Economic Developmentin the EU 0 5 10 15 20 25 30 35 GDP per capita in'000EUR Source: European Commission, Financial Integration Monitor 2005,Backgrounddocument While the insurance industry is still a minority player in the financial sector it is already becoming a significant capital market player, as seen in redent insurance! banking comparatives. Unlike the banlung sector, the insurance sector has had relatively steady growth and has not suffered any major crises or collapse in the last 15 years since the beginning of the Czech Republic's transition to a market economy. Table 2 Insurance LiabilitiesIBank Deposits Ratio - Million CZK 1997 2000 2004 Client deposits 1,112,050 1,408,063 1,731,850 Liabilities to policy-holders 110,645 156,196 239,669 Ratio 9.95% 11.09% 13.84% Source:C4P (w.cap.cz), Czch NationalBank ( w .cnb.~) Note: Liabilities to policy-holders are proxied as total liabilities minus shareholders equity, retail deposits as total liabilities to clients. The insurance sector accounts for a significant part of the bond market, although this is reducing as alternative uses are founds for funds: Table 3 FixedIncome Securities - Million CZK 2000 ZOO1 2002 2003 2004 Market capitalization of bonds issued in Czech Republic 280,075 319,399 372,487 505,535 577,036 Fixed income securities held by insurance companies 93,614 109,419 133,537 145,299 154,900 Ratio (%) 33.4 34.3 35.9 28.7 26.8 Some: Prague Stock Exchange (www.pse.cz), CAP(www.cap.cz) Note: As the total value of the fixed income securities issued in the Czech Republic was not available the market capitalization of bonds has been used as a proxy. The Czech insurance market is highly concentrated, as is common in the post-transition economies of central Europe. The five largest insurance companies write over 75 percent of premiums, with the largest insurer accounting for 35 percent. Four out of the five largest insurance companies are controlled by foreign strategic owners based in the European Union. Table 4 Major Czech InsuranceCompanies - DirectShareholdingStructure UltimateShareholding 2004 Market Structure Premiums Share O/O written Ceska Pojistovna 100 % CESPO B.V. (Netherlands) PPF Group (Czech Republic) 40,970 36.7 (CP) a.s. Kooperativa. 84.6 O/OWiener Stedtische Allgemeine As per direct shareholding 24,167 21.7 Pojistovna. as. Venicherung AG. (Austria) structure 12.3 O/OSvaz teskqch a moravslcjch ~ r o b n i c hdruistev (Czech Republic) 3.1 % VLTAVA majetkopravni a podilov6 spol. s r. o. (Czech Republic) Allianz Pojistovna. 100 O/O Allianz AG (Germany) as. CSOB Pojistovna. 75 % KBC Vetzekeringen NV (Belgium) as. 25 O/O CSOB (Czech Republic) Nationale- Branch of ING ING Vetzekeringen N.V. 5,325 4.8 Nederlanden Life (Netherlands) insurance branch Generali 100 % Generali Holding Vienna AG Assicurazioni Generali (Italy) 5,021 4.5 Poji5fovna a.s. Pojistovna Ceske 55.2 O/OCeska spofitdna. as. Erste Bank and Sparkassen 3,894 3.5 sporitelny. a.s. (Czech Republic) Versicherung konzern 44.8 O/OS~arkassenVersicheruno AG (Austria) Total 111,539 100 Source: C4P2004as cornpi/& by e-Merit; company websites The largest insurer, Ceska ~ojistovna'~,is owned by the Czech financial conglomerate PPF and has a Dutch registered parent. Under implementation of Article 3 of Directive 2002/87/EC (Conglomerates Directive), CP and as well as Cespo, PPF Group and Petr Kellner (the controlling shareholder of PPF Group) have been identified as financial conglomerates falling under the supervision of the Czech Ministry of Finance (OSS). CP is 100% owned by its parent, but issues listed corporate bonds.13 The Insurance Act of April 1,2000 specifies that licensed insurance companies are permitted to offer either life or non-life insurance products, but not both. Composites (insurance companies that hold licenses for both life and non-life insurance products) were required to separate one of their businesses by April 1,2010. An amendment approved in December 2003, after intense industry pressure, allows composite insurers to retain their license on condition of separate management of the two activities in line with the exemption permitted under the EU Insurance Directives. Table 5 CurrentTypes of InsuranceCompanies - 1993 1996 1999 2003 2004 Total 20 35 42 42 40 Of which: life 5 2 3 3 3 " ~ a r k e tanalysts still perceive Ceska Pojistovna (CP), the former monopoly insurer, as having significant influence,. The CEO of CP is currently the President of the Czech Insurance Association (CAP). "corporate bonds need to be listed to be admitted investments for various institutional investors. non-life 7 14 21 23 21 composite 8 19 18 16 16 Source: U P 2004 Sections 21,2l a and 21b of the Act defines the types of assets which can be held by insurance companies to support technical provisions. Section 4 of the Decree No. 30312004 Coll. of the Ministry of Finance defines asset class limits as in the following table. Table 6 PermittedTypes of Assets and Limitson Technical Provisions - Type of Asset Maximum Proportionon Technical Provisions Bonds, issued by Member State or its central bank, and bonds for which the guarantee has been 75O/O assumed by Member State Bonds issued by banks and similar credit institutions of the Member States 50% (one bank max 20%) Publicly negotiable corporate bonds 20% (one corporation max 5%) Treasury bills 75% Publicly tradable municipal bonds 20% (one municipality max 5%) Loans, credits and other receivables secured by a bank guarantee 10% (one borrower max 5%) Bills of exchange secured by a bank guarantee (aval) 10% Real estate in the territory of the Member States 20% (one estate max 10%) Registered mortgage bonds 50% (one issuer max 20%) Publicly tradable shares 10% (one issuer max 5%) Deposits and deposit certificates with banks authorized to operate as a bank in the territoty of 50% the Member States (one bank max 20%) Insured objects and works of art appraised by at least two appraisers 5% Bonds of EIB, ECB, EBRD, IBRD 75O/O Foreign securities traded on the regulated market of the OECD member states 10% (one issuer max 5%) Loans to insured persons with a life insurance contract 5'10 Hedging derivatives; these hedging instruments may hedge only items specified above (excerpt 5% of loans to insured persons) Reinsurance receivables; these receivables may be used only after due deduction of all commitments to the reinsurance undertakings Soume: Ministly of finance Section 13(8) of the Act requires that when placing financial assets for technical provisions, the insurance company is obliged to follow four principles: o The individual items of financial placements would provide a guarantee of return of invested resources (principle of safety), o The individual items of financial placements would ensure a yield from their possession or a profit from their sale (principle ofprofitability), o Depending on the nature of the insurance or reinsurance activity carried on, a part of the financial placements would be promptly available for the payment of claims within the period stipulated by a special provision (principle of liquidity), o The individual items of financial placements would be diversified among a larger number of legal persons, none of which is in a relationship of a controlled and controlling person or persons acting in conformity according to a special legal provision (principle of diversification). In line with the relevant EU Directives, there are no limits stipulated for the investment of assets supporting capital that does not form technical provisions of the insurance company. However at the time of mahng the investment, the insurance company has to make clear whether it is investing its own capital or technical reserves. Ex-post manipulations between the two are not permitted. Key Findings and Recommendations While there are a wide range of recommendations emerging from this assessment (see List of Recommendations in Annex 11) three issues stand out: o The potential for related party transactions and cash transfers to exceed prudent levels, as measured by economic capital and for such transactions to not be fully disclosed;14 o The virtual non-existent role of supervisory boards and audit committees in the risk management and overview of internal controls of many insurance companies; and o The absence of effective separation of life and non-life businesses combined with a bankruptcy and court system which has in the past lent itself to misallocation of earmarked assets. Related-Party Transactions and Financial Transparency The emergence of large financial and mixed conglomerates in international finance has created an additional layer of governance concern. By their nature, conglomerates seek to take advantage of the synergies and efficiencies inherent in a group corporate structure. Their presence across several jurisdictions and several sectors generates a powerful corporate engine that, in a competitive environment, can generate lowered prices and a higher quality of services for consumers. However, the synergies also provide the opportunity for corporate governance abuses through the transfer of cash (see Annex III- Confederation Life Case Study), goods and services among the companies in the conglomerate. For listed and publicly traded companies that are part of conglomerates or business groups, the risk is that minority shareholders may be disadvantaged. This could be through intra-group transfers that are made at above- market (or below-market) prices in order to avoid taxes or reduce profits available for distribution to minority shareholders. Similar issues apply for other stakeholders including policyholders. Reliable financial reporting lies at the heart of transparency and disclosure of related-party transactions. Czech insurance companies without listed securities continue to employ Czech Accounting Standards (CAS) set by the MOF. CAS has the advantage of familiarity, thus assisting local companies in fulfilling 141nthis regard economic capital can be seen to incorporate hidden reserves in the asset and liability valuation methodologies, however these are not seen as being significant in the Czech Republic. It can be expected that Solvency II will in many cases lead to increased statutory capital requirements in life insurance. their financial reporting obligations. However, they also have the disadvantage that non-Czech investors may not be fully aware of the implications of the different standards (for example the differing treatment of consolidated accounts, establishment expenses, leases etc). The EU requires that International Financial Reporting Standards (IFRS) be used for all consolidated accounts including companies with listed securities, starting in 2005: thus IFRS will apply to the CP group as it issues listed securities. The leading insurer is now obliged to adopt IFRS and a number of other large international insurers are required to prepare two sets of books. An effective approach would be to require that all public interest entities adopt IFRS. Such a move would reduce the cost of accounting and audit in the industry. In addition the average quality of audit would improve. Another weakness is that primary responsibility for the accuracy of the key accounts and ratios appears to lie with each company's responsible actuary with no legally required external review". The regulatory returns for Czech insurance companies are generally not audited by the external auditors. The actuaries are not subject to peer review. In addition the supervisors do not receive sufficient information to independently confirm the accuracy of the technical provisions and solvency ratios. Based on a number of failures and scandals in otherjurisdictions in recent years, international practice now requires peer review of actuarial work. This is particularly important given the shortage of actuaries in the Czech Republic and their concentration in one firm until recently. Such a formal review process is generally considered best practice and has been introduced in a number of European countries and elsewhere. Countries requiring peer review include the UK and Canada. Other countries are considering it, including India and Australia. Such additional audit services should not be overly expensive, if linked with the accounts audit. Disclosure of derivative financial contracts is an important issue for all contemporary financial institutions. Section 4 (2) of the Decree No. 30312004Coll. of the Ministry of Finance specifies that derivative instruments can be used only if the underlying contracts are held by the insurer and only if they contribute to a reduction of investment risk or facilitate efficient portfolio management (this latter term is not defined). They may not exceed 5 per cent of the total technical provisions. However, the decree does not specify the valuation methodology for derivative instruments. At least one major insurer, Ceska Pojistovna (CP), is active in derivative markets and discloses valuations in its published annual report. The supervisory skills required to oversee these activities need to be relatively advanced and there are numerous examples, even in advanced industrial countries, of institutional investors and banks failing to catch developing exposures before they did substantial damage. Ultimately the best defence is the quality of the insurers' internal controls and risk management. Investments in subsidiaries is also an important issue. Czech law does not establish guidelines limiting what types of subsidiaries an insurance company may set up or invest in. Ths is surprising given the Czech experience with "tunnelling" (illegal asset stripping) of banks and credit unions, when various forms of subsidiaries and special purpose vehicles (SPVs) were misused. However, when asked, stakeholders did not perceive this as a problem. The rules on consolidation have been tightened, and supplementary supervision of financial groups of which insurance companies are a part has been introduced (see Section 26b, 26c and 26d of the Act), and is to be strengthened further by the new law on financial conglomerates. The EU Directives, and particularly 2002187lEC on supplementary supervision of financial institutions in a financial conglomerate, provide clear direction on the supervision required for financial conglomerates. The EU Directive requires that a co-ordinating financial regulator be identified for financial groups and ' 5 number of small insurers are still audited by one man firms which do not have the capacity to overview the key actuarially ~ determined balances. A number of the largest insurers use one big 4 firm with in house actuarial capacity. However in a dispute between the actuary and the auditor the actuarywould probably prevail under current circumstances. The auditor should in fact have ultimate responsibility to sign off on all accounts. that the co-coordinator should report on intra-group transactions and risk concentration. The Directive also notes that the competent authorities should take into account the specific group and risk management structure of the conglomerate and define appropriate thresholds based on regulatory own funds and/or technical provisions. In particular, the authorities should monitor: (1) the possible risk of contagion within the financial conglomerate, (2) the risk of conflict of interests, (3) the risk of circumvention of sectoral rules (also called regulatory arbitrage), and (4) the level of risk. The Act on Financial Conglomerates dated August 2005 provides a solid basis for such supervision. In particular, the Act requires that intra-group transactions for financial conglomerates be conducted in such way that they: (1) will not damage the interests of policy-holders, investors or other clients, (2) will not bind regulated entities to transactions for which no adequate counter-value is provided, and (3) are concluded at the usual terms and conditions. The Act also specifies the co-ordinating supervisory authority and requires limits on risk concentration and intra-group transactions for financial conglomerates. Furthermore the OSS is the designated supervisor under a recent EC announcement listing CP as a financial conglomerate. The Czech insurance law also mentions supplementary supervision and some summary disclosure of related-party transactions is also required under the provisions of the Commercial Code, although until now it could effectively only be applied at the level of the insurer or accessible subsidiary and parent companies. At the time of the mission, the Bank Team saw no evidence of active supervision of non- insurance subsidiaries, associated non-insurer firms or non-resident holding companies-suggesting the need for the OSS to further develop its supervisory capacity over the non-insurance activities and holding companies of Czech insurance companies. Full implementation of the "Post-BCCI Directive" 95/26/EC would also be helpful. Among other things this Directive requires that competent authorities should not authorize (or continue the authorization of) financial undertakings where close links between the financial institution and natural or legal persons would prevent the authority from effectively exercising its supervising functions. This requirement is also mentioned in the prologue to the EU Life Insurance Directive and is mentioned in the Czech insurance law. It is critical that the supervisory authorities are able to effectively supervise the activities of all financial institutions in the Czech Republic in an integrated fashion, so that the full picture is available. Complex legal structures that obfuscate the true ownership and control structures of companies may prevent the authorities from fully fulfilling their supervisory responsibilities, including monitoring related-party transactions. The financial regulators should have sufficient tools at hand to minimize the risk that large related-party transactions might undermine the solvency of regulated entities. The issue applies to both Czech and foreign-owned insurance companies, since even in large international groups using full IFRS, it may be difficult to accurately trace intra-group transactions. Another issue involves captive insurers, which in other countries have been used for tax avoidance, capital transfer and money laundering. Ideally the US rules on captives should be employed for determining the legitimacy of an insurance placement. As concerns the criteria for acceptance of reinsurers for solvency purposes, the OECD 1998Recommendation on the Assessment of Reinsurance Companies could be usefully applied. Role ofthe Supervisory Board The corporate governance scandals of Ahold and Parmalat in Europe (and Enron and WorldCom and others in the United States) have encouraged advocates of corporate governance reform to review the mechanisms for oversight of company managers. Traditionally the corporate governance advocates in Anglo-American systems and those in continental systems have taken different approaches to corporate governance reform. While major differences continue to exist, both are paying attention to increasing the effectiveness of the supervisory or oversight board. In the unicameral system of the English speaking world the key issue is to increase the representation and effectiveness of those board members who are independent of company management. In Europe, the dual-tiered board structure has already established an oversight board (or "supervisory board") that theoretically excludes members of the executive management. The key issue then is to increase the authority and responsibilities of the supervisory board. The Czech Commercial Code establishes a board of directors (in Czech "predstavenstvo"), which is the statutory organ for a joint stock company. The board of directors decides all company matters, unless they fall within the powers of the general meeting or supervisory board under the Code or the company's statutes. Thus under the Czech law, the board of directors is effectively a management board. The supervisory board (in Czech "dozorci rada") monitors how the board of directors exercises its range of powers and how the business activity of the company is conducted. However under the Commercial Code, the supervisory board of a joint stock company is primarily an inspection organ. The assessment therefore assumes that the effective board of directors is essentially the management board, consisting of the company's executive management, and having responsibility for day-to-day matters. There appears to be no explicit fiduciary responsibility to insurance policyholders specified in any Czech Law, except to the extent that a claim has become manifest and a creditor status created16. The supervisory board has also filled a role as the employees' means of representing their interests. Given the current importance attached to this model in the Czech Republic it is probably unrealistic to effect fundamental change (although employees are increasingly being removed from boards elsewhere in Europe). A better alternative may be to apply the pension funds approach, wherein employees have nominated representatives on the supervisory board but may not sit on the board themselves. The assessment recommends that, to improve corporate governance in the insurance sector, the role of the supervisory board should be greatly strengthened and at a minimum, should include authority and responsibility for over-viewing and approving the company's strategic direction and the systems of internal controls and risk management. Insurance supervisory boards should also review the report of the responsible actuary, as part of its discussions with the external auditor. One key way of increasing the effectiveness of supervisory boards is through the establishment of committees within the boards. Establishment of an audit committee has become a standard minimum requirement for US-listed companies, following the provisions of the Sarbanes-Oxley legislation. It is also a reportable item under the German Corporate Governance codeI7.Best practice thus suggests that the supervisory boards of all insurance companies in a market as developed as that in the Czech Republic should also include audit committees". One leading Czech insurer and several small companies were reported as having active audit committees. However all insurance companies (and other financial institutions) should be required to have audit committees on the supervisory boards. Other committees may also be useful, including a remuneration committee to consider levels of remuneration for members of both boards, and a nomination committee to review the performance of supervisory board members and identify new members for consideration by the shareholders' meeting. 16The only reference to any type of fiduciary responsibility reads as follows: Members of the board of directors, who are responsible to the company for damage, shall be jointly and severally liable (as sureties) if the board member concerned failed to settle such damage (i.e. damages) and creditors cannot satisfy their claims (receivables) from the company's property due to its insolvency or because the company stopped making payments. The extent of such liability shall be limited by the extent of the duty of the board's members to provide compensation for damage. Liability of the board's member is discharged when he settles the damage caused (Section 194(6), Commercial Code). The status of policyholders before a formal claim arises is not clear under the law. 17A proposed amendment to the German Code recommends that the chairman of the audit committee should have special knowledge of accounting and internal control methods. '"he IAIS governance ICP covers committees as a supplementary requirement. While the European Commission is still developing recommendations on supervisory boards, it may be helpful to review the February 2005 Recommendation on Non-Executive or Supervisory ~irectors.'~The Recommendation suggests that the non-executive or supervising directors should have a key role in overseeing executive or managing directors and in dealing with situations involving conflicts of interest. The Recommendation further defines independence of the supervising directors as "the absence of close ties with management, controlling shareholders, and the company itself." In small tightly-knit economic markets, it may be difficult to identify sufficient directors with no ties with a major corporation. However the focus on independence ofjudgment and freedom from material conflicts of interest is a key issue in establishing an effective oversight function. Separation ofLife a n d Non-Life Business One of the key issues for institutions involving pooled funds is the segregation of assets. In the investment fund sector, for example, the assets of investors in mutual funds need to be clearly and legally separated from those of the broker or broker-dealer. Similarly in the insurance sector, the assets funding the liabilities of long-term life insurance policy-holders should be separated, both physically and legally, from the assets available to pay the claims of short term insurance business, such as property and casualty insurances. The key risk of concern is that assets may be commingled between the life insurance activities and the non-life business. Such commingling creates potential risks for life insurance policy-holders and places a special duty of care on the governance mechanisms, particularly the management and supervisory board. The IAIS Core Principles are unequivocal on this matter, specifying that separation is mandatory unless "the supervisory authority is satisfied that the insurer has satisfactory processes requiring that risks be handled separately on both a going concern and winding-up basis." This places a responsibility on the supervisor to assess insurers on a case by case basis, regardless of the legal regime. The EU Life Directive dealing with composites (mixed life and non-life insurance companies) provides more flexibility and, in addition, allows for grandfathered composites. In the Czech Republic, the insurance legislation requires separation of life from non-life businesses under Article 7(6). However the law also provides an indefinite grandfathering of composites that were authorized as of April 1,2000. A further defence to protect policy-holders and other stakeholders is a strong external audit process. As noted in the assessment, the Czech legislation does not require that the external auditor review and express histher opinion regarding regulatory returns such as solvency ratios and capital allocation. The supervisor again appears to rely on the responsible actuary and not to be in a position to access an independent review of the actuary's work or carry out its own check calculations. Furthermore the calculation of the solvency ratio is not sufficiently transparent to the public. For example, the use of subordinated debt can create confusion since subordinated debt may be considered a form of "quasi- equity": the minimum requirements for subordinated debt to qualify as solvency are defined in the relevant EU Directives and are included in the Czech enabling Decree. However, in the absence of transparency of the subordinated debt agreement, it is not possible for outside analysts to assess the quality of the capital, how it is allocated, and if part of the regulatory capital may be equity or may be debt: an insurer should be required to disclose in its audited financial reports whether subordinated debt qualifies under the solvency requirements. This assessment recommends that if life and non-life businesses are commingled, the published accounts should show the allocation of income, expenditure, assets, provisions, statutory capital and free funds and ' 9 copy can be downloaded at 11ttp.llwww.curopa.cu.~nt/comm/1ntcmal ~ markctlcompanyl~ndepcndcncclindcx cn.htin 2 0 ~ hEU Life Directive can be downloaded at httn:l/curo~a.cu.int/con~~~~/intemalmarkct/~nsurancc/life-nonlife e cn.htm that this be audited by the external auditor according to the Insurance Accounts Directive. The requirement is already set out the EU Life ~irective.~' A further onus lies on the insurance supervisor in the Czech Republic because of the weak bankruptcy system, which allows substantial discretion to the bankruptcy trustee. While the issue has not yet been tested in the Czech insurance sector, court decisions involving cases in other parts of the financial sector suggest that in case of bankruptcy, and in the absence of a stronger separation of assets covering policyholder liabilities, it would be possible for the assets of life-policy holders to be allocated to policy- holders of other types of insurance contracts from the same insurance company and even to other claimants. The bankruptcy legislation should be revised to protect life-insurance policy-holders against this outcome. In addition Article 19(1) of the EU Life Directive requires that the insurance supervisor apply an enhanced level of oversight for insurance activities that are part of mixed conglomerates. While the Act on Financial Conglomerates provides sufficient authority to the supervisory bodies, the key issue will be implementation of the Act. Composites will continue to place special responsibilities on the insurance supervisors, who are obliged to ensure that adequate measures are in place to provide effective separation of these two very different types of businesses. In fact challenges as concerns the protection of life policyholders are not restricted to composite insurance companies. Within insurance groups and financial conglomerates similar questions and problems appear, in particular with regard to capital links between companies, outsourced activities (like IT, investment function etc) and reputational risk. The supervisory authorities will need to have sufficient adequately qualified people to carry out this role once the Conglomerates law becomes effective, although the requirement is already implicit in the Insurance Law and Decrees. 2'~rticle19 of the Directive notes that the separate management ...must be organised in such a way that the activities covered by this Directive are distinct from the activities covered by Directive 73/239/EEC in order that: - the respective interests of life policy holders and non-life policy holders are not prejudiced and, in particular, that profits from life assurance benefit life policy holders as if the assurance undertaking only carried on the activity of life assurance, - the minimum financial obligations, in particular solvency margins, in respect of one or other of the two activities, namely an activity under this Directive and an activity under Directive 73/239/EEC, are not borne by the other activity, and 2. (a) Accounts shall be drawn up in such a manner as to show the sources of the results for each of the two activities, life assurance and non-life insurance. To this end all income (in particular premiums, payments by reinsurers and investment income) and expenditure (in particular insurance settlements, additions to technical provisions, reinsurance premiums, operating expenses in respect of insurance business) shall be broken down according to origin. Items common to both activities shall be entered in accordance with methods of apportionment to be accepted by the competent authority.(b) Assurance undertakings must, on the basis of the accounts, prepare a statement clearly identifying the items making up each solvency margin, in accordance with Article 27 of this Directive and Article 16(1) of Directive 73/239/EEC. Annex I Detailed Assessment of the Corporate Governance Framework for the Insurance Sector: A Comparison of Rules and Practices against Proposed Benchmarks The corporate governance benchmarks are divided into two groups: (1) internal elements of corporate governance within insurers, and (2) external factors that influence the corporate governance of insurers. The internal factors are: 1) Management, i.e. the management board and other senior management; 2) Risk management systems and internal controls; 3) The responsible (or appointed) actuary; and 4) Oversight of management by the supervisory board. The external factors are: 1) The insurance supervisory authority; 2) Public disclosure and market discipline; 3) External audit; and 4) Industry initiatives. In addition, the benchmarks discuss special provisions related to insurance companies that are wholly or majority owned or controlled subsidiaries of foreign parent insurers or financial groups, or branches of foreign insurers. were professional, with clearly defined responsibilities and adequate authorities to hlfil their duties. Boards of directors (i.e. the management boards) consisted only Two acts cover the fiduciary duties of management teams. Section 194 of the Commercial Code requires that members of the board of directors conduct their duties with "due managerial care" and thus with due diligence. Section 194 also establishes joint and several liability for members of boards of directors and with Section 66 (2) clarifies that board members should conduct their duties in the interests of the company and its creditors (see footnote 15). Section 194 also requires that board members should not disclose confidential information or facts to third parties, if such disclosure might be detrimental to the company. The Act on Insurance provides for additional fiduciary duties for members of boards of directors. Article 3 requires that the insurance undertalung conduct its activities prudently and in a way that would not damage the property entrusted to them by third persons (i.e. policy-holders) or endanger their security and stability or the security and stability of persons linked to the insurance undertaking. Under the Commercial Code, the statutory body of the insurance company is the board of directors. Section 65 of the Commercial Code also stipulates limitations on competitive conduct for members of boards of directors and supervisory boards, but the code does not provide for other restrictions related to conflicts of interest. Section 12of the Insurance Act prohibits members of Parliament, the financial regulators, or board members of other insurance companies from acting as members of the board of directors or supervisory board of a Czech insurance company. Recommendation None Manwmeatsbuld haveqemcientsWsandrsxpede~cein relationto insnrance,fmhee ando@er discipaisesrelevanttothe managementof an insurer,JMIkembers of$$e mmnaBmentteam shoulrt have aeceksto sdlklent resoupceslrndreceivesafffcisnttr-riningto assistthernin the i >&armatice oftbkrales. Description The management of the major Czech insurance companies appears to be highly professional and demonstrates sufficient skills to hlfil their duties. The Bank Team did not review the management of the small locally-owned insurance companies that are not members of the insurance association. Recommendation None fwaccountabletothe ,, , 3edchmirkA 3 &%@beresf the nrransgeienk-m shouldbe supervisoryboar&Tbc ac~ountnb~ifyhould elearlyrspecifiedidthe be companystahrtetes. Description Article 187 of the Commercial Code states that the shareholders' meeting- has the authority to appoint and recall members of the boards of directors (and supervisory boards) and set their remuneration-although the company statutes may authorize the supervisoryboard to appoint the management body. (For limited liability companies, similar provisions are found in Article 125of the Code.) In practice, the supervisory boards of Czech insurance companies rarely (if at all) appoint senior management. The Bank Team did not review company statutes but found that in practice, the management team is primarily accountable to the dominant shareholder(s) rather than the supervisory board. Recommendation In order to fully implement a dual-board structure, the senior management of Czech insurance companies should be hired and dismissed, and their remuneration set, by the companies' supervisory boards, which in turn should have an independent component when minority shareholders or long-term policyholders are involved. The statutes of Czech insurance companies should be revised to clarify that supervisory boards have such responsibilities. This move of supervisory boards from a subordinateto a superior role would represent a radical change of practice and should be phased in over a suitable time frame. SectienB Risk ManagementSystemsandCodtrbIs - BenchmarkB.l An insurer should havereliable dsk management systemsto identify, measure, monitorand contrdlaU bpsiaeas risksof the insurer.The risks should'beasayaea'anboth solo and consolidated bases (thatis, among upstream pafente and downsaeam subsidiiri~and acmsborders). Key qbks Mate to credit,interestrate&exchallgerater,basis risk,compllance risk, operations,-reputation,expasure$to'relatedparties,liquidity concentrationof exposum to singleorgroupedcwaterparties,sectoral, geographicalor industry exposureconcentration, and risks associated with criminal activityand moneylaundering. In hrge organizations, the risk management functionshould be aseparateunit Description The leading insurance companies appear to have reasonably sophisticated risk management systems in place, but the same may not be truk ofthe second and third tier companies. Nevertheless none of the insurers appear to have established .. separate global risk management functions within their organizations. CP lists sources or risk in its annual report and investment risks appear to be the responsibility of the ~xecutiveDirector for Investments. some foreign-controlled insurers and the maior domestic firm all list internal audit functions in their organization charts. The subsidiaries of the large international groups appear to - - - rely heavily on risk management systems imposed by their parent companies. Recommendation The major local insurance companies should be encouraged to establish dedicated risk management functions which are required to report to the supervisory board on a regular basis. Where subsidiaries rely heavily on risk management systems imposed by their parent companies the management board of the subsidiary should be satisfied that the systems are appropriate for the respectlve company. BenchmarkB.2 Theinsurer's risk managementsystemsshouldbe subjectto regular internal review, and periodic review by suitable, independentexperts,to ensurethat thesystemsare appropriateforthe natureof its business activitiesand risks. 1Description I The subsidiaries of the international groups all have effective internal functions - - for review of their risk management systems, and the Bank Team was advised that CP has a sophisticated risk management system. However the company's I annual report does not describe the risk management processes. Recommendation IInsurer annual disclosure documents should include a description of the company's risk management systems, including the name of the responsible officer, whether COSO Enterprise Risk Management (ERM) principles have been adopted, and the specific risks monitored. Theinsurershiiykll-liitrtiintaine$&&ve Intern##c ~ p l sSlacludinginternal, , Description The insurance legislation requires that insurance companies establish effective internal controls. Article 26c of the Act on Insurance requires that local insurance companies establish internal control systems that: (i) ensure the accuracy, integrity and verification of the insurer's information, (ii) document risks associated with the activities and determine the probability of such risks occurring, (iii) stipulate both procedures to safeguard the correctness of the data and test its accuracy, (iv) verify compliance with the legislation, and (v) evaluate the efficiency and effectiveness of the company management in resource- utilization. However the implementing regulations have yet to be prepared. Nevertheless the leading Czech insurers appear to maintain adequate internal audit functions. The foreign-owned insurance companies rely on the control systems of their parent organizations. However, several of the foreign-owned insurers are parts of foreign financial conglomerates and it is not clear if the integrated control systems for the conglomerates also provide for sufficient local controls. Several insurance companies, including Allianz, Aviva and ING are parts of international financial groups listed on the US securities markets and thus are obliged to follow the internal controls provisions of the US Sarbanes-Oxley legislation, including at the level of the local subsidiaries. Recommendation Implementing regulations should ensure that the supervisory board has overview responsibility for internal controls. Where subsidiaries rely heavily on internal control systems imposed by their parent companies the management board of the subsidiary should be satisfied that the systems are appropriate for the respective Description Section 66a of Commercial Code requires disclosure of related party transactions, that is, agreements and contracts between controlling and controlled persons. The same section provides extensive discussion of direct and indirect control and decisive influence, noting, for example, that a person holding 40 percent or more of the voting shares of another entity is considered as a "controlling" person. Furthermore the report under Section 66a must be audited by an independent auditor. Article 26(d) of the Insurance Act requires that institutions subject to supplementary supervision submit a report to OSS before March 31" of the year following the reporting year. In addition the supervisor has extensive powers to carry out on site inspections of an insurer in a group (and related entities based with the Czech Republic) as part of its supplementary supervision responsibilities (Articles 26), however MOFIOSS applies a general do no harm rule rather than specifying the examination of limits on inter-group transactions. Under Art. 21(5) the MOF is able to specify limits on investment classes, however the Bank Team found no evidence that related party transactions have been constrained using this authority. In addition, publication of the Commercial Code related-party transactions report is uneven, with some insurance companies publishing the report as part of its annual report and others requiring that the reader of the report specifically ask for a copy from the company. For at least one major insurer (which does provide some disclosure in its annual report) related party transactions appear to approach the quantitative limits generally seen elsewhere: in many insurance markets, regulations limit total related party transactions to 10% or less of assets. The 2005 Act on Financial Conglomerates also includes some provisions on related-party transactions, for which the MOFIOSS has just begun to develop procedures for implementation. )However the Czech Republic suffers from generally weak public disclosure of 1 1ownership and control of large corporations. In addition, the relationship between I 1 1company executive management and dominant shareholders raises concerns over I the quality of controls over related party transactions. Recommendation The insurance law (not a decree) should explicitly define related party transactions and should provide specific guidance on the maximum limits of 1 1 related party transactions and other related rules such as valuation. In addition, I I I all composites existing at the time the law was passed have been indefinitely I grandfathered, based on the option granted by the EU Life Insurance ~ i r e c i v as e extended in 2004. The law requires that the supervisor is advised of the assets matching technical provisions six monthly but does not require the maintenance of accounts and registers according to the EU insurance wind up directive (2001/17/EC, paras 16 and 17). The current insolvency legislation gives a trustee substantial discretion in the allocation of assets for bankrupt companies. Recommendation In the spirit of the EU Life Insurance Directive, there should be full implementation and strict application of the relevant EU rules for composites including earmarking of assets and apportionment of income and expenditures based on a system approved by the supervisory authority. Section C-Responsible(orAppointed)Actuary Benchmark C.1 Each insurancecompany shouldhave a responsible (or appointed) actuary for each of its major lines of business (Le. We, general insurance, health). The actuaryshould have specifiedskms, appropriatefor the type of insurance for which helaheis responsible.Theresponsible actuary shouldbe requiredto adviseon levep of technical reserves, on the proper risk premium calculation of insuranceproducts, prepareperiodic analyses of surplus (profits) and adviseon thedistribution of sarplusarisingfrom long-termbusiness (Ee. Ilfe insurance)tlnd long tail business (i.e. generalliability,worker's compensationand motor third party liability). Description The qualifications for certification are specified in the Insurance Law. In addition the concept of 'Responsible Actuary' is embedded in the Law and MOF has approval authority. Responsible actuaries have a wide range of duties and responsibilities under Article 23 of the Insurance Act, including setting premium levels, determining and certifying insurance provisions and reserves and allocation of surplus in a life insurer. The responsible actuary also has a 'whistle- blowing' responsibility if he or she cannot agree on a matter with management. The Czech Republic benefits from a small but very active and professional actuarial community. The concept of a "responsible" actuary is incorporated both in law and in practice. Some issues have evidently arisen with implementation due to confusion of the right to practice with the additional responsibilities implied in the title "responsible" actuary. Recommendation The insurance legislation should clarify the special status of responsible actuaries. In addition the responsible actuary should be required to provide detailed advice, in writing, on the distribution of surplus. Therctuaryshouldbe professisadly ce@&d andsubjectto bestpractice actuarid[~tandqdqcontinuouspm#&&sh;d devstlopment( f o d &dq), eW&sw&,i~@e!pUsrryproaedhs-Inall a@Mpri.a M a ~ l r & o %the:*~y, - &oddk x 4 d r 4 0 s s p e e w y statedl k d e n s & % l a w f i y i r n m t i e g Description The Czech actuarial profession (organized through the Czech Society of Actuaries) meets most of the requirements. However the profession is yet to prepare key professional standards, including a requirement that actuaries disclose their assumptions and identify levels of uncertainty. Perhaps the largest gap however is that there is as yet no standard for the format and presentation of actuarial reports, particularly regarding technical provisions and mathematical reserves and no requirement to prepare a financial condition report (FCR) for the boards and supervisor. As a full member of the International Actuarial Association the Society is, in principle, subject to its standards. There is a growing trend to set up actuarial standards boards with official status (for example in the UK, US, Australia and India) and this may be an option in the Czech Republic given the heavy dependence of the sector and the supervisor on actuarial certification. Recommendation The Czech actuarial profession should prepare and publish a professional standard covering actuaries' reporting to management, boards and the supervisor and this establishment of a "Reserving Committee" consisting of selected members of the board. In order to fulfil the advisory role, the actuary should not be a member of the supervisory board. In addition, Czech insurance companies should be required to establishing reserving committees. Supervisory boards should also be required to formally review and approve the levels of technical provisions and mathematical reserves. work of the responsible actuary involvedin settingprovisions and reserves for pubiishedaccountsor regulatory returns should be subject to an effectiveindependentreviewprocess. This requirementcould be satisfied by a certifiedactuaryemployedby theexternalauditor. No formal review process is in place. Formal peer review is generally co best practice and has been introduced in a number of European countries an elsewhere22.Other countries23,are also considering a requirement for a formal review process. While it may be helpful for the external auditor to review the regulatory returns in the Czech Republic, not even the "Big Four" international and proposed profit distribution and submit its opinion to the general meeting, and (iv) submit other reports as set by the company statutes. The official commentary for the section further clarifies that a supervisory board's main task is supervision and inspection. For insurance undertakings, no additional guidance is provided by the specific sector legislation. The role of the supervisory board of an insurance company in the Czech Republic does not cover approval of the company's strategic direction. Nor is the supervisory board considered as the governing body assuming ultimate responsibility for the prudent management of the company. As noted in the European Commission's February 2005 Recommendation on the Strengthening the Role of Non-Executive and Supervising Directors, two key responsibilities of the supervisory board are usually seen as: (i) ensuring that the financial reports 22For example, the UK and Canada "such as India and Australia and other related information disseminated by the company present an accurate and complete picture of the company's position and (ii) monitoring the procedures established for the evaluation and management of risks. It is not clear that the provisions of the Czech Commercial Code require that supervisory board members are obliged to fully assume these functions. Also unclear are the full fiduciary duties of members of the supervisory board. In particular it is not clear if the higher fiduciary requirements of the Act on Insurance are also applicable to members of supervisory boards. It appears therefore that members of supervisory boards in the Czech Republic have limited obligations to policy-holders, whch are not normally considered to be creditors in the absence of a current legal claim, and are treated as a special category in a number of leadingjurisdictions. Indeed the Bank Team was advised that the supervisory board is legally responsible to the company's shareholders only. With regard to the appointment of members of the supervisory board, the Commercial Code confirms that the shareholders' meeting should appoint and remove (and approve the remuneration for) members of the supervisory board. However neither the insurance legislation nor other guidelines assist companies in establishing a clear, transparent and accountable process for appointment and removal of supervisory board members. With regard to conflicts of interest, the Commercial Code specifies that no executive officer of the company may also sit on the supervisory board. However Section 200 establishes that in companies with more than 50 employees, the company employees have the right to elect one-third of the members of the supervisory board. The Bank Team found that the provision was followed in most large insurance companies. Although "co-determination" is a common concept in countries that base their legislation on the dual-board structure, the presence of employees on supervisory boards has been widely criticized and is slowly being removed in the countries of central Europe. The presence of employees on a supervisory board presents a material conflict of interest-and still fails to provide adequate legal protection of employees' interests. For foreign-owned companies, members of supervisory boards were often subject to substantial conflicts of interest. The supervisory boards of several insurers consisted entirely of non-resident executives from the parent companies. Recommendation The legislation should require that effective supervisory boards to be in place and their mandate to include approval of strategic direction and overview of the prudent management of the company. The fiduciary duties of boards of directors should also apply to supervisory boards. This is a system wide issue and would probably require amendments to the Commercial Code. In addition, supervisory boards of insurance companies should be free of conflicts of interest and in a position to effectively oversee the management function. The law or regulations (or possibly a code of conduct) should provide guidance on procedures for evaluation of the performance of supervisory board members and for their appointment and removal. In addition, the right of employees to elect members of the supervisory board should be periodically reviewed in light of peer country evolving practice. In particular, it is recommended that election of supervisory boards should follow the provisions of the pension law. That law allows employees to elect some members of the supervisory board but prohibits em~loveesfrom sitting on the boards themselves. supervisory boards. However, as ii true of many former transition countries, the liability has not yet been tested in the local courts. Members of supervisory boards are not required by law or generally by company policy, to hold professional liability insurance (known as "D&O" or directors and officers insurance). However several insurance companies, including CP and CSOB 1~ojistovna,do maintain D&O liability insurance for their board members. Recommendation Insurance companies should be encouraged to provide D&O insurance for the Article 10 of the Act on Insurance references the need for supervisory board members to submit information on their academic background and professional qualifications, but neither the legislation nor other guidelines specify minimum levels of experience or professional training. In addition, neither the company nor the insurance legislation includes provisions to ensure that supervisory board members devote sufficient time to complete their duties. In most countries, the legal provisions on joint stock companies require that supervisory boards meet at least four times a year. However the Czech legislation provides no such guidelines and the Bank Team found that one insurance company considered that semi-annual meetings of the supervisory board were sufficient. With regard to professional training, the insurance association provides some training of insurance company executives but neither the insurance association nor the Czech Institute of Directors is actively engaged in training of supervisory board members for insurance companies. Recommendation Additional guidance should be provided for supervisory boards of insurance companies: possibly through legislation or regulation but preferably through a written insurance industry code of corporate conduct. Insurance companies should boards' members should be required to undertake a minimum level of training to In foreign-owned Czech insurance companies, the supervisory board is generally staffed by members of the executive management of the parent company. In the large locally owned company CP, the supervisory board is chaired by a non- executive of the company and the board includes three non-executive members. A number of companies use the employee representative requirement of the Commercial Code to appoint members of management (such as the actuary) to the 2 4refers ~to The Committee of Sponsoring Organizations of the Treadway Commission, which focuses on internal controls. ~ ~ ~ The Committee was originally formed in the USA in 1985 to sponsor the National Commission on Fraudulent Financial Reporting. Description The Bank Team found that audit committees were not generally part of supervisory boards, although the insurer associated with one major bank (CSOB) does have an audit committee with specific responsibilities. Recommendation Following international practice, insurance companies should be required to maintain audit committees and the committees should be composed largely of independent supervisory board members. The chairman of the audit committee The Bank Team found that supervisory boards do not yet maintain proces reviewing their own performance. The concept that supervisory boards sh maintain processes for reviewing their own performance is a relatively recent development for corporate governance. At the current time, it may not be applicable to the Czech Republic but at a hture moment will likely become supervisory board members but one major company appeared to pay appropriate levels of remuneration but it appears that the remuneration levels vary widely from company to company. However the Bank Team was advised that some insurance companies hire specialized advisors to deal with the issues related to remuneration of supervisory board members. None of the insurance companies publishes the levels of remuneration of supervisory board members. Recommendation Insurance companies should be encouraged to seek specialized advice from qualified consilting firms on the levels of remuneration generally paid for supervisory board members. Alternatively a transparency regime could be introduced. - - shareholders, su~ervisoryboardmembers andsenior management. embers of supervisory boards (as well as members of boards of directors and significant shareholders) must meet minimum test of "credibility". Under Section 10a of the Act on Insurance, credible persons are those that have not been sentenced for criminal act during the prior 10years. The Act on Insurance Intermediaries goes further and covers persons who have not been declared bankrupt and who for the prior 5 years was not member of the board of directors or supervisory board of a bankrupt company. Overall the fit and proper requirements fall well short of the IAIS and CNB requirements. Four of the largest insurance companies are owned by foreign financial corporations that are listed on their home stock exchanges. According to its annual report, CP is controlled by a Netherlands based company which in turn is owned by a Czech national. It is subject to stock exchange rules and IFRS, since a small portion of its corporate bonds are traded. The insurance legislation provides for substantial authority for the supervisory authority to investigate the origin of capital for insurance companies. Article 7 of the Act on Insurance notes that an insurance undertaking may not be licensed if the Ministry of Finance has a "well-founded suspicion" that the capital or other financial resources of the insurance undertaking or reinsurance undertaking originate from criminal activity or from unidentifiable sources. Article 26b of the Act on Insurance allows an insurance company to request exclusion from supplementary supervision where the company has a seat in a non-member-country, for which legal obstacles exist on receiving the necessary information or where "the inclusion of its financial situation would be misleading for the exercise of the supplementary supervision." This would appear to be in violation of the provisions of the Post-BCCI Directive, which requires that the competent authorities not authorize (or continue to authorize) an insurance undertaking where the authority is liable to be prevented from effectively exercising supervising functions by the close links between that undertaking and other natural or legal persons. The Directive on supplementary supervision requires that the competent authorities identify a coordinating authority that will take the lead in supervision of the conglomerate. The Directive also notes that the coordinator should identify the types of transactions and risks that the regulated entity should report on with regard to intra-group transactions and risk concentrations. The authority should also define appropriate thresholds based on regulatory own funds andlor technical provisions. It is not clear that the MOFIOSS has done so for the financial groups, and in particular, for the conglomerate in which CP participates. Recommendation The insurance legislation should refine the definition of credible persons: the CNB criteria would provide a suitable guide in this regard. All of the provisions of EU Directives 95126lEC (generally called the "Post-BCCI Directive") and 2002187lEC on supplementary supervision of mixed conglomerates should immediately be hlly implemented. The MOFIOSS and its successor should set appropriate thresholds and restrictions on intra-group transactions and risk concentrations by regulation. For mixed financial and non- financial conglomerates, the authorities should require that a clear group structure is a prerequisite to obtain and keep a licence and provide the supervisor with the authority to ask for appropriate changes of the group structure in order to meet 1 ' review company-statutes and changes thereof. ow ever-it is not clear that the MOFIOSS conducts such reviews on a rermlar basis. 1Recommendation I The MOFIOSS should include reviews of insurance company statutes as part of - 1 A the periodic offsite reviews. BenehmarlcE.4 The supervisc)ry~l&&arityshaqIdpmiodfcaltyevaltrate(iacluding&rough meetingswith the auditcommittee, riskmaeiger,awl the interadrudi$o,r') eachinsurer's internalcoatrolsandrisk managementsystems, eitherdirectly or via indepedderptpsrtiesiitapproves. consulting actuaries. The Bank Team was advised that at least with KPMG, the MOFIOSS conducts regular meetings with the audit firm separate from the insurance companies. firm eligibility criteria) for insurance companies, based on similar rules to those applying for banks. Where an auditor provides consulting services (particular1 2.- - control of insurance companies. Control of the largest insurance company is held by a mixed (financial and non-financial) holding company, which also controls industrial and commercial enterprises in the Czech Republic. The insurance company has no independent directors. The 2005 Act on Financial Conglomerates will provide the MOFIOSS with additional authority to establish controls over over related-party transactions and provide the supervision required under the EU Directive on supervision of financial and non-financial conglomerates. Full application of the Directive would issue regulations on related party transactions and concentrated risk exposures here the ultimate control structure cannot be :*, ~,,#&Ii&&iqa:, - v z - , Description The Commercial Code requires some disclosure of related party transactions and . . the Bank Team was advised that enabling law specifies quantitative limits on certain related party transactions. There appear to be no provisions for prior approvals for related party cash transfers. Local insurance experts advised the Bank Team that the general provisions of the company law are insufficient for the nature of the insurance sector, which should involve an enhanced fiduciary duty to policy-holders. Furthermore the Czech Republic suffers from generally weak public disclosure of ownership and controls of large corporations. Relationships between company executive managements and dominant shareholders should be a matter of concern. One major insurer has recently established a reinsurance subsidiary in Cyprus. sector. Recommendation The MOFIOSS should publish an annual report that covers extensive information on Czech insurance companies. For non-life business, such key information should include net and gross earned premium income, net incurred claims, distribution and administration expenses, operating and other investment income, loss ratios, operating ratios, and amounts of net technical provisions. Details of reinsurance contracts, which have commercial value, should be excluded from disclosure. For life insurance activities, the financial information should include business in-force. new business. business discontinued, claims and surrenders, 25~uitabletemplates include the current Turkish and original Australian supervisors' statistical reports. (Australia's largest insurance failure occurred after these reports were reduced in scope under industry pressure). The US statistical reports are probably too detailed at this stage. statements using CAS, which are then converted to IFRS to allow the group to prepare their financial statements. Starting in 2005, publicly traded companies have been subject to the EU requirement to prepare consolidated financial statements using IFRS endorsed by the EU Commission (that is, all IFRS except certain parts of IAS 39). The combined effect of the limited number of insurance company listings, the consolidation exemption of the EU 7'hDirective and I F R S ~and ~ , the IAS 39 carve-outs will limit the availability of full IFRS-based financial statement information for stakeholders in Czech insurance companies. Similar to the UK, the Czech Republic has adopted asset and liability valuation bases with significant fair valued components, although this supplements a requirement that liabilities be valued at the pricing (or 'technical') interest rate. With interest rates being relatively low the fair value approach applies in practice. There is a requirement that supplementary reserves be established if future asset earning power will be inadequate to meet liabilities, but a supervisory methodology is not specified. Thus, unlike the UK no statutory stress or resilience testing is required to ensure that life insurer balance sheets can withstand substantial shocks, although the Bank Team was advised that leading insurers do cany out such prudential checks and report the results. 26The EU 7th Directive and IFRS contain the exemption so that companies in a group that are required by law to publish financial statements under IFRS, in addition to the group's consolidated financial statements, would not be unduly burdened. However, the EU and IFRS exemptions are conditional upon several conditions, including the availability of the group's consolidated financial statements and the approval of minority shareholders. The Czech exemption does not include these fundamental conditions, which may have an adverse impact on the transparency of financial reporting. Insurance companies provide annual reports to the MOFIOSS on solvency ratios but the reports are not available to the public. The insurance law provides for no authority for the MOFIOSS to require additional disclosure. Recommendation Regardless of whether or not they have publicly-traded securities, all financial institutions (including not only insurance companies but also banks and investment and private pension funds) should be considered as "Public Interest Entities" and required to prepare their financial statements in accordance with IFRS. Ideally companies should be able to prepare IFRS-compliant statements and not be obliged to prepare a second set of CAS-compliant statements. While the introduction of Solvency I1 may still take some time, the MOFIOSS should immediately start to require stress-testinn by all life insurers to ensure that among companies,they all appear to include basic financial data, and the Bank Team was advised that some of the reports do provide sufficient information to accurately calculate key ratios such as loss and operating ratios or to properly analyze cash flows. Most annual reports do not describe the activities or performance of the supervisory board or company management. While disclosure practice on risks varies among the Czech companies, even the best practice fails to provide sufficient information for financial analysts and intermediaries to quantify the risks. However returns submitted to the MOFIOSS are not available to the public. In addition, different insurance companies use different approaches to the entries of claims incurred and premium income, some using accrued amounts and other using paid amounts. Annual financial reports are available to the public. Life insurers are not required to publicly disclose the sources of annual surplus. Recommendation As a way of improving public disclosure and market discipline, insurance companies should be obliged to annually publish: (i) statements by the supervisory board and management of the performance of their responsibilities, (ii) statement describing the major risks of the business and how these are managed, (iii) sources of annual surplus for life insurers, and (iv) notes which are sufficiently comprehensive that a trained analyst can properly assess the real performance of the institution and trends in performance. The MOFIOSS should also establish a standard methodology for calculating key ratios and otherwise review the structure of published statistics by insurance can be improved by strengthening the disclosure regime for insurance companies in the Czech Republic. Other regulatory requirements appear not to inhibit contestability or competitiveness in the market for most classes of insurance. Workers' compensation is restricted tojust two insurance companies that operate on an agency basis on behalf of the state. Recommendation As noted throughout the assessment public disclosure should be strengthened. In addition there may be grounds for further privatizing workman's compensation Description The Czech Republic has no industry wide guarantee scheme aside from the usual MTPL nominal defendant arrangement. Service. CSOB also has a debt rating" from Standard & Poor's. 1Recommendation ICzech insurance comvanies, at least those above a defined size, should be obliged I The Czech financial press is still becoming acquainted with complex insurance issues and is not yet considered to be an effective mechanism for governance of the financial sector. In the case of the largest insurance company, the financial press has alleged control of a major media outlet that was sold in early 2005. As more information on insurance companies becomes available to the public, the of Auditors, are used rather than ISA. Fortunately the audit regulations endorsed by the Chamber for 2005 audits are direct translations of ISA and the recently issued ethical code is based on the IFAC Code of Ethics. Accounting systems and systems of internal controls of Czech insurance companies are generally subject to an annual audit. However no process exists for certifying auditors as being competent to apply ISA and there is no public oversight body for national auditors. Unlike the CNB, OSS does not have the power to determine which audit firms may act as external auditors for insurance companies. Recommendation Once the 8' Company Law Directive is enacted in the European Union, a national oversight body fo; the auditing profession should be created to comply with the Directive. The insurance supervisor should, at the very least, have the power to establish criteria which external auditors have to meet in order to be able to audit Description The large insurance companies are all audited by international "Big Four" audit firms, with one firm providing audit services for four out of the five largest insurers. However the small insurers tend to employ small local auditing firms or single individuals as their external auditors. The Bank Team was advised that the reviews prepared by small firms or single individuals may not be adequate to ensure a fully-reliable audit. There are no legal provisions or common practices on rotation of audit partners, although the recently adopted ethical code (modelled on the IFAC Code of Ethics) requires that for all listed companies, audit partners be rotated every seven years. The Bank Team was not informed of any cases of inadequate separation of audit from non-audit services. Audit fees are not generally disclosed. Recommendation All insurance companies in the Czech Republic should be subject to a comprehensive audit by a reputable auditing firm-and one that has the capacity and expertise to review the work of the insurer's responsible actuary. It may be helpful if the MOFIOSS has the authority to establish criteria which external auditors have to meet in order to be able to audit insurers In addition, audit partners for insurance company audits should be obliged to follow the rotation Description Section 15.5 of the audit legislation requires that auditors report to the board of directors and supervisory board any economic crime, corruption or crime against assets of which they become aware. In addition auditors have 'whistle-blowing' responsibilities to the MOF in the event that certain financial difficulties are 1 Description While theannual report with the company's financial statements are external auditor, the regulatory returns are not subject to an audit, although audit firms generally ieviewjhe technical provisions aspart of the external audits. Recommendation The insurance legislation should require that key regulatory returns should be and 99 percent of all premium income in the Czech Republic and identifie; its primary mandate as one of advocacy for the sector. The Association is an active member of the European Insurance Committee, CEA (Comite'Europe'en des Assurances). The Association advised the Bank Team that it is working on an amended Code of Ethics for the insurance sector. In addition it has recommended a corporate governance code, based on the code adopted by the Czech Securities Commission (CSC) for listed companies. The Association has carried out a number of seminars on insurance related law and promulgates technical information. However to date these seminars have not focussed on board members. Recommendation The Czech Insurance Association, possibly working with the Institute of Directors and MOFIOSS, should be encouraged to develop corporate governance The Czech Institute of Directors is active in providing training and corporate governance guidelines for members of supervisory boards but does not actively cooperate with the insurance association.. Recommendation The Czech Institute of Directors should be encouraged to work with the insurance Annex I1 List of Recommendations INTERNAL BENCHMARKS A. Management The senior management of Czech insurance companies should be hired and dismissed, and their remuneration set, by the companies' supervisory boards. The statutes of Czech insurance companies should ultimately be revised to clarify that supervisory boards have such responsibilities. However as this recommendation involves a fundamental upgrading of the role of the supervisory board, a suitable, relatively long term, transition plan would be required. B. Risk Management Systems and Controls Those members of management responsible for the risk management and compliance functions should be required to report to the supervisory board on a regular basis. Insurer annual disclosure documents should include a discussion of the company's risk management systems. Implementing regulations should ensure that the supervisory board has overview responsibility for internal controls. The insurance law should define and limit related party transactions. In addition insurance companies should be required to include specific disclosure on individual related-party transactions and balances in their annual reports. The insurance legislation should be revised to strengthen the rules on asset segregation and proper apportionment of income and expenditures w i t h a reasonable time frame for existing composites. Furthermore, supplementary supervision should be upgraded for defined insurance groups and conglomerates, and adequate resources provided to the relevant supervisory bodies. Responsible (or Appointed) Actuary The insurance legislation should clarify the special status of responsible actuaries. The responsible actuary should be required to report in detail on the emergence of surplus, preferably in the context of a full written financial condition report. However the external auditor should have ultimate responsibility for signing off on all accounts. The Czech actuarial profession should prepare and publish a professional standard covering actuarial reporting to management, boards and the supervisor. One role of the actuary should be to advise the management team and supervisory board. In order to fulfill the advisory role, the actuary should not be a member of the supervisory board. Czech insurance companies should be required to establishing reserving committees. A regulation should be put in place to require formal peer review process for the review of actuarial reserving reports and recommendations. This could be carried out by actuaries employed by the external auditor. D. Oversight of Management by the Supervisory Board The legislation should require that effective supervisory boards should be in place and their mandate should include approval of strategic direction and taking ultimate responsibility for the prudent management of the company. The fiduciary duties of boards of directors should also apply to supervisory boards. Supervisory boards of insurance companies should be free of conflicts of interest and in a position to effectively oversee the management functions. The law or regulations (or possibly a code of conduct) should provide guidance on procedures for evaluation of the performance of supervisory board members and for their appointment and removal. In addition, the right of employees to elect members of the supervisory board should be periodically reviewed in light of peer country evolving practice. Insurance companies should be encouraged to provide independent D&O insurance for the members of its supervisory board. The statutes of insurance companies should specify that shareholders' meeting shall appoint the members of the supervisory board and the supervisory board shall appoint the chief executive officer. Additional guidance should be provided for supervisory boards of insurance companies: possibly through legislation or regulation but preferably through a written insurance industry code of corporate conduct. Insurance companies should be limited to a maximum number of supervisory board members (such as nine). They should be required to conduct meetings at least quarterly. The members of the supervisory board should be required to undertake a minimum level of training to ensure that they are aware of both their statutory obligations under the law and best practices among supervisory boards of other countries. The EC's February 2005 "Recommendation on the Strengthening the Role of Non-Executive and Supervising Directors" should be reviewed and incorporated in the legislation, regulations or guidelines provided for the insurance sector as appropriate. Following international practice, insurance companies should be required to maintain audit committees. The committees should be composed largely of independent supervisory board members. The chairman of the audit committee should be independent and free of all material conflicts of interest. EXTERNAL BENCHMRKS E. Insurance Supervisory Authority The MOFIOSS should have the authority to set corporate governance and relevant disclosure requirements for insurance companies that involves approving a Code developed by, or with the industry, rather than one imposed by the supervisor. The insurance legislation should refine the definition of credible persons to be consistent with NBS requirements. The MOFIOSS should set appropriate thresholds and restrictions on intra-group transactions and risk concentrations by regulation. For mixed financial and non-financial conglomerates, the authorities should obtain all relevant information on the group or conglomerate structure that is necessary to effectively discharge supervisory functions. The MOFIOSS should include reviews of insurance company statutes as part of the periodic offsite reviews. Procedures for the on-site inspection of internal controls and risk management systems should be prepared. On-site inspections should focus particularly on internal controls and risk management systems. The MOFIOSS should approve a list of accepted audit firms for insurance companies, based on similar rules to those applying for banks. Insurance companies should be obliged to establish a designated function for legal and regulatory reporting and compliance. The legislation should fully implement the Post-BCCI Directive of EU as well as the Directive on Supervision of Conglomerates. As lead regulator for major financial groups, the MOFIOSS should issue regulations on related party transactions and concentrated risk exposures within financial and mixed conglomerates. The MOFIOSS should publish an annual report that covers extensive information on Czech insurance companies. For non-life business, such key information should include net and gross earned premium income, net incurred claims, distribution and administration expenses, operating and other investment income, loss ratios, operating ratios, and amounts of net technical provisions. Details of reinsurance contracts, which have commercial value, should be excluded from disclosure. For life insurance activities, the financial information should include business in-force, new business, business discontinued, claims and surrenders, investment returns on mean assets, expenses, and mathematical provisions. Reports on asset and technical provisions movements should be submitted to the supervisor on a regular basis (at least on a quarterly basis). Reports on major changes in the assets or technical provisions should be reported ad hoc or in shorter intervals. Only financially strong reinsurers should be accepted for solvency purposes. The 1998 OECD Recommendation on the Assessment of Reinsurers or equivalent would provide a suitable standard. F. Public Disclosure and Market Discipline All insurance companies should be required to prepare their financial statements in accordance with EU listed company requirements on both a solo and consolidated basis. Until the introduction of Solvency 11,the MOFIOSS should require stress-testing by all life insurers to ensure that balance sheet can withstand shocks. As a way of improving public disclosure and market discipline, insurance companies should be obliged to annually publish: (i) statements by the supervisory board and management of the performance of their responsibilities, (ii) statement describing the major risks of the business and how they are managed, (iii) sources of annual surplus for life insurers, and (iv) notes which are sufficiently comprehensive that a trained analyst can properly assess the real performance of the institution and trends in performance. Remuneration of individual board members and key managers should be disclosed by bands. The CEO and CFO of the insurance company should be obliged by law to sign the disclosure statements and attest to their accuracy and completeness. The Czech supervisory framework should be strengthened considerably before the EU's proposals on policyholder guarantee schemes are introduced. The Czech Republic should monitor developments but not take further action at this time. Czech insurance companies should be obliged to obtain and publish financial strength ratings, and if applicable, credit ratings. G. External Audit Once the 8'h Company Law Directive is enacted in the European Union, a national oversight body for the auditing profession should be created to comply with the Directive. Audit partners for all insurance companies should also be obliged to follow the rotation requirements applicable to listed companies. The insurance legislation or regulations should require that the supervisory board review the management letter and management's responses. The insurance legislation should require that key regulatory returns be audited by the external auditor. H. Industry Initiatives The Czech Insurance Association, possibly working with the Institute of Directors and MOFIOSS, should be encouraged to develop specific corporate governance benchmarks and training for board members. The PSE should amend listing rules to require statement of compliance with relevant corporate governance codes. The MOFIOSS should review the Corporate Governance Code to determine its applicability to non-listed insurance companies and to determine if a separate code of conduct should be prepared for insurance companies and intermediaries. I. Special Issues Relating to Wholly or Majority Foreign Owned or Controlled Insurance Subsidiaries and Branches The MOFIOSS should review the registration of assets held for branch liabilities. Annex I11 Confederation Life Case Study Summary Confederation Life made the fatal error of concentrating its assets in the real estate market at a time when real estate prices were inflated. In order to make a profit in the increasingly competitive insurance industry, Confederation Life invested heavily in real estate throughout the 1980s and early 1990s. By 1993, 71 percent of the company's assets were in real estate. The performance of the real estate market appeared to be too good to be true - and it was. The losses began to hit hard in the early 1990s. Between 1990 and 1993, appraised values fell from an average of $208 per square foot to $129 per square foot (based on properties held over the entire period), and a $200 million portfolio Confederation had assembled for various pension funds lost 34 percent of its value during the same time period. The company's problems were compounded by poor management in its business practices. Among these were lax application standards for loan applicants, and company employees who bought condominium units from the company, then sold them back at a considerable profit a short time later. Ultimately, federal officials, fearing investor panic, stepped in and shut the company down. KPMG, the liquidators, estimated losses at $1.3 billion. Overview In late 1993,Confederation Life Insurance Company ranked fourth among Canadian life insurance companies with 273,000 policy-holders, 4425 employees, and $19 billion in assets. A.M. Best Co., a leading ratings service for insurance companies, rated Confederation as "A (excellent)", the third-best of 15possible ratings. Executives at competing insurance companies have said that they knew Confederation was having some problems at that time, but nothing that couldn't be resolved - or so they thought. The problems stemmed from economic conditions in the early 1980's. At that time, competitiveness in the Canadian insurance industry was increasing, as insurance companies battled not only each other, but also mutual funds, banks, and trust companies for consumers' money. This led to decreasing profit margins, which, coupled with rising inflation rates, meant that pension fund managers had to be on their toes in order to provide customers with the returns they expected and still turn a profit for themselves. Confederation's CEO and Chairman decided that the best strategies were to: o Increase volume to acheve economies of scale; o Establish new ventures; and o Invest as much as possible in the real estate market, which was yielding impressive returns at that time. In 1982, Confederation had a mere $119,000 invested in property, but thanks to aggressive real estate investment, this sum had grown to $1.1 billion by August 1994. Likewise, Confederation's mortgage portfolio grew from $1.2 billion in 1982 to $8.5 billion in 1993. The company had 71 percent of its assets, far more than any of its rivals, invested in real estate, either through direct ownership or through mortgages on properties ranging from houses to condominiums to office buildings and shopping malls. In addition to the risks associated with having such a large proportion of the portfolio concentrated in one market, Confederation arguably couldn't have picked a worse time to make its foray into real estate. The real estate market was inflated, and the amazing returns could not continue forever. The losses hit hard in the early 1990's:between 1990 and 1993 appraised values fell from an average of $208 per square foot to $129 per square foot (based on properties held over entire period). A $200 million portfolio that Confederation had assembled for various pension funds lost 34 percent of its value during the same time period. If this lack of diversification and broad exposure to market risk weren't enough, Confederation also was plagued by poor management in its business practices. Perhaps the biggest liability in this respect was the Confederation Trust Company, which was set up in 1987 to provide loans to condominium promoters. Through partnerships with other companies, such as the Reemark Group in Southern Ontario and British Columbia, the company quickly grew its mortgage portfolio. For example, Confederation financed loans made through Reemark to the tune of about $350 million. Unfortunately, neither Confederation nor Reemark was thoroughly checking where these loans were going. In fact, many were going to buyers of apartments who were not planning to live there and had no chance of even breaking even unless rents and values rose - but they were granted large mortgages with down payments of as little as $1,000 per unit. By 1989, the trust company had $906 million in mortgages. Over the next three years, it lost $89 million, mostly due to defaults on loans, and received $70 million in capital from Confederation Life. Ultimately, Confederation Trust had to be shut down. Confederation reported impressive profits of over $100 million per year in 1989 and 1990. But problems were starting to become apparent by 1992,with the company reporting a mere $1.9 million in profits for that year. In the fall of 1993, Confederation announced that it needed help and opened its books to competitors who might be interested in a merger, take-over, business alliance, asset purchase, or almost about any other kind of financial assistance. Great-West Life Assurance Co. of Winnipeg expressed interest in the company in October, and in December agreed to try to work out a deal to save or absorb Confederation, on the condition that Confederation stop talking to all other companies. Confederation agreed. However, the proposed deal never materialized. In July 1994,Great-West announced that it would not be able to act alone. Great-West stated that Confederation needed $600-million in funds, and that Great-West would put up no more than $75 million. On July 23, Canada's six leading life insurers began planning a joint rescue of Confederation. The insurers had an incentive to help, since if Confederation failed, they would pay the costs of compensating Confederation's policy-holders, via the industry fund that existed for this purpose. However, the negotiations between the rival insurers stalled, and on August 11 the Canadian government stepped in to shut down Confederation, fearing that public anxiety would lead Confederation customers to initiate massive withdrawals and cancellations, a similar process to "a run on a bank". Confederation's individual life insurance policy-holders will fare relatively well, since death benefits up to $200,000 are guaranteed by the Canadian Life and Health Insurance Compensation Corp., an industry- sponsored fund. About 90 percent of Confederation's policies are fully covered by this limit. Larger policies will be paid out at a somewhat reduced rate, but Comp Corp is optimistic that the reduction will be as little as 10percent. Deferred annuities and accumulated cash values that customers can claim when they cancel their coverage are insured only up to $60,000, and so may present a stickier situation. Ultimately, all policy-holders will likely experience increased costs passed down to them from the remaining insurers, who must cover Confederation's debts through contributions to the Comp Corp fund. Counterparties to Confederation's interest rate and foreign exchange derivatives transactions also felt the pain; it is estimated that these aborted contracts ran into hundreds of millions of dollars. Events Early 1980s: Confederation decides to aggressively purchase real estate to be able to provide competitive returns in the life insurance business. 1987: Confederation Trust is established to provide mortgages on condominiums. 1989, 1990: Confederation reports profits exceeding $100 million in each of these years. 1992:Confederation reports an annual profit of $1.9 million. Third quarter 1993: Confederation announces that it needs financial help. December 1993: Great-West undertakes to work out a deal to save or absorb the company, and begins a review of Confederation's books to further evaluate the situation. 23 July 1994: Major Canadian life insurers band together to attempt a joint rescue of Confederation with a $600 million loan, but talks stall. 11 August 1994: Federal officials, fearing that public apprehension will lead to a surge in withdrawals and cancellations, decide to shut down Confederation. Lessons to be Learned Set limits and establish a balance The concentration of 71 percent of the company's assets in real estate was a major factor in the company's dissolution. It does not appear that the company planned any strategy for diversifying or otherwise limiting its risk in the real estate market. Apply checks and balances on the activities of those inpositions ofpower The Chairman's determination to concentrate vast amounts of assets in real estate went virtually unopposed. Michael Mackenzie, Canada's former superintendent of financial institutions, provides insight into the danger this poses: "I have been trying to train people that this is an early warning sign of trouble anywhere, it doesn't matter what the company, what the industry: When you see a CEO, a strong-minded CEO, who brooks no opposition inside, watch out. . .If he doesn't create an open working atmosphere where people can say, 'Pat, for Christ's sake, this doesn't make any sense,' [the company courts disaster] because if they're not going to say it at the operating level, they're also not going to say it at the board level." (The Globe and Mail, 12/22/94). Understandthe business. The cyclical nature of the real estate industry was apparently completely ignored. Mortgages were given out indiscriminately to some borrowers who probably would not have qualified under a normal application process. Source: ERisk Case Study Financial Sector I t l L W 3 1 j L O U i i N K 1818 H Street NW Washington DC 20433 www.worldbank.org/finance