ICP 9: Corporate Governance

Transcription

1 A Core Curriculum for Insurance Supervisors ICP 9: Corporate Governance Basic-level Module

2 Copyright 2006 International Association of Insurance Supervisors (IAIS). All rights reserved. The material in this module is copyrighted. It may be used for training by competent organizations with permission. Please contact the IAIS to seek permission. This paper has been prepared by Mr. John Thompson, a private consultant based in Toronto, Canada who provides advice and functional support to financial sector regulators, the financial services industry and educational organizations. He is the Chairman of the Insurance Advisory Group for the Toronto International Leadership Centre (The Toronto Centre is based in Toronto, Canada and provides leadership development training for financial sector regulators.). He is an actuary with over 24 years experience in senior positions within a life insurance company both in Canada and the UK. Prior to becoming a private consultant, he was Deputy Superintendent at the Office of the Superintendent of Financial Institutions in Canada. He also has broad experience at the international level as the former Chairman of the Executive Committee of the International Association of Insurance Supervisors and member of the Basel Committee for Banking Supervision. The paper was reviewed by Mr. Andre Swanepoel, South Africa and Mr. Alvaro Clarke, Chile. Andre Swanepoel is a private consultant, who retired in 2004 after 13 years as head of insurance and retirement funds supervision with the Financial Services Board in South Africa, where he dealt with all aspects of prudential and market conduct supervision. He is a qualified actuary and spent 15 years in the merchant and general banking industries. Prior to this, he worked for 12 years with a life insurer in the actuarial and investment research departments; he was a member of the Executive Committee of the International Association of Insurance Supervisors (IAIS) and chaired the Emerging Markets Committee of the IAIS. He is active in the Toronto International Leadership Centre.Mr. Clarke is the Principal Partner Clarke & Associates and Professor of Law at Universidad de Chile, Faculty of Law and Faculty of Economics. Mr. Clarke also held various senior government positions in Chile, including the Chairman of Superintendencia de Valores Y Seguros (the Insurance and Securities Supervisor) ( ) and as Vice Minister of Finance ( ). Mr. Clarke was the president of ASSAL between

3 Contents About the Core Curriculum v Overview and Learning Objectives vii Pretest ix A. Introduction B. Fundamentals of Corporate Governance C. Understanding the Core Principle D. Supervision and Inspection E. Principles of Corporate Governance to Protect Key Stakeholders F. Issues for Insurance Supervisors Appendix I. ICP 9: Corporate Governance Appendix II. Answer Key iii

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5 About the Core Curriculum A financially-sound insurance sector contributes to economic growth and well-being by supporting the management of risk, allocation of resources and mobilization of long-term savings. The Insurance Core Principles (ICPs), developed by the International Association of Insurance Supervisors (IAIS), is one of the key international standards relevant for sound financial systems. Effective implementation of the ICPs requires skilled and knowledgeable insurance supervisors. Recognizing this need, the World Bank and the IAIS partnered in 2002 to develop a Core Curriculum for insurance supervisors. The Core Curriculum project, funded and supported by various sources, supports the learning process of both new and experienced supervisors. The ICPs provide the structure for the Core Curriculum, which consists of a set of modules that summarize the most relevant aspects of each topic, focus on the practical application of supervisory concepts and cross-reference existing literature. The Core Curriculum is designed to help those studying it to: Recognize the risks that arise from insurance operations Know the techniques and tools used by private and public sector professionals to identify, measure, and manage these risks Operate effectively within a supervisory organization Understand the ICPs and other IAIS principles, standards and guidance Recommend techniques and tools to help your jurisdiction observe the ICPs and other IAIS principles, standards and guidance Identify the constraints and identify and prioritize supervisory techniques and tools to best manage the existing risks in light of these constraints. v

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7 Overview and Learning Objectives Note to Learner Welcome to ICP 9: Corporate Governance module! This is a basic-level module on Corporate Governance that does not require specific prior knowledge of this topic. The module should be useful to either a new insurance supervisor or an experienced supervisor who has not dealt extensively with the topic or is simply seeking to refresh and update knowledge. Start by reviewing the objectives which will give you an idea of what a person will learn as a result of studying the module. Then answer the questions in the Pretest to help gauge prior knowledge of the topic. Then proceed to study the module either on an independent, self-study basis or in the context of a seminar or workshop. The amount of time required to study the module on a self-study basis will vary but it is recommended that it be addressed over a short time, broken into six sessions on chapters if desired. To help you engage and involve yourself in the topic, we have interspersed the module with a number of hands-on activities for you to complete. These are intended to provide a checkpoint from time to time so that you can absorb and understand the material more readily. You are encouraged to complete each of these activities before proceeding with the next section of the module. An answer key in Appendix II sets out some of the points that you might consider when responding to the questions in each question set. You will also find question sets dealing with the local situation and related to practices in your jurisdiction. These are intended to help you apply the material in this module to your local circumstances. If you are working with others on this module, develop the answers through discussion and cooperative work methods. Since these vii

8 Insurance Supervision Core Curriculum responses will vary by jurisdiction, the answer key suggests where you might look for the answers. As a result of studying the material in this module, you will be able to do the following: 1. Summarize the requirements of insurance core principle (ICP) 9 2. Explain the concept of a corporation, specifically (a) the liability of the owners of the corporation; (b) the duties, rights, and powers of shareholders and directors; (c) the duties of directors to shareholders and other creditors; and (d) the way in which the structure of a corporation compares to other forms of business organization 3. Summarize the role of corporate governance in managing the business and meeting the duties of different parties under corporate law 4. Explain the ultimate responsibility of the board of directors, specifically (a) the information needed and available to the board; (b) the role of independent directors; (c) the role of committees of the board; (d) the setting and enforcement of company policy; and (e) the linkage to, and role of, internal controls 5. Explain why the board of a financial institution should have a higher standard of care than a general-purpose corporation 6. Identify the stakeholders affected by the corporate governance requirements for different forms of business organization 7. Describe the responsibilities of management to the board of directors and how these can be met 8. Explain how corporate governance can be used as a supervisory tool 9. Explain how corporate governance practices can be inspected 10. Summarize the linkages between other supervisors and regulators in setting and enforcing corporate governance practices. viii

9 Pretest Before studying this module on corporate governance, answer the questions on this page. The questions are designed to help you gauge your existing knowledge of this topic. An answer key is presented in appendix B at the end of the module. Q1 For each of the following questions, circle the responses that are correct. 1. Corporate governance refers to: a. The laws with which corporations must comply b. The way in which companies are directed, managed, and controlled for the benefit of key stakeholders c. The bylaws that a corporation has established d. The way in which meetings of the board of directors are managed. 2. Corporate governance requirements respond to the need to balance potential conflicts between the interests of: a. Investors and the board of directors of the corporation b. Investors and senior management of the corporation c. Investors and customers of the corporation d. The board of directors and senior managementcustomers of the corporation. ix

10 Insurance Supervision Core Curriculum Q1 continued 3. Corporate governance is important to insurance supervisors because: a. Well-governed insurers need no onsite inspection b. When it is performed effectively, the supervisor can rely on the work of senior management and the board of directors c. The board will establish conservative reporting standards with hidden reserves, and this will make financial results more predictable d. Shareholder rights are better protected, and this improves the ability of the insurance company to raise money from investorssecurities supervisors rely on them to protect the shareholders of insurers. 4. With respect to widely held insurance companies, the corporate governance requirements that are set by securities regulators or defined in corporate law meet the needs of insurance supervisors. a. True b. False. 5. Boards of directors establish committees in order to: a. Minimize the conflicts of interest among members of the board b. Review specific matters in detail without taking the time of the full board c. Meet the requirements of applicable corporate governance requirementsmore frequently than is practical for full board meetings and thereby keep in closer touch with senior management d. Relieve some of the liability for directors when faced with decisions that fall outside their area of expertise. 6. Delegation of duties to members of senior management should: a. Be done carefully so that the board has protection from legal liability for decisions made by management b. Be extensive complete so that management is fully able to run the company on a day-to-day basis with little inter ference from the board x

11 ICP 9: Corporate Governance Q1 continued c. Incorporate checks and balances to ensure that the board can have full confidence in the work of management d. Be limited to areas of the business that the board has insufficient time to work on effectively. 7. ICP 9 focuses on the role of corporate governance in protecting the rights of policyholders: a. True b. False. 8. Ultimate responsibility for the accuracy of information provided by an insurance company to its key stakeholders rests with: a. The insurance supervisor b. The securities regulator c. The external auditors d. The board of directors e. Senior management of the company. 9. A well-run insurance company should have independent members of the board of directors because: a. If it is widely held, these directors will protect the rights of minority shareholders b. These directors will facilitate business development, and this will increase the company s profitability c. If they have previous insurance experience, these directors will be able to provide market intelligence to the company d. These directors will stimulate discussion at board meetings and question management on the issues. 10. The insurance supervisor is able to assess the effectiveness of corporate governance through: a. Offsite analysis of regulatory filings, public documents, and news releases from the company b. Regular interviews and discussions with senior management and directors c. Onsite inspection of board minutes, internal audit reports, and discussions with senior management xi

12 Insurance Supervision Core Curriculum Q1 continued d. Onsite inspection of the effectiveness of the company s internal controls e. A combination of both onsite and offsite activities If a foreign insurance company is operating in your jurisdiction through a branch, your supervisory agency should: a. Enforce the same corporate governance requirements on the branch as apply to locally incorporated insurance companies b. Rely on the home supervisor where the company is located to enforce its corporate governance requirements on the branch c. Adapt the corporate governance requirements that apply to locally incorporated companies and places d. Require the branch to establish a board of directors in your jurisdiction. 12. For an insurance company that is owned by a single individual, corporate governance: a. Need not be applied b. Should be applied with the exception that members of the board may all be family members c. Should be applied except that strategic planning for the company should be left entirely to the shareholder since shareholder money is at risk d. Should be applied as it would for a widely held company. 13. Internal controls are important for effective corporate governance because: a. Fraud against the company is more easily caught and dealt with b. Management and the board can be more confident that their decisions are implemented c. Management is better able to control the areas of the business that auditors and actuaries are allowed to access d. Management and the board receive reports summarizing the results of implementing company policyon staffing decisions. xii

13 ICP 9: Corporate Governance Basic-level Module A. Introduction Corporate governance is an important topic for insurance supervisors as evidenced by the fact that one of the 28 insurance core principles (ICP 9) is dedicated entirely to this topic and six others make specific references to the role, composition, and function of the board of directors (see IAIS 2003b). This module focuses primarily on what corporate governance is and why financial sector supervisors are interested in this topic. It shows some of the similarities and differences between the objectives of the capital market regulators and insurance supervisors and illustrates why these regulatory authorities should work together cooperatively. Internal controls are an important tool for implementing decisions made by the board of directors and senior management and, as such, are an extension of the discussion on corporate governance. The importance of internal controls to insurance supervisors is evidenced by the fact that ICP 10 is dedicated to this topic (see IAIS 2003b). Other closely related topics covered by the core principles include suitability of persons (ICP 7), changes in control (ICP 8), onsite inspection (ICP 13), risk assessment and risk management (ICP 18), and information, disclosure, and transparency toward the market (ICP 26). As further evidence of the importance of this topic to insurance supervisors, many of the supervisory standards and guidance papers that have been issued by the International Association of Insurance Supervisors (IAIS) make reference to corporate governance issues (see IAIS 1998a, 2000, 2002a).

14 Insurance Supervision Core Curriculum Concept of corporate governance The concept of corporate governance is widely discussed, and the term is used to describe a range of practices and approaches. In this module, the term is defined as the processes, structures, information, and relationships used for directing and overseeing the management of the institution in the best interest of the institution and key stakeholders with a significant interest in the ongoing viability of the company. It is used in a broad sense so that it covers the interests of financial sector supervisors and policyholders as well as investors. If a more narrow interpretation is intended, this is made clear in the text. Corporate governance is most often thought of in terms of corporate entities. A corporation is a special form of business enterprise that is approved under corporate law or company law. This is distinct from a partnership, personal company, and so forth in that the liabilities of the corporation are limited to the value of the Corporate Governance assets of the corporation. The corporation often has the rights and Corporate governance consists of the processes, structures, information, and responsibilities of a person under relationships used for directing and overseeing the management of the institution the law, although it is a corporate entity. It is a legal person as distinct from a natural person. A cor- in the best interest of the institution and the key stakeholders that have a significant interest in the ongoing viability of the poration has a board of directors that provides oversight and advice company. to management on behalf of key stakeholders. The concept of corporate governance as used here applies to legal entities with a board of directors. The concept is not directly applicable to branches of foreign companies. However, the advanced-level corporate governance module develops some ideas on how supervisors can apply the same basic concepts to the supervision both of branches and of companies. This definition is supported by the requirements of the IAIS core principle on corporate governance, which sets out the powers, rules, and requirements that should be in place for the insurance supervisor to be able to use corporate governance as an effective supervisory tool. According to ICP 9, The corporate governance framework recognizes and protects the rights of all interested parties. The supervisory authority requires compliance with all applicable corporate governance standards. Supervisors need to understand what corporate governance means, why it is an important supervisory topic for inclusion in the core principles, what this principle requires, and how these requirements can be implemented.

15 ICP 9: Corporate Governance Context for corporate governance Corporate governance is a complex interweaving of legislation, regulation, business practices, institutions, traditions, culture, and social values. This complexity has produced different definitions and practices in different parts of the world as to what constitutes good corporate governance (see Iskander and Chamlou 2000 for a discussion of the history and range of practices). Corporate governance focuses on knowledge and behavior and so deals with the processes for sharing information, making decisions, and implementing decisions effectively. Corporate governance is not about power and centralizing power in a few people (for a more complete discussion, see the paper by John Pound in Salmon and others 2000). Good governance is the means of ensuring that there is adequate control over objectives, strategies, controls, and operations within the company. A great deal has been written about corporate governance, including the internationally recognized principles developed by the Organisation for Economic Co-operation and Development (see OECD 1999), and the topic is actively evolving. What is considered to be good corporate governance in a country has changed considerably, largely as a result of reviews undertaken after a large corporate failure in which the failure was a surprise or investors suffered significant losses. For example, consider the failure in 2001 of HIH Insurance Group in Australia (see HIH Royal Commission 2003) or the failure of Enron in the United States in 2002, which produced numerous recommendations for changes in corporate governance practices in the United States and other capital markets. This type of historical development of corporate governance is common in most developed countries. The term corporate governance is most often associated with requirements for the composition, structure, and work of the board of directors so that it can meet its obligation to shareholders in general and minority shareholders in particular. With this definition and its focus on investors, it is easy to understand why a capital market regulator is concerned about companies having sound corporate governance practices. Through these processes, the board ensures that the company is directed and managed in a way that is transparent to and protects the interests of shareholders. By extension, corporate governance as used here relates to meeting the needs of all of the key stakeholders through the practices and work of the board and senior management. By using this more comprehensive definition, we consider why an insurance supervisor presses for good corporate governance, as a key stakeholder working on behalf of the government (to bolster public confidence in the financial system) and on behalf of policyholders and claimants (to protect them from undue loss). The basic concept behind corporate governance is that the board should have sufficient influence on, and control of, the major decisions made by and the operations of the company to control its financial destiny as much as possible. Corporate governance defines the mechanisms for achieving this objective, and an important element of these requirements revolves around the business plan and its use in managing the company.

16 Insurance Supervision Core Curriculum This need to develop and implement business plans is an important part of the role of senior management and the board of any company. Relevance to insurance supervision Two elements of the corporate governance concept make it an important part of effective insurance supervision: Effective corporate governance can improve the confidence that investors have in a company and therefore strengthen the access that a company enjoys to capital and other forms of financing, as and when it might be required. Effective corporate governance strengthens the controls within a company to ensure that the strategies adopted and decisions made by the board, acting on behalf of stakeholders, are implemented effectively. Effective corporate governance allows the supervisor to rely on the work performed by the board of directors and senior management and, in so doing, allows the supervisory process to operate more efficiently and effectively than it could in the absence of such reliance. This reliance relationship must be reviewed from time to time to ensure that the reliance is well founded. 1 It is important for the supervisor to review the corporate governance practices in place in each company to ensure that the specific elements adopted by the company are appropriate for its circumstances. Each company should implement all of the corporate governance requirements. However, more complex companies must have more complex structures and procedures to manage the business and the inherent risks to which the company is exposed. As a result, the process that a supervisor might use to inspect corporate governance and internal controls forms a part of this module. Commonly used terms Before delving into the topic, it is important to define some commonly used terms: Board of directors. This term is used to mean the most senior body in the corporate structure. In some countries, senior management reports to a single board of directors. When there is one board, the term applies to the board. In other countries, a two-tiered system applies, so there is a supervisory board and a management board. 1. The term reliance relationship is used here to describe a relationship between people or groups under which one party depends on the other to perform certain work to prescribed and agreed standards. The party that depends on the other to perform the work is involved in setting the standards for performance or agrees to the standards as reasonable. Once the work is performed, the dependent party reviews the work to determine whether or not it was performed to the agreed standards but does not reproduce the work itself. If the work does satisfy the standards, the dependent party uses the results.

17 ICP 9: Corporate Governance In this case, the term board is used to mean the supervisory board, and members of the management board are referred to as senior management. Corporation. A corporation is a special form of company structure permitted under legislation: the company has limited liability but has the duties and responsibilities of an ordinary person. Closely held company. A closely held company is a business that is owned by shareholders who are few in number or closely associated so that control of the enterprise is focused in a few hands. Widely held company. A widely held company is a business that is owned by shareholders, none of whom owns a sufficient number of shares to exercise control of the company or its board. Q2 For each of the following questions, which responses are correct? Circle your choices. More than one may be valid. 1. Corporate governance refers to: a. The way that companies are directed, managed, and controlled for the benefit of all stakeholders and interested parties b. The structures, processes, and relationships used for directing the affairs of the company c. The framework that insurance supervisors have in place to protect the rights of policyholders d. The centralization of power and control in the company s board of directors. 2. In ICP 9, IAIS has defined: a. All of the corporate governance requirements that insurance companies must follow b. The corporate governance framework that insurance supervisors should have in place to support effective supervision c. The concept of corporate governance to include any rules that may be prescribed by securities regulators d. The concept of corporate governance so that supervisors can look to the board of directors to implement remedial action when necessary. 3. Effective corporate governance: a. Strengthens the confidence that the public places in the insurance sector b. Provides the supervisor with more flexibility in designing its supervisory methodology

18 Insurance Supervision Core Curriculum Q2 continued c. Creates a sound reliance relationship so that the insurance supervisor can rely on the work of the board of directors d. Creates complex structures for complex companies and simple structures for simple companies. 4. Corporate governance requirements for insurance companies can be defined in: a. Insurance companies legislation b. Insurance companies regulations c. Corporate law or the companies act d. Securities legislation and rules. Q3 Answer these questions in relation to the practices in your jurisdiction. If you are working with others on this module, develop the answers through discussion and cooperative work methods. 1. Are insurance companies required to comply with corporate governance requirements in your jurisdiction? What competent body sets these rules? Do these rules apply to all types of insurance companies? 2. What types of insurance enterprises operate in your jurisdiction? a. Locally incorporated companies b. Branches of foreign companies c. Friendly societies or cooperative or mutual insurance companies d. Fraternal benefit societies e. Government-owned companies under special enabling legislation. 3. What types of board structures are permitted in your jurisdiction? a. Single board b. Two-tiered board c. Other. Please describe. 4. What types of insurance corporations are present in your jurisdiction? And how are their boards of directors selected? a. Corporations with exchange-traded shares b. Closely held corporations.

19 ICP 9: Corporate Governance B. Fundamentals of Corporate Governance To understand corporate governance, it is appropriate to start with the role of corporate governance in meeting the needs of investors and securities regulators and then to consider how corporate governance is used by insurance supervisory authorities. Role in investor protection Much of the literature on corporate governance focuses on shareholder protection in general and on the rights of minority shareholders in particular. Providing this type of protection is intended to increase investor confidence and thus foster a more robust capital market. The more confidence that investors have in the marketplace and the companies whose shares are traded in the market, the greater is the likelihood that the market will be an active place for companies to raise capital and investors to buy and sell shares or other securities. Corporate governance emerges out of the need to balance the potential conflict between the investor (the lender of money who is seeking a good return in relation to the risks involved) and the interests of those who control the company (the individuals who decide how that money is used and may be more willing to take risks when using other people s money). When the owner of a company also manages the company, decisions will have to recognize and balance these divergent interests. When more than one shareholder is involved, these relationships become more complex, and a process must be established to oversee the operations of the company and protect the interests of the lenders of capital. The people who run the company are insiders because they have ready access to information about the company and its prospects for the future. 2 The lenders of capital are often outsiders and do not have ready access to this level of information. An important part of corporate governance is disclosure and transparency aimed at balancing the interests of outside investors and the interests of insiders so that the rights of all shareholders are distributed broadly and evenly. Corporate governance is intended to provide this balance so that outside investors are not at a significant disadvantage in relation to insiders. Access to information Investors with a majority shareholder position generally are able to obtain access to information about the performance of the company and its plans for the future. Minority 2. Insiders who also own shares can decide to buy and sell shares using this inside information if no system is in place to balance the interests of insiders and outside investors. Corporate governance is not generally intended to protect outside investors from this risk. However, most securities regulators have rules regarding insider trading. Most corporate governance regimes, however, include elements that minimize the undue influence of insiders on setting strategy and making important decisions that affect the rights of other shareholders.

20 Insurance Supervision Core Curriculum shareholders generally are not treated as insiders because the investment position they hold is small and they may only hold the securities for a short period before trading them. As a result, in the absence of rules protecting the rights of minority shareholders, these investors might not get good-quality information about the company and may be reluctant to make an investment. The possibility of uneven access to information about the company gives rise to many of the requirements and practices which may be defined in corporate law, securities law, or other legally enforceable ways that are fundamental to good corporate governance. Investor confidence One of the objectives of corporate governance is to provide investors Corporate Governance and Investor with the confidence to make informed investment decisions. To Good corporate governance can increase Confidence investor confidence in making investment make an informed decision, investors must have access to infor- decisions. This, in turn, can improve the access of companies to additional working capital, enabling them to improve their mation that allows them to assess the risks to which the investment range of products and services. This can is exposed and the potential for improve company profitability and retained investment gains. This is the basic risk-reward assessment that confidence that the company will meet its earnings, thereby improving policyholder informed investors carry out in promises. matching their own risk tolerance with their desire for a good return on investment. When investor information is distributed more evenly so that majority and minority shareholders have access to the information necessary to make this risk assessment, investor confidence increases, more investors are willing to take a position in the market, and companies have more opportunities to raise capital when needed. Having a wide range of investors making informed decisions contributes to building and maintaining a broad, deep, and diversified market for traded securities. The foundation of deep and broad capital markets is access to investor information: Investors need to have good-quality, reliable information so that they have confidence in making informed decisions. Investors need to understand the financial condition of the company and the impact of planned actions for the future. Investors should have information about the people running the company and how they manage and control the business activities of the company.

21 ICP 9: Corporate Governance Investors need to be confident that they are receiving accurate information in a timely manner. Investors need to be confident that the people who are running the company are doing so in a prudential manner. Internal controls These needs are met through checks and balances at the board level and internal controls at the company level that ensure that the board and senior management are fully aware of what is happening within the company. Having control of the operation of the business is important for the management of all companies and for good corporate governance. If the board or senior management has control of the company, the company is probably using elements of corporate governance. The basic concept is as appropriate for a closely held company as for a Internal Control widely held company. It is as appropriate Internal control is an important tool for a company with only majority shareholders as it is for a company with only used by the board of directors and senior management to ensure that minority shareholders. It is as appropriate for companies that are traded on rec- followed within the company. Know- their decisions are implemented and ognized exchanges as for those that are ing that a company has good internal not publicly traded. The basic need is controls allows the regulator or insurance supervisor to have greater con- for the board and senior management to have control of the company, to have a fidence that the company will be able suitable strategy for directing the operations of the company, to have adequate might be given. to comply with any directives that it information to control the company, and to ensure that appropriate checks and balances are in place so that the board and management have reasonable control of the future potential of the company. The board and senior management control the company through a combination of requirements for how the board operates, for management, and for the flow of information, controls for ensuring the accuracy of information and the implementation of company policy as well as other decisions of the board and management, and practices for managing risks. This range of requirements and processes defines the requirements for corporate governance. It also covers the tools required to make corporate governance effective. These include the individuals who hold senior positions, the size and composition of the board, compensation, the planning processes, and internal controls and audit. 9

22 Insurance Supervision Core Curriculum Figure 1: Checks and Balances in a Well-Run Company Delegation Range of action Authority Limits Tools Company policy Departmental role Job descriptions Business plans Board Senior management Staff Control Monitoring Reporting Review Revision Tools Performance appraisal Audit Variance reports Delegation of duties, with controls The knowledge and experience of members of the board and management are an important part of corporate governance. After all, the board effectively delegates matters to senior management, and senior management carries out the decisions of the board and runs the company on a day-to-day basis. Management, in turn, reports back to the board on its achievements and the progress of the company toward meeting its goals and objectives. The board must have confidence in management for the company to run effectively; for this reason, checks and balances are needed to ensure that the confidence in management is well deserved. 3 Once again, any well-run company would want to have controls in place in order to ensure that the individuals running the company set a direction and strategy and the individuals working for the company do what is expected of them (see figure 1). This process of delegation, review, assessment, and revision is an example of a reliance relationship. Capital market regulators Capital market regulators want to ensure that companies have these controls, checks, and balances in place because they look to the board to protect the interests of investors. Capital market regulators maintain that fair and efficient markets must be transparent. As a result, there are a great deal of rules around what market participants must do in order to keep the investing public informed about the activities and affairs of the company. 3. It is not unusual for the controlling shareholders of a closely held company to have undue influence in selecting senior management, setting strategy, and making important decisions. This influence can work to the disadvantage of other investors. Effective corporate governance minimizes this effect. 10

23 ICP 9: Corporate Governance Shareholder meetings are an important vehicle for providing investors with access to information and exposure to the board and management. This, in turn, contributes to the confidence of investors in how the company is managed. Insurance supervisors Corporate Governance and Confidence of Stakeholders The principles of sound corporate governance contribute to the confidence that all stakeholders place on management and the board to balance their interests with those of other stakeholders. Corporate governance allows the board to provide direction, leadership, and control to the company. Insurance supervisors seek to ensure that companies have good Exemptions from Compliance In many jurisdictions, legal entities are corporate governance practices as active in insurance that are not corporations and are not subject to corporate well. However, that interest is not simply to protect the rights and law. These may be insurance pools or interests of shareholders. After government-owned insurance providers all, the money that investors have established under special legislation. tied up in a company forms at least These entities may be exempted from part of its capital base, 4 and supervisors rely on that base to protect nance or supervisory requirements in the compliance with normal corporate gover- the rights of policyholders in the jurisdiction. event the company fails. Insurance supervisors want to ensure that companies have access to additional capital should that be necessary. They want to have insurance enterprises that are well managed, treat their customers fairly, are in compliance with the legislation and other requirements, and are managed by competent, ethical individuals. In addition, insurance supervisors want to have confidence that any supervisory sanctions, demands, or actions required of the company will be carried out. The principles of sound corporate governance contribute to all of these goals. It is, therefore, not surprising that insurance supervisors expect all companies to practice good corporate governance no matter what the corporate form of the company. Fiduciary duties Many insurance companies have more policyholder money than shareholder money. That is, the size of the policy and claims liabilities (and provisions or reserves) exceeds the amount of assets held as the result of shares and other capital instruments that the company has issued. In deciding to invest in the company, investors are aware 4. Capital is made up of retained earnings and a range of financial instruments that are subordinate to the rights and interests of policyholders and claimants. For a more complete discussion of capital, see IAIS (2002b). 11

24 Insurance Supervision Core Curriculum of the risks and seek information to assess the level of risk and potential rewards. Policyholders rarely recognize the risks involved in dealing with a particular insurance company. Rather, they seek the services of an insurance company to relieve them of unwanted exposure to risk. Since policyholders and shareholders both have money in the company and are at risk in the event of failure, they share a common interest that the company should be run in a prudential, profitable, and sound manner over an extended period. These groups are both interested in corporate governance to protect their interests. However, even though they have some interests in common, board decisions that benefit shareholders may not necessarily benefit customers and vice versa. Within the company, corporate governance must balance the potential conflict between the rights and interests of various stakeholders. 5 For example, a decision by the board may increase the risks to which shareholders are exposed, while reducing the risks to which policyholders are exposed. Investment strategies that seek to meet the long-term commitments to policyholders may not produce attractive short-term results for investors. Corporate governance must recognize, balance, and deal with these potential conflicts. The special relationship between the insurance company and its customers requires an especially high standard of care on the part of company management and the board. In addition, since the business is complex and few customers understand all aspects of the products and services they purchase, the insurance supervisor provides oversight of the industry on behalf of policyholders and the general public. This complex interaction of issues and interested parties makes the topic of corporate governance a challenging one for financial sector supervisors. Given the importance of corporate governance to supervisors, IAIS has prepared clear guidance for insurance supervisors on this topic Balancing the interests of stakeholders is an important function of the board. Some stakeholders have a long-term view, and this may be best met through strategies that focus on prudential, profitable approaches with a focus on the customers, staff, and the expectations of regulators. Other stakeholders have a short-term view, and this may be best met through a strategy that focuses on earnings and shareholder dividends. The need to balance these potentially divergent objectives often requires choices, and in making these choices, the decisionmakers need to understand the business and the issues involved.

25 ICP 9: Corporate Governance Q4 For each of the following questions, which responses are correct? Circle your choices. More than one may be valid. 1. Boards of directors control the flow of information out of the company so that: a. Proprietary information is kept confidential b. The information that is released is accurate c. Key stakeholders will have greater confidence in the company d. The company s profile is kept at a high level to increase sales. 2. Stakeholders need to make informed decisions about the company using information from the company. For example, a. Shareholders need to decide whether to buy, sell, or hold their shares b. Brokers need to decide whether to place business with the company c. Insurance supervisors need to determine if the company is in compliance with legislation and regulations d. Securities regulators need to decide if the company is viable. 3. Internal controls are designed to: a. Help companies identify members of staff who are stealing from the company b. Enforce decisions made by the board c. Ensure that information provided to the board is accurate d. Keep management and the board fully aware of what is happening in the company. 4. When the board of directors delegates duties to senior management: a. The board delegates accountability for the function as well b. The board intends to make it clear that management is fully accountable for decisions made in that area c. The board establishes benchmarks for measuring per formance d. The board intends to test the competence of management. 13

26 Insurance Supervision Core Curriculum Q4 continued 5. A board of directors has a duty to: a. Ensure that all promises made on behalf of the company are met b. Balance the expectations of policyholders and investors c. Invest the assets of the company for the maximum yield d. Ensure that the company is in compliance with all legislation and regulations. Q5 Answer these questions in relation to the practices in your jurisdiction. If you are working with others on this module, develop the answers through discussion and cooperative work methods. 1. What corporate governance requirements have the capital market regulators in your jurisdiction set that apply to insurance companies? 2. Have any of the locally incorporated insurance companies in your jurisdiction recently used the local capital market to raise additional capital? What type or types of financial instruments did they use? 3. For the largest corporate life insurance company in your jurisdiction, what is the ratio of the value of the liabilities related to policyholder obligations to the value of capital provided by investors and shareholders? 14

27 ICP 9: Corporate Governance C. Understanding the Core Principle The meaning of ICP 9 corporate governance should be considered with reference to the detailed wording of the explanatory notes, the essential criteria, and the advanced criteria. The complete text of this core principle is reproduced as appendix I to this module. The core principle itself focuses on the powers and authority that insurance supervisors must have in order to carry out their duties in an effective manner. The principle does not attempt to define corporate governance or provide a detailed list of every element that is required for the concept to be effective within a company. The focus is on the supervisory needs. The first sentence of the principle indicates that the corporate governance framework should protect the rights of all interested parties. These terms should be understood in the context of why an insurance supervisor should focus on these issues and how the principle can be met. The word protect does not mean that supervision will guarantee that the parties will never lose money. Rather, it means that supervision provides a defense against undue loss losses that are surprisingly large under the circumstances. As with any defensive system, the effectiveness cannot be guaranteed, so the test of the supervisory system is not whether there are failures or losses but whether those losses are unduly large. The term all interested parties refers to persons or entities that have a financial interest in the insurance company or are regulators or supervisors with responsibility for oversight of the insurance company. These are policyholders, claimants, investors or other creditors, securities regulators, and insurance supervisors. The second sentence of the principle deals with the need for the insurance supervisor to recognize and require compliance with all of the corporate governance requirements that apply to insurers, including those that may have been set by other competent regulatory authorities. This highlights the need for supervisors to work cooperatively, since each may have expectations and needs that can best be met through good corporate governance. The overall corporate governance regime only makes sense and is effective if insurers have a coherent, cohesive set of rules with which to comply. The explanatory notes In the explanatory notes, the first two sentences in paragraph 9.2 say, The board is the focal point of the corporate governance system and is ultimately accountable and responsible for the performance and conduct of the insurer. Thus the board has direct responsibility for management and oversight of the company. The board can delegate responsibility to full-time staff and executive officers, but this does not absolve the board from its responsibilities. 15

28 Insurance Supervision Core Curriculum The explanatory notes also indicate (in paragraph 9.3) that even in jurisdictions where corporate governance rules apply to all general-purpose corporations, it is necessary to establish additional requirements. This higher standard of care is required because of the board s fiduciary duty to policyholders and its duties to the insurance supervisor. 6 The essential criteria IAIS defines three essential criteria. The first deals with the possibility that insurance supervisors and others could promulgate corporate governance rules and regulations and that insurance companies would have to comply with all of them. The insurance supervisor must, as a result, have authority to verify and enforce compliance with all of these rules and regulations, whether they are defined under insurance legislation or not. This is necessary because only one set of corporate governance rules should apply to any one company, even if they are developed and promulgated by different empowered bodies in a jurisdiction. Therefore, if existing corporate governance rules apply to insurance companies, the insurance supervisor may expand on those rules to include duties for the board and management to meet its own special needs. However, in so doing, the existing rules and the additional rules must complement each other and work together. The second deals with the power and responsibility that falls to the board of directors. The 11 subcriteria in this section deal with the idea that the board has a duty to see that the company is well managed and has sound practices and procedures in place, including processes for ensuring that the company is in compliance with relevant laws and other requirements and that management is competent and fit for their position. These requirements are similar to what one would expect to be in place to protect the rights of investors. However, due to the special nature of the insurance business, these subcriteria include references to oversight of the company s risk management practices and actuarial practices and the need for the board to communicate and meet with the insurance supervisor, as may be required. The third of the essential criteria deals with the responsibility of management. The three subcriteria in this section focus on setting direction for the company, having control of its operations, and providing full and fair reporting to the board. A sound and open working relationship between the board and management is critical to the effectiveness of corporate governance within a company. The flow of information from management to the board is critical to the board s ability to understand the operations of the company The nature of these duties depends on the fact that a large proportion of the assets of the company should be treated as policyholder or claimant money and not as money that can be used at the complete, unfettered discretion of the company.