Japan s Insurance Market

Transcription

1 Japan s Insurance Market The Toa Reinsurance Company, Limited

2 Japan s Insurance Market 2009 Contents Page To Our Clients Hiroshi Fukushima President and Chief Executive, The Toa Reinsurance Company, Limited 1 1. Trends in Japanese Non-Life Insurance Industry and Business Strategy of NIPPONKOA Insurance Group Makoto Hyodo President and Chief Executive Officer, NIPPONKOA Insurance Co., Ltd Analysis of Long-Term Efficiency Gains and Evaluation of Large-Scale Consolidation in Japan s Non-Life Insurance Industry Hideya Kubo Professor, Graduate School of Economics, Shiga University 8 3. The Insurance Market in 2009: Changing Channels and Markets Hideki Ishii Insurance Journalist and Editor Inswatch A Review of Today s Japanese Non-Life Reinsurance Market Edward Fenton Managing Director, Asia Pacific, Guy Carpenter & Company, LLC Trends in Japan s Non-Life Insurance Industry Underwriting & Planning Department The Toa Reinsurance Company, Limited Trends in Japan s Life Insurance Industry Life Underwriting & Planning Department The Toa Reinsurance Company, Limited 36 Supplemental Data : Results of Japanese listed non-life insurance companies for fiscal 2008, ended March 31, 2009 (Non-Consolidated Basis) The Toa Reinsurance Company, Limited. All rights reserved. The contents may be reproduced only with the written permission of The Toa Reinsurance Company, Limited.

3 To Our Clients It gives me great pleasure to have the opportunity to welcome you to our 2009 brochure, Japan s Insurance Market It is encouraging to know that over the years our brochures have been well received even beyond our own industry s boundaries as a source of useful, up-to-date information about Japan s insurance market, as well as contributing to a wider interest in and understanding of our domestic market. During fiscal 2008, the year ended March 31, 2009, the Japanese economy rapidly deteriorated as the global financial crisis and turmoil in foreign exchange markets infected the real economy, as indicated by sharp declines in exports and production and the adverse impact on corporate earnings and the labor market. In the non-life insurance industry in Japan, sluggish automobile sales and declines in exports and imports reflecting the economic downturn led to lower premium income from motor insurance and marine insurance, resulting in an overall decline in premium income. In the life insurance industry in Japan, both the numbers of new contracts and in-force contracts declined from the previous year, affected by the economic downturn coupled with the aging society and a low birth rate. In the reinsurance market, many reinsurance companies experienced significant deterioration of their business results and financial positions owing to turmoil in financial markets. The operating environment of the Toa Re Group is expected to remain harsh in view of social and economic changes around the world, structural changes in the insurance industry, and the trend of the international regulatory environment for reinsurance. In order to respond to these changes in the business environment in a timely and effective manner, and to achieve sustainable growth of the Toa Re Group, we recognize that the provision of high added value to our customers and the reinforcement of risk management and other internal control systems throughout the Group are important issues. With the aim of promoting the development of the entire Group and enhancing our corporate value, we have formulated a new medium-term management plan, Crescendo 2011, covering the three-year period from fiscal 2009 to 2011 and founded on three core elements, namely Customer/Income, Management and Corporate Social Responsibility (CSR). By endeavoring to act as an exemplary reinsurance company, we are resolved to fulfill our mission: Providing Peace of Mind. In conclusion, I hope that our brochure will provide a greater insight into the Japanese insurance market and I would like to express my gratitude to all who kindly contributed so much time and effort towards its making. Hiroshi Fukushima President and Chief Executive, The Toa Reinsurance Company, Limited 1

4 Trends in Japanese Non-Life Insurance Industry and Business Strategy of NIPPONKOA Insurance Group 1.Makoto Hyodo President and Chief Executive Officer, NIPPONKOA Insurance Co., Ltd. Introduction The past two to three years have been a time of great change for Japanese non-life insurance industry, for several reasons. First, the first revision of the Insurance Law in nearly 100 years was promulgated in Currently, the non-life insurance industry is conducting various preparations for the enforcement of the law. Second, the economic environment surrounding the non-life insurance industry is changing rapidly. Similar to the global economy, Japanese economy is experiencing the kind of once-in-a century financial crisis. Since autumn 2008, stock prices have remained at low levels, numerous manufacturers have been forced to reduce production, and consumer sentiment for consumption has been poor. Premium income has continued to trend downward at non-life insurance companies, and they have been required to strengthen their financial foundation based on appropriate risk management. Japanese non-life insurance industry experienced several major problems involving the very foundation of the insurance business, including incidental unpaid insurance claims, inappropriate non-payment of third-sector products, and incorrect setting of premiums for fire insurance and other products. Over the past several years, the non-life insurance industry investigated the detailed causes of these problems and then revised business processes from the ground up and formulated countermeasures to make sure that they would not recur. Today, companies are working to raise the quality of their operations by implementing measures to preclude recurrence. I would like to cover trends in Japanese non-life insurance industry as it faces these major changes, and then explain the business strategy of NIPPONKOA Insurance Group. 1. Trends in Japanese Non-Life Insurance Industry (1) Revision of the Insurance Law The first revision of the Insurance Law in nearly 100 years was promulgated in June The main objectives of the revision are to adapt the rules of insurance contracts to the needs of modern society, and to revise the content of the law from the perspective of protecting policyholders. Currently, non-life insurance companies are executing initiatives such as revising insurance products to conform to the new Insurance Law, restructuring the system in terms of the insurance claims payment, and revising forms for canvassing and claims payment as they prepare for the enforcement of the new law. 2

5 The Toa Reinsurance Company, Limited Japan s Insurance Market 2009 (2) Overview of Results in the Non-Life Insurance Industry The scale of premium income in Japanese non-life insurance market ranks fourth following the United States, Germany and the United Kingdom. However, difficult economic conditions have caused the reduction of premium income for the past two years. According to aggregate performance data for its 26 member companies prepared by The General Insurance Association of Japan (GIAJ), for the nine months ended December 31, 2008, net premium income decreased by 3.5 percent, or billion, compared with the same period of a year earlier to 5,435.9 billion due to factors including reduced premium rates for Compulsory Automobile Liability Insurance and lower motor insurance premium income. Moreover, net claims paid increased by 1.1 percent, or 37.0 billion, compared with the same period of a year earlier to 3,258.9 billion due to an increase in claims paid on personal accident insurance and casualty insurance. The situations appear likely to remain difficult. The decrease in motor insurance, a mainstay product, is due to the decline in the number of vehicles sold. Moreover, fire insurance has failed to increase because of the decline in the number of housing starts. As you are aware, the result of non-life insurance industry correlate closely with the real economy. At its meeting in London in April 2009, the Group of 20 (G-20) announced economic stimulus packages totaling $5 trillion by the end of 2010 with the goal of a 4 percent economic growth rate. The Japanese government as well has devised and implemented various measures to counter the economic crisis. These policies are certainly expected to generate growth trajectories for the global economy and the Japanese economy. However, we, the non-life insurance industry, are not just passively looking at economic trends. Non-life insurance is able to deal with a variety of risks. Nonlife insurance companies can provide brand-new products to respond to the new risks that are arising because of various changes in consumer lifestyles and the activities of corporations. Actually, there is an expanding range of products, such as corporate liability insurance. Moreover, the rising age of society is also expected to broaden the scope for insurance products. (3) Initiatives to Enhance the Quality of Operations I became the chairman of GIAJ on June 30, The occurrence of problems in the non-life insurance industry created opportunities for GIAJ to formulate various measures to enhance the quality of operations. GIAJ is now in the process of promoting efforts to improve their practicality. Moreover, GIAJ is employing a plan-do-check-act cycle centered on the perspective of consumers voices to formulate and enforce the improvements of measures if needed to further improve the quality of operations. An overview of specific initiatives are as follows. 3

6 1. Trends in Japanese Non-Life Insurance Industry and Business Strategy of NIPPONKOA Insurance Group Holding an Advisory Panel to Listen to Consumers Voices The Advisory Panel to Listen to Consumers Voices was established to sincerely listen to consumer opinions so that the industry as a whole can reflect them in operations management. More than half of the panel s members are influential people from outside the industry, and their opinions will lead to measures to improve the quality of operations in various ways. Establishment of Various Guidelines GIAJ has established various guidelines such as canvassing, claims payment, insurance policy provisions and sales literature. Member companies are working to improve the quality of operations based on these guidelines. Enhancing the Quality of Non-Life Insurance Agents and Solicitors Non-life insurance solicitors are the primary point of direct contact with consumers. GIAJ has introduced the qualification renewal system for non-life insurance solicitors and an insurance product learning system in working to enhance the quality of non-life insurance solicitors. Strengthening Consultation and Complaint Resolution Systems GIAJ is strengthening consultation and complaint resolution systems to properly acknowledge the opinions of customers and use them in operational reforms. At present, Japanese financial industry is setting up a new framework for alternative dispute resolution (ADR), and GIAJ is also promoting required standards based on these movements. (4) Trends among Specific Companies in the Non-Life Insurance Industry NIPPONKOA Insurance Co., Ltd. and SOMPO JAPAN INSURANCE INC. have reached an agreement to establish a joint holding company for business integration in April In addition, the three companies of Mitsui Sumitomo Insurance Co., Ltd., Aioi Insurance Co., Ltd. and Nissay Dowa General Insurance Co., Ltd. have announced an agreement to commence discussions toward a business combination and business alliance under a holding company structure in April Japanese non-life insurance industry experienced a period of consolidation from 2001 to These two business integrations are a much more significant development than that. 4

7 The Toa Reinsurance Company, Limited Japan s Insurance Market Business Strategy of NIPPONKOA Insurance Group (1) Results of NIPPONKOA Insurance For the nine months ended December 31, 2008, at NIPPONKOA Insurance net premium income decreased by 4.6 percent, or 24.3 billion, compared with the same period of a year earlier to billion, due to factors including reduced premium rates for Compulsory Automobile Liability Insurance. This ranked fifth in Japanese non-life insurance industry. Net claims paid decreased by 3.3 percent, or 10.3 billion, to billion. For the nine months ended December 31, 2008, the seven listed companies among GIAJ members recognized revaluation loss on securities totaling approximately 500 billion due to factors including the substantial decrease in the value of their securities portfolios, and net loss for the seven companies totaled 19.5 billion. Among the seven companies, NIPPONKOA Insurance s revaluation loss was relatively low, and we recorded net income of 19.8 billion. (2) Medium-Term Management Plan of NIPPONKOA Insurance Group NIPPONKOA Insurance has formulated a medium-term management plan for fiscal 2009 throughout NIPPONKOA Insurance Group is acutely aware of the public responsibility of the insurance industry and aims to contribute to society under the premise of substantial management. The medium-term management plan, as explained below, basically entails executing the three main strategies of contributing to society, raising quality and increasing earnings in working to increase corporate value. Contributing to Society We will conduct all of our corporate activities to respond to social issues such as environmental protection. In addition, we will also contribute broadly to society by working to respond to social demands. Our main activities are as follows. Carbon Neutral Declaration We will achieve zero emissions of CO2 by reducing CO2 emissions by 15 percent or more compared to the level of fiscal 2006 by fiscal 2012, and by purchasing carbon credits to offset the portion of emissions that are difficult to reduce. Eco First Commitment NIPPONKOA Insurance is the first company in the insurance industry to be certified as an Eco-First Company under the Eco-First System established by the Ministry of the Environment of Japan. We have made the Eco-First Commitment to the Minister of the Environment to undertake initiatives includ- 5

8 1. Trends in Japanese Non-Life Insurance Industry and Business Strategy of NIPPONKOA Insurance Group ing the reduction of CO2 emissions. NIPPONKOA Insurance is using the character ECORaTTa to represent these environmental activities, and widely publicizes NIPPONKOA s initiatives. Raising Quality As detailed below, we are raising quality throughout our operations, from product development to sales and claims payment, to provide customers with safety and security. ECORaTTa The Highest Quality of Claims Handling We have implemented a system for rapid response to accidents 24 hours a day, 365 days a year. In addition, we aim to provide the highest level of service in ways such as promoting the use of environmentally sound parts when repairing vehicles that have been in an accident. Raising Sales Quality We aim to improve the quality of individual solicitors by conducting efficient and effective education and training. Raising Product and Administrative Quality We are developing simple, easily understood products in ways such as consolidating products or endorsements, and using plain and clear language for policy conditions. Moreover, we are upgrading our information technology base to simplify and standardize the contract procedures and improve administrative quality. Increasing Earnings We will increase corporate value by balancing allocation of Group profit generated through the measures to increase earnings between providing returns to all our stakeholders and investing in growth areas. Main initiatives are as follows. Measures to Strengthen Underwriting and Loss Prevention We are strengthening underwriting and moving to prevent or alleviate losses. Improving the Profitability of Business Units We will work to improve profitability by grouping existing businesses in units defined by products or sales channels and employing unique management indicators to thoroughly analyze, formulate and execute concrete plans for improving profitability. Raising Operating Efficiency We aim to reduce operating risk and achieve low-cost operations by raising operating efficiency. 6

9 The Toa Reinsurance Company, Limited Japan s Insurance Market 2009 (3) Business Integration of NIPPONKOA Insurance and SOMPO JAPAN INSURANCE NIPPONKOA Insurance and SOMPO JAPAN INSURANCE have agreed to establish a joint holding company for business integration in April 2010 for a new solution service group with the aim to provide customers with security and service of the highest quality and contributes to social welfare. The new group aims to make all value judgements from the perspective of customers and aims for enhancement of corporate value and contribution to social welfare, by maximizing synergy effects by way of such measures as standardization and sharing of functions and services. Within the joint holding company, NIPPONKOA Insurance and SOMPO JAPAN INSURANCE will diligently use the strengths of the existing brands and sales channels of each company. At the same time, they will work to achieve economies of scale by sharing IT systems and other resources to reduce the burden of cost centers with the aim of enhancing competitiveness. Conclusion In Japanese non-life insurance industry, deregulation from 1996 liberalized premiums on insurance products in the retail field, which had been uniform throughout the industry up to that time. This engendered competition in the areas of product development and premiums. Moreover, successive business integrations and mergers took place with the primary aim of increasing scale. Subsequently, as discussed earlier some major problems arose, however, over the past two to three years the insurance industry has dealt with them. Moreover, non-life insurance companies have restructured the way they do business from the ground up, from headquarters to front-line sales and claims branches. As a result, our industry has entered a new phase in which companies compete on the basis of the quality of operations. Non-life insurance companies have changed their corporate cultures so that they are better able to listen sincerely to customer opinions than they were in the past. This has created the chance to discuss the risks surrounding customer thoroughly as well as to find links to new business opportunities. In other words, nonlife insurance is fulfilling its responsibility to provide customers with security, which is enabling the industry to develop further. 7

10 Analysis of Long-Term Efficiency Gains and Evaluation of Large-Scale Consolidation in Japan s Non-Life Insurance Industry 2.Hideya Kubo Professor, Graduate School of Economics, Shiga University 1. Market Changes Due to Complete Liberalization of Insurance Rates Japan s non-life insurance industry generated stable, consistent growth without price competition under the rating system of Property and Casualty Insurance Rating Organization of Japan, which was established in Even during the deflation of Japan s bubble economy during the 1990s, in contrast to the negative spread of Japan s life insurance industry, where actual investment returns were below projected investment returns, the non-life insurance industry was only marginally affected by the issues of nonperforming loans, since its products, such as motor, fire and other types of insurance (excluding saving-type insurance), are of shorter duration, and the scale of its assets was only about one-fifth that of the life insurance industry. In addition, major revisions to the Insurance Business Law to 1) ensure the soundness of insurance companies; 2) promote the deregulation of insurance; and 3) ensure fair business operations, took effect in April Along with the revised Law Concerning Non-Life Insurance Rating Organizations (the Rating Organization Law ), these revisions served to promote deregulation, but the scope of liberalization of insurance rates was small at first. However, conditions dramatically changed as a result of the Japanese version of Big Bang that the cabinet of Prime Minister Ryutaro Hashimoto began promoting in November The U.S.-Japan Insurance Talks, which had previously made little headway, reached their policy conclusions, and consequently the Rating Organization s compulsory rates based on the Rating Organization Law were abolished. Property and Casualty Insurance Rating Organization of Japan issued regulated rates based on the Law Concerning Non-Life Insurance Rating Organizations of 1948, and it initially provided suggested rates based on its statistical data. However, a 1951 revision to the Rating Organization Law ended suggested rates in favor of compulsory rates, and these regulated rates remained in effect for the next 45 years. As a result of the U.S.-Japan Insurance Agreement in December 1996, the compulsory Rating Organization rates were abolished (Note 1) and regulations were maintained in the third sector. The Financial Reform Law of June 1998 and the revision of the Rating Organization Law of July 1998 also liberalized insurance rates. The liberalization of interest rates, which symbolized financial liberalization in Japan, began in the 1970s. It took approximately 20 years until the 1994 liberalization of interest rates on liquid deposits. In contrast, non-life insurance rates for all main fire, personal accident and motor insurance products were liberalized over a period of three years from 1995, when the revision of the Rating Organization Law rendered the banded rate reporting unnecessary, and advisory rates were introduced for fire insurance for industrial risks. The Rating Organization reportedly set the expected loss ratio (net premium component) lower, and set the additional rate component (premium accretion component) higher. Reductions in this larger accretion rate component have accelerated as a result of liberalization. In general, price liberalization and other aspects of deregulation draw an increased number of new market participants offering new products and services, 8

11 The Toa Reinsurance Company, Limited Japan s Insurance Market 2009 with a concomitant decrease in the market share of companies already in the market. Beginning in 1996, non-life insurance subsidiaries of life insurance companies and companies from other industries successively entered the market, which increased the number of non-life insurance companies doing business in Japan from 23 in 1993 to a peak of 34 in However, many of the new participants were unable to keep up with the high pace of rate liberalization, and became engulfed in a trend toward consolidation, mainly with existing non-life insurance companies. The non-life insurance market was strongly affected by the liberalization of the price of main products over a short period. Graph 1 shows long-term changes in Japan s non-life insurance market over the past 30 years or so. This time frame is broadly divided into three periods. The first period includes the era of stable growth under regulation and the growth of the bubble in the 1980s. The second period includes the protracted period of low growth in the 1990s as the bubble deflated. The third period includes the period of deregulation beginning in 1999 when premiums were completely liberalized. First, let s consider market change from the perspective of market consolidation as measured by the Herfindahl Index (HI). Here, the HI is calculated using direct premium income, which constitutes revenues for typical companies, and core earnings. Core earnings are calculated by subtracting one-time gains and losses from asset sales; valuation gains and losses; and foreign exchange gains and losses from ordinary income as reported on the income statement, and reflecting provisions to and reversals of the catastrophe loss reserve. In other words, this calculation expresses the primary income for a non-life insurance company. Prior to rate liberalization in fiscal 1998, both versions of the HI are uneventful and show little variation. They clearly show a market structure with little change in share, which is typical of a regulated industry. The HI using direct premium income (the graph with the solid line) stays at about At the peak of the bubble, when 9

12 2. Analysis of Long-Term Efficiency Gains and Evaluation of Large-Scale Consolidation in Japan s Non-Life Insurance Industry market concentration was generally considered to be low, the HI does not change (direct premium income increased 8 percent annually in 1989 and 1990). Incidentally, with the advent of the second period, the HI using direct premium income does not change, but the HI using core earnings (the graph with the dashed line) gradually rises. The profitability differential between companies widens, and the bar graph shows that among non-life insurance companies core earnings per unit of business expenses including personnel, non-personnel, and operating expenses decreased by half from about 0.2 to nearly 0.1. The non-life insurance industry took no drastic action to address decreasing profitability up to the complete liberalization of rates in The HI begins to change substantially in the third period. Admittedly, there were numerous extraordinary factors including 1) the occurrence of E. coli O157 food poisoning in 2001 that resulted in provisions to the reserve for outstanding losses (ordinary profit for the industry as a whole decreased billion); 2) a 7.0 percent increase in direct premium income (transitional revenue) as a result of the abolishment of government reinsurance of Compulsory Automobile Liability Insurance in fiscal 2002; and 3) the impact of a string of typhoons in fiscal 2004 (claims paid increased 16.1 percent compared with the previous fiscal year because of Typhoons 16 (Chaba), 18 (Songda) and 23 (Tokage)). Nevertheless, their influence on industry concentration could be considered neutral. The HI rose mainly because of the following two points. First, a flight to quality was evident among consumers in their swift reaction to the order to suspend operations given to The Daiichi Mutual Fire and Marine Insurance Company in May 2000 and the petition for corporate rehabilitation filed by The Taisei Fire and Marine Insurance Company, Limited in November Subsequently, competition intensified as a result of rate liberalization and largescale consolidation took place among existing insurance companies. Features unique to the non-life insurance industry also influenced the progress of large-scale consolidation. In general, deregulation attracts new entrants to a market, and the HI falls. However, the non-life insurance industry requires a large initial investment and the period until new entrants become profitable is long, which serves to limit market entry. Moreover, the non-life insurance industry provides similar products, and so the liberalization of premiums on main products put pressure on companies with weaker sales capabilities to reduce fixed expenses more substantially than the industries in general. Added to the longstanding horizontal structure of the industry, these factors led numerous companies toward consolidation. Domestic non-life insurance companies shortly aggregated into six groups. The HI using premium income from direct underwriting rose to the 0.15 level in fiscal 2004 from the 0.09 level in fiscal While factors such as the widely varying outcomes of industry consolidation, market concentration as evidenced by revenues accelerated, resulted in pronounced variation along a rising trend line in the HI using core earnings. 10

13 The Toa Reinsurance Company, Limited Japan s Insurance Market Analysis of Efficiency Using Stochastic Frontier Production Functions (1) Frontier Production Functions as an Indicator of Insurance Company Efficiency The large-scale reorganization of Japan s non-life insurance industry has greatly influenced the efficiency of each company in the industry. Careful consideration is required to determine if conventional financial indicators such as the growth rate of ordinary profit and the ratio of operating income to revenue are viable for measuring the efficiency of non-life insurance companies. For example, the disposal of real estate used for operations and the integration of computer systems during an analogous period of large-scale industry reorganization would increase earnings by reducing depreciation expenses but would have little impact on cash flow. In addition, in many cases a corporation that consolidates factories and sells real estate it owns as a result of mergers and acquisitions generally increases return on assets (ROA) and return on equity (ROE; ROA multiplied by leverage). However, a majority of the assets of nonlife insurance companies are managed in underwriting reserves as financial resources for the payment of future claims. The types of insurance products sold determine how a company will fund these reserves, and the level of underwriting risk varies among insurance companies. Consequently, ROA lacks validity as an evaluation tool. Low ROE due to low leverage does not necessarily equate to inefficiency because soundness of an insurance company is more important than for corporations in general. Insurance company efficiency therefore requires a different approach to measurement. In general, corporations are independent economic entities that produce using resources such as capital, technology, human resources and raw materials. Output is determined by the type and volume of inputs and the firm s efficiency. The production function is a simplified relationship between outputs and inputs, and is suitable for measuring the efficiency of non-life insurance companies. The following expresses the production function: Output = f (input a [e.g., capital], input b [e.g., labor], input c [e.g., overhead]... ) However, many of the firms in the current competitive market are inefficient. Therefore, setting the production function of the most efficient firms as F yields the following production function for all other firms: Output = F (input a, input b, input c.) + Inefficiency Moreover, the function should include a margin of error to reflect the use of estimates. Therefore, the function becomes the following: Output = F (input a, input b, input c.) + Inefficiency + Margin of error Various assumptions are available for function F. However, the Cobb-Douglas production function with its highly stable parameters is used here because it is simplest. Moreover, the inefficiency component assumes a half-normal distribution, and the margin of error assumes a normal distribution. The parameters expressing inefficiency are then estimated using the maximum-likelihood method. This methodology for estimating efficiency is known as a stochastic frontier production function (Note 2). The algorithm for this function is detailed in The Restructuring Strategies of Japanese Life and Non-Life Insurance Groups (2008)(Note 3). 11

14 2. Analysis of Long-Term Efficiency Gains and Evaluation of Large-Scale Consolidation in Japan s Non-Life Insurance Industry For productivity derived from the frontier production function, the efficiency of the subject firm is measured by the degree to which it deviates from the line calculated for the most efficient production of goods given capital and labor inputs. Consequently, the higher the number, the higher the productivity. With goods produced as a dependent variable for the production function, the estimates here have five components: 1) direct premium income as a proxy for the total turnover of a typical corporation; 2) ordinary income as reported on the income statement; 3) core earnings that exclude extraordinary gains and losses related to capital from ordinary income and reflect the increase or decrease in the catastrophe loss reserve; 4) core earnings including depreciation (cash flow); and 5) the sum of core earnings and business expenses to represent added value under the concept of gross profit. On the other hand, the independent variable for the production function involves inputs of capital stock and labor, which are defined as follows. Capital stock is net depreciation expense as reported by each company in the statement of depreciation and amortization in its financial statements for the most recently ended fiscal year. For those insurance companies that do not report net depreciation expense in a statement of depreciation and amortization, capital stock is calculated by discounting reported depreciation expense by the average depreciation rate for the industry. Labor inputs consist of 1) total expenses for both sales and internal administrative personnel; and 2) related business expenses other than personnel expenses. Sales personnel expense is the total of agency commissions and brokerage and customer acquisition costs (fees associated with direct sales). Internal administrative personnel expense is personnel expense as detailed in the income statement. The analysis covers direct insurance companies operating in Japan. Reinsurance companies and foreign non-life insurance companies with branches in Tokyo are excluded. The sources for the data are Insurance: The Statistics of Japanese Non-Life Insurance Business and the financial reporting issued by each company. For fiscal 2007, capital stock accounted for 20.4 percent of total input and personnel expenses (the total of sales and internal administrative personnel expenses as per 1) above) accounted for 79.6 percent. In further details, sales personnel expenses accounted for 48.1 percent, and internal administrative personnel expenses accounted for 31.4 percent. With the inclusion in labor input of related business expenses other than personnel expenses as per 2) above, capital stock accounted for 15.7 percent of total input and labor accounted for 84.3 percent, of which sales personnel expenses accounted for 37.0 percent. In all cases, sales channel expenses represent 40 to 50 percent of input cost, and the operation of the exclusive agency channel stands out as a major component of the cost structure. Moreover, the 48.1 percent share of sales personnel expenses in total input for fiscal 2007 mentioned above has increased by 10 percentage points from 37.8 percent in 1991, for two reasons. One, assuming commission-based compensation, commission payments to agencies should decrease if sales decrease, but in reality commissions are structured so that they do not fall in direct proportion to a decrease in performance. In fiscal 1991, premium income totaled 6.5 per 1.0 of sales personnel expense, but in fiscal 2007 had fallen to 5.9. Two, capital has decreased as a 12

15 The Toa Reinsurance Company, Limited Japan s Insurance Market 2009 result of consolidation. The ratio of capital stock to total input was 32.9 percent in fiscal 1998 prior to the liberalization of premiums, but had decreased by 12.4 percentage points to 20.5 percent in fiscal This reflected the rapid pace of reduction in assets such as owned real estate as a result of large-scale consolidation. In other words, the strategy of non-life insurance companies was to compensate for reduced labor productivity by increasing capital productivity. Incidentally, capital accounts for about 40 percent of total input in the life insurance industry, which would indicate that Japan s non-life insurance industry is more labor intensive than the life insurance industry. Panel data including cross-sections of annual insurance company data bundled with a time series is used to ensure the stability of the function when using estimates. The estimate period is the 17 years from fiscal 1991 through fiscal As a result, each estimate can be based on up to 458 samples. One sample requires extraction and synthesis of 55 data points from the financial statements of each company. Table 1 presents the result of estimates for each production function. The t-value of the good produced, which is the dependent variable in the estimate equations, is high (in any case, significant at the 1 percent level). The capital and labor parameters are also valid numbers. Table 1: Parameters for Frontier Production Functions for Japanese Non-Life Insurance Companies, FY1991 to FY2007 Good produced Parameter Direct premium income Ordinary profit Core earnings t-value Standard error Parameter t-value Standard error Parameter t-value Standard error Constant Capital Labor Sample, LI , , , Cash flow* Added value Good produced Standard Standard Parameter t-value error Parameter t-value error Constant Capital Labor Sample, LI , , Note 1: LI = log likelihood Note 2: *Capital cost (capital replacement cost: depreciation rate + interest rate) may be used in place of capital stock, and labor input reflects other business expenses. 13

16 2. Analysis of Long-Term Efficiency Gains and Evaluation of Large-Scale Consolidation in Japan s Non-Life Insurance Industry 3. Changes in the Operating Efficiency of the Non-Life Insurance Industry Let s consider the impact that deregulation had on the efficiency of the non-life insurance industry as indicated by the application of this production function. Graph 2 represents data for which this function is applied to calculate cash flow from fiscal 1991 to fiscal 2007 (core earnings + depreciation), ordinary profit and direct premium income to elucidate efficiency for the industry as a whole. Efficiency prior to liberalization (fiscal 1991-fiscal 1998) is significantly different from efficiency after liberalization (fiscal 1999-fiscal 2007). In the economic and financial environment of the 1990s, Japan s industry was subject to challenging deflationary pressure due to factors such as the anemic 0.9 percent average annual increase in the corporate price index. Efficiency as measured by premium income from direct underwriting premium income among non-life insurance companies (line graph) decreased continuously from 0.63 to On the other hand, two efficiency indicators related to profitability held steady at approximately 0.7. Corporate initiatives supported this efficiency, and regulated premiums also supported the profitability of each company. In contrast, however, the soundness of an insurance company is more important than for corporations in general, and changed significantly following deregulation in fiscal Moreover, this period is characterized by the divergence of cash flow efficiency and ordinary profit efficiency. Ordinary profit stands for the profit after employing one-time asset sales and other means to compensate for factors such as large fluctuations in operating income and loss and losses associated with asset management. As a result, insurance companies with sufficient strength were able to restrain fluctuations in ordinary profit. For example, actual cash flow and ordinary profit in fiscal 2004 differed by approximately 350 billion, mainly because of compensatory moves using the following two financial resources. The first was reversals 14

17 The Toa Reinsurance Company, Limited Japan s Insurance Market 2009 of the catastrophe loss reserve that had been set aside for major disasters. For fiscal 2004, companies that conducted reversals brought the industry total to approximately 154 billion, as estimated from changes in the balance of catastrophe loss reserves. The second financial resource was sales of investment securities. Compared with fiscal 2005, the loss on sales of securities and loss on revaluation of securities for fiscal 2004 was about 14 billion greater, but the gain on sales of investment securities was about 120 billion greater. This positive difference of approximately 100 billion was the factor that stabilized ordinary profit. From fiscal 1999, fluctuations in ordinary income efficiency show that insurance companies were only drawing down reserves created through financial statement manipulation as the revenue environment became increasingly challenging. The full-scale consolidation that began in fiscal 2001 to respond to these conditions made a substantial contribution to the increase in the efficiency of direct premium income (line graph). Consequently, evidenced by the black bar graph, cash flow efficiency recovered even though price competition had caused it to fall. Here, efforts to reduce costs among companies that had both merged and reduced cost of capital contributed substantially. However, the result was that cash flow efficiency peaked in fiscal Efficiency of Individual Insurance Companies and the Effect of Consolidation The next topic is the cash flow efficiency of individual companies. Graph 3 shows all individual insurance companies with positive cash flow (317 samples) from fiscal 1991 to fiscal Cash flow efficiency is on the vertical axis, and all corresponding log figures are plotted on the horizontal axis using the same scale. In general, cash flow efficiency increases as the level of cash flow increases. The distribution curve 15

18 2. Analysis of Long-Term Efficiency Gains and Evaluation of Large-Scale Consolidation in Japan s Non-Life Insurance Industry (line graph) is expressed as Log (cash flow efficiency) = x Log (same scale) The value of elasticity for the same efficiency on the same scale is Therefore, the scaled earnings for the non-life insurance industry can be observed. Furthermore, as the dashed lines in the graph show, the scale of the distribution allows the data to be divided between medium-sized companies (dashed line 1) and large companies (dashed line 2). The slope of line 1 is steep, and therefore shows that improvement in earnings efficiency is closely linked to expansion in scale in the group of medium-sized insurance companies. Thus it shows that consolidation is a better means of improving earnings efficiency for medium-sized companies than for large companies. The next topic is further detailed measurement of changes in efficiency as a result of this consolidation. The analysis focuses on the six companies that emerged from 15 companies that were involved in large-scale consolidation. Consolidations were conducted by Tokio Marine & Nichido Fire Insurance Co., Ltd. (a merger between Tokio Marine and Nichido) in October 2004; Mitsui Sumitomo Insurance Co., Ltd. (a merger of Mitsui Marine & Fire Insurance Co., Ltd., The Sumitomo Marine & Fire Insurance Co., Ltd. and Mitsui Life Insurance Co., Ltd., with the transfer to the new company of the entire non-life policy portfolio of Mitsui Life in November 2003) in October 2001; Sompo Japan Insurance Inc. (a merger between Yasuda Fire & Marine Insurance Company and Nissan Fire & Marine Insurance, with Taisei Fire and Marine Insurance Co., Ltd. merging with Sompo Japan in December 2002) in July The analysis also covers the medium-sized non-life insurance company NIPPONKOA Insurance Co., Ltd. (a merger of The Nippon Fire & Marine Insurance Co., Ltd., The Koa Fire & Marine Insurance Co., Ltd. and The Taiyo Fire & Marine Insurance Co., Ltd. with the latter merging with NIPPONKOA in April 2002); Aioi Insurance Co., Ltd. (an April 2001 merger between The Dai-Tokyo Fire & Marine Insurance Co., Ltd. and The Chiyoda Fire & Marine Insurance Co., Ltd.); and Nissay Dowa General Insurance Co., Ltd. (an April 2001 merger between The Dowa Fire and Marine Insurance Co., Ltd., and Nissay General Insurance Co., Ltd.). Table 2 shows cash flow efficiency prior to and following corporate consolidation over the 17 years from fiscal 1991 to fiscal Estimated data is panel data bundled with a time series including cross-section data by specific company and fiscal year. Consequently, the efficiency shown by the frontier production function incorporates differences in the market environment during each fiscal year. The difference in the market environment must be removed for continuous comparison and observation of the efficiency of companies after consolidation and each company prior to consolidation. Consequently, the companies included in the overall scale of the non-life insurance industry are treated as a single company. The five types of efficiency mentioned earlier are then examined, and averages over the same period of fiscal 1991 to fiscal 2007 are used as the standard deflator. Next, differences in the market environment are removed from the efficiency of each company and fiscal year using the deflator. The method is the way that public 16

19 The Toa Reinsurance Company, Limited Japan s Insurance Market 2009 economic data are used, and are adjusted to nominal prices to present the data in real terms for comparability. Table 2 shows the result of using nominal prices to present efficiency in real terms. Table 2: Changes in Cash Flow Efficiency Due to Consolidation in the Non-Life Insurance Industry Group Average Company 1 before Consolidation Company 2 before Consolidation Company 3 before Consolidation Companies after Consolidation Note 1: The figures showing efficiency are actual figures with differences in performance in each fiscal year eliminated using the deflator. Note 2: Figures are simple averages of actual numbers for each fiscal year from fiscal 1991 to fiscal Therefore, the figures do not reflect changes in the scale of companies. Table 2 shows average figures for cash flow efficiency for the companies that make up the groups prior to consolidation from fiscal 1991 to the year prior to consolidation, and the equivalent figures for the year in which consolidation took place up to fiscal For example, in Group 1 efficiency of and for the two companies prior to consolidation is shown to rise to after consolidation. For Groups 1 through 3, the efficiency of each company after consolidation generally rises compared to efficiency prior to consolidation. In contrast, efficiency after consolidation drops substantially for the companies in Groups 4 through 6. This shows that the progress of consolidation exerted a significant impact on efficiency. In Groups 1 through 3, large companies consolidated. In Groups 4 through 6, medium-sized companies consolidated. Therefore, while consolidation includes numerous elements, scale is clearly the most significant. Each company successively disclosed in fiscal 2008 that they would work to increase scale in their subsequent management plans, and the figures in Table 2 show the rationality of that approach. Conclusion Pricing in Japan s non-life insurance industry was regulated for nearly half a century beginning in Liberalization took only three years, and completely liberalized insurance rates. The effects of deregulation were substantial, and market concentration changed rapidly. Moreover, large-scale consolidation emerged as a means of enhancing competitiveness, and it effectively increased the efficiency of insurance companies by at least fiscal However, price competition among main products became more severe than expected and introduced a challenging revenue environment, resulting in significant variation in the effect of consolidation. Substantial differentiation among products 17

20 2. Analysis of Long-Term Efficiency Gains and Evaluation of Large-Scale Consolidation in Japan s Non-Life Insurance Industry and services is difficult in the non-life insurance industry, which suggests that the future will bring more consolidation with the objective of maximizing scale. Thus stochastic frontier production functions for analyzing efficiency are effective for analyzing long-term changes in the market and studying the relative effectiveness of management strategies. Looking forward, the use of improved production function models will offer worthwhile suggestions for risk management by each company and supervision of soundness by the Financial Services Agency. Notes 1. From July 1, 2002, Property and Casualty Insurance Rating Organization of Japan became the Non- Life Insurance Rating Organization of Japan (NLIRO), and its primary functions became calculating appropriate reference loss cost rates and standard full rates through high-precision analysis of insurance statistics and reporting them to the Minister of the Financial Services Agency. The reference loss cost rate is calculated for fire, personal accident, motor and nursing care expense insurance, and the standard full rate is calculated for Compulsory Automobile Liability Insurance and earthquake insurance. In other words, NLIRO assumed the functions of calculating insurance rates and serving as an industry databank. 2. Analysis using frontier functions primarily entails production functions and cost functions. Estimation methods are classified as data envelopment analysis (DEA) or parametric analysis through the use of linear programming. Moreover, the latter are classified as deterministic functions or stochastic functions. This paper uses parametric stochastic functions, otherwise known as stochastic frontier production functions. 3. Hideya Kubo The Restructuring Strategies of Japanese Life and Non-Life Insurance Groups. Journal of Insurance Science 601 (June):