Regulation: government intervention and harmonization

How do governments intervene?

Why do governments intervene?

Why do we need harmonization?

Harmonization

• Why is it important?

• Liberalization, harmonization and deregulation

• Arguments for

• Arguments against

• Recent experiences of harmonization

Why harmonize?

• Cross border trade has grown much faster than the growth of GDP (and trade growth causes GDP growth)

• Cross border borrowing and lending has grown even faster

• Thus, regulatory harmonization has become a necessity

• Unilateral changes causes turmoil

Underlying causes

• Economic convergence taking place across borders– Convergence is taking place at times with the

blessings of the respective governments but at other times against government wishes

• Governments are actively pursuing policies of harmonization– This has been more out of necessity than out of

foresight

Implication

• Capital mobility implies that much of borrowing and lending can be accomplished without any regard to national boundaries-borrowing in California can be financed in Hong Kong

• Technology has made communication cheaper across the world which has enhanced the process of internationalization

Lowering fences

• GATT rounds have done much to lower fences on cross border movement of goods and capital (however, it has not done so for cross border movement of labor)

• Some countries have unilaterally reduced tariffs, followed prudent macroeconomic policies and had success in stimulating economic growth and reducing inflation

Political trends

• More and more independent nations are joining world organizations such as the UN and the IMF (for example, China)

• US economic and political power has been diminishing since the end of World War II

• Centrally planned economies are falling apart and they have all adopted capitalist systems

International versus domestic

• If fences are high, we can distinguish between domestic and foreign policies

• Domestic: competition, product standard, worker’s safety, regulation and supervision of financial institutions, environment etc.

• Foreign: tariffs and quotas and other cross border issues

• With integration new issues: behind border

Examples

• Talks between Mexico and US next month include the following

• Drug issues in the US

• Illegal immigration to US

• Democracy in Mexico

• Pollution in Mexico

• Behind the border policies are discussed between countries!

Why?

• There are externalities

• Externality: When the action of one party affects another outside markets

• Example: Severe recession in Mexico due to a macroeconomic downturn may increase illegal immigration to the US

• Example: Default of international loans in Mexico may trigger bank failure in US

Environmental issues

• Should developing countries be forced to adopt environmental standards of developed countries?

• Problem: Now developed countries while developing had bad environmental record

• Problem: Difficult to force any country to adopt a particular environmental standard

• Problem: Cheap production possible with pollution and competitive issues

Diminishing national autonomy

• Setting domestic monetary and fiscal policies have international impact

• Example: German reunification had costs throughout Europe

• Bad economic policies lead to movement of capital out of country

• Example: Best known Swedish/Japanese companies produce more outside!

New issues

• Good externality: research and development

• Bad externality: pollution

• Both kinds of externalities flow across national boundaries

• Without coordination between countries, there will be too few good externalities and too many bad externalities

Conflicting values

• Human rights issues in China or Peru affects their discussions with US

• US talks with Japan about the use of timber products imported into Japan from Indonesia or Brazil

• Environmentalist proposals to ban tuna import from countries that use driftnets

Liberalization

• Types of liberalization

• Most favored nation (MFN) means trade concessions extended to one country are extended to all trading partners

• Reciprocity: Give and take between countries

Harmonization

• Making laws identical

• de jure: mirror image laws

• de facto: laws are similar in substance

• complete harmonization

• minimum harmonization

Deregulation and liberalization

• Deregulation: reduction in national regulation

• Liberalization: market opening

• Typically they go together

• It is possible to have domestic deregulation without allowing for foreign entry

Why harmonize?

• Regulatory diversity magnifies market failure or impede liberalization

• Harmonization reduces transaction costs

• If financial services are insulated then diverging rules do not pose problems

• If financial services are global, then they they will suffer from domestic regulations

Arguments against harmonization

• Differing regulatory philosophies would bring in more innovation and competition

• Risk of getting it wrong

• There is more risk of fraud when national boundaries are removed

• Insurance is about security, therefore less regulation may not be attractive

Harmonization: wrong level

• Government driven harmonization can create problems of harmonization at the wrong level: example qwerty keyboard

• Create barriers: example setting capital requirement too high/low

• Consumer protection

• Definitional issues: all countries do not have identical accounting procedures

Harmonization in insurance versus harmonization in banks

• Cross border harmonization rules are much more common in banks than in insurance companies. Why?

• Banks “create” money, therefore, banking crisis has a contagion effect

• Systematic risk is much higher in banks than in insurance companies

Recent experiences

• The only body that deals with some insurance harmonization issues is the International Association of Insurance Supervisors (IAIA)

• Formed in 1993 with 50 governments

• Most are developed countries

European Union

• Reinsurance Directive: 1964• First Non-life Directive: 1973• First Life Directive: 1979• EC White Paper: 1985 minimum harmonization

principle– prudential standards– technical reserve calculations– asset valuation– sovlency

EU experience

• Third Directive (Life and Non-life) 1992– intended for complete freedom and single

market in insurance

• Objective: Create a single integrated market for all financial services

• Has it succeeded?

• Emerging trends

OECD

• Code of Liberalization of Capital Movements• Code of Liberalization of Current Invisible

Operations• Production by foreign companies is typically

forbidden• Distribution may or may not be allowed• Subsidiary, foreign equity are favored

Government role: regulation

• Why regulate?

• Quality

• Affordability

• Availability

• Reliability

• Development: promoting domestic insurance industry

Types of regulation

• Liberal: UK, Chile, Hong Kong• Regulated: Germany, Japan, Korea• Mostly in between• Evolution:

– Socialized (no private)– National (no foreign)– Protected/transitional– Liberal

Mechanism of regulation

• Licensing of insurer/reinsurer• licensing of agents and brokers• filing and approving insurance rates• filling and approving materials and forms• financial reporting requirements• liquidity of insurers• guaranty funds• product and company taxation

Types of regulation

• EU: through directives

• Japan: through the Ministry of Finance– Department of Banking Bureau– Convoy principle (price competition

prohibited)– Insolvency prevented– Volatility minimized– Excessive competition is discouraged

Types of regulation

• US: 1945 McCarran Ferguson Act– Each state determines admittance, forms and

reserve requirements– regulatory rates– Rules vary

• Nation-wide body: National Association of Insurance Commissioners (NAIC) coordinates regulatory matters across states

India and China

• India– Started in 1818 by Oriental Life– Indian Life Assurance Company Act 1912 was

the first statutory measure to regulate life insurance business in India

– Insurance Act 1938 was the first comprehensive Act to regulate insurance

– Amendment of 1950 imposed stricter control

India

• 1956: 156 Indian insurers, 16 foreign and 75 mutual societies were selling life insurance in India

• Life Insurance Corporation Act of 1956, nationalized all of them and formed a monopoly

• To date, it is still a monopoly

India

• Thus, it is not always the case that over time we have all countries are moving to deregulation

• Note also that non-life business was not nationalized at the same time

• In 1973, General Insurance Corporation (GIC) Act was passed and non-life business was also nationalized

China

• Before 1949, there were 205 insurance companies operating in China

• After the revolution, life insurance was banned

• In early 1980s, People’s Insurance Company of China (PICC) was formed

• Rates were not actuarially set by PICC

China

• Banking system is non-existent in rural area

• Life insurance provides an avenue for saving

• PICC is forming global alliance through Hong Kong

• New competition but they need to reinsure at least 30% with PICC

China

• Only foreign company allowed to write domestic policies is AIG

• It started as a joint venture between PICC and AIG, China American Insurance Company, with the intention to write China’s exposure outside of China itself in 1980.

• Then, in April 1991, PICC formed another joint venture with AIG.

AIG

– AIG received a license to operate a life and a non-life business in Shanghai

– It has a license to underwrite property and casualty risks in the Shanghai area.

– It could also offer life and savings products, effectively throughout China

– It currently writes comprehensive business insurance coverages ranging from Property to Marine, from Casualty to Financial Services for both Joint-Venture and foreign-funded comp

AIG

– The Life operations sells life,personal accident and employee benefits insurance to the population of Shanghai

– Operation has been profitable– It could use old ties– It had the first mover advantages– Competition from PICC– Repatriation is a problem