Case Study on Change in Control

IAIS-ASSAL Training Seminar Lisbon, Portugal, 27-28 April 2006

CASE STUDY ON CHANGE IN CONTROL

Makoto Okubo – Member of Secretariat International Association of Insurance Supervisors (IAIS)

Imagine your group is responsible for the supervision of Merlion Life, which is a life insurance company wholly owned by Merlion Bank and incorporated in country X. One month ago, Merlion Bank finally reached an agreement with Unity Group wherein Unity Group would acquire 100% of Merlion Life.

Based on your preliminary assessment, Unity Group seems to be able to meet your admission criteria However, you should carry out as a supervisor a more in-depth review of the application before putting up the final recommendation to the senior management.

In this case study, your group is expected to :

1) Identify any concerns on the proposed acquisition, in particular, its impact on Merlion Life’s existing policyholders, the ongoing financial strength and any aspects of the proposed business plan. Task 1

2) Propose necessary steps to be taken with respect to the concerns identified. Task 2

3) Interview senior management of Unity Group to raise and clarify any concerns (5-10 min. per each group).

4) Taking the above input into account, please discuss whether or not to approve the application and reasons why. Task 3

5) Make a presentation of your group findings (5 mins per each group)

1 IAIS-ASSAL Training Seminar Lisbon, Portugal, 27-28 April 2006

INTRODUCTION

1 Country X is a country with a population of 7 million. Its main economic activities include manufacturing, commerce and financial services. It suffered a major recession during the financial crisis in 1997 but has since recovered. The government of Country X identified the financial services sector as a key growth area recognizing its competitive advantages of having a world-class infrastructure, reputable legal system and its current role as an important trading hub. 2. The Insurance Department, which is a unit within the integrated supervisory authority, is directly responsible for the supervision of life and general insurance business. The Insurance Act was enacted in late 1980s.

INSURANCE SECTOR OF COUNTRY X

3. Country X has a vibrant insurance sector, with a total of 15 life insurers and 35 non-life insurers. In addition, it has a pool of 15 professional reinsurers and 40 captive insurers, which makes Country X an important regional insurance hub.

Life Insurance

4. Country X has a very high life insurance penetration rate of 85%, with per capita expenditure on life insurance of $3,500. Despite the high penetration, the life insurance industry has grown by 25% p.a. for the last 3 years, boosted by the liberalisation of the personal pension rules that allows life insurance products to be used investment vehicle. The total new business premium written for 2003 was $10 billion (Annual Premium: $4 billion; Single Premium: $6 billion). The industry expects the growth to continue moving forward.

5. Five out of the 15 life insurers are foreign owned, with the rest owned by local conglomerates. The top four insurers control about 80% of the market share. All insurers offer a wide range of participating (with-profits), non-participating and unit-linked products, which include: term insurance, whole life insurance, endowment insurance, private pension plans, health insurance, annuities, various riders

6. These products are distributed primarily via insurers’ tied agency force. In total, there are 20,000 life insurance agents, generating about 80% of total business. Because of the stringent competency requirements and onerous needs-based sales process introduced 3 years ago, the number of agents has dropped by about 33%.

7. Bancassurance (ie selling insurance via bank counters), which was non-existent five years ago, contributes to about 10% of new business last year. Most major retail

banks have started to distribute life insurance policies to generate fee income and provide wide range of financial solutions to their clients. The remaining 10 percent of new business comes from independent brokers.

8. A new risk-based capital framework, which imposes explicit capital charges on asset, liability and mismatch risks, will be introduced beginning of next year. Based on the testing conducted by insurers, the new framework is likely to give rise to higher capital requirements for products with high investment guarantee, and lower capital requirements for protection plans. The move has been generally well received by the industry as it encourages greater discipline in pricing and asset liability management. However, some players, especially the smaller ones, are concerned about the additional work required to cope with the new framework.

Liberalisation of the Insurance Sector

9. Another important development was the liberalisation of the insurance sector announced two years ago, in conjunction with the government’s master policy to grow the financial services sector. Prior to the liberalisation, the only way for a new foreign insurer to gain access is via acquisition of an existing life insurer. Foreign insurer’s shareholding was used to be limited to 35%,.. With the liberalization, foreign insurers can acquire up to 100% of an existing insurer or apply for a new license, subject to meeting the admission criteria.

MERLION LIFE

10. Merlion Life is a wholly owned subsidiary of Merlion Bank, the second largest bank in Country X. Set up in 1978, it is currently the ninth largest in the life insurance market, with a market share of 2.0%. Key product lines are with-profits policies and fully guaranteed annuities. See Annex 1 for more information on Merlion Life

11. Merlion Life’s market share dwindled over the last 5 years due to a combination of following factors:

 Weaknesses in agency force - declining agency force; inability to recruit and retain good agents; more than 25% of the agents are incompetent to sell unit- linked business;  Poor strategic direction – senior management does not have a clear strategic plan; not clear whether it should grow its agency force or to rely more heavily on bancassurance channel; no clear plan on how to switch from selling traditional policies to unit-linked policies; and  Lack of strong parental support – Merlion Bank has not been actively distributing Merlion Life’s products;

12. The financial position of Merlion Life is one of the weakest amongst all life insurers. Although it has recovered from the temporary insolvency during the financial crisis in 1997, the low interest rate environment and poor returns from equity investment over last 5 years have put tremendous strain on its financial strength. The actual investment returns have been far below than what is required to meet guarantees provided in non-participating savings contracts and the current bonus rates of with-profits policies.

13. Merlion Life’s board of directors have responded by freezing dividend to shareholders and cutting bonus (dividends) to the with-profits policyholders twice over the last 5 years. The bonus cuts have given rise to complaints from many policyholders for failing to meet their expectations.

14. To address the regulator’s concern about its financial strength, the board managed to obtain a guarantee from its parent, Merlion Bank, which requires the bank to inject additional capital into Merlion Life to make good any capital shortfall.

15. The board of Merlion Bank has not been comfortable with its investment in Merlion Life, which is one of its major subsidiaries. In its group wide strategic review 2 years ago that focused on the potential divestment of non-core business entities, Merlion Bank concluded that it should fully divest its holdings in Merlion Life.

16. Merlion Bank has also been under pressure for not being able to capitalize on its large client base to sell life insurance products, compared to other banks in Country X. It did recognise the ability to provide a complete range of financial services products, including life insurance products, to its banking clients as an important strategy moving forward.

17. One month ago, Merlion Bank finally reached an agreement with Unity Group wherein Unity Group would acquire 100% of Merlion Life.

UNITY GROUP

18. Unity Group is an international financial services group, with an insurance operation that ranks the 10th largest in the world. Apart from its core activity which is insurance business, the Group also has asset management, property and banking businesses. Unity Group is given AA for its long-term credit rating by S&P. It is listed in the stock exchange in Country Y.

19. Unity Group has a successful bancassurance model. Nearly 50% of its business was distributed by the banks, 30% were distributed by independent financial advisers and 20% were by employed sales intermediaries.

20. The Group has decided to focus on life insurance business and has disposed of a number of non-life insurance businesses. Currently, the life insurance business comprises 70% of its total insurance business. The Group does not have any insurance business in Asia.

APPLICATION BY UNITY GROUP

21. Unity Group has submitted an application to acquire 100% shares of Merlion Life from Merlion Bank. It intends to rename the company as Unity Merlion (UM) Insurance.

22. Unity Group also sees this as an important step to expand its operations in the region, which it considers to be the key growth area for the coming decades. It intends to use Country X as its regional base to coordinate all its group’s activities in the region.

23. Some key highlights of Unity’s business plan are as follows:

Distribution  Unity intends to sell away the existing agency force of Merlion Life to other insurer or broking firm, so that it can concentrate fully on bancassurance channel and avoid any potential channel conflicts  Unity will enter into an eight-year exclusive arrangement with Merlion bank so that Merlion Bank can only sell life insurance products of Unity. Unity will make an upfront payment of $100 million to Merlion Bank for the distribution right. In addition, there will be yearly adjustment in the form of profit sharing if Merlion Bank meets agreed sales target, or claw back of a percentage of upfront payment if Merlion Bank fails to meet the target.  Unity Group will be providing support services to Merlion Bank’s sales force. These support services will be paid for by UM Insurance but the staff will be based in the bank’s premises. These services will include training of sales staff and compliance with regulations.  Unity may explore working with a select number of independent insurance brokers

Products  Unity intends to discontinue the sale of participating policies, which is currently Merlion Life’s largest product line. It thinks that participating policies are too complex for the bank channel; they do not meet its internal profit criteria (given the 90/10 restriction in profit allocation); and participating policies introduce high market conduct risk, especially given the recent rounds of bonus cuts  It intends to adopt a product strategy that focuses on profitability and meeting customers needs:

o Savings & investment products – unit-linked, non-participating policies, both single premium & regular premium o Protection products – term policies (especially mortgage related), critical illness policies (covering cancer, stroke & heart attack), and health insurance

Management  Unity intends to bring a new senior management team from its head office, including, new CEO, CFO, Appointed Actuary, Chief Marketing Officer and Chief Distribution Officer  Unity also intends to outsource the fund management of the insurance fund assets to its sister fund management company, Unity AMC, which has an operation in Country X  However it intends to retain most of middle management and staff of Merlion Life.

Business Projections  Unity expects business volume to increase by several folds within three years via the bancassurance channel

See Annex 2 for more information on the proposed business plan

24. Unity Group proposed that the shareholding in Merlion Life be held in a company, Unity International Pte Ltd, established in an offshore financial centre, Jurisdiction Z. This company was set up to hold all its overseas entities. Unity International Pte Ltd is 75% owned by Insurance Company of Country Y and 25% owned by Southern Land Insurance Corporation. Both owners were also holding companies set up for tax purposes. Unity International Pte Ltd has a paid-up capital of $200,000.

25. Unity Group highlighted in the business plan that Unity International Pte Ltd will merely act as a holding company. Unity Merlion will report a regional office in Country X, which will in turn report directly to Unity International Insurance Holdings. More information on the organization structure is given in Annex 2.

26. The home regulator of Unity Group in Country Y is a reputable integrated financial regulator. Unity Group has obtained the approval from its home regulator to acquire Merlion Life.

Annex 1: Information on Merlion Life

Table 1.1: Financial Highlights 2002 (actual) 2003 (actual) 2004 (pro forma) Profit after Tax -$20m -$40m -$5m Total Asset $1,005m $1,040m $1,088m Net Asset (Surplus) Paid-up capital $50m $50m $50m Retained profit $85m $45m $40m Required Capital (Solvency margin) $74m $76m $80m

Table 1.2: Business Statistics 2002 (actual) 2003 (actual) 2004 (pro forma) New Business Participating: Single Premium $18m $18m $11m Regular Premium $7m $7m $4m Non-participating: Single Premium $8m $8m $5m Regular Premium $4m $4m $2.5m Unit-linked Single Premium $2.5m $3.2m $2.2m Regular Premium $0.5m $0.8m $0.3m Total $40m $35m $25m Inforce Business Participating: Total Asset $700m $750m $780m No of policies 65,000 69,000 72,000 Non-participating: Total Asset $150m $170m $190m No of policies 15,000 18,000 21,000 Unit-linked: Total Asset $20m $22m $25m No of policies 1,900 2,200 2,800 Agency force (number) New Recruit 50 35 15 Termination 85 95 105 Total 550 490 400

Annex 2: Information on Unity (Unity’s Business Plan for UM Insurance)

Table 2.1: Projected New Business - 2005 to 2007 2004 (proforma) 2005 2006 2007 New Business Participating: Single Premium $11m - - - Regular Premium $4m - - - Non-participating: Single Premium $5m $20m $30m $40m Regular Premium $2.5m $7.5m $10m $15m Unit-linked Single Premium $2.2m $60m $90m $120m Regular Premium $0.3m $12.5m $20m $25m Total $25m $100m $150m $200m

Table 2.2: Extract of Projected P&L and Balance Sheet 2004 (proforma) 2005 2006 2007 Premium Revenue $55m $130m $200m $270m Management Expense $20m $35m $37m $39m Profit after Tax -$5m $20m $30m $40m

Total Asset $1,088m $1,200m $1,350m $1,510m Net Asset (Surplus) Paid-up capital $50m $50m $50m $50m Retained profit $40m $60m $90m $130m Required Capital (Solvency $80m $83m $85m $89m margin)

Annex 2: Information on Unity (Organisation Chart) Unity plc

Unity International Insurance Holdings Ltd

1% 99% Unity Insurance Unity Insurance Unity Properties Unity Bank UniAsia Insurance Company of Holdings Ltd Company Ltd Ltd Regional Pte Ltd Northhaven

Unity Financial 75% Holdings Ltd Southern Land Unity International Insurance Corporation Pte Ltd 25% Unity Asset 100% Management Limited UM Insurance Pte Ltd (Previously known as “Merlion Life Pte Ltd”) Unity Fund Management Limited

Annex 3: Relevant Regulations

The governing law in Country X with respect to insurance business is the Insurance Act 1980 which is administered by the Insurance Department.

Licensing Under the legislation, any insurer that wishes to carry on insurance business in Country X needs to obtain a licence from the Insurance Department.

Change of Control Any person that wishes to obtain effective control of any insurer incorporated in Country X needs the prior approval of the Insurance Department. A person shall be regarded as obtaining effective control of a licensed insurer by virtue of an agreement if the person alone or acting together with any associate or associates would, if the agreement is carried out — (i) acquire or hold, directly or indirectly, 20% or more of the issued share capital of the insurer; or (ii) control, directly or indirectly, 20% or more of the voting power of the insurer;

In addition, any person that wishes to obtain substantial control of any insurer incorporated in Country X also needs the prior approval of the Insurance Department. A substantial shareholder, in relation to an insurer, means a person who holds 5% or more of the voting power of the insurer.

Appointment of Key Persons Any person that wishes to be a member of the Board of Directors, a Chief Executive Officer or an Appointed Actuary needs to be fit and proper. He must be a person of integrity and be competent and must not be an undischarged bankrupt. He must also complete a prescribed application form giving information about his qualifications, experience, professional standing and financial situation. Prior approval from the Insurance Department is necessary under the Insurance Act.

Consumer Protection The Insurance Act regulates insurance intermediaries such as agents and brokers. Brokers are required to obtain licences from the Insurance Department while agents are regulated indirectly through the insurers.

Banks typically act as agents of the insurers. Therefore, the insurer will be held for the misconduct of the bank and the bank staff.

Products The Insurance Act requires the insurers to obtain the approval from the Insurance Department prior to the launch of any life insurance products. The Appointed Actuary needs to set the premium rates for life insurance products.

For non-life insurance products, the premium rates are not regulated.

Participating Fund The Insurance Act restricts the transfer to shareholders from participating fund to 1/9th of the bonuses/dividends allocated to participating policyholders.

The Insurance Act requires any allocation of bonus/dividend to participating policyholders to be approved by the board of directors of the insurer taking into account a written recommendation by the appointed actuary of the insurer.

In making the bonus/dividend recommendation, the appointed actuary should have regard to:

a) fairness and equity among different participating policies b) the impact on financial conditions of the participating fund

Annex 4: Admission criteria for new insurers

The applicant for new licence will be assessed based on the following  Track record in insurance business or financial services  Good reputation  Good domestic and international rankings  Good present and past credit ratings

In assessing the application, the Insurance Department also assesses the viability of business model/plan so as to minimize the risks of exit by insurers after a short period of time which may affect policyholders adversely.

This case study was originally developed by Monetary Authority of Singapore (MAS) and modified by the IAIS to be used in regional seminars.