No. 19 — May 12, 2000


Weekly Review

--- by Jon Choy

After several years of hard work and many trillions of yen, Japanese financial industry policymakers and executives appear to be well on the way to resolving the nonperforming-loan crisis that threatened the nation's banks and banking system. Just as the aftershocks of that debacle were waning, however, observers began to warn of similar problems in Japan's insurance industry. Regulators in the Ministry of Finance and the Financial Supervisory Agency started prodding insurers to address their own weak balance sheets in order to avoid the fate of banks that had not attacked their bad-loan problems aggressively enough.

Despite this jawboning, Daiichi Mutual Fire & Marine Insurance Co., Ltd. became May 1 the first Japanese nonlife insurer to close its doors since the end of World War II. Although several unique aspects of Daiichi Mutual's situation limit the relevance of its failure to the rest of the insurance industry, the collapse provides a clear warning of possible trouble ahead for other insurers regardless of their specialty. Even with the advantages of experience and new regulations, Tokyo could be hard-pressed to prevent a crisis similar to the upheaval in the banking business.

As was the case in the failure of any number of domestic banks large and small, Daiichi Mutual's descent from financial health to insolvency appeared to happen quickly. For the year through March 31, 1999, the Tokyo-based midsize property and casualty insurer posted net premium income of ¥59.7 billion ($542.7 million at ¥110=$1.00) and a pretax profit of ¥1.7 billion ($15.5 million). The company also reported a solvency ratio (total assets divided by total liabilities) of 330 percent, comfortably above the 200 percent level that the FSA considers healthy. Daiichi Mutual officers were ready to report less impressive but still-positive numbers for FY 1999 when regulators intervened.

After investigating the company's finances for three months beginning this past January, the FSA ordered the insurer to recalculate its books using more stringent rules for valuing its stock and outstanding loan portfolios. Daiichi Mutual executives presented their new numbers to FSA auditors April 24, showing greater latent stock portfolio losses, additional bad loans and a solvency ratio of 160 percent. However, even this lower figure exceeded the FSA's own results, which indicated that this measure of financial health had sunk to just 74.7 percent as of April 10. Under its Prompt Corrective Guidelines for insurers, the FSA ordered Daiichi Mutual to prepare a recapitalization and restructuring plan by May 10.

Executives frantically sought to repair the firm's finances, focusing mainly on finding a white knight to inject a significant amount of new capital. The insurer apparently had fallen into such a deep hole, however, that not a single prospect could be found, even for preliminary talks. Representatives told the FSA May 1 that the company had a capital deficit of 160 percent and that they were unable to develop a realistic rescue scenario. Agency officials then ordered Daiichi Mutual to cease most operations in preparation for a government takeover. Outside administrators were appointed so quickly to run the company that not all of Daiichi Mutual's top executives and board of directors had had a chance to submit their resignations.

Led by the head of the Marine and Fire Insurance Association of Japan, the takeover team immediately began pouring over Daiichi Mutual's books. At the same time, a statement was issued designed to calm policyholders and financial markets.

As per the FSA's orders, the company is barred from writing new coverage and from canceling existing policies. Payouts from the latter will be completely guaranteed through March 2001 by the Nonlife Insurance Policy-Holders Protection Corp. of Japan, a fund created by the industry to protect policyholders from any insurer's collapse.

After April 1, 2001, automobile liability and earthquake insurance claims will be paid in full. However, payments on claims for most other types of losses will be cut by 10 percent. Holders of annuity-type property and casualty policies will be guaranteed 90 percent of their principal at the time of the collapse. Interest on these policies will be cut according to Daiichi Mutual's financial situation. If and when the policies are taken over by another insurer, a final decision on reductions in policy values will be made based on changes in the contracts.

Regulators also are exploring whether Daiichi Mutual officials should be prosecuted for breach of fiduciary duty and illegal financial activities. An audit of a subsidiary of a foreign securities company — reportedly Deutsche Securities Ltd. — revealed deals made on behalf of Daiichi Mutual that had allowed the insurer to disguise its stock portfolio losses. Domestic brokerage houses got into hot water in the early 1990s for a similar practice dubbed tobashi (stock "flying"). Subsequent regulatory changes banned this technique, which essentially involves shuffling losses between clients and a broker, with transactions priced at historical book value rather than at current market prices.

The discovery of the questionable transactions between the securities firm and Daiichi Mutual led to the three-month investigation of the insurer's accounting practices and the unwinding of the company's efforts to doctor its books. While Daiichi Mutual executives deny any wrongdoing, observers say that legal action by the government is likely.

While not trying to downplay the gravity of the situation, industry watchers point to two unique aspects of the Daiichi Mutual case that may limit its relevance to insurers in general:

The failure of the midsize insurer did not affect the Japanese stock market, in part because Daiichi Mutual had withdrawn almost entirely from trading in recent months. Market players quickly shrugged off the psychological impact as well, arguing that the company's problems were unique in their severity and in management's inability to deal with them.

What does have observers worried, however, is that Daiichi Mutual might not have been the only insurer to use tobashi-like deals to hide losses. The company's latent stock portfolio losses for FY 1999 totaled somewhere between ¥34 billion and ¥42 billion ($309.1 million and $381.8 million), according to calculations by Daiichi Mutual and the FSA, respectively. If other insurers are using similar ploys to hide losses, then their financial reports also are suspect. A widespread loss of confidence in the industry could subject Japanese insurers to pressures similar to those suffered by their banking counterparts, including higher borrowing costs, customer flight and declines in their stock prices. With the industry already undergoing realignment to cope with deregulation (see JEI Report No. 29A, July 30, 1999), such problems could force other firms to seek Tokyo's help.

One immediate candidate for a lifeline is Kyoei Life Insurance Co., which in FY 1998 signed a ¥30 billion ($272.7 million) mutual capital injection pact with Daiichi Mutual. The midsize life insurer already was struggling with a capital deficiency before its partner's collapse and had been holding discussions with other firms to raise new money. Now, it faces the likelihood that its investment in Daiichi Mutual is worth substantially less than ¥30 billion ($272.7 million), if not zero. Equally troubling, Kyoei Life had a negative spread of ¥70 billion ($636.4 million) between its investment earnings and its obligations at the end of FY 1999 and was armed with capital of only ¥57.5 billion ($522.7 million). Executives have been negotiating the sale of ¥100 billion ($909.1 million) in new stock to Prudential Insurance Co. of America. If those talks fall through and no other company steps up to take Prudential's place, Kyoei Life may be forced to share its ill-starred equity partner's fate.

The outlook for the rehabilitation of Daiichi Mutual is a matter of hot debate. The FSA-installed management team has made it clear that its first priority is to find a buyer for the failed insurer. Under current rules, any such company would have to take over all of Daiichi Mutual's policies. However, most of the losses would have to be borne by Daiichi Mutual policyholders.

Some observers speculate that if the review of Daiichi Mutual's books takes several months, the appointed managers may opt to postpone their search for a buyer until legislation now pending in the Diet comes into force. The revised regulatory framework, which could be in place as early as July, would create more options, including permission to break up Daiichi Mutual's policy portfolio for sale and to seek bankruptcy-court protection while the insurer reorganizes. If this chain of events develops, Daiichi Mutual's actions and regulators' responses will be closely watched as a test case of the effectiveness of the new rules in today's more challenging business environment for insurers. The outcome will be especially relevant for Japan's large number of life insurers, almost all of which also are owned by their policyholders.

The views expressed in this report are those of the author
and do not necessarily represent those of the Japan Economic Institute

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