Reports on Observance of Standards and
1. An assessment of Estonia's observance of and consistency with relevant international standards and core principles in the financial sector, was undertaken under the auspices of the Bank-Fund Financial Sector Assessment Program (FSAP). This has helped to place the standards assessments in a broader institutional and macroprudential context, and identify the extent to which the supervisory and regulatory framework has been adequate to address the potential risks in the financial system. The assessment has also provided a source of good practices in financial regulation and supervision in various areas.
2. The assessment covered (i) the Basel Core Principles for Effective Banking Supervision; (ii) the International Association of Insurance Supervisors' (IAIS) Supervisory Principles; (iii) the International Organization of Securities Commissions' (IOSCO) Objectives and Principles of Securities Regulation; (iv) the Committee on Payment and Settlement Systems' (CPSS) Draft Core Principles for Systemically Important Payment Systems; and (v) the IMF's Code of Good Practices on Transparency in Monetary and Financial Policies. This comprehensive coverage of standards was carried out at the request of the Estonian authorities, in light of the rapid development of the financial sector, including nonbank financial institutions. It should be noted that some of the standards are still in draft form, and some do not yet have a complete methodology to systematically assess compliance or consistency.1
3. The assessment of standards and codes draws on the self-assessments by the Estonian authorities and on field work undertaken by a joint IMF-World Bank mission which visited Estonia during February 1–11, and February 29–March 14, 2000. The assessments were based on a peer review process by Stefan Niessner (Deutsche Bundesbank), M. Srinivasan (Reserve Bank of India) and Richard Abrams (IMF) on the Basel Core Principles, Martin Halvorsen (Kredittilsynet, Norway) on the IAIS Insurance Supervisory Principles, Melinda Roth Alexandrowicz (World Bank) on the IOSCO Objectives and Principles of Securities Regulation, and Charlie Garrigues (World Bank) on the Draft CPSS Core Principles for Systemically Important Payment Systems. Jingqing Chai (IMF) prepared the Code of Good Practices on Transparency in Monetary and Financial Policies, with inputs from the sectoral experts. The expert team was coordinated by the IMF-World Bank FSAP mission led by Alexander Fleming (World Bank, mission chief) and Richard Abrams (IMF, deputy mission chief).
4. The assessment, which was based on information available through March 2000, showed that Estonia has made great strides in strengthening its supervisory framework. Progress has been particularly strong in the area of banking supervision. Supervision of insurance firms is also improving, although some concerns remain. On the other hand, oversight in the securities sector is weak. While the payment system itself is viewed as relatively strong, payment system oversight could be improved.
5. The findings regarding transparency practices were quite favorable. No significant weaknesses were identified with respect to either monetary policy or the deposit guarantee scheme, while the shortcomings in banking and insurance supervision and on the payment system were relatively minor. Transparency practices in securities supervision were assessed as somewhat weaker than the others, although the flaws were not serious.
C. Background and Overview
6. The insurance sector in Estonia is just beginning to develop, and does not yet appear to pose a systemic risk for the financial sector as a whole. Total assets in the sector were EEK 1.6 billion, equivalent to approximately 3.7 percent of banking assets as of September 1999. At end-1999 there were 14 insurance companies (eight nonlife and six life companies), ten of which were directly or indirectly owned by foreign companies. The sector has exhibited signs of weakness, including low profitability and a number of bankruptcies. In 1999, three companies failed as a result of a combination of problems following the Russian crisis, irregular intragroup transactions, and fraud. In addition, three nonlife companies and five life insurance companies registered losses. A further two companies failed in early 2000.
7. The Insurance Supervisory Authority (ISA) is a member of the International Association of Insurance Supervisors (IAIS). The assessment was conducted on the basis of an examination of all relevant statutory and regulatory documents, including the Insurance Law (IL) and all amendments; the Instructions to Determine Solvency of Insurance Companies; the Regulation on Accounting and Reporting of Insurance Companies; and the Charter of the ISA. A new draft Insurance Law has been presented to Parliament, and has had its first reading. The new law contains major improvements over the present law. The assessors discussed the legal powers of the ISA and the supervisory practices with the Head of the ISA and senior members of her management team. Discussions were also held with the MOF, the Director of the Association of Insurance Companies, the Head of the Accounting Board, representatives of several insurance companies, and a major auditing firm.
D. Main Findings
8. The IAIS Insurance Supervisory Principles cover 17 key issues, which are assessed under 14 headings. The requirements relating to monitoring and on-site supervision have been assessed together with on-site inspection and access to information. Similarly, the requirements regarding coordination and cooperation have been assessed jointly.
9. The conclusion is that of the 14 assessed principles, Estonia fully observes three principles; does not observe one principle; and partially observes ten principles. Efforts are under way to secure improvements in most of the areas identified as weaknesses.
Principle 1: Licensing
The basic legal framework is contained in the IL (Articles 31, 32, 34, 35). The IL has no explicit requirements regarding information on the suitability of owners in the process of licensing. The proposed IL (§§ 12, 32) has explicit requirements in this respect. The proposed IL requires information on shareholders that own more than 10 percent of voting shares. For example, if a person has caused the bankruptcy of another company or has managed a company in such a way that creditors and clients have not been sufficiently protected, that person is not allowed to be in possession of more than 10 percent of the voting shares (§ 32). The IL will not cover institutions engaged in public security operations in relation to mandatory insurance lines, insurance societies, or other insurance-related mutual benefit associations (Article 26).
Assessment:Broadly observed. The existing IL has no explicit requirements regarding information on suitability of owners in the process of licensing. The proposed new IL contains some explicit requirements.
Principle 2: Changes in control
10. The IL has no requirement to notify the ISA prior to a change of control. The proposed IL (§ 32) requires that a person who intends to acquire a qualifying holding, or to increase a qualifying holding—so that the proportion of the share capital or votes held by the person exceeds 20, 33 or 50 percent or more—is required to seek prior approval from the ISA. The proposed IL (§ 33) describes certain circumstances that may lead to the withdrawal by ISA of the permission.
Assessment: Not observed. There is no notification requirement for a change of control under the current IL. The proposed new IL requires that a person who intends to acquire a qualifying holding or increase a qualifying holding be required to apply to the ISA for a corresponding permit beforehand.
Principle 3: Corporate governance
11. Issues of corporate governance affecting all corporate entities are adequately covered in the Commercial Code. However, the proposed IL will cover these issues in greater detail in relation to insurance companies. The proposed IL (§ 24) lists various reasons for which a person would be excluded from being elected to the board of directors or the supervisory board of an insurance company (for example, the involvement in bankruptcy of another company or insufficient protection of interests of previous shareholders and creditors of another company). According to the proposed IL, insurers are required to notify the ISA of the election, appointment, or resignation of the members of the management board and supervisory board, the auditor, and the responsible actuary. The proposed IL also provides a legal basis for the ISA to remove members of management boards and supervisory boards of insurers.
Assessment: Fully observed.
Principle 4: Internal control
12. The ISA has the authority to review the internal controls that the board of directors and management approve and apply, and may require that such controls be strengthened, through on-site inspections. However, regulations are needed requiring the establishment of internal rules to regulate the activities of the managers and employees and an independent internal audit unit that has to report any violation immediately.
13. The proposed IL (§ 45) requires that insurers establish internal rules to regulate the activities of the managers and employees to ensure observance with legislation regulating the activities of the insurer and with resolutions of the directing bodies. The new law will also require that an insurer form an independent internal audit unit to monitor all the activities of the insurer and its observance with legislation and best practice. The staff members performing internal audits are required to communicate immediately to the supervisory board and management board of the insurer, as well as to the ISA, any information that indicates a violation of law or which may affect adversely the interest of policyholders and the insured.
Assessment:Broadly observed. Full observance of the principle would be achieved through the proposed new IL, which requires the establishment of internal rules to regulate the activities of the managers and employees and an independent internal audit unit which has to report any violation immediately.
Principle 5: Assets
14. The technical provisions regarding committed assets are based on the relevant EU directives. However, neither the IL nor the proposed IL prescribes general restrictions on the use of financial instruments as laid out in the EU's third directives on nonlife and life insurance (Article 22). The basis for evaluating assets in financial reports is adequately detailed in the regulation issued by the MOF on Accounting and Reporting of Insurance Companies.
Assessment:Broadly observed. However, restrictions on the use of derivatives should be established, e.g., as in the EU's third directives on life and nonlife insurance, Article 22.
Principle 6: Liabilities
15. The IL has general requirements dealing with technical reserves in nonlife and life insurance companies (Article 46). The ISA has issued guidelines for the calculation of technical provisions in nonlife insurers (Decree of January 12, 1998). The guidelines define models and formulas to be used to calculate provisions for unearned premiums, provisions for outstanding claims, equalization provisions (in credit insurance), unexpired risk provisions, and provisions for annuities. Provisions for outstanding claims are to be calculated for all final and estimated charges related to insurance occurrences before the date of calculation of the provision, including incurred, but not reported claims and claim-handling expenses. Provision for unexpired risk must be calculated in classes of insurance where probability of insurance occurrence decreases in a nonlinear way over time due to seasonal fluctuation of the loss ratio. Provisions for annuities are calculated for personal lines of insurance where in case of insurance occurrences payments at regular intervals are made to individual persons. For life insurance companies, the ISA has issued business plans for term/endowment assurances and annuity insurance, including formulas for calculating provisions based on classic insurance mathematics. The ISA advised that the size of accounts payable from reinsurers compared with accounts receivable from reinsurers is controlled and evaluated through on- and off-site supervisions.
Assessment: Fully observed.
Principle 7: Capital adequacy and solvency
16. The IL stipulates minimum requirements for equity capital. Minimum solvency capital requirements are based on the EU directives on insurance. The MOF has issued an instruction on how to calculate the minimum solvency requirements for life insurance and nonlife insurance companies. The EU directives 73/239/EEC and 79/267/EEC have been used as a basis for calculating solvency requirements. The instruction on how to calculate the minimum solvency for nonlife insurance companies requires that the solvency margin be based on the higher of either 16 percent of a defined basis or 23 percent of another defined basis, independent of the size of the basis amount. The instruction should be changed to conform with Article 16 of the first EU nonlife insurance directive. This implies a somewhat higher solvency margin requirement for the insurers, because Article 16 requires the solvency margin to be the highest amount of 18 percent or 26 percent of the two defined basis amounts for basis amounts below € 10 million and € 7 million respectively.
Assessment:Broadly observed. The instruction issued by the MOF on calculating the solvency margin should be changed to conform with EU's first nonlife insurance directive, Article 16, which implies a somewhat higher solvency margin capital for nonlife insurers.
Principle 8: Derivatives and off-balance sheet items
17. The Accounting Act, Attachment 3, and the decree of the Minister of Finance of January 27, 1998 specify disclosure requirements for derivatives and other off-balance sheet items.
Assessment: Broadly observed. At the urging of the staff, the Estonian Accounting Board plans to issue draft guidelines on financial instruments in 2000.
Principle 9: Reinsurance
18. Before licensing an insurance company, the ISA requires a plan of operation (Article 31), which must include a reinsurance program. The IL requires that an insurer whose financial position is not adequate to cover assumed risks, conclude a reinsurance contract. The IL (Article 52) sets limits for the maximum exposure on the insurer's own account with respect to a single insurance object (10 percent of owners' equity) and the sum of insurable risks in respect of a single insurance occurrence (20 percent of owners' equity). During on-site inspections the ISA reviews the reinsurance arrangements to assess the degree of reliance placed on these arrangements and to determine the appropriateness of such reliance
Assessment: Fully observed.
Principle 10: Financial reporting
19. The MOF has established accounting and reporting requirements for insurers (Article 43). Consolidated annual accounts are to be submitted to the ISA no later than six months after the end of the financial year. Since 1998 insurers must submit to the ISA a quarterly report consisting of the balance sheet and the profit and loss account. This decree requires insurers to apply relevant parts of the guidelines on consolidated accounts issued for banks. The ISA advised that the solvency margin and the nominal equity capital for each insurer must be reported to the ISA. The ISA intends to establish reporting procedures for insurers on the compliance with solvency margins and nominal equity capital on a consolidated basis and an annual basis. Based on the quarterly reporting of annual accounts, the ISA may calculate solvency margin and nominal equity capital on a quarterly basis.
Assessment:Broadly observed. ISA intends to establish reporting procedures from insurers on an annual basis, including capital adequacy requirements on a consolidated basis.
Principle 11: Monitoring, on-site inspection, and access to information
20. The ISA is empowered to conduct audits on the premises of insurance companies (Article 65). Reports are prepared on the results of the audit of an insurance company. During 1999, 13 on-site inspections were carried out. One copy of the audit is furnished to the General Director of the insurance company. The ISA should also have the right to perform supervision of the affiliated undertakings of an insurer and the activities of companies belonging to the same group with an insurer, as is envisaged in the proposed IL.
Assessment:Broadly observed. The proposed new IL provides the legal basis for the supervision of affiliates and companies belonging to the same group.
Principle 12: Sanctions
21. The IL (Article 60) prescribes that the revocation of a license be done on the recommendation of the ISA. The ISA may temporarily suspend the license until the conditions causing the license revocation are corrected (Article 35). Petition for bankruptcy of an insurance company may be filed by the Minister of Finance and the ISA (Article 56). As stated in the proposed IL, the Director General of the ISA should have the power to prohibit an insurer from concluding new insurance contracts and extending existing contracts (special regime). It should also be able to dissolve an insurer and to file a bankruptcy petition against an insurer (§§ 50, 57, 58, 60). According to the IL (Article 62) the ISA has the power to recommend changes in the insurance conditions and tariffs of insurance companies if they are not in the interests of policyholders or if solvency has not been assured. The ISA may require the Board of Directors to remove the managing director if laws are being violated (Article 65). The proposed IL prescribes stronger sanctions than the present IL, for example, fines (§ 90) and a possible withdrawal of permission for acquisition of a qualifying holding from the ISA (§ 33).
Assessment:Broadly observed. The proposed IL will address this shortcoming by giving the Director General of ISA more powers, such as the right to prohibit an insurer from concluding new insurance contracts and extending existing contracts (special regime) as well as to dissolving an insurer. The new Law generally prescribes stronger sanctions--for example larger fines.
Principle 13: Coordination and cooperation
22. The ISA cooperates with the BoE and has also signed cooperation agreements with the Latvian and Lithuanian insurance supervisory offices and the Estonian Consumer Protection Board. However, the ISA has not signed any cooperation agreements or MOUs with home country supervisors of foreign insurance companies with affiliates in Estonia.
Assessment:Broadly observed. The ISA has not signed MOUs with the home country supervisors of foreign insurance companies that have affiliates in Estonia or with the Estonian Securities Inspectorate.
Principle 14: Confidentiality
23. According to the IL (Article 67) employees of the ISA and other persons who have gained access to trade secrets of an insurance company in the course of audits may disclose such information only to the management of the ISA and to the Board of Directors of the audited insurance company. However, the confidentiality requirement does not apply to information obtained during all state supervision activities. The proposed IL addresses this shortcoming. It will also allow confidential information obtained upon inspections to be disclosed to the MOF for the performance of its functions, as well as to the BoE and a foreign supervisory body for supervisory purposes only
Assessment:Broadly observed. The proposed IL prescribes that the confidentiality requirements also apply to information obtained during all state supervision activities.
Priorities for further action
24. The assessment of observance of the IAIS Insurance Supervisory Principles is summarized in Table 2. In addressing these weaknesses, priority should be given to the enactment of the new Insurance Law, for this legislation would lay the basis for the ISA achieving full or nearly full observance with all of the Insurance Supervisory Principles. Once this is done, priority should be given to moving to a risk based supervisory approach and establishing annual reporting procedures for insurers on the capital adequacy requirements on a consolidated basis. Pending the passage of the Law, the ISA should work to modify the instruction on calculating the solvency margin to make it consistent with the EU's first non-life insurance directive. The ISA should also consider whether it needs to develop rules on the use of derivatives, which can be issued by the MOF once disclosure requirements for derivatives and other off-balance items in the prescribed balance sheet are issued. Finally, the ISA should sign MOUs with the home country supervisors of foreign insurance companies with affiliates in Estonia, and when feasible with Estonian Securities Inspectorate as well.
Table 2. Estonia: Observance of IAIS Supervisory Principles
1/ FO: Fully observed.
2/ BO: Broadly observed.
3/ NO: Not observed.
1 The Basel Core Principles were issued in September 1997; a Core Principles Methodology was released in October 1999 by the Basel Committee on Banking Supervision. The Code of Good Practices on Transparency was adopted by the Interim Committee in September 1999; work on a supporting document is in progress. The IOSCO Objectives and Principles were issued in September 1998, and a detailed self-assessment methodology is being developed. A draft of the Core Principles for Systemically Important Payment Systems was issued for public comment in December 1999. The IAIS Insurance Supervisory Principles were issued in September 1997; a self-assessment program has been developed to assist member countries in evaluating compliance.