## cr17281

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### EXECUTIVE SUMMARY — INTRODUCTION AND SCOPE
- Technical note updating the Japanese insurance sector and selected aspects of the regulatory and supervisory regime, prepared as part of the 2017 Financial Sector Assessment Program (FSAP).
- Based on discussions in Japan from November 30 to December 20, 2016, and refers to the Insurance Core Principles (ICPs) issued by IAIS in October 2011, as revised in November 2015.
- Focus areas: risks from the low interest rate environment for life insurers; forward-looking, holistic supervisory approach; efforts to introduce an economic value-based solvency regime; corporate governance.
- Coverage: insurance activities regulated by the Insurance Business Act (IBA) and supervised by the Financial Services Agency of Japan (JFSA).
- Assets held by major cooperatives supervised by other ministries: ¥5.9 trillion and ¥1.6 trillion (two sectors), versus ¥399 trillion total private industry assets at end-2015.

### MARKET STRUCTURE, PRODUCTS, AND PERFORMANCE
- Market size and composition:
  - The insurance sector represents 13 percent of total financial sector assets.
  - Book value of assets at end of fiscal year 2015: ¥399 trillion (¥367 trillion for life and ¥31 trillion for non-life).
  - Life insurance is about 12 times the size of non-life by assets.
  - Number of insurers (end-2016): 93 total — 41 life (including five mutual insurers), 44 non-life, and eight reinsurers.
- Market concentration:
  - Top five life insurers account for 67 percent of life insurance sector assets.
  - Top four non-life insurers account for 88 percent of non-life insurance sector assets.
  - Japan Post Insurance: 22 percent market share by assets; Government owns 89 percent of its shares.
  - Reinsurance: top two reinsurers represent 90 percent of the market (by assets).
- Product mix, guarantees, and demographics:
  - Predominance of life insurance products with interest guarantees; most savings-type products (whole life and endowment) have interest guarantees.
  - Industry sources: old policies in force with guarantees in excess of 5 percent.
  - Consumers shifted toward living benefits (annuities, medical insurance, nursing home care).
  - 80 percent of annuities are fixed-term annuities.
  - Industry data indicate little longevity risk to insurers.
  - Demographic projection: By 2060, the age 60 and above segment is projected to be close to half of total population.
- Investments and returns:
  - Major life insurers increased non-yen investments from 14 percent in 2011 to 20 percent in 2015.
  - Foreign-currency exposure is partially hedged.
  - Rate of return on life insurance assets has hovered between 1.8 to 2.5 percent per year since 2009.
  - Foreign securities were the best performing asset class, helped by Yen depreciation.
- Profitability and solvency:
  - Industry is profitable; underwriting results form the bulk of profits.
  - Statutory solvency margin ratios (SMR) at end-2015:
    - Life: 990 percent
    - Non-life: 715 percent
    - Reinsurers: 500 percent
  - Statistical caveat: statutory SMRs are not on an economic value basis; economic value-based solvency ratios may differ.

### ASSET COMPOSITION, RETURNS, AND FOREIGN EXPOSURE
- Asset composition and market exposures (end-2015):
  - Life insurers: 44 percent of assets invested in long-duration Japanese government and semi-government bonds.
  - Non-life insurers: 20 percent exposure to government bonds and 22 percent exposure to equities (reduced from 27 percent in 2014).
  - Life sector: 4 percent of assets in alternative investments (mainly investment funds including hedge funds).
- Investments by asset class (Life Insurance Sector) — Overall Return and selected components:
  - 2009: Overall Return 1.86; Bonds 1.64; Domestic Stocks 2.33; Foreign Securities 2.52; Loans 2.23; Real Estate 2.87
  - 2010: Overall Return 1.79; Bonds 1.86; Domestic Stocks 1.25; Foreign Securities 2.06; Loans 1.98; Real Estate 2.52
  - 2011: Overall Return 1.92; Bonds 1.91; Domestic Stocks 1.56; Foreign Securities 2.91; Loans 1.94; Real Estate 2.27
  - 2012: Overall Return 2.36; Bonds 2.00; Domestic Stocks 0.61; Foreign Securities 5.25; Loans 2.18; Real Estate 2.35
  - 2013: Overall Return 2.40; Bonds 1.95; Domestic Stocks 5.14; Foreign Securities 4.60; Loans 2.15; Real Estate 2.43
  - 2014: Overall Return 2.58; Bonds 1.88; Domestic Stocks 5.31; Foreign Securities 5.50; Loans 2.28; Real Estate 2.50
  - 2015: Overall Return 1.92; Bonds 1.75; Domestic Stocks 5.17; Foreign Securities 2.24; Loans 1.70; Real Estate 2.62
- Foreign currency exposure and hedging:
  - Non-yen investments ~20 percent of total assets of the four major life insurers at end-2015 (up from 14 percent in 2011).
  - Currency breakdown of foreign currency exposure: about 60 percent in U.S. dollars, and 20 percent in euro.
  - Currency hedges (mostly shorter-term currency swaps) range from 20 percent to 80 percent.
  - Composition of non-yen securities: bonds, listed equity, private equity, managed funds including hedge funds; bonds may include structured bonds with complex embedded derivatives.

### PRODUCT MIX, DISTRIBUTION, AND KEY SECTOR RISKS
- New business premium composition as of March 2016:
  - Annuities comprised 28 percent of total new business premium.
  - Medical insurance (including cancer insurance) comprised 23 percent.
- In terms of number of policies sold, medical insurance has represented more than one third of new business for nearly two decades.
- Distribution channels:
  - Non-life: over 90 percent distributed through general agency sales force.
  - Life: agents accounted for 73 percent of sales overall.
    - In 2015, in-house agents 59 percent of sales and general agents 14 percent (compared to 66 percent and 7 percent, respectively, in 2006).
    - Bancassurance increased from 3.3 percent in 2006 to 5.5 percent in 2015.
    - Direct sales declined from 11.2 percent in 2006 to 8.7 percent in 2015.
- Key sector risks:
  - Life sector key risk: low interest rates.
    - Standardized discount rates for valuing liabilities declined from 2.75 percent in 1996 to one percent for regular premium policies and 0 to 0.75 percent for single premium policies in 2016.
    - Negative interest rate on JGBs earlier in 2016 led some insurers to stop selling single premium products.
    - Industry sources: old policies in force with interest guarantees in excess of 5 percent.
  - Non-life sector key risks: exposures to equities and natural disasters (earthquakes and typhoons).
    - Distribution of non-life business lines: Motor insurance 55 percent of total gross written premium; Fire insurance 17 percent; Personal accident insurance 12 percent; Miscellaneous casualty insurance 12 percent.
    - Earthquake insurance: 28.8 percent of households had earthquake insurance in 2015, up from 23.7 percent in 2010.
    - Government indemnity for earthquakes (post-April 1, 2016): Government pays 50 percent of claims between ¥115.3 billion and ¥437 billion; and 99.7 percent of claims above ¥437.9 billion, up to ¥11.3 trillion.
    - Temporary adjustment: Government reduced the ¥437.9 billion threshold to ¥182.7 billion from Oct 19, 2016 to recognize insurers’ reduced reserves following claims payments due to the Kumamoto Earthquake on April 16, 2016.
    - Private insurers’ exposure to residential earthquake losses substantially reduced due to reinsurance arrangement with the government; exposure to commercial earthquake losses remains.

### INSTITUTIONAL AND SUPERVISORY FRAMEWORK
- JFSA role and governance:
  - JFSA is the principal insurance supervisor; established in 1998 as an integrated financial supervisor and funded by government budget.
  - Strategic priority for 2016: explore a forward-looking, holistic supervisory approach focusing on business models and risk management.
  - Work underway to develop a risk assessment methodology for insurance supervision.
- Scope of supervision:
  - Some insurance activities are outside IBA scope and not supervised by JFSA (e.g., insurance activities of cooperatives/Kyosai, captives, certain closed-group arrangements).
- Recent supervisory developments:
  - JFSA has conducted three field tests of an economic value-based solvency regime; the third field test results will be available in March 2017.
  - Prudence Monitoring Office established in 2016 responsible for risk analysis and prudential supervision; insurers submit financial information quarterly, half-yearly and yearly.
  - New risk-based assessment methodology under trial for offsite monitoring and analysis.
  - ORSA implemented based on ERM in 2015 (pilot in 2014).
  - Shift in onsite supervision: from compliance verification to principle-based best practices; horizontal reviews across major insurers are primary inspection tool.
  - JFSA conducted 17 entity-specific inspections in the past three years, including two in 2015.
  - No minimum requirement for supervisory work on any insurer (for example, no requirement for an onsite inspection every three years).

### VALUATION, RESERVES, AND SOLVENCY FRAMEWORK
- Valuation and reserves:
  - Assets and liabilities valued according to Japanese Generally Acceptable Accounting Principles (JGAAP); statutory valuation of assets adopts accounting values partly on an amortized cost basis.
  - Life insurance liabilities valued on discounted future cash flows using assumptions locked-in at contract inception; mortality assumptions also locked in.
  - 10-year cash flow analysis prepared to gauge adequacy of premium reserves; since 2015 JFSA introduced additional cash flow analysis covering full policy time horizon under four scenarios.
  - Insurers required to hold special reserves: contingent reserves, catastrophe reserves, price fluctuation reserves.
  - JFSA analysis: special reserves absorbed losses from the financial crisis and the 2011 Great East Japan Earthquake.
- Solvency Margin Ratio (SMR) framework:
  - SMR = ratio of solvency margin (net assets and special reserves based on accounting balance sheet) to half of risk requirements.
  - Interpretation: 200 percent SMR means “margin” exactly covers the “risks.” An SMR of 200 percent triggers early remedial action; an SMR of 100 percent triggers more severe remedial action (capital injection, restraint/prohibition on paying dividend to policyholders or bonuses to directors, etc.).
  - SMRs are disclosed to the public four times a year.
- Gone-concern solvency:
  - Adjusted net assets approximate liquidation value; assets re-valued at fair value including bonds held to maturity, liabilities set to total surrender value. JFSA may order insurers to suspend business if adjusted net assets are negative.
- Economic value-based solvency (ESR):
  - ESR under consideration since 2006; three field tests conducted in 2010, 2014 and 2016.
  - Results of 2014 field test: aggregate ESR between 150 to 190 percent for life insurers and 190 to 220 percent for non-life insurers.
  - Due to decline in interest rates since 2014, ESRs likely lower compared to the second field test; results of 2016 field test available in March 2017.
  - Some insurers voluntarily calculate and disclose ESRs and embedded value for institutional investors.

### SUPERVISORY ASSESSMENT, MACROPRUDENTIAL SURVEILLANCE, AND GOVERNANCE
- Macroprudential surveillance:
  - Macroprudential Policy Office established in the Planning and Coordination Bureau in July 2015.
  - Staff: a staff of 25 as of end Jun 2016.
  - Mandate: analyze global markets and macro-economy, monitor potential threats to financial stability; share results with insurance supervisors.
- Onsite and offsite supervision — observations and recommendations:
  - Onsite supervision shifted to a more qualitative approach with horizontal reviews emphasizing interviews with senior staff and interaction with directors.
  - Entity-specific inspections follow a risk profiling process.
  - Observations: risk-based supervision is commendable but needs more development; prolonged low interest rates have driven insurers to take on more risks (including corporate bonds and non-yen securities); higher cross-border M&A increases risks.
  - Recommendations:
    - Continue development of risk-based supervisory framework including a risk and impact assessment based on objective criteria, resultant supervisory intensity, and a holistic supervisory plan for offsite and onsite supervision. Priority: Immediate.
    - Include frequency and scope of onsite inspections as part of the holistic supervisory plan. Priority: Near Term.
    - Onsite verification of qualitative and quantitative information used in offsite analysis to provide feedback to risk-based supervision. Priority: Near Term.
- Corporate governance:
  - Companies Act allows three governance structures; majority adopt traditional structure with a supervisory board (kansayaku-kai) and board of directors comprising mostly executive officers.
  - For companies with a supervisory board: at least three corporate auditors, and no less than half must be outside corporate auditors.
  - Supervisory Guidelines outline JFSA expectations (cultivate corporate culture emphasizing governance; articulate management policy; develop risk management policy; approve internal audit policies and plans; ensure independence of internal audit; design and manage remuneration; listed insurers and insurance holding companies should have at least two outside directors).
  - Tokyo Stock Exchange Corporate Governance Code (CCG) issued in 2015 on a comply-or-explain basis; less than 20 listed insurers subject to CCG.
  - As of December 2015, outside directors represent 29.7 percent of insurers’ boards in the aggregate.
  - Recommendation: consider extending key elements of good governance practice (including elements in CCG) to all insurers in a legally enforceable manner. Priority: Near Term.

### FX EXPOSURE, CROSS-BORDER COORDINATION, AND INTERCONNECTEDNESS
- FX exposure monitoring:
  - JFSA monitors FX exposure by country of domicile of issuer; this may not match true currency exposure because issuers may issue securities in other currencies.
  - Demand for foreign-currency denominated policies is not high; JFSA currently does not collect information on these policies.
  - Recommendation: collect more granular data to monitor insurers’ foreign exchange exposure by currency and collect statistics on foreign-currency denominated policies. Priority: Immediate.
- Cross-border supervision:
  - Increased cross-border M&A requires close cross-border coordination.
  - JFSA is the group-wide supervisor of Japanese insurers with material overseas operations and has established supervisory colleges.
  - Recommendation: continue periodically reviewing membership of supervisory colleges for insurers with material overseas operations and establish new supervisory colleges when necessary. Priority: Near Term.
- Interconnectedness with banking:
  - Bank-insurance linkages and interconnectedness with other parts of the financial sector appear limited.
  - Japan Post Holdings (80 percent government-owned) owns 89 percent of Japan Post Bank and 89 percent of Japan Post Insurance; all three are listed on the Tokyo Stock Exchange.
  - Other than Japan Post, no significant insurers are part of a group with significant banking activities; none of the insurance groups has significant market share in both life and non-life.

### IMPLEMENTATION FOLLOW-UP FROM THE 2012 FSAP (SELECTED POINTS)
- ICP 2: supervisory capacity and resources
  - Number of staff dedicated to supervision has not changed meaningfully (from 90 to 88).
  - JFSA hired 10 staff with industry experience or specialty knowledge.
  - IBA and Supervisory Guidelines amended to clarify supervisory expectations.
- ICP 5: suitability tests
  - IBA amended in 2014 to extend suitability requirements to corporate auditors.
  - Companies Act amended in 2015 to stipulate more stringent eligibility requirements for outside (independent) directors and outside corporate auditors.
- ICP 7: corporate governance
  - Tokyo Stock Exchange issued CCG in June 2015; applicability to non-listed insurers optional.
  - Supervisory Guidelines amended to indicate expectation for listed insurers and financial holding companies to have at least two outside directors.
- ICP 9 / ICP 10: risk assessment and inspections
  - Risk assessment methodology still work in progress.
  - Shift in supervisory approach lowered reliance on onsite inspection with increased interaction with board directors and senior management.
- ICP 14 / ICP 17: economic valuation and capital requirements
  - JFSA is field-testing an economic value-based methodology.
  - Long-term cash-flow analysis introduced for appointed actuaries to check adequacy of premium reserves.
- ICP 16: ERM and capital adequacy
  - ORSA implemented in 2015 after a 2014 pilot.
- ICP 25 / ICP 26: supervisory colleges and contingency plans
  - JFSA has established supervisory colleges for Japanese insurers with material overseas operations.
  - No formal requirement for insurers to develop contingency plans; ORSA reports include a description of an action plan in case of large loss due to market turmoil.

*International Monetary Fund — Japan Financial Sector Assessment (content unit: cr17281).*

### EXECUTIVE SUMMARY __________________________________________________________________________ 4

### EXECUTIVE SUMMARY

### INTRODUCTION AND SCOPE
- This technical note provides an update on the Japanese insurance sector and an analysis of selected aspects of the regulatory and supervisory regime, prepared as part of the 2017 Financial Sector Assessment Program (FSAP).
- The note draws on discussions in Japan from November 30 to December 20, 2016, and refers to the Insurance Core Principles (ICPs) issued by the International Association of Insurance Supervisors (IAIS) in October 2011, as revised in November 2015.
- Focus areas include: risks from the low interest rate environment for life insurers; a forward-looking, holistic supervisory approach; efforts to introduce an economic value-based solvency regime; and corporate governance.
- The assessment covers insurance activities regulated by the Insurance Business Act (IBA) and supervised by the Financial Services Agency of Japan (JFSA). Assets held by major cooperatives supervised by other ministries amounted to ¥5.9 trillion and ¥1.6 trillion (two sectors), versus ¥399 trillion total private industry assets at end-2015.

### MARKET STRUCTURE, PRODUCTS, AND PERFORMANCE
- Market size and composition:
  - The Japanese insurance sector represents 13 percent of total financial sector assets.
  - Book value of assets at end of fiscal year 2015: ¥399 trillion (¥367 trillion for life and ¥31 trillion for non-life).
  - Life insurance is about 12 times the size of non-life by assets.
  - Number of insurers (end-2016): 93 total — 41 life (including five mutual insurers), 44 non-life, and eight reinsurers.
- Market concentration:
  - Top five life insurers account for 67 percent of life insurance sector assets.
  - Top four non-life insurers account for 88 percent of non-life insurance sector assets.
  - Japan Post Insurance is the largest life insurer with 22 percent market share by assets; Government owns 89 percent of its shares.
  - Reinsurance sector concentration: top two reinsurers represent 90 percent of the market (by assets).
- Product mix and guarantees:
  - Predominance of life insurance products with interest guarantees; most savings-type products (whole life and endowment) have interest guarantees.
  - Industry sources indicate old policies in force with guarantees in excess of 5 percent.
  - Consumers have shifted away from savings products toward living benefits (annuities, medical insurance, and nursing home care) in response to demographic change and low interest rates.
  - Notably, 80 percent of annuities are fixed-term annuities.
  - Industry data indicate little longevity risk to insurers.
- Investments and returns:
  - Major life insurers increased non-yen investments from 14 percent in 2011 to 20 percent in 2015.
  - Foreign-currency exposure is partially hedged.
  - Rate of return on life insurance assets has hovered between 1.8 to 2.5 percent per year since 2009.
  - Foreign securities have been the best performing asset class, helped by Yen depreciation in recent years.
- Profitability and solvency:
  - The industry is profitable; underwriting results form the bulk of profits.
  - Consumers place emphasis on service and financial soundness over price.
  - Statutory solvency margin ratios (SMR) at end-2015:
    - Life: 990 percent
    - Non-life: 715 percent
    - Reinsurers: 500 percent
  - A closer analysis is required because statutory SMRs are not on an economic value basis and economic value-based solvency ratios may present a different picture.
- International expansion and risks:
  - Shrinking domestic market has driven major insurers to expand overseas through acquisitions and strategic investments, with main targets U.S., U.K., and emerging Asia; the United States received the lion share of investment.
  - M&A transactions increased in number and amount in the past two years.
  - Key risks for the non-life sector: exposure to equities and natural disasters (earthquakes and typhoons).
  - Non-life insurers’ equity exposure declined to 22 percent in 2015 from 27 percent in 2014.
  - Private insurers’ exposure to residential earthquake losses is substantially reduced due to reinsurance arrangement with the government, but exposure to commercial earthquake losses remains.

### INSTITUTIONAL AND SUPERVISORY FRAMEWORK
- JFSA role and governance:
  - The JFSA is the principal insurance supervisor; established in 1998 as an integrated financial supervisor and funded by government budget.
  - One strategic priority for 2016 is to explore a forward-looking, holistic supervisory approach focusing on business models and risk management.
  - Work is underway to develop a risk assessment methodology for insurance supervision.
- Developments in corporate governance and solvency:
  - Japan strengthened corporate governance requirements by introducing a more stringent definition of an outside (independent) director in the Companies Act and the Tokyo Stock Exchange issued a voluntary Code of Corporate Governance (CCG) for listed companies.
  - JFSA has conducted three field tests of an economic value-based solvency regime; the third field test results will be available in March 2017.
- Supervision scope notes:
  - Some insurance activities are outside IBA scope and not supervised by JFSA (e.g., insurance activities of cooperatives/Kyosai, captives, certain closed-group arrangements).

### MAIN FINDINGS AND POLICY RECOMMENDATIONS
- Solvency regime:
  - Recommendation: JFSA should take further steps to implement an economic-value-based solvency regime as soon as practicable.
    - Rationale: Economic valuation provides reliable measurement and enhances transparency; major insurers already disclose economic solvency information to institutional investors; implementing economic-value-based solvency will enhance policyholder protection by reducing information asymmetries.
    - Priority: Near Term.
  - Communication: Develop a communication strategy to help the public understand potentially large variance from the current, published statutory solvency ratio.
- Risk-based supervision:
  - Recommendation: JFSA should continue to develop its risk-based supervisory framework, including a risk and impact assessment based on objective criteria, resultant supervisory intensity, and a holistic supervisory plan for offsite and onsite supervision.
    - Priority: Immediate.
  - Onsite inspections:
    - Recommendation: The frequency and scope of onsite inspections should be part of the holistic supervisory plan to address entity-specific risks. Onsite verification of qualitative and quantitative information used in offsite analysis provides necessary feedback to the risk-based supervision.
    - Priority: Near Term.
- Governance:
  - Recommendation: JFSA should consider extending key elements of good governance practice (including elements in CCG) to all insurers in a legally enforceable manner, such as minimum of two independent directors and disclosure of governance information.
    - Priority: Near Term.
- Foreign exchange and data monitoring:
  - Recommendation: JFSA should collect more granular data to monitor insurers’ foreign exchange exposure more precisely, as well as statistics on foreign currency denominated policies.
    - Priority: Immediate.
  - Rationale: Current monitoring is based on country of domicile of issuers; more granular currency-based data would yield a more precise picture of FX exposure.
- Cross-border supervision:
  - Recommendation: In light of increased cross-border M&A activities, JFSA needs to continue periodically reviewing membership of supervisory colleges for insurers with material overseas operations and establish new supervisory colleges when necessary.
    - Priority: Near Term.

### SUPERVISORY ASSESSMENT CONTEXT
- The note analyzes selected ICPs without scoring observance levels; the most recent detailed ICP assessment was in 2012 (based on October 2011 ICPs).
- The 2012 FSAP rated Japan’s observance as: 12 Observed, 10 Largely Observed, and 4 Partly Observed (of 26 ICPs).

*Source: IMF Technical Note — EXECUTIVE SUMMARY (Japan Insurance Sector, 2017 FSAP).*

### 13.      Life insurers have high exposure to government bonds and non-life insurers to

### 13.      Life insurers have high exposure to government bonds and non-life insurers to 

### Asset composition and market exposures
- Life insurers: 44 percent of assets invested in long-duration Japanese government and semi-government bonds at the end of 2015.
- Non-life insurers: 20 percent exposure to government bonds and 22 percent exposure to equities at the end of 2015 (reduced from 27 percent in 2014).
- Life sector: 4 percent of assets in alternative investments, which are mainly investment funds including hedge funds.
- Investments by asset class (Life Insurance Sector) — Overall Return and selected components:
  - 2009: Overall Return 1.86; Bonds 1.64; Domestic Stocks 2.33; Foreign Securities 2.52; Loans 2.23; Real Estate 2.87
  - 2010: Overall Return 1.79; Bonds 1.86; Domestic Stocks 1.25; Foreign Securities 2.06; Loans 1.98; Real Estate 2.52
  - 2011: Overall Return 1.92; Bonds 1.91; Domestic Stocks 1.56; Foreign Securities 2.91; Loans 1.94; Real Estate 2.27
  - 2012: Overall Return 2.36; Bonds 2.00; Domestic Stocks 0.61; Foreign Securities 5.25; Loans 2.18; Real Estate 2.35
  - 2013: Overall Return 2.40; Bonds 1.95; Domestic Stocks 5.14; Foreign Securities 4.60; Loans 2.15; Real Estate 2.43
  - 2014: Overall Return 2.58; Bonds 1.88; Domestic Stocks 5.31; Foreign Securities 5.50; Loans 2.28; Real Estate 2.50
  - 2015: Overall Return 1.92; Bonds 1.75; Domestic Stocks 5.17; Foreign Securities 2.24; Loans 1.70; Real Estate 2.62

### Foreign currency exposure and yield-seeking behavior
- Non-yen denominated investments accounted for about 20 percent of total assets of the four major life insurers at the end of 2015, increased from 14 percent in 2011.
- Composition of non-yen securities: bonds, listed equity, private equity and managed funds including hedge funds; bonds may include structured bonds with complex embedded derivatives.
- Currency breakdown of foreign currency exposure: about 60 percent in U.S. dollars, and 20 percent in euro.
- Currency hedges (mostly shorter-term currency swaps) range from 20 percent to 80 percent.
- Foreign securities were the best performing asset class, helped by the depreciation of the yen in recent years.

### Product mix, demographics, and business trends
- Demographic projection: By 2060, the age 60 and above segment is projected to be close to half of total population.
- Shift in consumer demand from savings products to living benefits such as annuity, medical insurance, and nursing home care.
- New business premium composition as of March 2016:
  - Annuities comprised 28 percent of total new business premium.
  - Medical insurance (including cancer insurance) comprised 23 percent.
- In terms of number of policies sold, medical insurance has represented more than one third of new business for nearly two decades.
- More than 80 percent of annuities are fixed-term annuities, which provide periodic payments for a pre-determined time period (thus entail little longevity risk).
- Insurers are expanding overseas for growth; U.S. market is the top target.

### Distribution channels
- Non-life insurance distribution: over 90 percent distributed through general agency sales force.
- Life insurance distribution:
  - Agents accounted for 73 percent of sales overall; shift from in-house agents to general agents noted.
  - In 2015, in-house agents accounted for 59 percent of sales and general agents 14 percent, compared to 66 percent and 7 percent, respectively, in 2006.
  - Bancassurance increased from 3.3 percent in 2006 to 5.5 percent in 2015.
  - Direct sales declined from 11.2 percent in 2006 to 8.7 percent in 2015.

### Key sector risks
- Life sector key risk: low interest rates.
  - Insurers still have a large stock of old policies in force with interest guarantees in excess of 5 percent according to industry sources.
  - The standardized discount rates for valuing liabilities have declined from 2.75 percent in 1996 to one percent for regular premium policies and 0 to 0.75 percent for single premium policies in 2016.
  - Negative interest rate on JGBs earlier this year led some insurers to stop selling single premium products.
- Non-life sector key risks: exposures to equities and natural disasters.
  - Distribution of non-life business lines: Motor insurance 55 percent of total gross written premium; Fire insurance 17 percent; Personal accident insurance 12 percent; Miscellaneous casualty insurance 12 percent.
  - Earthquake insurance: 28.8 percent of households had earthquake insurance in 2015, up from 23.7 percent in 2010.
  - Earthquake insurance premium rates standardized by region; bulk of losses reinsured by the government via JER and retrocessions.
  - Government indemnity for earthquakes (post-April 1, 2016): Government pays 50 percent of claims between ¥115.3 billion and ¥437 billion; and 99.7 percent of claims above ¥437.9 billion, up to ¥11.3 trillion.
  - Temporary adjustment: Government reduced the ¥437.9 billion threshold to ¥182.7 billion from Oct 19, 2016 to recognize insurers’ reduced reserves following claims payments due to the Kumamoto Earthquake on April 16, 2016.
  - Besides earthquakes, susceptibility to typhoon losses and market risk from equity exposure.

### Interconnectedness with banking sector
- Bank-insurance linkages and interconnectedness with other parts of the financial sector appear to be limited.
- Japan Post Holdings (80 percent government-owned) owns 89 percent of Japan Post Bank and 89 percent of Japan Post Insurance; all three entities are listed on the Tokyo Stock Exchange.
- Other than Japan Post, no significant insurers are part of a group that also includes significant banking activities; none of the insurance groups has significant market share in both life and non-life.

### Valuation, reserves, and solvency framework
- Valuation framework:
  - Assets and liabilities valued according to Japanese Generally Acceptable Accounting Principles (JGAAP); statutory valuation of assets adopts accounting values partly on an amortized cost basis.
  - Life insurance liabilities valued on discounted future cash flows using assumptions locked-in at contract inception; mortality assumptions also locked in.
- Premium reserve and statutory measures:
  - A 10-year cash flow analysis is prepared to gauge adequacy of premium reserves; since 2015 JFSA introduced an additional cash flow analysis covering the full policy time horizon under four scenarios.
  - Insurers required to hold special reserves: contingent reserves, catastrophe reserves, price fluctuation reserves.
  - JFSA analysis: special reserves served well to absorb losses from the financial crisis and the 2011 Great East Japan Earthquake.
- Solvency Margin Ratio (SMR):
  - SMR = ratio of solvency margin (net assets and special reserves based on accounting balance sheet) to half of risk requirements.
  - Interpretation: 200 percent SMR means “margin” exactly covers the “risks.” An SMR of 200 percent triggers early remedial action; an SMR of 100 percent triggers more severe remedial action (capital injection, restraint/prohibition on paying dividend to policyholders or bonuses to directors, etc.).
  - SMRs are disclosed to the public four times a year.
- Gone-concern solvency:
  - Adjusted net assets calculated approximating liquidation value; assets re-valued at fair value including bonds held to maturity, liabilities set to total surrender value. JFSA may order insurers to suspend business if adjusted net assets are negative.
- Economic value-based solvency (ESR) development:
  - ESR under consideration since 2006; three field tests conducted in 2010, 2014 and 2016.
  - Results of 2014 field test: aggregate ESR between 150 to 190 percent for life insurers and 190 to 220 percent for non-life insurers.
  - Due to decline in interest rates since 2014, ESRs likely lower compared to the second field test; results of 2016 field test will be available in March 2017.
  - Some insurers voluntarily calculate and disclose ESRs and embedded value in response to institutional investor requests.

### Conclusions and policy recommendations (excerpted)
- JFSA has promoted an economic-value-based solvency regime and conducted field tests to assess impacts.
- Need to protect policyholders from information asymmetry if ESR is disclosed selectively to institutional investors but not to ordinary policyholders.
- Recommendation: JFSA should take further steps to implement an economic value based solvency regime as soon as practicable to support the strategic priority of moving towards a risk-based prudential supervision regime.
- Recommendation: JFSA should develop a public communication strategy before implementation, given potentially large differences between ESR and SMR.

### Insurance supervision and supervisory reforms
- JFSA strategic priority (fiscal year 2016): move toward a forward-looking, holistic prudential supervisory framework.
- Initiatives since 2013: implementation of Own Risk and Solvency Assessment (ORSA) reporting; new approach to onsite supervision.
- Prudence Monitoring Office established in 2016 responsible for risk analysis and prudential supervision; insurers submit financial information quarterly, half-yearly and yearly.
- New risk-based assessment methodology is under trial for offsite monitoring and analysis; results to inform dialogues with senior management and onsite supervision planning.
- Onsite supervision: shift from compliance verification to principle-based best practices; horizontal reviews across major insurers are primary inspection tool (topics: M&A, corporate governance, product-selling practices, compliance); smaller insurers receive offsite supervision and limited-scope inspections.

_Italic: International Monetary Fund — Japan Financial Sector Assessment (content unit: cr17281)._

### 35.      Onsite supervision has become more qualitative. The approach of the horizontal

### cr17281 - 35.      Onsite supervision has become more qualitative. The approach of the horizontal

### Onsite and offsite supervision: practice and trends
- Onsite supervision has shifted to a more qualitative approach: horizontal reviews focus more on interviews with senior level staff and less on examination of systems, books, and records.
- The JFSA believes quality of inspections has improved because of greater interaction with directors and senior management.
- Entity-specific inspections are conducted when a risk profiling process (conducted by inspectors, with input from the offsite supervisors) identifies concerns.
- The JFSA has conducted 17 entity-specific inspections in the past three years, including two in 2015.
- There are no minimum requirements for supervisory work on any insurer (for example, there is no requirement for an onsite inspection every three years).

### Macroprudential surveillance enhancements
- A Macroprudential Policy Office was established in the Planning and Coordination Bureau in July 2015.
- Staff: a staff of 25 as of end Jun 2016.
- Mandate and activity:
  - The office analyzes the state of the global markets and the macro-economy, and monitors potential threats to the stability of financial systems.
  - The results of the analysis are shared with the insurance supervisors to feed into their industry-wide and entity-specific monitoring.

### Conclusions on supervisory approach and recommendations
- Observations:
  - The effort to focus on risk in offsite and onsite supervision is commendable but more is needed.
  - The risk-based supervisory approach more efficiently prioritizes supervisory resources to impactful areas.
  - The prolonged low interest rate environment has driven insurers to take on more risks in search of yield, including increased allocation to corporate bonds (in the case of life insurers), and non-yen securities.
  - Higher cross-border M&A activity in search of growth presents more risks and challenges to insurers.
  - The JFSA needs to understand individual insurers’ business strategy, governance, risk management, operations and financials as bases for risk-based supervision, and to monitor commonalities in insurers’ exposures to assess susceptibility to common and/or aggregate shocks.
- Recommendations:
  - The JFSA should continue the development of its risk-based supervisory framework. The framework should include a risk and impact assessment based on objective criteria, the resultant supervisory intensity, and a holistic supervisory plan for offsite and onsite supervision.
  - The frequency and scope of onsite inspection should be part of the holistic supervisory plan to address entity-specific risks. Onsite verification of the qualitative and quantitative information used in offsite analysis provides the necessary feedback loop to the risk-based supervision.

### Corporate governance: structure, recent changes, and implications
- Governance structure:
  - The Companies Act allows corporations to choose any one of three main governance structures.
  - The majority of Japanese firms adopt the traditional structure with a supervisory board (kansayaku-kai) comprising corporate auditors (kansayaku) appointed by shareholders, and a board of directors comprising mostly executive officers.
  - For companies with a supervisory board: at least three corporate auditors 1/, and no less than half must be outside corporate auditors.
  - Corporate auditors attend board of directors’ meetings but have no voting rights.
- Trends and practices:
  - Some companies adopt Anglo-Saxon governance features (conversion to Anglo-Saxon model, voluntary committees such as nominating and remuneration committees, or appointing more independent directors).
  - Internal audit functions sometimes collaborate with the supervisory board for greater independence from management.
- Governance requirements and guidance:
  - The Companies Act specifies basic governance requirements (qualification of directors and outside directors, duty of loyalty of directors, shareholders’ approval of directors’ remuneration, establishment of an internal control system).
  - IBA duplicates Companies Act requirements for mutual companies and stipulates additional governance requirements for insurers (internal control systems to ensure regulatory compliance, disclosure obligations).
  - OEIBA specifies detailed disclosure items (organizational, operational, financial, statistical, and risk management information).
  - The Financial Instrument and Exchange Act requires listed companies to disclose information on governance.
  - Supervisory Guidelines express JFSA’s expectations of directors, including:
    - Cultivate a corporate culture that emphasizes the importance of governance.
    - Articulate a corporate management policy for achieving the insurer’s overall targets.
    - Develop a corporate management plan and a risk management policy.
    - Approve internal audit policies and internal audit plans, and take appropriate actions with respect to the results of internal audits.
    - Establish a system that enables the internal audit division to perform its functions, including ensuring its independence.
    - Develop an appropriate design and management of the remuneration system.
    - Listed insurers and insurance holding companies should have at least two outside directors.
- CCG (Corporate Governance Code):
  - Issued in 2015 by the Tokyo Stock Exchange; articulates principles on shareholder rights, cooperation with stakeholders, transparency, responsibilities of the board, and dialogue with shareholders.
  - Applied on a comply-or-explain basis.
  - Less than 20 listed insurers are subject to CCG.
- Conclusions and recommendations on governance:
  - Governance standards have been raised in Japan through amendments to the Companies Act, IBA, and Supervisory Guidelines.
  - As of December 2015, outside directors represent 29.7 percent of the insurer’s board of directors in the aggregate.
  - Good governance is important to implement risk-based supervision given rising complexity of risk management (search for yield, cross-border expansions, increased market and FX risks).
  - Recommendation: consider further extending key elements of good governance practices, including those found in CCG, to all insurers in a legally enforceable manner.

### Other issues: FX exposure and cross-border coordination
- FX exposure monitoring:
  - JFSA monitors insurers’ FX exposure by country of domicile of the issuer. The country of domicile matches the currency most of the time, but issuers may issue securities in another currency; monitoring by country may therefore not provide an accurate picture of true currency exposure.
  - Demand for foreign currency denominated policies is not high; JFSA currently does not collect information on these policies.
- Conclusion and recommendation:
  - The JFSA could strengthen the monitoring of increased foreign currency exposure by collecting more granular information to monitor insurers’ exposure by currencies to get a more precise picture of insurers’ exposure.
  - JFSA should also consider collecting statistics on foreign-currency denominated policies.
- Cross-border M&A and supervisory coordination:
  - Increased cross-border M&A necessitates close cross-border coordination.
  - The JFSA is the group-wide supervisor of Japanese insurers with material overseas operations and has established supervisory colleges with relevant supervisors.
  - Recommendation: JFSA should continue to periodically review membership of supervisory colleges and establish new colleges when necessary.

### Implementation follow-up from the 2012 FSAP (selected points)
- ICP 2: To improve supervisory capacity by increasing resources (particularly in the area of onsite inspections) and making regulatory expectation known to the industry through primary and subsidiary legislation and guidelines.
  - The number of staff dedicated to supervision has not changed meaningfully (from 90 to 88).
  - JFSA has hired 10 staff with industry experience or specialty knowledge to deepen its internal capability.
  - The IBA and Supervisory Guidelines have been amended in a number of areas to clarify supervisory expectations.
- ICP 5: To extend suitability test to all directors, senior management and persons in key control functions, and to increase JFSA’s power to disqualify unsuitable persons from holding office.
  - The IBA was amended in 2014 to extend suitability requirements to corporate auditors.
  - The Companies Act was amended in 2015 to stipulate more stringent eligibility requirements for outside (i.e., independent) directors, and outside (independent) corporate auditors.
- ICP 7: To revise corporate governance requirements to strengthen independent oversight, and consider making some of its expectations regarding corporate governance legally-binding.
  - The Tokyo Stock Exchange issued the CCG in June 2015 for listed companies on a comply-or-explain basis. Less than 20 insurers are listed.
  - Applicability of CCG to non-listed insurers is optional.
  - Supervisory Guidelines has been amended to indicate JFSA’s expectation for listed insurers and financial holding companies to have at least two outside directors.
- ICP 9 / ICP 10: To enhance the risk-assessment methodology and increase the frequency of inspection of large insurers; to make greater use of the enforcement tools available.
  - The risk assessment methodology is still work in progress.
  - There has been a shift in supervisory approach that has lowered reliance on onsite inspection, with increased interaction with board directors and senior management.
- ICP 14 / ICP 17: To adopt economic valuation of assets and liabilities, and capital requirements.
  - JFSA is field-testing an economic value-based methodology.
  - Long-term cash-flow analysis is introduced for appointed actuaries to check adequacy of premium reserves.
- ICP 16: To enhance requirements on enterprise risk management (ERM) and capital adequacy.
  - JFSA has implemented ORSA based on ERM in 2015, after a pilot study in 2014.
- ICP 25 / ICP 26: To establish supervisory colleges for Japanese insurers with material foreign operations; and to require insurers to prepare contingency plans including specific procedures for use in a gone-concern situation.
  - JFSA has established supervisory colleges for Japanese insurers with material overseas operations.
  - While no formal requirement exists for insurers to develop contingency plans, the ORSA report includes a description of an action plan in case of large loss due to turmoil in financial markets.

*International Monetary Fund — Selected sections from the Japan insurance sector report (cr17281).*

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_Source: https://www.imf.org/-/media/files/publications/cr/2017/cr17281.pdf_