ICP 9: Corporate Governance

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ICP 9:

Corporate Governance

Basic-level Module

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The material in this module is copyrighted. It may be used for training by competent organizations with permission. Please contact the IAIS to seek permission.

This paper has been prepared by Mr. John Thompson, a private consultant based in Toronto, Canada who provides advice and functional support to financial sector regulators, the financial services industry and ed-ucational organizations. He is the Chairman of the Insurance Advisory Group for the Toronto International Leadership Centre (The Toronto Centre is based in Toronto, Canada and provides leadership development training for financial sector regulators.). He is an actuary with over 24 years experience in senior positions within a life insurance company both in Canada and the UK. Prior to becoming a private consultant, he was Deputy Superintendent at the Office of the Superintendent of Financial Institutions in Canada. He also has broad experience at the international level as the former Chairman of the Executive Committee of the International Association of Insurance Supervisors and member of the Basel Committee for Banking Supervision.

The paper was reviewed by Mr. Andre Swanepoel, South Africa and Mr. Alvaro Clarke, Chile. Andre Swane-poel is a private consultant, who retired in 2004 after 13 years as head of insurance and retirement funds supervision with the Financial Services Board in South Africa, where he dealt with all aspects of prudential and market conduct supervision. He is a qualified actuary and spent 15 years in the merchant and general banking industries. Prior to this, he worked for 12 years with a life insurer in the actuarial and investment research departments; he was a member of the Executive Committee of the International Association of Insurance Supervisors (IAIS) and chaired the Emerging Markets Committee of the IAIS. He is active in the Toronto International Leadership Centre.Mr. Clarke is the Principal Partner Clarke & Associates and Professor of Law at Universidad de Chile, Faculty of Law and Faculty of Economics. Mr. Clarke also held various senior government positions in Chile, including the Chairman of Superintendencia de Valores Y Seguros (the Insurance and Securities Supervisor) (2000–2003) and as Vice Minister of Finance (1999– 2000). Mr. Clarke was the president of ASSAL between 2001–2003.

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About the Core Curriculum

A financially-sound insurance sector contributes to economic growth and well-be-ing by supportwell-be-ing the management of risk, allocation of resources and mobilization of long-term savings. The Insurance Core Principles (ICPs), developed by the Inter-national Association of Insurance Supervisors (IAIS), is one of the key interInter-national standards relevant for sound financial systems. Effective implementation of the ICPs requires skilled and knowledgeable insurance supervisors.

Recognizing this need, the World Bank and the IAIS partnered in 2002 to develop a “Core Curriculum” for insurance supervisors. The Core Curriculum project, funded and supported by various sources, supports the learning process of both new and ex-perienced supervisors. The ICPs provide the structure for the Core Curriculum, which consists of a set of modules that summarize the most relevant aspects of each topic, focus on the practical application of supervisory concepts and cross-reference existing literature.

The Core Curriculum is designed to help those studying it to: • Recognize the risks that arise from insurance operations

• Know the techniques and tools used by private and public sector professionals to identify, measure, and manage these risks

• Operate effectively within a supervisory organization

• Understand the ICPs and other IAIS principles, standards and guidance

• Recommend techniques and tools to help your jurisdiction observe the ICPs and other IAIS principles, standards and guidance

• Identify the constraints and identify and prioritize supervisory techniques and tools to best manage the existing risks in light of these constraints.

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Note to Learner

Welcome to ICP 9: Corporate Governance module!

This is a basic-level module on Corporate Governance that does not require spe-cific prior knowledge of this topic. The module should be useful to either a new insur-ance supervisor or an experienced supervisor who has not dealt extensively with the topic—or is simply seeking to refresh and update knowledge.

Start by reviewing the objectives which will give you an idea of what a person will learn as a result of studying the module. Then answer the questions in the Pretest to help gauge prior knowledge of the topic. Then proceed to study the module either on an independent, self-study basis or in the context of a seminar or workshop. The amount of time required to study the module on a self-study basis will vary but it is recommended that it be addressed over a short time, broken into six sessions on chapters if desired.

To help you engage and involve yourself in the topic, we have interspersed the module with a number of hands-on activities for you to complete. These are intended to provide a checkpoint from time to time so that you can absorb and understand the material more readily. You are encouraged to complete each of these activities before proceeding with the next section of the module. An answer key in Appendix II sets out some of the points that you might consider when responding to the questions in each question set. You will also find question sets dealing with the local situation and related to practices in your jurisdiction. These are intended to help you apply the material in this module to your local circumstances. If you are working with others on this module, develop the answers through discussion and cooperative work methods. Since these

Overview and

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responses will vary by jurisdiction, the answer key suggests where you might look for the answers.

As a result of studying the material in this module, you will be able to do the fol-lowing:

1. Summarize the requirements of insurance core principle (ICP) 9

2. Explain the concept of a corporation, specifically (a) the liability of the owners of the corporation; (b) the duties, rights, and powers of shareholders and direc-tors; (c) the duties of directors to shareholders and other credidirec-tors; and (d) the way in which the structure of a corporation compares to other forms of business organization

3. Summarize the role of corporate governance in managing the business and meeting the duties of different parties under corporate law

4. Explain the ultimate responsibility of the board of directors, specifically (a) the information needed and available to the board; (b) the role of independent di-rectors; (c) the role of committees of the board; (d) the setting and enforcement of company policy; and (e) the linkage to, and role of, internal controls

5. Explain why the board of a financial institution should have a higher standard of care than a general-purpose corporation

6. Identify the stakeholders affected by the corporate governance requirements for different forms of business organization

7. Describe the responsibilities of management to the board of directors and how these can be met

8. Explain how corporate governance can be used as a supervisory tool 9. Explain how corporate governance practices can be inspected

10. Summarize the linkages between other supervisors and regulators in setting and enforcing corporate governance practices.

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Pretest

Before studying this module on corporate governance, answer the questions on this page. The questions are designed to help you gauge your existing knowledge of this topic. An answer key is presented in appendix B at the end of the module.

For each of the following questions, circle the responses that are correct. 1. Corporate governance refers to: a. The laws with which corporations must comply b. The way in which companies are directed, managed, and controlled for the benefit of key stakeholders c. The bylaws that a corporation has established d. The way in which meetings of the board of directors are managed. 2. Corporate governance requirements respond to the need to balance potential conflicts between the interests of: a. Investors and the board of directors of the corporation b. Investors and senior management of the corporation c. Investors and customers of the corporation d. The board of directors and senior managementcustomers of the corporation.

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3. Corporate governance is important to insurance supervisors because: a. Well-governed insurers need no onsite inspection b. When it is performed effectively, the supervisor can rely on the work of senior management and the board of directors c. The board will establish conservative reporting standards with hidden reserves, and this will make financial results more predictable d. Shareholder rights are better protected, and this improves the ability of the insurance company to raise money from investorsSecurities supervisors rely on them to protect the shareholders of insurers. 4. With respect to widely held insurance companies, the corporate governance requirements that are set by securities regulators or defined in corporate law meet the needs of insurance supervisors. a. True b. False. 5. Boards of directors establish committees in order to: a. Minimize the conflicts of interest among members of the board b. Review specific matters in detail without taking the time of the full board c. Meet the requirements of applicable corporate governance requirementsmore frequently than is practical for full board meetings and thereby keep in closer touch with senior management d. Relieve some of the liability for directors when faced with decisions that fall outside their area of expertise. 6. Delegation of duties to members of senior management should: a. Be done carefully so that the board has protection from legal liability for decisions made by management b. Be extensive complete so that management is fully able to run the company on a day-to-day basis with little interference from the board

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c. Incorporate checks and balances to ensure that the board can have full confidence in the work of management d. Be limited to areas of the business that the board has insufficient time to work on effectively. 7. ICP 9 focuses on the role of corporate governance in protecting the rights of policyholders: a. True b. False. 8. Ultimate responsibility for the accuracy of information provided by an insurance company to its key stakeholders rests with: a. The insurance supervisor b. The securities regulator c. The external auditors d. The board of directors e. Senior management of the company. 9. A well-run insurance company should have independent members of the board of directors because: a. If it is widely held, these directors will protect the rights of minority shareholders b. These directors will facilitate business development, and this will increase the company’s profitability c. If they have previous insurance experience, these directors will be able to provide market intelligence to the company d. These directors will stimulate discussion at board meetings and question management on the issues. 10. The insurance supervisor is able to assess the effectiveness of corporate governance through: a. Offsite analysis of regulatory filings, public documents, and news releases from the company b. Regular interviews and discussions with senior management and directors c. Onsite inspection of board minutes, internal audit reports, and discussions with senior management

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d. Onsite inspection of the effectiveness of the company’s internal controls e. A combination of both onsite and offsite activities.. 11. If a foreign insurance company is operating in your jurisdiction through a branch, your supervisory agency should: a. Enforce the same corporate governance requirements on the branch as apply to locally incorporated insurance companies b. Rely on the home supervisor where the company is located to enforce its corporate governance requirements on the branch c. Adapt the corporate governance requirements that apply to locally incorporated companies and places d. Require the branch to establish a board of directors in your jurisdiction. 12. For an insurance company that is owned by a single individual, corporate governance: a. Need not be applied b. Should be applied with the exception that members of the board may all be family members c. Should be applied except that strategic planning for the company should be left entirely to the shareholder since shareholder money is at risk d. Should be applied as it would for a widely held company. 13. Internal controls are important for effective corporate governance because: a. Fraud against the company is more easily caught and dealt with b. Management and the board can be more confident that their decisions are implemented c. Management is better able to control the areas of the business that auditors and actuaries are allowed to access d. Management and the board receive reports summarizing the results of implementing company policyon staffing decisions.

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ICP 9:

Corporate Governance

Basic-level Module

A. Introduction

Corporate governance is an important topic for insurance supervisors as evidenced by the fact that one of the 28 insurance core principles (ICP 9) is dedicated entirely to this topic and six others make specific references to the role, composition, and function of the board of directors (see IAIS 2003b). This module focuses primarily on what cor-porate governance is and why financial sector supervisors are interested in this topic. It shows some of the similarities and differences between the objectives of the capital market regulators and insurance supervisors and illustrates why these regulatory au-thorities should work together cooperatively.

Internal controls are an important tool for implementing decisions made by the board of directors and senior management and, as such, are an extension of the discus-sion on corporate governance. The importance of internal controls to insurance super-visors is evidenced by the fact that ICP 10 is dedicated to this topic (see IAIS 2003b). Other closely related topics covered by the core principles include suitability of persons (ICP 7), changes in control (ICP 8), onsite inspection (ICP 13), risk assessment and risk management (ICP 18), and information, disclosure, and transparency toward the market (ICP 26). As further evidence of the importance of this topic to insurance su-pervisors, many of the supervisory standards and guidance papers that have been is-sued by the International Association of Insurance Supervisors (IAIS) make reference to corporate governance issues (see IAIS 1998a, 2000, 2002a).

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Concept of corporate governance

The concept of corporate governance is widely discussed, and the term is used to de-scribe a range of practices and approaches. In this module, the term is defined as the processes, structures, information, and relationships used for directing and overseeing the management of the institution in the best interest of the institution and key stake-holders with a significant interest in the ongoing viability of the company. It is used in a broad sense so that it covers the interests of financial sector supervisors and policyhold-ers as well as investors. If a more narrow interpretation is intended, this is made clear in the text.

Corporate governance is most often thought of in terms of corporate entities. A corporation is a special form of business enterprise that is approved under corporate law or company law. This is distinct from a partnership, personal company, and so forth in that the liabilities of the

corpora-tion are limited to the value of the assets of the corporation. The cor-poration often has the rights and responsibilities of a person under the law, although it is a corporate entity. It is a legal person as dis-tinct from a natural person. A cor-poration has a board of directors that provides oversight and advice to management on behalf of key stakeholders.

The concept of corporate governance as used here applies to legal entities with a board of directors. The concept is not directly applicable to branches of foreign com-panies. However, the advanced-level corporate governance module develops some ideas on how supervisors can apply the same basic concepts to the supervision both of branches and of companies.

This definition is supported by the requirements of the IAIS core principle on cor-porate governance, which sets out the powers, rules, and requirements that should be in place for the insurance supervisor to be able to use corporate governance as an effective supervisory tool. According to ICP 9,

The corporate governance framework recognizes and protects the rights of all in-terested parties. The supervisory authority requires compliance with all applicable corporate governance standards.

Supervisors need to understand what corporate governance means, why it is an important supervisory topic for inclusion in the core principles, what this principle requires, and how these requirements can be implemented.

Corporate Governance Corporate governance consists of the processes, structures, information, and relationships used for directing and over-seeing the management of the institution in the best interest of the institution and the key stakeholders that have a signifi-cant interest in the ongoing viability of the company.

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Context for corporate governance

Corporate governance is a complex interweaving of legislation, regulation, business practices, institutions, traditions, culture, and social values. This complexity has pro-duced different definitions and practices in different parts of the world as to what con-stitutes good corporate governance (see Iskander and Chamlou 2000 for a discussion of the history and range of practices). Corporate governance focuses on knowledge and behavior and so deals with the processes for sharing information, making decisions, and implementing decisions effectively. Corporate governance is not about power and centralizing power in a few people (for a more complete discussion, see the paper by John Pound in Salmon and others 2000). Good governance is the means of ensuring that there is adequate control over objectives, strategies, controls, and operations within the company.

A great deal has been written about corporate governance, including the interna-tionally recognized principles developed by the Organisation for Economic Co-opera-tion and Development (see OECD 1999), and the topic is actively evolving. What is considered to be good corporate governance in a country has changed considerably, largely as a result of reviews undertaken after a large corporate failure in which the failure was a surprise or investors suffered significant losses. For example, consider the failure in 2001 of HIH Insurance Group in Australia (see HIH Royal Commission 2003) or the failure of Enron in the United States in 2002, which produced numerous recommendations for changes in corporate governance practices in the United States and other capital markets. This type of historical development of corporate gover-nance is common in most developed countries.

The term corporate governance is most often associated with requirements for the composition, structure, and work of the board of directors so that it can meet its obliga-tion to shareholders in general and minority shareholders in particular. With this defini-tion and its focus on investors, it is easy to understand why a capital market regulator is concerned about companies having sound corporate governance practices. Through these processes, the board ensures that the company is directed and managed in a way that is transparent to and protects the interests of shareholders.

By extension, corporate governance as used here relates to meeting the needs of all of the key stakeholders through the practices and work of the board and senior manage-ment. By using this more comprehensive definition, we consider why an insurance su-pervisor presses for good corporate governance, as a key stakeholder working on behalf of the government (to bolster public confidence in the financial system) and on behalf of policyholders and claimants (to protect them from undue loss).

The basic concept behind corporate governance is that the board should have suf-ficient influence on, and control of, the major decisions made by and the operations of the company to control its financial destiny as much as possible. Corporate governance defines the mechanisms for achieving this objective, and an important element of these requirements revolves around the business plan and its use in managing the company.

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This need to develop and implement business plans is an important part of the role of senior management and the board of any company.

Relevance to insurance supervision

Two elements of the corporate governance concept make it an important part of effec-tive insurance supervision:

• Effective corporate governance can improve the confidence that investors have in a company and therefore strengthen the access that a company enjoys to capi-tal and other forms of financing, as and when it might be required.

• Effective corporate governance strengthens the controls within a company to ensure that the strategies adopted and decisions made by the board, acting on behalf of stakeholders, are implemented effectively.

Effective corporate governance allows the supervisor to rely on the work performed by the board of directors and senior management and, in so doing, allows the supervi-sory process to operate more efficiently and effectively than it could in the absence of such reliance. This reliance relationship must be reviewed from time to time to ensure that the reliance is well founded.1

It is important for the supervisor to review the corporate governance practices in place in each company to ensure that the specific elements adopted by the company are appropriate for its circumstances. Each company should implement all of the corporate governance requirements. However, more complex companies must have more com-plex structures and procedures to manage the business and the inherent risks to which the company is exposed. As a result, the process that a supervisor might use to inspect corporate governance and internal controls forms a part of this module.

Commonly used terms

Before delving into the topic, it is important to define some commonly used terms: • Board of directors. This term is used to mean the most senior body in the corporate

structure. In some countries, senior management reports to a single board of direc-tors. When there is one board, the term applies to the board. In other countries, a two-tiered system applies, so there is a supervisory board and a management board.

1. The term reliance relationship is used here to describe a relationship between people or groups under which one party depends on the other to perform certain work to prescribed and agreed standards. The party that depends on the other to perform the work is involved in setting the standards for performance or agrees to the standards as reasonable. Once the work is performed, the dependent party reviews the work to determine whether or not it was performed to the agreed standards but does not reproduce the work itself. If the work does satisfy the standards, the dependent party uses the results.

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In this case, the term board is used to mean the supervisory board, and members of the management board are referred to as senior management.

• Corporation. A corporation is a special form of company structure permitted under legislation: the company has limited liability but has the duties and re-sponsibilities of an ordinary person.

• Closely held company. A closely held company is a business that is owned by shareholders who are few in number or closely associated so that control of the enterprise is focused in a few hands.

• Widely held company. A widely held company is a business that is owned by shareholders, none of whom owns a sufficient number of shares to exercise con-trol of the company or its board.

For each of the following questions, which responses are correct? Circle your choices. More than one may be valid.

1. Corporate governance refers to: a. The way that companies are directed, managed, and controlled for the benefit of all stakeholders and interested parties b. The structures, processes, and relationships used for directing the affairs of the company c. The framework that insurance supervisors have in place to protect the rights of policyholders d. The centralization of power and control in the company’s board of directors. 2. In ICP 9, IAIS has defined: a. All of the corporate governance requirements that insurance companies must follow b. The corporate governance framework that insurance supervisors should have in place to support effective supervision c. The concept of corporate governance to include any rules that may be prescribed by securities regulators d. The concept of corporate governance so that supervisors can look to the board of directors to implement remedial action when necessary. 3. Effective corporate governance: a. Strengthens the confidence that the public places in the insurance sector b. Provides the supervisor with more flexibility in designing its supervisory methodology

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Answer these questions in relation to the practices in your jurisdiction. If you are working with others on this module, develop the answers through discussion and cooperative work methods.

1. Are insurance companies required to comply with corporate governance requirements in your jurisdiction? What competent body sets these rules? Do these rules apply to all types of insurance companies? 2. What types of insurance enterprises operate in your jurisdiction? a. Locally incorporated companies b. Branches of foreign companies c. Friendly societies or cooperative or mutual insurance companies d. Fraternal benefit societies e. Government-owned companies under special enabling legislation. 3. What types of board structures are permitted in your jurisdiction? a. Single board b. Two-tiered board c. Other. Please describe. 4. What types of insurance corporations are present in your jurisdiction? And how are their boards of directors selected? a. Corporations with exchange-traded shares b. Closely held corporations.

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c. Creates a sound reliance relationship so that the insurance supervisor can rely on the work of the board of directors d. Creates complex structures for complex companies and simple structures for simple companies. 4. Corporate governance requirements for insurance companies can be defined in: a. Insurance companies legislation b. Insurance companies regulations c. Corporate law or the companies act d. Securities legislation and rules.

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B. Fundamentals of Corporate Governance

To understand corporate governance, it is appropriate to start with the role of corporate governance in meeting the needs of investors and securities regulators and then to con-sider how corporate governance is used by insurance supervisory authorities.

Role in investor protection

Much of the literature on corporate governance focuses on shareholder protection in general and on the rights of minority shareholders in particular. Providing this type of protection is intended to increase investor confidence and thus foster a more robust capital market. The more confidence that investors have in the marketplace and the companies whose shares are traded in the market, the greater is the likelihood that the market will be an active place for companies to raise capital and investors to buy and sell shares or other securities.

Corporate governance emerges out of the need to balance the potential conflict between the investor (the lender of money who is seeking a good return in relation to the risks involved) and the interests of those who control the company (the individuals who decide how that money is used and may be more willing to take risks when using other people’s money). When the owner of a company also manages the company, deci-sions will have to recognize and balance these divergent interests. When more than one shareholder is involved, these relationships become more complex, and a process must be established to oversee the operations of the company and protect the interests of the lenders of capital.

The people who run the company are insiders because they have ready access to information about the company and its prospects for the future.2_{The lenders of capital}

are often outsiders and do not have ready access to this level of information. An impor-tant part of corporate governance is disclosure and transparency aimed at balancing the interests of outside investors and the interests of insiders so that the rights of all shareholders are distributed broadly and evenly.

Corporate governance is intended to provide this balance so that outside investors are not at a significant disadvantage in relation to insiders.

Access to information

Investors with a majority shareholder position generally are able to obtain access to in-formation about the performance of the company and its plans for the future. Minority

2. Insiders who also own shares can decide to buy and sell shares using this inside information if no system is in place to balance the interests of insiders and outside investors. Corporate governance is not generally intended to protect outside investors from this risk. However, most securities regulators have rules regarding insider trading. Most corporate governance regimes, however, include elements that minimize the undue influence of insiders on setting strategy and making important decisions that affect the rights of other shareholders.

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shareholders generally are not treated as insiders because the investment position they hold is small and they may only hold the securities for a short period before trading them. As a result, in the absence of rules protecting the rights of minority shareholders, these investors might not get good-quality information about the company and may be reluctant to make an investment. The possibility of uneven access to information about the company gives rise to many of the requirements and practices—which may be defined in corporate law, securities law, or other legally enforceable ways—that are fundamental to good corporate governance.

Investor confidence

One of the objectives of corporate governance is to provide investors with the confidence to make in-formed investment decisions. To make an informed decision, in-vestors must have access to infor-mation that allows them to assess the risks to which the investment is exposed and the potential for investment gains. This is the ba-sic risk-reward assessment that informed investors carry out in matching their own risk tolerance with their desire for a good return on investment. When investor

in-formation is distributed more evenly so that majority and minority shareholders have access to the information necessary to make this risk assessment, investor confidence increases, more investors are willing to take a position in the market, and companies have more opportunities to raise capital when needed. Having a wide range of investors making informed decisions contributes to building and maintaining a broad, deep, and diversified market for traded securities.

The foundation of deep and broad capital markets is access to investor informa-tion:

• Investors need to have good-quality, reliable information so that they have con-fidence in making informed decisions.

• Investors need to understand the financial condition of the company and the impact of planned actions for the future.

• Investors should have information about the people running the company and how they manage and control the business activities of the company.

Corporate Governance and Investor Confidence Good corporate governance can increase investor confidence in making investment decisions. This, in turn, can improve the access of companies to additional work-ing capital, enabling them to improve their range of products and services. This can improve company profitability and retained earnings, thereby improving policyholder confidence that the company will meet its promises.

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• Investors need to be confident that they are receiving accurate information in a timely manner.

• Investors need to be confident that the people who are running the company are doing so in a prudential manner.

Internal controls

These needs are met through checks and balances at the board level and internal con-trols at the company level that ensure that the board and senior management are fully aware of what is happening within the company.

Having control of the operation of the business is important for the management of all companies and for good corporate governance. If the board or senior management has control of the company, the company is probably using elements of corporate gov-ernance. The basic concept is as

appro-priate for a closely held company as for a widely held company. It is as appropriate for a company with only majority share-holders as it is for a company with only minority shareholders. It is as appropri-ate for companies that are traded on rec-ognized exchanges as for those that are not publicly traded. The basic need is for the board and senior management to have control of the company, to have a suitable strategy for directing the opera-tions of the company, to have adequate information to control the company, and to ensure that appropriate checks and

balances are in place so that the board and management have reasonable control of the future potential of the company.

The board and senior management control the company through a combination of requirements for how the board operates, for management, and for the flow of infor-mation, controls for ensuring the accuracy of information and the implementation of company policy as well as other decisions of the board and management, and practices for managing risks. This range of requirements and processes defines the requirements for corporate governance. It also covers the tools required to make corporate gover-nance effective. These include the individuals who hold senior positions, the size and composition of the board, compensation, the planning processes, and internal controls and audit. Internal Control Internal control is an important tool used by the board of directors and senior management to ensure that their decisions are implemented and followed within the company. Know-ing that a company has good internal controls allows the regulator or insurance supervisor to have greater con-fidence that the company will be able to comply with any directives that it might be given.

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Delegation of duties, with controls

The knowledge and experience of members of the board and management are an im-portant part of corporate governance. After all, the board effectively delegates matters to senior management, and senior management carries out the decisions of the board and runs the company on a day-to-day basis. Management, in turn, reports back to the board on its achievements and the progress of the company toward meeting its goals and objectives. The board must have confidence in management for the company to run effectively; for this reason, checks and balances are needed to ensure that the confidence in management is well deserved.3

Once again, any well-run company would want to have controls in place in order to ensure that the individuals running the company set a direction and strategy and the individuals working for the company do what is expected of them (see figure 1). This process of delegation, review, assessment, and revision is an example of a reliance relationship.

Capital market regulators

Capital market regulators want to ensure that companies have these controls, checks, and balances in place because they look to the board to protect the interests of investors. Capital market regulators maintain that fair and efficient markets must be transparent. As a result, there are a great deal of rules around what market participants must do in order to keep the investing public informed about the activities and affairs of the com-pany.

3. It is not unusual for the controlling shareholders of a closely held company to have undue influence in selecting senior management, setting strategy, and making important decisions. This influence can work to the disadvantage of other inves-tors. Effective corporate governance minimizes this effect.

Figure 1: Checks and Balances in a Well-Run Company Delegation • Range of action • Authority • Limits Tools • Company policy • Departmental role • Job descriptions • Business plans Control • Monitoring • Reporting • Review • Revision Tools • Performance appraisal • Audit • Variance reports Board Senior management Staff

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Shareholder meetings are an important vehicle for providing investors with access to informa-tion and exposure to the board and management. This, in turn, contrib-utes to the confidence of investors in how the company is managed.

Insurance supervisors

Insurance supervisors seek to en-sure that companies have good corporate governance practices as well. However, that interest is not simply to protect the rights and interests of shareholders. After all, the money that investors have tied up in a company forms at least part of its capital base,4_and

super-visors rely on that base to protect the rights of policyholders in the event the company fails.

Insurance supervisors want to

ensure that companies have access to additional capital should that be necessary. They want to have insurance enterprises that are well managed, treat their customers fairly, are in compliance with the legislation and other requirements, and are managed by competent, ethical individuals. In addition, insurance supervisors want to have confi-dence that any supervisory sanctions, demands, or actions required of the company will be carried out.

The principles of sound corporate governance contribute to all of these goals. It is, therefore, not surprising that insurance supervisors expect all companies to practice good corporate governance no matter what the corporate form of the company.

Fiduciary duties

Many insurance companies have more policyholder money than shareholder money. That is, the size of the policy and claims liabilities (and provisions or reserves) ex-ceeds the amount of assets held as the result of shares and other capital instruments that the company has issued. In deciding to invest in the company, investors are aware

4. Capital is made up of retained earnings and a range of financial instruments that are subordinate to the rights and interests of policyholders and claimants. For a more complete discussion of capital, see IAIS (2002b).

Corporate Governance and Confidence of Stakeholders The principles of sound corporate gover-nance contribute to the confidence that all stakeholders place on management and the board to balance their interests with those of other stakeholders. Corporate governance allows the board to provide direction, leadership, and control to the company.

Exemptions from Compliance

In many jurisdictions, legal entities are active in insurance that are not corpora-tions and are not subject to corporate law. These may be insurance pools or government-owned insurance providers established under special legislation. These entities may be exempted from compliance with normal corporate gover-nance or supervisory requirements in the jurisdiction.

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of the risks and seek information to assess the level of risk and potential rewards. Policyholders rarely recognize the risks involved in dealing with a particular insur-ance company. Rather, they seek the services of an insurinsur-ance company to relieve them of unwanted exposure to risk.

Since policyholders and shareholders both have money in the company and are at risk in the event of failure, they share a common interest that the company should be run in a prudential, profitable, and sound manner over an extended period. These groups are both interested in corporate governance to protect their interests. However, even though they have some interests in common, board decisions that benefit share-holders may not necessarily benefit customers and vice versa.

Within the company, corporate governance must balance the potential conflict be-tween the rights and interests of various stakeholders.5_{For example, a decision by the}

board may increase the risks to which shareholders are exposed, while reducing the risks to which policyholders are exposed. Investment strategies that seek to meet the long-term commitments to policyholders may not produce attractive short-term re-sults for investors. Corporate governance must recognize, balance, and deal with these potential conflicts.

The special relationship between the insurance company and its customers requires an especially high standard of care on the part of company management and the board. In addition, since the business is complex and few customers understand all aspects of the products and services they purchase, the insurance supervisor provides oversight of the industry on behalf of policyholders and the general public.

This complex interaction of issues and interested parties makes the topic of cor-porate governance a challenging one for financial sector supervisors. Given the im-portance of corporate governance to supervisors, IAIS has prepared clear guidance for insurance supervisors on this topic.

5. Balancing the interests of stakeholders is an important function of the board. Some stakeholders have a long-term view, and this may be best met through strategies that focus on prudential, profitable approaches with a focus on the customers, staff, and the expectations of regulators. Other stakeholders have a short-term view, and this may be best met through a strategy that focuses on earnings and shareholder dividends. The need to balance these potentially divergent objectives often requires choices, and in making these choices, the decisionmakers need to understand the business and the issues involved.

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1. Boards of directors control the flow of information out of the company so that: a. Proprietary information is kept confidential b. The information that is released is accurate c. Key stakeholders will have greater confidence in the company d. The company’s profile is kept at a high level to increase sales. 2. Stakeholders need to make informed decisions about the company using information from the company. For example, a. Shareholders need to decide whether to buy, sell, or hold their shares b. Brokers need to decide whether to place business with the company c. Insurance supervisors need to determine if the company is in compliance with legislation and regulations d. Securities regulators need to decide if the company is viable. 3. Internal controls are designed to: a. Help companies identify members of staff who are stealing from the company b. Enforce decisions made by the board c. Ensure that information provided to the board is accurate d. Keep management and the board fully aware of what is happening in the company. 4. When the board of directors delegates duties to senior management: a. The board delegates accountability for the function as well b. The board intends to make it clear that management is fully accountable for decisions made in that area c. The board establishes benchmarks for measuring performance d. The board intends to test the competence of management.

Q4

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Q4

continued 5. A board of directors has a duty to: a. Ensure that all promises made on behalf of the company are met b. Balance the expectations of policyholders and investors c. Invest the assets of the company for the maximum yield d. Ensure that the company is in compliance with all legislation and regulations.

1. What corporate governance requirements have the capital market regulators in your jurisdiction set that apply to insurance companies? 2. Have any of the locally incorporated insurance companies in your jurisdiction recently used the local capital market to raise additional capital? What type or types of financial instruments did they use? 3. For the largest corporate life insurance company in your jurisdiction, what is the ratio of the value of the liabilities related to policyholder obligations to the value of capital provided by investors and shareholders?

Q5

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C. Understanding the Core Principle

The meaning of ICP 9—corporate governance—should be considered with reference to the detailed wording of the explanatory notes, the essential criteria, and the advanced criteria. The complete text of this core principle is reproduced as appendix I to this module.

The core principle itself focuses on the powers and authority that insurance super-visors must have in order to carry out their duties in an effective manner. The principle does not attempt to define corporate governance or provide a detailed list of every ele-ment that is required for the concept to be effective within a company. The focus is on the supervisory needs.

The first sentence of the principle indicates that the corporate governance frame-work should “protect” the rights of “all interested parties.” These terms should be un-derstood in the context of why an insurance supervisor should focus on these issues and how the principle can be met.

The word “protect” does not mean that supervision will guarantee that the parties will never lose money. Rather, it means that supervision provides a defense against un-due loss—losses that are surprisingly large under the circumstances. As with any defen-sive system, the effectiveness cannot be guaranteed, so the test of the supervisory system is not whether there are failures or losses but whether those losses are unduly large.

The term “all interested parties” refers to persons or entities that have a financial interest in the insurance company or are regulators or supervisors with responsibility for oversight of the insurance company. These are policyholders, claimants, investors or other creditors, securities regulators, and insurance supervisors.

The second sentence of the principle deals with the need for the insurance supervi-sor to recognize and require compliance with all of the corporate governance require-ments that apply to insurers, including those that may have been set by other competent regulatory authorities. This highlights the need for supervisors to work cooperatively, since each may have expectations and needs that can best be met through good cor-porate governance. The overall corcor-porate governance regime only makes sense and is effective if insurers have a coherent, cohesive set of rules with which to comply.

The explanatory notes

In the explanatory notes, the first two sentences in paragraph 9.2 say, “The board is the focal point of the corporate governance system” and “is ultimately accountable and responsible for the performance and conduct of the insurer.” Thus the board has di-rect responsibility for management and oversight of the company. The board can del-egate responsibility to full-time staff and executive officers, but this does not absolve the board from its responsibilities.

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The explanatory notes also indicate (in paragraph 9.3) that even in jurisdictions where corporate governance rules apply to all general-purpose corporations, “it is nec-essary to establish additional requirements.” This higher standard of care is required because of the board’s fiduciary duty to policyholders and its duties to the insurance supervisor.6

The essential criteria

IAIS defines three essential criteria.

The first deals with the possibility that insurance supervisors and others could promulgate corporate governance rules and regulations and that insurance companies would have to comply with all of them. The insurance supervisor must, as a result, have authority to verify and enforce compliance with all of these rules and regulations, whether they are defined under insurance legislation or not. This is necessary because only one set of corporate governance rules should apply to any one company, even if they are developed and promulgated by different empowered bodies in a jurisdiction. Therefore, if existing corporate governance rules apply to insurance companies, the in-surance supervisor may expand on those rules to include duties for the board and man-agement to meet its own special needs. However, in so doing, the existing rules and the additional rules must complement each other and work together.

The second deals with the power and responsibility that falls to the board of direc-tors. The 11 subcriteria in this section deal with the idea that the board has a duty to see that the company is well managed and has sound practices and procedures in place, including processes for ensuring that the company is in compliance with relevant laws and other requirements and that management is competent and fit for their position. These requirements are similar to what one would expect to be in place to protect the rights of investors. However, due to the special nature of the insurance business, these subcriteria include references to oversight of the company’s risk management practices and actuarial practices and the need for the board to communicate and meet with the insurance supervisor, as may be required.

The third of the essential criteria deals with the responsibility of management. The three subcriteria in this section focus on setting direction for the company, having con-trol of its operations, and providing full and fair reporting to the board. A sound and open working relationship between the board and management is critical to the ef-fectiveness of corporate governance within a company. The flow of information from management to the board is critical to the board’s ability to understand the operations of the company.

6. The nature of these duties depends on the fact that a large proportion of the assets of the company should be treated as policyholder or claimant money and not as money that can be used at the complete, unfettered discretion of the company.

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The advanced criteria

IAIS defines four advanced criteria.

The first deals with the establishment of board committees with specific responsi-bilities, such as compensation, audit, or risk management. The use of board committees is discussed in the section of this module dealing with the structure and functioning of the board.

The second notes that remuneration of directors and senior management should give regard to the performance both of the individual and of the company. Remunera-tion policy should not include incentives that encourage imprudent behavior.

The third recommends that one or more officers be given responsibility for ensur-ing compliance with relevant legislation and required standards of business conduct. The existence of an effective compliance officer, who reports to the board of directors at regular intervals, can be an important part of an insurer’s system of internal controls.

The last of the advanced criteria indicates that when a “responsible actuary” is part of the supervisory process, the actuary should have direct access to the board of direc-tors or a committee of the board and report relevant matters to it on a timely basis. IAIS (2003a) contains a full discussion of this topic.

Please answer the following questions:

1. Why would ICP 9 require the insurance supervisor to protect the rights of all interested parties, where these include shareholders? 2. Why should an insurance supervisor have the power to enforce the corporate governance requirements of other competent regulatory bodies? 3. Why might an insurance supervisor prescribe corporate governance requirements for insurance companies in addition to those that apply to other companies?

Q6

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Answer these questions in relation to the practices in your jurisdiction. If you are working with others on this module, develop the answers through discus-sion and cooperative work methods.

1. After reviewing the material above and the text of ICP 9 (appendix I), consider the degree to which the insurance supervisory authority in your jurisdiction has the powers to specify and enforce the corporate governance requirements described in ICP 9. 2. Which of the duties described in the second essential criteria are required of a board of directors in your jurisdiction? Whether or not they are legally required, which of these criteria are commonly met? Which require strengthening?

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D. Supervision and Inspection

Supervision of corporate governance involves a combination of offsite analysis and on-site inspection. The measurable elements of the corporate governance requirements can generally be assessed through offsite analysis, while it is generally necessary to inspect the principles-based requirements through a document review and through discussions with senior management. These are generally possible only onsite.

Compliance assessment

Compliance assessment is an im-portant extension of a company’s corporate governance regime be-cause sound corporate governance and internal controls processes are needed for the company to ensure that it is in compliance with all of the requisite laws and regulations.

Therefore, supervisors should review the internal controls and

compliance assessment procedures. The compliance assessment process should be in place and used effectively to support the information needs of senior management and the board.

Board oversight

Part of what constitutes good cor-porate governance relates to what the board does to oversee and as-sess its own work, the work of senior management, and inter-nal control processes. Appraising boardroom performance is not an easy task, and it is best carried out through formal processes that are accepted and understood by the board. Increasingly, companies are implementing this aspect of good

corporate governance (for a discussion of this topic, see the contribution by Jay Conger in Salmon and others 2000).

Internal Controls and Inspection

When a supervisor is satisfied that a company has effective internal controls in place, the supervisor is able to focus inspection on the internal procedures and internal enforcement actions taken by the company rather than carry out a detailed review of compliance itself.

Planned Activities in Onsite and Offsite Inspection Inspection of corporate governance re-quires planned activities in both onsite and offsite inspection. Neither element of the inspection process can be used effectively on its own to review the corporate gover-nance and internal control procedures that a company has in place and to determine how well they work.

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A supervisory review of a company’s corporate governance includes both offsite analysis and onsite inspection.

Offsite analysis entails the following activities:

• Review public documents on board structure and membership

• Review regulatory filings that include information on board members, changes in composition, curriculum vitae of board members, and changes in commit-tees of the board

• Review documents prepared by the company to disclose its financial position (see IAIS 2002a for the range of information that should be made available to stakeholders)

• Review news releases to identify the types of issues that are disclosed during the year and the reaction of industry commentators (either analysts or journalists) to this disclosure.

Onsite inspection entails the following: • Review the minutes of the board

• Review information provided to the board • Review the minutes of board committees • Review the reports of external auditors

• Review the reports of internal auditors and discuss them with audit staff as well as staff in the areas affected.

The quality of this type of review is highly dependent on the support and involve-ment that the inspection team receives from the company. Access to information by inspectors must be unimpaired for this review to be useful.

Reliance relationships

Inspectors are, in effect, reviewing a reliance relationship that corporate governance creates between the staff of the company and the board of directors. A party deter-mined to hide information from another can always find ways to do so. Recent events involving some very large companies in various parts of the world have demonstrated this. In some cases, the boards of these companies included very knowledgeable and able people, and yet transactions were completed in a way that avoided scrutiny by the board and auditors of the company. However, even though corporate governance is not a perfect mechanism for protecting the rights and interests of key stakeholders, those interests are far better served through the use of corporate governance than would be the case in its absence.

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A supervisor cannot check every transaction to ensure that every law is followed and that sound accounting and risk management practices are employed. The cost of such a system would be prohibitive. However, relying on the work of the board and the sound corporate governance practices it has adopted allows the supervisor to verify that a company uses the appropriate systems and processes in its day-to-day operations.

Internal controls

Inspecting the internal controls procedures is also important because doing so allows the inspection team to determine the level of control that the board and senior manage-ment have over the operations of the company. Inspecting internal controls involves verifying the following:

• Policy is set by the board.

• The board is specific in identifying the person to whom authority is delegated. • The delegation includes an accountability framework, which means in most

cases that this person reports on the use and effectiveness of the policy. • The policy is clearly communicated to everyone who needs to know about it. • The application of the policy is monitored regularly.

• There is an independent review process (probably an internal audit).

• The effectiveness is assessed regularly, recommendations for strengthening are made, and the recommendations are considered and implemented, where ap-propriate.

• The policy is reviewed by the board from time to time and is updated regularly. If these steps are not in place, the inspectors will need to be satisfied that what-ever processes are in place are effective in implementing, overseeing, and verifying the decisions of the board. For a more extensive discussion of internal control issues, see the core curriculum module on ICP 10 and Basel Committee on Banking Supervision 1998.

Influences on supervisory effectiveness

In order for the insurance supervisor to be effective in carrying out his or her duties: • The supervisor must be able to obtain comprehensive written information about

the company and rely on its accuracy and completeness.

• The supervisor must be able to assess and have confidence in the competency of management.

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• Since some board records are only available at company offices, some of this review can only be carried out through the onsite inspection process (for a more extensive discussion, see IAIS 1998b).

• The supervisor must have access to people in the company and to proprietary in-formation about the company’s operations that is timely, reliable, and accurate. • The supervisor must have confidence that a commitment for action by the

com-pany can be made and met.

• The supervisor must be able to conduct effective onsite inspections to verify all important facts and to talk to staff and management as appropriate.

• The supervisor must have confidence that the company is managed in a manner that meets the requirements of the law.

• The supervisor must have confidence that the company is managed in a pruden-tial manner that recognizes and manages risks inherent in the business.

• The supervisor must have confidence that policyholders and prospective policy-holders are treated fairly.

These objectives can be met through sound corporate governance practices and good internal controls procedures.

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1. Effective corporate governance allows the insurance su-pervisor to look to the board of directors: a. To assure that directives issued by the authority are implemented b. To ensure that information filed with the authority is filed on a timely basis c. To attract and retain a competent senior management team d. To provide inspectors with free access to people and in-formation. 2. The licensing process requires the insurance company to have a board of directors and senior management that are competent and experienced. It is not necessary to review the fitness and propriety of management after the license has been granted. a. True b. False. 3. In carrying out an offsite analysis of a company’s corpo-rate governance regime, the supervisory authority will: a. Focus on a review of public documents and regulatory fil-ings b. Consider articles on the company that were published in the newspapers c. Assess the depth of discussion that is reported in board minutes d. Review the effectiveness of the company’s internal con-trol procedures. 4. In conducting an onsite inspection of a company’s corpo-rate governance process, the supervisory authority will: a. Work through senior management to get copies of the in-formation that was provided to the board to support any important decisions that were made b. Review internal audit reports on control procedures c. Talk to department heads to see what they understand of specific compliance requirements that have been pre-scribed by the authority d. Review business plans and reports on achievements ver-sus goals.

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1. How is compliance with corporate governance requirements done in your jurisdiction? 2. What process would the inspectors follow if they uncovered a violation of one of the requirements set out under corporate law? How would remedial action be enforced, and what body would lead the effort?

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E. Principles of Corporate Governance to Protect Key Stakeholders

This section presents some elements of corporate governance that may practically be applied in less developed economies or insurance sectors. However, it is instructive to understand how some of the best practices are integrated and defined. In the ad-vanced-level corporate governance module, a section discusses some of the issues that supervisors face and how they have implemented or might implement a revised regime to compensate for the gaps.7

This section discusses best practices that build on those that are often promoted for general-purpose companies with shareholders. Where appropriate, these concepts are expanded for insurance enterprises. As a result, this discussion goes beyond the scope and content of ICP 9.

Basic principles

Corporate governance regimes are usually based on the basic principles of transparen-cy, fairness, accountability, responsibility, and control (for a more complete discussion, see Iskander and Chamlou 2000). These can be embodied in a few common concepts:

• Shareholders should have a right of access to information about the company and should be involved in key decisions that affect the fundamental framework of the company.

• There should be fair and equitable treatment of all shareholders and all key stakeholders so that no group is at either an advantage or a disadvantage in the process.

• Timely and accurate financial information should be made available.

• Boards should provide oversight of the operations of the company and balance the interests of all key stakeholders with those of the company.

These principles are met by dealing with the following topics and issues: • Board membership

• Structure and functioning of the board • Business planning and controls

• Information provided to the board

• Information provided to key stakeholders.

7. There are basic differences in how these elements are put into effect in different countries. For countries that use the civil code approach, it is common for the requirements to be defined clearly in legislation or regulations in a prescriptive manner. This could be thought of as a rules-based approach, and the onus is on the supervisor to demonstrate noncompliance. For countries that follow the common law approach, the requirements could be defined in a rules-based way or in a principles-based approach. The latter approach includes a clear definition of the objective that is to be achieved, and the onus is placed on the company to demonstrate that the regime meets these objectives. The legal system can affect how corporate governance is implemented within a country.

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Each of these areas is considered in turn.

Board membership

The following issues are relevant to board membership: • Independent directors

• Executive and nonexecutive directors

• Experience and ability to work as a board member • Attendance and level of involvement of board members • Terms of appointment

• Separation of duties • Conflict of interest.

Best practices in these areas are intended to ensure that individuals on the board of an insurance company have adequate experience and knowledge and few direct links to management. This will improve their ability to achieve the following objectives:

• Provide insightful direction to management and oversight in balancing the in-terests of the company with the inin-terests of investors and other stakeholders • Question the decisions and results of the company as an investor would in the

same circumstances.

ICP 9 includes several references to these issues. The second essential criterion deals with the duties and composition of the board and links directly to the core principles on suit-ability of persons (ICP 7). Some of the best practices noted are included in the advanced criteria. Some of these may be more readily applied in an established mature market than in a less developed insurance market. However, the insurance supervisor

should have the authority to require boards of directors of insurance companies to have in place procedures dealing with these issues. This best practice category is directed at ensur-ing that the board is able to oversee the company and management in a way that balances the interests of key stakeholders with those of the company. To achieve this objective, the board must be composed of capable individuals who are willing, and have the time, to oversee the operations of the company.

Who May Be a Member

Who may be a member of the board of an insurance company is an important part of determining the ethical and business stan-dards to which the day-to-day operations of the company are held. Board members must be not only fit and proper for their role but also willing to dedicate the time and effort required to perform their duties effectively.

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One of the functions of the board is to establish the roles and duties of senior man-agement and to select the most senior person to look after the day-to-day operations of the company. In doing this work, it is important to minimize the conflicts of interests that may emerge. Because of this, concentration of power and authority is usually bal-anced with the need for efficiency, range of responsibility of senior people, and author-ity to act. Separation of duties is a common way to avoid the concentration of power and provide checks and balances in the management system.

The size of the board is also important for its effective operation. The board should be small enough to attract involved, capable, and interested individuals but large enough so that the burden on any one individual is manageable.

Structure and functioning of the board

The following issues are relevant to the structure and functioning of the board: • Setting of the board agenda

• Provision of information in advance of meetings • Frequency and scope of meetings

• Board committees and composition

• Setting of board and management compensation • Performance of board members.

Best practices in these areas are desirable for the following reasons:

• How a board makes decisions and the matters that are discussed with the board all influence its effectiveness.

• The person who controls the agenda influences the scope of work of the board and the level of understanding that the board has on issues.

• Use of board committees can relieve the full board of the detailed review that some issues require by having a

few individuals conduct the review on behalf of the full board. Board committees can also be structured to provide more independence in the review process when that is ap-propriate.

• The base level of compensation and incentive compensation can affect

behavior and the degree to which the interests of key stakeholders are met. • The role of the board is critical, and the performance of individual board

mem-bers can affect the performance of the board as a whole.

Effectiveness and Efficiency of the Board The effectiveness and efficiency of the board are influenced by what matters are brought to the board and the processes the board has in place to consider the is-sues and make decisions.

ICP 9: Corporate Governance

ICP 9:

Corporate Governance

Basic-level Module

Contents

About the Core Curriculum

Overview and

Pretest

Q1

Q1

Q1

Q1

ICP 9:

Corporate Governance

Basic-level Module

Q2

Q3

Q2

Q4

Q4

Q5

Q6

Q7

Q8

Q9