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The Risk of Contagion

Contagion
The risk of contagion or financial infection refers to the exposure (or damage) that a tainted activity or component might inflict upon the financial services conglomerate. A bank, for example, may have a property and casualty subsidiary that has experienced enormous losses. If the bank transfers significant amounts of capital to the insurer, it might jeopardize the entire group’s financial security. This transaction may be completely transparent or accomplished surreptitiously depending upon management’s objectives (e.g., off-market or inter group transactions).

Although no one questions the possibility of financial contagion within a financial services conglomerate, financial conglomeration could lead to greater diversification. If true, this fact theoretically should lower overall firm risk, not increase it. Information disclosure and analysis by customers, intermediaries, rating agencies, and governments have been suggested as means of controlling the contagion exposure. Many observers believe, however, that a completely different approach is necessary whereby deposit insurance is privatized and regulation focuses on a narrow range of financial services activities.

Transparency
Transparency is concerned with the assurance that accurate information needed by customers, intermediaries, rating agencies, and governments will be readily available. The more complex the organizational structure, the less transparent it is ordinarily. To assume that customers have the time or the resources to perform due diligence on a financial conglomerate is unrealistic.

Traditionally, so long as there was enough unrestricted capital to meet contingencies, organizations were deemed safe. Although this approach may have worked reasonably well when institutions stayed within sectoral boundaries and like institutions were roughly comparable, the new world of mixed services requires a broader consideration of factors (e.g., competitive position).

Management Responsibility
Management responsibility is concerned with the possibility that managers compromise their entity’s sound operation in favor of the conglomerate’s fiscal health (e.g., through unwise loans to connected parties). Where a financial services group is regulated functionally, how can each sector’s regulator be assured that managers will fulfill their responsibility to meet regulatory requirements given other interests within the group?
Financial services regulators have struggled with this problem for many years as regulated units have become part of broadly based financial and commercial groups. Although there are serious analysis and enforcement limitations on regulatory agencies, some believe the solution is to include a broad obligation to disclose major inter group transactions. Disclosure would entail transactions that affect the regulated entity or the basic integrity of the regulated unit’s assets and operating capacity. At a minimum, these data should constitute a prerequisite for continuing authority to operate.

Double-Gearing
Double-gearing, a European term, exists when a company includes the capital of subsidiaries to meet its own solvency requirements. This double counting acts to artificially inflate the conglomerate’s capital adequacy. Supervision becomes more complex if certain operations within the conglomerate are unregulated. Clear, uniform accounting standards and requirements are necessary to identify double-gearing. Issues related to appropriate disclosure and the appropriate Focus of regulatory responsibility must be resolved.

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Financial Market Power

Market power relates to the ability of one or a few sectorally dominant firms (e.g., through oligopoly or monopoly) to influence market prices. A highly concentrated market or the existence of vertical agreements could lead to market power that hinders market efficiency. Many countries have granted regulators supervisory powers over merger and acquisitions to curtail such risk. In the past, traditional indicators have proven effective for sectoral analysis. The introduction of integrated financial services, however, renders this supervisory function more arduous. Moreover, with the exponential growth of cross-border trade and foreign penetration into domestic markets, many believe globalization will thwart any domestic concentration of power.

We have seen significant concentration of market shares, particularly among traditional banks and insurance companies, in many major markets. Simultaneously, we have seen considerable new entry. When a subsidiary, such as Predica, can enter the life market in France and become a leading company in a few years, the risk of oligopoly or monopoly power seems limited. Overall, the trends toward cross-sector and cross-border entry (and new technologies) would seem to reduce the potential for concentration of market power. Most countries will retain anti-monopoly authorities to protect against the rare cases of potentially sustainable market control combinations. Openness and rapid change in financial services markets are likely to preserve strong competitive forces.

Conflicts of Interest
The potential for conflict of interest exists when a financial institution offers multiple financial services and promotes proprietary products through coercion or other power for the organization’s benefit over the best interest of the customer. In the United States particularly, some have argued that banks should not be permitted to sell insurance because they may condition the availability of other products on the customer’s agreement to purchase insurance. The Glass-Steagall Act was born from this concern. Most financial services regulatory systems, including those of the United States, prohibit tying the purchase of one product to another, although discounts are permitted for joint purchase. As with prior points, some believe information disclosure and competitor exploitation of potential abuses may minimize such conflicts.

Regulatory arbitrage is the tendency of financial services conglomerates to shift activities or positions within the group to avoid or minimize certain regulation. For example, a conglomerate might shift the production and sale of a particular savings product to its insurance company if insurance regulation were judged less intrusive than banking regulation. In the absence of comprehensive cross-sector and international regulatory harmonization, opportunities for such arbitrage will always exist. To control this practice, some believe sectoral regulators should engage in extensive cross-sector information sharing. This is beginning to take place between state insurance regulators and federal bank regulators under the auspices of the NAIC. Internationally, regulators of multinational financial services firms could also engage in informational reciprocity with trading partners to help identify possible distress situations. The possibility of regulatory arbitrage encourages cross-sectoral and international regulatory harmonization.

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Policy owner Dividend Treatment

According to current tax law, distributions to customers should be fully deductible by a corporation, whereas distributions to owners of the enterprise should not be deductible. In the case of mutual organizations, however, the customers are also effectively the owners. Mutual insurers often charge comparatively high premiums and return the unneeded excess premiums as dividends to policy owners. This excess is properly deductible at the corporate level. Also included in policy owner dividends, however, may be distributions of investment and underwriting earnings of the mutual company (as the policy- owner is effectively an owner of the company, as well as a purchaser of its services). Many believe that, in contrast with the return of excess premiums, these earnings should not be excluded from corporate income taxation, just as dividends payable to stockholders are not deductible by corporations.

Intertwined with the dividend deductibility issue at the time Congress was debating life insurer taxation was the issue of the amount of revenue to be raised from the life insurance industry and its apportionment between stock and mutual companies. With a 100 percent policy owner dividend deduction, a mutual insurer may have paid little or perhaps no tax. On the other hand, if no deductions were permitted, legitimate payments to policy owners as customers (rather than as owners), which should be deductible under general tax principles, would be denied to mutual’s an unfair result as it would have overtaxed those companies. Thus, it was (and is) crucial to impose appropriate relative tax burdens on each segment, so that the tax law does not favor one segment over the other. Accordingly, in an effort to treat the stock and mutual segments equitably and to raise appropriate revenues from the industry, it was judged necessary to limit the dividend deduction for mutual companies.

The assumption underlying the segment balance (55/45) was that an appropriate guide to the profitability of mutual life insurers is the profitability on equity of stock life insurers. The mechanics of the limitation on the deductibility of policy owner dividends by a mutual insurer involve the determination of a differential earnings rate on “equity” between stock and mutual companies. The imputed earnings rate on equity for stock insurers is assumed to be higher than that for mutual insurers, and this difference is assumed to represent a return to policy owners in mutual companies on their ownership interests in the companies. The procedure results, in effect, in a tax on mutual insurer surplus.

The 1990 DAC Tax
The Revenue Reconciliation Act of 1990 added a new provision to life insurer tax law that purports to defer (capitalize and amortize) acquisition costs of life insurance and annuity contracts. This provision is known as the DAC (deferred acquisition costs) tax.The theory for this tax is that certain insurance company expenses—commissions, underwriting expenses, agency expenses, and other costs of acquiring and retaining business—should be capitalized and amortized to produce a better matching of deductions with revenues. Such a capitalization is done under generally accepted accounting principles but not under statutory accounting principles. The DAC provision, however, came about because the Treasury Department and Congress believed the life insurance business should pay more in federal income taxes.

In form, the provision is a proxy for true deferral, which was seen as administratively complex. For each year, the amount of the insurer’s general deductions to be capitalized is the sum of specified percentages of premiums by line of business:
• 1.75 percent of annuity contract premiums
• 2.05 percent of group life insurance premiums
• 7.70 percent of other life and noncancellable accident and health insurance premiums

In determining the amount to be capitalized, premiums on pension plan contracts are not included, nor are imputed premiums (e.g., where dividends are applied to reduce premiums). Generally, reinsurance ceded reduces premiums and reinsurance assumed increases them. The capitalized amounts are to be amortized in a straight-line fashion over a 10-year period starting at the middle of the year of capitalization. It is of interest to smaller companies that the amortization period for the first $5 million capitalized in any year is five years. This $5 million amount is phased out as the capitalized amount moves from $10 million to $15 million, so large insurers obtain no benefit. The DAC tax substantially raised the U.S. life insurance industry’s federal income taxes. In turn, life insurers have had to make appropriate adjustments in existing and new-product pricing to account for this increase. Interest rate credits, dividends, and other non-guaranteed benefits are somewhat lower than they otherwise would have been.

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