Developing Financial Supervision The Canadian Solution

Major developments on the world stage have led to widespread opening of markets and renewed interest in privatizing economies. While our markets and business/government infrastructure have had several hundred years to mature, many new and emerging countries now have to make the leap almost overnight to free market systems on a highly sophisticated global stage.

In these circumstances one can expect to see excessively entrepreneurial behavior, extreme volatility and high risk. A key requirement as these countries pursue rapid evolution is something we take for granted in a developed country such as Canada: an appropriate system of risk transfer, primarily through the vehicle of insurance coverage. The critical importance of the insurance industry in these countries is made clear by considering some typical circumstances:

Entire industries are being privatized. In most cases, state-owned enterprises were self-insured but are now having to find private coverage;

There is a movement towards the privatization of insurance services traditionally offered by the government (for example, health insurance and worker’s compensation);

Many countries are encouraging the growth of private pension funds, which depend on a vibrant, competitive insurance industry for the provision of disability insurance and life annuities;

In developed countries, demographics are giving rise to huge amounts of funds that are seeking investment opportunities, leading to greater availability of foreign capital for fund development in emerging countries;

Many countries have had a state owned insurance company, operating as a bureaucracy in which sound business and insurance practices had little relevance. These companies are now being privatized and are expected to rapidly transform themselves into private sector insurance entities;

Developing countries frequently have a growing middle class which will increasingly seek insurance protection for their assets and savings products.

Insurance sector

Against this background, we typically find a fragile insurance industry, in terms of financial stability and management resources. The phenomena outlined above have occurred with amazing rapidity, and in most instances the domestic insurance industry is undercapitalized and unprepared to deal with the new reality. Insolvency is common place, shaking the confidence of foreign investors as well as giving rise to political problems when consumers aren’t compensated for claims.

Financial institution insolvency has played a significant role in the financial and economic setbacks that have recently occurred in a number of developing countries. As a result, we see developing country governments becoming increasingly sensitized to the critical importance of sound public policy in the supervision of financial institutions. This has been heightened by encouragement from international agencies such as The World Bank and the Inter-American Development Bank. Not surprisingly, there is growing interest in developed countries’ supervisory frameworks and their potential applicability to the developing country situation.

The Canadian regulatory environment for financial institutions has become the focus of interest for many developing countries. Having recently prepared an investigative paper for the Inter-American Development Bank and The World Bank — titled “Re-engineering Insurance Supervision” — I believe there are several sound reasons why:

Firstly, Canada has an excellent reputation in developing countries. Canadians tend not to be aggressive in assuming that “our way of doing things is the right way”(in our firm’s work in developing countries, we insist that our role is that of a resource based on Canadian experience);

Another reason Canada is welcomed in these countries is that we have taken an interest in developing country assistance generally. In the insurance world, the Office of the Superintendent of Financial Institutions (OSFI) has been a leader in the International Association of Insurance Supervisors. OSFI deputy superintendent John Thompson recently completed a term as chair of the organization. Furthermore, former OSFI superintendent Michael Mackenzie helped to establish the Toronto International Leadership Centre for Financial Sector Supervision at York University while Don McIsaac, the former director of the Life Insurance Division at OSFI, now holds the senior insurance consultant position at the World Bank.

But, in my view, the Canadian system’s popularity largely relates to its close relevance to the needs of developing countries. Canadians have learned that regulators cannot prevent insolvency merely by prescribing rules and monitoring data. The corporate governance supervisory model takes a different approach by making sure the law facilitates the flow of necessary and appropriate operational information to the directors and senior management, empowering them to take decisions as required.

As such, the onus is placed squarely on the board of directors and senior management to ensure that their institutions are operated in accordance with sound business and financial practices. The incentive to do this is both direct through obligations set out in the insurance act and the law which opens the door to personal liability in the event that sound business and financial practices are not adhered to.

The system is further refined by spelling out in general terms key operational areas and types of risk management activities that would normally be considered to be a part of “sound business and financial practices”. (As an aside, I personally think if you get into too much detail in the “spelling out” part, you will soon find yourself back with the model we started with — the regulator checking a lot of detailed “rules” and a small number of determined companies finding ways to get around them.)

While the model is very effective in a country like Canada, it is also a particularly good fit in the developing country situation. Developing countries don’t have the resources to staff up large supervisory groups whose main task will be to verify data and maintain a regulatory presence, so a model which focuses on corporate responsibility has appeal.

Also, a key problem area in developing countries, probably stemming from a lack of maturity in financial institution operations, has been excessively risky behavior by financial institution directors and management. The corporate governance model, placing strong responsibility on management to “do the right thing”, goes to the heart of the issue.

There are difficulties of course. The Canadian model relies heavily on a highly developed infrastructure of independent, professional auditing and actuarial practitioners. In most developing countries the level of professionalism and training of such individuals is far from what we are used to. Nevertheless, accounting and actuarial associations in these countries are eager to improve their professional standards and to work alongside government authorities to assume a more prominent position in the supervisory system.

Furthermore, international auditing and actuarial firms have a presence in virtually every developing country. They have the resources to assist their local staff with professional training, and thereby recognize that it is in their business interest to do so. By working together, supervisors, industry personnel, auditors and actuaries can develop a resource base of professionals able to play an important role in supervisory function.

While efficiencies through partnership are occurring, there is much that can be done directly to make improvements in the supervisory framework of developing country models.

For example, in some of these countries the financial reporting system for supervised institutions is almost meaningless. Data that is collected may not be relevant for risk assessment purposes and that which is collected may be so out of date as to be useless.

Many countries do not track the claims run-off for property and casualty insurers and do not see what is really happening with claims experie nce. Supervisory personnel also require training in financial analysis and understanding of financial institution practices, on-site inspections and the use of electronic systems. Organizational changes through streamlining of internal work procedures and developing frameworks for dealing with specific issues would further boost supervisory effectiveness.

Thus we see that, on the one hand, professional standards can be upgraded to permit the country’s auditors and actuaries to assume greater responsibility within a developing corporate governance model, while specific steps can be taken to improve efficiency of supervisory teams.

The Canadian model is gaining international attention because it is sufficiently flexible to embrace local market conditions. It also provides for goals and focuses on corporate behavior without excessive use of government resources. While our system can be improved in many areas, it is well to remember that we are perceived internationally as having a world class model.