Room document 9

Statistics Directorate

National Accounts

Who Owns Mutual Life Insurance Companies?
– Mutual Life Insurance Companies under the Flow of Funds Statistics

Paper prepared b y Katsufumi Yoshino, Toshie Kori
Research and Statistics Department (Bank of Japan


OECD MEETING OF NATIONAL ACCOUNTS EXPERTS
Château de la Muette, Paris
8-11 October 2002
Beginning at 9:30 a.m. on the first day

13

Who Owns Mutual Life Insurance Companies?– Mutual Life Insurance Companies under the Flow of Funds Statistics

Katsufumi Yoshino*, Toshie Kori**

Research and Statistics Department

Bank of Japan

CPO Box 203 Tokyo

100-8630 JAPAN

*e-mail:

** e-mail:

The views expressed in this paper are those of the authors and do not necessarily reflect those of the Bank of Japan or the Research and Statistics Department.


1. Introduction

While Japanese law permits two forms for firms engaged in the life insurance businesses – joint stock corporations and mutual companies – Japan’s leading life insurers are mutual companies, and mutual companies account for a high percentage of the Japanese life insurance market.[1] In Japan, the mutual company is unique to the life insurance industry. Under this special form there are no shareholders or investors, and the policyholders’ role approximates that of shareholders at joint stock corporations.[2] On the other hand, this mutual company scheme for life insurance firms is not unique to Japan. In the U.S., mutual companies account for a substantial proportion of the life insurance industry, although not to the extent that is prevalent in Japan.[3]

On April 1, 2002, however, the Daido Life Insurance Company changed from a mutual company to a joint stock corporation, and simultaneously listed its shares on Japanese stock exchanges. As part of this “demutualization” process, Daido allocated shares to its policyholders based on the extent of their contributions to the firm’s profits during prior fiscal years, and as a result the policyholders came to enjoy unexpected listing profits.[4]

This phenomenon raises the questions of who really owns Japan’s mutual life insurance companies and of how this ownership should be handled under the Flow of Funds Accounts (hereafter, “the FFA”). Under the FFA, when life insurance firms are joint stock corporations, households have ownership of the life insurance firms’ shares (as shareholders) and of their insurance and pension reserves.[5] When life insurance firms are mutual companies, however, households only have ownership of the insurance and pension reserves, and are not recognized as equity holders (see Chart 1). That is, even though the mutual company policyholders’ (households’) role approximates that of shareholders at joint stock corporations, this ownership is not recorded by the FFA.

In general, policyholders of mutual life insurance companies are recognized to be approximately the same as shareholders, and in cases of demutualization shares are in fact allocated to the policyholders. Despite this, under the methods presently used for compiling the FFA, mutual life insurance company policyholders are not recognized as shareholders (while the shareholders of joint stock corporation life insurers are recognized as such). Thus, when firms like the Daido Life Insurance Company demutualize, shareholdings suddenly appear in the FFA (these are recorded as household credits and life insurance company debits).

The current trend toward the demutualization of mutual life insurance companies demands that we reconsider the present approach taken under the FFA. There are also diverse theoretical issues regarding life insurance that need to be examined in social accounting and in corporate accounting, such as the recognition timing and method of valuation for both assets and liabilities, and these corporate accounting issues are now being actively debated. This paper, however, limits its discussions to the “Financial Assets and Liabilities Table” (the “Stock Table”) in the FFA, and specifically to how the market value of mutual life insurance companies’ capital should be determined, and how the statistics should reflect the changes that occur when mutual life insurance companies become joint stock corporations. This paper focuses on deriving tentative conclusions based on a fundamental conceptual review, and refers to the practical problems only when necessary.

1.  The Nature of Mutual Life Insurance Companies’ Capital

(1) The Owners of Mutual Life Insurance Companies’ Capital

As shown in Chart 1, mutual life insurance companies do have capital,[6] and in practice their capital functions in the same manner as that held by joint stock corporations. Under the present FFA, the capital held by mutual life insurance companies is considered as the companies’ own capital, and is not recognized as other entities’ assets. To start, we need to reexamine this approach by reviewing how this capital is accumulated. When a mutual life insurance company’s operating performance surpasses the growth in its insurance reserves, strictly speaking, the resulting surplus should be distributed to the policyholders as dividends.[7] Since mutual companies are established for the purpose of mutual assistance, in theory all such surpluses should ultimately be allocated to the policyholders. In practice, however, such surpluses are not necessarily completely distributed to the policyholders as dividends every period. Rather, portions of the surpluses are kept and accumulated as retained earnings to fund future insurance claims and future dividends. These retained earnings become the mutual life insurance companies’ capital.[8]

In the 1993 System of National Accounts (hereafter, “the 1993 SNA”), Chapter VI Paragraph 6.138 proposes the use of a fictitious system whereby income from the investment of insurance reserves is “attributed to the policyholders for whose benefit the reserves are held,” and “…recorded as receivable by the policyholders who pay it all back again to the insurance enterprises as premium supplements.” On the other hand, the 1993 SNA does not provide any specific instructions on the accounting of the mutual life insurance companies’ capital which is accumulated in this manner.[9] As a general understanding, because retained earnings are not a liability but rather companies’ own capital, they should not be posted as financial liabilities (conceptually, retained earnings are actually the differential between financial assets and financial liabilities). Because of this, the present approach under the FFA is that mutual life insurance companies’ capital comprises retained earnings, and thus does not have to be explicitly treated within the account.

The FFA recognizes retained earnings (the retained earnings = profit reserves + voluntary reserves + unappropriated surpluses or deficits for the current term, etc.) as corporations’ own capital. In the case of joint stock corporations, the FFA records and evaluates “shares” at the market value, which reflects the corporations’ overall value including their retained earnings. On the other hand, mutual companies have nothing directly corresponding to “shares,” and as a result the retained earnings of joint stock corporations are recorded as shareholders assets, while those of mutual companies are not.

As noted above, mutual companies’ retained earnings should ultimately be distributed to the policyholders, and the policyholders’ ownership rights to these funds have been converted into shares in demutualizations. This implies the need to somehow explicitly post the policyholders’ rights to the retained earnings in the statistical accounting.

(2) Positioning the Capital of Mutual Life Insurance Companies among Financial Assets

The problem then becomes what kind of financial asset the policyholders’ rights to the retained earnings belong to in the FFA. If the retained earnings are simply “funds that should properly be distributed as dividends” then they should probably be listed under “accounts receivable and accounts payable.”

However, listing the retained earnings under “accounts receivable and accounts payable” would be inappropriate under the framework of the fictitious system whereby retained earnings are momentarily distributed to policyholders as dividends and then reinvested, as detailed in the 1993 SNA. In that case, the retained earnings might be categorized under “insurance reserves” as companies’ liabilities to their policyholders. Under the SNA, however, “insurance reserves” are considered to be the discounted present value of the funds required to pay future claim benefits, as calculated using actuarial statistics.[10] In other words, insurance reserves are not defined by the amounts of funds actually held by insurance companies. From this perspective, it is entirely inappropriate to categorize the retained earnings as “insurance reserves.”

Considering the above issues, a better idea might be to consider the retained earnings as something close to “other equities” which are defined as “a claim or ownership over residual property (surplus assets) at the time of liquidation.” This would be more or less consistent with the fictitious reinvestment approach adopted by the 1993 SNA. [11]

(3) The Market Value of the “Other Equities”

Up until this point, this paper has used the expressions “capital” and “other equities” rather freely, without making significant distinctions, but there is no guarantee that the “capital” as recognized by the FFA, which is evaluated by accrual and market price based accounting, will always coincide with the “capital” as recognized by the life insurance companies’ accounting. For example, it is entirely possible that the market values of net assets may exceed their book values in the insurance companies’ accounting, forming so-called “undeclared gains” or “unrealized profits.” Accordingly, let us now consider the practicality of adopting market values for the capital account.

One method is to use the book value as a proxy for the market value, but in the case of the Daido Life Insurance Company’s demutualization, there was a huge gap between the book value of the capital (net assets of ¥158.4 billion as of April 1, 2002) and the firm’s market capitalization (¥459 billion on the same day). This may have been because the book value ignored goodwill, brand value, human capital and other intangible assets that did not appear on Daido’s balance sheet.[12] While the market apparently gave an explicit value to these intangible assets once the firm was listed, this example shows it is clearly unreasonable to take the book value as a proxy for the market value.

Another option is to directly measure the value of goodwill and other intangible assets, and then estimate the market value using the following equation.

Capital market value = financial assets + real estate, etc.

+ goodwill, etc. – liabilities (insurance reserves, etc.)

Unfortunately, this approach would be extremely difficult. In practice, it is by no means simple to accurately determine the value of intangible assets that are not listed on balance sheets, and there is an ongoing debate in accounting circles regarding this very issue.[13] Moreover, there is also a debate regarding the valuation methods that should be used for insurance liabilities between the International Accounting Standards Board (IASB) and the insurance associations in Japan, the U.S. and Germany, which disagree with the IASB’s proposals, and a consensus has not yet been reached (see International Accounting Standards Board [2002], The Life Insurance Association of Japan et al. [2002a] and The Life Insurance Association of Japan et al. [2002b]).

As the best practical option, this paper proposes that the capital account be valued using the comparative method,[14] which estimates the market-equivalent value (or fair value) of the capital account by comparisons with the values at other firms in the same industry. It is also adopted in Japan’s FFA for the valuation of unlisted firms’ shares. For our proposed application of the comparative method, we assume that the mutual life insurance companies do have capital (“other equities”), and recognize them as funds similar to unlisted firms’ capital. We then estimate the value of this capital based on the market value of listed life insurance firms’ shares. This approach presently involves some difficulties since there is only one firm (the Daido Life Insurance Company) that can be used for the comparison estimates, but with the ongoing trend toward demutualization this problem should be mitigated over time. Thus, it may be concluded that adopting the comparative method is presently the most realistic approach.

3.  Accounting When Firms Demutualize

As the previous sections have reviewed the capital accounting issues, let us now consider the accounting procedures when mutual companies change their business format to joint stock corporations.

(1)  Shift from “Other Equities” to “Shares”

When insurance mutual companies change their business scheme and become listed joint stock corporations, the FFA should record a shift from “other equities” to “shares.” Conceptually, this is similar to the procedures adopted when unlisted companies become listed companies. As noted above, however, in demutualization cases, shareholdings suddenly appear under the present FFA, and this problem emerges precisely because of the present recording methods in which the mutual companies’ capital account (conceptually equals “other equities”) figures are not covered prior to demutualization. Ideally, a demutualization should not result in the abrupt appearance of previously unrecorded capital. Rather, the demutualization should simply be noted as a transfer from “other equities” to “shares.”

Theoretically, if it were possible to accurately estimate the market value of the capital account, it would then become possible to record the effects of demutualization through this simple shift from “other equities” to “shares.” As mentioned above, the comparative method was initially devised for calculating inheritance taxes, and is generally believed to have a bias toward undervaluation. Returning to the Daido Life Insurance Company example, if we use the comparative method to estimate the market value of the firm’s capital account at the time of demutualization using Daido’s own figures, the result turns out to be less than the actual market value. Thus, when firms actually demutualize, there is a high probability that the increase in their “shares” will significantly surpass the decrease in their “other equities.”

(2)  Trial Estimations

Considering the above points, let us now estimate the market value of the life insurance sector’s “other equities and shares (liabilities)” and its components under the FFA using the comparative method as of the end of March 2002, just prior to Daido’s demutualization. As shown in Chart 2, the amount of “other equities” was ¥9,197.6 billion on March 31st, and this declined to ¥8,876.3 billion on April 1st as Daido became a joint stock corporation. At the same time, the amount listed as “shares” increased from zero to ¥459 billion (and the total of “other equities and shares” rose from ¥9,197.6 billion to ¥9,335.3 billion). Turning to Daido itself, the comparative method estimates the value of Daido’s “other equities” as ¥321.3 billion”[15] at the end of March, and this shifts to ¥459 billion in “shares” on April 1st. Thus, in this case, the undervaluation due to the use of the comparative method is ¥137.7 billion (equivalent to 30% of Daido’s market capitalization after listing).