1. The Financial Services Industry: Other Financial Institutions
Chapter 2
The Financial Services Industry: Other Financial Institutions

2. Overview
This chapter provides an overview of the activities of FIs other than DIs.
We explore how these FIs are regulated.
We learn that the risks taken by these FIs are similar to those taken by DIs.
We discuss the structure and characteristics of life insurance organisations, general insurers, superannuation funds, public unit trusts, merchant banks and finance companies.
Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Institutions Management 2e, by Lange, Saunders, Anderson, Thomson and Cornett
Slides prepared by Maike Sundmacher

3. Life Insurance Organisations
Size, Structure and Composition of the Industry:
Highly concentrated industry.
Three largest groups account for 59% of total industry assets.
By June 2004, 40% of total assets and 43% of total premiums held by bank insurance companies.
Since 1995, demutalisation of many life insurers.
Life insurers allow income loss protection through death or retirement.
Risk pooling.
Transfer of income-related uncertainties from individuals to group.
Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Institutions Management 2e, by Lange, Saunders, Anderson, Thomson and Cornett
Slides prepared by Maike Sundmacher

4. Life Insurance Organisations
Size, Structure and Composition of the Industry:
According to the Life Insurance Act, superannuation business is defined as:
Business effected for the purposes of a superannuation or retirement scheme.
Business that is vested in the trustee of an established fund where the terms and provisions provide for:
contribution payments by the person, and
payments to the person in certain circumstances.
Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Institutions Management 2e, by Lange, Saunders, Anderson, Thomson and Cornett
Slides prepared by Maike Sundmacher

5. Life Insurance Organisations
Ordinary Business:
Policies marketed on an individual basis.
Policy holder makes periodic payments or lump sum payment.
Basic Life Insurance Contract Types:
Term insurance.
Whole of life.
Endowment insurance.
Unbundled life insurance (investment-linked insurance).
Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Institutions Management 2e, by Lange, Saunders, Anderson, Thomson and Cornett
Slides prepared by Maike Sundmacher

6. Life Insurance Organisations
Other Life Insurance Contract Types:
Annuities.
Disability insurance.
Critical illness insurance.
Individual versus group life insurance policy:
Individual usually covers one insured person.
Group usually covers a large number of persons under one policy.
Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Institutions Management 2e, by Lange, Saunders, Anderson, Thomson and Cornett
Slides prepared by Maike Sundmacher

7. Balance Sheet and Recent Trends of Life Insurance
Long-term liabilities usually matched by long-term assets.
Loans on policy: loans made to policy holders with policies serving as collateral.
Policy reserves: liabilities that reflect the expected payment commitments on existing policies.
Surrender value of policies: cash value received from insurer if policy is not held until maturity.
Increased use of junk bonds due to competitive pressures.
Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Institutions Management 2e, by Lange, Saunders, Anderson, Thomson and Cornett
Slides prepared by Maike Sundmacher

8. Regulation of Life Insurance
Review of industry supervision in 1994 by Insurance and Superannuation Commission (ISC).
Life Insurance Act 1995.
Industry supervised by APRA.
Key strategies:
Early failure risk identification,
Early and effective response to remediate identified risks.
Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Institutions Management 2e, by Lange, Saunders, Anderson, Thomson and Cornett
Slides prepared by Maike Sundmacher

9. Regulation of Life Insurance
Key features of regulatory and supervisory environment:
To strengthen prudential supervision and consumer protection.
Changes in solvency and capital adequacy requirements: development of Life Insurance Actuarial Standards Board.
Additional reporting requirements.
Additional measures such as:
Establishment of audit committees,
Higher responsibility for directors, auditors etc for performance of company,
Establishment of Board Compliance Committee.
Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Institutions Management 2e, by Lange, Saunders, Anderson, Thomson and Cornett
Slides prepared by Maike Sundmacher

10. Regulation of Life Insurance
APRA’s Supervisory Oversight and Response System:
SOARS
Entities allocated to one of four categories:
Normal entities,
Oversight entities,
Mandated improvement entities,
Restructure entities.
Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Institutions Management 2e, by Lange, Saunders, Anderson, Thomson and Cornett
Slides prepared by Maike Sundmacher

11. Regulation of Life Insurance
APRA’s Supervisory Oversight and Response System:
SOARS
Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Institutions Management 2e, by Lange, Saunders, Anderson, Thomson and Cornett
Slides prepared by Maike Sundmacher

12. Superannuation Funds Size, Structure and Composition of the Industry:
Australian governments have encouraged national savings over last 20 years through:
Taxation incentives.
Legislative requirements.
Award superannuation.
Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Institutions Management 2e, by Lange, Saunders, Anderson, Thomson and Cornett
Slides prepared by Maike Sundmacher

13. Superannuation Funds Size, Structure and Composition of the Industry:
Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Institutions Management 2e, by Lange, Saunders, Anderson, Thomson and Cornett
Slides prepared by Maike Sundmacher

14. Balance Sheet and Recent Trends of Superannuation Funds
Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Institutions Management 2e, by Lange, Saunders, Anderson, Thomson and Cornett
Slides prepared by Maike Sundmacher

15. Regulation of Superannuation Funds
Industry regulated by APRA.
Superannuation Industry (Supervision) Act (SISA) 1993 and the Superannuation Industry (Supervision) Regulations 1994.
Changes in SISA compared to previous legislation:
Strengthened supervisory powers.
Assurance: superannuation funds to be used for genuine retirement purposes.
Trustees subject to sanctions in case of violations of fiduciary responsibilities.
Enhanced member participation.
Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Institutions Management 2e, by Lange, Saunders, Anderson, Thomson and Cornett
Slides prepared by Maike Sundmacher

16. General Insurance Supervised by APRA. Insurance Act 1973.
Insurance protection for losses of real and personal property, and legal liability exposures.
Very tight competition.
Strong industry performance since 2000.
Reasons for strengthened performance:
More effective supervisory regime,
Cost management,
Better risk management systems and processes.
Reinsurance: Used to limit risk exposures while still writing large contracts.
Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Institutions Management 2e, by Lange, Saunders, Anderson, Thomson and Cornett
Slides prepared by Maike Sundmacher

17. General Insurance: Main Product Groups
Motor vehicle (domestic and commercial),
Professional indemnity,
House-owners’ and householders’,
Product liability,
Fire,
Loan, mortgage and lease,
Public liability,
Trade credit,
Compulsory third party motor vehicle,
Consumer credit,
Employers’ liability,
Sickness and accident,
Marine,
Travel,
Aviation.
Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Institutions Management 2e, by Lange, Saunders, Anderson, Thomson and Cornett
Slides prepared by Maike Sundmacher

18. General Insurance: Balance Sheet and Recent Trends
Lower proportions of investments in equity assets.
Higher proportion of investments in bonds and more secure assets.
Large proportion of liabilities: provisions made for outstanding claims.
Provisions due to underwriting risk.
Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Institutions Management 2e, by Lange, Saunders, Anderson, Thomson and Cornett
Slides prepared by Maike Sundmacher

19. General Insurance: Balance Sheet and Recent Trends
Underwriting risk results if received premiums are insufficient to cover:
Claims incurred insuring the peril,
Administrative expenses of providing insurance.
Causes of underwriting risk:
Unexpected increases in loss rates,
Unexpected increases in expenses,
Unexpected decreases in investment returns.
Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Institutions Management 2e, by Lange, Saunders, Anderson, Thomson and Cornett
Slides prepared by Maike Sundmacher

20. Loss Risk: General Insurance
Key feature of claims loss exposure: actuarial predictability of losses relative to premiums earned.
Predictability dependent on:
Property versus liability.
Severity versus frequency.
Long-tail versus short-tail.
Product inflation versus social inflation.
Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Institutions Management 2e, by Lange, Saunders, Anderson, Thomson and Cornett
Slides prepared by Maike Sundmacher

21. Expense Risk: General Insurance
Major sources:
Underwriting expenses.
Commission costs.
Sudden, sharp increases can result in an insurance line being unprofitable.
Common measure of overall underwriting profitability: total (combined) ratio.
If combination ratio < 100, premiums alone are sufficient to cover expenses and losses related to insurance line.
Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Institutions Management 2e, by Lange, Saunders, Anderson, Thomson and Cornett
Slides prepared by Maike Sundmacher

22. Investment Yield/Return Risk: General Insurance
Interest rates and default rates crucial to profitability of insurers.
Risk of insolvency reduced through large surplus reserves.
Losses and exit from industry increase premiums.
New entrants compete through low premiums and low underwriting quality standards.
Underwriting cycles: peak to peak approximately 10 years.
Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Institutions Management 2e, by Lange, Saunders, Anderson, Thomson and Cornett
Slides prepared by Maike Sundmacher

23. Regulation of General Insurance
APRA’s supervisory power embodied in:
Insurance Act 1973 (current),
Insurance Act 1973 (as in force before 1 July 2002),
Insurance Regulations 2002 (current),
Insurance Regulations 2002 (as in force before 1 July 2002).
Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Institutions Management 2e, by Lange, Saunders, Anderson, Thomson and Cornett
Slides prepared by Maike Sundmacher

24. Managed Funds and Unit Trusts
Focus on non-life and non-superannuation managed funds.
First established in 1936.
Steady industry growth since 1970s/1980s.
Pooling of investment funds of unit holders.
Investment of pool into specific asset types.
Examples:
Foreign equities,
Property.
Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Institutions Management 2e, by Lange, Saunders, Anderson, Thomson and Cornett
Slides prepared by Maike Sundmacher

25. Managed Funds and Unit Trusts
According to ASIC, popular funds include:
Cash management trusts,
Property trusts,
Australian equity trusts,
Agricultural schemes,
International equity trusts,
Film schemes,
Timeshare schemes,
Mortgage schemes,
Actively managed strata title schemes.
Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Institutions Management 2e, by Lange, Saunders, Anderson, Thomson and Cornett
Slides prepared by Maike Sundmacher

26. Managed Funds and Unit Trusts
Rationale for managed funds:
Opportunity for investors to achieve superior diversification.
Fund-pooling
Risk-pooling.
Assets of cash management trusts generally highly liquid and short-term.
Return to investors reflects three aspects of underlying portfolio:
Dividends,
Capital gains,
Capital appreciation.
Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Institutions Management 2e, by Lange, Saunders, Anderson, Thomson and Cornett
Slides prepared by Maike Sundmacher

27. Managed Funds and Unit Trusts
Important concepts:
Marking-to-market, and
Net asset value.
Categories of Managed Funds:
Open-ended managed funds, and
Closed-end investment companies.
Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Institutions Management 2e, by Lange, Saunders, Anderson, Thomson and Cornett
Slides prepared by Maike Sundmacher

28. Regulation of Managed Funds
Regulated by ASIC:
Fund raising,
Securities licensing provisions.
Partial regulation through RBA:
Financial reporting responsibilities: Financial Corporations Act 1974.
Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Institutions Management 2e, by Lange, Saunders, Anderson, Thomson and Cornett
Slides prepared by Maike Sundmacher

29. Money Market Corporations
Financial intermediaries concerned with wholesale deposit raising and lending.
Diverse activities.
First established in 1950s.
Five main activities:
Investing,
Investment banking: IPOs and private placements,
Market making,
Trading: position trading, pure arbitrage trading, risk arbitrage and program trading.
Back-office and other service functions.
Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Institutions Management 2e, by Lange, Saunders, Anderson, Thomson and Cornett
Slides prepared by Maike Sundmacher

30. Money Market Corporations: Balance Sheet and Recent Trends
Traditionally, highly-geared companies.
Recently, lower gearing due to capital adequacy guidelines.
Growing influence of international assets.
Increased borrowings from foreign sources.
Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Institutions Management 2e, by Lange, Saunders, Anderson, Thomson and Cornett
Slides prepared by Maike Sundmacher

31. Regulation of Money Market Corporations
Regulated by ASIC:
Predominant concern: regulation of market rather than individual entities.
Supervision of compliance.
Partial regulation through RBA:
Disclosure requirements under Financial Corporations Act 1974.
No specific prudential regulations.
Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Institutions Management 2e, by Lange, Saunders, Anderson, Thomson and Cornett
Slides prepared by Maike Sundmacher

32. Finance Companies
Major source of funds: issue of debentures and unsecured notes.
Provision of finance to individuals, small businesses and medium-sized businesses.
Modest growth industry.
Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Institutions Management 2e, by Lange, Saunders, Anderson, Thomson and Cornett
Slides prepared by Maike Sundmacher

33. Finance Companies: Balance Sheet and Recent Trends
Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Institutions Management 2e, by Lange, Saunders, Anderson, Thomson and Cornett
Slides prepared by Maike Sundmacher

34. Regulation of Finance Companies
Regulated by ASIC.
No prudential supervision.
Regulation of specified operational aspects only.
Partial supervision through RBA:
Disclosure requirements under Financial Corporations Act 1974.
Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Institutions Management 2e, by Lange, Saunders, Anderson, Thomson and Cornett
Slides prepared by Maike Sundmacher