Chapter 3 The financial services industry other financial institutions PDF

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Chapter 3 The financial services industry: other financial institutions Chapter outline Insurers and fund managers Life insurance General insurance Superannuation funds Managed funds and unit trusts Other financial institutions Money market corporations Finance companies Securitisation vehicles Lear...

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Chapter 3 The financial services industry: other financial institutions Chapter outline Insurers and fund managers Life insurance General insurance Superannuation funds Managed funds and unit trusts Other financial institutions Money market corporations Finance companies Securitisation vehicles Learning objectives 3.1 Learn that despite the apparently diverse nature of activities, other FIs face risk exposures similar to those faced by DIs. 3.2 Gain an understanding of the structure, characteristics and regulation of life insurers and their products. 3.3 Learn about the general insurance industry and an understanding of its products. 3.4 Appreciate the importance of superannuation in the Australian financial system. 3.5 Learn that many superannuation and life insurance products are managed funds. 3.6 Gain an appreciation of the role that managed funds, money market corporations, finance companies and securitisation vehicles and their products play in the Australian financial markets and their structure and regulation.

Instructor’s Resource Manual t/a Financial Institutions Management 4e by Lange, Saunders & Cornett (c) McGraw-Hill Education (Australia) 2015

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Overview of chapter The RBA describes the three main types of financial institution (FI) in Australia as: depository institutions (DIs) (discussed in Chapter 2); insurers and fund managers; and nonDI financial institutions. Insurers cover both general and life insurance. The funds management industry is dominated by the superannuation funds and also includes cash management trusts, unit trusts, common funds and friendly societies. The non-DI financial institutions are made up of money market companies, finance companies and securitisation vehicles. In this chapter, we outline the key features of the other FIs by concentrating on (1) the size, structure and composition of the industries in which they operate; (2) balance sheets and recent trends; and (3) regulations. Although we categorise or group FIs and label them ‘life insurance companies’, ‘general insurance companies’ and so on, in fact the risks that they face are more common than different. Specifically, all the FIs described in this chapter hold some assets that are potentially subject to default or credit risk, tend to mismatch the maturities of their balance sheets to a greater or lesser extent, and are thus exposed to interest rate risk. Moreover, all are exposed to some degree of saver withdrawal or liquidity risk, depending on the type of claims sold to liability holders. In addition, most are exposed to some type of underwriting risk whether through the sale of insurance, the sale of securities or issuing various types of credit guarantees on or off the balance sheet. Finally, all are exposed to operating cost risks because the production of financial services requires the use of real resources and back-office support systems. Note that many of the FI groups we discuss in this chapter make up parts of FI conglomerates which cover banking, insurance and funds management. In the remaining chapters we introduce the risks of FIs, and later examine the ways that FI managers measure and manage the inventory of risks identified in our discussion of Australian FIs to produce the best return–risk trade-off for shareholders in an increasingly competitive and contestable market environment. Chapter 3 Teaching Suggestions (Also see teaching suggestions for Chapter 2) Please read the teaching suggestions for Chapter 2 prior to the following, as many of those relate directly to this chapter also. Like Chapter 2, this chapter covers institutional material, which provides a background to the discussion of the risks of FIs which follow in later chapters. The way to approach the material in this chapter depends in part on the type of course which you are taking. For example, if a bank management course, then I would suggest a direction which relates and compares the information in this chapter with that of the banks; but if a financial institutions course, then more complete coverage of the institutional material. For bank management course If your course fundamentally relates to banks and bank risk, then I would use the material in this chapter to answer the following types of questions: 1. By how much do the banks dominate the sector and what proportion of total FI assets, profitability, etc. are held by banks? 2. A comparison of the key risks of each type of institution. 3. Do Australia’s major banks have insurance companies, superannuation and fund management activities, finance companies, etc. in their conglomerates, and if so, how large are these relative to the sector as a whole? The point here is that the banks dominate in most areas of financial institution activity, and this is not always obvious as the names don’t tend to indicate the associations. For example, Westpac Bank includes in its group: St George Bank, Bank West, Bank of Melbourne and BT Funds Management. Instructor’s Resource Manual t/a Financial Institutions Management 4e by Lange, Saunders & Cornett (c) McGraw-Hill Education (Australia) 2015

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4. You could also discuss the size and the potential growth of the superannuation fund sector, and how these funds are always looking for suitable investments. Another point to cover in this regard is the discussion pre-, post- and during the Murray Inquiry 2014 about the need for banks to review their deposit strategies and develop new products which may satisfy longer term investors like the superannuation funds. This could do a number of things to improve bank liquidity and funding strategies— for example, it could lengthen bank liabilities, and reduce the reliance on offshore funding. 5. The risks of insurance are often thought to be very different to those of banks, and in many cases they are. However, general insurance risk is a good way to describe the way in which banks should manage their operational risk measurement and management—and especially as operational risk is an important part of capital management (as operational risk makes up a component of capital adequacy regulation). 6. One key operational risk which has been the subject of a great deal of political discussion, inquiry, media coverage and public debate has been the issue of ‘financial advice’. Much of the media coverage related the issue directly to bank management. Look for the various media coverage or ask students to search for this—relating in particular to Commonwealth Bank and Macquarie Bank. The reputational damage to the banks, despite it being outside their normal ‘banking functions’, is worth discussing. Such an issue is a good one to show students how: (a) bank conglomerates are impacted by the activities of their other FI activities (b) operational risks for banks are not just related to strictly bank activities—this may assist in students better understanding APRA’s approach to the measurement of operational risk. 7. While Chapter 2 outlines the regulation framework for APRA supervised FIs, this should be again highlighted in discussion of insurers and superannuation funds. You may then wish to compare the APRA style of supervision and capital adequacy requirements to those of the other FIs which are in general supervised by ASIC. For more general FI courses In this case, I would suggest following the general approach outlined for banks and other DIs in Chapter 2 Teaching Suggestions.

Instructor’s Resource Manual t/a Financial Institutions Management 4e by Lange, Saunders & Cornett (c) McGraw-Hill Education (Australia) 2015

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Answers to end-of-chapter questions Questions and problems 1 Which of the listed risks are faced by life insurance companies, general insurers, superannuation funds, cash management trusts, money market corporations, finance companies and securitisation vehicles: liquidity risk, operational risk, underwriting risk, interest rate risk, derivative related risks, default risk? LO 3.1

Liquidity risk Operational risk Underwriting risk Interest rate risk Derivative related risks Default risk

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What are the similarities and differences between the four basic lines of life insurance products? LO 3.2

The two lines of life insurance are ordinary business and superannuation business. Ordinary life policies are sold on an individual basis in units of $1000. Payments can be made in the form of a lump sum at the commencement of the policy or at regular periods. Both individual and group life policies are available. Group life insurance covers a large number of insured persons under a single policy. These may be an association of individuals, such as a professional or sporting association, or an association of employees of a particular employer. Most of the group life insurance written is for superannuation. Superannuation makes up the bulk of the business written (72 per cent) and, as a result of government regulation making superannuation cover compulsory for all employees, it is the fastest growing class of business. 3

How can you use life insurance and annuity products to create a steady stream of cash disbursements and payments so as to avoid either the payment or the receipt of a single lump-sum cash amount? LO 3.2

A life insurance policy requires regular premium payments, which then entitle the beneficiary to a single lump sum. Upon receipt of such a lump sum, a single premium deferred annuity could be obtained, which would generate regular cash payments until the value of the insurance policy was depleted. The federal government is using tax incentives to encourage people to roll their superannuation lump-sum payments over into an annuity.

Instructor’s Resource Manual t/a Financial Institutions Management 4e by Lange, Saunders & Cornett (c) McGraw-Hill Education (Australia) 2015

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Contrast the balance sheet of DIs with that of a typical life insurance company, a money market company and a managed fund. LO 3.1, 3.2, 3.6

The majority of depository institutions’ liabilities are short term, while the majority of a life insurance company’s liabilities are long term. Banks have both short-term and long-term assets, but need to hold short-term assets to meet liquidity needs. Insurance companies match their long-term liabilities with an emphasis on longer term assets. Historically, both groups used their funds to finance an asset portfolio made up of debt securities, but insurance companies have been increasing their holdings in equity at the expense of debt since the 1960s. Banks generally do not hold equity securities in large proportions. A similarity between the two groups is in the high degree of financial leverage. Life insurance companies access sources of funds (from policyholders) in much the same way as depository institutions obtain deposits. Money market corporations’ liabilities tend to be more like those of banks— relatively short term. However, the assets of money market corporations also tend to be short term in nature. Unit trusts, on the other hand, have longer term asset and liability structures. 5

How do general insurance companies earn profits? Use the method by which insurance companies generate profits to explain their investment in high risk securities. LO 3.3

Insurance companies earn profits by taking in more premium income than they pay out in terms of policy payments. They can increase their spread between premium income and policy payout in two ways. One way is to decrease future required payouts for any given level of premium payments. This could be accomplished by reducing the risk of the insured pool (provided the policyholders did not demand premium rebates that fully reflected lower expected future payouts). The other way is to increase the profitability of interest income on net policy reserves. Since insurance liabilities are typically long term, the insurance company has long periods of time to invest premium payments in interest-earning asset portfolios. The higher the yield on the insurance company’s investments, the greater the insurance company’s profitability. Since junk bonds offer high yields, they offered insurance companies an opportunity to increase the return on their asset portfolio. 6

Why is the structure of the balance sheet of general insurers different to the structure of life office balance sheets? LO 3.2, 3.3

General insurance is principally a short-term product—that is, the claims or liabilities are short term in nature. In contrast, life insurance products are usually at least 10 years in duration and liabilities may be much longer than this, depending on the type of product. Consequently, general insurance companies tend to have more quality debt securities that can easily be liquidated and shorter term assets. Life insurers have a higher proportion of ‘growth’ type assets, such as equities, and debt securities are likely to have a longer maturity profit. 7

What are the key regulators for each of the following: life insurers, general insurers, superannuation funds, managed funds, finance companies? LO 3.2, 3.3, 3.4, 3.6

Type of institution Money market corporations (merchant banks) Finance companies (including general financiers and pastoral finance companies) Securitisers Life insurance companies General insurance companies (www.rba.gov.au/fin-stability/fininst/index.html#f)

Main supervisor/ regulator ASIC ASIC (www.rba.gov.au/finstability/fin-inst/index.html#b) APRA (www.rba.gov.au/finstability/fin-inst/index.html#d) APRA (www.rba.gov.au/finstability/fin-inst/index.html#d)

Instructor’s Resource Manual t/a Financial Institutions Management 4e by Lange, Saunders & Cornett (c) McGraw-Hill Education (Australia) 2015

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Type of institution Superannuation and approved deposit funds Public unit trusts Cash management trusts Friendly societies

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Main supervisor/ regulator APRA ASIC ASIC APRA

Why has superannuation grown so rapidly in Australia? LO 3.4

Superannuation represents the second most important source of wealth generation for Australian households behind the family home. Superannuation funds manage funds saved throughout an employee’s working life with the aim of providing the employee with a retirement income. Contributions to superannuation funds are usually made by both employees and their employers. Compulsory superannuation was introduced in 1992 and employers are required to contribute 9 per cent of employee salaries to their superannuation. Incentives for both employees and employers to increase superannuation above the regulated minimum has led to annual double-digit asset growth, although the equity market volatility during the GFC impacted asset growth from 2008 to 2011. 9

How are public unit trusts, life insurance and superannuation similar? LO 3.5

The similarity is the prominence of managed funds in their product range. Public unit trusts are publicly offered managed funds. Within superannuation there are many managed funds, some public and some corporate or industry related. Life insurance companies offer managed funds as a part of their suite of financial services. 10 Which institutions make up the ‘shadow banking system’? LO 3.6 The shadow banking system is made up of FIs that are not regulated by APRA—such as FIs like the money market corporations, finance companies and securitisation vehicles. 11 What are merchant banks and why is the term ‘merchant bank’ no longer allowed to be used? LO 3.6 Money market companies have traditionally been called merchant banks. In 2012, however, APRA revoked the use of the term ‘merchant bank’ to avoid confusion by customers who may have difficulty distinguishing between APRA regulated banks (which operate under the force of the Banking Act 1959 (Cth) and have deposit insurance in terms of the Financial Claims Scheme) and non-APRA regulated money market companies.

Instructor’s Resource Manual t/a Financial Institutions Management 4e by Lange, Saunders & Cornett (c) McGraw-Hill Education (Australia) 2015

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12 What is the main business activity of finance companies? Discuss the changes in the distribution of activities since the 1980s. LO 3.6 The main business activity of finance companies is lending, representing 75 per cent of total assets—lending to small business and households is the main focus. Finance leases represented 25 per cent of finance company activities in 1985, but had fallen to only 7 per cent by 2011, whereas lending to business and households had increased from 60 per cent to 66 per cent in 2011. 13 The total assets of securitisation vehicles equal their total liabilities. Does this mean that securitisation vehicles have no equity? Why is this the case and what is the nature of their liabilities? LO 3.6 Securitisation vehicles are special purpose vehicles set up specifically to sell asset-backed securities to investors to finance the purchase of the assets backing the securities. They are set up to manage a single securitisation issue. The funding is undertaken totally by the sale of securities and so their liabilities are made up of obligations to asset-backed security holders. Web questions 14 Go to the APRA website and find the Guidelines on Authorisation of General Insurers. Identify the key factors determining APRA’s assessment of an application for authorisation. LO 3.3 Go to the APRA website (www.apra.gov.au) and find the document ‘GI-authorisationguidelines’. Found at www.apra.gov.au/GI/Documents/GI-authorisation-guidelinesDecember-2007_1.pdf. The key factors relate to the capacity to establish and carry out business on an ongoing basis, ensuring sufficient capital, risk management strategies and processes, and risk measurement capability. 15 Go to APRA’s website and find the list of registered financial corporations. Try to identify the number of money market corporations which are owned or associated with Australian or foreign banks. LO 3.6 Go to the APRA website (www.apra.gov.au) and click on ‘non-regulated entities’ along the top menu. Click on ‘registered financial corporations’, scroll down and find ‘Click here to view a list of RFCs’, click on this, and then select money market corporations to obtain the list.

Instructor’s Resource Manual t/a Financial Institutions Management 4e by Lange, Saunders & Cornett (c) McGraw-Hill Education (Australia) 2015

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