FSA Newsletter December 2005

Conduct Prompt Inspections, etc., targeting the Big Four Auditing Firms

CPAAOB will:

1)		Assess and inspect quality control reviews conducted by the Japanese Institute of Certified Public Accountants (JICPA) targeting the Big Four auditing firms one after the other, and take necessary measures if improvements are deemed essential;
2)		Follow up each auditing firm with respect to the improvements pointed out in the inspection, and take necessary measures if improvements are not made within a year; and

Strive to ensure the reliability of accounting audits by publishing actual overall status of audit quality controls in the Big Four auditing firms.

Review the CPA Rotation Rule

Under the existing rotation rule, continuous audit periods are up to seven years and intervals are two years, aimed at ensuring the independence of auditors. We have decided to request JICPA to amend the continuous audit period to five years and the interval to five years for chief accountants at Big Four auditing firms.

Impose Quality Control Standards, etc.

In order to enhance the quality control of audits, we decided to promptly impose quality control standards for audits and request auditing firms to develop a quality control system by next March. We have also decided to revise the auditing standards, so that falsification risks would be analyzed in a precise fashion, based on sufficient understanding of companies and their business environment, and proper auditing procedures would be selected according to the nature of the risks. The Business Accounting Council compiled and published the revised auditing standards, etc., on October 28.

Develop Internal Controls for Financial Reports of Disclosing Companies

We have decided to hasten the speed of work being done on the study of standards, etc., at the Business Accounting Council and to conduct studies on the institutional front, in relation to the effectiveness of internal control regarding financial reports of disclosing companies, in order to determine how top management should perform evaluations and how CPAs should conduct audits.

Overview of Reporting Request

In order for an insurance company to run a life insurance business, it is absolutely imperative that claims are properly paid. However, there has been an incident recently involving Meiji Yasuda Life Insurance Company which undermined confidence in the life insurance business due to improper application of the provisions for insurance policy annulment on the grounds of fraud and mishandling claims which resulted in the non-payment of death benefits. With this situation in mind, on July 26, the Financial Services Agency (FSA) requested all life insurance companies to report the following pursuant to the Insurance Business Law by September 30:

(1)		Results of reexamination of cases in which insurance money and benefits (hereinafter referred to as ''claims'') were not paid between fiscal 2000 and fiscal 2004, as to whether the non-payment was legitimate in the light of relevant laws and regulations, the solicitation status at the time, the terms of the policy, business manuals, etc. with respect to each fiscal year; and
(2)		Results of rechecking of the claims payment management system, such as the extent to which the management team is involved in deciding important matters relating to the payment of claims.

Findings based on Reports from Life Insurance Companies

(1)	Results of Reexamination of Non-payment Cases
	The number of cases of inappropriate non-payment was exceptionally high at Meiji Yasuda Life Insurance Company compared to all the other 38 life insurance companies combined, with respect to both insurance money and benefits. Additional payments made in cases where non-payment was deemed inappropriate amounted to 4.94 billion yen in insurance money and 260 million yen in benefits at Meiji Yasuda Life Insurance Company, compared to 1.93 billion yen in insurance money and 70 million yen in benefits at all the other 38 life insurance companies combined.
[Number of Cases of Inappropriate Non-payment]

	The ratio of inappropriate non-payment cases to the total number of non-payment cases was also exceptionally high at Meiji Yasuda Life Insurance Company compared to the other 38 life insurance companies combined, with respect to both insurance money and benefits.
[Ratio of Inappropriate Non-payment Cases to Total Number of Non-payment Cases]

A breakdown of inappropriate non-payment by reason revealed that at Meiji Yasuda Life Insurance Company, policies annulled on the grounds of fraud or cancelled due to serious reasons stood out with respect to insurance money, and policies cancelled due to serious reasons stood out with respect to benefits.
The majority of inappropriate non-payment cases at Meiji Yasuda Life Insurance Company involved applying the provisions for insurance policy annulment on the grounds of fraud when the insured had no knowledge of the name of his/her illness, and applying the provisions for insurance policy cancellation due to serious reasons as an alternative when the insured could not be accused to have breached his/her duty of disclosure due to the expiry of the cancellation period or exclusion period. Inappropriate non-payment cases at the other 38 life insurance companies included determining that there are no grounds for payment because the surgery was mistakenly regarded as being outside the scope of coverage, and applying the provisions for insurance policy cancellation on the grounds that the duty of disclosure has been breached when the causal link between the claim and the undisclosed information could not be challenged.

[Breakdown of Inappropriate Non-payment of Insurance Money]

[Breakdown of Inappropriate Non-payment of Benefits]

Annual trends in inappropriate non-payment show that the number of cases has been rapidly increasing at Meiji Yasuda Life Insurance Company since fiscal 2001, whereas the number of cases has hovered between 50 and 100 cases at the other 38 life insurance companies combined.

[Annual Trends in Inappropriate Non-payment]

An analysis of the causes of inappropriate non-payment in combination with inappropriate non-payment categories revealed that the causes at Meiji Yasuda Life Insurance Company were intentional in nature, such as improper application of the provisions for insurance policy annulment on the grounds of fraud and stretching the interpretation of the reasons for non-payment based on the terms of the policy, etc., whereas those at the other 38 life insurance companies combined were mainly due to insufficient investigation and confirmation of facts and clerical errors. The nature of inappropriate non-payment was therefore found to be different as well.

(2)

Results of Rechecking the Claims Payment Management System

Judging from the rechecking results reported by 38 life insurance companies other than Meiji Yasuda Life Insurance Company, there were no common problems that would immediately lead to inappropriate non-payment. However, the following areas were deemed to require improvement:

1)		A considerable number of life insurance companies have failed to get the Board of Directors or other divisions sufficiently involved in examining the revision of payment assessment criteria, etc. (for example, they were decided solely by the officer in charge of payments or the head of the department).
2)		None of the life insurance companies have established a framework to have the appropriateness of the payment assessment checked by outsiders by adding outside legal experts, academics, etc. as members.
3)		At more than a quarter of the life insurance companies, the Board of Directors receives no reports on the non-payment situation, which, based on common sense, should be reported to the management team.
4)		At more than a third of the life insurance companies, the division in charge of payments handles non-payment and complaints internally, when they should be playing an important part as a function for overseeing the division in charge of payments.

Actions to be taken by FSA

The FSA will encourage the life insurance companies to improve and develop their respective claims payment management systems through inspection and supervision, in consideration of the problems identified by the recent reporting request. Further, the FSA will consider some kind of measures, including revising the comprehensive supervision guidelines for insurance companies, taking into account the analysis results of the causes of such a serious problem as the inappropriate non-payment of claims.
On October 28, the FSA requested the Life Insurance Association of Japan to look into establishing a sound and speedy claims payment management system and measures to fully ensure the protection of policyholders--including developing industry-level voluntary guidelines for non-payment of claims in general and enhancing systems for handling complaints and inquiries--and submit a report by the end of January 2006.

In the ''Comprehensive Guideline for Supervision of Major Banks, etc.,'' which was laid down and released to the public on October 28, 2005, the Financial Services Agency (FSA) addressed the interpretation of the Enforcement Regulations of the Banking Law regarding restructured loans by clearly defining: (1) the purpose of corporate restructuring and support; (2) the provisions for the method of setting the basic rate of interest, etc.; and (3) other interpretations. In conjunction with this, the FSA compiled the questions and queries received from the parties concerned in the said provisions in the form of FAQ and released it to the public under the title ''FAQ: Restructured Loans'' on the same date.

A restructured loan is a type of non-performing loan (risk management loan) set forth in the Enforcement Regulations of the Banking Law. In paragraph 1-5-b (4) of Article 19-2 of the said Enforcement Regulations, it is defined as ''a loan for which arrangements have been made in favor of the debtor with the aim to promote the debtor's corporate restructuring or to provide support to the debtor, such as reducing/exempting interest, granting a grace period for interest payment, granting a grace period for the repayment of the principal and forgiving the debt.''
After the said provisions came into force in December 1998, the ''Operational Guidelines No.1: Deposit-taking Financial Institutions'' was revised at the end of March 1999, which defined ''loans with reduced or exempted interest,'' ''loans with a grace period for interest payment,'' ''loans with a grace period for the repayment of the principal,'' etc. as examples of ''arrangements made in favor of the debtor'' and clearly defined the disclosure criteria.
This was followed by the establishment of the Industrial Revitalization Corporation of Japan (IRCJ) in May 2003. This triggered the revision of the aforementioned Guidelines, which further clarified the disclosure criteria, aimed at improving the predictability of the parties concerned in corporate revival. Specifically, the basic rate of interest was introduced to serve as the criteria for determining and graduating restructured loans, and provisions were laid down to enable IRCJ and other parties concerned in corporate revival to improve the predictability of the upgrade from restructured loans.
Under the revised Guideline at the time, the basic rate of interest was defined as ''the actual lending rate for new loans normally applied to debtors with a similar credit risk as the debtor concerned'' which ''should be set according to economic rationality''. However, the interpretation of such ''economic rationality'' was not clear at the level of the operational Guideline. As it was generally understood and widely accepted that the effective lending rate must ''not be set arbitrarily but must be rationally and objectively demonstrable that returns commensurate with credit risks are ensured,'' there were some cases where the theoretical value for each individual loan was calculated based on uniquely-established methods and was used as the basic rate of interest, which substantially differed from the ''the effective lending rate for new loans normally applied''.

In consideration of the practical problems and other issues that arose from such not-necessarily-clearly-defined criteria, the FSA decided to review the provisions for restructured loans in general, including clearly defining the method of setting the basic rate of interest, and to publish FAQ on the topic under the title ''FAQ: Restructured Loans'', following the recent formulation of the ''Comprehensive Guideline for Supervision of Major Banks, etc.'' The FAQ explains the gist of the latest revision, how the revised provisions will be applied to small- and medium-sized and regional financial institutions, the timing at which the revised provisions will be applied, and the details regarding the implementation of the clarified provisions.

The following is a summary of the revision of the provisions for restructured loans.

(1)		Clearly defining the purpose of corporate restructuring and support: In the latest revision, it is clearly defined that in cases where ''the purpose of corporate restructuring and support'' is deemed to be nonexistent, the loans will not correspond to restructured loans. The FAQ shows examples of cases in which it is deemed that the loan is not for the purpose of corporate restructuring or support (examples include cases in which the relaxed lending terms were decided in view of competition with other financial institutions or had been decided at the time of concluding the contract in the first place).
(2)		Clearly defining the provisions for the method of setting the basic rate of interest, etc.: In the latest revision, appropriate and detailed categories were established according to the debtor's credit risk, and the ''average contract interest rate for new loans'' (the weighted average of the respective contract interest rates for new loans in each category) is regarded as the basic rate of interest. If the ''average contract interest rate for new loans'' in a certain category is substantially lower than the interest rate calculated based on a method that can rationally and objectively demonstrate that returns commensurate with credit risks, etc. are ensured (a theoretical value reflecting the average credit risks, etc. in each category); the said interest rate (theoretical value) is regarded as the basic rate of interest in that category. The FAQ provides a detailed explanation of how to calculate the average contract interest rate for new loans, the theoretical value, and so on.
(3)		Clearly defining other interpretations: In the latest revision, provisions for individual types of restructured loans, treatment of loans whose lending terms have not been changed, graduation criteria and the requirements for ''feasible drastic plans'', etc., were reviewed and clearly defined. The FAQ provides a more detailed explanation on these topics.

It is hoped that the latest review of the provisions for restructured loans and the publication of FAQ will clarify the provisions for restructured loans and solve practical problems which have occurred in the past. In the event that any practical problems are identified in relation to the clarified provisions, the FSA will amend the provisions and/or the FAQ as necessary in a flexible fashion.

Introduction

Following the ''Action Program to Promote Further Enhancement of Region-Based Relationship Banking Functions (FY2005-06)'' (hereinafter referred to as the ''New Action Program'') released by the Financial Services Agency (FSA) in March 2005, small- and medium-sized and regional financial institutions (RFIs; i.e., regional banks, regional banks II, credit associations and credit unions) have each drawn up and published their ''Relationship Banking Promotion Plans'' (hereinafter referred to as ''Promotion Plans'') and also submitted their contents to the FSA by the end of August. With the aim of further promoting region-based relationship banking, the Promotion Plans describe the efforts to be made in the ''Concentrated Consolidation Period,'' which is until FY2006, toward (1) business revitalization and facilitation of small- and medium-sized enterprise (SME) financing, (2) strengthening of management functions, and (3) enhancement of convenience for regional users.
The FSA compiled a summary of the submitted Promotion Plans and released it to the public on October 26, 2005.

Overview of Promotion Plans

The New Action Program requested that in composing and publishing a Promotion Plan, each RFI draw up a unique plan reflecting regional features and other factors, and in implementation, clarify its business model through ''selection and concentration'' based on regional features and user needs, subject to independent managerial decision-making, and carry it out under the principle of self-responsibility and fair competition. Promotion Plans were drawn up and published by 585 RFIs (65 regional banks, 48 regional banks II, 297 credit associations and 175 credit unions). The plans were not only diverse, reflecting the efforts over the past two years as well as regional features and user needs, but also exhibited signs of contrivance in the way they were released.

(1)

Examples of distinctive efforts by RFIs

The RFIs' Promotion Plans included distinctive efforts as described below.
In particular, a relatively large number of distinct efforts was seen in such areas as ''strengthening functions to support creation of new businesses,'' ''strengthening functions of management consultations and support for client companies'' and ''enhancement of convenience for regional users.'' These can be considered as substantial signs of RFIs' will to build a business model reflecting the features of and user needs in the relevant region.
On the other hand, in the area of ''proactive efforts for business revitalization,'' for example, many plans mentioned methods that are common across different regions. Although the text does not convey the exact nature of the relationship with the regional economy in such areas, it appears that in many individual cases, efforts are being made through regional networks in consideration of the industrial structure and other factors of each region.

I. Example of distinctive efforts in business revitalization and facilitation of SME financing

1)	Strengthening functions to support creation and opening of new businesses
Hold a ''patent exhibition'' jointly with local universities, and introduce the patents owned by the universities to commercial companies on an individual basis. Also, train 100 branch manager-grade employees as industry-university collaborators at the universities to facilitate the transfer of intellectual property. Enhance efforts in business areas which have larger shares in gross production of the prefecture such as agribusiness (agriculture and other related industries) and medical and nursing businesses.
2)	Strengthening functions of management consultation and support for client companies
Proactively use the information network created by eight regional banks II in order to collect information broadly from the Kyushu region, rather than limiting the scope to the prefecture, and thus provide management assistance such as business-matching services and M&A consultation for clients. Commercialize consulting services for establishing locally-incorporated subsidiaries in China as an international business support activity. Further, hold business meetings in Shanghai jointly with other banks that have local offices there.
3)	Proactive efforts for business revitalization
	Integrate the management of several ailing Japanese inns featuring hot springs into a new company to be established by utilizing regional revitalization funds, and increase its corporate value in a short period of time by inviting an experienced turnaround manager. The final aim is to sell the new firm to a local company, and thus revitalize the entire hot spring community. Exchange information and share revitalization expertise at the ''corporate revitalization staff meeting'' consisting of RFIs in the prefecture.
4)	Promoting loans without excessive reliance on collateral and guarantees
	Announce a nationwide CLO plan with a local regional bank acting as the lead manager, build a scheme that enables efforts at regional banks across the country and carry out securitization. Promote the introduction of loans focusing on business values, such as those secured by intellectual property, chattel, and claims against third parties, instead of taking real estate as collateral or depending on personal guarantees.

II. Examples of typical efforts in ''strengthening of management functions''

1)	Enhancing risk management
	Make efforts to improve the accuracy of the calculation method of the capital adequacy ratio and to develop a system for enhancing abilities of risk management.
2)	Strengthening compliance
	Enhance efforts for strict management of customer information
3)	Strategic utilization of IT
	Enhance Internet banking functions and introduce cash cards with IC chips

III. Examples of distinctive efforts in ''enhancement of convenience for regional users''

Enhancement of convenience for regional users

Make its (a credit association's) president and/or officers visit local elementary and junior high schools and give students lectures on how finance works and what the RFIs are about in an easy-to-understand manner, in order to promote efforts to revitalize the region while showing the significance of the credit associations in the region.
Share with customers consideration for the environment and awareness of disaster prevention by providing environment- and disaster prevention-related products.
Promote low-interest loan products applicable to houses using roof tiles which constitute a major local industry, in order to encourage their use.

(2)

Efforts with numerical targets

The New Action Program requested that RFIs make efforts to incorporate specific and comprehensible targets--including numerical targets if possible--when drawing up their Promotion Plans, based on their own managerial decisions, so that regional users could fully understand their objectives.
It is noteworthy that in response, a considerable number of RFIs have sought to make improvements by stating voluntary numerical targets in their Promotion Plans with regard to the enhancement of efforts in individual fields such as providing far-reaching support to new and existing borrowers (e.g., extending support for management improvement at client companies and thereby upgrading their borrower classification, supporting creation and opening of new businesses including ventures, etc.) and developing human resources at hand aimed at ''improvement of business judgment abilities'' in addition to various financial indicators.

(3)

Overall evaluation

Looking at the above Promotion Plans as a whole, the FSA evaluates them highly for having included efforts and targets with varying focus reflecting the nature of region-based relationship banking (Note 1) and ''selection and concentration'' based on regional features and user needs, while building on the accomplishments made during the ''Intensive Improvement Period'' (FY2003-04) under the Former Action Program (Note 2).

(Note 1)	Improving RFI's profitability as well as strengthening their financial intermediary functions to SMEs by grasping borrowers' business conditions through quality communication including via face-to-face transactions, while utilizing the information acquired through long-term business relationships with borrowers
(Note 2)	''Action Program concerning enhancement of Relationship Banking Functions'' (released by Financial Services Agency on March 28, 2003)

The FSA expects that RFIs will further promote region-based relationship banking by steadily pushing ahead with various efforts incorporated into their Promotion Plans, and strive toward revitalization and stimulation of regional economies, facilitation of SME financing, and strengthening of their management functions, while winning full trust from their regional users.
The FSA will follow up on the progress of the Promotion Plans on a semiannual basis, in order to make sure that region-based relationship banking functions are being enhanced.