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The ''Program for Further Financial Reform,'' published by the Financial Services Agency (FSA) in December 2004, highlighted the need to review the calculation standard for the solvency margin ratio in order to improve insurers' financial soundness and further optimize their risk management.

In response, (chaired by Takau Yoneyama, professor of the Graduate School of Commerce and Management, Hitotsubashi University), a group comprised of academicians and others as members, began deliberations in November of last year and published a report ''Regarding Solvency Margin Ratio Calculation Standards" on April 3.

These deliberations represented the first opportunity for conducting comprehensive discussions on the solvency margin ratio since this ratio was introduced to Japan in 1996. The study group not only deliberated on the method for calculating the solvency margin ratio but also held comprehensive discussions on a wide range of issues such as how to evaluate solvency, how to further optimize insurance companies' risk management and how to communicate the solvency margin ratio to policyholders.

The following are the major points that were discussed by the study group.

In light of these points, the FSA will conduct deliberations in order to implement specific revisions of the calculation standard for the solvency margin ratio and realize solvency evaluation based on economic value.

1. Outline

• Objectives for reform of Solvency Margin Ratio

«Concerning insurance companies»: to encourage change in the mindset of the management team by providing incentives for implementing measures to make their risk measurement and management techniques more advanced, particularly an implementation of ALM (asset liability management).

«Concerning policyholders»: To communicate the meaning of the solvency margin ratio through public disclosure by insurance companies in order to enhance consumers' understanding regarding the ratio.

• Improvements in credibility

*To improve the credibility of the solvency margin ratio of 200% as a trigger point for early corrective action by reflecting the actual status of financial markets and enhancing confidence levels.

• Direction of solvency¹ evaluation

*To aim to realize the solvency regime that recognizes the volatility of the net asset, the difference between the value of assets and the value of liabilities (net assets) on an economic value basis² as the risk quantity and manages the volatility appropriately.

2. Approach to Implementing Specific Revisions

To continue the use of existing evaluation techniques while improving them up until the introduction of an solvency evaluation based on economic value.

• Approach to specific revisions

*To update data used as a basis for calculation of the risk coefficients so as to reflect the most recent actual conditions of the market. It is necessary not only to replace old data with new but also to ensure the accountability of the new method so as to obtain public understanding.

*To consider raise the confidence levels of the risk coefficients so as to improve the credibility of the solvency margin ratio. As a first step, it would be appropriate to raise the confidence level to around 95%.³

(Specific revisions)

• Risks

«Assumed interest rate risk» To revise the risk coefficients based on the most up-to-date data, etc.

«Price volatility risk» To examine the risk based on the most up-to-date data after reviewing the confidence level and the measurement period.

«Effects of diversified investment» To consider a method for calculating the effects based on the asset composition ratios of each company.

• Margin (excess ability to make payments)

«Tax deferred assets/tax effect equivalent amount/future profits» It is necessary to consider a certain degree of correction in relation to these items.

3. Efforts to Establish Solvency Evaluation Based on Economic Value

To make constant efforts with a view to realizing solvency evaluations based on economic value by 2010.⁴

(Specific measures)

• Measure for liability evaluation based on economic value

*To start work on waking the best estimates of the technical provisions.

• Measure for sophisticating standard approaches

*To aim to develop a standard approach for measuring interest rate risk, etc. in ways that reflect the ALM of the companies concerned

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¹Solvency refers to ability to pay insurance benefits.

²Evaluation based on economic value means evaluation of the asset-liability cash flow that is consistent with market value.

³With regard to the price volatility risk, the current confidence level stands at 90%.

⁴The year 2010 is regarded as a watershed point for implementing solvency regime based on economic value in Europe.

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1. Introduction

The Financial Services Agency (FSA) on March 30 revised the Comprehensive Guidelines for the Supervision of Major Banks, etc., the Comprehensive Guidelines for the Supervision of Small- and Medium-Sized and Regional Financial Institutions and the Guidelines for the Supervision of Financial Conglomerates.

Specifically, the amendments concerned:

Meanwhile, on March 28, the Fair Trade Commission issued a cease and desist order to a financial institution due to an alleged violation of the ban, under the Act Against Unjustifiable Premiums and Misleading Representations,

on misrepresentation of advantage with regard to the advertising representation of structured deposits. In light of the purpose of the above-mentioned amendment point (1) and this latest case of the alleged misrepresentation, the FSA issued a notice of request to financial institutions and the All Banks Fair Trade Council with regard to customer explanations, including advertising representations.

Here, we will provide background to- and an outline of the amendment point (1) as we can assume that consumer interest in regards to this point is particularly strong.

We will also provide background to- and an outline of the notice of request issued to financial institutions and the All Banks Fair Trade Council.

2. Background to and outline of amendments to supervisory guidelines

Structured deposits refer to deposits that involve derivative transactions such as interest rate options and currency options. If structured deposits are, for example, held until maturity, they return higher yields than ordinary fixed term deposits. On the other hand, if they are cancelled prematurely, the depositors in some cases face a high probability of a principal loss as they need to bear the cost of restructuring the derivative transactions involved. With regard to sales (including advertising representations) and explanations concerning risky products, including structured deposits, the FSA called for the enhancement of the arrangement for the provision of explanations and the function of processing consultation requests and complaints as a priority item under the Guidelines for the Supervision of Major Banks for PY 2006, formulated in August 2006, and is conducting supervision so as to make sure that sufficient explanation is provided so that customers can fully understand the risks involved in financial products as well as the characteristics thereof.

However, as the FSA's Counseling Office for Financial Services Users received information and complaints concerning the handling of premature cancellations of structured deposits, we revised the Guideline for Supervision as follows in order to ensure thorough compliance with rules related to customer protection and to improve user convenience.

(1) Regarding arrangement for providing explanations concerning structured deposits

With regard to structured deposits, the revised guidelines, taking account of the purpose of the provisions of Paragraph 1, Article 12-2 of the Banking Act and Article 13-3 of the Order for Enforcement of Banking Act, point to the need to pay attention to whether there exist arrangements for providing explanations in writing as follows, irrespective of the presence or absence of requests from the customer, except in cases where no problem is recognized in light of the status of the customer knowledge, experience and assets.

(2) Addition of supervisory criteria concerning Article 13-3 of the Banking Act (prohibited acts)

Taking account of the addition of a provision concerning acts which banks are prohibited from engaging in, such as providing customers with false information, the section of the amended guideline that relates to "the arrangements for sales of and explanations concerning deposits, risky products, etc. and functions for handling consultation requests and complaints" requires examination of the possibility of supervisory actions in such forms as demanding reports in cases where prohibited acts, such as the provision to customers of potentially misleading representations, are suspected. A similar requirement was added regarding "the arrangement for customer explanations concerning credit transactions (loan contracts and the accompanying collateral and guarantee contracts) and the functions for handling requests for consultation and complaints."

2. Issuance of Notice of Request to Financial Institutions and All Banks Fair Trade Council

Structured deposits, following the amendment of the section regarding guidelines for supervision in relation to the arrangement for explanations concerning such products, is due to be subjected, under the Financial Instruments and Exchange Act, to restrictive measures such as regulations on advertising, requirements for the provision of pre-contract-conclusion forms and the suitability rule.

Meanwhile, on March 28 this year, the Fair Trade Commission issued a cease and desist order to a financial institution due to an alleged violation of the ban, under the Act against Unjustifiable Premiums and Misleading Representations, on misrepresentation of advantage with regard to the advertisement of structured deposits. With regard to the advertisement by financial institutions, the FSA in August of last year urged all deposit-taking financial institutions to make thorough efforts to ensure easy-to-understand advertisement so as to prevent the misleading of customers, following a warning issued by the Fair Trade Commission against a financial institution regarding the content of its advertisements. As the latest case of misrepresentation occurred despite this action, the FSA is taking the matter very seriously.

As a result, on March 30, the same day as the date of the revision of the supervisory guidelines, the FSA urged all deposit-taking financial institutions to further enhance their arrangements for customer explanations, including those pertaining to advertising. In addition, the FSA urged the All Banks Fair Trade Council, which has established "rules concerning fair competition in relation to representations in the banking industry," in order to further enhance the standard for easy-to-understand advertisement so as to prevent the misleading of customers.

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The Program for Further Financial Reform, which covered a two-year period beginning in April 2005, has played an important role in moving Japan's financial regulations from the phase of concentrating efforts on the issue of nonperforming loans to the phase of working towards the establishment of a desirable financial system for the future. The FSA believes that during this process, the objective of the Program for Further Financial Reform has for the most part been achieved as laws such as the Financial Instruments and Exchange Act and the amended Moneylending Business Control and Regulation Law , etc., have been enacted, thus strengthening the market surveillance functions of the above-mentioned regulations.

The FSA believes that continued efforts aimed at tackling new challenges in response to changes in customers' needs are required, both in terms of socio-economic conditions and the financial environment. Major new challenges for the FSA include:

Although the Program for Further Financial Reform is coming to an end, the FSA will continue to strive to implement a transparent and credible financial regulatory regime while establishing financial and capital markets that provide a high level of satisfaction to customers, contribute to regional economies and attract overseas investors.

The FSA has published the implementation status of various measures in the past two years. The following are major measures implemented during the period in question.

Implementation date	Major measures
June 2005	Drew up and published the ''Guidelines for Financial Conglomerates Supervision,'' which deal with issues that extend across various business sectors by clarifying regulatory viewpoints and points of attention concerning group-based risk management systems (published on June 24, 2005 and amended on May 1 and July 31 of 2006 and on March 30 of 2007).
July	Published ''Financial Inspection Rating System for Deposit-Taking Financial Institutions,'' which provides graded ratings of inspection results, in order to encourage financial institutions to improve their management systems (July 1).
	Opened ''Counseling Office for Financial Services Users,'' which single-handedly handles financial service users' questions, comments and requests for consultation (July 19).
September	Drew up and published ''Principles of Financial Regulation and Guidelines for Employees of Regulatory Divisions/Sections (Code of Conduct)'' (September 2).
October	Revised the bank agent system through the amendment of the Banking Act in order to enable the designing of programs aimed at providing diverse and high-quality financial products and services (October 26)
	Drew up and published the ''Comprehensive Guidelines for the Supervision of Major Banks'' (published on October 28, 2005 and amended on March 31 and May 1 of 2006 and on January 23, March 13 and March 30 of 2007)
March 2006	Issued notification concerning First Pillar of Basel II (minimum capital requirements) (March 27).
June	The Financial Instruments and Exchange Act was enacted as comprehensive, cross-sectoral legislation intended to ensure customer protection (June 7).
	Published ''Summary of Issues Discussed by Consultative Council on Market Intermediary Function of Securities Companies'', which was compiled based on deliberations on what securities companies should do in order to fulfill their intermediary market function, etc. (June 30).
	Published a summary of issues discussed by ''Joint Study Group on Development of Financial and Capital Markets of Asia and Japan,'' based on a study on measures aimed at transforming the Japanese market into Asia's Financial Center''(June 30).
July	Reorganized the Securities and Exchange Surveillance Commission's Executive Bureau, which previously comprised of two divisions and three sections, into an entity comprised of five divisions overseen by a single senior official, in order to strengthen the enforcement of the surcharge system as well as the execution of operations (July 1).
December	The Act concerning the Establishment of Related Acts in Line with the Enforcement of the Trust Business Act, which includes revision of the Trust Business Act, was enacted as legislation aimed at promoting the utilization of the trust function (December 8).
	The Act to Amend the Money-Lending Business Control and Regulation Law was enacted so as to resolve the issue of multiple debts (December 13).
	Revised the Inspection Manual for Deposit-Taking Institutions so as to deal with Basel II (December 26).
January 2007	Initiated discussion on ways to enhance the attractiveness of Japan's financial and capital markets as an international financial center at the ''Study Group on the Internationalization of Japanese Financial and Capital Markets Under the Financial System Council's Sectional Committee on Financial System (January 30).
March	Submitted a ''Bill to Amend the Certified Public Accountants Act'' to the 166th ordinary session of the Diet in order to enhance the public certified accountant and corporate auditor systems (March 13).
	Submitted a ''Bill concerning Electronic Recording of Debts'' to the 166th ordinary session of the Diet in order to facilitate fundraising by business operators by specifying rules concerning electronically recorded debt under private laws and requirements for regulation of organizations that conduct electronic record-keeping for information relating to debt (March 14).
	Issued a notice concerning Pillar 3 of Basel II (market discipline) (March 23)
	Put Basel II into effect (March 31).

The Financial Services Agency (FSA) has published a draft of the Cabinet Office Ordinance for the Amendment of Part of the Ordinance for the Enforcement of the Banking Act.

Details of the amendment are as follows:

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1. The Japan-EU High-Level Meeting on Financial Issues was held at the offices of the Financial Services Agency (FSA) in the afternoon of March 26, 2007. Such meetings provide the opportunity for Japan and the European Union (EU) to share information concerning financial regulation and, where necessary, to coordinate their positions. From the Japanese side, Deputy FSA Commissioner for International Affairs Junichi Maruyama participated in the latest session and Pierre Delsaux, Director, Directorate-F of DG Internal Market and Services represented the European Commission (EC).

2. First, the FSA explained Japan's preparations for the introduction of Basel II in March 2007 and outlined key points and a detailed implementation schedule of the Financial Instruments and Exchange Act, which was enacted last year.

3. The EC explained the technical measures to be implemented before the Markets in Financial Instruments Directive (MiFID) takes effect in November 2007 as well as the status of progress thereof. It also provided an update on the status of deliberations on cost effectiveness and investor protection in relation to investment funds. With regard to policy concerning credit rating agencies, the EC indicated that the current EU legislative framework is sufficient and that it will monitor the compliance of credit rating agencies with the IOSCO (International Organization of Securities Commissions) code, in cooperation with the Committee of European Securities Regulators (CESR).

4.Both sides recognized that hedge funds, which have been drawing increased interest recently, and the emergence of

advanced financial techniques have made significant contributions to the efficiency of the financial system in recent years and agreed on the need to remain vigilant and attentive to the hedge fund industry and the instruments handled thereby, given the strong growth of this industry. The FSA briefed the EC on the results of its second survey on hedge funds (published on March 15, 2007).

5. The FSA and the EC also briefed each other and exchanged views concerning:

(1) The Solvency II initiative for which the EC is to adopt a Directive in July 2007, and (2) XBRL (eXtensible Business Reporting Language), a sophisticated method of financial disclosure, which the FSA is preparing to introduce.

It should be noted that a press release providing an outline of the meeting was issued on the day after the meeting based on an agreement between the two sides. For details, please access "Japan-EU High-Level Meeting on Financial Issues"(March 27, 2007) at "Press Releases" of the FSA's web site.

*The next meeting is scheduled to be held in Brussels (the date of which has yet to be set).

Under the Financial Instruments and Exchange Law enacted in June 2006, listed companies will be subject to the internal control report system, effective from their respective first business years beginning in April 1, 2008. This system obliges managers to issue ''assessments'' of the effectiveness of their companies' internal controls in regards to financial reporting and the auditors' ''audits'' thereof.

With regard to the internal control report system, the manner in which it is to enforce in practice is drawing considerable interest. The Business Accounting Council (chaired by Hideyoshi Ando, a professor at Hitotsubashi University) conducted deliberations on this system while examining the status of enforcement in the United States, which has already introduced a similar system. On February 15, 2007, the council drew up a standard for assessment by managers and audits by auditors under this system as well as guidelines for applying said standard in practice (hereinafter referred to as the ''Practice Standards'') and published these in a position paper.

The Standards and the Practice Standards mandate that internal controls are to be effectively and efficiently established and the status thereof evaluated and audited while simultaneously ensuring the efficacy of this system in securing the reliability of financial reporting without imposing excessive burden on companies and auditors. This system is expected to help improve the reliability of information disclosure as a whole through the enhancement of internal controls due to enforcement activities based on these Standards, etc.

All of the Standards and Practice Standards are comprised of three sections-Establishment of Internal Controls, Assessment and Audits. The Practice Standards cite specific items from the Standards and explain how they are to be applied in practice.

The key points of the Standards and the Practice Standards are as follows:

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