Integrating trade agreements in the international expansion plans of insurance and reinsurance companies.

Globalisation of insurance companies has become a reality. With a few exceptions (for example, insurance companies in Japan), in most OECD countries the largest domestic insurance companies are either a subsidiary of a global giant or an affiliate of a global insurance company. These firms lower risk through geographic diversification and enhance long-term growth through demographic diversification.

The race for mergers and acquisitions is on. For example, on 12 May 2001, AIG announced a takeover of American General, a deal worth $23bn. With demutualisation providing shares to use as acquisition currency, the process of takeover has taken a new dimension in the insurance industry.

Success in the insurance business is very scale dependent. The larger the company, the greater the chance of higher profitability. A simple way of expanding the size of the company is through mergers and acquisitions. For example, ING exercised the option of buying the remaining part of the Mexican insurance company Seguros Comercial America (SCA) on 4 June 2001 to consolidate its position in the Mexican insurance market. SCA now has 29% of the insurance market in Mexico. Even though SCA has a market value of less than $2bn (compared with the market value of ING at $453bn), it is the sum of all these relatively small deals across the globe that adds value to the company.

Domestic mergers and acquisitions in a mature market are often not enough. Developing markets with rapidly expanding insurance business are often the best place to improve profitability. For example, the biggest return on investment of AIG comes from emerging markets.

It is not enough for a company to decide to expand internationally. It has to make decisions about where and how. To expand in uncharted territories, it has to weigh in the risks along with the potential rewards. When entering a new market, a company needs to know what legal barriers it might encounter.

Regulations in international financial services are changing. Global deregulation has a major impact on risk management and strategic choices. In this paper, we explore international changes in regulation and how it can and does affect international expansion in the insurance business. While the strategic choices and risk management strategies may be well-known, we take an innovative look at how they are affected by international trade agreements and what the future of global trade in insurance services may be.

North American markets
With economies of scale in insurance business, it is clear why a company needs to get bigger. International expansion brings risk reduction. Entry into the North American market allows a company to operate in Mexico (a rapidly developing market) in addition to the US and Canada. Although the last two are more mature markets, their aging baby boomers make them the fastest developing annuity markets. Thus, a company with business in all three countries can expand the sales of traditional insurance products (such as life and auto) in Mexico, and sell complementary products like annuities in the US and Canada. This diversification reduces risk.

NAFTA (the North American Free Trade Agreement) plays a big role in risk reduction by protecting foreign investment. Therefore, a combination of Mexico and the US/Canada is not the same as combining the US/Canada with some other country, such as China or Indonesia, where such explicit protection is not available.

Mexico also plays the role of a gateway. As an integral part of NAFTA, it can serve as an entry point for a non-NAFTA company to enter the US/Canada market. Mexico has also signed a free trade agreement with the European Union. Thus, companies in the US/Canada might find it easier to enter the EU through Mexico. Mexico has also signed free trade agreements with nine countries in Latin America, and is participating in hemispheric negotiations. Thus, Mexico might be a convenient entry point for North American or European companies to enter other Latin American countries through Mexico. Mexico is also a member of APEC (Asia Pacific Economic Co-operation). Thus, it will become an entry point for the Asia-Pacific region when APEC completes its negotiations. Indeed, Mexico has the unique distinction of participating in all major regional trade blocks.

The US insurance market is the largest in the world. To understand the NAFTA market for insurance, we can look at its place in the top ten markets in the world. Mexico does not feature there, but Canada does. Thus, in global scheme of things, NAFTA represents a small extension of the US market. The US market represents 34% of the global market and Canada has just over 1.8%, eighth place in the international league. Mexico appears as a blip in 24th place, with 0.35% of the market. However, in regulatory reform, NAFTA represents a giant leap. It has brought together three countries: a large developed market (US), a small, developed market (Canada) and a small but potentially large developing market (Mexico).

It is probably unfair to think of the US insurance market as one single market. Given that state insurance commissioners have strong influence on policymaking in each of the 50 states and state governments regulate insurance, it might be instructive to think of each state as a separate market. Table 2 shows the results of this exercise. Separating out the states leads to four – New York, California, Texas and Florida – falling into the top ten insurance markets in the world. Among the top 20, another five states join in. Among the top 50, 30 states of the US find a place. Thus, by global standards, each US state represents an important piece of the insurance market.

Strategies and regulation
The law relating to insurance is complex. Not surprisingly, international agreements reflect this complexity, for example, NAFTA and WTO add international layers to domestic laws. Insurance firms that wish to expand internationally must wade through a dizzying array of rules to determine what services they may provide, how they may deliver those services, and where.

International and domestic regulations affect the strategies available to firms. The degree to which a firm can achieve economies of scale through the centralisation of operations is affected by the modes of service delivery that are available in a given market. The exploitation of new technologies to improve service and lower costs is also limited by the mode of delivery that may be employed. The degree of control over international operations is restricted where market entry is available only through a minority equity stake in local firm. Thus strategic business alliances may be a necessity, rather than a choice to be taken. Even hiring and promotion decisions are limited by the degree of mobility that is allowed for natural persons. Restrictions on the movement of natural persons may also affect the transfer of knowledge and expertise from one operation to another.

Ultimately, decisions regarding international expansion and business strategies cannot be made without a careful review of state, federal, regional and global laws affecting international trade and investment in the insurance industry.

International agreements NAFTA restricts the way Canada, the US and Mexico may regulate insurance companies. Chapter 11 governs foreign investment and Chapter 14 covers international trade in financial services. Of the 140 members of the WTO, 104 have made commitments to liberalise financial services regulation, including Canada, the US and Mexico. WTO rules on financial services are found in a labyrinth of seven intersecting agreements: the Agreement Establishing the World Trade Organisation; the Understanding on Rules and Procedures Governing the Settlement of Disputes; the General Agreement on Trade in Services (GATS); the GATS Annex on Financial Services; the Financial Services Agreement; the Schedules of Commitments on Financial Services; and the Understanding on Commitments in Financial Services. All WTO members are bound by the first four agreements, Mexico is bound by the first six agreements, while Canada and the US are bound by all seven. We will refer to these agreements collectively as the WTO.

NAFTA vs non-NAFTA firms
Canada, Mexico and the US have two sets of international obligations that apply to insurance regulation. In principle, firms from outside the NAFTA region are only entitled to WTO treatment. However, they may be able to use the access acquired under the WTO to enter the North American market and gain NAFTA treatment.

NAFTA applies to ‘persons' of a NAFTA country, which includes an enterprise (corporation, trust, partnership, joint venture and other forms of business organisation) constituted or organised under the law of a NAFTA member. Thus, as long as a company from outside the NAFTA region is able to meet the requirements for incorporation (or other forms of business organisation) and complies with foreign investment laws, it may become a NAFTA company. For example, it may acquire an existing firm, establish a wholly-owned subsidiary, or create a joint venture in one of the NAFTA countries.

Scope of NAFTA and WTO
Both NAFTA and WTO cover all types of insurance. Their obligations apply primarily to federal governments. However, under international law, a country may not invoke the provisions of its internal law as justification for its failure to comply with international treaties. In addition, NAFTA and WTO both make it clear that national governments are responsible for the actions of their states or provinces, as well as self-regulatory organisations that play a role in market access for the financial services industry.

Both agreements set out general principles, general exceptions and exceptions specific to financial services regarding exclusivity of government social programs and prudential regulations required for the protection of consumers or the financial system. In addition, each sets out a series of specific exceptions – regarding specific laws or sectors – to the application of the general principles. This latter type of exception – referred to as reservations – is set out in annexes for each country. All insurance regulations must either comply with the general principles, qualify as exceptions, or be listed as reservations in the annexes.

NAFTA uses a ‘negative list' of reservations, listing specific measures that do not comply with the general rules. This serves two key functions. First, it prevents the governments from creating future restrictions that violate the general rules, except where such restrictions qualify under the exceptions. This limits the circumstances under which governments may create further restrictions on the sale of insurance. Second, the listing of non-conforming measures makes them easier to identify, simplifying future negotiations to eliminate them.

NAFTA thus encourages innovation by providing insurance firms with an incentive to create new services that are not restricted by the negative list. NAFTA clarifies that this is the case by specifically prohibiting governments from discriminating against firms from the other members in the provision of new types of financial services.

WTO uses the exact opposite of the NAFTA approach to liberalise trade in insurance services. Whereas NAFTA uses a ‘negative list' of reservations to set out specific areas that are not being liberalised, WTO sets out individual ‘positive lists' of services that are being liberalised. Thus, under WTO, if a WTO member has not made a specific commitment to liberalise a particular aspect of the insurance industry, it is under no obligation to do so. Even when a general commitment is made to liberalise a particular mode of delivering a specific type of insurance, the country in question may submit lengthy lists of reservations for measures that contradict the commitment.

WTO members may create free trade areas that go beyond their WTO obligations, even though this results in differential treatment among members. If there is a conflict between WTO and NAFTA, as a general rule NAFTA will prevail. All three NAFTA countries are members of WTO and have made commitments thereunder. Should one of the NAFTA countries make WTO commitments that are better than the commitments they previously made to the other NAFTA members, NAFTA requires that the better commitment be immediately extended to its NAFTA partners. It is thus not possible for a NAFTA member to give a non-member more favourable access to its insurance market than it does to a NAFTA member. Indeed, NAFTA opens up the financial services markets to a greater degree than the WTO financial services agreements.

In NAFTA, two principles of non-discrimination – national treatment and most favoured nation (MFN) treatment – prohibit discrimination against insurance firms on the basis of nationality. Under national treatment, foreign investors and firms must be treated no worse than domestic firms. However, this does not entitle them to identical treatment. Rather, national treatment for financial services is defined as treatment that affords equal competitive opportunities. Differences in treatment are permitted as long as they do not put foreign insurance companies at a disadvantage as compared to domestic insurance companies. While differences in market share, profitability or size do not in themselves constitute proof that equal competitive opportunities are being denied, they may be used as evidence of such. At the state or provincial level, governments must treat member country firms no worse than they do firms from other states or provinces. Under MFN treatment, the firms and investments from a member country must be treated no worse than those from any other country.

WTO only applies the principle of non-discrimination with respect to MFN treatment. Unlike NAFTA, the general obligations of WTO in financial services do not include market access or national treatment. Instead, members decide the conditions to set in these areas and specify those conditions in its schedule of commitments for each service sector.

These market access commitments must be applied without discrimination to all WTO members unless exceptions are listed in an Annex on MFN exemptions. Mexico has not submitted any MFN exemptions that affect trade in insurance services, while Canada and the US each have one exemption. The US commitments do not apply to any WTO members that restrict the expansion of existing operations, prevent the establishment of a new commercial presence or compel a person of the US, on the basis of nationality, to reduce their share of ownership in an insurance firm. Canada's MFN exemption permits Ontario to grant preferential access to non-resident individual insurance agents from all states in the US.

Countries may use their WTO schedules of commitments to place limits on market access and national treatment. However, the limitations only apply to existing measures that would otherwise be inconsistent with these obligations, effectively freezing their restrictions so that future measures they might take will not be more restrictive. For example, a country might permit foreign insurance companies to establish a commercial presence, but maintain a limit on national treatment by preserving a foreign investment law that limits the percentage of a domestic insurer owned by a foreign company.

WTO exceptions override any obligations a member may commit to with respect to trade liberalisation. However, they may not abuse the exceptions to create disguised restrictions on trade in services or to arbitrarily discriminate between countries. Key exceptions permit laws against deceptive and fraudulent practices, and aimed at the collection of taxes or the avoidance of double taxation. NAFTA contains more detailed rules than WTO with respect to the application of taxation measures to financial services obligations.

Both agreements allow prudential measures to protect consumers, maintain the integrity of insurance firms and ensure the stability of the financial system. While the governments are generally prohibited from interfering in transfers and international payments, NAFTA permits non-discriminatory transfer pricing rules to maintain the safety, soundness, integrity or financial responsibility of insurance firms. This exception would apply to regulations regarding minimum deposit and capitalisation requirements, for example. However, governments may not use the prudential exceptions to avoid their obligations.

Dispute settlement
Disputes between governments over the compatibility of domestic laws with the agreements are resolved through arbitration if they cannot be settled through consultations. If the arbitration panel rules in favour of the complaining party and the other party does not take steps to comply with the panel's ruling, the complaining party may retaliate against the financial services sector of the other party. These types of disputes can only take place between the member governments. Insurance companies must persuade their own government to file a case against another member government when the latter violates its obligations. Unlike NAFTA decisions, WTO panel decisions can be appealed.

Unlike the WTO, NAFTA provides for dispute settlement for foreign investors from one NAFTA country to sue the host government of another NAFTA country for compensation in the event of expropriation or measures equivalent to expropriation. In addition to seeking compensation, this process may be used to seek the repeal of the legislation that led to the expropriation.

Any expropriation must be for a public purpose, non-discriminatory, follow due process of law, and pay compensation at fair market value, plus interest. These rules provide NAFTA investors with the power to demand compensation whenever government measures interfere with business activities to such an extent that it prevents the use, enjoyment or disposal of their property. A mere reduction in profits is not considered a sufficient degree of interference to constitute expropriation. However, government regulations can be applied in a way that would constitute ‘creeping expropriation', where they have the effect of ‘taking' the property in whole or in large part, outright or in stages.

Claims for compensation represent a powerful tool for insurance companies to dissuade NAFTA governments from implementing legislation that is harmful to their investments. Even if a claim is ultimately unsuccessful, the mere threat of a claim can be used as a bargaining tool.

Both NAFTA and WTO determine market access by four modes of supply:

  • cross-border supply (when a service is provided in one country to a customer in a second country without either party travelling, for example by internet);

  • consumption abroad (when the customer travels to the service provider's country to purchase the service);

  • presence of natural persons (where the service provider travels to the customer's country on a temporary basis to provide the service); and

  • commercial presence (where the service is provided by foreign investment).

    WTO commitments
    In WTO, Canada has liberalised insurance trade the most and Mexico the least. Canada has liberalised all four modes of supply. The US has liberalised three, leaving out presence of natural persons. Mexico has only liberalised commercial presence. In terms of reservations for state restrictions, the US has the most, Canada has fewer, and Mexico has none at all. This reflects the constitutional structures of the three countries.

    In terms of the kinds of services that have been liberalised, Canada is the most open, followed by the US and Mexico. State restrictions in the US limit the delivery of insurance services to a far greater extent than Canada's provincial regulations. Mexico's commitments cover a broad range of services, some of which are unique to the Mexican insurance industry. However, foreign firms may only deliver these services through a minority investment in Mexican-controlled insurance firms. Canada and the US are more open to foreign investment in the insurance industry than Mexico, but state and provincial restrictions on residency and citizenship of firms mitigate that openness to varying degrees.

    Because NAFTA permits restrictions on soliciting and ‘doing business' for firms that seek to supply their services via cross-border supply and consumption abroad1, the least restricted method of entering the market is through the establishment of a commercial presence. Restrictions on soliciting mean that the customer must initiate the transaction, thereby limiting marketing activities. While WTO also permits restrictions on soliciting, it does not permit restrictions on ‘doing business'. However, this advantage may be negated by the extensive WTO reservations for federal, state and provincial measures submitted by Canada and the US. In the case of Mexico, the market may only be entered through a commercial presence for non-NAFTA firms.

    For a foreign investor, NAFTA provides better treatment than WTO because WTO has no equivalent to NAFTA Chapter 11. Moreover, WTO applies no general national treatment requirement to trade in services. Finally, there are fewer foreign investment restrictions in NAFTA.

    Non-NAFTA firms may acquire rights under NAFTA by investing in one of the NAFTA countries. This means that such firms should first establish a commercial presence in the NAFTA country that has the fewest foreign investment restrictions for non-NAFTA firms, then expand into the other NAFTA countries from that base.

    The restrictions that exist at the state level in the US are protected by reservations under WTO and make entry into the US market more complicated than entry into Mexico, which has no state regulations for insurance. Moreover, the only mode of entry Mexico provides for WTO members is by way of foreign investment. If a non-NAFTA firm establishes a commercial presence in Mexico, it can expand into the US through foreign investments that enjoy NAFTA protection. As a Mexican enterprise, it may take advantage of NAFTA provisions permitting the entry of natural persons who are citizens of a NAFTA country, and the entry of senior managerial and other essential personnel of any nationality. Once established in Mexico, it can serve the Mexican market without being impeded by Mexican restrictions on cross-border supply and consumption abroad. Finally, Mexico's numerous trade agreements provide potential access to markets in Europe, Asia and Latin America.

    The main drawback of adopting this strategy is that it may not work in Canada, since Canada has reserved the right to require that a company from a NAFTA member be controlled by residents of that member to be entitled to NAFTA benefits. This provision was designed to get non-NAFTA firms to enter NAFTA countries through Canada. Canada has liberalised its market under WTO more than the US or Mexico, and the Canadian market is being opened further by the introduction of new financial services legislation. Thus, Canada is competing with Mexico in its efforts to attract foreign investment. However, Canadian restrictions that limit both foreign and domestic shareholders to a non-controlling minority interest in insurance companies, together with its relative paucity of trade agreements compared to Mexico, make it a less attractive gateway.

    For European firms, Mexico provides the added advantage of the Mexico-European Union Free Trade Agreement (MEUFTA) and Bilateral Investment Treaties (BITs). The MEUFTA contains provisions for financial services that mirror those of NAFTA. However, it contains no equivalent to NAFTA Chapter 11. Nevertheless, 13 of the 15 members of the European Union (all except the UK and Ireland) have negotiated BITs with Mexico that provide substantially the same protection for foreign investors as NAFTA. Mexico's MEUFTA reservations limit foreign investment in insurance firms to 49%. However, Mexico allows European investors to avoid this restriction by establishing or acquiring a financial holding company, through which they may establish or acquire insurance firms.

    The benefits of increasing growth and diversifying risk through expansion into developed and developing markets with different demographic and economic profiles are obvious to global insurance companies. However, a major challenge lies in integrating the rules of international trade agreements into the strategic planning process. This paper has analysed how two major agreements affect market entry strategies in the world's largest and most economically diverse insurance market. We have reached the conclusion that the challenge of regulatory barriers to entry can be mitigated by entering the market through foreign investment in Mexico to take advantage of the market entry and investment protection provisions of NAFTA.

    Under both NAFTA and WTO, Canada, Mexico and the US have demonstrated a preference for foreign investment as the market entry mode for foreign firms. This is due to the perception that foreign investment is more beneficial than allowing imports of insurance services. However, they also want their firms to be able to export their services. To open other markets to exports, they have to open their markets to imports. We can therefore expect to see increasingly liberalisation of cross-border trade in insurance services, which will provoke further consolidation in the industry and widen the selection of market entry strategies available to firms.

    NAFTA has important implications for the international expansion plans of insurance firms. First, it is a trailblazer that provides clues as to the direction other agreements will take. As a regional agreement involving only three increasingly integrated economies, NAFTA can move the liberalisation process further and faster than larger agreements, such as the proposed Free Trade Agreement of the Americas (FTAA) and APEC, both of which are 20 years behind. As NAFTA moves forward, its members also push for more rapid global liberalisation in WTO that will mirror the achievements of NAFTA. Second, NAFTA plays a role in risk reduction. With investment in Mexico as the optimal entry mode, the combined protection foreign investors enjoy under NAFTA Chapter 11 and Mexico's BITs reduces the risk of investment loss in all three countries.

    NAFTA also reduces political and economic risk in Mexico by locking in the regulatory reforms that have been made, integrating the Mexican economy with Canada and the US, and improving Mexico's long-term growth potential. NAFTA brings a wide range of trade and investment rules under one roof, so Mexico cannot backtrack on one set of commitments without pulling out of the agreement entirely. Because NAFTA is so important to Mexico's economy, this is highly unlikely to happen. Finally, as NAFTA widens to include the rest of the hemisphere under the FTAA, Mexico will push for a deeper integration of the original three members in order to maintain better access to Canada and the US than other developing countries have. This will lead to a further reduction in barriers to trade in insurance services, yet again blazing a trail for other agreements to follow.

    Mexico thus enjoys several strategic advantages as a gateway for the international expansion of insurance firms. For non-NAFTA firms, it provides a means to enjoy NAFTA benefits in the North American market. For example, ING invested in Mexico and used its Mexican subsidiary to enter the California market rather than using its New York subsidiary. Once licensed in California, it was able to expand more easily into Arizona. Thus, even for NAFTA firms, there are benefits. Due to the regulatory segmentation of the US market, a firm from one US state may choose to enter another US state via a Mexican subsidiary, in order to gain foreign investor protection under NAFTA and thereby challenge barriers to trade in insurance services between states. In addition, with the GDP Mexican-American population of the US approaching that of Mexico itself, entering the US market with a Mexican brand name may overcome cultural marketing barriers. Finally, Mexico's enthusiastic pursuit of foreign investment and trade agreements in all corners of the globe will continue to enhance its potential as a gateway to not only the North American insurance market, but the emerging global market as well.