Policy statement

Nature and consequences of pyramid activities in life and accident insurance
Commission on Financial Services and Insurance, 30 May 1997

These operations seek to involve participants in activity of a criminal or legally dubious nature over a period of many years, bringing the insurance industry in general into disrepute. The insurers underwriting such schemes are exposed to the danger of being exploited for money laundering.

To the extent that such non-admitted sales abroad are not identified to home country regulators, the statutory reports of the insurers involved are distorted. The use of inappropriate actuArial, Helvetica, sans-serif data for such sales, and the high rate of cancellations and lapses, have a damaging effect upon the insurance consumers of the western country, not least by reducing potential returns.

In addition, the structure of the pyramid sales process is such that no effective financial, prudential, or other management control can be exerted over the sales process by the insurers involved. This is a potential threat to the stability of the underwriting insurer.

Sales by ill-trained personnel motivated by factors entirely unconnected with the well-being of the client jeopardises the confidence necessary to secure the stable development of a long term life insurance market, and therefore the future capital markets and domestic investment potential of the countries of the region.

The position of reputable foreign investors in the life and non-life insurance industry is jeopardised by the activities of unlicensed foreign insurers. The outflow of foreign exchange through illicit insurance channels strengthens the local political lobby in favour of restrictions upon foreign investment and a free reinsurance market.

ICC Recommendations

The ICC recommends the adoption of co-ordinated approach by the insurance regulators, and associations of insurers and brokers in the countries of central and eastern Europe and member countries of the European Economic Area to secure from their governments the legislation and enforcement powers necessary to suppress unauthorised pyramid sales of life insurance in their countries;

That insurance regulators of European Economic Area countries monitor insurers under their jurisdiction to ensure that non-admitted sales of life insurance abroad are correctly disclosed and accounted for and based upon appropriate actuArial, Helvetica, sans-serif data, and assess any effects upon home country policyholders, in particular examining insurers reported to them to be engaged in such activity by their counterparts in eastern and central Europe. Supervisors should instruct insurers under their supervision to desist from pyramid sales activities on a non-admitted basis, and seek the appropriate legal powers if they do not exist.

That associations of insurers and intermediaries in western Europe introduce a code of ethics outlawing non-admitted sales of life insurance through pyramid-sales agencies and publicly suspend members which do not comply from membership.

That reputable insurers and reinsurers be encouraged to offer reinsurance and other support to insurers in the region seeking to introduce improved life insurance products in their own states.

For further information contact:
Oliver Keserue
Policy Manager, Insurance

Introduction
The transition economies of central and eastern Europe depend upon a functioning and reliable insurance industry to protect national assets, including the personal protection of individuals and employees. In a very short period of time, the foundations for the creation of insurance markets have successfully been laid in most of the countries of the region.

Unfortunately, in addition to the partnerships and co-operation represented by the participation of western insurers and reinsurers in joint ventures and the provision of reinsurance capacity, some western market participants have been unable to resist the temptation to exploit these new markets solely for the purpose of short-term revenue. The life and accident insurance branch, in particular, has seen the widespread organisation of "pyramid sales" (Strukturvertrieb) networks (also known as "multi-level marketing" or the Schneeball (snowball) system). These networks seek to take advantage of nave consumers, and to exploit the absence of a fully-functioning market or completely effective supervision and legal infrastructure.

Investment market frauds such as Caritas in Romania or MMM in Russia are often misleadingly described as pyramid schemes. These are more accurately described as "Ponzi Schemes", a simple fraud whereby past depositors are paid dividends with the deposits of a growing number of new investors.

The insurance pyramid structures of central and eastern Europe, by contrast, are true pyramid schemes, utilising the methods developed in the late 1950s and 1960s by Bernie Cornfeld’s notorious Investors Overseas Services Inc (IOS).

In most cases, these structures operate under the same or similar names, and utilise the same western underwriting capacity. In all but a few cases, there is no local incorporated entity responsible for sales legally established in compliance with local insurance legislation. At best, a simple commercial representation is registered, frequently in a small town close to a frontier rather than in a major urban centre. Even less often is the insurance company underwriting the policies legally registered and licensed to operate in the country of activity. Typically, a network of sub-agents, agents, general agents, sales managers and general managers conduct operations often across national borders.

The Method
In a typical operation, the aim is to turn all policy purchasers into agents. At the same time, purchase of a policy — typically a 10- or 15-year life policy, together with accident cover — is a requirement for becoming an agent. The agent earns "points" for each sale, depending upon the details of the policy, and commission is calculated by points. Points are also earned for the recruitment of new agents. There are two levels of basic agent, promotion (and a marginally higher commission per point) being earned by reaching a points target. In order to recoup the cost of the agent’s own annual premium, s/he will need to be at least half way up grade 2.

Higher levels are only accessible to those with sufficient recruitment points. At these levels, although the agent may still sell policies directly, commission is earned on the policies sold by agents and sub-agents, and as progress up the pyramid progresses, also on the earnings of local managers, and so on. According to the training manuals of one agency, the basic grade agent will receive 16.9% of the annual premium, and a further 9.3% will pay commissions up to the level of local network manager, the third stage of the pyramid, and the first of its permanent structure. Incentives, such as holidays and gifts, also typically accompany increasing points totals.

In order to attempt to evade local insurance legislation, some of these organisations have, for example, organised bus trips to foreign cities for prospective clients — where they can, of course, be more easily pressurised to sign a policy. Postage of policy applications is another method. The simple expedient of driving across a border with a trunk load of policies and foreign currency is also used.

Background
These pyramid sales structures first came to prominence in the former SFR-Yugoslavia during the late 1980s, when Austrian insurers permitted agents to sell policies, particularly in Croatia and Slovenia, to local residents with foreign currency, earned while working abroad or remitted home. (In some cases, insurers were unaware that such sales were taking place, or through inadequate internal controls, unable to prevent them.) At that time, hyperinflation had destroyed the m arket for dinar-based life insurance. Such was the extent of sales that in order to prevent outflow of foreign currency, the SFR-Yugoslavia was forced to legalise the sale of foreign currency policies in December 1990.

With the opening of the former Soviet bloc in 1990, these operators saw a further opportunity to take advantage of insecurity over the value of domestic currencies and existence of exchange controls, two factors which particularly favour such pyramid operations. Given the rapidity which any agent’s ability to exploit potential recruits is exhausted, there is also a natural tendency — as with chain letters — for the enterprising to expand first towards and then across neighbouring frontiers. Both these tendencies were also observable in the operations of IOS in the 1960s.

As sales networks based in the countries of the region have prospered, and many of the insurance companies which initially supported their operations have withdrawn, a number of other developments have been observable. In various countries:

• local agencies have severed connections with their original western parents, and established autonomously, sometimes splitting more than once.
• In some cases, they have continued solely to act as distribution networks, continuing activity across borders. Fake policy documents unauthorised by the purported western insurer have also been reported.
• In others, they have secured a source of local capital and created insurance companies for which they either act as distribution agents or become the employed sales force. In one or two cases, these have subsequently developed into operations which are adequately capitalised and secure in local terms; in others they have not.
• Affiliates of the foreign sales agencies have registered legal local subsidiaries, acting as intermediaries for local insurers, local insurers fronting for foreign insurers, or foreign insurers directly. These often offer a range of other financial products as well, but the pyramid principle remains intact.
• The western underwriting backers or former backers of the pyramid agencies have established local subsidiaries or joint ventures.
• The Austrian agency which continues to be the most active in the region has split into two, with each claiming to be more legitimate than the other. The original Austrian underwriters which supported this group have been replaced by a Swiss life company now owned by a major multinational insurer with extensive legitimate interests in the region.

Broadly, the penetration has been in three waves

• 1988-90, initially into former Yugoslavia then Hungary and Czechoslovakia, by a number of agencies backed by Austrian insurers.
• 1991-92, throughout the region, mainly by one agency acting for a single Austrian insurer
• 1992-date, throughout the region, by the same agency but operating for a Swiss insurer. (According to sources in the region, this change resulted fundamentally from an instruction from the Austrian Insurance Association to members to cease using such methods.)

Regulators in the region are very much aware of the pyramid operators. The ability to take effective control measures has, however, tended to be hampered by the absence of a consistent legislative framework, lack of co-ordination between different branches of government and enforcement agencies, and — very importantly — lack of co-operation, or timely co-operation, by the insurance supervisors and representative organisations of the OECD countries most closely involved.

The Exent of the Problem

Former Yugoslavia
Early 1991: The Federal State Accountancy Service estimated that one office in Maribor (Slovenia) which it had closed in 1990 had alone sold 30,000 policies.

September 1991: Local insurance industry sources suggested that total sales from the country were in the region of 120,000, at that time yielding probable annual premium outflow of US$70m to US$120m.

In Croatia, a former pyramid network has transformed itself into a life insurance company of some importance in the local market which appears to be functioning normally. There have been no further reports of pyramid operations since the outbreak of hostilities in the region.

In Slovenia, following the legalisation of foreign currency insurance, joint ventures were established between the former backers of the pyramid agencies and local insurers and/or the sales agencies themselves. In mid-1994 an Austrian agreed to make refunds to policyholders in Slovenia who had since defaulted.

Of the two local joint ventures established, one has also obtained a reinsurance licence. A pyramid agency is legally registered, distributing policies on behalf of three locally-registered insurers, as well as other financial products. It is currently challenging the clauses of the Slovenian Insurance Law relating to the qualifications and approval of insurance intermediaries in the Constitutional Court. In early 1996 it claimed that its Austrian parent company had operations in eight countries of central and eastern Europe, with 10,000 agents issuing 10,000 policies worth $7m each month ($85m annually).

In Serbia & Montenegro, one locally-domesticated agency reported 1994 turnover of US$104m and sale of 150,000 policies since 1990. It planned to expand into Bulgaria, FYR-Macedonia (where it has a legally-registered subsidiary), Romania, Russia and Ukraine. At least two other pyramid agencies, one owned by a major Serbian financial group, are known to operate or have operated.

Czech Republic & Slovakia
Late 1990: The Czechoslovak insurance authorities reported six Austrian insurers and two agencies to their Austrian counterparts for illegal policy sales, estimating that 50,000 policies at an average annual premium of $600 (US$30m annually) had already been sold. Most of the insurers cited ceased such activity, and most also refunded all premiums.

Others, however, continued, especially in Slovakia, throughout 1991-93. In January 1994, the Slovak insurers’ association announced a new campaign against the problem, citing for the first time a Swiss insurer. In May 1994, assistance with the problem of pyramid sales agencies was the only formal request for assistance made by Slovak supervisors at the first East-West Conference of Insurance Supervisors. A further public warning and appeal for information was made by the Czech supervisor in mid-1994.

According to the Slovak supervisor, there was a further surge in sales at the beginning of 1995, and that policyholders were reporting difficulties in securing claims, especially for accident policies.

Poland
Austrian pyramid agencies were active at least as early as 1990, holding training seminars across the border in the Czech Republic. One agency claimed to have been operating in Yugoslavia since 1988, in Hungary since 1989 and in Czechoslovakia, Bulgaria and Romania since 1990, as well as plans to expand into the USSR. It claimed total policy sales of over one million, which would have been worth US$600m to US$1bn, but some of these would have been from legitimate activity in western Europe.

The insurance supervisor has been issuing public warnings against illegal underwriting and distribution operations since at least mid-1991. One Austrian insurer took out advertisements warning consumers not to buy policies sold by pyramid agencies.

A renewed surge of activity took place in 1992. Insurers approached by the Polish authorities blamed sales agents over which they had no direct control. The operations of a Swiss insurer have been investigated by local prosecutors.

In October 1994, the insurance supervisor named four companies which had had policies sold illegally.

Hungary
Hungary was penetrated by the pyramid sales organisations very rapidly due to its relatively liberal economic climate and the absence of any clear provisions in insurance legislation dealing with insurance intermediaries. At least six Austrian insurers and as many intermediary organisations, were active from 1989-90.

In April 1992, four Hungarians from Kecskemet were arrested by customs police in possession of policies, Austrian cheque books and foreign currency.

Also in 1992, an Austrian insurer agreed to refund all premiums, and this event, together with the cessation of operations by two agencies, were the subject of a special feature in the house magazine of the Customs police. The Budapest District Court prosecutor had investigated 139 cases involving illegal currency export related to insurance by mid 1992.

An agency registered as an advertising agency was targeted by the authorities. Although the Foreign Economic Relations Ministry was requested to withdraw its commercial licence by the insurance supervisor, it did not do so. The agency was finally closed by court decision in December 1993, but not removed from the commercial register by the Ministry until 1 June 1994. It immediately applied to re-register under a slightly different name.

An Austrian insurer was refused permission to establish a local operation in 1994 after it wished to use illegally-withdrawn premium to part-capitalise its subsidiary. A second application was granted initial approval at the end of 1995, but has since been disallowed due to alleged continuing involvement with illicit sales.

The insurance supervisor estimated in autumn 1994 that the total value of illegally sold insurance was in the region of US$40m per year, with 50,000 policyholders.

Bulgaria
Two agencies were a ctive by 1992. In April of that year, the local network of one established itself as a mutual insurance company. In 1994, a further agency was established in Sofia, described in local reports as a subsidiary of the Swiss insurer for which it underwrites.

CIS
By 1992, a local insurer in Russia was advertising in the local press offering policies at premiums between US$300 and US$3,550 annually, and offering returns of 130% to 150% at term (10 to 15 years) and 68% to 97% of sum insured on death. Russian insurers were seriously and publicly concerned about the activities of a Swiss insurer at least by April 1994, and remain so. One estimate by a senior insurance industry executive put premium volume at $160m.

The same insurer/agency combination has also been reported as active in Ukraine, where the insurance supervisor reports that three buses per week take insureds across the Hungarian border.

Activity in Belarus is probable.

The agency also has an office in Latvia, where it has been active for some time. At the end of 1995, the insurer agreed to cancel all policies written through this office in Estonia, but on Swiss cancellation terms, which are unlikely to generate any returns to policyholders.

Romania
An insurer with an identical name to a well known pyramid sales agency was licensed as a limited liability company with capital of US$30,000 late in 1993. By August 1994, it no longer appeared upon the authorised insurers list. Currently, a mutual fund with a similar (but perhaps coincidental) name is in severe financial difficulty.

Consequences

1. Non-admitted sales by pyramid agencies are in breach of local insurance legislation, or exploit grey areas where legilsation is not advanced. There are also breaches of local exchange control and other regulations. By committing thousands of individuals over 10 to 15 year periods to securing regular foreign currency earnings, they are encouraged not only to engage in criminal activity, but also to extend its influence.

Illegal and quasi-legal exploitation of non-admitted insurance sales opens the networks and their underwriting backers to the risk of money laundering.

2. Such sales may also be in breach of the legislation or regulatory requirements of the domicile of the issuing insurer. Products and tariffs calculated on the basis of an OECD country cannot be applied to a country in eastern and central Europe, where different risk factors apply, and do not have the same actuArial, Helvetica, sans-serif foundation. In addition, it appears that the premium from such sales are credited to the domestic account, leading to a distortion of income statements to the home regulator. This is of concern to all European Economic Area regulators.

The high lapse and cancellation rates associated with pyramid sales of insurance even where these are not also illegal (ie, eastern Germany) represents a potential threat to the solvency of the issuing insurer, as well as distorting the lapse rates for genuine domestic policyholders.

The structure of the pyramid agencies is such that it is clear that no financial, prudential, or other management can be exercised by the insurers backing the policies.

3. Sales by ill-trained personnel motivated by factors entirely unconnected with the well-being of the client to nave customers will inevitably lead to disappointment. This jeopardises the confidence necessary to secure the stable development of a long term life insurance market, and therefore the future capital markets and domestic investment potential of the countries of the region.

Customers are likely to find that claims are refused on the grounds of incomplete information through poor intermediation. Cancellation terms under the issuing county’s legislation will typically mean that no return will be made in the early years at all, and are typically more stringent than cancellation provisions in the local market. This remains the case where the pyramid agencies distribute locally-issued policies which are then 100% reinsured with the original foreign carrier, the claims process may be difficult or impossible. In the event of bankruptcy of the local carrier, the policyholder will have no claim against the pseudo-reinsurer which has booked the premium.

The position of reputable foreign investors in both the life and non-life insurance industry is jeopardised by the activities of unlicensed foreign insurers.

4. The outflow of foreign exchange through illicit insurance channels strengthens the local political lobby in favour of restriction on foreign investment and a free reinsurance market, again jeopardising the development of a full market economy in insurance.

Recommendations

A co-ordinated effort should be made by the insurance regulators, and associations of insurers and brokers in the countries of eastern and central Europe and the FSU to lobby for government action to stamp out sale of non-admitted life insurance. Such action might involve harmonisation of insurance, general commercial, foreign exchange, and other legislation; co-ordination of the authorities responsible for controlling such activity, and the granting to them of adequate powers to suppress the activity, and introduction of severe judicial penalties for those in positions of authority within the local pyramid networks.

Insurance regulators of European Economic Area countries should monitor insurers under their jurisdiction to ensure that non-admitted sales of life insurance abroad are correctly disclosed and accounted for and based upon appropriate actuArial, Helvetica, sans-serif data, and assess any effects upon home country policyholders if technical results of non-admitted sales are combined with domestic business. Attention should be paid, in particular, to insurers reported to them to be engaged in such sales by their counterparts in eastern and central Europe. Supervisors should instruct insurers under their supervision to desist from pyramid sales activities on a non-admitted basis, and seek the appropriate legal powers if they do not exist.

Associations of insurers and intermediaries in western Europe should introduce a code of ethics outlawing such practices, and suspend members which do not comply from membership. The most effective single measure which could be taken to restrain the activities of the pyramid sales agencies would probably be for insurers to cancel contracts with them in their home territory if they engage in non-admitted sales abroad.

Insurers and reinsurers in Europe should be encouraged to offer reinsurance and other support for local insurers seeking to introduce improved life insurance in their own states.

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