COUNCIL OFTHE EUROPEAN UNION

Brussels, 27 July 2006

12043/06

ECOFIN 279EF 29

COVER NOTEfrom: Secretary-General of the European Commission,

signed by Mr Jordi AYET PUIGARNAU, Directordate of receipt: 26 July 2006to: Mr Javier SOLANA, Secretary-General/High RepresentativeSubject: Commission Staff Working Document - Financial Integration Monitor 2006

Delegations will find attached Commission document SEC(2006) 1057.

________________________

Encl.: SEC(2006) 1057

12043/06 gw 1DG G I  EN

COMMISSION OF THE EUROPEAN COMMUNITIES

Brussels, 26.07.2006SEC(2006) 1057

COMMISSION STAFF WORKING DOCUMENT

Financial Integration Monitor 2006

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EXECUTIVE SUMMARY

As the integration of the EU Internal Market for financial services advances, market structures adjust and new ones develop, offering opportunities and economic benefits while raising new challenges in terms of financial stability and competition.

This year's Financial Integration Monitor considers the EU financial sector in the global context and analyses two market segments, the EU insurance and pension funds sector and the EU investment funds sector.

1. THE EU FINANCIAL SECTOR AND ITS EXTERNAL DIMENSION

The EU is a major player in global financial markets, comparable to the US. According to the market segment, its share in the global market varies from 20% to 40%.

The integration of the EU financial sector in global financial markets is intensifying, as demonstrated by the strong increase in its International Investment Position (IIP) -from 100 to 140% of GDP - over the period 1999-2005, making international regulatory cooperation ever more important.

In providing financial services to third countries, establishment is the most widely used integration channel by EU companies.

2. EU INSURANCE AND PENSION FUNDS

The EU insurance and pension fund sector has been and is still growing in importance: investments of primary insurers reached 6.0 trillion euro at the end of 2005 and the assets under management of EU private pension funds 2.5 trillion at the end of 2004. Differences between Member States remain noticeable.

The sector is increasingly organised on a cross-border as well as a cross-sector basis but, from a customer point of view, insurance largely remains a "domestic" service as retail insurance markets are mainly, although not exclusively, accessed through establishment.

The potential for further development of the sector exists but much depends on the economic growth performance and changes in legislation. Considering the ageing of the EU population and the pension challenge, a further expansion can reasonably be expected.

3. EU INVESTMENT FUND SECTOR

In the past decade, EU investment funds have more than quadrupled their assets under management to nearly 6.4 trillion euro at the end of 2005. Today, they play an important role in the EU's household savings and capital markets. Harmonised – for large part equity- funds (UCITS) dominate the market (80% of total).

The situation regarding intra-EU cross-border activity in this sector is mixed. While in some parts of the value chain and for some products cross-border activity is rather low, there are also more encouraging signs: In 2005, two thirds of EU-wide sales took place on a cross-border basis and true cross-border funds1

represented 17% of all UCITS in the EU. The area of fund distribution is where the lack of competition is most keenly felt.

This is reflected in high charges imposed by the distributors.

1 True cross-border funds are funds notified for sale in at least two jurisdictions other than their country of domiciliation, i.e. distributed in at least three Member States

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Financial Integration Monitor 2006TABLE OF CONTENTS

1. THE EXTERNAL DIMENSION.................................................................................5

1.1. The global financial position of the EU........................................................................5

1.2. Channels of globalisation..............................................................................................5

1.3. Financial stability..........................................................................................................8

1.4. Conclusions...................................................................................................................9

2. THE EU INSURANCE AND PENSION FUND SECTOR.........................................9

2.1. Provider of services.......................................................................................................9

2.2. The investor role.........................................................................................................14

2.3. Channels of integration...............................................................................................16

2.4. Financial stability........................................................................................................17

2.5. Conclusions.................................................................................................................17

3. THE EU INVESTMENT FUND SECTOR................................................................18

3.1. The sector....................................................................................................................18

3.2. Towards an integrated market.....................................................................................22

3.3. Efficiency and competition.........................................................................................23

3.4. Conclusions.................................................................................................................23

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Financial Integration Monitor 2006

The Financial Integration Monitor (FIM) seeks to document major trends in the European financial system as an input for policy discussion. This is the third annual report.

The report focuses on three areas of particular interest in the context of the consolidation of the EU financial sector and its further development in a global context, as set out in the Commission's White paper on Financial Services Policy for the period 2005-20101, namely: the EU financial sector and its external dimension, the EU insurance and pension fund sector and the EU investment fund sector.

As the EU Internal Market for Financial Services takes shape, it is evident that this is not a stand-alone project: intra-EU financial activity impacts upon the world financial markets as it represents about one third of worldwide financial activity. The first section of the report therefore examines the global position of the EU financial sector and looks into the channels of EU financial activity with third countries, with particular emphasis on EU-US financial flows.

The second section of the report examines whether and how integration is taking place in EU insurance and pension fund markets. With the ageing of the Europeans, these markets are becoming increasingly important, both as institutional investors on international capital markets and as providers of private pension solutions to consumers.

The third section of the report shows how integration is taking place in the EU investment fund industry. Investment funds play an important role in households' savings and capital markets and have been developing quickly in the past decade. This is also one of the areas of possible further development, as outlined in the White paper on Financial Services Policy (2005-2010).

A detailed presentation of these three topics and an updated statistical annex on the state of integration of EU financial services and markets can be found in the background document to the Financial Integration Monitor 2006, which is published as a DG Internal Market and Services Working Document, available at: http://ec.europa.eu/internal_market/finances/cross-sector/index_en.htm#monitor

1 COM(2005)629, Available at http://ec.europa.eu/internal_market/finances/docs/white_paper/white_paper_en.pdf

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1. THE EXTERNAL DIMENSION

This section considers the international importance of the EU financial sector as well as the EU-US financial flows over the period 1999-2005. During this period, the euro was introduced and the Financial Services Action Plan2 was adopted and gradually implemented.

1.1. The global financial position of the EU

The EU is one of the main actors in international financial markets, together with the US and Japan. Depending on the market segment, the EU holds 20% to 40 % of world markets. While its overall size is comparable to the US, the prevalence of commercial banking in the EU financial sector is reflected in its global position on world banking markets (45% of total assets). The EU has also obtained an important market share in global reinsurance business (35% of total non-life net written premiums).

Chart 1: EU-15 contribution to world financial activity2, (2004 data).

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Banking assets Debt securities Stock markets Investment funds Insurance Reinsurance

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Source: IMF, World Federation of Exchanges, BIS, SwissRe, EFAMA, annual company reports for reinsurers.

The EU is the main contributor to world commercial banking activity, whilst the US clearly leads in equity and investment funds markets.

Whereas the respective shares in debt securities and insurance markets are of comparable sizes, the US clearly dominates in the area of investment funds (50% against 34% in the EU-15) and stock markets (40% against 25% in the EU-15).

1.2. Channels of globalisation

1.2.1. Establishment

In the context of EU-retail financial markets, local establishment has been identified as the dominant channel for market entry and integration. This

2 http://ec.europa.eu/internal_market/finances/policy/index_en.htm2 Global market shares in commercial bank assets, outstanding amount of debt securities, stock market

capitalisation, investment fund net assets, life and non-life premiums and non-life net written premiums in reinsurance (among top 100 reinsurance companies) respectively.

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also seems to be the case for the links the EU-financial sector establishes with third countries. A first indication of this is that the average amount of EU15 foreign direct investment outward flows (FDI) in financial intermediation over the period 1999-2003 was three times more important than the financial services exported to those countries over the same period.

Chart 2: Comparison of EU-15 external trade and FDI in the financial sector, average annual value for the period 1999-2003, bn euro

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Exports Imports FDI outf low s FDI inf low s

Source: OECD (trade) and Eurostat (FDI)

The importance of "establishment" as a channel of integration in the global financial sector is confirmed by the data on transatlantic shareholding (see table 1) and M&A activity. In the period 1999-2004, the EU financial sector acquired 126 bn euro worth of foreign companies of which 84 bn euro (67% of total) in US financial companies. In the same period, the US financial sector acquired 40 bn euro worth of foreign companies of which 31bn (76.5%) in EU financial companies.

US shareholders tend to hold much higher stakes in major EU banks (3-23%) than European shareholders in major US banks (1-7%). The same is true for the insurance sector: US shareholding in European insurance companies is well entrenched and by far more important than the shareholding of EU investors in US insurance groups. In 2003, for instance, US investors were holding between 9% and 40% of the capital of the top European insurers while European investors held between 1% and 6% of US insurers' capital.

Table 1: Top ten European and US banks – bilateral shareholding in 2003 – in % Establishment is the most frequently used, but not the only, way for providing cross-border financial services

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European bank US shareholding

American bank EU shareholding

Credit Suisse Group 2,8 Citigroup Inc 4,2 UBS AG 7,6 JP Morgan Chase & Co 4,4 ABN Amro Holding NV 21,2 Bank of America Corp 7,4 ING Groep NV 23,0 Wells Fargo & Co 0,0 BBVA Bancomer S.A. n.a. Wachovia Corp 1,1 Santander Central Hisp. Group n.a. American Express Co 1,3 BNP Paribas 12,5 Morgan Stanley 1,9 HBSC Holdings Plc n.a. US Bankcorp 1,1 Royal Bank of Scotland Group Plc 15,00 Goldman Sachs Group, Inc 1,3 Barclays Bank Plc n.a. Merrill Lynch & Co, Inc 1,2

Source: BIPE/PWC (January 2006)

worldwide.

The relatively high US stakes in EU financial companies can most likely be ascribed to the generally higher level of market capitalisation in the US compared to the EU and the ensuing widespread ownership of major US financial institutions, which makes it more difficult for EU institutions to acquire controlling stakes in major US banks and insurance companies.

1.2.2. Direct provision of cross-border financial services

Statistics of foreign trade in financial services provide information on the structure and trends in direct cross-border provision of services (net flows). It is clear from the charts below that the EU, the US and Japan are net exporter of non-insurance financial services. In fact, the size of extra-EU1

net exports in non-insurance financial services is comparable to the US.

Chart 3: Foreign trade in non-insurance financial services in the EU, the US and Japan (2004 data, in bn euro).

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Japan

USA

EU25

Exports Imports Net exports

Source: Eurostat

The EU is a net exporter of financial services…

The situation is different for insurance services where the US is a major net importer, mainly from the EU15.

Chart 4: Foreign trade in insurance financial services in the EU, the US and Japan (2004 data, in bn euro).

…also of reinsurance services

1 Extra-EU foreign trade includes the foreign trade of the Member States with third countries, thus excluding intra-EU foreign trade.

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-30.0 -20.0 -10.0 0.0 10.0 20.0 30.0

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Exports Imports Net exports

Source: Eurostat

whereas the US is the main receiver of those services.

This can mainly be related to reinsurance products: in the period 1999-2003, growth of US imports of EU reinsurance products has indeed been impressive and reached 31% of total US imports of reinsurance products by the end of the period.

1.2.3. The EU International Investment Position (IIP)

The International Investment Position (IIP) measures the value of an economy's outstanding financial claims/liabilities to the rest of the world. The sharp increase of the euro area IIP1 during the period 1999-2005, from around 100 to 130-140 per cent of GDP, is one indicator of the area's rapid financial integration with the rest of the world (see chart below).

Chart 5: Euro area IIP, as a percentage of GDP

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euro area liabilities

euro area assets

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Source: ECB, Monthly bulletin

The EU's integration in global financial markets has taken place very rapidly during the period 1999-2005.

1.3. Financial stability

The globalisation of the EU financial sector may entail both positive (e.g. by promoting a better risk distribution) and negative (e.g. by providing potential channels for financial contagion) consequences for financial

While creating opportunities for better risk

1 Even though figures are only available for the euro area, they provide a good proxy for the whole EU.

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stability. The outcome will depend on the vigilance of and cooperation between regulators in setting up and enforcing proper prudential rules, thus providing the right incentives for robust risk management.

diversification, globalisation also provides

One example of potential risk transmission can be found in the reinsurance sector, where Europe is a net receiver of major and unusual US risks (e.g. terrorism, natural disasters etc). However, whether there is any financial stability risk ultimately depends on the quality of risk management in the companies and on proper monitoring and supervision.

channels for potential risk transmission.

Another example is off-shore centres as counterparties or transfer points for European portfolio investments. Together they are the second most important counterparty for EU portfolio investments, after the United States (see chart below). Effective global cooperation among regulators is needed to ensure that Europe is not building up risk exposures towards less regulated areas.

Chart 6: Geography of euro area IIP portfolio assets (bn euro), 2005

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1.4. Conclusions

The European Union is an important global financial player: its financial sector represents 20 to 40% of worldwide financial activity, depending on the market segment. In general, EU financial markets are expanding and there is optimism that this can continue as integration intensifies in the EU.

In providing financial services to third countries, establishment is the most widely used integration channel by EU companies. This is clear from data on M&A and shareholding as well as from the fact that FDI flows are on average much larger than trade flows.

Looking at financial services trade flows involving the European Union, it can be concluded that the EU is not only a net exporter of non-insurance financial services but also of insurance services, where it seems to hold a significant share of the US reinsurance market.

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2. THE EU INSURANCE AND PENSION FUND SECTOR

The importance of the EU insurance and pension fund sector as provider of services as well as an institutional investor has grown strongly over the past decade. To assess developments in this sector, this section examines the areas of primary insurance, occupational pension funds and reinsurance.

2.1. Provider of services

2.1.1. Primary insurance

The size of the insurance sector has increased noticeably with EU25 gross premiums growing from 362.5 bn euro in 1992 to 925 bn euro at the end of 2005. In the EU15, gross premiums nearly tripled while they grew six-fold in the new Member States (NMS) over the same period.

The importance of the insurance sector to the domestic economy varies widely among EU Member States, from less than 2% of GDP in Lithuania to well over 40% of GDP in Luxembourg.

As a provider of services, the insurance sector has gained in importance in the period 1992-2005,

Chart 7:Gross premiums as a % of GDP, 2005 data

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LT LV EE gr HU PL SK CZ CY MT es SI at de se it dk ie eu25 eu15 pt fi nl fr be uk lu

Luxembourg44.7%

Source: CEA and Eurostat

but its size varies widely across Member States…

While this clearly demonstrates the role of Luxembourg as a financial centre, it does not reflect the relative importance of the different national insurance markets to the EU market. Chart 9 shows that Luxembourg represents just over 1% of overall EU primary insurance activity while the UK accounts for nearly a quarter of the market1.

Chart 8: Share of the domestic markets in the EU primary insurance market -2005 data

So does the share of the national markets in the

1 Under the heading 'other Member States' are gathered those Member States with less than 1% of the EU market. Percentages for all Member States are listed in the background document.

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DE, 17.1%

DK, 1.8%

ES, 5.3%

FI, 1.5%

FR, 18.9%UK, 23.9%

IE, 1.4%

IT, 11.9%

LU, 1.2%

NL, 5.4%

PT, 1.5%

SE, 2.4%

others, 2.5%

AT, 1.7%

BE, 3.7%

Source: CEA

overall EU market.

The insurance sector is a sector in continuous development, evolving from a preponderance of non-life insurance in the earlier stages of market development towards a prevalence of life premiums as markets mature. When comparing the share of life and non-life in total insurance (see chart 10), the share of non-life insurance is more important in developing insurance markets, in some cases close to 100% of total. In the more mature insurance markets or markets where pension provisioning is being supplied by non-budgetised life insurance schemes, life markets tend to represent an increasingly important share of the overall domestic insurance market (often well over 50%).

The sector is in continuous development

Chart 9: Share of life and non-life in total insurance- 2005 data

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lv lt ee si cz sk es hu de at cy pl gr nl mt EU eu15 dk it se pt uk fr ie be fi lu

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Source: CEA

with increasing shares of life insurance as markets develop, reaching over 80% of the market in Luxembourg.

The potential for further development of EU insurance markets is significant but developments will depend a lot on economic growth performance, changes in the legislative and fiscal environment as well as reforms or arrangements regarding the national pension systems1. Examples

1 FIM 2005, background document p10, http://ec.europa.eu/internal_market/finances/docs/cross-sector/fin-integration/050708background.pdf

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of the impact of legislation (and taxation) can be found in the Baltic States: following pension reforms, life insurance grew strongly in Estonia and Lithuania whereas life insurance markets dropped dramatically in Latvia in 2000, after a significant reduction of tax incentives.

2.1.2. Pension funds

In line with the enhanced importance of life insurance markets, pension funds have gained in significance as providers of private pension solutions: in 2004, the assets under management of private pension funds in the EU amounted to 2,468 bn euro (compared to 1,600 bn in 2002)1.The United Kingdom has the largest private pension funds with 1.107 bn euro of assets under management, or 45% of the EU market. The Dutch are also very large in relative terms, representing 21% of the EU market.

Private pension funds are becoming increasingly important as an alternative

1 ECB, Banking structures, October 2005. For GR and FR no data are included as all pension funds are state owned, for SK no data are provided because of the current reform of the social security.

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Chart 10: Share of EU private pension fund market (assets under management), (2004 data)

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MTNL

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Source: ECB

to state-funded pensions but, to date, EU private pension funds are still mainly concentrated in a few Member States, with the UK representing close to half of the EU market.

2.1.3. Reinsurance

The structure of the reinsurance markets is quite different from the markets for primary insurance. Reinsurance is very much an international activity and not directly linked to the development of the domestic insurance markets. Germany, for instance, is home to a number of large reinsurers (see table 2) and the reported levels of reinsurance accepted are high for both non-life (34.1%) and life (15.0%). The UK, where Lloyds is domiciled, also has relatively high levels of accepted reinsurance for non-life (15.0%). Other main reinsurers are registered in Switzerland, the US, Bermuda and Japan. In 2003, EU-based companies represented over 40% of the global top-10 reinsurers' net premium. This confirms the strong position of EU reinsurers worldwide (see chapter on the EU external dimension).

EU reinsurers hold a strong position worldwide with over 40% of the top-10 market.

Table 2: Top 10 reinsurers, according to net premiums earned- 2003 datamn USD

1 Munich Re DE 25,4992 Swiss Re CH 22,7793 GE insurance solutions US 10,0014 Hannover Re DE 9,1815 Gen Re US 8,2456 Berkshire Hathaway Re US 4,4307 Scor FR 4,1628 Converium US 3,6779 PartnerRe US 3,50310 Transatlantic US 3,171Source: SwissRe

Given the basic concept of reinsurance to accept and spread the risks underwritten by the primary insurer, reinsurance is naturally more about non-life insurance than life insurance. Life insurance products contain an important savings element, and carry a smaller insurance risk; they are therefore to a lesser extent reinsured: in 2004, ceded premiums in the life segment worldwide amounted to 33.4 bn USD (20% of total) and 134.4 bn

80% of reinsurance business worldwide is constituted by reinsuring

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USD in the non-life segment (80% of total). The non-life reinsurance activity is also less concentrated than the life activity, with a CR101 of 52% in non-life and 87% in life.

non-life insurance risks

2.2. The investor role

2.2.1. An increasingly important role 2.2.2.

As a financial intermediary, the sector plays a role in the pooling and channelling of savings from the household sector towards investments. It thus offers retail customers access to a diversified investment. As an institutional investor, the sector provides funds to both borrowers and issuers of securities, investing in equity and debt securities markets as well as in non-listed securities.

The economic significance of the insurance sector and its presence on international capital markets increased strongly throughout the 80s and 90s1

and is still on the rise: investments grew from 2,357 bn euro in 1995 to 5,981 bn euro in 2005, representing over 50% of the EU's GDP. Given the different business lines, it comes as no surprise that the "investor role" of the insurance sector chiefly concerns the life insurance sector: over the period 1995-2005, the share of life-insurance in total investments represented close to 80% of the total (see chart below).

The increasingly important investor role of insurance companies and pension funds

Chart 11: Investments of the EU insurance sector in terms of gross premium (bn euro)

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TOTAL LIFE NON-LIFE

Source: CEA

is linked to the strong development of pension plans and other pension solutions (life insurance products)

The investments of funded (private and public) pension fund schemes2 (see table 3) have also known a robust growth over the 1994-2004 period. In the

1 CR10 is the market share of the 10 biggest companies and provides an indication of the level of concentration of activity in a particular market.

1 The IMF reported a stronger growth in insurance sector assets than in banking assets in the period 1990-1999. IMF, 2002

2 The OECD takes into account private and public pension funds that are privately funded. Data availability is limited to the Member States listed in the table.

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more recent years (2001-2004), significant growth can be reported for France, Spain, Hungary, Poland, the Czech Republic and Slovakia, most of which are countries where pension funds started recently from a low base. In the same period, countries with more mature pension systems, like the Netherlands and the United Kingdom, have shown stability or even a decline in the importance of pension fund investments expressed as a percentage of GDP.

Table 3: Investment by pension funds1, expressed as a percentage of GDP2

2001 2002 2003 2004

at 3.9 3.9 4.2 4.5be 5.6 5.0 4.0 4.1cz 2.3 2.8 3.1 3.6de 3.3 3.4 3.6 3.8dk 27.2 25.6 27.6 30.0es 5.8 5.7 6.2 9.0fi 8.2 8.0 8.3 45.3fr 3.9 6.6 7.0 7.0uk 72.5 66.5 65.1 65.1hu 4.0 4.6 5.4 6.8ie 44.3 35.1 39.4 42.6it 2.3 2.4 2.5 2.6nl 107.0 89.4 106.2 106.2pl 2.5 4.0 5.5 7.0pt 12.1 12.1 12.5 11.2se 8.3 7.7 7.8 12.7sk 10.7 16.6 22.7 22.7

Source: OECD, Global Pension Statistics, 2005

The growth of assets managed by pension funds and life insurance companies as well as by the fund industry in general can be expected to accelerate in coming years as efforts to prepare for the impact of the ageing population are being stepped up. The importance of the "investor role" of these institutional investors on securities markets can thus be expected also to gain in importance.

2.2.3. The allocation of assets

Insurance companies mainly invest in fixed income and equity: on average, 66% of European (non unit-linked) insurance assets are allocated to fixed income products, 24% to equities and participations. Practice, however, diverges considerably between European countries, depending on investment practices and differing legal provisions regarding the diversification of asset allocation.

Investments include bonds but also equity, investment fund assets…

This is also the case for the allocation of pension fund3 assets: in the UK and the Netherlands, investments in shares represent approximately 50% of total, in Poland, Germany and Finland about 30%. In the other countries,

As far as pension funds are concerned,

1 OECD definition, see footnote 12.2 The OECD reports that this jump is due to the inclusion of the statutory pension funds, which had not

been the case previously.3 OECD definition, see footnote 12.

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asset allocation seems to include a larger share of fixed income but the amounts involved are significantly less impressive. Taking into account the importance of the Dutch and British, but also increasingly the German pension funds in total EU pension fund business, the capital market impact of pension fund investment could be more significant for equity markets, in particular for early-stage Venture Capital funds, than for fixed income markets.

the share of equity seems to be larger the bigger the funds are.

2.3. Channels of integration

As an investor, insurance companies and pension funds are increasingly operating on integrated EU capital markets. As a provider of services, potential benefits of integration seem to remain largely unexploited as insurance and pension fund products are primarily sold by domestic or foreign providers (branches, subsidiaries) present in the national market.

2.3.1. Establishment

From a services provision perspective, integration in the EU insurance sector has mostly, though not exclusively, taken place through establishment.

Insurance is still largely provided

For the EU as a whole, consolidation has mainly taken place within national borders (85.5% of total activity), resulting in domestic concentration levels (CR5) of well above 35% of the market in most Member States.

on a local-establishment-basis

This being said, integration has not only taken place within national borders: the main exception is the consolidation of the insurance activity in the new Member States, which has largely taken place on a cross-border basis and has resulted in high foreign market shares, for instance in Slovakia (97.45% in non-life and 99.25% in life insurance). Within the EU15, cross-border consolidation has taken place but levels are much lower, reflected by considerably lower levels of foreign ownership (5-55%).

mainly, but not exclusively, by domestic companies.

Integration has also taken place through cross-sector consolidation with other financial sectors such as banks, investment and market activities. The emergence of the bancassurance at the domestic level has been the dominant combination in cross-sector consolidation in the EU insurance sector.

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Chart 12: Proportion of target types by type of acquirer in domestic and cross-border deals (measured in value) in the period 1999-2004.

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Domestic insurance Cross-border insurance

Dom. bank/cong. Dom. insurance Dom. inv. activities Dom. mkt activities Dom. Other

For. bank/cong. For. insurance For. inv. activities For. mkt activities For. other

Source: FIM 2005, data Bureau van Dijk, Zephyr database

2.3.2. Other channels of integration

Intra-EU cross-border provision of services is anecdotal but exists. The EU life insurance market in cross-border provision of services is broadly organised around Luxembourg and Ireland, who hold 90 % of the market.

Cross-border selling of insurance could be further promoted by changes in distribution channels, in particular by the development of electronic channels. At present, this distribution channel is only used in a few countries (NL, UK, PT) and mostly for non-life products.

Integrating links with other financial market segments (banking, stock markets) have been created through the development of products such as unit or index-linked.

Direct cross-border selling remains limited and could be further developed by changes in the present use of electronic distribution channels.

2.4. Financial stability

These "channels of integration" provide opportunities of market access, risk spreading and cost reduction but at the same time constitute "transmission channels".

The changing structure of the EU insurance sector also has impacts on financial stability questions, which are mainly linked to the increased importance of the insurance sector as an institutional investor, to the increased size of some pan-European insurance companies with a global reach and to the links with other market segments involving risk transfers.

Changing structures and links involving the sector may raise new financial stability issues.

2.5. Conclusions

The EU insurance and pension fund sectors have been and are still growing in importance. The size of the sector varies substantially across member

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states and its potential for further development very much depends on economic growth, changes in legislation and demographics.

From a "consumer" point of view, insurance largely, remains a "domestic" service. Retail insurance markets are mainly, although not exclusively, accessed through establishment. Other "channels of integration" can nevertheless be identified.

From an "investor" point of view, the sector is increasingly organised on a cross-border as well as on a cross-sector basis, as evidenced by the high levels of foreign market shares in some Member States and by cross-sector consolidation activity, mainly with the banking sector.

3. THE EU INVESTMENT FUND SECTOR

Investment funds receive individual, corporate and public sector savings and channel them into investments. Compared to the more traditional financial intermediaries, investment funds may offer higher returns and more possibilities of risk diversification.

3.1. The sector

3.1.1. The sector's importance in the economy

In recent years, investment funds have been expanding in most of the EU countries. Total assets of investment funds more than quadrupled between 1995 and 2005 to come close to 6.4 trillion1 euro by the end of 2005.

Between 1995 and 2005, assets under management grew in each Member State. The increases were highest in Ireland, the Nordic countries and Central Europe. By the end of 2004, assets under management averaged 50% of EU GDP.

Chart 13: Assets of investment funds in the EU(1995-2005)

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1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005

Investment funds have been growing quickly all over the EU…

1 Data refer to UCITS (see the Glossary) and non-UCITS, excluding hedge and private equity funds; for Member States covered by EFAMA data (EU-15 plus Czech Republic, Hungary, Poland and Slovakia)

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Source: EFAMA

The countries with the biggest funds sectors2 by domiciliation in the European Union are Luxembourg and France, each with total assets exceeding one trillion euro. They are followed by Germany (where non-UCITS3 have a big share of the market), United Kingdom, Ireland, Italy and Spain.

Chart 14: Assets under Management (2005 data)By domiciliation By management

Luxembourg 23.23%

Germany 14.70%

Others 13.73%Spain 4.19%

Italy 6.25%

Ireland 8.88%France 19.35%

United Kingdom 9.67%

France 20.93%

UK14.71%

Others 10.92%

Germany19.35%

Italy9.19%

US7.40%

Switzerland6.32%

Ireland**0.19%

Luxembourg*3.00%

Spain4.19%

Belgium3.81%

Source: EFAMA, Association Française de Gestion Financière1

…but specific activities of the value chain, such as asset management and administration are concentrated in a few Member States.

From a perspective of localisation of the managers (and after reallocating the assets of funds domiciled in Luxembourg and Ireland) France, Germany and the UK are the biggest European asset management centres. This can be considered to be a better approximation of "real size" of national markets.

3.1.2. The structure of the market

UCITS (harmonized funds2) dominate the EU investment fund market: in 2005 their assets amounted to nearly 5,2 trillion euro, which corresponded to a 79% market share. In 2005 UCITS grew by 23% (11% in 2004 and 13% in 2003).

Equity funds had the biggest share of the UCITS3 market in 2005. Following the developments on the global stock markets, they were on rise again from 2003 to 2005. The overall share of equity funds in the UCITS market increased from 26% in 1995 to 41% in 2005. Bond and money funds experienced the reverse trend: the bond funds' share fell from 36% to 27%

UCITS dominate the EU market…

… and equity funds have gained the biggest share among UCITS.

2 UCITS and non-UCITS, without hedge funds and private equity (EFAMA Quarterly Statistical Release No 24, March 2006)

3 In particular special funds for institutional investors and real-estate funds, offered also to retail clients.1 For Luxembourg: AFG estimate based on CSSF data;**For Ireland: AFG estimate based on DIFA data

(2004)Note: EFAMA data includes data for non-EU countries: Lichtenstein, Norway, Switzerland and Turkey.

2 Collective investment schemes exclusively dedicated to the investment of assets raised from investors. They benefit from a "passport" allowing them, subject to notification, to be offered to retail investors in any EEA jurisdiction once registered in one Member State.

3 Data breakdown for the UCITS categories is not available for Ireland.

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and the money market funds' share from 30% to 19% in the same period.

Non-UCITS, including hedge, private equity and real estate funds, have also been growing fast in the recent years. They have traditionally been reserved for professional investors, but an increasing interest of retail investors typifies the current trend. Non-UCITS are concentrated in a few Member States, for example hedge funds in the UK and real estate funds in Germany.

The evolution of assets under management suggests that there might be a geographical concentration and specialisation trend in the EU investment fund market. In 2004, assets of the five biggest national markets reached 80% or more of the EU market across all UCITS segments. Between 1999 and 2004, Luxembourg and France clearly strengthened their overall position as pan-European fund centres. In the equity segment, the combined share of three main players (Luxembourg, France and the United Kingdom) has increased from 59% in 1999 to 66.6% in 2004. In the bond segment, Luxembourg clearly leads and has strengthened its position in the period considered. France holds over 40% of both the balanced and money market fund segments, although its share in the money market has been reduced somewhat.5 The share of the other big national markets decreased in almost all cases (e.g. Germany, Italy).

Hedge, private equity and real estate funds have also been developing quickly.

A certain regional specialisation trend could be noticed in the UCITS segments. Such trend is even more visible for non-UCITS funds.

3.1.3. Provider of services

Saving in investment funds is one of the options for households to allocate their assets. Some funds are suitable vehicles for long-term investment. They can therefore be potential saving instruments for retirement, depending on the degree of portfolio diversification and the investor's willingness to take risk.

A number of Member States have undergone a reform of pension schemes from pay-as-you-go to more investment-based systems, including a role for specially regulated funds.

Although banking deposits (34.9%) and insurance reserves (29.3%) still dominate household savings in most European countries, funds have acquired an important position (12.8% of EU household assets) but vary strongly among the Member States: between 4,4% in the UK and 23% in Sweden.

Investment funds play an increasingly important role for consumers and retail investors…

3.1.4. Importance for the capital markets

By investing in various types of assets, funds have contributed to faster growth of the capital markets: over the period 1995-2004, savings placed in banks grew 1.5 times, in capital markets 2.3 times and in investment funds 2.7 times.

… and for development of the capital markets.

5 Without taking account of Ireland, for which the data is not available.

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Chart 15: Growth of EU investment funds versus capital market and banking assets (1995=100)

100

120

140

160

180

200

220

240

260

280

1995 1996 1997 1998 1999 2000 2001 2002 2003 2004

All non-intermediated assets Mutual funds shares Deposits and currency in banks

Source: Eurostat

The role of EU funds in capital markets can be analysed by comparing the development of equity funds with the growth of stock markets. Statistics suggest a positive correlation between the volume of equity funds assets and the stock market capitalisation (see the chart below).1 Overall, countries with a high level of stock market development, such as the UK, France or Sweden are also characterised by high equity funds assets/GDP ratio. The opposite can be observed in countries with low stock market capitalisation, such as Slovakia, Poland and Hungary.

Chart 16: Equity funds compared to stock market capitalisation in 2004

SE

SK

UKFR

FI

ES

BE

DK

EL

IT

DE

AT

CZHUPL

0%

2%

4%

6%

8%

10%

12%

14%

16%

18%

20%

0% 20% 40% 60% 80% 100% 120% 140%

Stock market capitalisation / GDP

Equity f

unds a

ssets

/ G

DP

Source: EFAMA, FESE, Eurostat

The role of investment funds in the European equity markets has been

1 The caveat to this comparison is that the data on stock market capitalisation reflect both domestic and foreign capital (of domestic and foreign investors), while the data on assets of equity funds cover only domestically domiciled funds. In a given country, domestically domiciled equity funds can invest on stock exchanges home and abroad, just as the foreign domiciled equity funds can invest on the domestic stock exchange. Luxembourg and Ireland have been excluded from the analysis due to a special role of investment funds in these countries.

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steadily increasing in recent years. The proportion of aggregated equity funds’ assets compared to aggregated stock market capitalisation in the EU-15 grew from 12% in 1998 to 19% in 2004, i.e. an increase of more than 50% in only 6 years.

3.2. Towards an integrated market

3.2.1. Establishment

Domestically domiciled funds seem to dominate the UCITS markets in most of the Member States. It appears that the level of cross-border consolidation of funds in the EU is very low. But most of the new funds set up between 2001 and 2004 are of a cross-border nature, i.e. distributed in at least three Member States. In 2004, the number of true cross-border funds amounted to 4,875, or 17% of all UCITS in Europe (up from 12% in 2001).

Most EU funds are registered in one country. But many new funds are set up to operate

3.2.2. Cross-border sales cross-border.

Data on fund sales in the EU suggest a high level of cross-border distribution. Sales of funds domiciled in Luxembourg (236 bn euro) and Dublin (45 bn euro) accounted for about two thirds of total sales in the EU in 2005 (see chart 17). Given the fact that almost all Luxembourg and Dublin domiciled funds are sold abroad, the combined volume (281 bn euro) can be considered as a good proxy for the volume of cross-border sales in the EU.

Luxembourg and Dublin are hubs for cross-border fund registration…

Chart 17: Net sales of investment funds in selected domiciliations1

-50

0

50

100

150

200

250

€ bn

2003 2004 2005

Source: EFAMA Quarterly Statistics

… and about 66% of total sales in the EU comes from funds domiciled in these two centres!

From the demand side, there seem to be significant differences in investors' preference for foreign domiciled UCITS. To estimate the market share of foreign funds, assets of funds domiciled and sold in a given country are compared with assets of funds sold in the same country, but domiciled

Demand for foreign funds varies significantly

1 The negative values for Italy (2003-2005) and for Germany (2004) can be explained by investors redeeming funds domiciled in those countries.

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abroad. This comparison shows that in some markets clients tend to hold their assets only in nationally domiciled funds, while elsewhere they are more willing to choose foreign based funds. For example, in 2004 only 3% of assets belonging to French investors were placed in funds domiciled abroad, whereas this share was reaching in 41% Germany and 36% in Belgium.

by Member State.

3.3. Efficiency and competition

Due to complexity of the value chain and scarcity of the data, it is difficult to draw conclusions on EU asset management sector's efficiency or on the level of competition in the market. The operational costs of EU asset managers are lower than the costs of their US counterparts (see chart below), which might testify of higher efficiency. But an average EU fund is five times smaller than an US fund. Therefore, the EU asset managers might still forego a part of the latent economies of scale.

An average EU fund is many times smaller than an US fund…

Chart 18: Profitability of the EU and US fund industries

20 20 19

30 3027

1013 14

10 11

10

3033 33

40 4137

0

5

10

15

20

25

30

35

40

45

2002 2003 2004 2002 2003 2004

Europe US

Basis

poin

ts in %

of

AuM

Operating costs Profit margins Net revenues

Source: Mc Kinsey

…which means that there might be some unexploited economies of scale.

The higher operational profits of EU asset managers compared to US asset managers could be related to a lower level of competition in some EU markets

Level of competition is another issue.

3.3.1. Distribution

The area of fund distribution is where the lack of competition is most keenly felt. This is reflected in relatively high charges imposed by the distributors. According to available sources, charges for distribution account for two thirds of total expenses incurred by investors1 in the EU, as opposed to only one third in the US. This would mean that the total costs of the EU fund industry (both production and distribution costs) are higher than those of the American industry. New trends in distribution in the EU markets, such as the open architecture or sales via the internet, might

Competition seems to be missing above all in the area of fund distribution.

1 Equivalent to asset managers total gross revenues.

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contribute to introducing more competition into the distribution segment.

3.4. Conclusions

Investment funds play an important role in EU savings and capital markets. For the last ten years they have on average been growing by 15% per year, developing faster than the banking sector and the capital markets.

There is a clear geographical split in the value chain: France, Germany and the UK have developed as centres for asset management, whereas Luxembourg and Ireland are centres for middle and back office activities (administration, custody).

EU harmonised funds (UCITS) dominate the EU fund market1 with a share of about 80%. Non-UCITS, including hedge, private equity and real estate funds, have been also growing fast in the recent years.

The level of cross-border distribution of funds is high in spite of the lack of competition in local fund distribution, reflected in high charges imposed by distributors. New trends in distribution may contribute to introducing more competition into the distribution segment.

1 Excluding the hedge funds and private equity funds.

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