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14 Jul 2010

Proposed Australian changes to capital adequacy requirements for insurers

General and life insurers in Australia could face changes to the required and eligible capital standards, following the release of technical papers by the Australian Prudential Regulation Authority (APRA) for public comment.

The changes, which are part of APRA's harmonisation of capital standards across general insurance, life insurance and authorised deposit-taking institutions (ADIs), are intended to make capital requirements more risk-sensitive. While individual insurers will be impacted differently, the proposed changes will increase capital requirements for some companies.

On the other hand the changes should simplify risk management for corporate groups that have entities in more than one APRA-regulated industry, and reduce the number of regulatory checklists for multinationals, allowing them to operate with greater confidence.

Public comment on the proposed changes must be in by 29 October.

Why are these changes being made?

Despite the comparative strengths of the Australian insurance industry evidenced during the economic downturn, it is clear that insurers face some changes in APRA's current review of prudential capital requirements. These changes reflect the shift in global regulation sentiment and international initiatives such as and Solvency II (and Basel II in the banking sector).

Consistent with Solvency II, APRA's proposal embody a risk-based system that measures assets and liabilities, demanding insurers maintain a certain level of capital and transparency to be allowed to operate.

The general approach is based on the philosophy that the goals of prudential regulation include improved risk management rather than compliance with a set of rules.

The three pillar approach

APRA advocates the adoption of three-pillar approach for life and general insurers, which is similar to that already in place for ADIs. Consistent with international trends, the proposed approach is:

  • Pillar I: the quantitative requirements ie. assessment of required capital, eligible capital and liability valuation to cover asset, asset concentration, insurance, insurance concentration and operational risk.
  • Pillar II: the supervisory review process. As part of this process, APRA will be able to impose a supervisory adjustment to required capital where necessary following review of an insurer's risk management and capital management practices if APRA considers that an insurer's prescribed capital amount does not adequately account for all its risks, such as reputational or strategic risks. This will not be a formulaic calculation.

    Issues to be explored in the future include how it will move from year to year, what action can be taken to reduce it and also the impact upon different entities within a conglomerate. This will provide an incentive for insurers to strengthen their operational risk management. It is not proposed that any supervisory adjustment would be the subject of disclosure.
  • Pillar III: disclosure requirements designed to encourage market discipline.

Prudential Capital Requirement

The minimum capital required to be held is the Prudential Capital Requirement. It would consist of the prescribed capital amount (under Pillar 1), plus any supervisory adjustment applied by APRA (under Pillar 2).

The prescribed capital amount covers:

  • insurance risk (including a specific allowance for losses from extreme events)
  • insurance concentration risk
  • asset risk
  • asset concentration risk; and
  • operational risk (based on exposure measures such as based on exposure measures premium, liabilities, and funds under management).

An aggregation benefit is then applied to produce the prescribed capital amount.

Aggregation benefit will also be assessed in circumstances where the current requirements do not directly allow for diversification between risk types. APRA proposes that there should be an explicit allowance for diversification between asset and insurance risks only which would reduce the required capital for insurers exposed to both risks.

The new asset risk capital charge

The resilience reserve requirement of life insurance is being renamed the "asset risk capital charge" and will be used across life and general insurers. The charge is to be based on a series of stress tests which would be applied to the balance sheet using parameters specified by APRA. The capital required for each risk would be the change in net assets for a specified stress.

Together, these net asset movements would be combined by reference to a correlation matrix to provide the overall capital requirement. A standardised correlation matrix may result in a substantial difference compared to the current resilience reserve for some life insurers.

APRA also intends to introduce an explicit capital risk charge as a component of prescribed capital which it considers consistent with the principle of improving risk sensitivity.

What effect will the changes have?

These proposals will have more impact upon life insurers compared to general insurers.

For life insurers, the current requirements for solvency and capital adequacy would be replaced by a single measure of required capital. There will be no expense or new business reserves. The impact upon individual life insurers will depend upon their risk drivers and exposures and asset/liability relationship. It seems possible that separate asset stress tests may reveal correlations and offsets which were not previously apparent in the resilience reserve calculation and that surplus capital will be exposed to asset risk capital charges.

For general insurers, the proposals leave largely unchanged the regulatory framework introduced after the collapse of HIH with the proposed capital requirements broadly corresponding to the existing Minimum Capital Requirement. The insurance concentration risk charge will maintain the current principle, that is, that adequate capital is needed to withstand one large event.

Conglomerates

Recent international experience has highlighted the contagion risk caused by the failure of one entity within a conglomerate group.

APRA's proposals include the extension of capital, governance and risk management standards to groups that have material operations in more than one APRA-regulated industry or have one or more material unregulated entities (Level 3 Supervision framework).

Under APRA's proposals, a Level 3 head entity will be required to maintain an appropriate capital management plan for the group's risk, capital requirements, group relationships and the disposition of capital across the group.

Timetable

The timetable for implementation of the proposal is:

  • July 2010 - October 2010: Quantitative impact study period
  • August 2010: Deadline for first discussion paper comments
  • December 2010: Draft standards and second discussion paper issued
  • 2011: Final standards and reporting forms issued
  • 2012: Implementation

Getting ready for the new capital adequacy requirements

In light of the proposals it may be timely for companies to commence a risk management framework and capital management plan to understand and address any capital implications in advance of the 2012 implementation.

There is no doubt that there will be some increased capital requirements for many industry members and risk sensitivity will be enhanced. In particular, there will be major changes for life insurance in the calculation of capital.

The capital requirements for general insurance are also becoming more risk sensitive and there will be tighter limits on large investment exposures (but no change to reinsurance limits). Careful consideration will also be given to calculation of PML (possible maximum loss) and MER (maximum event retention) for the calculation of the MCR (minimum capital requirement) in terms of concentration of risk. Steps are also being taken to ensure that there is no double counting of regulatory capital, for example, by careful treatment of investments in other institutions. This is one question which Australian insurers will need to turn their mind too in their respective calculations although it is not expected that it will present major difficulties.

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Disclaimer

Clayton Utz communications are intended to provide commentary and general information. They should not be relied upon as legal advice. Formal legal advice should be sought in particular transactions or on matters of interest arising from this communication. Persons listed may not be admitted in all States and Territories.