update The APRA Capital Update: What does it mean for you?

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1 Taylor Fry Newsletter August 2010 The APRA Capital Update: What does it mean for you? In May this year APRA released a discussion paper outlining a raft of proposed changes to current capital standards. Since then, APRA has participated in an Insurance Council Seminar, released the first technical paper directly related to the proposals affecting general insurers and issued the draft template of a Quantitative Impact Study. As they stand, the proposals raise many questions for general insurers, especially regarding the nature of the changes and their potential effects good and bad. For many of you the crucial question is: what can be done to best prepare? At Taylor Fry we have been following the process closely. In this edition of the Taylor Fry newsletter, we take a good look at what has been laid on the table so far and ask: what are the main changes and how are they likely to affect general insurers of all shapes and sizes? We recognise that the proposed changes to capital standards are likely to result in significant changes to capital requirements for many of you despite APRA s reassurance that the aim of the review is not to significantly vary the overall level of industry capital. In light of this, we encourage you to start the work of understanding the potential impacts now, so that you can, if necessary, begin the process of mitigating any adverse impacts. And, of course, of capitalising on any positive ones. update

2 Our breakdown at a glance We have analysed the APRA Capital standards update according to the following breakdown. Click on the headings below to read our detailed analyses of what is going on and how it affects you. OVERVIEW: A SNAPSHOT OF THE APRA CAPITAL UPDATE 3 What Is The APRA Update? 3 Why Is APRA Updating? 3 What Does The Update Look Like? 3 Where Are We Now? 4 THE MAIN CHANGES AND HOW THEY AFFECT YOU 5 THE INSURANCE RISK CAPITAL CHARGE 5 What s On The Table? 5 How Will This Affect You? 5 RISK MARGINS 6 What s On The Table? 6 How Will This Affect You? 6 THE LIABILITY CONCENTRATION RISK CHARGE 7 What s On The Table? 7 How Will This Affect You? 7 THE ASSET RISK CAPITAL CHARGE 8 What s On The Table? 8 How Will This Affect You? 8 THE ASSET RISK CONCENTRATION CAPITAL CHARGE 9 What s On The Table? 9 How Will This Affect You? 9 OPERATIONAL RISK 10 What s On The Table? 10 How Will This Affect You? 10 THE AGGREGATION BENEFIT 11 What s On The Table? 11 How Will This Affect You? 11 THE SUPERVISORY ADJUSTMENT AND THE INSURER S CAPITAL ADEQUACY ASSESSMENT PROCESS (ICAAP) 12 What s On The Table? 12 How Will This Affect You? 12 WHAT NEXT? 13 ANY QUESTIONS? CONTACT US 13 August

3 OVERVIEW: A SNAPSHOT OF THE APRA CAPITAL UPDATE What is the APRA update? In May 2010, the Australian Prudential Regulation Authority (APRA) released a discussion paper outlining a proposal to update capital standards for general and life insurers. In this paper APRA laid the conceptual groundwork for undertaking significant changes to capital standards and initiated what promises to be an involved process. This process will culminate in 2012 when the changes are implemented. Since then, APRA has participated in an Insurance Council seminar (in June) to discuss its proposals and released one technical paper affecting general insurers, which details changes to the Asset Risk Capital Charge. We expect another technical paper affecting general insurers to be issued shortly, on the Insurance Concentration Risk Capital Charge. APRA recently released a draft Quantitative Impact Study ( QIS ) template for consultation purposes and is aiming to finalise the design of its QIS survey of insurers during August. The QIS results will provide critical data for APRA as they seek to understand and (if necessary) reshape the proposed changes. Why is APRA updating? APRA s intentions for the update are twofold. Firstly, the changes are aimed at improving the alignment of capital standards across industries. And secondly, they are intended to make capital requirements more risk sensitive. APRA has stated that it is not aiming to increase the overall capital requirements for insurers. Nonetheless, the proposed changes will likely result in significant increases to required capital for some and significant decreases for others, even if the overall level of market capital required remains the same. What does the update look like? The following diagram juxtaposes the components of the Minimum Capital Requirement under APRA s current standards with the components of the Total Required Capital under APRA s proposed new standards. Revised APRA Insurance Capital Standards Operational risk Supervisory adjustment Investment concentration Asset concentration Minimum Capital Requirement Investment Insurance concentration Asset Insurance concentration Total Required Capital Insurance Insurance APRA propose changes to each of the elements of the MCR, with some more affected than others. A Snapshot of the APRA Capital Update Overview August

4 Where are we now? The diagram below shows the implementation timeline for APRA s revised capital standards. Aug Deadline for submissions to discussion paper Aug Draft QIS issued to insurers Aug Insurance concentration technical paper released Early 2012 Implementation Jul Asset charge technical paper released May Discussion paper released Aug (End) - Final QIS released Dec Draft standards and 2nd discussion paper released Mid 2011 Final capital standards released Jun Insurance capital review seminar Oct Deadline for submissions to QIS As the timeline shows, the process of change to capital standards will be involved and consultative. In this newsletter we take a close look the proposed changes in light of the information currently available. We identify what the major changes are and how they relate to you. And we will, of course, endeavour to keep you posted on each new development as further information is released. A Snapshot of the APRA Capital Update Overview August

5 THE MAIN CHANGES AND HOW THEY AFFECT YOU The Insurance Risk Capital Charge Overall, APRA intends to keep the basic approach to calculating insurance risk capital. That is, even after the standards update you will continue to calculate risk capital as a percentage of outstanding claims and premiums liability, with the applicable percentage being based on the specified risk category for each class of business. What APRA is proposing to change is the risk categorisation of a number of business classes. These changes will have different effects, depending if you are a direct insurer or reinsurer. The key change for direct insurers involves Travel and Mortgage insurance being shifted to a higher category. In addition, Other business which does not fall into one of the specific named classes will now have to be categorised by the Appointed Actuary. For reinsurers, the central change concerns the current three-way groupings of businesses into Property, Marine/ Aviation and Casualty. This grouping will be restructured to bring these businesses into line with the same classes of business as direct business. Additionally, although for each class of reinsurance business, Non-Proportional will continue to attract higher capital charges than Proportional, there will no longer be any differentiation between Facultative and Treaty business. At this stage, if you are a direct insurer, the changes appear to be limited. For those of you writing Travel or Mortgage insurance there will be modest increases in insurance risk capital. And those writing Other business (e.g. extended warranty) may face either an increase or decrease in insurance risk capital. This last change will come down to your Appointed Actuary s view of the underlying risk characteristics. Implications for reinsurers are trickier to gauge, given the proposed restructuring of the business groupings. It is worth noting, however, that if you are a reinsurer you will no longer derive any capital benefit from writing Facultative business rather than Treaty. The Insurance Risk Capital Charge August

6 Risk Margins APRA is proposing two key changes in relation to the determination of risk margins. Currently, you are required to report net liabilities inclusive of a risk margin at the 75% probability of sufficiency but not explicitly a gross liability inclusive of a risk margin. Under the proposed changes, APRA has explicitly defined the requirement to disclose both gross and net risk margins to be estimated on the basis of 75% probability of sufficiency. The reinsurance recovery asset will then be calculated as the difference between the gross and net insurance liabilities at 75% probability of sufficiency. In addition, the current framework allows the diversification benefit within the risk margin to be set by the Appointed Actuary, with no specific limits imposed by APRA. In order to reduce possible inconsistencies, APRA is considering placing some limits on the overall level of diversification benefit allowed in the insurance risk margins. Only limited details of this particular change have been released to date. The impact on you will depend on your current approach to showing gross and net risk margins in your APRA reporting. For many of you there will be no change. However, some of you will see an increase in your reinsurance recoverable asset and this may in turn result in a modest increase in asset risk capital charge. There will be a further consideration for those of you who have non-apra regulated reinsurance, with collateralisation being required in regard to this higher reinsurance recoverable asset. International reinsurers are likely to find this requirement difficult to understand. These issues are likely to have more of an impact on insurers with Non-Proportional reinsurance (because of the significant difference between risk margins on a gross and net of reinsurance basis). Even for those insurers whose capital is not impacted, there may still be an increase in the work required by the Appointed Actuary to properly estimate gross risk margins, with that work in some cases adding little to no value. The devil will be in the detail in regard to any limits on diversification benefits, with the impact on small and large insurers alike likely to be an increase in capital requirements. This increase will depend on the level of diversification currently allowed for by the Appointed Actuary. Risk Margins August

7 The Liability Concentration Risk Charge The change to the liability concentration primarily involves further guidance regarding the calculation of the Maximum Event Retention ( MER ) of the Insurer. The MER will continue to be calculated as the net retention of the insurer plus the cost of reinstating the reinsurance coverage, under a 1-in-250 year event. However, at the Insurance Council seminar in June, APRA flagged a couple of key changes likely to be made to current practice. Firstly, the standard will be clarified to be based on a single region/ single peril Probable Maximum Loss ( PML ), rather than whole of portfolio PML. Secondly, they will introduce an additional component to the charge to allow for multiple events. For those who currently apply the whole of portfolio approach the first of these changes looks likely to be positive, and may result in a reduced charge. The second change is still in early discussion and APRA is yet to determine the basis for calculation. However, a provisional formula put forward by APRA at the June seminar related to the weighted sum of a series of MERs arising from different events. This change will probably be introduced in some form since the current framework does not address the risk of multiple large losses, which is clearly relevant for the Australian market where recent years have seen multiple large losses, such as the Perth Hailstorms and Melbourne Storms of March Further details regarding this change are expected to be included in the forthcoming technical paper. Regardless of the eventual method used to calculate this allowance, you would do well to consider your exposures to multiple losses, and hence the likely. This is particularly true as the proposed MER charge flows straight through as an addition to the MCR. Aggregate deductible reinsurance cover, although currently considered expensive (particularly as it offers little capital relief), may become more desirable after these changes as a means of reduction to the capital charge. Reinsurance modelling in the context of the new capital framework will assist you in making decisions regarding optimal risk mitigation, whether it be via direct holding of capital or additional reinsurance. the Liability Concentration Risk Charge August

8 The Asset Risk Capital Charge APRA is proposing to replace the current factor based approach to calculating the asset risk capital charge with a more complex approach which will apply a series of balance sheet stress tests. These stress tests span a variety of different asset risks, which are grouped into eight risk modules, namely: real interest rates, inflation, currency, volatility, equity, property, credit spreads and default risk. Each module measures the impact on the capital base (i.e. both assets and liabilities) of pre-defined changes in that particular asset risk variable. Of course it is unlikely that all your asset risks will be adversely affected simultaneously, and APRA recognises this. Accordingly, APRA is proposing to apply a correlation matrix when combining the capital charges for the different asset risk modules. It is difficult to predict winners and losers of this change given the scope of the changes and the complexity of these changes. Nonetheless, we can make the following comments on which insurers are most likely to be affected. If you are an insurer with significant exposure to growth assets, you may face capital increases as there appears to be a significant uplift in the stand alone charges for equity and property assets relative to the current capital factors for these asset types. However, the quantum of this increase will be (at least partially) mitigated by the operation of the correlation matrix. Insurers will need to hold additional capital to the extent that there is a mismatch between assets and liabilities (for which no additional capital charge is levied by the current approach). This change may pose particular difficulties for insurers who have liabilities with inflation linked cash flows, due to the absence of a deep and liquid market in inflation linked assets. We think that although APRA s proposed changes certainly appear to provide a more risk sensitive approach to measuring asset risk capital than is offered by the current prudential standard, this needs to be balanced against the additional complexity of the required calculations. And, given the need to apply stress tests to both assets and liabilities as well as the requirement to aggregate capital charges using a correlation matrix, many of you may feel that you could do with actuarial assistance in preparing your quarterly APRA returns (although this is not mandated by APRA). In any event, it is likely to make capital management and planning a far trickier exercise! the Asset Risk Capital Charge August

9 The Asset Risk Concentration Capital Charge In order to discourage insurers from having an excessive exposure to a single counterparty or group of related counterparties, APRA is proposing to impose a 100% capital charge on exposures exceeding a defined threshold (expressed as a percentage of the insurer s capital base). This proposed approach is in line with current capital standards. However, current capital standards do not define a threshold for exposures to counterparties with rating grades 1 to 3, and APRA is proposing to define a threshold for exposure to all counterparties (excluding governments with counterparty grade 1 or 2). The proposed thresholds (for non-reinsurance assets) are outlined below: For unrelated counterparties, a threshold of 50% of capital base with APRA regulated companies, and 25% for non-apra regulated companies. For related counterparties (e.g. parent company), a threshold of 100% of capital base with APRA regulated companies, and 25% for non-apra regulated companies. For APRA regulated counterparties, a minimum threshold of $20M applies (which will be of most relevance to smaller insurers). There is no proposed change to the thresholds for reinsurance assets from current capital standards. The proposed changes to thresholds for non-reinsurance assets are likely to result in a number of you (particularly larger insurers) incurring significant increases in your capital charges. And if you have invested primarily in counterparties with rating grades 1 to 3 as a means of avoiding any concentration capital charge, you will need to reassess your exposures and possibly revisit your spread of investments. Asset Risk Concentration Capital Charge August

10 Operational Risk APRA have identified operational risk as a key risk for insurers and have, as a result, deemed it appropriate to address this risk explicitly in the proposed capital standards. Operational risk has been defined as the risk of loss resulting from inadequate or failed internal processes, people and systems or from external events. In recognition of the infancy of capital modelling for operational risk, APRA have proposed a relatively simple formulaic approach to the calculation of an appropriate operational. The formula is based on the level of, as well as changes in, gross premium volume and gross insurance liabilities. From a practical perspective, the formula driven approach which APRA has taken should mean a relatively straightforward transparent calculation. The main drawback is that a simple formula will not fully capture some risks and may potentially overestimate the risk in some circumstances. For instance, for those of you whose business is growing or declining, the inclusion of the new charge is likely to increase your capital requirements, irrespective of any sound and orderly plans for this change in your business volumes. Moreover, you may at times be temporarily subject to a large increase in your capital requirements due to a large event which results in a temporary increase in gross liabilities, even if the change in net liabilities is immaterial. Operational Risk August

11 The aggregation benefit APRA recognises that your asset and liability risks are largely independent of each other, with the exception of those instances where both your balance sheet (asset risks) and claims experience (liability risks) are simultaneously impacted. The proposed capital standards explicitly recognise the degree of dependency within, and between, asset and liability risks. This change is good news, as it is likely to be a major source of reduction in your capital requirements - even more important given the likely increases in capital requirements tallying up in other areas! The amount of the aggregation benefit will be calculated using a simple, objective formulaic approach, dependent on the following components: amount of insurer s asset risk capital charge amount of insurer s insurance risk capital charge, and fixed correlation factor set by APRA. Please note that the aggregation benefit excludes asset and liability concentration, as well as operational risk components of the prudential capital requirements. Details of the likely capital savings will largely depend on the actual value of correlation factor. APRA has indicated that further details will be released after the QIS and consultation process, and we will, of course, update you then. Those of you whose asset and/or insurance s dominate your overall capital requirement will be rewarded with a higher aggregation benefit. However, those of you with a significant proportion of your capital requirement made up of asset and/or liability concentration s (such as mortgage insurers) will derive less of a benefit from this change. The aggregation benefit August

12 The Supervisory Adjustment and the Insurer s Capital Adequacy Assessment Process (ICAAP) APRA is considering mandating that insurers hold capital in addition to the sum of the various s. This additional capital will be called the supervisory adjustment. The purpose of the supervisory adjustment is to address those risks which APRA considers to be inadequately covered by the prescribed s. Examples given by APRA include an insurer exhibiting high levels of operational risk, or inadequately addressed reputational/strategic risks, or poor corporate governance or risk management systems. The supervisory adjustment may require an insurer to hold either additional capital or higher quality capital. APRA proposes to replace the current requirement for an insurer s business plan, to document the approach to capital management and include three-year capital projections, with the requirement to develop and maintain a rigorous and well-documented Insurance Capital Adequacy Assessment Process (ICAAP) report. The ICAAP is to be submitted to APRA annually and whilst no format is mandated, it is expected to be a living document. The ICAAP will require you to: maintain at all times a level and quality of capital commensurate with risks have adequate systems for identifying, measuring, monitoring and managing risks determine target capital to support risks associated with your current activities and business plan have a clear strategy for maintaining appropriate capital, including sourcing additional capital monitor compliance with APRA s minimum capital requirements have procedures for effective and comprehensive review of the ICAAP itself. It is expected that the ICAAP will be a key element in APRA s annual review of an insurer, which will determine any supervisory adjustment. In light of these changes, we suggest that you ensure thorough review of your capital process at Board and senior management levels. This would ensure that risks are comprehensively addressed, capital strategies are clearly articulated and documented, effective monitoring and reporting processes are established and that internal controls are in place. Supervisory Adjustment Insurers Capital Adequacy Assessment Process ICAAP August

13 WHAT NEXT? We encourage you to participate in APRA s QIS when the final version is released. This will help you to assess the impact of the proposed changes on your capital requirements. If you are likely to be impacted adversely, the earlier you are aware of this the better. In addition, you ll be able to identify where the significant contributors to any rise in your capital requirements will arise. Finally, completing the QIS will give you the opportunity to undertake the following steps, should they prove helpful: a. You will be able to highlight any unintended consequences of the capital changes to APRA before they are cast in stone. b. You will be able to re-arrange your operations to mitigate the impact (e.g., if the cause is mismatched asset/liabilities, focus on re-organising your assets). c. You will be able to assess what aspects of the new capital determinations require greater actuarial input, or internal capability/education, and the timing or financial consequence of this external help. d. You will be prepared for capital raising, potential modifications to business plans/reinsurance arrangements/capital management plans and so on. You may find that only one of the above steps applies to you, a combination of them, or even all of them. We hope our analysis helps you to better understand the proposed changes and to prepare for what lies ahead. Until next time, Any questions? Contact us Kevin Gomes ph: e: kevin.gomes@taylorfry.com.au Win-Li Toh ph: e: winli.toh@taylorfry.com.au Sydney office Level 8 30 Clarence Street Sydney NSW 2000 ph: fax: e: sydoffice@taylorfry.com.au Melbourne office Level 6 52 Collins Street Melbourne VIC 3000 ph: fax: e: melboffice@taylorfry.com.au Consulting Actuaries & Analytics Professionals Disclaimer This newsletter is general in nature and provided for information purposes only. It does not constitute actuarial or investment advice. In certain cases the discussion is based on incomplete information from APRA that is subject to change. We recommend that you refer to APRA ( for updated information regarding the proposed changes, and discuss your specific circumstances with your Appointed Actuary, or the Taylor Fry contacts above.