Ready, Set, LAGIC! [ APRA regulation ] In this edition. Summary: The Changes

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1 d finitive Keeping you informed. DECEMBER 2012 [ APRA regulation ] Ready, Set, LAGIC! APRA s new capital framework LAGIC is finally complete, and comes into effect on 1 January APRA has made a series of changes to the framework over the last two and a half years. In this d finitive we ve summarised all you need to know about LAGIC for general insurance in its final form: the standards, the rules, the timing. We compare the end-point with the old framework. Summary: The Changes MCR becomes PCR Introduction of ICAAP New, more complex method for calculating minimum capital requirement six main components. Capital more risk-sensitive. The Internal Capital Adequacy Assessment Process. Two new documents are required. Capital base New definitions and minimum levels for Tier 1, Tier 2 capital. Some changes in timing Annual returns and actuarial reports brought forward. In this edition Why the Changes?...2 The New Minimum Capital....2 The Risk Charges...3 Asset Risk Charges....4 ICRC (Insurance Concentration Risk Charge)....5 Capital Base...6 ICAAP...7 What s new for Appointed Actuaries?... 8 Timetable from Here....9 Other changes Reporting form changes. Some new jobs for actuaries. Which Insurers are Different?...10 The Suite of Standards Sydney Auckland Melbourne Wellington

2 LAGIC has been a major project for APRA, aimed at resolving a number of issues and inconsistencies. Why the Changes? APRA felt that the existing capital requirements were not sensitive enough to an individual insurer s risks. They also did not effectively allow for: >> Asset/liability mismatching >> Currency risk >> Asset concentration of non-reinsurance assets >> Exposure to multiple events in a year >> Operational risk. The changes to the capital framework were also designed to align the standards for all entities APRA regulates, including life insurers and banks; LAGIC also involved changes to the life insurance standards. The New Minimum Capital The new minimum requirement is the PCR (Prudential Capital Requirement). PCR Prudential Capital Requirement = PCA Prescribed Capital Amount Pillar 1 + Supervisory Adjustment Pillar 2 Pillars 1 and 2 of APRA s prudential regulation of general insurance relate to capital. Pillar 3 is the reporting requirements. The PCR is intended to be at a level to maintain solvency with a 1 in 200 year failure level: >> The PCA is the sum of risk charges calculated using the Standard Method >> APRA may make a Supervisory Adjustment to an insurer s capital requirement if it believes the PCA is not sufficient. Some examples of where a Supervisory Adjustment may be required: a start-up; an unusually complex business model or organisational structure; where APRA has concerns about governance, risk management, or management capabilities. We note that a requirement to hold additional capital is not the only approach APRA may take in these circumstances. 2 d finitive DECEMBER 2012

3 The Risk Charges This diagram summarises the calculation of the PCA using APRA s Standard Method. With APRA s approval, an insurer may use an internal capital model to determine the PCA. Insurance Concentration Asset Risk Charge Real Interest Rate Expected Inflation Currency Equity Property Vertical Requirement Horizontal Requirement Other Accumulations Aggregation Formula Insurance Risk Charge Insurance Concentration Risk Charge (ICRC) Asset Risk Charge Aggregation Benefit PRESCRIBED CAPITAL AMOUNT Credit Spreads Asset Concentration Risk Charge Default Operational Risk Charge Changes in the Risk Charges Charge Old Method LAGIC Insurance risk charge MER/ICRC Investment/asset risk charge Investment/asset concentration risk charge Factors applied to OSC and PL >> Factors depend on class of business, and whether RI or direct. MER (Maximum Event Retention) >> Retained cost of in 1 in 250 year event. Risk charge percentage applied to each asset >> Charges vary with riskiness of asset Limit on amount which can count as capital, for counterparties graded 4 or below. Same methodology >> Travel and Mortgage classes moved to higher risk bracket >> Charges for RI business simplified >> Charges for long tail classes reduced. ICRC (Insurance Concentration Risk Charge) >> Covers 1 in 200 year event on whole of portfolio basis >> New horizontal requirement risk of multiple events >> More explicit re natural perils vs other accumulations. Assets and liabilities are stressed together under seven different modules. Same approach for reinsurance exposures. For non-reinsurance exposures limits imposed on all non-government assets. Operational risk charge None Percentage factor applied to greater of GWP and net insurance liabilities >> Extra charge if GWP changes by more than 20% Aggregation benefit >> Reduces capital requirement None Formula which allows for diversification between assets and liabilities. DECEMBER 2012 d finitive 3

4 The asset risk charge calculations have been simplified a little during consultation. However, in Finity s view they remain too complex. Asset Risk Charges The LAGIC asset risk charges are much more complex than the percentage factors applied under the old framework: >> Seven different modules are used to stress the capital base in different ways in each case, the capital charge is the fall (if any) in the capital base >> The capital charges from the stress modules are added together using an aggregation formula which allows for diversification among the assets and reduces the total Asset Risk Charge. The calculations are complex, and insurers will need to establish a streamlined way of calculating the charges at each quarterly reporting date see the back page of this d finitive for news about a useful tool to do this. Module Risk addressed Stress factors Comments Real interest rate Mismatch in timing of asset and liability cashflows. Changes in real interest rates (up and down). Expected inflation Mismatch in extent of inflation risk of assets and liabilities. Changes in CPI rate (up and down). Most important impact is on nominal bond values. No impact on inflation-linked bonds and most GI liabilities as increase in CPI is assumed to be offset by increase in yields. Currency Currency mismatch risk between assets and liabilities. Movements in value of AUD against foreign currencies (up and down). Increase in capital base for one currency cannot be used to offset reductions for other currencies. Equity Riskier nature of this asset class. Increase in ASX 200 dividend yield. Charge likely to be higher when equity markets are high. Also includes impact of increase in equity volatility. Property Riskier nature of this asset class. Increase in rental (earnings) yield. Charge likely to be higher when property markets are high. Credit spreads Counterparty risk for investment assets. Increase in credit spreads for investment assets. Also includes allowance for risk of default for these assets. Results in significant capital charge for holding lower quality investments. Default Counterparty risk for noninvestment assets (e.g. RI recoverables). Uses assumed counterparty default rates. Specified factors are generally higher than in credit spreads module. Aggregation formula Correlations between asset classes (reduces the charge). Aggregates risk charges using assumed level of correlation between modules. Depending on results of first three modules, may need to repeat aggregation benefit calculation to determine largest impact. 4 d finitive DECEMBER 2012

5 ICRC (Insurance Concentration Risk Charge) The ICRC replaces the MER and is estimated as: ICRC = greatest of Natural Perils Vertical Requirement Retained cost of 1 in 200 year event and Natural Perils Horizontal Requirement Cost of multiple smaller events From 1 Jan 2014 and Other Accumulations Retained cost of 1 in 200 year nonnatural perils event Note: ICRC calculation is different for LMI business Vertical Requirement (VR) The VR is equivalent to the current MER, but based on the 1 in 200 year wholeof-portfolio event rather than the 1 in 250 year single site/single peril event. The charge is the net retained cost of the event, including reinstatement costs. The VR may change during the year if there is a significant claims event. Horizontal Requirement (HR) The HR has been introduced to recognise the risk that an insurer may be hit by multiple smaller events in a single year (shades of 2011!). The HR is the greater of: The introduction of the Horizontal Requirement makes the calculation of the ICRC much more complex than the old MER. >> The net retained cost of four 1-in-6 year events (H4), less PL offset, and >> The net retained cost of three 1-in-10 year events (H3), less PL offset. The PL offset is the annualised portion of the insurer s premium liabilities which represents the allowance for the cost of events (for events with return periods of three months or more). The insurer s Appointed Actuary determines the PL offset. The HR is fixed at the start of a year, for the whole year, irrespective of actual events. The HR has a major impact on the ICRC for some property insurers depending on their reinsurance arrangements. APRA has given insurers a year s grace for the HR s introduction, so affected insurers have time to adapt their reinsurance arrangements (or put in place other mitigation). Other Accumulations If an insurer is exposed to accumulations of losses from a common dependent source or non-natural perils ( other accumulations ), it needs to consider the 1 in 200 year exposure to these. If the retained 1 in 200 year cost (including reinstatements) is greater than the Natural Perils VR and HR, this will be the ICRC. Insurers who need to reduce their Horizontal Requirement have until 1 January 2014 to take action via reinsurance arrangements or other mitigation. DECEMBER 2012 d finitive 5

6 The capital base is still split into Tier 1 and Tier 2, and there have been some adjustments to the calculations and limits. Capital Base APRA has made some changes to the definitions and requirements relating to an insurer s capital base: Capital base Still made up of Tier 1 and Tier 2. Tier 1 capital Comprises Common Equity Tier 1 (CET1) plus Additional Tier 1. CET1 replaces Fundamental Tier 1, but has a similar definition. Getting APRA s approval ICRC Under some circumstances insurers will need to get APRA s approval for elements of the ICRC calculation: >> Recalculating the Horizontal Requirement (HR) after a change in the insurer s business or reinsurance program (GPS 116, para 12) >> Where the insurer s reinsurance program has multiple inception dates: > Approach to calculating the Vertical Requirement (VR; GPS 116, para 15) > The reporting date that will apply to the HR (GPS 116, para 28) >> Where allowance is made for aggregate reinsurance cover in the VR or HR, need to agree the methodology with APRA (GPS 166, paras 26, 33, 40). CET1 adjustments Tier 2 capital Limits on capital base Changes to capital adjustments in the calculation of CET1 include: >> Capital held in subsidiaries and joint ventures the PCA of the subsidiary/jv is deducted from CET1 >> Assets subject to a fixed or floating charge will be deducted from CET1 (were previously subject to a 100% asset risk charge) >> Expected dividends no longer deducted from capital. Dividends are deducted once declared (may add back an allowance for dividend reinvestment plans). Upper and Lower categories removed. >> CET1 must be greater than 60% of the PCA (previously 37.5% of capital base) >> Tier 1 must be greater than 80% of PCA (previously 50% of capital base) >> Capital base must be greater than PCR. 86 d finitive DECEMBER 2012

7 ICAAP APRA now requires each insurer to have an ICAAP Internal Capital Adequacy Assessment Process. This links and integrates the insurer s risk appetite, risk management framework, business plan and capital management strategy. APRA expects an insurer s Board to own the risk appetite and ICAAP, and to integrate the ICAAP into decision-making processes, strategy and business planning. Risk Appetite & RMF ICAAP Reporting ICAAP Capital Management & Monitoring Strategy & Business Plan Risk Analysis ICAAP Documents Two new reports are linked to the ICAAP: >> ICAAP summary statement ICAAP policy document which summarises the insurer s ICAAP framework. APRA can request a copy any time from 1 January >> Annual ICAAP report reviews the experience of the previous year relative to the insurer s ICAAP. Projects the capital position for three years. APRA has not fixed the timing of the annual ICAAP report, so it can be done at the time of year that suits each insurer best. The insurer needs to provide the report to APRA within three months of preparing it. Finity s observations on the process of ICAAP development during 2012 are: Key Challenges >> Getting it done in time most companies were active early, but some left it late >> Risk appetite statement format (how detailed, mathematical vs words) >> Risk analysis: > Developing scenarios, estimating their probabilities > Dealing with operational risk and other less quantifiable risks > Explaining results and their implications >> Target Operating Range (TOR) for capital: > Top of range how much is too much capital? > Bottom of range what probability of breaching PCR is OK? >> ICAAP Summary Statement: > How much detail? > Document going round in circles (review by different people) > Sometimes highlighted inconsistency between risk appetite and risk analysis results. Outcomes >> Clearer, more explicit risk appetites >> Risk analysis better understanding of range of risks, and of likelihood of unfavourable outcomes >> TOR more sophisticated in some cases, better understanding of how/ why chosen >> Other areas increased Board engagement, better integration of ICAAP elements, better documentation of capital management. What s next? ICAAP during 2013 >> Embedding ICAAP into business as usual >> For some companies refinement of the framework >> Documentation settling what goes where between Summary Statement, ICAAP annual report and FCR >> Planning for the independent ICAAP review. Overall we see these outcomes as consistent with what APRA would have hoped. DECEMBER 2012 d finitive 7

8 What s new for Appointed Actuaries? Elements requiring sign-off by the Appointed Actuary under LAGIC are: Gross uncertainty Include assessment of uncertainty in gross insurance liabilities in ILVR (GPS 320, para 14). Other business Allocate to category A, B or C, for Insurance Risk Charge calculations, and document reasons in the ILVR. (GPS 115, paras 13-15, and GPS 320, paras 26-27). ICRC Estimate the natural perils PL offset, the portion of the net premium liability which relates to catastrophic losses. Show details in the ILVR. (GPS 116, para 43, and GPS 320, para 28). Determine the Other Accumulations (OA) PML Offset and include in the ILVR. The OA PML is the PML relating to accumulations of losses from a common dependent source or non-natural perils. The OA PML can be offset by any losses already allowed for in the premium liability (GPS 116, para 48, and GPS 320, para 29). FCR Include commentary on ICRC, ICAAP (GPS 320, Attachment B). LMI >> Net PL deduction determine proportion of net premium liability relating to an economic downturn (GPS 116, Attachment A, para 25, and GPS 320, para 30) >> Available RI review level as part of ILVR or FCR (GPS 116, Attachment A, para 20). Reinsurance arrangements Assess whether sufficient to cover PML (GPS 320, Attachment B, (i)). Asset Risk Charge No mandated requirement, but AAs will likely be involved due to complex nature of calculations. 8 d finitive DECEMBER 2012

9 Timetable from Here Date 1 Jan Apr Oct 13 1 Jan 14 All insurers LAGIC takes effect ICAAP Summary Statements signed off by now ICRC - Horizontal Requirement takes effect Reporting to APRA June balance dates Jun 13 annual returns, ILVR, FCR (4 months) December balance dates Dec 12 annual returns, ILVR, FCR (4 months) Changes in Timing >> ILVR and FCR due to APRA within three months (currently four months) for balance dates after 31 March 2014 >> Annual returns due to APRA within three months (currently four months) for reporting periods from 31 March 2015 >> Quarterly returns APRA has proposed a change to 28 calendar days (currently 20 business days), but will consult further on this in Mar Apr 14 First annual ICAAP reports to APRA by now Dec 13 annual returns, ILVR, FCR (4 months) 30 Sep Oct 14 Jun 14 ILVR, FCR (3 months) Jun 14 annual returns (4 months) 31 Mar Apr 15 Dec 14 ILVR, FCR (3 months) Dec 14 annual returns (4 months) 30 Sep 15 Jun 13 annual returns, ILVR, FCR (3 months) 31 Mar 16 Dec 15 annual returns, ILVR, FCR (3 months) DECEMBER 2012 d finitive 9

10 Which Insurers are Different? Insurer Type Groups LMI Branches Run-Off Insurers What s different? Requirements consistent with those of insurers apply at Level 2 Group level. Half yearly reporting rather than quarterly. Group requirements previously set out in separate prudential standards GPS 111, 221 and 311. Now incorporated into GPS 110, 220, 310, 320. Different correlation factor in PCA aggregation benefit formula. Different ICRC calculation set out in GPS 116 Attachment A. No difference in LAGIC requirements. Senior Officer Outside Australia stands in place of Board. Access to additional capital is more straightforward transfer from home office. Run-Off Plan in place of business plan. Actuary reviews run-off plan (no FCR). No ICAAP requirement. Changes to Counterparty Grades APRA s counterparty grades have been refined by breaking grade 5 up into three grades, and unrated entities have a higher grade see below (for more detail see GPS 001 Attachment C). APRA Grade S&P Ratings Old New AAA 1 1 AA+,AA,AA- 2 2 A+,A,A- 3 3 BBB+,BBB,BBB- 4 4 BB+,BB,BB- 5 5 B+,B,B- 5 6 Below B- 5 7 Unrated d finitive DECEMBER 2012

11 The Suite of Standards The landscape of APRA s prudential standards, and other guidance, is different now. The key elements of the current standards and guidance are summarised below. GI Prudential Standards Capital Adequacy GPS 110 GPS 112 GPS 113 GPS 114 GPS 115 GPS 116 GPS 117 GPS 118 Capital Adequacy capital levels, ICAAP, capital disclosures, capital reductions Measurement of Capital Internal Model-Based Method Asset Risk Charge Insurance Risk Charge Other GI Prudential Standards Insurance Concentration Risk Charge Asset Concentration Risk Charge Operational Risk Charge Changes in APRA Reporting Forms >> APRA has made changes to a number of forms to reflect calculation of new risk charges >> GRF series (RI Assets) removed details are now in other forms >> GRF and (information by geographic location etc) now required quarterly >> Other minor changes. APRA plans to consult in 2013 on the collection of additional information on reinsurance arrangements. GPS 001 GPS 120 GPS 220 GPS 230 GPS 310 Definitions Assets in Australia Risk Management Reinsurance Management Audit GPS 320 Actuarial Prudential Standards for GI, NOHCs and Groups CPS 231 CPS 232 CPS 510 Outsourcing Business Continuity Management Governance CPS 520 Fit and Proper Other new APRA guidance CPG 110 GPG 116 Information Paper Actuarial Standards (IAA) ICAAP and Supervisory Review Insurance Concentration Risk Asset Risk Charge PS 300 PS 315 PS 305 Valuation External Peer Review FCRs and reviews of Run-Off Plans DECEMBER 2012 d finitive 11

12 d finitive [ APRA regulation ] Conduct your asset risk stress tests with Finity s new userfriendly Excel template. To find out more, please contact Brett Riley on Finity Consulting Finity is one of Australia and New Zealand s leading actuarial and management consulting firms. Our expertise in the insurance industry is highly regarded and has been developed by working with the industry since the early 1980s. Specialising in general and health insurance, Finity works closely with large and niche insurers as well as government agencies to deliver world-class actuarial, pricing and strategic advice. We provide Appointed Actuary services to around 30 APRA-regulated general insurers. Finity was inducted into the Australian Insurance Industry Awards Hall of Fame in 2012 after being awarded Service Provider of the Year to the Insurance Industry in five of the previous six years. Our advice is innovative and practical. It is aimed at helping our clients make decisions that improve their business. This article is based on Finity s current understanding of APRA s framework. It does not constitute either actuarial or investment advice. While Finity has taken reasonable care in compiling the information presented, Finity does not warrant that the information is correct. We refer the reader to APRA s website ( for further detail, or contact one of our consultants. Contacts Karen Cutter karen.cutter@finity.com.au David McNab david.mcnab@finity.com.au Gae Robinson gae.robinson@finity.com.au Australia & New Zealand Insurance Industry Award Service Provider of the Year 2006, 2007, 2008, 2009 and Australian Insurance Industry Awards - Inaugural Inductee into the Hall of Fame Australia Sydney Tel Level 7, 155 George St The Rocks, NSW 2000 Melbourne Tel Level 3, 30 Collins Street Melbourne, VIC 3000 New Zealand Auckland Tel Level 27, 188 Quay St Auckland 1010 Wellington Tel Level 16, 157 Lambton Quay Wellington 6140 Contact the Author Gae Robinson Tel gae.robinson@finity.com.au Sydney Office Finity Consulting Pty Limited ABN