APRA Capital: What s ahead for General Insurers?

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1 APRA Capital: What s ahead for General Insurers? APRA released a discussion paper in mid May on the capital standards for life and general insurers. The paper highlights two aims. The first is to improve the risk sensitivity of the capital standards. The second is to better align life and general insurance in the areas of capital requirements and methods of calculation. The paper is only the first step in what is quite an involved process. APRA will release three supporting technical papers in June, as well as asking insurers to complete a quantitative impact study (QIS) shortly after. Much of the detail will be in the technical papers, and APRA will only really be able to assess the impact of its proposals once it has received the results from the QIS. The final proposals may change as a result. We focus here on the changes that general insurers face. June 2010

2 The changes at a glance Our commentary is presented in the following order: use the links to view our assessments in detail. An overview of the changes Click here for more details The proposals we support Inadmissible assets Asset concentration risk capital charge Insurance concentration risk capital charge (MER) Supervisory capital requirement Insurer s capital adequacy assessment process (ICAAP) The proposals we partially support Insurance risk capital charge The proposals we consider too complex relative to their benefit Asset risk capital charge Risk margins Operational risk Aggregation benefit Minor proposals Click here for more details Our summary Click here for more details June

3 Overview The diagram below shows the elements that make up an insurer s minimum capital requirement (MCR) under the current standards, alongside those APRA propose to introduce. (Although the diagram shows the MCR under both systems as being the same, this will not necessarily be the case for each individual insurer.) APRA propose changes to each of the elements of the MCR, with some more affected than others: The insurance risk charges are largely unchanged, other than for Travel, Mortgage and Reinsurance. Details of changes to the insurance concentration risk charge are still to come, and could be significant for some insurers, particularly those who do not now derive their Maximum Event Retention (MER) from property catastrophe exposure. The investment risk capital charge is being significantly revised and renamed the asset risk capital charge. The investment concentration risk capital charge is being expanded to capture a wider range of assets, and renamed the asset concentration risk capital charge. APRA are also proposing some new elements an operational risk charge based on the size of the insurer, and an aggregation benefit (that is, a reduction in the MCR) which allows for correlations between assets and liabilities. Overall, we think that many of the proposals make sense, but some appear only to move required capital from one bucket to another. APRA themselves have stated that the proposals are intended to keep the overall level of capital for the industry more or less as is. June

4 To the extent that the proposals allow for a better differentiation of risk between insurers and therefore more risk-sensitive capital requirements we do not have an issue. But in some areas we do not believe the proposals achieve this. Some of APRA s proposed changes will make the capital rules for general insurers more complicated, while doing little to improve differentiation of risk between insurers. This seems out of step with APRA s moves towards simplification over the past few years. For general insurers, the additional complexity mainly arises from APRA s desire to make the general insurance and life insurance standards consistent. In our view, the need for consistency is overstated, as general insurance is different in nature from life insurance. The risks (and hence the need for capital) are concentrated in different areas, so it is reasonable to have simpler capital requirements for general insurance in some areas. For example, the complexity of the asset risk capital charge is probably justified for life insurers where there is a high degree of correlation between the assets and liabilities but this is less of an issue for general insurers, so a simpler calculation would suffice. The complexity these proposals introduce would mean the Appointed Actuary would need to be far more involved in the capital calculations, with no guarantee of a corresponding benefit to the insurer or the regulatory system. [back to key points] Proposals we support Inadmissible assets Proposal: Currently, a general insurer may include the regulatory capital of subsidiaries, associates and joint ventures in determining its capital base. APRA have proposed to exclude this regulatory capital, on the grounds that it may represent double counting. Who this affects: Only the few insurers that own, or have joint venture investments in, other regulated insurers. Comment: This change appears sensible. Capital requirements are set for regulated entities in order to protect policyholders. The policyholders of one regulated entity may bear no resemblance to the policyholders of a related parent, joint venturer, or associate. Quarantining regulatory capital protects the relevant policyholders. Asset concentration risk capital charge Proposal: There is currently no limit to the amount of assets that counterparties with a grade of 1, 2, or 3 may have placed with them. APRA are proposing to introduce limits based on the type of counterparty regardless of its grade (noting that exposures to governments with a counterparty grade of 1 or 2 remain unlimited). June

5 page 5 link Insurers will be limited to placing 50% of their capital base with APRA regulated insurers and ADIs, and 25% with non-apra regulated institutions. The important thing to note is that the limit applies to an insurer s capital base, not its investment assets. Limits for APRA-regulated related parties (e.g. a parent) will be 100% of the insurer s capital base. This means that subsidiary insurers will not be able to invest all of their assets with their parent, and will generally need to invest most of their assets elsewhere. If the related entity is not APRA regulated, the limit will be 25% of the insurer s capital base. A small insurer can hold assets with any one counterparty of up to $20m, even if that exceeds the percentage of capital base described above. Who this affects: Possibly many insurers should check their current capital base and schedule of investments to see if they comply with the proposed rules. Comment: We have no objection to proposed changes to the asset concentration risk charge, although the limits may be more restrictive than they first appear. The following table shows the five largest authorised insurers in Australia, each with investment assets of more than $3 billion. The table shows individual insurance entities, rather than groups. Company Allianz Australia Insurance Limited Insurance Australia Limited QBE Insurance (Australia) Limited Suncorp Metway Insurance Limited Vero Insurance Limited Capital Base ($m) 1,191 2,129 1,113 1,385 2,484 Investment assets ($m) 5,197 7,767 3,630 5,025 4,649 Source: APRA s Half Yearly General Insurance Bulletin, June % cap base (APRAregulated unrelated parties, $m) 595 1, ,242 25% cap base (non-apraregulated unrelated parties, $m) Under APRA s proposals, Allianz, for example, would be limited to investing $595 million with each ADI, just over 11% of its total invested assets. We note that this capital charge is aimed at addressing default risk that arises from asset concentration only. For example, if an insurer has more than 50% of its capital base invested with an Australian AArated ADI, the amount above 50% will receive a 100% risk charge. If, instead, the insurer invests its assets in direct property, our understanding is that there will be no asset concentration risk charge as there is no counterparty default risk (although the property investment will be subject to the asset risk capital charge). In that sense, the charge does not allow for liquidity risk arising from asset concentration. June

6 Insurance concentration risk capital charge Proposal: Concentration risk charges are presently based on a Probable Maximum Loss (PML), which is then reduced for reinsurance to give a Maximum Event Retention (MER). The logic and assumptions behind these calculations make perfect sense for property insurers. However, other insurers often struggle with exactly what an event means. One of APRA s forthcoming technical papers will consider concentration risk in more detail. In particular, the technical paper will consider: the definition of an event, with particular attention given to non-property insurers; the extent to which the PML double-counts what an insurer has already allowed for in Premium Liabilities; what a whole of portfolio approach means; whether concentration risk should capture single event risk (as it does now) or allow for multiple events during the year. Who this affects: All insurers with an MER not deriving from property catastrophe (such as medical indemnity, credit, professional indemnity and lenders mortgage) may see a change, hopefully for the better. If property catastrophe is the source of the MER, then any insurer not using a whole of portfolio approach to PML may find it needs to buy higher reinsurance limits. Comment: While details are not yet known, we like the general thrust of this proposal. We hope that some ambiguous areas of the current standard will be codified in the new standard, making the calculation of the concentration risk capital charge more consistent across the industry. Supervisory capital Proposal: APRA s proposals for supervisory capital do not differ greatly from their current practice, but should make the application of supervisory adjustments to capital across insurers more consistent. Under the proposals, APRA may make a supervisory capital adjustment (if, for example, they feel that operational risk is not adequately addressed) in addition to requiring insurers to hold the prescribed capital amount (i.e. the sum of the risk charges). The adjustment may require the insurer to hold either additional capital, or a greater proportion of higher quality capital. The sum of the prescribed amount and any supervisory adjustment will be the prudential capital requirement (PCR). Insurers who fall below the PCR would be subject to intense APRA intervention. Any supervisory capital adjustment would be prohibited from disclosure as the PAIRS and SOARS ratings are currently. Who this affects: Those who now have non-standard capital requirements. Comment: These proposals largely formalise the current situation, and we have no objections. June

7 Insurer s Capital Adequacy Assessment Process (ICAAP) Proposal: Capital management is currently dealt with in several of APRA s prudential standards. GPS 110 requires a capital management plan, while GPS 220 requires a business plan discussing capital management and including capital projections. APRA propose to require insurers to develop an insurer capital adequacy assessment process (ICAAP), which would replace the business plan requirements for capital. The ICAAP would require insurers to maintain and document systems and procedures for: identifying, measuring, monitoring and managing risks; assessing the capital needed for those risks; determining target capital; maintaining appropriate capital, including sources of additional capital; monitoring compliance with APRA minimums; review of the ICAAP itself. The ICAAP would broadly align the capital assessment process of general insurers with ADIs. Who this affects: All insurers, but additional work should be minimal. Comment: We quite like this. The existing capital management requirements are a bit fragmented, and replacing them with a more focussed framework is a step in the right direction. The key change is for insurers to see ICAAP as an annual process rather than a static requirement. [back to key points] Proposals we partially support Insurance risk capital charges Proposal: APRA propose to move the Travel and Mortgage classes of business to a higher insurance risk capital charge group (e.g. the outstanding claims capital charge for Travel would move from 9% to 11%, and for Mortgage from 11% to 15%). APRA also propose allowing the Appointed Actuary to determine which risk charge should apply to Other business (that is, classes not specified in the schedule). Otherwise, the risk charge factors for direct business would remain unchanged. The direct classes would be grouped as follows: lowest charges: householders, commercial motor, domestic motor; middle level: travel, fire & ISR, marine & aviation, consumer credit, other accident; highest charges mortgage, CTP, public & product liability, professional indemnity, employers liability. For inwards reinsurance, APRA propose to change the classification of classes of business from the current property/marine/casualty division to align with the direct business classes shown above. There is no longer any differentiation between facultative and treaty business. The distinction remains between proportional and non-proportional, with the latter having higher risk charges. Who this affects: Mortgage insurers, those who write Travel, and reinsurers. June

8 page 7 link Comment: We think that Travel is probably riskier than the other classes in the lowest grouping particular risks include pandemics and volcanic ash and so higher risk charges are probably appropriate. For Mortgage, it is debatable whether the inherent volatility in the outstanding claims and premium liabilities (i.e. volatility unrelated to the maximum event retention) is as high as for the other classes that are subject to the highest capital charges. While the Mortgage class is subject to a high degree of systemic volatility, this is covered in the MER, and does not justify increasing the insurance risk capital charges for this class. For reinsurers, the line between facultative and treaty business is often blurred, so it seems reasonable to have only one set of charges. Proposals we consider too complex relative to their benefit Asset risk capital charges Proposal: Under the current capital rules, asset risk charge factors are applied to the value of assets in each APRA-defined asset class (including investments such as cash, bonds, reinsurance recovery assets, property, plant, and equipment). APRA s proposal is to replace the schedule of asset risk charge factors with a stresstesting methodology, undertaken by the Appointed Actuary, that stresses an insurer s assets and liabilities in tandem. Full details of this proposal are still to come in APRA s technical papers. Who this affects: All insurers, with significant work required by insurers and their Appointed Actuaries to implement the changes. Comment: APRA believe that the current rules do not sufficiently allow for mismatches between the duration, inflation risks, and currency risks of assets and liabilities. Also, credit risk does not take into account the outstanding term of the assets. The new stress-testing methodology will take these mismatches into account and aims to foster a better risk differentiation between insurers. It is good risk-management practice to conduct these kinds of stress tests, so there is a benefit to the proposal, but we believe that the approach is too complex for general insurers. There is less transparency because of the more complex calculations. Greater discretion is also placed with the Appointed Actuary as to how to model the scenarios. Risk margins Proposal: APRA s proposals on risk margins clarify some grey areas in the existing standards. APRA will require that both gross and net risk margins be calculated (with the difference between the gross and net insurance liabilities at the 75 per cent probability of sufficiency representing the reinsurance recovery asset). APRA is also considering placing some limits on the overall level of diversification benefit assumed in the insurance risk margins (i.e. diversification between outstanding claims and premium liabilities, diversification between classes). APRA will seek information in the QIS. June

9 page 9 link Who this affects: Insurers with significant levels of reinsurance and who currently calculate net risk margins only, and/or those that are highly diversified across classes of business. Comment: For insurers who now calculate net risk margins only, the first part of this proposal will lead to higher reinsurance assets (as the reinsurance recovery asset will be larger than the central estimate), overstatement of assets and liabilities on the balance sheet, and, as APRA acknowledge, higher asset risk capital charges (due to the higher reinsurance assets). We question the value of these changes. While it is worth trying to understand the volatility in gross claims, there are better ways to achieve this than by inflating the reinsurance asset and imposing further risk charges. It is not clear why APRA would consider it necessary to impose limits on diversification. If diversification exists, then the calculations should reflect it without arbitrary limits. Operational risk Proposal: The current capital rules make no explicit allowance for operational risk. APRA s proposals will change this. In the first instance, the operational risk charge will be calculated as a percentage (set by APRA) of an insurance company s size, defined as some combination of premium volume, outstanding claims liabilities, and assets. If APRA feels that an insurer has a higher operational risk profile, or an inadequate approach to operational risk management, they can make a supervisory adjustment to allow for this (see comments on supervisory capital above). Who this affects: All insurers. Comment: This proposal primarily differentiates among insurers on the basis of size, rather than of risk. It appears to add an additional level of complexity, without any real benefit. While APRA s ability to make a subjective allowance for operational risk has more bite, this provision already exists without having to create a separate risk charge. Aggregation benefits Proposal: APRA are proposing to make an explicit allowance for diversification between asset and insurance risks. The asset risk and insurance risk capital charges would be combined with an allowance for diversification (APRA have specified the formula to use). APRA will seek information in the QIS. Who this affects: All insurers. Comment: While this approach is theoretically appropriate, we believe that the extra complication of the proposed sum of squares formula is unlikely to improve the differentiation of risk across insurers. The extra complexity of the formula also reduces the transparency and ease of explanation of the capital regime. [back to key points] June

10 Minor Proposals In addition to the proposals discussed above, there are several minor changes proposed in the document. These are: Taxation In the technical papers, APRA will consider tax issues such as tax consolidation and deferred tax assets. Liquidity APRA notes that liquidity risk is not to be subject to capital charges, but will continue to be addressed by business plans and risk management. Disclosure The discussion paper says there will be no changes to disclosure requirements for general insurers, but then goes on to say that insurers will need to disclose the individual components of both the prescribed capital amount and the capital base components that do not now need to be disclosed. Disclosure of any supervisory adjustment will not be permitted. Groups Most proposals are likely to flow to Level 2 groups. Summary While we welcome many aspects of APRA s proposed changes, we are not convinced that all are necessary. And while APRA have stated they intend the overall level of capital for the industry to remain the same, some individual insurers will undoubtedly see a significant change. We look forward to seeing APRA s supporting technical papers. We would encourage all insurers to undertake the QIS so that the potential effects are well understood and any issues can be raised with APRA in good time. Contacts Karen Cutter karen.cutter@finity.com.au Francis Beens francis.beens@finity.com.au Disclaimer The article is based on our current understanding of the proposals, which in some cases are incomplete. 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 the discussion paper on APRA s website ( for further detail. Further clarification can be sought from our consultants. This flier will be the subject of an article to be published in the June/July edition of the ANZIIF journal. Copyright 2010 Finity Consulting Pty Limited Sydney ph: fax: Level 7, 155 George Street THE ROCKS NSW 2000 Melbourne ph: fax: Level 6, 30 Collins Street MELBOURNE VIC 3000 Auckland ph: fax: Level 27, 188 Quay Street AUCKLAND 1010 Finity Consulting Pty Limited ABN: