MLL Appointed Actuary Report. on the Proposed. Scheme of Transfer. of the. Risk Insurance Life Insurance Business. Macquarie Life Limited

Transcription

1 MLL Appointed Actuary Report on the Proposed Scheme of Transfer of the Risk Insurance Life Insurance Business of Macquarie Life Limited to Zurich Australia Limited

2 KPMG Actuarial Pty Ltd ABN: Australian Financial Services Licence No Telephone: International Towers 3 Sydney Facsimile: Barangaroo Ave DX: 1056 Sydney Sydney NSW PO Box H67 Australia Square NSW 1215 Australia The Directors Macquarie Life Limited 1 Shelley St SYDNEY NSW 2000 MLL APPOINTED ACTUARY REPORT ON THE PROPOSED SCHEME OF TRANSFER OF THE RISK INSURANCE LIFE INSURANCE BUSINESS OF MACQUARIE LIFE LIMITED TO ZURICH AUSTRALIA LIMITED Please find enclosed my report on the proposed scheme of transfer of the risk insurance business of Macquarie Life Limited to Zurich Australia Limited. Yours sincerely Martin Paino Executive KPMG Actuarial Pty Ltd

3 Table of Contents Proposed Transfer of Life Insurance Business Main Report Sections Executive Summary... i 1 Introduction Overview of MLL Overview of ZAL Overview of Transfer Proposal Financial Impact of Transfer Transferring Policy Owner Considerations Contractual Benefits and Rights Transferring Policy Owner Considerations Reasonable Benefit Expectations Transferring Policy Owner Considerations Benefit Security MLL Remaining Policy Owners Summary of Conclusions Appendices A Glossary B Data & Assumptions C Policy Liabilities Calculation Basis... 69

4 Executive Summary Background to Proposed Transfer Macquarie Life Limited ( MLL ) is an Australian life insurance company registered under the Life Insurance Act 1995 ( the Act ). It has issued a range of life insurance products, including a range of life risk insurance products and a range of unit-linked investment based products. MLL is part of the Macquarie group of companies of which Macquarie Group Limited is the ultimate parent company ( Macquarie Group ), headquartered in New South Wales, Australia. Following a review of its business strategy and plans in 2015, Macquarie Group concluded that MLL should discontinue its activities in the life risk insurance product market. Zurich Australia Limited ( ZAL ) is an Australian life insurance company registered under the Life Insurance Act ZAL s parent company is Zurich Financial Services Australia Limited ( ZFSA ) and is part of the Zurich group of companies which Zurich Insurance Group Ltd is the ultimate parent company ( Zurich Group ), headquartered in Switzerland. Zurich Group has operated in Australia since 1961 and offers a range of life risk insurance and savings products. On 4 March 2016 MLL and ZAL announced that they had agreed to propose to the Federal Court of Australia a scheme for the transfer of MLL s life risk insurance business from MLL to ZAL. Purpose & Scope of Report This report addresses various actuarial aspects of the proposed transfer of the life risk insurance business from MLL to ZAL. The report describes and comments upon the arrangements proposed as the basis of this transfer. This report has been prepared by the Appointed Actuary of MLL, Mr Martin Paino. The key focus of the report is the effect of the proposed transfer on: The transferring policy owners contractual benefits and rights; The benefit security and reasonable benefit expectations of the transferring policy owners; and The contractual benefits and rights, benefit security and reasonable benefit expectations of the other (non-transferring) policy owners of MLL. In addressing this scope, I have focussed on the changes that arise as a result of the proposed transfer, rather than changes that might arise in the ordinary course of business irrespective of the occurrence of the proposed transfer. i

5 Proposed Scheme of Transfer Major Points It is proposed that all of the life polices (within the meaning of the Act) of MLL referable to Statutory Fund No.4 that are in force (including, for clarity, life policies which may have expired but under which benefits remain payable) or in respect of which a person has a guaranteed renewal right as at the Transfer Date ( MLL Policies ) will be transferred to the ZAL No.2 Fund. The proposed Transfer Date is 12.01am on 1 October The transfer will involve the transfer of all liabilities of MLL (whether arising or accruing before or after the Transfer Date) to the extent they relate to the life insurance business conducted through the MLL No.4 Fund, including all liabilities under the MLL Policies ( Life Risk Insurance Liabilities ), except for various tax and Macquarie group related liabilities ( Excluded Liabilities ). The assets of the MLL No.4 Fund will transfer to the ZAL No.2 Fund. MLL has the right to repatriate any assets of the MLL No.4 Fund that are in excess of the capital requirements (including regulatory requirements and MLL s Enterprise Capital Reserve, also known as Target Surplus) to the Shareholder Fund prior to the transfer. All MLL Policies will be transferred with the same policy terms and conditions as applied prior to the transfer. This report examines the impact of the proposed transfer on the transferring policy owners benefit security. There are also certain aspects of the operation of, and/or benefits provided to, the MLL Policies that have been identified that involve some discretion being exercised by MLL historically, and ZAL in future, that may potentially impact policy owner reasonable benefit expectations. The key material discretions (i.e. reasonable benefit expectations) addressed in the report relate to: Premium rate changes. Claims handling. Policy administration. Underwriting of sum insured increases. Benefit upgrade policies. In addition, as this transfer represents a substantial financial transaction that will have a material impact on the future financial operation of MLL, the potential consequences of the transfer on the other remaining policy owners of MLL have also been examined in the report. ii

6 Overall Conclusion on Proposed Scheme The principal conclusions of this report on the proposed transfer are summarised below. MLL s Transferring Policy Owners In terms of the policy owners contractual benefits and rights: In terms of the proposed transfer of the MLL Policies terms and conditions, there is no reduction to the transferring policy owners contractual benefits or rights. In terms of the policy owners reasonable benefit expectations: ZAL's intended basis of determining and implementing the non-contractually specified and/or discretionary aspects of the MLL Policies will continue to meet the overall reasonable benefit expectations of the transferring policy owners. In terms of the policy owners benefit security: The ZAL No.2 Fund and ZAL as a whole will remain in a sound financial position and the transferring policy owners benefit security will remain adequate with financial assets exceeding all regulatory requirements and internal ZAL targets after the proposed transfer. Furthermore, there are practical long term benefit security advantages in transferring the MLL Policies to ZAL. There are no material disadvantages to transferring policy owners. MLL s Remaining Policy Owners In terms of the policy owners contractual benefits and rights and reasonable benefit expectations: There will be no adverse impact on the contractual benefits and rights or reasonable benefit expectations of the remaining policy owners of MLL arising from the proposed transfer. In terms of the policy owners benefit security: Each of the Statutory Funds of MLL and MLL as a whole will remain in a sound financial position and the remaining policy owners benefit security will remain adequate with financial assets exceeding all regulatory requirements and internal MLL targets after the proposed transfer. Furthermore, there are no material disadvantages to remaining policy owners of MLL in transferring the MLL Policies to ZAL. iii

7 Executive Summary Not Report Please note that this executive summary is intended only as an overview of this report and it does not cover or mention all of the issues addressed in the report. To properly understand the analysis and the basis of the comments and conclusions requires an examination of the report in full. iv

8 1 1 Introduction Proposed Transfer of Life Insurance Business 1.1 Purpose of Report This report has been prepared at the request of Macquarie Life Limited (ABN ) ( MLL ). The purpose of this report is to address the actuarial aspects of the proposed transfer of certain life insurance liabilities of MLL to Zurich Australia Limited ( ZAL ). This report describes and comments upon the arrangements proposed as the basis of this transfer and provides the opinion of the author on the matters set out in Section 1.2 below. In terms of Section 191(2)(a) of the Life Insurance Act 1995 (the Act ), this report forms one of the actuarial reports upon which the proposed Scheme of Transfer (the Scheme ), to be the subject of an application to the Federal Court of Australia for confirmation, is based. 1.2 Scope of Report The scope of this report is to review the basis and terms of the proposed transfer of the risk insurance business of MLL to ZAL, and identify and comment upon the effect of the proposed transfer on: The transferring policy owners contractual benefits and rights; The benefit security and reasonable benefit expectations of the transferring policy owners; and The contractual benefits and rights, benefit security and reasonable benefit expectations of the other (non-transferring) policy owners MLL. In considering the proposed transfer, I note that there are aspects of the transferring and non-transferring policy owners contractual benefits and rights, reasonable benefit expectations and benefit security that can evolve and/or experience change in the ordinary course of business. In addressing the above scope I have focussed on the changes that arise as a consequence of the proposed transfer, rather than changes that might arise in the ordinary course of business. The author of this report has read, understood and complied with the Federal Court of Australia s Practice Note CM 7 on Expert Witnesses in Proceedings in the Federal Court of Australia. This report has been prepared in accordance with the professional requirements of the Institute of Actuaries of Australia, specifically: 1

9 The Code of Professional Conduct; and Professional Standard 200: s and Advice to a Life Insurance Company. 1.3 Policy Owners, Members and Beneficiaries In many instances, the life insurance policies of MLL and ZAL are issued directly to the persons applying for the policies. However, in some instances the life insurance policies of MLL and ZAL are issued in the name of a third party e.g. a trustee. For example, where an individual applies to MLL for a superannuation policy, legally the individual applies for a superannuation interest and becomes a member of the relevant superannuation fund. The relevant underlying policy is issued by MLL to the trustee of the superannuation fund and insures the life of the superannuation fund member. Such legal ownership and trustee structures are common across the insurance industry. In addressing the scope set out in Section 1.2 I have extended my consideration to include the underlying beneficiaries of such policies. 1.4 Author of Report & Disclosures This report has been prepared by the Appointed Actuary of MLL, Mr Martin Paino, B. Com, FIAA. Mr Paino is a Fellow of the Institute of Actuaries of Australia and an executive of KPMG Actuarial Pty Limited ( KAPL ), a firm of consulting actuaries, and a Partner of KPMG. Mr Paino has 15 years life insurance industry experience including 5 years as a partner at KPMG. The opinions in the report are substantially based on the specialised knowledge gained from this experience. He has the following interests in Macquarie Group and Zurich Group: Consulting fees earned by KAPL in relation to work performed as the Appointed Actuary to MLL. Remuneration earned as executive of KAPL and partner of KPMG from consulting fees earned by those entities from Macquarie Group and Zurich Group. No other existing consulting, business or other relationships with Zurich Group. 1.5 Structure of Report Sections 2 and 3 of this report provide an overview of the financial and business structure of MLL and ZAL, and Section 4 provides an overview of the proposed transfer. 2

10 Section 5 examines the financial consequences of the proposed transfer on ZAL and MLL. Sections 6 to 9 discuss the ramifications of the proposed transfer for the contractual benefits and rights, reasonable benefit expectations and benefit security of the various groups of policy owners. The principal conclusions of the report are summarised in Section Data In preparing this report I have relied on certain data and information as provided by MLL and ZAL. Appendix B sets out a summary of the data and information relied upon. 1.7 Glossary of Terms A glossary of terms, parties and relevant legislative instruments referred to in this report is included in Appendix A to help readers with the interpretation of the report. 1.8 Reliances and Limitations Inherent Limitations This report has been prepared as outlined in the Scope Section. The services provided in connection with this engagement comprise an advisory engagement, which is not subject to assurance or other standards issued by the Australian Auditing and Assurance Standards Board and, consequently no opinions or conclusions intended to convey assurance have been expressed. No warranty of completeness, accuracy or reliability is given in relation to the statements and representations made by, and the information and documentation provided by, MLL and ZAL management and personnel consulted as part of the process. I have indicated within this report the sources of the information provided. I have not sought to independently verify those sources unless otherwise noted within the report. The findings in this report have been formed on the above basis and on the basis of the circumstances and information as at the date of this report. 3

11 1.9 Third Party Reliance This report is solely for the purpose set out in Scope Section of this report and for MLL s information and is not to be used for any other purpose. It is not intended to be used for any other purpose or distributed to any other party without KAPL s prior written consent. In that regard, we consent to the report being made available for public inspection in relation to the Scheme and being provided to owners of policies referable to the MLL No.1,3 and 4 Funds (and members of superannuation funds whose lives are insured under such policies), owners of policies referable to the ZAL No.2 Fund (and underlying lives insured in group arrangements in relation to such policies), the Australian Prudential Regulation Authority and the Federal Court of Australia as part of the proposed Scheme of Transfer application, pursuant to Section 191(2)(a) of the Life Insurance Act This report has been prepared at the request of MLL in accordance with the terms of KAPL s engagement contract with MLL covering the period 1 April 2016 to 31 March Other than KAPL s responsibility to MLL, neither KAPL nor any member or employee of KAPL undertakes responsibility arising in any way from reliance placed by a third party on this report. Any reliance placed is that party s sole responsibility. 4

12 2 2 Overview of MLL Proposed Transfer of Life Insurance Business 2.1 Macquarie Life Limited MLL is a wholly owned subsidiary of Macquarie Bank Limited ( MBL ), which itself is a wholly owned subsidiary of Macquarie Group Limited. MLL is operationally part of the Macquarie Asset Management ( MAM ) and Banking & Financial Services ( BFS ) group divisions. MLL has not acquired any of its existing policies through the acquisition of another company s portfolio. 2.2 Statutory Funds & Shareholder Fund The financial structure of MLL is comprised of five Statutory Funds and a Shareholder Fund. The five Statutory Funds maintain all the life insurance business of MLL and are as follows: MLL No.1 Fund: Superannuation investment linked business covering a broad range of investment pool options (closed to new members). MLL No.2 Fund: Dormant. MLL No.3 Fund: Superannuation investment linked business focusing on short term fixed interest based investment pools (closed to new members). MLL No.4 Fund: Ordinary and superannuation risk insurance business including term life, trauma and disability insurance business. MLL No.5 Fund: Dormant. All business is classified as non-participating under the Act. The Shareholder Fund is maintained separately from the Statutory Funds as required under the Act. The activities of the Shareholder Fund include: The investment of the assets of the Shareholder Fund; and The management of the True Indexing Swap portfolio. 2.3 Nature of Business & Major Products MLL No.1 Fund The MLL No.1 Fund issues Superannuation investment linked business covering a broad range of investment pool options. All products are closed to new members, although new contributions from existing members are still accepted. 5

13 These products offer a range of investment fund options, including single and multisector investment options, and access to a number of investment managers. The products are targeted at the superannuation and/or pension markets, with separate products developed for individual and wholesale investors MLL No.2 Fund The MLL No.2 Fund is now dormant with no policy owners or residual liabilities. The MLL No.2 Fund previously issued the Macquarie Lifetime Income Guarantee ( MLIG ) product. The MLIG product was closed to new business in 2015 and all inforce policies were purchased from policy owners (i.e. all policy owners surrendered their policies in return for cash payments) MLL No.3 Fund The only product issued from the MLL No.3 Fund is a group policy issued to the Macquarie Approved Deposit Fund ( ADF ) Superannuation Fund. The product provides a single deposit style investment option to superannuation and allocated pension investors. The ADF product was closed to new members from July 2012, although new contributions from existing members are still accepted MLL No.4 Fund Life insurance risk products are issued from the MLL No.4 Fund. The life risk insurance benefits provided under each product varies. Benefits provided via the MLL No.4 Fund include: Death, Total and Permanent Disability ( TPD ) trauma and income protection benefits resulting from sickness or an accident. Severity based health condition benefits. Short term unemployment benefits. The following table summarises the life risk products issued from the MLL No.4 Fund and the statistical inforce premium at 31 March MLL Insurance Business Volumes Premiums ($ m) New Business Year to 31/3/2016 Inforce as at 31/3/2016 Life TPD Trauma DI Total Life TPD Trauma DI Total FutureWise* Active Sumo Other / Direct Total Prior Year

14 *Includes Super Protector business Though new business volumes are low for Other / Direct, open products remain in this category. Section 4.2 provides further details on these products MLL No.5 Fund The MLL No.5 Fund is now dormant with no policy owners or residual liabilities. MLL previously reinsured a share of the risk associated with direct marketed accident death and disability products issued in Japan. The product was closed to new business and the existing business recaptured from 31 March Under the terms of the recapture agreement MLL retained a residual late notified claims liability that expired on 31 March Policy Classification & Participation Rights In terms of Section 9 of the Act: The business of the MLL No.1 Fund is life insurance business under Section 9(1)(g). The business of the MLL No.3 Fund is life insurance business under Section 9(1)(f). The business of the MLL No.4 Fund is life insurance business under Section 9(1)(a) or Section 9(1)(e). It is noted that, in terms of Section 15 of the Act, and specifically Sections 15(2) and 15(3), all of the business of MLL is non-participating business. The policies are not entitled to share in the profits or performance of MLL. Issues concerning participating policy owner rights and expectations and/or their interests in any retained profits within MLL do not arise for consideration under this proposed transfer Shareholder Fund As noted in Section 2.2, MLL conducts the True Indexing Swap investment activities in its Shareholder Fund. In broad terms, under the True Indexing Swap investments, institutional clients invest in a fund that guarantees index returns for a zero fee. This involves the fund swapping with MLL the actual investment performance of the fund the client invests in for the agreed index return. The fund is not entitled to any out-performance of its investment above index, and any underperformance is topped up by MLL to the index return. In some cases the index for the swap includes a performance margin above or below the actual underlying index. These swap arrangements are managed entirely within the Shareholder Fund. 7

15 During 2015, the True Indexing Swap investments business was sold to a related Macquarie entity. As part of the sale process, MLL agreed to transfer all economic profits / losses for the True Indexing Swap to another related Macquarie entity. However legally, the True Indexing Swaps continue to be issued by MLL until investor consultation in respect of the transfer has occurred, expected to be 1 October The transfer will result in a reduction in the capital requirements of MLL. 2.4 Operations & Administration The basic policy administration, sales and marketing, business management, finance, investment management and reporting functions of MLL are substantially conducted in-house by the MAM and BFS divisions of Macquarie Group. Some claims management and underwriting support services are also performed externally by International Life Insurance Solutions Pty Limited ( ILIS ), which is a Macquarie Group company located in South Africa. 2.5 Expense Allocation Basis The MAM and BFS services are provided on a cost recovery basis plus a margin, which is up to 10%, determined on a monthly apportionment. These costs comprise both direct expenses and a share of the overheads and general management expenses. ILIS also provides support services on a cost recovery basis plus a margin, currently 15%. The expense apportionment methodology allocates expenses incurred within MAM and BFS between products, functions and cost categories. The basis used for this allocation is broadly as follows: All direct product based expenses and activities are directly identified within products and are accordingly allocated to the relevant product and Statutory Fund. Product allocations for overheads and general management expenses are based on department time sheets, head count or policy count, which reflect both the function and type of costs incurred within the relevant cost centres of MAM and BFS. 2.6 Tax Status and Basis Income Tax Basis Under the tax rules applicable, income tax is levied on MLL at two levels: 8

16 2.6.2 GST Tax on policy owner assets associated with the investment linked business is levied at 15% for superannuation business and 0% for pension business. Tax on shareholder profits is levied at the corporate rate of 30%. In general MLL is input taxed for GST. MLL incurs GST on a range of business costs but is unable to levy GST to its customers. MLL receives a 75% reduced input tax credit on commissions paid to intermediaries and on outsourced administration service fees Tax Consolidation Macquarie Group pays tax on a consolidated basis, with a tax sharing agreement applying between MLL and Macquarie Group Limited. Under the agreement MLL incurs a tax charge from Macquarie Group Limited, with tax calculated on a standalone basis for MLL. 2.7 MLL No.4 Fund Investment Strategy MLL adopts a conservative investment strategy with assets backing capital requirements and uncommitted capital invested in cash. The two primary investment structures used by the MLL No.4 Fund are: Cash management accounts ( CMA ) held with MBL. Units in the Macquarie Treasury Fund ( MTF ). The MTF is a cash management trust with an investment target to match the Bloomberg AusBond Bank Bill Index (previously named the UBS Bank Bill Index). 2.8 MLL No.4 Fund Reinsurance Strategy MLL relies significantly on reinsurance for both risk transfer and capital efficiency. As well as automatic treaty reinsurance arrangements MLL maintains facultative reinsurance arrangements with 3 reinsurers to ensure access to competitive underwriting terms for a broad range of clients. All MLL reinsurance arrangements are with APRA licenced Australian subsidiaries of global reinsurers FutureWise MLL retains the following share of each risk assumed under the FutureWise product: For lump sum cover, 25% of each risk to a maximum of $100,000 per policy. For Income Protection and business expenses cover, 25% of each risk to a maximum of $2,000 per policy per month. The overall effect of MLL s reinsurance arrangements is that approximately 83% of the FutureWise insurance risk is reinsured. 9

17 2.8.2 Active MLL retains the following share of each risk assumed under the Macquarie Life Active product: For lump sum cover, 50% of each risk to a maximum of $250,000 per policy. For income cover, 25% of each risk to a maximum of $3,000 per policy per month. The overall effect of MLL s reinsurance arrangements is that approximately 65% of Active insurance risk is reinsured Other Products The other insurance products issued from the MLL No.4 Fund are covered by reinsurance arrangements with a number of reinsurers. The level of retention on these arrangement is low. 2.9 Capital & Risk Management Risks & Risk Management MLL and its Statutory Funds face a number of risks in satisfying its obligations to, and the reasonable expectations of, its policy owners. The key areas of risk involve: Insurance contract related risks, e.g.: The variability and/or mis-pricing of insurance risks. Product design risks. The pattern and degree of policy owners exercising policy options. Asset value risks and asset/liability mismatch risks, e.g.: Assets subject to credit default or value variation ( credit and market risk). Reinvestment return risks from mismatches in asset/liability cash-flows. Business and operational risks, e.g.: Disputes with third parties or other legal claims. Inappropriate underwriting and claim management processes. Fraud, non-compliance, expense levels, staff turnover, system errors, business interruption risks. MLL manages many of these risks via its management procedures or practices (e.g. policy terms, compliance monitoring, the quality and nature of the investments held to back its policy liabilities) or mitigates them (e.g. the use of reinsurance). 10

18 Nonetheless, there is a range of residual risks that MLL and its Statutory Funds remain exposed to that are ultimately supported by its capital reserving and capital management strategy, with this strategy comprising two key elements: The regulatory capital it is required to retain under the prudential standards within its Statutory Funds and Shareholder Fund in respect of its residual risk exposures; and Its additional Target Surplus that it retains within its Statutory Funds and Shareholder Fund above its regulatory capital requirements, to meet its preferred total capital reserving target. These two capital reserving elements are discussed further below Regulatory Capital Reserve Requirements The capital requirements for Life Insurance Companies are set out in a series of APRA Life Prudential Standards. The core framework for determining capital requirements is set out in Life Prudential Standard LPS 110 Capital Adequacy. In order to satisfy and demonstrate appropriate prudential management of the business and policy owner benefit security, LPS110 Capital Adequacy requires a life company to: Determine the capital base of each Statutory Fund and the Shareholder Fund. The capital base of a fund recognises the quality of the support provided by various forms of capital by imposing restrictions on certain sources of capital to meet regulatory requirements. In addition, the capital base includes adjustments to recognise that: A fund may contain certain assets (such as deferred tax assets, goodwill and other intangibles) that are acceptable from an accounting perspective. However, for prudential purposes, such assets are either generally not available, or of questionable value, should the fund encounter difficulties. The policy liabilities on the balance sheet may reflect allowance for future transactions (such as future premium income) that are not appropriate to recognise for prudential purposes. Determine its Prescribed Capital Amount ( PCA ) of each Statutory Fund and the Shareholder Fund. The PCA is the required level of capital for regulatory purposes. The PCA is intended to achieve the outcome that if a fund was to start the year with a capital base equal to the PCA, and losses occurred at the 99.5 per cent confidence level then the assets remaining would be at least sufficient to provide for the adjusted policy liabilities and other liabilities of the fund at the end of the year. Ensure for each Statutory Fund and the Shareholder Fund that the capital base exceeds the PCA plus any supervisory adjustment. The PCA plus any 11

19 supervisory adjustment is referred to as the Prudential Capital Requirement ( PCR ). APRA has stated that it will intervene at an early stage should a regulated institution s capital show any signs of falling below the PCR and will require remedial action if capital is not maintained or restored 1. The objective of the above requirements is to ensure that each Statutory Fund retains sufficient funds to meet the reasonable expectations of policy owners under a range of reasonably foreseeable adverse circumstances Target Surplus LPS 110 requires life insurers to set a target capital level that ensures an adequate level of capital is maintained over time, which is set in the context of the life company s risk profile, the MLL Board s risk appetite and regulatory capital requirements. Consequently, life insurers maintain additional Target Surplus reserves. The typical philosophy underlying the amount of such additional reserves is to hold the greater of: An additional capital buffer to allow the company reasonable time to implement remedial action in the event of significant adverse experience emerging, without breaching its regulatory capital requirements; Holding total capital (regulatory capital requirement plus Target Surplus) consistent with an overall risk based capital assessment reflecting the risk tolerances of the shareholders and the desired financial strength of the business; and The capital required to be held in excess of the regulatory capital requirement to maintain an appropriate business profile in the market place (e.g. in order to maintain a certain minimum credit rating). MLL maintains such additional Target Surplus, broadly reflecting the above philosophy Net Assets Above Capital Reserves In considering these two capital reserving amounts, it is noted that: The total of the PCA and Target Surplus represents the total capital benchmark or target that the life insurer believes is appropriate for the prudent and practical management of the company. Any excess above this level represents 1 APRA Prudential Practice Guide CPG110 Internal Capital Adequacy Assessment Process and Supervisory Review. 12

20 resources that are available for alternative productive use (e.g. repatriation to the shareholder or supporting increased business volumes). The MLL capital management policy anticipates that assets in excess of the Target Surplus are available for distribution. It is noted that any dividend or other capital reduction exceeding the after tax earnings of the company requires APRA approval MLL s Current Financial Position Key Financial Measures The following key financial statistics as at 31 December 2015, provide an indication of the overall financial dimensions and significance of MLL and its underlying business and product lines. The following are noted on the results presented in the table: The profit results for the MLL No.1 Fund excludes a one-off profit of $1.6million resulting from the sale of investment management rights to another Macquarie Group entity. The profit result for the Shareholder Fund excludes a one-off profit of $55.4million resulting from the sale of the True Index business to another Macquarie Group entity. The PCA as at 31 December 2015 for the Shareholder Fund does not include any component in respect of the True Index business. 13

21 MLL Financial Indicators 31 December 2015 ($ m) MLL No.1 Fund MLL No.2 Fund MLL No.3 Fund MLL No.4 Fund MLL No.5 Fund Shareholder Fund Profitability 12 months to 31/12/15 Gross Premium Income Reinsurance Expense (59.5) (59.5) Gross Claims Expense (44.6) (44.6) Reinsurance Claim Recoveries Investment Income Earned (14.1) (1.4) Other Revenues Change in Policy Liabilities (3.9) (30.6) (26.4) Expenses Incurred (5.4) 0.0 (2.8) (78.4) 0.0 (0.3) (86.9) Gross Profit Before Tax (4.2) Income Tax Incurred (2.4) (5.7) (0.1) (1.4) (4.4) Net Profit After Tax Total Financial position Total assets Net policy liabilities (440.7) 0.0 (353.8) (5.0) (799.5) Other liabilities (10.9) (0.6) (6.3) (25.7) (0.5) (9.1) (53.1) Net assets Regulatory adjustment to net assets (109.8) (109.3) Capital base Prescribed Capital Amount Capital in excess of PCA Capital Base over Regulatory Capital % 283.1% % 400.2% 865.6% % 650.0% Comments on Financial Results and Position The above analysis is broadly indicative of MLL s underlying results over recent years, noting that profitability for: MLL No.1 and No.3 Funds have exhibited a decreasing trend over recent years, reflecting that Funds under Management ( FUM ) has been reducing over this period. 14

22 MLL No.2 and No.5 Funds are representative of the closed nature of these Statutory Funds where no active policies remain. The MLL No.4 Fund has exhibited an increasing trend over recent years, reflecting the growing size of the portfolio. The Shareholder Fund largely reflects the profits arising from the True Index Swap portfolio prior to the sale of this business Overall Profitability Based on the above results, the overall financial performance and profitability of MLL is sound Regulatory Capital Requirement The background to the required PCA held by MLL was discussed above in Section As discussed earlier, the capital base must exceed the PCA and is the key regulatory capital benchmark. As per the requirements of LPS 110, the PCA for the whole of MLL cannot be less than $10m. The total Capital Base of MLL of $88.5m, significantly exceeds the minimum PCA of $10m and the actual PCA of $13.6m Excess Assets and Target Surplus The MLL capital in excess of the PCA of $74.9m is available to back the MLL internal Target Surplus. The background to the Target Surplus held by MLL was discussed in Section Assets in excess of the Target Surplus would be available for distribution to shareholders. The relative differences between the PCA and the capital base amounts held reflect the different risk characteristics of the different Statutory Funds Overall Capital Position Overall, MLL s capital position and the benefit security this provides to its policy owners is regarded as sound, exceeding all external regulatory requirements and internal targets Events Subsequent to 31 December 2015 There have been no material changes to the MLL financial position or capital targets (including regulatory capital and internal Target Surplus) since 31 December 2015 that would change the commentary or conclusions above. 15

23 3 3 Overview of ZAL Proposed Transfer of Life Insurance Business 3.1 Introduction This Section of the report provides a brief overview of ZAL based on the information provided by ZAL management. 3.2 Zurich Australia Limited Zurich Australia Limited is a wholly owned subsidiary of Zurich Financial Services Australia Limited ( ZFSA ), which itself is a wholly owned subsidiary of Zurich Insurance Company ( ZIC ) incorporated in Switzerland. ZIC is, in turn, wholly owned by Zurich Insurance Group, the ultimate holding company. ZAL operates only in Australia. 3.3 Statutory Funds & Shareholder Fund The financial structure of ZAL is comprised of two Statutory Funds and a Shareholder Fund. The two Statutory Funds maintain all the life insurance business of ZAL and are as follows: ZAL No.2 Fund: Contains all insurance business covering mortality and morbidity risks for both individual business and corporate schemes. The ZAL No.2 Fund also contains annuities, participating and non-participating traditional contracts and investment account business. ZAL No.3 Fund: Contains all investment linked business. All business, with the exception of the participating traditional and investment account business in the ZAL No.2 Fund, is classified as non-participating under the Act. The Shareholder Fund is maintained separately from the Statutory Funds as required under the Act. 3.4 Nature of Business & Major Products ZAL No.2 Fund Benefits/products provided via the ZAL No.2 Fund include: Traditional business, providing both participating and non-participating benefits (closed to new business). 16

24 Investment account business, providing both participating and nonparticipating benefits (closed to new business). Individual risk business, providing death, TPD, trauma and income protection benefits resulting from sickness or an accident. Lifetime annuity business (closed to new business). Term certain annuity business (closed to new business). Investment account business through Corporate Schemes (closed to new business). Group Life Insurance, providing death and TPD benefits (closed to new business). Group Salary Continuance benefits (closed to new business) ZAL No.3 Fund Investment linked business is issued from the ZAL No.3 Fund, including: Retail Investment Linked Business. Account Based Pension benefits Policy Classification & Participation Rights In terms of Section 9 of the Act: The business of the ZAL No.2 Fund is life insurance business under Sections 9(1)(a) - 9(1)(f). The business of the ZAL No.3 Fund is life insurance business under Section 9(1)(g). It is noted that, in terms of Section 15 of the Act, and specifically Sections 15(1), 15(2) and 15(3), the ZAL No.2 Fund includes business that is classified as participating business. These policies are entitled to share in the profits or performance of ZAL. This business makes up approximately $222m of the total $1,370m of ZAL s policy liabilities as at 31 December The remaining business within the ZAL No.2 Fund and all business within the ZAL No.3 Fund is classified as non-participating business and these policies are not entitled to share in the profits or performance of ZAL Shareholder Fund The Shareholder Fund is maintained separately from the Statutory Funds as required under the Act. The main activity of the Shareholder Fund is the investment of the assets of the Shareholder Fund and the facilitation of paying dividends to the wider Zurich Group. 17

25 3.5 Operations & Administration The basic policy administration, sales and marketing, business management, finance, investment management and reporting functions are substantially conducted in-house by employees of ZFSA through a resources agreement with ZAL. Claims management and underwriting services are also conducted in-house by employees of ZFSA through a resources agreement with ZAL. Investment accounting for ZAL s investment-linked products is performed by Zurich Investment Management Limited, part of Zurich Group. 3.6 Expense Allocation Basis Unit cost assumptions for management information, business planning and policy liability calculations are based on projected expenses for the following calendar year, divided by the average expected policies inforce over that year. The plan expenses are allocated to products and split into maintenance, acquisition and investment expenses, using information from a regular assessment of the time spent by staff and on which products. Rules for allocating expenses in accordance with this activity-based information are managed by the Planning & Performance Management team. As resources are supplied by ZFSA to ZAL, acquisition and maintenance resource fees are paid by the Statutory Funds to ZFSA for product related expenses and by the Shareholder Fund for non-product expenses. 3.7 Tax Status and Basis ZAL pays tax at the corporate rate of 30% on business profits. Tax on pools of policy owner investment assets is levied on investment earnings at the specific policy owner tax rate. Both are in accordance with the relevant tax legislation pertaining to life insurance entities. 3.8 ZAL s Investment Strategy For the ZAL No.2 Fund, ZAL adopts an investment strategy which predominately seeks to mitigate risk by investing in assets with matching characteristics to the size and nature of the liabilities. The ZAL Board has an approved Strategic Asset Allocation ( SAA ) that has been established for each sub-fund within the ZAL No.2 Fund. Each of these sub-funds corresponds to a pool of liabilities with similar profiles (set out below). 18

26 Within the ZAL No.2 Fund, there are discrete asset pools for the Ordinary and Virtual Pooled Superannuation Trust Funds. The sub-fund investment strategies are as follows: Non-Participating Capital Guaranteed Business: invested in cash and short term fixed interest. Disability Income Claims in Payment: invested in cash (target allocation of 10%) and long-term fixed interest (target allocation of 90%). Participating Capital Guaranteed Business: invested in cash, short and long term fixed interest and Australian equities. Participating Traditional Business: invested in cash, long term fixed interest and Australian equities. Non-Participating Traditional Business: invested in cash and long-term fixed interest. Default: invested in short-term fixed interest. The default sub-fund includes assets held to support a number of Retail and Group current claims reserves, as well as a number of other liabilities. The shareholder net assets have a target investment of 12% in equities and property assets with the remainder invested in a mixture of fixed interest securities and a small percentage in cash. The shareholder net assets consists of the Shareholder Fund assets and assets in excess of policy owner and other liabilities in the ZAL No.2 Fund and ZAL No.3 Fund. The ZAL No.2 Fund has a share in two owner occupied property companies, which forms part of the 12% target for the SAA of shareholder net assets. The ZAL No.3 Fund contains unit linked investment business where the value of policy liabilities is tied to the underlying assets. The assets are invested according to the asset allocation for each investment option available to policy owners. Assets in excess of policy owner and other liabilities are invested in cash and medium term (duration of 2.5 years) fixed interest securities in order to minimise balance sheet risk. The majority of investment assets within the Shareholder Fund are invested in medium term fixed interest securities (96%), with the remainder in cash (4%). The Shareholder Fund also holds the funds management company, ZIM, at a value of $12.8m. The investment strategy backing the risk insurance business of ZAL is very similar to the equivalent MLL No.4 Fund strategy being predominantly high grade short duration fixed interest and cash investments. 19

27 3.9 ZAL Reinsurance Arrangements Business written from 1 March 2014 Within the ZAL No.2 Fund, ZAL has reinsurance in place for its Wealth Protection and Ezicover policies, which are the current life insurance risk products. ZAL reinsures 100% of risk above $1.25m for Life and TPD products and $0.5m for Trauma. For Income Protection, 100% of risk is reinsured above a notional lump sum of $1.5m, where the notional lump sum is calculated as [benefit period x monthly benefit x 12] with caps on the benefit period for longer benefit periods Business written from 1 January 2009 to 28 February 2014 For Life and TPD products, 100% of sums insured above $0.75m are reinsured, and $0.375m for Trauma. The notional lump sum retention limit is $1m Business written from 1 January 1998 to 31 December 2008 For Life, TPD and trauma benefits, ZAL retains between 5% and 60% of the sum insured (depending on the date of inception of the policy), with 100% reinsurance for sums insured above $0.7m. For income protection benefits, ZAL reinsures 100% of sums insured above $7,000 per month Catastrophe reinsurance A reinsurance arrangement exists with ZIC to reinsure ZAL against losses for death claims in the event of a catastrophe (with certain exclusions). The cover is for claims up to $50m in excess of $5m from a catastrophe. With reinstatement allowances, the cover can theoretically provide cover up to $100m in a year if there were multiple catastrophes Other treaties The ZAL No.2 Fund also has treaties relating to: Group Risk schemes. Select Term product. Annuities. These products (and reinsurance treaties) are closed to new business and in runoff. Other miscellaneous, low volume, treaties also exist Capital & Risk Management Risks & Risk Management ZAL and its Statutory Funds face a number of risks in satisfying its obligations to, and the reasonable expectations of, its policy owners. The key areas of risk involve: Insurance contract related risks, e.g.: 20

28 The variability and/or mis-pricing of insurance risks such as mortality and morbidity. Product design risks. The pattern and degree of policy owners exercising policy options, including policy lapses. Asset value risks and asset/liability mismatch risks, e.g.: Assets subject to credit default or value variation ( credit and market risk). Reinvestment return risks from mismatches in asset/liability cash-flows. Business and operational risks, e.g.: Disputes with third parties or other legal claims. Inappropriate underwriting and claim management processes. Fraud, non-compliance, unplanned expense levels, excessive staff turnover, system errors, business interruption risks. These risks are consistent with the risk appetite set out in ZAL s Board-approved Risk Appetite Statement. ZAL manages many of these risks via various management procedures and practices, or mitigates them, but nonetheless, it and its Statutory Funds remain exposed to a range of residual risks that are ultimately supported by its capital reserving and management strategy. ZAL s risk management processes focus around the following key principles: Identifying, measuring and evaluating risks. Controlling or mitigating risks. Monitoring and reporting risks. ZAL capital reserving and management strategy comprises three key elements: The PCA it is required to retain under the Act within its Statutory Funds and Shareholder Fund in respect of its residual risk exposures, plus any supervisory adjustment required by the regulator; Any additional supervisory adjustment required by APRA; and Additional Target Surplus that it retains within its Statutory Funds and Shareholder Fund above its regulatory capital requirements, to meet its preferred total capital reserving target. 21

29 Regulatory Capital Reserve Requirements The PCA in respect of its Statutory Funds and the Shareholder Fund are determined in accordance with APRA Prudential Standard LPS 110: Capital Adequacy and the Prudential Standards referred to above in this report Target Surplus Requirements ZAL maintains additional capital buffers over PCA, referred to as Target Surplus, broadly reflecting the philosophy discussed in Section 2.9.3, although the approach and parameters, and therefore the resulting amount held, differ between the two companies. Broadly, the principles of ZAL s Target Surplus Policy are: Target Surplus is an integral element of the ZAL Capital Management Policy, and is designed to provide management and the ZAL Board with a buffer to help ensure that the PCR is met continuously; Target Surplus applies at the entity level. As capital is fungible between Statutory Funds and the Shareholder Fund, the excess assets of the entity are available to provide for policy owners in each of the Statutory Funds. For each Statutory Fund, ZAL s business will be managed over time towards holding a target level of capital in the fund above the PCR. This is to limit the likelihood that the PCR for the fund is breached before a transfer of capital from the Shareholder Fund can be made; and The Target Surplus ratio is monitored quarterly by ZAL s Capital and Investment Management Committee ( CIMC ). The Appointed Actuary advises the Board on the Target Surplus amount in the annual Financial Condition Report Net Assets Above Capital Reserves Any excess net assets held above these capital reserving amounts represent idle resources that are available for alternative productive use (e.g. repatriation to the shareholder, supporting increased business volumes or supporting more capitalintensive investment strategies). 22