Australian Direct Offshore Foreign Insurers Prudential Regulation Impact Statement

This article by me first appeared in Complinet.

The Australian Prudential Regulation Authority (APRA) has published a Regulation Impact Statement (RIS) discussing the modifications and clarifications to the prudential framework arising from the Financial Sector Legislation Amendment (Discretionary Mutual Funds and Direct Offshore Foreign Insurers) Act 2007 (the Act) as well as other changes to the prudential framework.

The Act requires that all insurers wishing to carry on general insurance business in Australia, whether directly or through the actions of an intermediary (e.g. an agent or a broker), are required to become authorised under the Insurance Act 1973.

To give effect to the Australian Government announcement in relation to the regulation of Direct Offshore Foreign Insurers (DOFIs) and, more generally, to recognise different categories of insurer based on risk profiles APRA has had to modify and clarify its prudential framework. APRA has consulted extensively on all the proposals. Because of their proposed simultaneous introduction, all of the proposals were subject to consultation at the same time. Based on feedback received, the implementation of the proposals relating to non-APRA-authorised reinsurance will be delayed six months.

Insurers affected by these proposals generally are:
• all existing APRA-authorised insurers; and
• DOFIs that intend to become APRA-authorised insurers.

Main issues arising

Most proposals relevant to this RIS affect the suite of capital adequacy standards applicable to general insurers. In essence, the capital adequacy standards set a risk-based Minimum Capital Requirement (MCR) for a general insurer and the capital base of the general insurer must at all times be greater than this amount.

There are three different policy changes covered by this RIS. These are:
• from 1 July 2008, APRA has harmonised the definition of the capital base for general insurers and authorised deposit-taking institutions (ADIs);
• from 1 July 2008 in calculating the prescribed MCR of an insurer, APRA has doubled the capital factor for investments in listed equities from 8 per cent to 16 per cent (applied to net exposure after allowing for derivative hedging) and doubled the factor applied to investments in unlisted equities and direct property from 10 per cent to 20 per cent. Investments in unit trusts will also be treated on a ‘look through’ basis where it is administratively practical to do so; and
• from 1 January 2009, APRA proposes to require insurers to recognise the greater risk arising from reinsurance from non-APRA-authorised reinsurers through three changes to the prudential standards:

– in calculating the prescribed MCR of an insurer, APRA proposes to require a higher investment capital charge on reinsurance recoverables from non-APRA-authorised reinsurers compared with reinsurance recoverables from APRA-authorised reinsurers. It is proposed to increase each existing factor by 1.5 times (e.g. two per cent becomes three per cent and eight per cent become 12 per cent) for all grades of reinsurers;

– APRA proposes that, after a grace period, the MCR relating to reinsurance recoverables from non-APRA-authorised reinsurers would be increased when they are not supported by suitable security arrangements in Australia. This will be applied to unsecured reinsurance recoverables arising from new reinsurance arrangements commenced from 31 December 2008. Recoverables from reinsurance arrangements prior to that date are to be subject to greater scrutiny by actuaries, management and the board of the insurer but no additional capital requirements will apply; and

– APRA also proposes that reinsurance arrangements must specify that Australian law will apply to the contract and that any disputes heard in a court must be heard in an Australian court.

The implementation of the proposals relating to non-APRA-authorised reinsurance will be delayed six months.

Implications of changes

Harmonised definition of capital base
The costs of this change will be incurred by those who undertake the development of capital instruments that do not meet the substance of APRA’s requirements or where a general insurer engages in activity that is sufficiently risky to justify the use of APRA’s supervisory discretion. It is not expected that either situation will occur very frequently and it will only affect a minority of insurers. Therefore, the potential cost to policyholders is insignificant and is outweighed by the increased prudential benefits derived from the proposals in those situations where there is an impact.

Investment capital factors for equity and real property
Costs will be incurred by those insurers that have higher risk investment portfolios and that need to raise additional capital as a result of the MCR. On the other hand, proposals relating to derivatives and unit trust investments will benefit insurers that manage the risks of their equity portfolios using derivatives and use lower risk managed investment products. On balance, APRA believes that the cost to the industry does not seem significant compared to the benefits derived by other stakeholders.

Reinsurance from non-APRA-authorised reinsurers
Costs will  be incurred by those insurers that have higher risks due to the use of non-APRA-authorised reinsurers.

When will the changes start?
• Harmonise capital adequacy: the new requirements commenced on 1 July 2008.

• Investment capital factors for equity and real property: the new requirements commenced on 1 July 2008.

• Reinsurance from non-APRA-authorised reinsurers: APRA proposes to delay until 1 January 2009 implementation of the requirements of the MCR calculation related to non-APRA-authorised reinsurance. This will allow insurers more time to make changes, if required, to their reinsurance strategies. This delay was based on feedback received during consultation.

The standards will be scheduled for review in three years.

Compliance tips and next steps
At a minimum, all DOFIs that operate in Australia will be required to have a presence in Australia and keep assets in Australia that meet the necessary capital requirements.

Compliance officers should discuss the potential implications of the changes with their CFO’s and determine what impact the legislation will have on your business, and your business’ response to the changes.

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