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Focus: APRA looks to update capital standards and group prudential supervision

16 June 2010

In brief: The Australian Prudential Regulation Authority recently released a discussion paper on updating capital standards for general insurers and life insurers. This followed another on proposals to extend the current prudential supervision framework to Level 3 conglomerate groups to protect individual entities from contagion risks associated with conglomerate group membership. These reflect two of the items on APRA's substantial policy agenda for the next few years. Partner Dean Carrigan (view CV), Senior Associate Claire Machin and Lawyer Andrew Lazzaro report.

How does it affect you?

  • The changes to capital standards will have some impact on the capital position of general insurers but will bring about substantial changes for life insurers by replacing the existing life company requirements for solvency and capital adequacy measures with a single measure of required capital.
  • Insurers with well-matched assets to liabilities and high quality reinsurance programs may benefit from the more risk-sensitive capital requirements now proposed.
  • APRA-regulated entities within conglomerate groups may become subject to Level 3 group supervision. This will have implications for group capital management plans and will require the boards of those affected entities to develop Level 3 group risk management and governance requirements. This will affect not only insurance companies but also authorised deposit-taking institutions (ADIs) – representing another step closer to streamlining and harmonising the prudential framework across various different financial services sectors.

Background

In late 2008, APRA commenced a review of the capital standards for general insurers and life insurers with a view to improving the risk sensitivity and appropriateness of the capital standards and, where appropriate, to make the capital standards more consistent across sectors. APRA has stated that it is not its intention to achieve any material change to overall industry capital levels.

The release of this discussion paper is the first major outcome of the review process.1

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Proposed changes to capital requirements

APRA proposes to introduce a common framework for required capital and eligible capital across general insurers and life insurers. In particular, APRA is proposing the introduction of a three-pillar supervisory approach for insurers, which is similar to that already in place for ADIs. The three pillars are:

  • Pillar 1 – quantitative requirements in relation to required capital, eligible capital and liability valuation so as to comprise capital charges to cover asset risk, asset concentration risk, insurance risk, insurance concentration risk and operational risk;
  • Pillar 2 – the supervisory review process, which includes the supervision of insurers' risk management and capital management practices, and may include a supervisory adjustment to required capital; and
  • Pillar 3 – disclosure requirements designed to encourage market discipline.

The minimum level of capital an insurer would be required to hold at all times would be the total required capital amount, referred to as the Prudential Capital Requirement (PCR). The PCR would consist of the prescribed capital amount (Pillar 1), plus any supervisory adjustment applied by APRA under Pillar 2. It is envisaged that APRA would apply a supervisory adjustment in circumstances where it considers that an insurer's prescribed capital amount does not adequately account for all its risks, for example if there are particular strategic or reputational risks faced by an insurer.

For general insurers, the proposed capital requirements broadly correspond to the existing Minimum Capital Requirement (including any additional capital that APRA may determine is necessary in particular cases). For life insurers, the two existing requirements for solvency and capital adequacy would be replaced by a single measure of a required capital. This is a more substantial change for life insurers. This measure would be compared with the life insurer's capital base, rather than the current solvency and capital adequacy requirements that are compared with total assets. It is anticipated that this new measure will provide a clearer and more accurate view of the financial position of a life insurer and should therefore be of benefit to the board and management of life insurers.

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Supervision of conglomerate groups

To date, APRA's group supervision requirements have been limited to ADIs and general insurer groups that operate primarily within a single industry (Level 2 Supervision framework). While APRA has acknowledged that its current industry-based approach has worked reasonably well to date, the international experience during the global financial crisis has highlighted the risk of contagion posed by the failure of one entity within a conglomerate group.

The Discussion Paper considers the extension of capital, governance and risk management standards to groups that have material operations in more than one APRA-regulated industry or have one or more material unregulated entities (Level 3 Supervision framework).2 APRA's preliminary assessment of potential Level 3 groups suggests that between 10 and 15 groups comprising of approximately 65 APRA-regulated entitles will be subject to the proposed Level 3 group supervision.

The capital management proposals for Level 3 groups are anticipated to supplement existing capital requirements at Level 1 and Level 2 and are therefore expected to have a relatively small impact on existing capital holdings by affected groups.

APRA's proposal is to require a Level 3 head entity to establish and maintain an appropriate capital management plan to manage and monitor the group's risk, capital requirements, group relationships and the disposition of capital across the group. APRA has proposed that the total capital of the Level 3 group must be in excess of required capital and, within the surplus, an amount can be transferable within the group without affecting the capital adequacy of any one member. This is intended to provide an opportunity for flexibility in managing capital across the group by allowing groups to determine where they will hold capital.

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Impact of the proposed changes to capital standards

The proposed changes would result in capital requirements that are more consistent across ADIs, general insurers and life insurers. This is intended to improve the ability of all stakeholders to understand APRA's capital requirements and, in particular, would simplify risk management for corporate groups that have entities in more than one APRA-regulated industry.

The proposed changes are likely to result in many insurers having different capital requirements to what they do currently, although it is difficult to anticipate the precise impacts at this stage. APRA intends that the changes should result in simpler and more risk-sensitive capital requirements. Accordingly, insurers with assets that are well matched to liabilities, or with well-constructed reinsurance arrangements, should benefit from lower capital requirements than would apply to insurers where this is not the case.

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Next steps

The review of capital standards discussion paper is the first major outcome of APRA's review process. The next steps are:

  • the release of three supplementary technical papers scheduled for June 2010;
  • a request to insurers to participate in a quantitative impact study, to be issued in July 2010 with responses by September 2010; and
  • a response paper and draft prudential standards, which are scheduled to be issued in late 2010 following an assessment of the submissions received on this discussion paper, the technical papers and the quantitative impact study.

In regard to the discussion paper on supervision of conglomerate groups, the next steps are for APRA to prepare draft prudential standards and draft reporting standards for public consultation.
APRA envisages issuing final prudential standards during 2011 with a view to commencement of the Level 3 group supervision in 2012.

Footnotes
  1. Discussion Paper, Review of capital standards for general insurers and life insurers, 13 May 2010.
  2. Discussion Paper, Supervision of conglomerate groups, 18 March 2010.

For further information, please contact:

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