APRA releases final Capital Standards with lots to read

Capital guards against trouble

In one of the major milestones of the review of Capital Standards for Australian insurers, this week APRA released many of the final Standards, with some further draft changes to other Standards that will also because of the review.

Most of the changes had been foreshadowed as part of the consultation process for some time, but there were a few variations, partly in response to submissions, and also more detailed changes that hadn’t really been considered before.

In this post, I look at the more significant pasts of the release, but there is a lot there. If you are interested in this professionally, you should read the whole explanatory memorandum. In addition, many of the changes that APRA mentions in passing as “consequential” may well be significant. I haven’t read all the marked up Standards yet, but there are some material changes in the ones I have read that don’t make it to  the explanatory memorandum.

 

Composition of the capital base

This part of the changes may well have the biggest economic impact, long term. This looks at how insurance companies are funded, and how secure their funding must be. APRA is intending, as much as possible, to aligned the proposals for the composition of the capital base for insurers with their draft proposals for ADIs in response to Basel III.

A reminder on the various capital definitions

The Capital Base of an Insurer is made up of Common Equity Tier 1 (CET1), Additional Tier 1 capital, and Tier 2 Capital. These all have fairly technical definitions, but broadly, CET1 consists of paid up equity and retained earnings (including current year earnings), Additional Tier 1 capital is very high quality capital providing permanent commitment of  funds, freely available to absorb losses, and ranks behind policyholders fully discretionary capital distributions. Tier 2 capital is defined very technically in the standard, but broadly contributes to the overall strength of the insurer and its ability to absorb losses.

The Prudential Capital Requirement (PCR) consists of the Prescribed Capital amount (either from the standards or an internal capital model), plus any Supervisory Adjustment.

Changes to the composition of capital

APRA received a number of submissions suggesting that their initial limits on the composition of capital were not entirely consistent. As a result, they have changed them, while still reserving the right to increase the limits of capital that must be CET1 if they have concerns with the composition of an individual insurer’s capital base.  The new proposals  (still in draft) are that:

  • CET1 must exceed 60%  (previously 70%) of Prescribed Capital amount for general insurers and life insurers as a whole;
  • Tier 1 capital must exceed 80% of the Prescribed Capital amount (previously the PCR);
  • The Capital Base must exceed the PCR (unchanged);
  • The Capital Base of each statutory fund of a life insurer must exceed 80% of the Prescribed Capital amount for the fund (previously a percentage of PCR);
  • The Capital Base (including Tier 2 capital) of each Statutory Fund of a life insurer must exceed the PCR (unchanged);
  • the Capital Base of the General Fund must exceed the PCR of the fund (unchanged).

There are a number of other technical changes to various definitions of capital, particularly for Level 2 groups and companies that are part of bigger Groups more generally. There are also transitional arrangements for any capital issued between now and when the standards are implemented (1 January 2013) – although I suspect the best transitional arrangement will be early and detailed consultation with APRA.

Specific industry issues – changes to calculations

For general and life insurance, there are still some changes to the detailed calculation requirements for the prudential capital amount. What has been released now, though, is supposed to be the final standard, so it is very unlikely that anything will change from here unless there are significant drafting errors that have slipped through the net.

General Insurance

APRA has clarified the words around the calculation of the natural perils vertical requirement to make it clear that insurers must consider the probably maximum loss both gross and net of reinsurance, to avoid the possibility that insurers may consider purchasing reinsurance that protects against only one type of event, without considering other extreme events which may affect the portfolio.

APRA confirmed the requirement to hold the contractual reinsurance restatement premium unless an insurer can conclusively show that the actual reinsurance reinstatement premium in the event of a loss will be materially different.

APRA has clarified the timing requirements for the calculation of the insurance concentration risk charge (ICRC), to confirm that the calculation would be expected to change if reinsurance changes in response to an event, as would the natural perils vertical requirement. The calculation should be forward looking at all times.

Life Insurance

APRA has confirmed that there will be no opportunity to offset capital requirements in different Statutory Funds, even if they arise from mutually contradictory economic scenarios (eg bond yields rising in one and falling in the other). Their view is that in stressed scenarios, transfers between funds may not be possible.

APRA once again confirmed that they will not allow for any value of deferred acquisition costs in the calculation of capital, a position the industry has been trying to change for years, but didn’t really expect success.

Consequential changes to other APRA Standards

The substantial changes to APRA’s Capital Standards have led to consequential changes in a number of other key standards.  Most of these are fairly unexciting, but there are few that may have material impacts for insurers:

  • LPS and GPS 220 – the Risk Management Standards – have changed  to clarify the interaction between the Risk Management Strategy and the ICAAP, and to align the list of material risks between the Risk Management and Capital standards
  • GPS 230 – the Reinsurance Management Standard – mainly changed to require consistency with the ICAAP, but also to clarify the way in which the two month and six month rules for treaty confirmation should work in conjunction with the annual reinsurance declaration
  • LPS and GPS 320 – the Actuarial Standards – are made more consistent with each other, in particular, for life insurers, to now allow for capital levels to be set by the company on the advice of the Appointed Actuary, using calculations that have been documented by the Appointed Actuary, with any departures from the advice being notified to APRA.

The role of the Appointed Actuary

In my view, there will be an impact from this regulatory change on the role of the Appointed Actuary (particularly for life insurers, but also general insurers), with Appointed Actuaries moving towards the second, or even third lines of defence. In the new LPS and GPS 320 draft Standards, APRA is now requiring the Appointed Actuary to, in the FCR (inter alia)

  • assess the extent to which the company has complied with the capital standards
  • assess the company’s capital management framework.

In GPS 320, the AA is also required to discuss the Insurer’s ICAAP, and assess the suitability and adequacy of reinsurance arrangements

APRA is also proposing to change a number of other responsibilities of the Appointed Actuary of a Life Insurer, so that the AA is providing advice to the company, rather than determining particular amounts. These responsibilities include:

  • Determining policy liabilities
  • Determining surrender values
  • Determining the cost of investment guarantees
  • Determining paid-up policy values

The change to policy liabilities makes the AAs roles in life insurers more consistent with the role in General Insurers, and in both cases moves the Appointed Actuary to advice from doing, and even further, towards review rather than advice in some cases.

Other items of interest

APRA has decoupled the timing of the ICAAP process from year end. Companies can now choose to do the ICAAP review as part of the business planning process (because much of the review is about the plan for the next three years). APRA has also provided more detail in the Standards themselves about what should be included in the ICAAP, partly because of many submission asking for the promised guidance to be brought forward (it is currently due out in September).

APRA has not changed anything about the supervisory adjustment process, but has written more about how it will work. They have reiterated previous comments (in a letter to all CEOs) that provided a well-considered and developed ICAAP is in place from  1 January 2013 there won’t be a supervisory adjustment from any aspect of that ICAAP which will be further refined over the next 18 – 24 months.

There are a lot of changes in this review, with a lot for the Insurance Industry to digest and implement by 1 January 2013. As a principles based regulator, APRA has done a good job with these standards of keeping them as much as possible at a principled, rather than rules-based, level. But that means that each new aspect of the standards will have issues for companies to work out how to best apply for their own individual situations. With seven months left before they go live, there’s still a lot of work to go.