Discussion Paper. Maximum Event Retention for Lenders Mortgage Insurers. Australian Prudential Regulation Authority.

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1 Discussion Paper Maximum Event Retention for Lenders Mortgage Insurers September Australian Prudential Regulation Authority

2 Disclaimer and copyright This prudential practice guide is not legal advice and users are encouraged to obtain professional advice about the application of any legislation or prudential standard relevant to their particular circumstances and to exercise their own skill and care in relation to any material contained in this guide. APRA disclaims any liability for any loss or damage arising out of any use of this prudential practice guide. Commonwealth of Australia This work is copyright. You may download, display, print and reproduce this material in unaltered form only (retaining this notice) for your personal, noncommercial use or use within your organisation. All other rights are reserved. Requests and inquiries concerning reproduction and rights should be addressed to: Commonwealth Copyright Administration Copyright Law Branch Attorney-General s Department Robert Garran Offices National Circuit Barton ACT 2600 Fax: (02) or submitted via the copyright request form on the website Australian Prudential Regulation Authority 2

3 Preamble The current standard for the calculation of the Maximum Event Retention (MER) for lenders mortgage insurers, GPS 116 Attachment A, was originally released as GGN 110.6, effective 1 January It then became GPS 110 Attachment F on 1 January 2007 and GPS 116 Attachment A in June 2008 when APRA finalised its position on the Refinements to the General Insurance Prudential Framework. During the consultation process on the general insurance refinements package, APRA asked the lenders mortgage insurers (LMIs) to provide submissions on any substantive issues with GPS 116 Attachment A which warranted immediate attention. APRA received a number of submissions from LMIs. In view of the issues raised in these submissions, APRA has reviewed GPS 116 Attachment A in its entirety. The intention of APRA s review is to clarify the intention of the Standard and make technical modifications to improve the ease of application of the Standard. While the calculation of PML remains necessarily prescriptive, APRA recognises that the structure of reinsurance arrangements in the industry is diverse and a principles-based approach needs to be taken in relation to the allowance for reinsurance. APRA is not proposing to change the foundations on which the MER for an LMI is based - the foundations were changed in 2006 and resulted in a significant, but prudent, increase in the minimum capital requirement for LMIs. The MER will continue to be based on the net impact on the LMI of a hypothetical three-year economic downturn. The minor changes outlined in the paper would have an impact on the minimum capital requirement for LMIs if they were introduced without adjustment to the current probability of default, loss given default and seasoning factors. Having made changes in 2006, APRA is not proposing to materially alter the minimum capital requirement for LMIs. APRA will look to recalibrate the factors used in the calculation of the MER so as not to materially alter the c apital requirement of the LMI industry. Attached to this paper is a draft of GPS 116 Attachment A incorporating the proposed changes set out in this paper. Next steps Responses to this paper should be sent to apra.gov.au by 19 November 2008 and addressed to: David Rush General Manager Policy Development APRA intends that the final GPS 116 Attachment A will be released in the second quarter of 2009 and for it to take effect from 1 July Important Submissions will be treated as public unless clearly marked as confidential and the confidential information contained in the submission is identified. Submissions may be the subject of a request for access under the Freedom of Information Act 1982 (FOIA). APRA will determine such requests, if any, in accordance with the provisions of the FOIA. Australian Prudential Regulation Authority 3

4 Glossary ADI Authorised Deposit-taking Institution Appointed Actuary Appointed Actuary as defined in GPS 310 APRA Australian Prudential Regulation Authority Calculation factors PD, LGD and seasoning factors used to determine PML for an LMI GPS 110 Prudential Standard GPS 110 Capital Adequacy GPS 116 Prudential Standard GPS 116 Concentration Risk Capital Charge GPS 116 Attachment A Attachment A of GPS 116 GPS 230 Prudential Standard GPS 230 Reinsurance Management GPS 310 Prudential Standard GPS 310 Audit and Actuarial Reporting and Valuation LGD Loss given default LMI Lenders mortgage insurer LVR Loan-to-Valuation Ratio as detailed in GPS 116 Attachment A MCR Minimum Capital Requirement as detailed in GPS 110 MER Maximum Event Retention as detailed in GPS 110 and GPS 116 PD Probability of default PML Probable Maximum Loss as detailed in GPS 116 Attachment A REMS Reinsurance management strategy referred to in GPS 230 Australian Prudential Regulation Authority 4

5 Summary of clarifications and modifications Section Three-year stress scenario Inclusion of expected claims in PML Reinsurance principles Capitalised Premium Clarification of the calculation of PML for pooled policies Claims handling expense Adjustment for reinsurance cover for new business Reporting forms Description APRA has restated its principle that the MER calculation will continue to be based on a three-year downturn event. Due to the potential impact of the proposed changes, the calculation factors will be recalibrated so the minimum capital requirement is not materially altered. APRA is proposing to define the PML arising from the three-year stress scenario as inclusive of the level of claims anticipated by the LMI. As a result, an LMI will be allowed to deduct from the PML not only Allowable Reinsurance but also a portion of its net premium liabilities. APRA has clarified the requirements and principles around the reinsurance cover which can be credited against an LMI s PML. APRA has reiterated that the LVR calculation for PML purposes will be based on the loan including any capitalised premium, whether or not the premium is insured. APRA is proposing to clarify the calculation of PML for pooled policies. In addition, APRA is proposing to no longer allow an LMI that provides pooled policies to determine the PML based on a weighted-average LVR. APRA is proposing to remove the claims handling expense component of the MER (but will recalibrate the calculation factors). APRA proposes that there will be no requirement for an LMI to consider new business volumes in the calculation of PML and MER although the LMI will still be required to assume a constant sum insured across the three-year scenario. APRA is proposing that an LMI outline in detail in its REMS how it manages its future reinsurance needs and the mitigants it has in place for the risk in relation to future reinsurance arrangements. The availability and cost of future reinsurance should be outlined in business plans and capital management plans. APRA will update the LMI reporting forms to capture the above proposed changes. The draft forms will be released during Australian Prudential Regulation Authority 5

6 Introduction Same three-year stress scenario, subject to recalibration of PML calculation factors The MER model for LMIs was changed materially in 2006 and resulted in a significant increase in the minimum capital requirement for all LMIs. APRA is not proposing to change the foundations of the MER calculation which were put in place in The MER calculation will continue to be based on a hypothetical three-year downturn in the housing market. The model calculation factors will continue to be calibrated to ensure that LMIs meeting the minimum APRA requirements could manage a nationwide housing downturn that is more severe than worst-case historical Australian experience. This does not imply that APRA is seeking to guarantee a zero failure rate of LMIs or provide absolute protection for authorised deposit-taking institutions. However, it is important that the prudential framework applying to LMIs maintain a low incidence of failure while not impeding continued improvements in efficiency or hindering competition. The proposed amendments outlined below would affect the level of capital required by the LMI industry if implemented without any adjustment to the probability of default (PD), loss given default (LGD) and seasoning factors ( calculation factors ) which are currently in GPS 116 Attachment A. Having made changes in 2006, APRA is not proposing to materially alter the capital requirements for LMIs and will recalibrate the calculation factors to achieve this result. For this reason, APRA is requesting each LMI complete a Quantitative Impact Study (QIS) and return it to APRA by 19 November Details of the QIS are in the attachment to this consultation paper. APRA will use the results of the QIS to recalibrate the calculation factors in Draft GPS 116 Attachment A. Draft GPS 116 Attachment A is included with this consultation paper. As part of updating Draft GPS 116 Attachment A to reflect the outlined changes below, APRA has taken the opportunity to re-order some sections of the Standard. Changes have been highlighted in yellow in the draft (except where the only change is a re-ordering of the paragraphs). APRA recommends that each LMI review the draft in its entirety as part of its consideration of this paper. Australian Prudential Regulation Authority 6

7 Clarifications and modifications Inclusion of Expected Claims in PML The current version of GPS 116 Attachment A defines the three-year stress scenario as being claims in addition to those incurred in the normal course of business. When GPS 116 Attachment A (then GGN 110.5) was finalised in October 2005, APRA stated its position with respect to the deduction of premium liabilities. In summary, APRA s view was that whilst it is difficult to distinguish between normal claims and MER claims (due to common drivers of default), APRA did not accept that premium liabilities should be deducted from the MER. APRA did however allow an LMI to include a portion of its premium liabilities in the calculation of reinsurance recoveries where the reinsurance protected against both normal working losses and catastrophic losses. A number of submissions noted that APRA s current approach may be acceptable in a benign claims environment but that in a stressed environment the PML would not be reduced by the claims already incurred or provided for, creating a requirement for additional capital. APRA has considered the issues raised in the submissions and is proposing that a more stable approach, and one suited to the nature of LMI, is to define the PML event as representing total claims, including those already anticipated by the insurer. As a consequence, APRA is proposing to allow an LMI to deduct from the calculated PML (net of reinsurance recoveries) a portion of the amount currently held as net premium liabilities. The amount of net premium liabilities which is deducted should be the net premium liabilities which will contribute to losses over the three-year period. APRA will not be setting a limit with respect to the size of this deduction, but the portion which the LMI deducts will be recorded in the reporting forms and will be reviewed as part of normal supervision activities. APRA expects that in most circumstances the net premium liabilities taken into account in the PML calculation will not exceed 60 per cent of net premium liabilities. It is important to note that, as stated in the introduction, APRA does not intend to materially alter the capital required by the LMI industry. Therefore APRA has sought specific information in the QIS as to the result of this proposed change, so that the calculation factors can be adjusted. This change is set out in paragraphs 19(c) and 38 in Draft GPS 116 Attachment A. Reinsurance principles Reinsurance protection, especially the various forms of aggregate excess of loss or stop loss covers often used by LMIs, form an important component of the MER calculation for many LMIs. It is therefore important that the treatment of the various forms of reinsurance is clear. APRA is not proposing to change the assessment of allowable reinsurance. An LMI will continue to calculate the PML over each year of the prescribed three-year stress scenario and then apply its reinsurance program to the resulting projected claims. Currently, GPS 116 Attachment A prescribes the calculation for allowable reinsurance based on whether the reinsurance is quota share cover, claimsyear cover or underwriting-year cover. APRA is proposing to delete these instructions and simply require the LMI to apply a principles-based approach to the calculation. The principles are: only reinsurance contracts that satisfy the two-month and six-month rules 1 as well as the Australian governing law and jurisdiction requirements 2 may be taken into account; reinsurance may be taken into account only for the period for which there is contract certainty. In particular the LMI may not take into account any reinsurance that has not yet been contractually committed. The principle here is that the LMI can only claim credit for reinsurance where the reinsurer can not walk away from the protection provided; and 1 Refer to GPS 230 for the definition of the two month (paragraph 38) and six month (paragraph 39) rules 2 Refer to GPS 230 paragraph 31 Australian Prudential Regulation Authority 7

8 no more than 60% of the PML may be deducted as allowable reinsurance. 3 APRA accepts that the calculation of Allowable Reinsurance will vary by LMI and an LMI may need to make some approximations or simplifying assumptions. Draft GPS 116 Attachment A has been altered to reflect APRA s proposed principles-based approach to this calculation. In addition, Draft GPS 116 Attachment A now requires an LMI to consider the impact of the prescribed stress scenario on its overall reinsurance arrangements and take account of all the relevant financial impacts, such as reinstatement premiums and reversal of experience bonuses. An LMI would continue to be required to set out in the REMS the details of reinsurance credits for MER purposes. In addition, APRA is proposing to introduce more detailed information to be included in reporting forms on the composition of allowable reinsurance. This additional information will be included in the draft reporting forms when they are released for consultation at a later date. The proposed reinsurance principles and calculation of allowable reinsurance are set out in paragraphs 32 to 37 in Draft GPS 116 Attachment A. Capitalised Premium Several submissions referred to the issue of measuring the Loan-to-Valuation Ratio (LVR) in a situation where the lender adds the LMI premium to the loan balance. In some situations the LMI insures this capitalised premium, while in other situations the capitalised premium is not insured by the LMI policy. APRA s position is that, when calculating the LVR for applying PDs and LGDs to the LMI s current book of business, an LMI must include any capitalised premium in the calculation of the loan amount, irrespective of whether the capitalised premium is insured. This is because the probability of default on the loan by the borrower is dependent on the total quantum of the loan and not the amount of protection which the LMI has extended to the lender. This approach is also consistent with the LVR definition used in the ADI capital standards. A number of arguments have been raised in submissions in respect of this issue. These are detailed below along with APRA s response in italics. Where the capitalised premium is not insured, there is no exposure to the LMI and therefore additional capital should not be required to be held. Also, when underwriting and pricing a loan, the LMI may not know whether or not the lender will capitalise the LMI premium into the loan and may not have records after the mortgage insurance is extended as to which loans have capitalised premium. APRA reiterates its above position that the probability of default by the borrower is dependent on the quantum of the total loan which is secured by the mortgage and not the cover extended by the LMI. If the LMI does not have access to information on loans which have capitalised premium, the LMI and its insured(s) will need to work together to rectify this issue. If the capitalised premium is not insured, the lender s loss must be greater than the capitalised premium before a claim arises and therefore the probability of a claim is lower (this argument distinguishes between the probability of default on the loan and the probability of a claim on the LMI). APRA s position is that the PD and LGD factors are applied to the sum insured not the loan amount which acknowledges that the risk faced by the LMI is related to the sum insured. The key point is that the PD and LGD factors are determined according to the risk of the loan. 3 Note that this cap is currently in place and APRA is proposing that the cap will remain. Australian Prudential Regulation Authority 8

9 Rating agency models and many foreign jurisdictions do not require the premium to be used in LVR calculations. Rating agency and other foreign jurisdictions assessment of capital adequacy vary in a number of ways from the APRA minimum capital requirement. APRA is of the view that including the premium in the assessment of the PD and LGD factors is correct in the context of the APRA methodology. APRA is therefore intending to continue its position in relation to the inclusion of capitalised premium in the calculation of LVR, irrespective of whether it is insured. For clarity, APRA has added the words irrespective of whether the premium is insured to the definition in paragraph 5 in Draft GPS 116 Attachment A. APRA reiterates that an LMI must still ensure that the borrower passes standard credit checks and income requirements to classify the loan as standard. This process may include assessing the extent to which the lender extends other facilities to the borrower which are secured by the mortgage. Clarification of the calculation of PML for pooled policies GPS 116 Attachment A currently sets out the PML calculation for a number of products, but some submissions have stated that it is ambiguous in its interpretation and does not deal adequately with the full range of products offered. The current GPS 116 Attachment A describes three coverage types, 100 per cent cover, top cover and pool mortgage insurance, and sets out how to deal with each coverage type when calculating PML. The calculation of PML for pool mortgage insurance does not make a distinction as to whether the LMI provides 100 per cent cover or less than 100 per cent cover. APRA is proposing to clarify the definitions of product types and coverage types by defining two categories of product, individual and pooled, and two coverage types for each of these categories. Individual products are defined as those where cover for each loan is individually underwritten (even if by delegated authority) and cover is issued at inception of the loan. Coverage type for these policies is 100 per cent cover or partial cover. Partial cover is referred to in the industry as top cover and is cover extended for a percentage of the loan value, eg 30 or 40 per cent. Pooled products are defined as those where cover is issued as a single transaction covering many loans, at a date after origination. Coverage type for these policies is 100 per cent cover or partial cover. Partial cover for a pool may be based on an aggregate deductible or limit relating to the whole pool, sometimes referred to as tranche cover. APRA expects that an LMI will have full records of each of the individual loans or policies which make up a pooled LMI product. APRA is proposing that the current approach of only using summarised information with a weighted average applied to determine PML will no longer be acceptable. Feedback about the need to apply grandfathering provisions to existing pooled business in this respect is requested. Where respondents assert that full records of pooled business are not available they are asked to provide details of the reasons for the difficulty in obtaining this information. APRA requests feedback from LMIs as to whether the proposed definitional categories above provide a suitable categorisation on which to base the PML calculation. APRA also asks that LMIs provide commentary on the clarity of Draft GPS 116 Attachment A with respect to the PML calculation for the products which it currently offers, including the amended definitions in the Standard. APRA proposes that an LMI be required to consult with APRA where it is not clear how to calculate the PML for any of its business. This position is intended to ensure that an LMI does not write business without proper consideration of the capital requirements. These changes are set out in paragraphs 12 to 14 and 22 to 27 of Draft GPS 116 Attachment A. Australian Prudential Regulation Authority 9

10 Claims Handling Expense The current MER calculation for LMIs includes a standard five per cent of gross PML for claims handling expenses. Several submissions have commented that the current allowance is greater than the actual likely costs in a stress scenario. This may be due to several factors such as much of the expense burden being carried by the insured lender, no recognition of economies of scale during the threeyear stress scenario and some double counting due to the factor being applied to gross PML not net PML. APRA is proposing to remove the explicit claims handling expense allowance. In doing so, APRA will consider the impact of this change in the recalibration of the calculation factors. Cover for new business In previous guidance to LMIs, APRA has referred to the importance of an LMI having reinsurance cover in place for business to be written over the next three years. APRA stated that if an LMI did not have reinsurance in place for new business it would need to make an adjustment to available reinsurance recoveries for claims that could arise from new business written over the next three years which are not covered by reinsurance. APRA adopted this position because, in the event of an economic downturn, an LMI may experience some difficulty in placing or renewing its reinsurance. This policy position meant that LMIs would need to build the three-year requirement into the capital adequacy calculations and would require the LMI to undertake a comprehensive projection of future new business. Submissions have provided a number of comments in relation to this issue, including: There is nothing written in GPS 116 Attachment A which specifically requires this prospective position and the position is directly contradictory or inconsistent with other aspects of the Standard; If this position is adopted, other forward looking concepts should be included in the Standard such as investment income during the period and premium income from new business; The application of this principle is difficult in practice, due to the need to estimate new business volumes in an economic downturn as well as applying the calculation method to prospective business; The position appears to apply more to claims year cover than underwriting year cover and this is why GPS 116 Attachment A requires reinsurance to be in place for at least a full year in advance; and The type of reinsurance which would cover new business for the next three years would be difficult to place; and if placed would be extremely expensive. APRA accepts that incorporating three years of forward projections in the MER calculation can be problematic and is proposing to base the MER calculation on the current business in force. APRA proposes that there will be no requirement for an LMI to consider new business volumes in the calculation although the LMI will still be required to assume a constant sum insured across the three-year scenario. APRA continues to be of the view that it is important for an LMI to consider its new business volumes and the extent to which these volumes are protected by reinsurance. APRA is proposing that an LMI describe in its REMS how it manages this exposure and the mitigants it has in place for the risk in relation to future reinsurance arrangements. The availability and cost of future reinsurance should be outlined in business plans and capital management plans. In addition, APRA would expect that an LMI apply a stress scenario to its capital position and plans for potential risks such as limited or no access to future reinsurance. Reporting Forms As a result of the proposed changes outlined above, the current reporting forms will need to be amended. As the changes to the forms are not major, the amended draft forms will be released at a later date, probably in the second quarter of 2009 and APRA will consult with LMIs on the forms at that time. Australian Prudential Regulation Authority 10

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