LIFE INSURANCE ACT 1995 CIRCULAR TO LIFE INSURANCE COMPANIES. ADMINISTRATION No B.4 ADMINISTRATION OF SECTION 42 OF THE LIFE INSURANCE ACT 1995

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1 LIFE INSURANCE ACT 1995 CIRCULAR TO LIFE INSURANCE COMPANIES ADMINISTRATION No B.4 ADMINISTRATION OF SECTION 42 OF THE LIFE INSURANCE ACT 1995 JUNE 1997 June LIFE No B.4

2 ADMINISTRATION OF SECTION 42 OF THE LIFE INSURANCE ACT 1995 INTRODUCTION It is noted that this Circular replaces section 6 of Circular No B.1 issued in July That circular was issued in July 1995 to coincide with the commencement of the Life Insurance Act 1995 (the Act). Section 6 provided a commentary on the intentions of the provisions of section 42 of the Act and the manner in which they would be administered by the ISC. As a consequence of the development of the actuarial standard for the calculation of the cost of investment performance guarantees, the considerations of the ISC in respect of this issue have progressed. Accordingly the commentary in this section of Circular No B.1, in particular the paragraphs included in respect of the determination of the cost of the guarantees, reflect views that have now been superseded. BACKGROUND - THE INTENT OF THE LEGISLATION The Statutory Fund The statutory fund concept is integral to the Life Insurance Act 1995 (the Act) as the mechanism for quarantining the life insurance business of the company - and hence the entitlements of the policy owners - from any other business of the company. The Act imposes the establishment of separate statutory funds in two instances only: 1. overseas business must be written in a separate statutory fund to Australian business (subject to some grandfathering provisions in respect of mixed funds in existence at the date of commencement of the Act). 2. Australian investment-linked business must be written in a separate statutory fund. The provisions of section 42 of the Act go to reinforce the concept and objective of the statutory fund - in particular, the investment-linked statutory fund. The Investment-Linked Statutory Fund The purpose of requiring investment-linked business to be written and maintained in a separate statutory fund is to ensure that the assets of the fund are available to meet the liabilities of policy owners of that business and are not called upon to meet any liabilities in respect of non investment-linked policies. June LIFE No B.4

3 The definition of an investment-linked contract in the Act allows some flexibility for product design and innovation. In particular, it does allow for the investment-linked benefits, while primarily linked in value to the underlying value of a prescribed group of assets, to incorporate some element of guarantee on the investment performance of those assets. The structure of the Act - in differentiating investment-linked business from other types of life business and requiring investment-linked business to be written exclusively in a separate statutory fund - could be undermined if the guarantees provided within the investment-linked contract become substantial. The purpose of section 42, therefore, is to limit the scope of an investment-linked statutory fund to be used to support guarantees in relation to the contracts within the fund. Extent of the Guarantees The assessment of what constitutes substantial guarantees is a subjective one. For the purposes of section 42, a trigger point is defined at the point at which the cost of the guarantees exceeds 5% of the total policy liability of the fund. The Investment Performance Guarantee Factor is defined, in section 42, as: Total cost of providing the Investment Performance Guarantee Total of the current Policy Liabilities of the Fund The determination of both the numerator and denominator in the above equation are required to be in accordance with actuarial standards. It is not the purpose of section 42 to limit the ability of the company to offer products which provide more substantial guarantees. Rather it is to ensure that those guarantees, if offered, are not provided from an investment-linked fund. The guarantee benefit may be provided by another (generally a non investment-linked) statutory fund; this reinforces other requirements which impose on the industry the discipline of separately identifying and costing the guarantee component and disclosing this information to the policy owner and prospective policy owner. June LIFE No B.4

4 ADMINISTRATION OF SECTION 42 Introduction The ISC in administering the requirements of section 42 will do so in a manner: consistent with the original intent of the provisions described in the earlier part of this circular; and consistent with the acknowledged arbitrariness of the prescribed 5% limit. The ISC acknowledges that it may be difficult, in practice, to monitor the level of the investment performance guarantee factor at all times, and that the factor itself may be volatile over time in response to movements in the market. However, the ISC also considers that the 5% limit, while a somewhat arbitrary one, is a relatively liberal allowance. (Given our understanding of the guarantees currently provided in the market, most investment-linked funds operate significantly below this limit.) Established as it is as a trigger point, it would be expected that the management of investment-linked business would involve early preventative measures by the company and, only in extreme circumstances would the intervention by the ISC be necessary. In this context the ISC is fully supportive of the approach being proposed for the actuarial standard under section 42 - the pragmatic approach to determining the cost of the investment performance guarantees is considered fully consistent with the intentions of the provision as a trigger for action rather than as a precise or absolute limit. Breach of Section 42 It is the requirement of section 42 of the Act that the investment performance guarantee factor of a statutory fund must not exceed 5%. There is no explicit penalty prescribed in the Act for a breach of this requirement - this is, in fact, common of many of the requirements of the Act, where specific penalty is not prescribed but rather the general administrative powers of the ISC (show cause notices, investigations etc) prevail. As described above, it is not the purpose of section 42 to limit the ability of the company to offer products which provide more substantial guarantees than those possible within the prescribed 5% limit. Rather it is to ensure that those guarantees, if offered, are not provided from an investment-linked fund. Therefore the ultimate remedy for a potential breach of the section 42 limit, is to write the guarantee benefit in another statutory fund. June LIFE No B.4

5 The ISC would expect that the Appointed Actuary would be integral in advising the company in the management of its investment-linked business, and in complying with the requirements of section 42. In this regard, professional judgement would be used to ensure appropriate preventative measures are undertaken. For instance: at the time of pricing a new product, where assessment indicates a potential cost of any investment performance guarantees in excess of the 5% limit, consideration should be given to segregation of the guarantee benefit to a different statutory fund. at the time of annual valuation, where assessment of the then cost of investment performance guarantees for in force business approaches the 5% limit, consideration should be given to the segregation of the guarantee benefit in respect of new business to a different statutory fund. Where these types of practices have been undertaken and yet the investment performance guarantee factor at a particular date exceeds 5%, for reasons out of the direct or reasonable control of the company, the ISC would not require any action in respect of the then in force business (despite the technical breach of section 42.) In assessing the actions of the company in the management of the investment-linked business under section 42, or in evaluating a technical breach of the section 42 provisions, the ISC may be willing to consider presentations from the Appointed Actuary as to why the costing methods of the actuarial standard are inappropriate to the circumstances. However, it is hoped that in the majority of circumstances such a course of action should not need to be resorted to. Mixed Statutory Funds A specific circumstance in the administration of section 42, is that of a statutory fund where the business of the fund comprises both investment-linked policies and other (non investment-linked) policies. Such circumstances may arise in practice as a consequence of the grandfathering provisions in the Act (section 31) in respect of statutory funds which contain both Australian and overseas business, which may include both investment linked and non investment linked business, and were in existence at the date of commencement of the Act. The application of the section 42 provisions extends to a statutory fund if it is an investment-linked statutory fund and includes investment performance guarantees. Hence the requirements of section 42 extend to such mixed statutory funds. In administering the requirements of section 42 for such mixed funds, the ISC will recognise the special nature of the funds, and the limited appropriateness of the objectives of section 42 in this respect. June LIFE No B.4

6 Were the investment performance guarantee factor to exceed 5% for a mixed statutory fund, the ISC would not consider this a breach of the Act warranting the impost of any form of remedy, since those guarantee benefits could be written, or considered to have been written, as part of the non investment-linked business of the mixed fund. RG Glading Deputy Commissioner Life Insurance 20 June 1997 June LIFE No B.4