CAPITAL STANDARDS REVIEW Consultation paper A paper detailing the proposed operation of the Capital Adequacy and Solvency requirements established by PHIAC to apply to health insurers in the private health insurance industry.
Comments and Inquiries PHIAC invites comments regarding this discussion paper. Comments and inquiries may be directed to: Chief Executive Officer Private Health Insurance Administration Council PO Box 4549 KINGSTON 2604 (02) 6215 7900 @ phiac@phiac.gov.au www.phiac.gov.au Important PHIAC welcomes responses received by 31 July 2013. 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 made under the Freedom of Information Act 1982. PHIAC will determine such requests, if any, in accordance with the provisions of the FOIA. Accessing this paper online This report, together with further information about PHIAC and the private health insurance industry can be accessed from our website www.phiac.gov.au Use of this Paper While PHIAC endeavours to ensure the quality of this publication, it does not accept any responsibility for the accuracy, completeness or currency of the material included in this publication and will not be liable for any loss or damage arising out of any use of, or reliance on, this publication. Private Health Insurance Administration Council (PHIAC) With the exception of the Commonwealth Coat of Arms and cover image, this work is licensed under the Creative Commons Attribution 3.0 Australia Licence (CCBY 3.0). This licence allows you to copy, distribute and adapt this work, provided you attribute the work and do not suggest that PHIAC endorses you or your work. To view a full copy of the terms of this licence, visit www.creativecommons.org/licenses/by/3.0/au/ Use of the Coat of Arms The terms under which the Coat of Arms can be used are detailed at http://www.itsanhonour.gov.au/coat-arms/
About PHIAC PHIAC is an independent statutory authority that regulates the private health insurance industry. Private health insurance policy is set down by the Australian Government via the Department of Health and Ageing. Section 264-5 of the Private Health Insurance Act 2007 (the Act) specifies the objectives of PHIAC to achieve an appropriate balance between: a) Fostering an efficient and competitive health insurance industry b) Protecting the interests of consumers c) Ensuring the prudential safety of individual private health insurers The Act empowers PHIAC to make a range of Standards that apply to private health insurers and the funds conducted by them. PHIAC s power to make a Solvency Standard and a Capital Adequacy Standard are granted by Divisions 140 and 143 of the Act respectively. 1 About PHIAC PHIAC
Preface Following an internal process of consideration of the performance of the current Solvency and Capital Adequacy Standards (the Standards) and the development of a proposal for new Standards, PHIAC released an initial consultation package to the industry and other interested stakeholders on 2 nd July 2012. That package included: a consultation paper; a technical annexure; and the first Quantitative Impact Study (QIS1a). Subsequently, on 1 st August 2012, PHIAC released further guidance relating to the completion of QIS1a. This paper, the second consultation paper, details the proposed changes to the Standards for Private Health Insurers, taking into account: feedback from the industry and other stakeholders during the initial consultation period which followed PHIAC s consultation paper and technical annexure released on 2 nd July 2012; submissions from insurers on the first Quantitative Impact Study (QIS1a); and PHIAC s own continued consideration of the operation and performance of the Standards. PHIAC s responses to the submissions received from the industry and other stakeholders are detailed in a separate paper released in conjunction with this paper. The objectives of the review are to: ensure that the Standards consistently and accurately reflect the risks faced by insurers; improve both insurers engagement with those risks and the quality of information available to support PHIAC s regulation of the industry; and provide protection for policyholders against financial loss in the context of both today s industry, and that of the likely future. This paper is released as part of a package intended to initiate the second round of consultation for changing the Standards. The full contents of this consultation package are: this paper; 2 Preface PHIAC
a paper detailing responses to submissions received during the first round of consultation; draft legislation for the proposed Standards (included as an appendix to this paper); and a second Quantitative Impact Study (QIS2) to be released shortly after this paper. PHIAC encourages responses from all stakeholders and interested parties to ensure the best design of the proposed Standards will be achieved. 3 Preface PHIAC
Contents About PHIAC... 1 Preface... 2 Contents... 4 Summary of the proposal... 5 Derivation of the proposal... 6 Meeting the statutory requirements of the Standards... 6 Meeting the objectives of the review... 7 Overview of the proposal... 10 Technical details of the proposal... 17 Capital Adequacy Standard... 17 Solvency Standard... 38 Reporting requirements associated with the proposed Standards... 47 Regular reporting... 47 Conditional reporting... 48 Expected impacts of the proposal... 50 Implementation phase and transition... 50 Future compliance... 51 Non-compliance... 55 Transitional arrangements... 55 Next steps & invitation to comment... 56 Appendix 1 proposed legislation... 57 4 Contents PHIAC
Summary of the proposal The proposed Standards would introduce a comprehensive risk-based capital regime aimed at ensuring that: Capital Adequacy Standard: each health benefits fund conducted by an insurer has sufficient assets to ensure the continuing financial soundness of the fund s balance sheet, taking into account business plans and the potential of adverse profitability outcomes and catastrophic losses in the asset portfolio; and Solvency Standard: each health benefits fund conducted by an insurer has sufficient assets of a sufficient quality to ensure that obligations to, and reasonable expectations of, policyholders and creditors can be met under adverse cash outflow circumstances. The fundamental question posed by the Capital Adequacy Standard would ask, Are the health fund s assets large enough to ensure that it can survive a very bad year with its balance sheet intact? The fundamental question posed by the Solvency Standard would ask, Are the health fund s highly liquid assets large enough to meet three months of stressed cash outflows? Philosophies The general philosophies included within the proposed Standards in order to meet their aims are: principles-based approaches for key risks; simplicity; recognition of all types of risk; putting policyholder protection at the core of the Standards; and promote best-practice management of surplus assets. 5 Summary of the proposal PHIAC
Derivation of the proposal PHIAC has designed the proposed Standards so that the overall aim of the Standards meets statutory requirements, while the philosophies introduced ensure that the proposed Standards meet PHIAC s objectives for the review. Meeting the statutory requirements of the Standards The Act specifies a two tier capital requirement, consisting of both a Capital Adequacy Standard and a Solvency Standard, for the health benefits fund of an insurer, with each tier considering the capital requirements under different circumstances. It is, therefore, in keeping with the Act that a two tier regime would continue. The purpose of the Capital Adequacy Standard is described in the Act as follows: 143-10 Purpose of Capital Adequacy Standard The purpose of the Capital Adequacy Standard is to ensure, as far as practicable, that there are sufficient assets in a health benefits fund conducted by a private health insurer to provide adequate capital for the conduct of the fund: a) in accordance with this Act; and b) in the interests of the policy holders of the fund. It aims to ensure the continuing financial soundness of the fund s balance sheet. The purpose of the Solvency Standard is described in the Act as follows: 140-10 Purpose of Solvency Standard The purpose of the Solvency Standard is to ensure, as far as practicable, that at any time the financial position of a health benefits fund conducted by a private health insurer is such that the insurer will be able, out of the fund s assets, to meet all liabilities that are referable to the fund as those liabilities become due. It aims to ensure that obligations to, and reasonable expectations of, policyholders and creditors will be met. The aims of the proposed Standards are consistent with these statutory requirements. 6 Derivation of the proposal PHIAC
The Solvency Standard has been aligned more closely to its statutory purpose in two key ways: 1. Timing and liquidity the current Standard does not require consideration of the timing of cash outflows and as such does not necessarily ensure that liabilities will be met at the time that fall due (as required under the purpose); and 2. Ongoing sense the current Standard considers the fund in a run-off situation, however such a situation is unlikely to arise in the current legislative context. As such, it does not necessarily ensure that the purpose of the Standard will be met in practice. The asset requirements under the proposed Standards would give an overall level of sufficiency of at least 98%. This is designed to meet the as far as practicable components of the statutory purposes of the Standards. Although it is lower than the 99.5% sufficiency targeted by other insurance regulatory regimes, such a level of sufficiency is justifiable because of the short-tailed nature of the Australian private health insurance business, which provides opportunities for insurers to respond to and correct adverse experience relatively quickly - within 12 months. Meeting the objectives of the review PHIAC s objectives for its review of the Standards are to: ensure that the Standards consistently and accurately reflect the risks faced by insurers; improve both insurers engagement with those risks and the quality of information available to support PHIAC s regulation of the industry; and provide protection for policyholders against financial loss. The philosophies underpinning the proposed Standards are used to ensure that the proposal meets these objectives as described below. Ensure that the Standards consistently and accurately reflect the risks faced by insurers Principles-based approach for key risks In the proposed Standards, the most significant risks are assessed using principles-based approaches. That is, the Standards would dictate a principle to be followed (e.g. that it is sufficient to cover insurance losses at the 2 nd percentile), with the precise methodology behind the calculation at the insurer s discretion. This philosophy ensures that the asset requirements reflect the required level of protection both consistently and accurately because: 7 Derivation of the proposal PHIAC
There are many significant differences between insurers that impact their individual risk profiles. As such, a principles-based approach, stating a desired level of protection, is the best way of ensuring that the requirements under the Standards would provide a consistent level of protection across insurers. The risk profile of an individual insurer varies significantly over time due to frequently evolving changes to the insurer s membership, products and strategy, as well as changes to the external and economic environments. As such, a principles-based approach provides the Standards the flexibility required to ensure that they would continue to meet their aims under any possible future circumstances. Simplicity Less significant risk areas would be assessed using prescribed rules. Clearly, for these risk areas, a simpler prescribed rules-based approach would not materially impact the consistency and accuracy by which the Standards reflect the risks faced by insurers. Address all risk types In order to ensure consistency and accuracy, it has been necessary to ensure that all types of risk are addressed by the proposed Standards. This has resulted in the proposed Standards explicitly including recognition of some risks, such as liquidity risk and operational risk, which are not explicitly recognised in the extant Standards. Improve both insurers engagement with those risks and the quality of information available to support PHIAC s regulation of the industry Principles-based approach for key risks and simplicity for other risks By designing the Standards in this way, insurer and PHIAC engagement with the key risks is maximised. It is PHIAC s intention that key risks would be well understood by both parties, while the simpler approaches prescribed for other risks would ensure that emphasis can and would be devoted to the most significant risk areas. The principles-based approach is centred around calculating asset requirements based on an explicitly stated level of protection. The results of this analysis enable both the insurer and PHIAC to develop more meaningful interpretations of the implications of different levels of assets relative to the asset requirements. The consistent and accurate reflection of risks that this approach would deliver would improve the quality of information available to PHIAC through insurers regular reports to PHIAC. This would 8 Derivation of the proposal PHIAC
enable PHIAC to gain a better understanding of the financial position of the insurer with a smaller level of uncertainty, better informing the regulatory role performed by the Council. Promote best-practice for managing assets in excess of the minimum levels required by the Standards The proposed Standards also require insurers to develop and maintain a Capital Management Policy. In order to do so, insurers would need to comprehensively understand the risks to their businesses. Once created, the Policy would ensure that insurers continue to run their businesses within risk tolerances and with due regard to the prevailing risks at the time. Provide protection for policyholders against financial loss The proposed Standards are deliberately constructed with policyholder protection at their core. Capital Adequacy aims to ensure that policyholder liabilities would be well covered after a sustained period of stress (12 months). Solvency aims to ensure that an insurer will have a sufficient cash balance to pay its policyholder benefits after 3 months of stressed cashflows. 9 Derivation of the proposal PHIAC
Overview of the proposal Under the proposed Standards, each health benefits fund would be required to comply with four separate asset tests: Capital Adequacy Standard: o Test 1 quantum of assets test o Test 2 concentration of assets test Solvency Standard: o Test 1 liquidity test o Test 2 concentration of liquid assets test The tests are designed to answer the fundamental questions posed by the Standards, as introduced above, namely: (Capital Adequacy Standard) Are the health fund s assets large enough to ensure that it can survive a very bad year with its balance sheet intact? ; and (Solvency Standard) Are the health fund s highly liquid assets large enough to meet three months of stressed cash outflows? There would also be requirements on insurers conducting health benefits funds relating to Capital Management Policies, governance and reporting. Asset tests: Structure of the Capital Adequacy Standard Note: the descriptions of the tests in this section ignore the possible presence of subordinated debt. Test 1 quantum of assets test At a high-level, this test aims to ensure that the fund holds sufficient assets so that, after 12 months of adverse experience, it would still have more assets than its (then) prudent liabilities. As such, the Stress Test Amount represents the depletion in assets from 12 months of adverse insurance and investment experience, and an adverse operational event. The current value of prudent liabilities is taken as a proxy for the value in 12 months time. Chart 1 below shows how the test would operate: 10 Overview of the proposal PHIAC
Chart 1: Capital Adequacy Standard quantum of assets test Test 2 concentration of assets test This test aims to ensure that no single plausible asset loss should be catastrophic to a fund s financial health. This would be measured by ensuring the fund would still have enough assets to meet its prudent liabilities after such a loss. Chart 2 below shows how the test would operate: Chart 2: Capital Adequacy Standard concentration of assets test 11 Overview of the proposal PHIAC
Asset tests: Structure of the Solvency Standard Test 1 liquidity test The liquidity test in the Solvency Standard is designed to ensure that the fund has sufficient high quality liquid assets in order to meet three months of stressed liquidity needs. It measures the availability of qualifying liquid assets against stressed liquidity needs over the next three months. Chart 3: Solvency Standard liquidity test Both the stressed liquidity needs and qualifying liquid assets are split into two categories, creating two separate requirements within the liquidity test: 1. that the qualifying liquid assets as a whole exceed the stressed liquidity needs as whole; and 2. that the higher quality liquid assets (the Band 1 Qualifying Assets) exceed the core liquidity requirements (the Cash Management Amount). 12 Overview of the proposal PHIAC
Test 2 concentration of liquid assets test In a similar way to the concentration test in the Capital Adequacy Standard, the concentration of liquid assets test is designed to provide assurance that the fund would survive after an asset default from within the fund s portfolio of Band 1 Qualifying Assets. Survival would be measured by ensuring that the fund could still meet stressed liquidity needs with a reasonable level of sufficiency (measured as 60% of the Cash Management Amount) after such a default. Chart 4: Solvency Standard concentration of liquid assets test Proposed Solvency Standard - concentration of liquid assets Largest single loss (must not cause a catastrophic problem) 60% 60% Assets Band 1 Cash Qualifying Management Liquid Assets Amount Band 1 Cash Qualifying Management Liquid Assets Amount 13 Overview of the proposal PHIAC
How the asset tests address each risk type The following table summarises the types of risk covered by the proposed Standards, and the method by which each is addressed: Table 1: asset requirements for each risk type Risk Asset: market and currency Asset: credit Objective of regulatory requirement Contributes to objective of the Stress Test* Contributes to objective of the Stress Test* Nature of Element by which proposed approach to Standards address risk calculation Principles-based Capital Adequacy Standard, Test 1 (Stress Test Amount) Principles-based Capital Adequacy Standard, Test 1 (Stress Test Amount) Asset: liquidity Liability valuation Health insurance business losses Other business losses Operational Ensure sufficiently diverse counterparty exposures, so that the failure of one counterparty would not cause the fund to fail Ensure sufficient liquid assets available to meet stressed liquidity needs over the next 3 months Ensure sufficient assets to meet a prudent valuation of liabilities Contributes to objective of the Stress Test* Contributes to objective of the Stress Test* Ensure sufficient assets to continue to meet prudent liabilities after 12 months of adverse operational losses Prescribed rules Capital Adequacy Standard, Test 2 Solvency Standard, Test 2 Combination of Solvency Standard, Test 1 principles-based and prescribed rules Combination of Capital Adequacy Standard, Test 1 principles-based (Prudent Liabilities Amount) and prescribed rules Principles-based Capital Adequacy Standard, Test 1 (Stress Test Amount) Principles-based Capital Adequacy Standard, Test 1 (Stress Test Amount) Prescribed rules Capital Adequacy Standard, Test 1 (Operational Risk Amount) 14 Overview of the proposal PHIAC
*The objective of the Stress Test is to ensure that the fund has sufficient assets to continue to meet prudent liabilities after 12 months of adverse experience, where the adverse experience could arise from any, or all, of the following: losses on the health insurance business; losses on any other business; and losses on investments. This approach is in keeping with the philosophy, as described above, of adopting a principlesbased approach for key risks, and simple rules-based approaches for other risks. Broadly speaking, the key risks to private health insurers in Australia are: 1. Insurance risks the risk of incurring losses to due to unexpectedly high benefit payments; 2. Asset risks the risk of a fund s asset values moving unexpectedly and/or the risk that the insurer is unable to liquidate an asset when required; 3. Liability risks the risk of a fund s liability valuation proving insufficient; and 4. Operational risks risks relating to the people, processes, systems and external events associated with, or affecting, the execution of the business of the fund. As such, the proposed Standards would deal with the most significant of these through principlesbased asset requirements, namely: insurance risks through the Stress Test Amount (Capital Adequacy), a component of which measures potential losses over 12 months on the fund s insurance business; and the largest asset risks also through the Stress Test Amount (Capital Adequacy), a component of which measures the potential adverse investment income and changes in asset values over 12 months. Liability risks would be measured using a combination of principles and rules, through the Prudent Liabilities Amount (Capital Adequacy), at a 98% probability of adequacy. Insurers already apply the same as or similar methods in complying with the Australian Accounting Standards Board (AASB) Standard for General Insurance Contracts (AASB 1023) as would be required under the proposed Capital Adequacy Standard. The remaining risks would be dealt with through prescribed rules that establish minimum benchmarks in line with PHIAC s risk appetite, namely: Liquidity risks (Solvency Standard) the qualifying asset criteria prescribe the types of assets that can be counted for liquidity purposes, whilst the Cash Management Amount and Stressed Losses Amount describe the stressed liquidity needs; 15 Overview of the proposal PHIAC
Concentration risks concentration tests (Capital Adequacy and Solvency) aim to ensure that a fund can withstand losses from its largest asset exposures without placing policy holder liabilities or benefit payments in jeopardy. Operational risks through the Operational Risk Amount (Capital Adequacy), which uses a simple formula to estimate a fund s exposure to adverse operational events. Other requirements Capital Management Policy As well as the stipulated requirements on assets (through the four different tests described above), the Capital Adequacy Standard would also require insurers to have a Board-endorsed Capital Management Policy relating to their fund. This would include: a capital management plan, featuring probabilistically-determined capital targets and triggers; a pricing philosophy, with explicit consideration of capital implications; liquidity requirements designed to ensure ongoing compliance with the Solvency Standard; and investment rules, which include consideration of capital strength. Governance Ensuring compliance with both the Capital Adequacy Standard and the Solvency Standard would be the sole responsibility of the Board of the insurer. Reporting As is required under the extant Standards, insurers would be required to report compliance, via a standard written form (the PHIAC2 return), shortly after the end of a specified period, usually quarterly, or monthly in certain circumstances. In the event of non-compliance with either Standard, the insurer would need to immediately notify PHIAC. 16 Overview of the proposal PHIAC
Technical details of the proposal This part details the operations of each element comprising the proposed Standards. Thumbnail maps are included to remind the reader of how the specific element in question fits in with the relevant Standard as a whole. Subordinated debt is described in a self-contained sub-section. Capital Adequacy Standard As described above, the proposed Capital Adequacy Standard consists of two tests. The first test (the quantum of assets test) is designed to ensure that the fund has sufficient assets so that after 12 months of adverse experience (at the 2 nd percentile) it would still be able to meet a prudent measure of its liabilities at that point in time. The second test (the concentration of assets test) is designed to ensure that the fund could continue to meet a prudent measure of its liabilities after the failure of any one single counterparty (or group of related counterparties), taking into account any compensatory recoveries. Prudent Liabilities Amount The Prudent Liabilities Amount represents a conservative valuation of the liabilities of the fund, using 98% probabilities of adequacy. Its calculation is a combination of a principles-based approach and prescribed rules. It is the sum of the following four amounts, each described in more detail below: Outstanding Claims Liability Amount; Future Claims Liability Amount; Risk Equalisation Trust Fund Accrued Liability Amount; and Other Liabilities Amount Legislation The Prudent Liabilities Amount is defined in clause 5 of Schedule 3 (Capital Adequacy Standard) in the proposed legislation (see Appendix 1). 17 Technical details of the proposal PHIAC
Outstanding Claims Liability Amount The Outstanding Claims Liability Amount aims to achieve a 98% probability of adequacy by applying a prescribed, size-based margin (the Size Margin) to the insurer s determination of outstanding claims at a 75% probability of adequacy (the Outstanding Claims Liability), i.e.: Outstanding Claims Liability Amount = Outstanding Claims Liability (1 + Size Margin) The Outstanding Claims Liability should be measured in accordance with AASB 1023, which requires a central estimate of all (i.e. both health insurance and health related business) outstanding claims to which a risk margin is applied to allow for uncertainty in the valuation. The risk margin would be determined by the insurer so that the Outstanding Claims Liability achieves a 75% probability of adequacy. Although principles-based, this approach employs methodologies familiar to insurers. The Size Margin is based on the number of single equivalent units (SEUs) of the fund, and is calculated as: Size Margin = 0.75 SEUs ^ -0.16 The table below shows the Size Margin for some examples of different numbers of SEUs: Table 2: example Size Margins Number of SEUs Size Margin 10,000 17.2% 50,000 13.3% 100,000 11.9% 500,000 9.2% 2,000,000 7.4% These values have been determined by PHIAC to increase the level of sufficiency of an outstanding claims estimate from 75% to 98%. The specific values of the Size Margins are considered to achieve an acceptable level of accuracy, notwithstanding that they are approximations to the true values required, which would also depend on variables other than the number of SEUs. This formula approach is preferred to alternatives 18 Technical details of the proposal PHIAC
since it avoids step changes in the Size Margin without being overly complex. Legislation The Outstanding Claims Liability Amount is defined in clause 6 of Schedule 3 (Capital Adequacy Standard) in the proposed legislation (see Appendix 1). Future Claims Liability Amount The Future Claims Liability Amount aims to achieve a 98% probability of adequacy by applying the same size margin (as used to calculated the fund s Outstanding Claims Liability Amount) to the insurer s determination of future claims at a 75% probability of adequacy (the Future Claims Liability), i.e.: Future Claims Liability Amount = Future Claims Liability (1 + Size Margin) The future claims liability is defined consistently with elements of the Liability Adequacy Test in AASB 1023 and, as such, should not require any further analysis from insurers. Specifically, the insurer should make a central estimate of all future cashflows from future claims arising from the rights and obligations under current policies, and add a risk margin to allow for uncertainty. This risk margin would be determined by the insurer so that the value (with no discounting) of the cashflows achieves a 75% probability of adequacy. Any related intangible assets or deferred acquisition costs should be added to this value (since the existence of these would create additional liabilities on the Balance Sheet, and the Prudent Liabilities Amount aims for a 98% probability of adequacy of the Balance Sheet value) in order to achieve the Future Claims Liability. Legislation The Future Claims Liability Amount is defined in clause 7 of Schedule 3 (Capital Adequacy Standard) in the proposed legislation (see Appendix 1). Risk Equalisation Trust Fund Accrued Liability Amount For an individual insurer, the calculated deficit component of risk equalisation liabilities depends on the claims experience of other insurers. Near to the time that payment into (or receipt from) the risk equalisation trust fund (RETF) are due once per quarter the value of the calculated deficit component is known with near certainty. At other times, between RETF transfers, the value of the RETF liability accruing against earned premiums can contain a significant degree of uncertainty. 19 Technical details of the proposal PHIAC
Since insurers would be required to comply with the Capital Adequacy Standard at all times, it would therefore be necessary that the Standards reflect the uncertainty in the calculated deficit component of RETF transfers. For simplicity, the proposed Standards would simply inflate the insurer s central estimate of the calculated deficit by 15%, a margin calculated by PHIAC to approximate 98% sufficiency. The remainder of the RETF liability calculation would be in accordance with the Private Health Insurance (Risk Equalisation Policy) Rules 2007. Note that these rules only relate to calculations as at the end of each financial quarter. Insurers would therefore need to ensure that the calculation of the Risk Equalisation Trust Fund Accrued Liability Amount includes all transfers that would have accrued up to the date on which the calculation is being made. Legislation The Risk Equalisation Trust Fund Accrued Liability Amount is defined in clause 8 of Schedule 3 (Capital Adequacy Standard) in the proposed legislation (see Appendix 1). Other Liabilities Amount All other liabilities (including, for example, liabilities relating to loyalty bonuses, tax liabilities and creditors of the fund) should continue to be valued following existing rules and guidance, except that any estimates required should be made so that the liability achieves a 98% probability of sufficiency. Liabilities known with certainty will not need to be inflated. Legislation The Other Liabilities Amount is defined in clause 9 of Schedule 3 (Capital Adequacy Standard) in the proposed legislation (see Appendix 1). 20 Technical details of the proposal PHIAC
Case Study: Prudent Liabilities Amount calculation Insurer XYZ has 100,000 SEUs. The following table shows Insurer XYZ s balance sheet liabilities and prudent liabilities amount the derivation of each row is described below. Balance Sheet Prudent Liabilities Amount 1. Outstanding Claims $25m $26.3m 2. Future Unexpired $30m Claims Premium Liability Unexpired Risk $2m $35.8m Reserve 3. Risk Equalisation Trust Fund $5m $8.8m Accrued Liability 4. Other Loyalty bonus $5m liabilities Other certain $33m $41m liabilities Total $100m $111.9m 1. Outstanding Claims Liability Amount In accordance with AASB 1023, Insurer XYZ calculates its central estimate for outstanding claims at $18m, and chooses to add a $7m risk margin, determined by XYZ so that its Balance Sheet liability has a 90% probability of adequacy. Hence, the total balance sheet liability is $25m. However, in order to achieve a 75% probability of adequacy, XYZ determines that its risk margin should be $5.5m, so a $23.5m liability would have a 75% probability of adequacy. XYZ s size margin is: 0.75 100,000 ^ -0.16 = 11.9% Hence, the Outstanding Claims Liability Amount is: 2. Future Claims Liability Amount $23.5m (1 + 11.9%) = $26.3m In accordance with AASB 1023, Insurer XYZ has $30m of unearned premiums. Its best estimate of cash flows relating to future claims arising from the rights and obligations under current policies is a $25m outgo. Under the Liability Adequacy Test, it applies a $7m risk margin (determined by XYZ to be the 90 th percentile) to this amount. XYZ has a Deferred Acquisition Cost (DAC) asset of $3m (and no intangible assets), and so its deficiency is $5m (= $25m + $7m - $3m $30m). It therefore 21 Technical details of the proposal PHIAC
Case Study (continued) writes-down its DAC asset and creates an Unexpired Risk Reserve liability of $2m (=$5m - $3m). However, XYZ determines that the risk margin should be $4m at the 75 th percentile. Its future claims liability is therefore $32m (= $25m + $4m + $3m). Hence, the Future Claims Liability Amount is: $32m (1 + 11.9%) = $35.8m 3. Risk Equalisation Trust Fund Accrued Liability Amount In accordance with the Risk Equalisation Rules, XYZ estimates its calculated deficit to be $25m and its gross deficit to be $20m, giving a balance sheet liability of $5m (=$25m - $20m). Hence, the Risk Equalisation Trust Fund Accrued Liability Amount is: $25m 1.15 - $20m = $8.8m 4. Other Liabilities Amount XYZ s other liabilities total $38m on its Balance Sheet. $5m of these represent a 90 th percentile estimate of loyalty bonuses it intends to pay to some of its policyholders. Since this is an uncertain quantity, XYZ determines its value at the 98 th percentile to be $8m, and this is the contribution it makes towards the Other Liabilities Amount. The remaining $33m (which includes $20m of issued subordinated debt see below) on the balance sheet have a certain value, and so contribute that amount to the Other Liabilities Amount. Hence, the Other Liabilities Amount is: $8m + $33m = $41m 22 Technical details of the proposal PHIAC
Assets This quantity is simply the full value of the assets in the health benefits fund, valued in accordance with the accounting standards issued by the AASB. In other words, all assets are fully admissible the concentration test deals separately with concentration risks. Legislation The asset tests in clause 4 of Schedule 3 (Capital Adequacy Standard) refer to the value of the assets of the health benefits fund. Clause 2 of Schedule 3 requires that any value be worked out in accordance with the AASB (see Appendix 1). Case Study: Assets calculation Insurer XYZ has $200m of assets on its balance sheet, all contained within the health benefits fund. Stress Test Amount The Stress Test Amount represents the amount by which a fund s capital could deplete over 12 months under a 2 nd percentile stressed scenario, taking into account tax. As such, there are four elements to calculating the Stress Test Amount, covering all aspects that could lead to movements in capital over a 12 month period, namely dollar values of the following: (1) the Stressed Net Margin Estimate; (2) the Stressed Investment Income Estimate; (3) the Stressed Other Income Estimate; and (4) tax Elements (1)-(3) form the insurer s estimate of the fund s stressed net profit before tax over 12 months. Each of these elements is itself calculated at the same percentile as the other two 23 Technical details of the proposal PHIAC
elements in order that they combine to achieve a 2 nd percentile stressed net profit before tax over 12 months. The insurer would need to use its own methodology, assumptions and data in order to: determine the appropriate percentile at which to stress each element (1) to (3); and determine the size of each of the stresses at that percentile. Losses under elements (1)-(3) would make a positive contribution towards the Stress Test Amount (and profits a negative contribution), whereas tax payments would make a positive contribution (and tax credits a negative contribution). There is an overall floor of $0 on the Stress Test Amount. Correlations Calculating the Stress Test Amount requires analysis of correlations between net margins on health insurance business, profits from other business and returns on investments. Having analysed the correlations, the insurer can determine the appropriate percentile, the x th percentile, at which to stress each of these elements in order that they combine to achieve a 2 nd percentile profit outcome over the coming 12 months. Stressed Net Margin Estimate There are two stages necessary to calculating the dollar value of the Stressed Net Margin Estimate. Firstly, the insurer must calculate its Premium Income Estimate - the best estimate of the amount of premium income that the fund will earn on health insurance business in the following 12 months. All elements of this calculation would be entirely at the insurer s discretion, except for any assumed premium increases, which will be capped at a level slightly above recent insurer-specific benefit inflation (the methodology for the calculation of this amount will be published by PHIAC from time to time). Premium increases are uncertain due to market forces and regulation, and this approach will not allow recognition of larger premium increases until they have been implemented or confirmed. Secondly, the insurer must calculate the fund s x th percentile stressed net margin i.e. all benefits and expenses as a percentage of contribution income over the coming 12 months. Benefits should relate to health insurance business only, and be net of risk equalisation trust fund payments/receipts. All elements of this calculation would be entirely at the insurer s discretion, although the insurer should ensure that the distribution of potential net margins properly reflects: historical variability of net margin outcomes; 24 Technical details of the proposal PHIAC
the potential effect of changes in membership growth on net margins; and the potential effects of any planned product or strategic changes. The dollar value of the Stressed Net Margin Estimate is then the product of the Premium Income Estimate and the x th percentile stressed net margin). Stressed Investment Income Estimate The insurer would calculate the fund s x th percentile stressed investment income over the coming 12 months as a dollar value. Investment income would fully reflect: any investment income cashflows (including, for example, coupons, maturity payments, dividends, payouts on options, transaction fees, servicing costs, etc.); and asset valuation changes (from changes to both the market value of the asset, or changes to the valuation methodology). Each element of this calculation would be determined by the insurer, although the insurer should ensure that the distribution of investment income properly reflects all material risks, to both individual asset holdings and the asset portfolio as a whole, including: market risk; credit risk; and the risk of incorrect asset valuation on the balance sheet. Stressed Other Income Estimate The insurer must calculate the fund s x th percentile stressed other income over the coming 12 months as a dollar value. Other income can arise from a variety of different sources, including: profits and losses on health related insurance business in the fund; profits and losses from other health related business operated within the fund; and profits and losses from other business operated within the fund. Tax The insurer would calculate the amount of tax the fund would be liable to pay on profits in the stressed scenario. If the stressed profit is a negative amount, then the insurer may recognise a negative tax amount to reflect future income tax credits in a manner consistent with accounting standards (i.e. to the extent that the fund would be expected to return to profits in the years 25 Technical details of the proposal PHIAC
following such a stressed scenario). Case Study: Stress Test Amount calculation Insurer XYZ examines the correlations between net margins on health insurance business, profits from other businesses and investment returns, and determines that a 4 th percentile stress to each would be appropriate so that they combine to produce a 2 nd percentile stress to profit before tax over the coming 12 months. Insurer XYZ s Premium Income Estimate for the next 12 months is $220m. In calculating this amount, XYZ replaced their intended premium increase of 6.5% (due to be implemented in 9 months) with the maximum allowable increase, as recently specified by PHIAC, of 6%. XYZ s best estimate net margin over the 12 months is 5.0% but, by modelling the distribution of potential profit outcomes, determines the 4 th percentile net margin over the 12 months to be -8.0%. The Stressed Net Margin Estimate is therefore: $220m x -8.0% = -$17.6m XYZ s best estimate investment return on its $200m asset portfolio is 5.0% p.a. XYZ uses its own internal asset model programmed with its investment policies to determine a 4 th percentile investment return of -2.0% p.a. The Stressed Investment Income Estimate is therefore: $200m -2.0% = -$4m XYZ models the distribution of profits from other business it operates within the fund (dental and optical centres), and determines the 4 th percentile outcome would be a $2m loss. Its Stressed Other Income Estimate is therefore -$2m. XYZ s 2 nd percentile profit before tax is therefore -$23.6m (= -$17.6m - $4m - $2m). XYZ pays income tax of 30% on profits. It expects that it would make sufficient profits in the years following a $23.6m loss in order to be able to fully utilise its corresponding tax credits against future profits. The Stress Test Amount is therefore: -(-$23.6m) + (0.3 -$23.6m) + 0 = $16.5m 26 Technical details of the proposal PHIAC
Operational Risk Amount The Operational Risk Amount is a simple formula designed to represent potential losses from operational events over the coming 12 months. The formula is: Operational Risk Amount = $1m (indexed from 2014) + 0.5% Health Business Revenue Estimate where the Health Business Revenue Estimate is the Premium Income Estimate (relating to premium revenue from health insurance business as determined under the Stress Test calculation above) plus expected premium revenue from health related business in the fund over the next 12 months. After 2014, the fixed $1m component in the Operational Risk Amount formula would increase by 2.5% (compound) at the start of each calendar year. PHIAC acknowledges that there is a wide range of existing practice in relation to the recognition of operational risk parameters in capital. PHIAC is satisfied that the proposed approach provides a reasonable amount of protection against plausible adverse operational events, and in the future, as insurers operational risk models become more sophisticated, PHIAC will consider whether some refinement of the formula or approach is justified. The $1m (indexed) is designed to cover operational losses that could impact any fund regardless of size for example correcting system failures, natural disasters, fines or legal fees. Intuitively its value should remain constant in real terms, though for simplicity PHIAC has chosen to index the $1m amount by 2.5% p.a. The size-based component is designed to cover operational losses that would depend upon the size of the fund for example compensating members as a result of database errors or mis-sales. Legislation The Operational Risk Amount is defined in clause 11 of Schedule 3 (Capital Adequacy Standard) in the proposed legislation. 27 Technical details of the proposal PHIAC
Case Study: Operational Risk Amount calculation As calculated under the Stress Test Amount, Insurer XYZ s Premium Income Estimate is $220m. It also expects revenue of $15m from its optical and dental centres over the next 12 months. Its Health Business Revenue Estimate is therefore $235m. It is 15 June 2014. Therefore, the Operational Risk Amount is: $1m + 0.5% $235m = $2.2m Capital Adequacy Supervisory Adjustment Amount To cater for unusual circumstances, PHIAC would have the capacity to apply a Capital Adequacy Supervisory Adjustment Amount which could adjust any element comprising the quantum of assets test. A Capital Adequacy Supervisory Adjustment Amount could also be applied in the concentration of assets test (potentially of a different value to that applied in the quantum of assets test). Such an adjustment may be necessary from time to time since the measurement of principlesbased elements of the Standards requires the application of judgement. Furthermore, the very broad range of possible risks means the Standards cannot be expected to perform perfectly under every possible circumstance. The application of a Capital Adequacy Supervisory Adjustment Amount, in either the quantum of assets test or the concentration of assets test, could arise when the calculation of any of the other elements in those tests prove inadequate, i.e. situations including, but not limited to, the following: the fund s Stress Test Amount makes inadequate allowance for: o growth in policyholders, including in new markets; o changes to the fund s products, including the launch of new products; o a lack of asset diversification; o market risk; o mis-measurement of asset values; or o credit risk. the fund s Prudent Liabilities Amount provides insufficient protection; the fund s Operational Risk Amount provides insufficient protection; the fund s assets are not valued appropriately; the insurer has inadequate data to assess the fund s risks; 28 Technical details of the proposal PHIAC
the fund is exposed to contagion risks from a related entity not captured by the Standards; or the fund s Capital Adequacy Maximum Default Loss Amount provides insufficient protection. A Capital Adequacy Supervisory Adjustment Amount would be applied only after extensive examination of the particular area of risk and in-depth discussion and consultation with the affected insurer. In most circumstances, PHIAC envisages that these discussions would result in either the insurer satisfactorily allaying PHIAC s concerns, or the insurer electing to adjust its calculations in the quantum of assets test accordingly. If, after discussions with the insurer, PHIAC still considers that the insurer requires an adjustment, PHIAC will notify the insurer, in writing, of the nature of the adjustment (either a fixed dollar value or a prescribed methodology for calculating its value). Insurers would have the opportunity to appeal, through the Administrative Appeals Tribunal, against any decision by PHIAC to apply an adjustment. Legislation The Capital Adequacy Supervisory Adjustment Amount is defined in clause 12 of Schedule 3 (Capital Adequacy Standard) in the proposed legislation. Case Study: Capital Adequacy Supervisory Adjustment Amount calculation PHIAC is satisfied that Insurer XYZ has correctly determined all the elements of the quantum of assets test and the concentration of assets test, and that the resultant amounts do provide the desired level of protection. As such, no Capital Adequacy Supervisory Adjustment Amount is applicable to either asset test. 29 Technical details of the proposal PHIAC
Subordinated Debt In certain situations, the asset requirements under the Capital Adequacy Standard, as described so far, could be adjusted where insurers have issued subordinated debt from within the health benefits fund. When a health benefits fund issues fully paid-up subordinated debt, the fund s asset base increases by the cash value paid to the fund by the investors, while a corresponding liability to repay the debt is created. The subordinated nature of subordinated debt ensures that interest and capital repayments to investors occur only after all debts to policy holders and other creditors have been met. Furthermore, interest and capital repayments cannot be made if, by doing so, the fund would be in breach of either of the Capital Adequacy or Solvency Standards. As such, it makes sense that subordinated debt improves a fund s financial strength in some circumstances. However, the Capital Adequacy Standard tests whether the fund has sufficient assets to survive a bad year in an ongoing sense. If not, it would fail the quantum of assets test, and not comply with the Standard. Within this context, subordinated debt which operates only as described above would not improve the financial strength of a fund. In order to gain additional recognition, the subordinated debt issue would need to contain genuine loss-absorbing characteristics within its terms and conditions. Therefore, only subordinated debt that exhibits genuine loss-absorbing characteristics could bring about an adjustment to the asset requirements under the Capital Adequacy Standard. Such an adjustment would effectively take the form of a negative liability (to offset the liability created by the issue) by subtracting subordinated debt from the Prudent Liabilities Amount in both the quantum of assets test and the concentration of assets test. However, it is proposed that subtraction of subordinated debt as described above may only occur following a successful application by the insurer to PHIAC for approval. Key criteria that PHIAC would consider for approval would be that the issue is genuinely loss-absorbing when the fund is considered in an ongoing sense, as it is only under this condition that a subordinated debt issue can improve the fund s chances of answering the fundamental question posed by the Capital Adequacy Standard. Further conditions necessary for the issue of subordinated debt to be approved include: it must have a minimum term of 10 years from the commencement of the loan; there must be no circumstances where repayment may be accelerated or called at the lender s or any third party s option; 30 Technical details of the proposal PHIAC
interest payments are not to be payable where the payment of these would cause the fund to breach the capital adequacy obligation; interest payment obligations may be capitalised and interest may be charged on capitalised interest; capital repayments are not to be made where the repayment of these would cause the fund to breach the capital adequacy standard; delayed capital repayments may be subject to continuing interest charges, on the interest charge and repayment conditions specified in this subclause. PHIAC may elect not to approve the full value of a fund s subordinated debt issue and instead approve only a portion of the full issue. Legislation Subordinated Debt is defined in the definitions in Schedule 1 (Amendments) in the proposed legislation (see Appendix 1). Note that it is the sum of Approved Loss Absorbing Subordinated Debt, the definition of which describes the requirements consistent with the above discussion, and Previously Approved Subordinated Debt, which represents transitional arrangements for subordinated debt approved under previous Capital Adequacy Standards (see the below discussion in expected impacts of the proposal). Case Study: Subordinated Debt calculation Insurer XYZ has issued $20m of Subordinated Debt, which is completely convertible into common equity at the discretion of XYZ in the event that XYZ would otherwise breach the Capital Adequacy Standard. The debt meets the other conditions required and PHIAC has determined to approve its full value of $20m. 31 Technical details of the proposal PHIAC
Quantum of assets test The quantum of assets test now checks that, having calculated all of the amounts described above, there is an excess of assets. The test (as depicted in Chart 1) requires that: { Assets Stress Test Amount Operational Risk Amount } { Prudent Liabilities Amount Subordinated Debt } after making any necessary adjustments for a Capital Adequacy Supervisory Adjustment Amount. Legislation The quantum of assets test can be found in clause 4, subclause 2(a) of Schedule 3 (Capital Adequacy Standard) in the proposed legislation (see Appendix 1). Case Study: Capital Adequacy Standard, quantum of assets test For Insurer XYZ, the left-hand side of the above calculation equals: The right-hand side equals: $200m - $16.5m - $2.2m = $181.3m $111.9m - $20m = $91.9m There is no Capital Adequacy Supervisory Adjustment Amount. XYZ complies with the quantum of assets test in the Capital Adequacy Standard. 32 Technical details of the proposal PHIAC
Capital Adequacy Maximum Default Loss Amount The Capital Adequacy Maximum Default Loss Amount is designed to reflect the maximum uncompensated loss that could occur if all the assets held with a single counterparty (or related group of counterparties) were to lose their full value. Conceptually, the calculation is simple the insurer must find its largest exposure to a related group of counterparties with two conditions: exposures to the Australian government and deposits held with Authorised Deposit-taking Institutions (ADIs) are not considered; and exposure is measured net of any recoveries that may occur were the assets in question to lose their full value in the legislation this concept is described as an uncompensated loss. However, there are some complications that may arise when calculating the maximum default loss: Assets with no counterparty for some assets, such as direct property holdings, there is no counterparty. In these cases, the exposure is the uninsured (or otherwise uncovered) value of that asset. Related counterparties is any 2 or more counterparties that fit the Australian Accounting Standards Board definition of being a related party, or that are linked by financial interdependency or any other connection or relationship that might expose the counterparties in the group to a single risk. Ultimately, the insurer will need to determine whether or not 2 counterparties are related. As with all other elements of the Solvency and Capital Adequacy Standards, PHIAC will regularly monitor and review these determinations. Indirect holdings many funds have indirect exposures to underlying counterparties, for example through investments in managed funds. Nevertheless, it remains the insurer s responsibility to calculate its capital adequacy maximum default loss as described above. That is, the insurer would need to consider the fund s exposure to underlying counterparties. In circumstances where look-through to underlying exposures is not possible, then the insurer would need to ensure that its calculation of the fund s Capital Adequacy Maximum Default Loss Amount is definitely at least as large as its true correct value (for example, it could assume that a managed fund is entirely exposed to one counterparty, or it could seek further definitive information from the fund managers to provide some level of break-down to this assumption). Approximations to the calculation would be permitted, but only where the insurer can adequately demonstrate to PHIAC that 33 Technical details of the proposal PHIAC
looking-through any further would be immaterial to the fund s Capital Adequacy Maximum Default Loss Amount. Legislation The Capital Adequacy Maximum Default Loss Amount is defined in clause 13 of Schedule 3 (Capital Adequacy Standard) in the proposed legislation. Case Study: Capital Adequacy Maximum Default Loss Amount calculation Insurer XYZ has $200m of assets on its Balance Sheet, of which $90m are in cash and term deposits with ADIs and $10m is in government bonds. Of the remaining $100m, only $80m are financial instruments. Amongst these, the largest uncompensated loss would be $10m if the issuer of a corporate bond defaulted (although XYZ owns a $15m property, it is fully insured). As such the Capital Adequacy Maximum Default Loss Amount is $10m. 34 Technical details of the proposal PHIAC
Concentration of assets test The concentration of assets test now checks that, having calculated all of the amounts above, there is an excess of assets. The test (as depicted in Chart 2) requires that: { Assets Capital Adequacy Maximum Default Loss Amount } { Prudent Liabilities Subordinated Debt } after making any adjustments for a Capital Adequacy Supervisory Adjustment Amount. Legislation The concentration of assets test can be found in clause 4, subclause 2(b) of Schedule 3 (Capital Adequacy Standard) in the proposed legislation (see Appendix 1). Case Study: Capital Adequacy Standard, concentration of assets test For Insurer XYZ, the left-hand side of the above calculation equals: The right-hand side equals: $200m - $10m = $190m $111.9m - $20m = $91.9m There is no Capital Adequacy Supervisory Adjustment Amount. XYZ complies with the concentration of assets test in the Capital Adequacy Standard. 35 Technical details of the proposal PHIAC
Capital Management Policy As outlined in the overview of the proposals above, insurers would be required to have a Boardendorsed Capital Management Policy for each health benefits fund comprising: a capital management plan; a pricing philosophy; and investment rules. The rules surrounding the required inclusions under each of these are described in more detail below, along with the proposed rules on maintenance of the Policy. The means by which insurers satisfy the required inclusions would be entirely at the insurers discretion. Capital management plan The capital management plan would, necessarily, centre on the Board s risk appetite, which would be described in the plan (along with the processes used to determine it). Having done so, the plan would quantify: capital targets; and capital trigger points and the corresponding management actions that would occur at those trigger points both of which would reflect the risk appetite of the Board, the insurer s ability to raise further capital for the fund, the impact on future premium increases of maintaining any particular capital level, and any other practical considerations that the insurer considers important. The method of measurement for each of these values would be entirely at the insurer s discretion, but it would be required that the insurer uses probabilistic methods in their determination. Pricing philosophy The pricing philosophy would describe the insurer s ongoing approach to pricing under all foreseeable circumstances and, as such, would need to reference profitability targets and how different profitability levels (including the target) would impact capital levels. Any practical considerations which might impact the speed at which profitability deviations from the target are corrected would need to be outlined. 36 Technical details of the proposal PHIAC
Investment rules As with the other elements of the capital management plan, the details of these rules would be entirely at the insurer s discretion, although they should be constructed in a way that depends on the capital strength of the fund and includes: clear objectives; asset class allocation limits; concentration limits; and liquidity requirements. Maintenance The Policy itself would need to include rules around when it should be reviewed, which would occur at a minimum of every two years. Having reviewed the Policy, the Board would need to either reendorse it, or develop and endorse a revised Policy. Other circumstances which would trigger a review would include changes, of a size or type determined appropriate by the insurer, to: membership growth rates; registration status of the insurer (i.e. open, closed, for-profit and/or not-for-profit); profitability; and economic conditions. Legislation The requirements of the Capital Management Policy can be found in clause 15 of Schedule 3 (Capital Adequacy Standard) in the proposed legislation (see Appendix 1). 37 Technical details of the proposal PHIAC
Solvency Standard As described in the overview of the proposals above, the proposed Solvency Standard consists of two tests. The first of these tests, the liquidity test, is designed to ensure that the fund has sufficient high quality liquid assets to meet three months of stressed liquidity needs. Stressed liquidity needs over the next three months can theoretically be split into those arising from four sources: timing mismatches that might arise between cash inflows and outflows; regular seasonality that occurs in benefit outgoes; stressed net margin and other business losses; and volatility in the path by which those losses emerge. Intuitively, the amount of liquid assets required against all of these needs would be related to a fund s premium income. For some needs, the appropriate percentage would not be correlated to the size of the insurer (in particular seasonality, and a large component of timing mismatches) the Cash Management Amount is designed to cover these needs. For the others (in particular the size of adverse losses and volatility in the emergence of such losses), the appropriate percentage would be correlated to the size of the insurer the Stressed Losses Amount is designed to cover these needs. The requirement would be that only the highest quality liquid assets (i.e. the Band 1 Qualifying Assets) would be available to meet the Cash Management Amount, while all of the qualifying liquid assets (i.e. both the Band 1 and Band 2 Qualifying Assets) would be available to meet the combination of the Cash Management Amount and the Stressed Losses Amount. The second test, the concentration of liquid assets test, is designed to ensure that the fund would still have enough high quality liquid assets after the failure of any one counterparty (or related group of counterparties). Cash Management Amount This amount is designed to represent a cash buffer that funds would need to hold to ensure that they are able to survive potential timing mismatches that may occur between cash inflows and cash outflows, as well as seasonality that may occur in benefit outgoes. 38 Technical details of the proposal PHIAC
The Cash Management Amount would be calculated as 8% of the fund s Health Business Revenue Estimate for the next 12 months. The Health Business Revenue Estimate is the insurer s estimate of revenues from health insurance business and health related business over the next 12 months and would have already been produced in calculating the Stress Test Amount in the Capital Adequacy Standard. PHIAC s view is that the formula provides an adequate approximation to the true amount of cash a fund would need to hold against such needs with the desired probability of adequacy (i.e. 98%). Legislation The Cash Management Amount is defined in clause 6 of Schedule 2 (Solvency Standard) in the proposed legislation (see Appendix 1). Case Study: Cash Management Amount calculation As described under the Capital Adequacy Standard above, Insurer XYZ s 12 month Health Business Revenue Estimate is $235m. The Cash Management Amount is therefore: $235m x 8% = $18.8m Stressed Losses Amount This amount is designed to represent a cash buffer that funds would need to hold to ensure that they are able to survive adverse losses that may arise in the fund over the next three months. As well as being able to fund the overall size of such losses, liquidity needs would require consideration of the path by which these losses emerge. It is calculated by the following formula: Stressed Loss Amount = Health Business Revenue Estimate min ( [ 0.62 SEUs ^ -0.22 ], 13% ) The term in the square brackets above yields a percentage by which the Health Business Revenue Estimate is multiplied. This percentage is smallest for large funds, reflecting: a) the smaller expected size of adverse losses for larger funds; and b) the lower volatility in the emergence of such losses for larger funds, 39 Technical details of the proposal PHIAC
stemming from the larger pooling of risks available to larger insurers. The cap of 13% prevents the percentage becoming unmanageably large for very small insurers. Table 3 below gives some examples of this multiplier for funds of different sizes: Table 3: example multipliers Number of SEUs Multiplier 10,000 8.2% 50,000 5.7% 100,000 4.9% 500,000 3.5% 2,000,000 2.5% As accurate calculation of a 98% sufficient solvency requirement would require very complex statistical analysis, PHIAC has instead preferred a simple formulaic approach, in conjunction with consideration of liquidity needs as part of the Capital Management Policy. The simplified methodology and formula to approximate the true extent of the risks involved reflects the philosophies behind the review of the Standards. Legislation The Stressed Losses Amount is defined in clause 7 of Schedule 2 (Solvency Standard) in the proposed legislation (see Appendix 1). Case Study: Stressed Losses Amount calculation As described under the Cash Management Amount, Insurer XYZ s 12 month Health Business Revenue is $235m. It has 100,000 SEUs (also required for the Prudent Liabilities Amount calculation under the Capital Adeuqacy Standard). Its Stressed Losses Amount is therefore: $235m min( [ 0.62 100,000 ^ -0.22 ], 13% ) = $235m min ( 4.9%, 13% ) = $11.6m 40 Technical details of the proposal PHIAC
Qualifying Assets All of the assets which qualify for Solvency purposes are intended to be high quality and liquid. Since stressed liquidity needs take the form of a core requirement (the Cash Management Amount) and a secondary requirement (the Stressed Losses Amount), it is appropriate that qualifying assets are also split, by quality and liquidity, into two bands (Band 1 Qualifying Assets and Band 2 Qualifying Assets), described below. Band 1 Qualifying Assets These are assets which are of the highest liquidity and are expected to remain so over any reasonably foreseeable future stressed circumstances. The definition of Band 1 Qualifying Assets takes the form of the following prescribed list of asset types: cash cash equivalents 1 ; and assets with an Australian government counterparty (excluding any amounts owed to the fund in relation to the Risk Equalisation Trust Fund) 2. Band 2 Qualifying Assets These assets are designed to provide a secondary source of liquidity behind the Band 1 Qualifying Assets. These assets comprise of securities listed on the ASX or a principal foreign exchange 3. However, to cover uncertainty in the values of these assets at the time liquidation is required, only half of their market value may contribute to the Band 2 Qualifying Assets. Furthermore, only those assets that 1 The definition of cash equivalents is taken from the Australian Accounting Standards Board i.e. short-term, highly liquid investments that are readily convertible to known amounts of cash and which are subject to an insignificant risk of changes in value 2 This definition is designed so that it incorporates Australian government bonds and any receivables relating to the PHI rebate 3 Principal foreign exchanges would be the Frankfurt Stock Exchange, Hong Kong Stock Exchange, London Stock Exchange, NASDAQ, New York Stock Exchange, Shanghai Stock Exchange, Tokyo Stock Exchange and Toronto Stock Exchange 41 Technical details of the proposal PHIAC
the Board of the insurer is satisfied could be readily converted to cash under highly stressed market scenarios may contribute to the Band 2 Qualifying Assets. Indirect exposures Many insurers have significant indirect exposures to Qualifying Assets, for example through managed funds. It is only the liquidity of direct exposures (e.g. the exposures to these managed funds) that should be considered against the Band 1 and Band 2 Qualifying Assets criteria. In certain cases, some of the managed fund exposure could contribute towards the qualifying assets total, for example where: the managed fund is listed on the ASX or another principal foreign exchange; and/or the managed fund can reasonably be considered a cash equivalent. 42 Technical details of the proposal PHIAC
Legislation Band 1 and Band 2 Qualifying Assets are defined in clause 5 of Schedule 2 (Solvency Standard) in the proposed legislation (see Appendix 1). Case Study: Band 1 and Band 2 Qualifying Assets calculation Insurer XYZ holds $200m of assets as follows: Cash $50m Deposits which the Board of the insurer determines are cash $30m equivalents Other deposits $10m Australian government bonds $10m Corporate bonds $30m Equities listed on the ASX which the Board of the insurer $20m determines would lose 50% in highly stressed market conditions Equities listed on the ASX which the Board of the insurer $10m determines would lose >50% in highly stressed market conditions Property $20m Other non-financial instruments $20m Total $200m The Band 1 Qualifying Assets therefore total $90m, made up of the $50m cash, the $30m cash equivalents and the $10m government bonds. The Band 2 Qualifying Assets total $10m, made up of half of the $20m equities that the Board determines could be readily converted to cash in highly stressed market conditions. Solvency Maximum Default Loss Amount The Solvency Maximum Default Loss Amount is part of the concentration of liquid assets test, which is designed to ensure that a single asset default could not cause a fund s highly liquid assets to fall to a dangerously low level of less than 60% of its Cash Management Amount. It measures the maximum loss that could occur from a default event amongst the counterparties of its Band 1 Qualifying Assets. Its derivation is essentially the same as that for the Capital Adequacy Maximum Default Loss Amount, except that only counterparties of the Band 1 Qualifying Assets are under consideration. 43 Technical details of the proposal PHIAC
The principles behind the derivation of the Solvency Maximum Default Loss Amount are: only the direct counterparty exposures of the assets explicitly counted as Band 1 Qualifying Assets (and not any indirect counterparty exposures) should be considered; exposures to Australian government counterparties are not considered when calculating the Solvency Maximum Default Loss amount; exposures to ADIs do fall under consideration; and the concept of related counterparties applies. Legislation The Solvency Maximum Default Loss Amount is defined in clause 9 of Schedule 2 (Solvency Standard) in the proposed legislation (see Appendix 1). Case Study: Solvency Maximum Default Loss Amount calculation As seen above, Insurer XYZ has $90m of Band 1 Qualifying Assets, made up of: $50m of cash a $30m cash account with Bank A and a $20m cash account with Bank B (both Bank A and Bank B are ADIs); $30m of cash equivalents a $15m deposit account with Bank A and a $15m deposit account with Bank B; and $10m of government bonds. Banks A and B are unrelated. XYZ s Solvency Maximum Default Loss Amount is therefore $45m (the total exposure to Bank A). Solvency Supervisory Adjustment Amount In a similar way to the Capital Adequacy Supervisory Adjustment Amount, to cater for unusual circumstances, PHIAC would have the capacity to apply a Solvency Supervisory Adjustment Amount which could adjust any element comprising the liquidity and concentration of liquidity assets tests. Its application could arise when the calculation of any of the other elements in those tests prove inadequate, and would be applied only after extensive examination of the particular area of risk and in-depth discussion and consultation with the affected insurer. 44 Technical details of the proposal PHIAC
Legislation The Solvency Supervisory Adjustment Amount is defined in clause 8 of Schedule 2 (Capital Adequacy Standard) in the proposed legislation. Case Study: Solvency Supervisory Adjustment Amount calculation PHIAC is satisfied that Insurer XYZ has correctly determined all the elements of the liquidity test and the concentration of liquid assets test, and that the resultant amounts do provide the desired level of protection. As such, no Solvency Supervisory Adjustment Amount is applicable to either asset test. Liquidity test The liquidity test now checks that, having calculated all of the amounts above, there are sufficient Band 1 Qualifying Assets and sufficient qualifying assets (i.e. Band 1 Qualifying Assets and Band 2 Qualifying Assets) as a whole. The test, as depicted in Chart 3, requires that both: 1. Band 1 Qualifying Assets Cash Management Amount and 2. Band 1 Qualifying Assets + Band 2 Qualifying Assets Cash Management Amount + Stressed Losses Amount 45 Technical details of the proposal PHIAC
after making any adjustments for a Solvency Supervisory Adjustment Amount. Legislation The liquidity test can be found in clause 4, subclause 2(a) and clause 3 of Schedule 2 (Solvency Standard) in the proposed legislation (see Appendix 1). Case Study: Solvency Standard, liquidity test Insurer XYZ passes both of the tests which comprise the liquidity test. For test 1, XYZ s Band 1 Qualifying Assets ($90m) are greater than the Cash Management Amount ($18.8m). For test 2, XYZ s Band 1 and Band 2 Qualifying Assets ($100m) are greater than the Cash Management Amount plus the Stressed Losses Amount ($30.4m = $18.8m + $11.6m). Concentration of liquid assets tests The concentration of liquid assets test, as depicted in Chart 4, now checks that: { Band 1 Qualifying Assets Solvency Maximum Default Loss Amount } 60% Cash Management Amount after making any adjustments for a Solvency Supervisory Adjustment Amount. Legislation The concentration of liquid assets test can be found in clause 4, subclause 2(b) of Schedule 2 (Solvency Standard) in the proposed legislation (see Appendix 1). Case Study: Solvency Standard, concentration of liquid assets test For Insurer XYZ, the left-hand side of the above calculation equals $45m (= $90m - $45m), which exceeds the right-hand side of $11.3m (=60% $18.8m). Hence XYZ complies with the concentration of liquid assets test in the Solvency Standard. 46 Technical details of the proposal PHIAC
Reporting requirements associated with the proposed Standards Reporting requirements under the proposed Standards would be broadly the same as those under the extant Standards. The specific information collected in, and design of, the regular statutory reporting form would be updated to reflect the new Standards. There would be some additional reporting requirements surrounding the Stress Test and Capital Management Policies. Regular reporting The timing of the regular reporting requirements relevant to the Standards would be unaltered, namely: Quarterly PHIAC2 returns; and Annual audited PHIAC2 Quarterly returns As per the extant Standards, insurers would be required to submit quarterly financial reports to PHIAC via the quarterly PHIAC2 return form. The PHIAC2 form is designed so that PHIAC has sufficient financial (and other) information to understand the financial strength of the fund at the end of the quarter, and its performance since the end of the previous quarter. This, therefore, includes reporting on compliance (or otherwise) with the Standards. It is not necessary for this form to be externally audited. As such, the PHIAC2 form will need to be redesigned from its current format in order to incorporate the proposed changes to the Standards. PHIAC will use the opportunity to incorporate any other changes to the PHIAC2 form that are necessary or desirable. The QIS2 form to be released soon after this discussion paper has been designed as a proposed revision of the PHIAC2 form. The form, reflecting the proposed Standards and other improvements, provides an opportunity to align systems and processes with proposed reporting requirements prior to implementation of the new Standards. 47 Reporting requirements associated with the proposed Standards PHIAC
As required by PHIAC Occasionally PHIAC may require insurers to demonstrate their compliance with the Standards at times other than those covered by the regular reporting requirements (see legislation for regular quarterly reporting above). Legislation The requirement to report compliance on a quarterly basis, or as otherwise required by PHIAC, can be found in clause 4, subclause 4 of Schedule 2 (Solvency Standard) and clause 4, subclause 4 of Schedule 3 (Capital Adequacy Standard) in the proposed legislation (see Appendix 1). Annual returns As per the extant Standards, insurers would be required to submit an annual PHIAC2 return form (of exactly the same format as the quarterly PHIAC2 return form) which has been externally audited. This would represent the financial position of the fund as at 30 June each year, with analysis of its financial performance over the previous 12 months. Conditional reporting Non-compliance Insurers would be required to notify PHIAC immediately in the event of non-compliance with either the Solvency or Capital Adequacy Standard. Since insurers are required to comply with both Standards at all times, such an event and its consequent report to PHIAC could occur at any time during the year (and not just at the end of each financial quarter). Legislation The requirement to report non-compliance immediately can be found in clause 4, subclause 5 of Schedule 2 (Solvency Standard) and clause 4, subclause 4 of Schedule 3 (Capital Adequacy Standard) in the proposed legislation (see Appendix 1). 48 Reporting requirements associated with the proposed Standards PHIAC
Potential non-compliance The proposed legislation for these Standards would not include any obligation for insurers to report to PHIAC in the event that they anticipate, with a certain level of probability, non-compliance at some future point in time. However, any such obligation would appear in the Private Health Insurance (Insurer Obligations) Rules 2009, which are currently also under review by PHIAC and will be open for consultation shortly. Capital management policy The capital management policy (as described in above) would need to be submitted to PHIAC, in full, on (or before) inception of the new Standards. At least every two years, the Board of the insurer would need to either re-endorse the existing policy or endorse a new policy. Every time a policy is re-endorsed or new policy endorsed, the insurer must submit that policy, in full, to PHIAC. Stress Test methodology At, or before, the inception of the new Standards, each insurer must submit to PHIAC its methodology and output from the calculation of the Stress Test Amount. This submission would need to be of sufficient detail in order to satisfy PHIAC that the resultant asset requirement provides a 98% probability of adequacy against insurance, market and credit risks. The output would be required in the same format as in the PHIAC2 return, but the communication of the methodology used would be at the discretion of insurers. It would be at each insurer s own discretion how often and when to review the methodology, assumptions and data used to calculate the Stress Test Amount. Whenever a material change is made to the methodology or the nature of the assumptions or data underpinning the Stress Test, the insurer would need to immediately notify PHIAC of the change. It would be at the responsibility of the insurer to determine whether or not a change is material. The review of insurers Stress Test methodologies would form part of PHIAC s ongoing monitoring and review of all funds. PHIAC would not formally approve methodologies or assumptions, but would provide informal feedback. 49 Reporting requirements associated with the proposed Standards PHIAC
Expected impacts of the proposal PHIAC does not expect that the changed asset requirements under the proposed Standards, as compared to the capital requirements under the extant Standards, would be significantly detrimental to the prudential position of any insurers indeed, many insurers would have significantly less onerous requirements. However, there would be several new responsibility requirements, which would impact insurers, as well as the costs associated with the transition to new Standards. Implementation phase and transition Process impacts of changing Standards PHIAC anticipates that elements of the proposed Standards, as described above, would require either: the adaption of an existing process, where the calculation depends on analysis performed elsewhere e.g. for the accounting standards; or the development of a new but simple process, where the calculation is a prescribed formula;. In relation to the Stress Test, PHIAC expects that its calculation would require many insurers to either develop new processes, or make at least moderate changes to existing processes. PHIAC expects that it would be necessary for many insurers to seek expert advice, such as from Appointed Actuaries. However, as outlined above, PHIAC s view is that it is critical for insurers to be closely engaged with the risks inherent in their private health insurance business. Although the transition costs would be highest for those insurers that do not already conduct risk analyses in the manner proposed, the benefits (from the enhanced understanding of risks that the Standards would facilitate) would also be highest for those insurers. In order to assist insurers in making the necessary process changes, QIS2, which will follow this discussion paper, has been designed with the intention that it reflect as closely as is possible the final format of the future PHIAC2 reporting form. 50 Expected impacts of the proposal PHIAC
Once insurers have developed and implemented systems and processes to calculate the proposed Standards, PHIAC expects that ongoing costs associated with compliance monitoring and reporting would be similar to or less than those incurred under the extant Standards. The Stress Test should require similar levels of ongoing attention to the current renewal option and resilience amounts, and there are significant simplifications in other elements of the proposed Standards. Expected impact of new asset requirements PHIAC has closely analysed insurers submissions from QIS1a in order to understand the potential impacts of the changes to the Standards as proposed in DP1. It was as a result of this analysis that many of the changes between the proposals in DP1 and DP2 arose. PHIAC has modelled potential outcomes under the Standards as proposed in this paper by applying judgment to adapt QIS1a submissions, and incorporating its own views on the potential future experience for different funds. The findings of this analysis are summarised below. Capital Adequacy Standard: o Quantum of assets test for almost all insurers the resulting asset requirement was similar to or less than the requirement under the extant Standard; o Concentration of assets test due to, in general, the high exposures to ADIs, most insurers would pass this test comfortably. Solvency Standard: the proposed solvency requirements are, in combination, significantly smaller than the extant requirement, but they can only be met with restricted assets. PHIAC s assessment is that virtually all insurers would pass this test comfortably. Future compliance Once implemented, the ongoing operation of the Standards would require input from: the Boards of insurers; the management of insurers; the Appointed Actuaries of insurers; and PHIAC. The responsibilities of each of these is summarised in the following chart, and described in more detail below: 51 Expected impacts of the proposal PHIAC
Chart 5: Responsibilities under the proposed Standards Feedback Industry data Issue supervisory adjustments The insurer The Board Set direction Challenge Question Management PHIAC Enforce Standards Monitor compliance Review insurer systems Reporting Keep informed Ensure compliance Institute Capital Management Policy Report to PHIAC Respond Keep informed Calculate asset requirements Build and maintain systems Build regulatory reports Adhere to Capital Management Policy Challenge Question Keep informed Notifiable circumstances Advice Assistance Appointed Actuary FCR Statutory review and sign-offs Advice on notifiable circumstances Responsibilities of the Board Compliance with the asset requirements It would be the responsibility of the Board to ensure that the insurer is compliant with both the Solvency and Capital Adequacy Standards. Compliance would include passing each of the asset tests at all times, as well as meeting the reporting requirements described above. The Board would therefore need to ensure that each element of the Standards is properly calculated. In the case of the principles-based requirements, this would involve the Board understanding the nature of the risks for which the insurer s management will have determined the appropriate asset requirement. PHIAC regards it as a crucial element of improving insurers engagements with their risks that the Boards of the insurers can, and do, question and challenge the assumptions and methodology adopted by the insurers management and Appointed Actuaries. 52 Expected impacts of the proposal PHIAC
In addition, the definition of the Band 2 Qualifying Assets in the Solvency Standard explicitly requires that the Board be satisfied that the assets included meet the criteria. Legislation The requirement that the Board ensure compliance can be found in clause 1, subclause 5 of Schedule 2 (Solvency Standard) and clause 1, subclause 4 of Schedule 3 (Capital Adequacy Standard) in the proposed legislation (see Appendix 1). The Board requirement under the Band 2 Qualifying Assets can be found in clause 5, subclause 2(a) of Schedule 2 (Solvency Standard) in the proposed legislation. Compliance with the Capital Management Policy requirement The Board would also be required to endorse the insurer s Capital Management Policy, which the insurer is required to review at least every two years. After a review, the Board would be required to either endorse the new Policy, or re-endorse the existing Policy. In practice, endorsement means that the Board is saying that they are comfortable that the insurer s management runs the business in accordance with the Policy. Since the Policy includes fundamental business decisions including target levels of capital and profitability and investment rules, all of which would reflect the Board s risk appetite, it is expected that Board members would need to play a significant role in the development of the Policy. Legislation The requirement that the Board review and endorse the Capital Management Policy can be found in clause 15, subclause 3 of Schedule 3 (Capital Adequacy Standard) in the proposed legislation (see Appendix 1). 53 Expected impacts of the proposal PHIAC
Responsibilities of management Assessing compliance Although the Board would be responsible for ensuring compliance with the Standards, the insurer s management would play a critical role in developing and maintaining the systems and processes that would be used to assess compliance with the asset requirements under the Standards. Whilst it is encouraged that management seek independent advice in this regard, for example from the Appointed Actuary, ownership of the processes, and responsibility for any calculations would rest with the insurer. Reporting to PHIAC The Insurer would also need to report compliance to PHIAC, as described above. Adhering to the Capital Management Policy Management would need to ensure adherence to the Capital Management Policy in the day-to-day operations of the business. Regulatory oversight responsibilities The improved risk measurements of the proposed Standards should, of themselves, result in greater clarity over the capital position of insurers and reduce the need for regulatory intervention. As currently occurs, insurers could expect discussions with PHIAC regarding business plans, experience, assumptions formulation and capital management policy (and related policies). The proposed Standards should continue to provide a sound basis for routine regulatory interaction between the insurer and PHIAC. Insurers would continue to be encouraged to manage their risks effectively and, in many cases, would be better positioned to engage with PHIAC in discussion about their approach to risk and capital management. Responsibilities of the Appointed Actuary Responsibilities of the Appointed Actuary are detailed in the Appointed Actuaries Standard, which contained within the Private Health Insurance (Insurer Obligations) Rules 2009. These rules, as they currently stand, reflect the current Solvency and Capital Adequacy Standards and, as such, it is necessary that they be updated to incorporate two consequential changes to the Standards. Firstly, the Appointed Actuary s obligation to assess the reasonableness of any discretionary margin adopted by the insurer for the purpose of assessing the capital adequacy of a fund would instead refer to assessing the reasonableness of the stresses applied as part of the Stress Test. 54 Expected impacts of the proposal PHIAC
Secondly, a new notifiable circumstance will be inserted in relation to the failure to meet an 18 month version of the Stress Test. Non-compliance PHIAC does not expect that the processes involved when either heightened regulatory oversight or intervention is necessary would change significantly from those that exist under the current Standards. However, PHIAC intends to release a Standard Operating Procedure (SOP) that will detail how these processes will work under the proposed Standards. Transitional arrangements The only area that PHIAC regards transitional provisions as being necessary is in relation to previously existing approved subordinated debt. PHIAC proposes that these arrangements would continue to count in respect of the proposed standards, but would be wound down over time. PHIAC does not envisage that ensuring compliance with either Standard on the implementation date would cause insurers any difficulty which would require transition relief, as: all insurers are expected to comply with the asset tests without the need for significant management action, with the possible exception of some changes to asset allocations; most of the requirements on systems and processes necessitated by the new Standards would either be already in place or relatively straightforward for insurers to adapt towards; and a reasonable period of time is being provided for insurers to adapt systems and processes to reflect the new Standards in the areas where larger scale changes are necessary. 55 Expected impacts of the proposal PHIAC
Next steps & invitation to comment This paper provides detail of the proposed modifications to the Standards for private health insurers. PHIAC invites you to comment on the proposals herein. It is important to note that these proposals are included for discussion and comment, and that the Council has yet to endorse any proposal as regulatory requirement. All information (including name and address details) relating to a submission will be made publicly available via PHIAC s website, and may be referenced in future PHIAC papers and reports with the exception of QISs, which will be treated as confidential. If you prefer that some of your submission remains in confidence, the confidential material should be clearly identified and included in a separate attachment. You should carefully consider the information contained in your submission as the confidentiality of your response might be affected by legal requirements such as the Freedom of Information Act 1982. PHIAC welcomes responses received by 31 July 2013. Responses can be sent to: Chief Executive Officer Private Health Insurance Administration Council PO Box 4549 KINGSTON 2604 or emailed to phiac@phiac.gov.au 56 Next steps & invitation to comment PHIAC
Appendix 1 proposed legislation 57 Appendix 1 proposed legislation PHIAC
Private Health Insurance (Health Benefits Fund Administration) Amendment Rule 2013 (No. 1) 1 Private Health Insurance Act 2007 The Private Health Insurance Administration Council makes the following rule under section 333-25 of the Private Health Insurance Act 2007. Dated 2013 [DRAFT ONLY NOT FOR SIGNATURE] Commissioner of Private Health Insurance Administration 1 Name of rule This rule is the Private Health Insurance (Health Benefits Fund Administration) Amendment Rule 2013 (No. 1). 2 Commencement This rule commences on 31 March 2014. 3 Amendment of Private Health Insurance (Health Benefits Fund Administration) Rules 2007 Schedule 1 amends the Private Health Insurance (Health Benefits Fund Administration) Rules 2007. DRAFT ONLY