SUBMISSION TO THE HIH ROYAL COMMISSION FUTURE POLICY DIRECTIONS FOR THE REGULATION AND PRUDENTIAL SUPERVISION OF THE GENERAL INSURANCE INDUSTRY

SUBMISSION TO THE HIH ROYAL COMMISSION FUTURE POLICY DIRECTIONS FOR THE REGULATION AND PRUDENTIAL SUPERVISION OF THE GENERAL INSURANCE INDUSTRY AUSTRALIAN PRUDENTIAL REGULATION AUTHORITY SEPTEMBER 2002

EXECUTIVE SUMMARY The Australian Prudential Regulation Authority (APRA) welcomes this opportunity to make a submission to the HIH Royal Commission on Policy Directions for the Regulation and Prudential Supervision of General Insurance. Future policy directions cannot be developed in an historical vacuum. A proper appreciation of the existing framework for prudential supervision of general insurers is a critical preliminary to any attempt to devise further development. In particular, proper account must be taken of the comprehensive and radical changes that have flowed from the amendments to the Insurance Act 1973 and the issue of Prudential Standards by APRA effective from July 2002. It must be recognised that in large part the prudential regime under which HIH was supervised has been replaced. APRA was created in 1998 as the single prudential supervisor for Australia s financial sector supervising, as well as general insurance companies, banks, building societies, credit unions, life insurance companies, friendly societies and superannuation funds. Our role with respect to general insurance is to reduce the probability that an authorised insurer will fail to pay its contractual obligations to policyholders when due, and to reduce the severity of loss to policyholders should such a failure occur. It is important to note that it is not APRA s objective to prevent failure in all circumstances, nor to guarantee that policyholders can never suffer loss. The nature of financial institutions, which earn profits by taking and managing risk, means that there is always a possibility that an institution will encounter adverse outcomes that will be beyond its financial capacity. It is also impossible for regulation to guarantee absolute protection against losses following gross mismanagement and/or deception in financial institutions. As a result, failure by a regulated entity can and will occur even within a well-regulated industry. Until July 2002, the supervision of the general insurance industry, including the HIH group, was governed by the prudential requirements set down by the Insurance Act 1973. These requirements were inadequate being limited in scope, inflexible and open to evasion and manipulation. APRA s new prudential regime as set out in the Prudential Standards issued under the revised Insurance Act significantly strengthens the supervisory framework applying to general insurers in Australia. Had these Standards been in place in earlier years, we believe they would have provided both better warning signals, and the grounds for earlier intervention in the HIH group. The most important provision of the new Insurance Act is the power for APRA to issue Prudential Standards (section 32). Pursuant to this section APRA has issued four key Prudential Standards that impact on the financial soundness and the corporate governance of authorised insurers. These Standards significantly upgrade the rigour with which insurers must value their insurance liabilities and assess their capital adequacy, and impose much higher standards of governance on an insurer s Board and management. APRA is of the view that these Standards reduce the capacity for insurers to act

imprudently, and increase the scope for APRA to detect and respond to signs of emerging difficulties. A major weakness of the prudential and accounting regime under which HIH operated was that an insurer s Board and management had too much discretion in valuing their insurance liabilities. Insurers could choose what, if any, level of prudential margin should be included within their liability valuations, could select a discount rate of their own choosing, and need not consider their future liabilities on existing policies on a prospective basis (ie did not need to provide for evident under-pricing of risk). There was also no obligation on insurers to seek or follow actuarial advice on the value of their insurance liabilities. As a result, the process of liability valuation was largely opaque to the supervisor, and more so for policyholders and investors. In its Prudential Standard on Liability Valuation APRA has eliminated much of the potential for subjectivity in liability valuation. The Standard requires an insurer to have an actuary approved by APRA, and the actuary to provide written advice to the Board on the value of the insurer s liabilities on an annual basis. Furthermore the actuary must ensure that the insurance liabilities are valued to a level of 75% sufficiency, that the riskfree rate be used to discount future cash flows, and that future liabilities be considered on a prospective basis. Had these requirements been in place prior to HIH s collapse, the group s balance sheet would have looked significantly different, and its financial difficulties would have been apparent much earlier. Similarly, the regulatory solvency or capital adequacy requirements in the Insurance Act 1973, which applied to the Australian insurers within the HIH group, were weak and arbitrary, and provided perverse incentives to under-provide for claims and under-price for risk. APRA s new Prudential Standard on Capital Adequacy, which came into force in July 2002, provides a far more rigorous, risk-based methodology for measuring an insurer s financial soundness. It is also more transparent, better able to deal with changes in market conditions, and is more consistent with the modern supervisory practices applied in the life insurance and banking sectors. Ensuring appropriate corporate governance and risk management arrangements are in place is just as important for a prudential supervisor as is examining an insurer s financial strength. APRA recognised shortly after its establishment in 1998 that the prudential regime at that time provided little in the way of guidance or minimum requirements in relation to corporate governance. The new Prudential Standards seek to establish strong governance and risk management arrangements within Australian authorised insurers. New requirements include minimum standards in relation to Board composition, the creation of Audit Committees, fit & proper tests for directors, senior managers, auditors and actuaries (with APRA having the capacity to remove persons who, in its view, do not meet these tests), clearly documented risk management strategies, and annual attestations to APRA by Boards that they are adhering to legislative and prudential requirements and have established appropriate internal reporting and control mechanisms. While no regulatory and reporting system can provide total protection against deliberately deceptive behaviour by regulated entities especially where collusion is present at senior ii

levels APRA s new prudential regime has significantly enhanced the system of checks and balances that will reduce the likelihood of such behaviour proceeding undetected. The shift in the style of prudential supervision implied by the new supervisory regime introduced in July 2002 is probably most obvious in the area of reinsurance. APRA is shifting its supervision from a transaction focussed, return-based regime to a regime which emphasises that the primary responsibility for establishing and managing reinsurance arrangements rests with the insurer s Board of Directors. APRA s energies will be more productively deployed reviewing the reinsurance strategies adopted by insurers, and building its capacity to undertake more intensive analysis and inquiry, including of individual transactions, when complex issues and concerns arise. When coupled with the substantial improvements being made to APRA s internal supervisory processes, the new Prudential Standards summarised above significantly reduce the possibility of further failures in the general insurance sector. They greatly strengthen the prudential regime compared with that which applied to the Australian insurers within the HIH group. Notwithstanding this considerable progress, further work is required before all significant weaknesses in the regulatory framework for general insurance have been addressed. Areas for further policy reform include: Given the increasing trend for insurers to operate as part of a complex corporate group, and/or in a range of jurisdictions using multiple legal entities, there remains a considerable risk that adverse developments in unsupervised activities could damage the soundness of the Australian insurer. For this reason, we believe that the next stage of reform for the prudential supervision of general insurance must include a component of consolidated supervision, including capital adequacy requirements measured on a group-wide basis. Prudential supervisors around the world are increasingly focussing on the capacity of disclosure and market discipline to act as an ally of the supervisor. Market discipline has the potential to reinforce capital regulation and other supervisory efforts to promote safety and soundness in financial institutions, by creating strong incentives for insurers to conduct their business in a safe, sound and efficient manner. APRA intends to examine means by which it can increase the level of disclosure about the activities of insurers, both in terms of its own data collection and by increasing the information flow from insurers themselves. Notwithstanding the important revisions of the Insurance Act, we believe that the legislation remains deficient in a number of areas and that further legislative amendments are necessary. These amendments would include important initiatives designed to increase APRA s enforcement powers and independence, and enhance our capacity to deal with insurance-type activities that presently do not come within the ambit of the Act, as well as a range of administrative issues. Ultimately, of course, legislative changes are matters for Government consideration and decision. iii

Some further strengthening of governance and assurance mechanisms may be warranted to deal with lessons learnt from the failure of the HIH group. These involve both the expansion of existing aspects of the prudential regime for example, extending whistle-blowing protections beyond the Approved Auditor and the Approved Actuary and the introduction of new requirements, such as for a Financial Condition Report similar to that which is required annually in the life insurance sector. In its prudential supervision activities, APRA seeks to reduce the probability that a general insurer will find itself in a position in which it cannot meet its obligations to policyholders. However, given the nature of the insurance business, we cannot guarantee that a policyholder will never suffer loss from the failure of an Australian insurance company. Therefore, we believe it appropriate that the existing arrangements for the protection of policyholders be reviewed, and consideration be given to the establishment of formal compensation mechanisms. This is ultimately a matter of Government policy. At present, APRA is required to operate with a series of industry-based Acts that, in many cases, contain disparate powers in relation to the same issue. This creates unnecessary complexity in training staff and in establishing a consistent supervisory approach. It also has the potential to significantly complicate APRA s capacity to act in the event of difficulties within a financial conglomerate (eg an entity involving banking, life insurance, general insurance and superannuation). Beyond further amendments to the Insurance Act 1973, we believe a broader review of APRA s legal infrastructure is required to make APRA more consistent and efficient as an integrated prudential supervisor, as envisaged by the Wallis Inquiry. APRA has had preliminary discussions with the Government on this issue. iv

TABLE OF CONTENTS 1. INTRODUCTION... 2 2. A SHORT HISTORY OF THE SUPERVISION OF GENERAL INSURANCE... 4 3. THE ADEQUACY OF THE NEW PRUDENTIAL FRAMEWORK FOR GENERAL INSURERS... 7 3.1 LEGISLATIVE FRAMEWORK... 8 3.2 PRUDENTIAL STANDARDS... 9 3.2.1 Liability Valuation... 10 3.2.2 Capital Adequacy... 13 3.2.3 Governance and Risk Management... 16 3.2.4 Reinsurance... 21 3.2.5 Regulatory Reporting... 23 4. FUTURE POLICY DEVELOPMENT... 27 4.1 CONSOLIDATED SUPERVISION... 28 4.2 DISCLOSURE... 31 4.3 APRA S LEGAL POWERS... 34 4.4 IMPROVEMENTS TO AUDIT, ACTUARIAL AND OTHER ASSURANCE MECHANISMS... 38 4.5 COMPENSATION ARRANGEMENTS... 43 4.6 AN INTEGRATED LEGAL INFRASTRUCTURE FOR APRA... 49 5. THE INTERACTION OF COMMONWEALTH, STATE & TERRITORY GOVERNMENTS...51 6. THE IMPACT OF TAXATION ON THE GENERAL INSURANCE MARKET... 53 Attachment 1... 55 Attachment 2... 58 Attachment 3... 60 Attachment 4... 63 Attachment 5... 65 Attachment 6... 70 Attachment 7... 72 Attachment 8... 75 Attachment 9... 80 Attachment 10... 85 Attachment 11... 105

SUBMISSION TO THE HIH ROYAL COMMISSION This submission is in response to the request of 22 May 2002 by the HIH Royal Commission, seeking views on the future policy directions for the regulation and prudential supervision of general insurance. The views expressed in this submission are those of APRA, and do not necessarily represent the views of the Commonwealth Government. The topics covered by this submission are structured to be broadly consistent with the Commission s request. However, some additional items have been included, reflecting issues that APRA believes could usefully be reviewed by the Royal Commission under its terms of reference. Some other aspects of the Commission s request have not been covered, as they deal with areas that are beyond APRA s mandate and hence are items on which we do not wish to offer a view. This submission focuses on the policy framework for the prudential supervision of general insurance. It does not describe in detail the changes in APRA s internal supervisory processes applying to general insurers these have changed significantly in the past two years and will change further in the future. Australian Prudential Regulation Authority September 2002

1 INTRODUCTION APRA was created in 1998 as the single prudential supervisor for Australia s financial sector supervising, as well as general insurance companies, banks, building societies, credit unions, life insurance companies, friendly societies and superannuation funds. Our role with respect to general insurance is to reduce the probability that an authorised insurer will fail to pay its contractual obligations to policyholders when due, and to reduce the severity of loss to policyholders should such a failure occur. It is important to note that it is not APRA s objective to prevent failure in all circumstances, nor to guarantee that policyholders can never suffer loss. The nature of financial institutions, which earn profits by taking and managing risk, means that there is always a possibility that an institution will encounter adverse outcomes that will be beyond its financial capacity. It is also impossible for regulation to guarantee absolute protection against losses following gross mismanagement and/or deception in financial institutions. As a result, failure by a regulated entity can and will occur even within a well-regulated industry. With respect to the regulation of general insurance companies in Australia, APRA is responsible for their prudential supervision. 1 The prudential supervision of general insurers has two primary objectives: to reduce the probability that an authorised insurer will fail to pay its contractual obligations to policyholders when due; and to reduce the severity of loss to policyholders should such a failure occur. Prudential supervision is accepted world-wide as a necessary component of the regulation of financial institutions. As the Wallis Committee noted, prudential supervision involves the imposition of rules and standards designed to ensure financial institutions operate in such a manner as to promote a high degree of confidence that they will be able to continue to meet their financial promises to customers. The emphasis of prudential supervision, therefore, is to encourage prudent management by the managers of financial institutions themselves, and to intervene in any cases where the risk of failure is high. The primary emphasis, therefore, is on the avoidance of problems rather than penalising those who may be found to have caused problems. That is not to say that legal sanctions and penalties for those found to have breached prudential rules are not important, but that their value is greatest as an important deterrent mechanism for ensuring regulated institutions remain within the bounds of the prudential framework. In relation to general insurance, prudential supervision involves the establishment of a system of: mandatory licensing for companies wishing to offer general insurance to the public; on-going operational requirements (eg Prudential Standards) designed to ensure that, as far as practicable, the insurer is managed in a prudent fashion; 1 APRA is also the prudential supervisor for banks, building societies, credit unions, life insurance companies, friendly societies and superannuation funds. 2

procedures and processes for monitoring compliance with licence conditions and ongoing operational requirements; and where necessary, undertaking enforcement action to either force a non-compliant company into compliance, or remove it from the industry. Such a system of prudential supervision is designed to ensure that, in all reasonable circumstances, financial promises to policyholders by general insurers are met. It is not APRA s goal (nor should it be APRA s goal) to prevent failure in all circumstances, or to guarantee that policyholders can never suffer loss. To even attempt to do so would require extremely burdensome regulation, which would stifle the efficiency of the industry to the detriment of the general community, 2 and even then could not provide an absolute guarantee against failure. As a result, failure by a regulated entity can and will occur even within a well-regulated industry. The nature of financial institutions, which earn profits by taking and managing risk, means that there is always a possibility that the institution will encounter adverse outcomes that will be beyond their financial capacity. Similarly, prudential supervision is unable to guarantee that fraudulent activities, particularly where this involves collusion, cannot occur. Recent insurance company failures in the United Kingdom (eg Independent) and North America (eg Reliance) illustrate this general point. 3 Attachment 1 provides further data on general insurance insolvencies over the past three decades and is evidence that the failure of an insurer is, unfortunately, not an uncommon event. Nor does prudential supervision seek to minimise losses to shareholders or other creditors. Indeed, the prudential supervisor may at times be required to sacrifice the interests of other parties to ensure that its beneficiaries (ie policyholders) are protected. This emphasises an important distinction between the roles of APRA and the Australian Securities and Investments Commission (ASIC). ASIC is responsible for ensuring that all classes of investor are appropriately dealt with in accordance with the Corporations Act 2001. It is therefore primarily a legal regulator, i.e. it is concerned with the enforcement of legal rights and obligations, and the punishment of those that break the law. APRA, on the other hand, is primarily an economic regulator, in that it is trying to influence and limit the financial activities of regulated entities to remain within prudent bounds. Reflecting the rationale for prudential regulation noted above, APRA s remit covers only the financial sector (as distinct from ASIC s interest in all forms of commercial activity) and our focus, with respect to general insurance, is on the prevention and minimisation of loss by policyholders due to institutional failure. 2 3 The trade-off between regulation and market efficiency is recognised within the Australian Prudential Regulation Authority Act 1998. APRA is required under s8(2) of the Act to balance the objective of financial safety with considerations of efficiency, competition, contestability and competitive neutrality. The website of the US National Association of Insurance Commissioners (www.naic.org) reports 16 insurers, including HIH s US-based business, were placed into liquidation or receivership in 2001, with a further 7 insurers in rehabilitation. Between 1983 and 2001, an average of 14 general insurers were placed into liquidation, receivership or rehabilitation each year in the US. 3

2 A SHORT HISTORY OF THE SUPERVISION OF GENERAL INSURANCE Until APRA s establishment in 1998, the prudential supervision of general insurance was undertaken by the ISC. The ISC s approach to supervision was, by and large, relatively unobtrusive, relying almost solely on off-site supervision. After taking responsibility for general insurance supervision, APRA sought to introduce a system of supervision that was more in keeping with modern supervisory practices. Such a system included both an improved policy framework which is covered in detail in this submission and a corresponding strengthening of supervisory processes. Any framework of prudential policies can be fully effective only if it is complemented by a proactive and comprehensive supervisory approach. Prior to APRA s formation, prudential supervision of the general insurance sector was undertaken by the General Insurance Division of the Insurance & Superannuation Commission (ISC). The ISC supervised the sector in accordance with the requirements of the Insurance Act 1973. By and large, the ISC relied on off-site supervision to fulfil its responsibilities: for example, the review of quarterly and annual statistical returns, the review and approval of reinsurance arrangements, and the review and (where appropriate) approval of related party assets for inclusion with the insurer s solvency calculations. Occasional short meetings were also held between the ISC and insurers. In summary, the ISC s supervision was, on the whole, relatively light, with no regular on-site review processes, limited use of legislative provisions for inspections, and only a small supervisory staff (around 10-12 staff supervising about 160 authorised insurers). The Financial System Inquiry was established by the Federal Government in 1996, and was chaired by Mr Stan Wallis. In its final report, released in March 1997, the Wallis Committee recommended, amongst other things, a reorganisation of the regulatory agencies overseeing the financial sector. This included the establishment of a single prudential supervisor governing deposit-takers, insurance companies and superannuation funds. APRA s establishment required the integration of supervisory resources from the Reserve Bank of Australia (RBA), the ISC and seven State-based organisations. The objective of establishing a single agency, rather than continuing to operate multiple, industry-based agencies, was to: offer regulatory neutrality and greater efficiency and responsiveness; provide a sound basis for regulating conglomerates; offer greater resource flexibility and economies of scale in regulation; and provide the flexibility and breadth of vision to cope with changes in the financial system. Following the Government s acceptance of this Wallis Committee recommendation, APRA was established on 1 July 1998. In its initial stages, the organisation was primarily a combination of the Bank Supervision Department of the RBA and the prudential regulatory functions of the ISC. In late 1998, APRA s head office was established in Sydney, and 4

supervisory staff from the RBA and some (mostly Sydney-based) ISC staff transferred to its new premises. Interstate offices were also established in Melbourne, Canberra, Brisbane, Adelaide and Perth (largely by assuming the offices used by the ISC). Additional supervisory responsibilities were transferred to APRA in 1999, when various State-based supervisors for building societies, credit unions and friendly societies were merged into the organisation. Once APRA had obtained its full suite of responsibilities, a new organisational structure (termed New APRA ) was established in the latter part of 1999; some Canberra-based ISC staff then moved to the APRA head office to undertake senior management and frontline supervisory roles. The new organisation structure involved moving away from the industry-based silos that had existed during the transitional first year of operation to an integrated structure more in keeping with the philosophy espoused by the Wallis Committee. It is notable that the Wallis Committee itself did not recommend widespread changes to specific supervisory processes or standards. However, the very process of establishing a single prudential supervisor charged with, amongst other things, enforcing consistent regulatory approaches and standards across industry sectors did provide APRA with a significant mandate for regulatory reform both of the prudential standards that it applied to supervised entities, and of the corresponding supervisory processes by which those standards were enforced. This mandate was a significant driver of the general insurance reforms discussed in detail later in this submission. In reforming the prudential regulation of general insurance, APRA sought to introduce a policy framework and a supervisory approach that were reflective of the organisation s desired style of supervision one that is: based on the premise that that management and Boards of supervised institutions are primarily responsible for financial soundness; forward-looking; primarily risk-based; consultative; consistent; and in line with international best practice. A revised regulatory policy framework for general insurers which we believe is consistent with these objectives was introduced in July 2002 and is discussed in detail in the remainder of this submission. Importantly, the new policy framework has been accompanied by the (continuing) evolution of APRA s supervisory processes. This has involved in the past year: a significant increase in the number of staff involved in general insurance supervision; 5

changes to the style of off-site supervision (e.g. new reporting requirements and data analysis tools (see section 3.2.5), more detailed analysis of governance and risk management processes); a structured program of on-site reviews of all insurers, including the creation of a dedicated Insurance Risk team; and the recruitment of additional specialist staff. Changes currently being implemented include: the roll-out of a new risk rating framework, in which all regulated entities will be assessed using a consistent methodology (APRA s Probability and Impact Rating System (PAIRS)); and building from the PAIRS rating, a Supervisory Oversight and Response Systems (SOARS) designed to bring high risk/impact entities earlier to the attention of senior management, ensure appropriate supervisory strategies are implemented in a timely manner, and to provide mechanisms for tracking compliance (or otherwise) with those supervisory strategies. A stronger policy framework, without the capacity to adequately monitor and enforce it, will not achieve its objectives. Similarly, a strong supervisory process will be hampered if the policy framework is weak. We believe that the new policy framework, coupled with the enhanced supervisory processes that APRA has developed, produces a significantly strengthened prudential regime compared with that under which the HIH group was supervised. 6

3 THE ADEQUACY OF THE NEW PRUDENTIAL FRAMEWORK FOR GENERAL INSURERS Until July 2002, the supervision of the general insurance industry, including the HIH group, had been limited by the prudential requirements set down by the Insurance Act 1973. Under this Act, the prudential supervision regime applying to general insurers was inadequate being limited in scope, inflexible and open to evasion and manipulation. APRA s new prudential regime as set out in the Prudential Standards issued under the revised Insurance Act significantly strengthens and modernises the supervisory framework applying to general insurers in Australia. While some areas have been identified for further work (both in terms of additional legislative reform, and further strengthening of APRA s Prudential Standards), we believe the new framework substantially strengthens the prudential requirements applying to general insurers and, had it been operating in earlier years, would have provided both better warning signals, and the grounds for earlier intervention in the HIH group. In March 1995, the ISC recognised that improvements to the prudential regime for general insurance were probably warranted. To facilitate this, two working groups were established with the Institute of Actuaries of Australia (IAAust) the Working Group on the Consistency and Reliability of Outstanding Claims and the Working Group on the Determination of Solvency Standards for General Insurers. As the names implied, these groups examined the potential for improvement to the existing requirements in relation to liability valuation and solvency, and two reports were provided to APRA in March 1999. Around the same time the newly-formed APRA Board, in some of its earliest deliberations on APRA s initial policy priorities, recognised that the general insurance framework was an area within its prudential responsibilities that required a significant overhaul. The Insurance Act 1973, which serves as the basis for regulation of the general insurance sector, and the prudential regime that had been designed around it, were seen as out-of-date. However, more important than the passing of time itself was the pace of change that has been evident in the financial sector over the period, the developments in corporate governance processes, and the dramatic improvements in risk measurement and management practices within financial institutions, particularly over the 1990s. As a result, the scope of the reforms was expanded beyond the technical issues of liability valuation and solvency to a more comprehensive approach that encompassed improvements in governance and risk management as well. The objectives of the reforms were to create a supervisory regime that: makes it clear that the Act is designed to protect policyholders and beneficiaries of insurance policies; responds to the risk profile of an insurance company; is more transparent; is capable of adapting over time to developments in the market and improvements in supervisory techniques; 7

is more consistent with other supervisory regimes administered by APRA; is in line with international codes and standards including, in particular, the IAIS Core Principles; and minimises restriction on competition and compliance costs for industry where these restrictions and costs cannot be justified on cost/benefit grounds. A full chronology of events leading up to this point is contained in Attachment 2. It demonstrates that the reform process was lengthy, reflecting the highly contentious nature of many of the measures being proposed, and involved considerable consultation with interested parties: the insurance industry, foreign supervisors, auditors, accountants, actuaries, lawyers, consultants, and individual members of the public. The key milestones were the passage through Parliament in August 2001 of the General Insurance Reform Act 2001, and the subsequent finalisation of the supporting Prudential Standards in February 2002. Most insurers have now successfully made the transition to the new framework, which took effect from 1 July 2002. 3.1 Legislative Framework Recent amendments to the Insurance Act 1973 have substantially upgraded APRA s supervisory capacity, and provided a range of powers that were not available to assist in the supervision of HIH. These will substantially strengthen APRA s capacity to identify and intervene more promptly with problem companies in the future. The revised Insurance Act 1973 came into effect on 1 July 2002. The revised Act is a significant improvement on the previous legislation, offering a range of benefits designed to improve the flexibility of the regime to respond to changes in market conditions; harmonise the regulatory requirements between general insurers and other financial institutions supervised by APRA; and increase the protection provided to policyholders of general insurers, commensurate with the risks involved. This has been achieved by: the insertion of an objective section (section 2A) to make it clear that the Act is designed to protect policyholders; the insertion of a power (section 32) allowing APRA to make subordinate Prudential Standards for general insurers. A large proportion of the prudential supervisory requirements set out in the Insurance Act were repealed and replaced with modernised and refined requirements within new Prudential Standards administered by APRA; the inclusion of the requirement (section 33) that APRA consult insurers (at a minimum) on the development of Prudential Standards, so as to ensure Standards being imposed are both prudentially and commercially realistic; the addition of powers (section 36) that allow APRA to issue directions to an insurer if APRA is satisfied that the insurer has breached, or is likely to breach, the Prudential Standards; 8

the inclusion of new powers (section 18) that allow APRA to authorise non-operating holding companies (NOHCs). The authorisation of NOHCs is an important step towards consolidated supervision for insurance groups (see section 4.1). the inclusion of new rules (sections 40-45) governing the appointment, duties and termination of an APRA approved actuary. The Insurance Act has also been amended to allow APRA to disqualify auditors and actuaries, and to refer matters to the auditing or actuarial professional associations (section 48). the addition of an obligation (section 49A), consistent with the Life Insurance Act 1995, for actuaries and external auditors to report certain matters to insurers and APRA (whistle-blowing responsibilities). the imposition of fit & proper requirements (sections 27, 42) on directors, senior managers, actuaries and auditors; and the provision of greater certainty as to the procedures for the effective transfer and amalgamation of insurance businesses (Division 3A). The effect of these amendments has been to significantly upgrade APRA s capacity to supervise general insurance companies. They also give effect to a prudential regime that is substantially in compliance with the IAIS Insurance Core Principles. 4 In particular, the provision for the issuance of legally-binding Prudential Standards facilitates a major shift in the structure and process of supervision, by establishing APRA as the primary driver of the prudential framework applying to insurers in Australia. This will ensure that the Prudential Standards are not only more flexible, but can be kept up-to-date with developments within the industry, as well as within financial markets, accounting rules and other influences on the financial well-being of insurance companies. Most of the legislative amendments that APRA sought during the reform process have been included within the revised Insurance Act 1973, and we are pleased that the Government accepted the need for these reforms. That said, there are still a number of areas where, in APRA s view, legislative shortcomings remain. These areas for further review are discussed in more detail in Section 4.3. 3.2 Prudential Standards An important addition to APRA s regulatory powers, introduced by the General Insurance Reform Act 2001, was the power to issue Prudential Standards applying to general insurance companies. Pursuant to this section APRA has issued four key Prudential Standards that now apply to all authorised general insurers in Australia (two other Standards were also issued, covering primarily administrative matters). These Standards impact on both the financial soundness and governance of authorised insurers: they significantly upgrade the rigour with which insurers value their insurance liabilities and assess their capital adequacy, and impose 4 Attachment 3 provides a short summary of Australia s compliance with the IAIS Insurance Core Principles. 9

much higher standards of governance on an insurer s Board and management. APRA is of the view that the Prudential Standards reduce the capacity for insurers to act imprudently, and increase the scope for APRA to detect and, importantly, act upon signs of emerging difficulties. When coupled with APRA s improved supervisory processes, the Standards significantly reduce but do not eliminate the possibility of further failures within the general insurance sector. As discussed above, APRA has been pursuing reforms to the prudential framework for general insurance since its establishment. These were introduced through the General Insurance Reform Act 2001 and associated Prudential Standards from 1 July 2002, and will significantly strengthen APRA s supervisory oversight of Australian insurers. The new Prudential Standards that form part of this framework will introduce more consistent valuation of liabilities, mandatory actuarial advice, more discriminating risk-based capital requirements and greater attention to corporate governance, including risk management strategies. While the new framework will significantly enhance APRA s powers and improve its capacity to oversee the activities of insurers, it also recognises that regulation cannot, of itself, guarantee a sound and healthy industry. Insurers will also be provided with larger incentives and obligations to improve the quality of their risk management, internal control and governance systems, recognising that it is primarily the responsibility of each insurer s Board and senior management to ensure that the company is prudently managed. The key improvements with respect to each of APRA s new Prudential Standards are discussed below. 3.2.1 Liability Valuation A major weakness of the prudential and accounting regime under which HIH operated was that an insurer s Board and management had too much discretion in valuing their insurance liabilities. Insurers could choose what, if any, level of prudential margin should be included within their liability valuations, could select a discount rate of their own choosing, and need not consider their future liabilities on existing policies on a prospective basis (ie did not need to provide for evident under-pricing of risk). There was also no obligation on insurers to seek actuarial advice on the value of their insurance liabilities. As a result, the process of liability valuation was largely opaque to the supervisor, and more so for policyholders and investors. APRA has eliminated much of the potential for subjectivity within the liability valuation process by mandating that an insurer must have an actuary approved by APRA, and having that actuary provide written advice to the Board on the value of the insurer s liabilities on an annual basis. Furthermore, in providing that advice, the actuary must ensure that the insurance liabilities are valued to a level of 75% sufficiency, that the risk-free rate be used to discount future cash flows, and that future liabilities be considered on a prospective basis. Had these requirements been in place prior to HIH s collapse, the group s balance sheet would have looked significantly different, and its financial difficulties would have been far more apparent much earlier. 10

One of APRA s key objectives throughout the reform process was to improve the consistency and reliability of the valuation of insurance liabilities. From a prudential perspective, AASB 1023 provided insurers with too much latitude for adjusting their provisioning practices due to profit, taxation or other considerations. 5 Primarily, this was due to the absence, within the accounting standard, of any requirement for a risk margin as part of the valuation process, but also reflected the absence of sufficient guidance on the choice of discount rates, and the failure to consider the risk of future claims from existing policies on an actuarially-assessed, prospective basis. When coupled with the complex nature of the valuation process for insurance liabilities, and relatively weak disclosure requirements, the adequacy of provisions has been difficult for the supervisor let alone policyholders, investors and creditors to assess. Given that under-provisioning, coupled with management weaknesses, are the typical cause of insurance company failure, the lack of consistency, reliability and transparency in liability valuation was an issue that, in APRA s view, required attention. The new Prudential Standard GPS 210 Liability Valuation for General Insurers seeks to deal with many of the weaknesses that we perceive, from a prudential perspective, in AASB 1023. The new Standard requires insurers to establish a risk margin within their liability valuation so as to increase the likelihood that provisions will be adequate, allow for the inherent uncertainty in valuing insurance liabilities, and recognise that the fair value of insurance liabilities will be some value greater than the central estimate itself. Specifically, the new Standard requires liabilities to be valued on a basis that is intended to cover the insurance liabilities of the insurer at a given level of sufficiency that level is 75 per cent. 6 During the consultation period on the new Prudential Standards, there was a great deal of opposition to APRA establishing a mandatory 75% level of sufficiency. While there was little disagreement that risk margins over and above the central estimate are a necessary component of valuing insurance liabilities, there was little acceptance that the 75th percentile is necessarily the appropriate level to mandate. Many submissions argued that some flexibility was necessary, while a limited number claimed that the supervisor should not even attempt to be prescriptive on this issue. Most submissions also noted that the 75th percentile did not necessarily equate to fair or market value. Despite this opposition, APRA remained of the view that, in the absence of clear accounting standards on fair value, a mandated risk margin is necessary to ensure sufficiently objective, reliable and consistent valuation of insurance liabilities. However, no alternative to the 75th percentile was proposed that met APRA s policy objectives. APRA acknowledges that the 75th percentile is an arbitrary proxy for fair value, in that it has not been derived from the extensive analysis of a wide range of insurance portfolios. However, we remain of the view 5 6 While this is not intended to suggest that wide-spread abuse of the accounting rules has occurred, it is notable that in many recent instances where insurance companies have encountered financial difficulties, the absence of risk margins, and the failure to adequately provision for under-priced products, have been prominent contributing factors. See paragraph 10 of GPS 210. Also, paragraph 11 notes that due to the highly skewed nature of some insurance distributions, the level of sufficiency established in paragraph 10 may result in a value regarded as insufficient for prudential purposes. Therefore, the risk margin should not be less than one half of the coefficient of variation for the insurance liabilities of the insurer. 11

that its simplicity more than offsets any potential drawbacks from its general application. Once the accounting standards are updated to produce a more meaningful and rigorous methodology for establishing the fair value of a portfolio of insurance liabilities, APRA will examine whether this can be incorporated within its Prudential Standards. It is also worth noting that, while each insurer s Approved Actuary is required to provide a written report to the insurer s Board on the value of the insurer s liabilities, valued in accordance with GPS 210, the Board is not obliged to adopt that figure within the insurer s financial accounts. The Board retains the right to choose to set the value of its insurance liabilities at a different level, but must inform APRA of the decision, and should disclose the fact in its published financial accounts. This aspect of the new liability valuation requirements is important, as it preserves the fundamental principle that it is ultimately the responsibility of the insurer s Board (not the Approved Actuary, or APRA) to set the value of its insurance liabilities, but at the same time ensures that APRA and other interested parties are informed when an insurer steps away from what is regarded as good practice. GPS 210 also seeks to reduce the flexibility in valuation techniques by mandating that the discounting of future liabilities is to occur at the risk-free rate (ie the government bond rate). While there are conceptual arguments why other discount rates might be superior (eg the rate of return on the insurer s investment portfolio), we believe that, as a practical matter, the value of an insurer s liabilities is typically independent of the value of the underlying assets. For this reason, a discount rate that is observable, market-based and objective is most appropriate. The choice of the Government bond rate provides a degree of transparency and consistency that outweighs the benefits of other options. Finally, and in many respects most significantly, GPS 210 requires insurers to make provision for their premium liabilities: that is, future claim payments arising from future events insured under existing policies. The premium liabilities are to be determined on a fully prospective basis, both net and gross of expected reinsurance recoveries, and include an amount in respect of the internal expenses that the insurer expects to incur in administering the policies and settling the relevant claims. AASB 1023, on the other hand, allows insurers to simply allocate unearned premium payments against their future exposure to policies in force at the balance date. In a market where significant under-pricing can often occur as insurers seek to maintain or build market share, we believe such an approach can significantly understate the potential liabilities of the insurer. GPS 210, by requiring an actuarial assessment of future potential claims, avoids this problem by immediately bringing to account any apparent under-pricing, ie an insurer that under-prices will need to bring to account the income, and the up-front recognition of future claims, in the current accounting period (rather than allowing the loss to be deferred into future periods when the actual claims emerge). This aspect of the reform proposals was strongly contested during the consultation period, with many submissions expressing concern that the proposal was contrary to existing accounting standards. The prospective accounting approach that the concept of premium liabilities requires has another important benefit it prevents some of the accounting practices that the Royal Commission has uncovered that allowed financial reinsurance to be used to distort reported profitability. By bringing to account in the current period all future obligations and expected claims under a policy (be it direct insurance or reinsurance), an insurer will no longer be 12

permitted to recognise up-front benefits while at the same time deferring future costs. (Indeed, it could be argued that this should not have been permitted under existing accounting standards, but the new accounting framework should remove any discretion that is currently available). A simple example of the APRA accounting methodology applied to a financial reinsurance contract is contained in Attachment 4. The role of the actuary within the new prudential framework, and in particular the actuary s relationship with the Board, is still evolving and inevitably there will be some difficulty for actuaries in being satisfied that they have met their more onerous obligations under the amended Insurance Act 1973 and the new Prudential Standards. 7 This teething period is understandable, and APRA will need to continue to work with the actuarial profession to ensure the new framework is bedded down as quickly as possible. To assist this process, APRA has developed a guidance note (GGN 210.1 Actuarial Opinions and Reports on General Insurance Liabilities) as a temporary measure until the IAAust is able to develop its own professional standard. APRA has also assisted with the IAAust s development process, by providing a member of the IAAust Task Force charged with developing the new professional standard, and by co-sponsoring a study by consulting firm Tillinghast to provide some interim guidance to actuaries with respect to the setting of risk margins. Notwithstanding the need to continue to work to improve the ability of actuaries to perform their important duties, we believe the GPS 210 is a significant improvement on the requirements of AASB 1023, and should materially strengthen the consistency, reliability and transparency of insurance liability valuation from a prudential perspective. Of course, we will review the Standard in light of developments in the proposed international accounting standard for insurance, and any modifications the Australian Accounting Standards Board might subsequently make to AASB 1023. 8 However, while we would hope that further work could lead to a single accounting standard that both the accounting profession and supervisors are satisfied with, we reserve the right to continue to impose different and/or additional requirements where we think that prudential considerations require it. 3.2.2 Capital Adequacy The capital adequacy (or regulatory solvency) requirements set out in the Insurance Act 1973, and which applied to the Australian insurers within the HIH group, were undoubtedly weak, and provided perverse incentives to under-provide for claims and under-price for risk. APRA s new Prudential Standard on capital adequacy, which came into force on 1 July 2002, provides a far more rigorous, risk-based methodology for measuring an insurer s financial soundness. It is also more transparent, able to deal with market developments more easily, and is more consistent with the modern supervisory practices applied in the life insurance and banking sectors. 7 8 Further discussion on the role of Approved Actuaries is contained in Section 3.2.3. A comparison between the views of IASB (as expressed in its 1999 Insurance Issues Paper) and APRA s new liability valuation framework is contained in Attachment 5. 13

Building on the foundation of more consistent liability valuation, APRA s new capital adequacy requirements GPS 110 Capital Adequacy for General Insurers are designed to overcome the deficiencies of the old solvency regime. 9 Prior to the introduction of the new Prudential Standards, insurers were required by the Insurance Act 1973 to maintain net assets which exceeded the greater of: $2 million; 15% of the outstanding claims provision; and 20% of annual premium income. APRA s primary objective in moving away from this simple but relatively crude solvency framework was to introduce greater risk sensitivity into the regulatory capital requirement that is, to better align regulatory capital requirements with the underlying risk profile of each individual insurer. The simplistic regime provided by the pre-july 2002 version of the Insurance Act in which an insurer can lower its net asset requirement by under-pricing or under-providing for outstanding claims provides incentives which are clearly at odds with our objective. The new system is a significant step forward in removing many of the previously perverse incentives and is more clearly focussed on the risks facing each company. No regulatory framework based on simple factors can hope to perfectly measure the capital needs of a regulated entity, but APRA is strongly of the view that the new system provides a much better measure than the one it succeeded. APRA also sought to develop a measure of capital adequacy that is clearer and more transparent than that provided by the old framework. The old regime made comparisons difficult for the supervisor, let alone the rest of the community. Even assuming assets and liabilities were appropriately valued, anyone trying to rate or rank the solvency position of an insurer would need to know, for example, whether a risk margin had been employed, what discretionary s30 assets may or may not have been approved, and what maximum event retention (MER) existed within the reported solvency buffer. The new framework, although slightly more complicated to calculate, provides a standardised measure of the minimum requirement, and more importantly, the amount by which an insurer exceeds that requirement. APRA also aimed to introduce a regime that can evolve to accommodate market developments. The new Standards already allow for the use of innovative capital instruments and term subordinated debt to meet minimum capital requirements. The flexibility of the standard-setting process also means further changes can be incorporated in a timely manner. 9 APRA decided to use the term capital adequacy for all institutions, rather than solvency, which has been used in the past in the insurance industry. The term capital adequacy was chosen as it helps to distinguish regulatory terminology from the normal commercial use of the term solvency, and better reflects the goal of supervisory requirements; that is, that institutions not just be commercially solvent, but maintain an adequate level of capital to support the risks inherent within their on-going activities. 14