Australian Prudential Regulation Authority

Chapter 2 - APRA's supervisory activities in 2010/11
Authorised deposit-taking institutions
Authorised deposit-taking institutions (ADIs) in Australia benefitted from a broadly supportive economic environment during 2010/11. The global economy continued to expand and conditions in global funding markets were generally favourable. The Australian economy showed underlying strength, with low unemployment and the boost of a record terms of trade, but the growth pattern was uneven. The resources sector boomed but cautious behaviour by households and businesses and the high level of the exchange rate had a significant dampening effect in other sectors. Growth was also disrupted for a time by a series of natural disasters. For the ADI industry, the prevailing tone of caution was reflected in two developments. One was the continued subdued pace of credit growth, still at its lowest rate since the early 1990s recession. Housing lending grew only moderately and business lending, despite some more recent positive signs, remained in the doldrums. The second development was the strong growth in deposits, well in excess of the growth in credit, which has had important and positive implications for ADI funding patterns. Asset quality remained sound and non-performing loan ratios, incorporating some temporary impacts from the natural disasters, were steady overall. Provisions as a percentage of total lending declined slowly from their earlier peak.
Notwithstanding the subdued growth in credit, the profitability of the ADI industry as a whole strengthened in 2010/11, largely as a consequence of further reductions in bad debt expenses. Interest margins were broadly steady. For the largest ADIs, profits were above pre-crisis levels but the recovery in profits by some other ADIs has been slower. Continued profit retention and dividend reinvestment schemes have pushed total capital ratios for the ADI industry to their highest levels since the early 1990s, and Tier 1 ratios (the best quality capital) to record levels. The substantial industry consolidation spurred by the crisis appears to have run its course to this point but credit union numbers have continued to decline through mergers.
Liquidity and funding
Since the severe dislocations to global funding markets that first marked the crisis, the management of liquidity and funding by ADIs has remained under APRA's close supervisory watch. An enhanced range of supervisory activities related to liquidity and funding is now embedded in APRA's routine supervision work. At least annually, supervisors expect ADIs to prepare a forward-looking plan with specific quantitative funding targets. Benchmarking analysis conducted by APRA allows supervisors to compare expectations for asset growth across ADIs and how they expect this growth will be funded. Supervisors are alert to issues such as aggressive expectations about deposit growth relative to peers, or increasing reliance on short-term wholesale funding or securitisation. Regular discussions are held with ADI treasurers on their funding plans and targets.
In addition, supervisors monitor a range of liquidity measures on a monthly (or in some cases more frequent) basis including, for example, liquid asset levels and composition, upcoming wholesale funding maturities, the average duration of wholesale funding and trends in the share of funding sourced from offshore. Unusual changes or outliers are raised for explanation, in some cases at the ADI board level. APRA is increasingly seeing liquidity metrics, such as stable funding ratios or deposit/ loan ratios, incorporated into the liquidity risk appetite targets of ADIs.
During 2010/11, APRA asked all large, locally incorporated ADIs to undertake a self-assessment of their liquidity risk management, including the identification of funding gaps and closure plans, against the Basel Committee on Banking Supervision's Principles for Sound Liquidity Risk Management and Supervision. APRA established a team of frontline supervisors, liquidity risk specialists and policy staff to consider these self-assessments, allowing a detailed institution-specific review and an industry-wide comparison. Generally speaking, the ADIs involved either meet the principles already or are well placed to enhance their risk management frameworks where current practice falls short. Common areas for further development relate to stress-testing, contingency planning and liquidity risk transfer pricing. APRA has observed that many ADIs need to enhance the range and severity of their current stress-testing suite, link stress-tests more explicitly to contingency planning and use stress-testing to assist the board in determining its risk appetite. ADIs recognise the value of the discipline of transfer pricing for liquidity risks but acknowledge a need to drive this discipline deeper into the decision-making of the institution. APRA has been following up on any significant issues with relevant ADIs as part of its normal supervision of liquidity risk management.
Since the crisis, ADIs have substantially improved their funding positions. They have built up their liquidity buffers as a contingency against market disruptions and have made significant changes to the structure of their liabilities. In particular, ADIs have been able to reduce their reliance on short-term wholesale funding because of strong growth in retail deposits and they have taken advantage of good market opportunities to lengthen the maturity profile of their funding books.
These improvements have left ADIs better placed to meet new global liquidity and funding requirements, although these remain some way off (see Chapter 3). With an eye to the requirements, ADIs have been looking carefully at the stability characteristics of different types of funding instruments and their underlying terms and conditions. In the case of term deposit contracts between ADIs, APRA identified instances of asymmetric treatment, where the ADI that had placed the term deposit was treating it as an asset that can be readily converted into cash but the ADI that had received the deposit was treating it as a liability with a contractual final maturity. APRA wrote to ADIs in December 2010 setting out its expectations for the symmetric treatment of term deposit contracts. The consequence has been a material reassessment of liquid asset holdings by some ADIs.
More immediately, the improved funding position of ADIs will help them better withstand the stresses in global funding markets that have re-emerged over recent months. These stresses had initially been confined to bank funding markets in the euro area, reflecting increasing concerns about the exposure of European banks to sovereign debt problems in Europe and to each other, but stresses have now extended to all term funding markets. The larger Australian ADIs that tap global funding markets have retained good access to short-term funding, although spreads have been widening, and they are, in any event, ahead of targets on their wholesale funding. As a consequence, ADIs could survive a period without access to global funding provided domestic markets continue to operate relatively normally. However, any protracted dislocation that extended well into 2012 would start to coincide with wholesale debt maturities, in a market likely to be crowded by sovereigns and banks offshore.
The securitisation market in Australia, an important source of funding and capital management for regional banks and other ADIs before the crisis, showed further signs of improvement in 2010/11. The volume of new issuance was at its highest since the crisis, spreads tightened and support from the Australian Office of Financial Management was not needed for a number of issues. Notwithstanding this improvement, investor caution is still such that the originating ADI has been required to retain all, or nearly all, of the most subordinated tranche(s) of the issue, where credit risks associated with the securitisation transaction are concentrated. Longstanding prudential policy, in Australia and globally, is that ADI originators can only claim regulatory capital relief on securitisations if there has been significant credit risk transfer to third parties. In reviewing recent securitisations, APRA found that some originating ADIs had been applying this policy appropriately while others had not. Against this background, APRA wrote to ADIs in August 2010 restating its policy in this area and clarifying those features of securitisations that would not be consistent with the requirements for capital relief. Following discussions with industry, APRA wrote again to ADIs in December 2010 outlining an alternative capital treatment it was prepared to approve, as an interim measure, for securitisations that did not meet APRA's prudential requirements because of inadequate credit risk transfer.
Credit quality
APRA's traditionally close oversight of ADI credit quality has changed in focus though not in intensity over the past couple of years. In the early phase of the crisis, APRA paid greatest attention to corporate and commercial property exposures. The latter exposures were the cause of significant losses for ADIs in previous downturns and that proved the case again for some ADIs. Commercial property exposures have been the main source of the increase in ADI impaired assets since 2007 and were over-represented on ADI 'watch lists'. In response, affected ADIs have scaled back both the volume and the concentration of their commercial property lending and have tightened underwriting requirements, applying more conservative loan-to-valuation ratios (LVRs) and stronger covenants. They have also given clear priority to maintaining existing relationships with longer-term property borrowers over the pursuit of new financing opportunities. The rise in the share of commercial property and corporate exposures that is impaired appears to have peaked.
During 2010/11, APRA shifted its attention to credit quality in ADI housing lending. Non-performing loan ratios for housing lending remain low by historical and international standards but ratios have been drifting steadily upwards, particularly amounts past due, for which the (temporary) impact of recent natural disasters provides only part of the explanation. This upward drift has occurred in the context of higher mortgage interest rates, unprecedented low growth in housing lending, intensifying competition and signs of pressure on credit standards. APRA is also well aware of a view abroad that the ADI industry in Australia has a particular vulnerability in housing lending because balance sheets have become concentrated on this form of lending and, on some objective measures, Australian housing prices are viewed as overvalued.
Against this background, APRA wrote to the boards of the larger ADIs active in housing lending to remind them of the need to be alert to any deterioration in housing lending standards. APRA also sought assurances from each board that:
Each of the boards concerned provided those assurances. One theme to emerge from the responses was that, although boards are active in monitoring the performance of housing lending portfolios, they do not always involve themselves in a pre-emptive way in setting housing lending standards; many are only informed of material changes to policy after the event. APRA expects that boards will take a close interest in housing lending standards and not intervene to amend these standards only after signs of trouble. In its follow-up, APRA will be seeking further information from a number of ADIs about the basis on which their boards provided the assurances APRA sought. APRA will also be reviewing the supervisory action plans for those ADIs that could be lapsing into poor underwriting practices, to ensure that the quality of housing lending remains at the forefront of APRA's supervision.
Living wills
In the wake of the global financial crisis, global policymakers have committed to strengthening the powers and tools available to supervisory agencies to restructure or resolve financial institutions in crisis. This initiative is encapsulated in the term 'living will'. A living will refers to two separate but related matters: recovery plans and resolution plans. Recovery planning focuses on measures that would enable a financial institution to survive a severe crisis, such as through strategies for raising additional capital, accessing liquidity or disposing of non-core business. Resolution planning focuses on measures that would enable a cost-effective resolution of the institution by the authorities where recovery is not possible, such as through simplifying complex group structures to facilitate resolution. Recovery and resolution planning are related in that both deal with distress events that threaten the viability of a financial institution and both seek to achieve a resolution that minimises adverse systemic impact, at the lowest risk to taxpayers.
In July 2011, the Financial Stability Board released for consultation a set of proposals on resolution that encompass recovery and resolution plans; though aimed at systemically important financial institutions, the proposals also apply in principle to any regulated financial institution. The living will concept has been adopted by supervisory agencies in a number of countries and is increasingly becoming a core element of prudential supervision.
Against this background, APRA has begun its own work on living wills. Its initial priority is recovery planning in the ADI industry. In the latter part of 2010/11, APRA established a pilot program on recovery planning for a number of the larger ADIs. This will require the ADIs to prepare a comprehensive recovery plan that sets out the specific actions they would take to restore themselves to a sound financial condition in the face of a major depletion of capital and associated liquidity pressures. Draft recovery plans will be required by the end of 2011. Finalised plans, signed off by the board of each ADI, will be required by mid 2012. APRA intends to extend its recovery planning program to a wider set of ADIs in 2012/13 once the results of the pilot program have been analysed. Recovery planning is also likely to be extended to the larger general insurers and life insurers in due course, modified to suit the nature of their business. APRA will also be undertaking an assessment of institution-specific resolution planning, but only after it is satisfied that substantial progress has been made on recovery planning.
Executive remuneration
During 2010/2011, APRA took its oversight of executive remuneration arrangements a step further by meeting with the Board Remuneration Committees of the largest listed ADIs and insurers.
APRA's prudential requirements on remuneration, which came into force in April 2010 as extensions to APRA's governance standards, have at their heart two basic objectives: to promote a strong alignment between remuneration and risk-taking, and to ensure that boards are actively involved in determining the remuneration framework and outcomes for senior executives and other key individuals. Reflecting this focus on the role of the board, the purpose of APRA's meetings with the Board Remuneration Committees was to assess firsthand the involvement of the board in establishing sound remuneration practices and to discuss any challenges facing boards in implementing APRA's remuneration requirements.
APRA has concluded that the remuneration practices of the institutions it met are generally sound. All of these institutions had well-established Board Remuneration Committees with clear and robust governance arrangements. Typically, there was also a strong linkage between the Board Remuneration Committee and the Board Risk Committee, usually via a number of common members. APRA was able to confirm that the Board Remuneration Committees sought advice from external sources independent of the advice obtained by management, as required by the governance standards. As a trend, institutions are increasing the proportion of variable reward that is subject to deferral and vesting arrangements, and vesting periods are being lengthened.
Nonetheless, APRA saw scope to improve the alignment of risk and reward. One area for improvement is the application of the governance standards to APRA-regulated subsidiaries, which have to meet the standards in their own right. While many subsidiary boards have elected to adopt the remuneration policies and guidelines of their parent/group, which is allowed, it was not clear in all cases that the remuneration arrangements for responsible persons of the subsidiary were receiving scrutiny at subsidiary board level. Secondly, most of the Board Remuneration Committees had introduced performance assessment arrangements based on a scorecard approach, in which financial, risk and operational objectives and benchmarks are established against which to assess performance. However, the application of these scorecard approaches varied widely, with quite different balancing of objective and subjective measures of performance. This made it difficult to assess the robustness of some individual approaches. Finally, while all institutions concerned have risk-based performance measures, in many cases the measures focus on group or organisation-wide performance rather than on the contribution of the individual to overall outcomes. Such approaches do not necessarily provide a strong link between individual risk-taking and remuneration outcomes.
Operational risk
A number of material operational risk incidents during 2010/11 required supervisory attention. Most significant were the natural disasters in Queensland, which tested the business continuity plans of ADIs, particularly those headquartered or with activities concentrated in the areas affected. A number of ADIs experienced significant disruptions and many were forced to close branches for a period of days. APRA was in regular contact with the ADIs affected as to the status of their operations. Overall, disaster coordination arrangements worked well to ensure reasonable continuity of banking services. This no doubt owes in part to the considerable attention APRA and the ADI industry have paid to business continuity and disaster recovery capabilities in the last few years.
Other operational risk issues included security breaches, payment system outages and deficient information technology (IT) outsourcing arrangements. A number of the larger ADIs have ageing core banking systems and are in the process of replacing these systems or planning to do so. Technological innovation can be a powerful basis for differentiating customer service and controlling costs. That said, APRA has been monitoring progress on system upgrades because of the significant risks, investment costs, management distraction and IT development fatigue that can be associated with replacing old, large-scale and complex banking platforms. APRA also wrote to the ADI industry (and the other APRA-regulated industries) in November 2010 outlining its expectations for the outsourcing or off-shoring of any material business activity, including the use of cloud computing.
APRA has also been reviewing the extent to which the operational risk capital models of the 'advanced' ADIs – those ADIs with APRA approval to determine their operational risk capital requirements using an internal model – have adequately captured, and are sufficiently sensitive to, changes in operational risk profiles. Generally speaking, APRA has found that current models have not been particularly sensitive to material changes in risk profiles. In addition, in a number of instances scenarios appear to be insufficiently stressed, especially in light of the operational risk issues highlighted above. As a consequence, APRA will be reviewing model inputs and outputs, and therefore the regulatory capital requirements, in the year ahead to ensure they generate appropriate and risk-sensitive capital holdings.
General insurance
The general insurance industry remained profitable and well capitalised over 2010/11, despite the adverse impact of a spate of natural disasters in Australia and New Zealand.
A large proportion of the industry's premium revenue is derived from property classes of business; as a consequence, the financial performance of the industry is heavily influenced by the number and size of natural disasters. Gross claims from the natural disasters in 2010/11, which were unprecedented in their rapid succession, already dwarf the claims experience of previous natural disasters underwritten by the industry, and the final claims figures from the New Zealand earthquakes will not be known for some time. However, a large amount of these claims was covered by reinsurance and this has significantly dampened the impact of the natural disasters on industry profitability. Profitability was also supported by strong increases in premium rates for some classes of business over the previous year and by stable investment earnings. The aggregate capital ratio fell over the year, largely reflecting increases in required capital for the higher reinsurance recoveries and insurance concentration risk. It was nonetheless around 1.75 times APRA's minimum capital requirements, a strong position.
Given the unprecedented sequence of natural disasters, APRA established a small team of specialist staff to monitor the insurance claims from these events and to assess the impact of these claims on individual insurers and on the industry as a whole. APRA wanted to satisfy itself that each insurer had the financial capacity to meet its capital requirements and, ultimately, its claims from policyholders. The team examined insurers one-by-one and worked closely with those insurers most impacted. Some smaller insurers, where the relative claims cost was larger, secured additional capital from their foreign parents to cover future claims. Broader issues identified by this review process were the varying quality of the Reinsurance Arrangements Statements provided to APRA and the need for more robust stress-testing. APRA has highlighted these issues to industry through a range of forums and as part of APRA's ongoing supervisory reviews.
One particular market development that APRA is monitoring closely is the increasing presence of price comparison platforms (or 'aggregators') in the Australian insurance market. Experience in the personal lines market in the United Kingdom has shown that growth in the market shares of aggregators has been linked to falling underwriting profits and soft market conditions. By its very nature, insurance pricing involves an element of uncertainty; hence, the premium for identical risks will vary across insurers depending on the assumptions that underpin their pricing process. Aggregators highlight to customers the insurer offering the lowest premium for their particular risk characteristics. As a result, insurers tend to only 'win' business in the segments in which they are the cheapest, and customers are likely to switch insurers more frequently. This makes it more difficult for insurers to underwrite a profitable portfolio of risks.
The impact of aggregators in the Australian personal lines market (particularly motor insurance) has been relatively modest to date. In the commercial lines market, broker groups have recently developed price comparison platforms for products sold to small to medium enterprises (SMEs), although it is too early to assess their impact. In this more competitive environment, it is incumbent on insurers to maintain prudentially sound approaches to underwriting and pricing business.
Counterparty exposure
The exposure of the general insurance industry to reinsurers is a material source of counterparty risk and that risk is heightened after a series of domestic or global catastrophes. Hence, this risk has been receiving particular attention from APRA. APRA regularly receives information on reinsurance counterparties of individual reinsurers through the Reinsurance Arrangements Statement and sometimes through the Financial Condition Report. However, this information is difficult to aggregate; in particular, it is not possible to quantify the impact on the capital of the industry of any downgrade in the rating of a significant reinsurer. To overcome this information gap, APRA undertook a special data collection during 2010/11 to assist its assessment of the degree of industry exposure to particular reinsurers ('concentration risk'). The data collection showed that most reinsurers were rated AA- or A+; under APRA's prudential requirements, a downgrade of a reinsurer by one notch from AA- would have an impact on the capital requirements of an insurer that has ceded risk to that reinsurer. That said, the data collection also indicated that there was a reasonable spread of reinsurers used across the industry and that most insurers did not have material concentrations of exposure to particular reinsurers. The majority of large reinsurance exposures are to major overseas insurance groups, particularly those located in Bermuda, the United States, Germany and Switzerland. APRA is currently considering whether additional data on reinsurance exposures should be collected on a regular basis.
Reinsurance placement risk
The recent spate of natural disasters in Australia and New Zealand has increased the possibility that key reinsurers might withdraw or restructure their capacity (either partially or totally) in this region. Some reinsurers have already raised prices significantly for reinsurance cover, which will flow into direct premium rate increases and a tightening of underwriting standards for property classes of business. Furthermore, some reinsurers are now likely to be less willing to underwrite the lower layers of insurers' catastrophe reinsurance programs or provide aggregate or other types of reinsurance protection programs. This provides opportunities for overseas reinsurers, possibly of lower credit quality, to enter the Australian market to underwrite reinsurance arrangements in which existing reinsurers no longer wish to participate. In this environment, insurers might opt to retain increased catastrophe risk on their balance sheet by increasing their retention, or accept higher credit risk by using reinsurers of lower credit quality. Both outcomes potentially weaken the capital position of insurers and increase their capital requirements. In the case of insurers with material property exposures, APRA's priority has been to monitor their reinsurance strategy and its alignment with their risk and capital management strategy, and assess how reinsurance arrangements operate under different claims scenarios and the stress-testing being undertaken in this area. APRA has also been reviewing insurers' systems and processes for managing aggregate exposures and concentrations of exposures.
Adequacy of pricing processes
The adequacy of the pricing processes of insurers receives significant supervisory attention from APRA. Its review of these processes during 2010/11, using information provided in Financial Condition Reports and from on-site visits, found wide variation in the adequacy of pricing processes across industry; in many cases, pricing processes have weaker management and controls than other aspects of insurers' activities. Specific areas for improvement include enhancements to the quality of input data used for pricing, identification of technical prices to achieve a target profit margin rather than relying on market rates, and more comprehensive monitoring. Examples of better practice in monitoring include analysis of quote conversion, comparison of book and actual prices to technical prices, and segment analysis of actual versus expected business written to detect inadequate pricing.
A number of recent developments may increase the risk that inadequate pricing processes expose insurers to the possibility of significant losses. These include:
Life insurance and friendly societies
The continued recovery in domestic and global equity markets from crisis lows over much of 2010/11, though faltering in the later months, underpinned a further strengthening in profitability and capital in the life insurance industry (including friendly societies). Industry profitability returned to levels prior to the crisis, driven mainly by higher investment income attributable to shareholders and continued strong growth in risk insurance business. Over the year, life insurance assets rose only slightly, with the increase in asset values largely offset by net cash outflows.
The improvement in profitability and in asset values, in turn, enabled the capital position of the life insurance industry to stabilise around pre-crisis levels. The industry is therefore well placed to cope with the renewed turbulence in equity markets over more recent months. The capital strength of the industry had been a major focus of APRA throughout the crisis and it worked closely with life insurers, particularly those most heavily invested in equities, to secure improvements in capital management and reporting. As a consequence, though APRA is on heightened alert status, it remains confident that the industry has adequate capital resources and sufficiently robust capital management to absorb further shocks. That said, life insurance boards and management will need to remain especially vigilant about their capital positions.
Consolidation in the industry has continued apace, with the acquisition of the Australian business of AXA Asia-Pacific by AMP Limited, and other ownership changes. Further rationalisation of multiple licences held by a number of financial groups is expected over the next couple of years. At the same time, the industry is witnessing the recent entry of a small number of major foreign life insurers after a long period in which foreign insurers, particularly those headquartered in the United Kingdom, had exited the Australian market. Friendly society numbers fell to 14 and friendly society assets remained unchanged over 2010/11 despite the positive investment performance.
Two recent sets of Government reforms will have potentially significant impacts on the business models and distribution systems of life insurers (and other wealth management entities). The Future of Financial Advice reforms, the first tranche of which was released in August 2011, propose changes to remuneration arrangements for the provision of financial advice. The Stronger Super reforms, originally announced in December 2010 and firmed-up in September 2011, include proposals for a new type of simple, cost-effective superannuation option that a member could choose or be assigned to by default ('MySuper'). APRA will be working with life insurers to ensure that they fully understand the prudential implications of these reforms and their flow-on consequences for governance, operational risk and product risk.
Product rationalisation
Over a number of years, APRA has been in discussions with the Government, Treasury and the life insurance industry about the development of a more effective mechanism for the rationalisation of legacy products in the life insurance and superannuation industries. During 2009/10, the Government released a proposals paper that offered a specific product rationalisation mechanism involving a 'no disadvantage' test for investors. However, there is little follow-up work to report at this point.
Group risk insurance
Group risk insurance, largely through superannuation funds, now accounts for a little over one-third of risk insurance business, although its contribution to profit is proportionately lower. In its 2010 Report, APRA noted that the consolidation of the larger industry superannuation funds in recent years has led in turn to a concentration in buying power in the purchase of group risk insurance from the life insurance industry, and price and service competition in this market has become intense. Group risk contracts are now reaching a size that is testing the capital and operational capacity of some of the participating life insurers, giving rise to operational and strategic risk when these contracts are won and concerns that premiums will not prove sustainable. APRA is continuing to monitor developments in this market, with a particular focus on the capital support for, pricing disciplines in, and operational management of these contracts. An additional area of attention will be the pricing and capital management practices that insurers put in place for reserving against shocks such as a pandemic or a marked increase in disability claims.
Directly marketed business
Recent years have witnessed an increase in the number of life insurers marketing products directly to the public through call centres, the internet and television advertising. Often, the products are being offered through third-party providers. APRA has no issue with the use of direct marketing channels as such, but is concerned to ensure that appropriate governance, pricing and operational management frameworks are being applied to the design, distribution, underwriting and claims management of these products. APRA is increasing its dialogue with the industry to ensure that the risks associated with direct marketing, including reputational risk, are being appropriately managed by insurers.
Experience studies
APRA has continued its discussions with the life insurance industry over the importance of industry-based mortality and morbidity experience studies and on the quality of data used to produce them. Such studies establish a sound foundation for pricing and reserving. To this end, APRA welcomes the production of an industry lump sum mortality/morbidity experience study that covers the majority of the yearly renewable term insurance market. Another experience study covering one year of disability income protection has recently been completed and a three-year period of analysis will commence shortly. Against a background of deteriorating results for many life insurers from their income protection business, findings from these types of studies will provide supplementary indicators for insurers that are crucial to appropriate pricing of their portfolios.
APRA continues to support a research project at the University of New South Wales to develop an integrated framework for the economic, actuarial and regulatory aspects of longevity. This four-year project is now fully staffed and has produced 14 working papers to date.
Notwithstanding the recurring bouts of volatility, the overall strengthening in domestic and global equity markets in 2010/11 and higher fixed-interest earnings meant that most superannuation funds earned positive returns over the year. The balances of superannuation fund members generally improved, for the second consecutive year, as did the funding position of many defined benefit funds. This improvement, however, has been reversed in more recent months as a consequence of sharp declines in equity markets. Over the year, fund mergers and acquisition activity saw the number of trustees with Registrable Superannuation Entity (RSE) licences fall by 26 to 225 (compared to 307 licences when the superannuation licensing regime began on 1 July 2006) and the number of registered funds under their trusteeship fall by 401 to 4,017 (6,886 on 1 July 2006).
In its supervision of the superannuation industry during 2010/11, APRA's main priority was to encourage more robust governance and risk management practices. Activities have covered investment risk and governance, liquidity management, operational risk including IT issues and data integrity, and risks associated with mergers and acquisitions. The Government's Stronger Super reforms, which will have a significant bearing on the future shape and direction of the superannuation industry, are discussed in the following chapter of this Report.
The large swings in domestic and global equity markets over the past six months and more, and the continuing fragility of investor sentiment, pose ongoing challenges for trustees for managing investments and the associated risks, and for APRA's supervision.
APRA had been encouraging trustees to pay greater attention to investment risk since the onset of the crisis, but its supervisory reviews still identify concerns about the level of trustee understanding of the more complex aspects of investment risk and the management of specific risks of some asset classes. In particular, APRA sees scope for further improvement in respect of unlisted assets, with some trustees yet to demonstrate a strong understanding of the inherent valuation risks with such investments. In August 2010, APRA wrote to trustees emphasising that trustees should have a strong governance framework for valuation of unlisted assets, should give due consideration to equity issues between members and should be mindful of the inherent valuation risks associated with investments that have multiple management layers, complex investment structures and/or underlying assets that are opaque in nature. Valuation methodologies for unlisted assets receive more attention during APRA's on-site visits and the issue has now been imbedded in APRA's regular supervisory reviews. During 2010/11, APRA surveyed a number of funds with significant exposure to unlisted assets and in some cases noted a lag in repricing, relative to other assets, that had the potential to impact on published returns.
APRA has also noted instances where trustees have not been adequately reviewing investment strategies or where the strategies they have adopted are not properly implemented and monitored. On-site reviews also continue to identify weakness in the application and assessment of controls on unit pricing and crediting rate processes, despite efforts by APRA over many years to highlight these areas for attention.
During the year, APRA continued its work with the Australian Securities and Investments Commission (ASIC) and industry associations to develop guidance for trustees on the labelling of investment options offered by superannuation funds. APRA's aim is to improve member understanding by increasing consistency in the measurement of fund performance by trustees and by standardising the descriptors of risk that trustees use for their investment offerings. In August 2011, the Financial Services Council and the Association of Superannuation Funds of Australia (ASFA) issued a guidance paper for trustees, recommending use of a seven-level classification system of investment risk based on the expected number of negative annual returns over a 20-year period. APRA fully supports this guidance as a step in improving risk descriptors and is considering how it will be incorporated into APRA's prudential regime for superannuation. Further work in this area will also be progressed as part of the Stronger Super reforms.
Despite the strong net inflows to superannuation, continuing market volatility requires the management of liquidity to remain 'front of mind' for trustees in their consideration of the best interests of members. Even though the general economic environment is much improved, APRA continues to assess and grant applications for relief from the portability requirements under the Superannuation Industry (Supervision) Regulations 1994 (SIS Regulations). An increasing number of these applications have related to investments in ASX-listed securities where the company has gone into administration or has been suspended. Moreover, the number of trustees with funds in frozen or suspended managed investment schemes, predominantly property and mortgage schemes, has not fallen significantly.
APRA has provided guidance to trustees on its expectations for liquidity management and has observed improvements in this area. However, liquidity management practices have not reached the level of sophistication APRA observes in the other industries it supervises. Some trustees maintain a business-as-usual mentality in liquidity management and do not undertake comprehensive liquidity stress-testing (including crisis scenarios).
Management of information security and data
The management of IT system issues and data integrity is receiving increasing attention from APRA, given that many trustees outsource fund administration to unregulated IT providers. Evidence from APRA's on-site reviews and supervisory activities indicates that while IT risk is generally included in risk management frameworks, the measurement and management processes surrounding this risk are still immature. Trustees need a clear understanding of the security practices of administrators and of their own responsibilities to ensure that these practices provide adequate security for member and fund information. A lack of pre-emptive testing of data across the industry also suggests that trustees need to give more focus to data integrity. Issues arising from incorrect or poor data tend to be addressed on a needs or recovery basis, instead of forming a key part of a trustee's forward-looking risk management framework.
As noted earlier in this Chapter, in November 2010 APRA wrote to all trustees (and to all other APRA-regulated institutions) outlining its expectations for the management of IT security and, in particular, the outsourcing or offshoring of any material business activity, including the use of cloud computing. Trustees have been requested to consult with APRA before entering into any offshoring agreement. The recent spate of natural disasters in Australia has highlighted potential deficiencies in disaster recovery and business continuity for IT facilities, another area for trustee attention.
Mergers and acquisitions
In February 2011, APRA wrote to trustees about the implications of the continuing consolidation in the superannuation industry. APRA set out its expectations of trustees when they are considering and implementing mergers, restructures, successor fund transfers or changes to service providers. Trustees should ensure they have a well-documented change management plan in place that has adequate regard to due diligence, adequacy of resources and legal issues, particularly where interaction with APRA is required.
Although the Government's Stronger Super reforms have no specific recommendations regarding mergers, APRA expects that trustees will regularly examine the scale, viability and strategy of their institution. Some trustees have already concluded that, from a scale perspective, their members' best interests would be served by being part of a larger merged institution.
Early release of superannuation benefits
Under longstanding arrangements in the SIS Regulations, APRA could approve the early release of superannuation benefits on specified compassionate grounds. These arrangements have been changed. Since February 2011, Medicare Australia, as a portfolio agency within the Department of Human Services, has acted as APRA's delegate to determine applications for early release of superannuation on specified compassionate grounds. This arrangement was introduced as a precursor to the formal transfer of the function to the Department of Human Services. The role of dealing with the early release of superannuation on compassionate grounds fitted better with Medicare Australia rather than with a prudential regulator; in addition, APRA would have needed to substantially upgrade the technology and infrastructure used to process applications, while Medicare Australia is able to use its existing technology.
The Superannuation Legislation Amendment (Early Release of Superannuation) Bill 2011, which gives effect to the formal transfer, has now been approved by Parliament. Medicare Australia will take over formal responsibility for the function by the end of 2011.
APRA, industry and government remain concerned about schemes that promote the illegal early release of superannuation benefits. The majority of these early release schemes involve a request to an APRA-regulated fund to roll-over a member's benefit to a self-managed superannuation fund (SMSF) and the subsequent cashing out of the benefit, in breach of the preservation standards. APRA also notes there is increasing evidence of identity theft, where an individual's details are obtained and their benefits accessed by an unrelated party. APRA and the Australian Taxation Office (ATO) continue to work together to reduce the incidence of illegal early release of superannuation benefits. In October 2010, APRA wrote to trustees to alert them to the new SMSF member verification system provided by the ATO.
Early release of superannuation benefits
Number of
approved in part
or full
Amount approved
for release
Average amount
released per application
2006/07 18,245 15,412 156,905,338 10,181
2007/08 20,524 14,947 173,602,110 11,615
2008/09 17,918 11,776 144,739,434 12,291
2009/10 16,331 10,539 111,121,975 10,544
2010/11 15,795 10,141 122,975,798 12,127
APRA's letter details the practical steps that trustees or their authorised administrators need to follow to satisfy themselves that transfers were being made to legitimate members of SMSFs in a timely manner. This member verification system is in addition to the Super Fund Lookup facility that confirms the regulatory and complying status of SMSFs. Trustees will still need to have proof of identity through their identification procedures to ensure they are dealing with the correct member.
The number of applications for early release of superannuation benefits received by APRA fell in 2010/11 for the third consecutive year, after rising strongly over earlier years.
Enforcement activities
APRA's supervisory approach is based in the first instance on a cooperative and open working relationship with boards and management of supervised institutions to resolve prudential issues that may affect an institution's ability to meet its financial promises to beneficiaries (depositors, policyholders and superannuation fund members). However, APRA may take enforcement action if this cooperative approach does not resolve the issues in a way that appropriately protects the interests of beneficiaries. Enforcement actions available to APRA include instigating formal investigations into the affairs of a supervised institution, appointing a third party to manage an institution's affairs, imposing conditions on an institution's licence, issuing directions related to the conduct of the institution's affairs, or accepting enforceable undertakings. Where necessary, APRA can initiate criminal proceedings, seek restraining orders or seek to disqualify individuals from holding senior roles within supervised institutions. APRA can also take action to prevent unlicensed entities from conducting business that can only be conducted by a financial institution that APRA has authorised.
During 2010/11, APRA undertook 377 enforcement actions. This was a decrease on the 432 actions reported the previous year and reflects the fact that, although APRA had more investigations underway during 2010/11, the majority were smaller investigations requiring less enforcement action.
APRA continued its investigation in relation to Trio Capital Limited, which was formerly the trustee of four superannuation funds and one pooled superannuation trust. APRA had previously frozen the assets of and appointed an Acting Trustee to the Trio superannuation entities due to concerns surrounding the valuation of assets and indications of fraudulent conduct, particularly in regard to investments in offshore hedge funds. Further enforcement action is being considered. APRA continues to work closely with ASIC, which is conducting a concurrent investigation into Trio's role as a Responsible Entity of various managed investment schemes. APRA has accepted enforceable undertakings from four of the former Trio directors to remain out of the superannuation industry for periods ranging from four to 15 years. In April 2011, in response to an application by Trio's Acting Trustee and on the recommendation of APRA, the Assistant Treasurer announced his decision to grant approximately $55 million in financial assistance to over 5,000 members of the Trio superannuation entities as a result of funds being lost to fraud or theft. APRA worked with the Acting Trustee to obtain independent verification of the amount sought in the application and will continue to work with the Acting Trustee to oversee the distribution of the financial assistance to members.
In the superannuation industry, the Commonwealth Director of Public Prosecutions acting on behalf of APRA took action against the former executive director of a superannuation trustee company. This person had been charged with committing an act of victimisation and was committed to stand trial. The criminal charges arose from APRA's investigation into allegations that two directors of the company were victimised because they carried out their duties as trustee directors to act in the best interests of fund members. Under the SIS Act, it is a criminal offence to commit an act of victimisation against a responsible officer of a corporate trustee of an employer-sponsored superannuation fund. The criminal trial resulted in the acquittal of the former executive director.
During 2010/11, APRA received 28 complaints relating to the failure by employers to remit employees' voluntary post-tax employee superannuation contributions to their superannuation fund. The number of complaints received by APRA was significantly lower than the previous year. Although it has no specific prudential powers in this area, APRA's investigations resulted in the successful recovery of all outstanding contributions, except where the employer had gone into administration or liquidation. APRA also continued to investigate cases of fraudulent early release, resulting in one conviction and other cases either in the early stages of investigation or nearing finalisation.
Legal proceedings instigated by APRA on behalf of an Acting Trustee of a superannuation fund were successfully concluded during the year. APRA had used its powers under the SIS Act to bring proceedings on behalf of the Acting Trustee to challenge the ownership of a major asset of the fund. APRA had been successful in obtaining orders both at first instance and on appeal. An application for special leave to the High Court for a further appeal was refused.
During the previous year, the Minister for Financial Services, Superannuation and Corporate Law and Minister for Human Services had determined that the Financial Claims Scheme in the general insurance industry (the Policyholder Compensation Facility) be triggered in relation to one of two small general insurers to which a judicial manager had been appointed. The aim of the Scheme is to ensure claims by eligible policyholders can be met. During 2010/11, an amount of around $73,000 was paid out under the Scheme. The Scheme has been extended for a further 12 months to enable the lodgement of claims and APRA continues to work through claims applications. APRA has also been working closely with the judicial manager (now liquidator) of the other small general insurer to assess the likelihood of any policyholder shortfall in the liquidation.
In the banking industry, APRA considered 31 matters during 2010/11 relating to the use of restricted words 'bank', 'banker', 'banking' or like names under s66 of the Banking Act 1959. A significant proportion of these related to the use of the restricted words by an unauthorised institution.
Enforcement actions1
  ADIs Superannuation General
Life insurance Friendly
Other2 Total
2010 2011 2010 2011 2010 2011 2010 2011 2010 2011 2010 2011 2010 2011
AAT/Federal Court review         3               3  
Appointment of Acting Trustee     5                   5  
Appointment of liquidator/inspector     5   7           3   15  
Civil litigation     2   1               3  
Directions and contravention notices3 12 9 91 164 46 2         15 5 164 180
Enforceable undertaking 1                       1  
Follow-up delayed contributions     102 40               2 102 42
Investigation action 2   5 73 11           30   48 73
Other actions4 28 37 8 13             31 11 67 61
Refer to other agency/police 2 1 10 15 5           5 5 22 21
Removal, withdrawal or revocation of license     1                   1  
Show cause letter         1               1  
Total 45 47 229 305 74 2 0 0 0 0 84 23 432 377
1. Year ending 30 June.
2. Includes institutions not regulated by APRA suspected of conducting unauthorised activity.
3. Includes consents to use restricted words.
4. Includes monitoring of foreign bank representative offices.