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Annual Report 2013 - Chapter 2

Supervisory Activities

APRA's Supervisory Approach
 
The cornerstone of APRA's supervision is its risk-based approach. In brief, this approach seeks to ensure that APRA's supervisory attention and resources are targeted at weaknesses in an APRA-regulated institution's operations, or in its risk management capabilities, that pose the greatest risk to its ability to fulfil its financial obligations to its beneficiaries, or that could present a threat to the stability of the financial system as a whole.
 
APRA's risk-based approach has evolved over time and has been given a more rigorous structure in recent years, starting before the global financial crisis. The objective has been twofold. One is to ensure that APRA supervisors can form a full picture of the risk profile of an institution, and the industry conditions in which it is operating, through better integration of prudential data, supervisory analysis, market intelligence and other sources of information. The other is to promote a more cohesive approach to risk-based planning and response to risk issues that acknowledges the competing demands on APRA's supervisory resources.
 
The main elements of this structured approach include:
  • a formal risk-rating of APRA-regulated institutions that must be kept current and is subject to peer group analysis to promote consistency in ratings;
  • a comprehensive planning and assessment process around the conduct of detailed on-site reviews, which clarifies APRA's expectations about the outcomes of the reviews and prioritises the involvement of specialist risk teams;
  • streamlined review and approval processes to ensure that supervisory interventions are both timely and subject to appropriate management oversight and review; and
  • identification of emerging risks and issues in each of the APRA-regulated industries through risk registers, with assigned risk 'owners', which provide context and focus for APRA's supervision of individual institutions.
Though now seasoned and tested by the crisis, APRA's supervisory approach must continue to evolve and be responsive to a dynamic financial system. One of the main pillars of the G20 Leaders' global reform agenda is more effective supervision; it is now clear that differences in the ability and willingness of supervisors to act were a significant factor in the different performance of financial systems during the crisis. The search for improved supervisory effectiveness is a constant one. To this end, two particular initiatives during 2012/13 can be highlighted.
 
Firstly, significant steps were taken in the rebuilding of APRA's systems infrastructure to provide a more robust and efficient IT platform on which to run APRA's supervision processes. Having undertaken the foundation work of designing the systems architecture, selecting an experienced systems integrator and choosing the technology components the previous year, the design, build and testing of a new suite of integrated software was largely completed by the end of 2012/13. Roll-out of the core elements of the new system is scheduled for later in 2013.
 
Introduction of the new system has three key goals:
  • to better support APRA's risk assessment and response processes with improved capabilities to monitor key risks and issues, plan supervisory activities and track those activities and the associated outcomes to completion;
  • to improve supervisors' ability to search for and access prior regulatory decisions to facilitate consistency in decision-making; and
  • to lay the foundation for a new electronic document and records management system that will support both supervision and other business processes across APRA as well as statutory record-keeping obligations.
APRA has begun planning for the next series of systems releases, which will be delivered in stages over the next few years. Ultimately, the rebuilding program will produce significant efficiency gains and sharper supervision processes from end to end.
 
Secondly, APRA has strengthened its oversight of the capital management processes of general and life insurers (including friendly societies). This follows the introduction of a requirement that these institutions have an Internal Capital Adequacy Assessment Process (ICAAP), as part of the revised capital framework for the general and life insurance industries (see Chapter 3). The requirement mirrors one that has applied to ADIs since 2008.
 
An ICAAP summary statement is expected to describe in sufficient detail how the institution determines and monitors its risks and the capital to be held against these risks. It should also describe the institution's capital management strategy including how regulatory capital requirements will be met, capital targets above regulatory minima, capital held against identified risks and the stress tests and scenario analysis that are used to demonstrate the institution's capacity to absorb shocks to its capital. APRA expects that institutions will use the ICAAP to manage their business and when making key strategic decisions.
 
Whilst the detail of the ICAAP will be developed by senior management with input as appropriate from relevant areas and experts, the ICAAP is fundamentally a board responsibility. The board needs to be actively engaged in the development of the ICAAP and its implementation, and must ultimately approve the ICAAP. While many insurers were already doing much of what would be required in a well-developed ICAAP under their previous capital management processes, others have needed to make more fundamental changes to meet the new requirement.
 
General and life insurers were requested to provide their initial ICAAP summary statements to APRA early in 2013. APRA has completed an initial high-level review of whether the statements meet the requirements of the prudential standards and will finalise a more qualitative review of the content of the statements in the first half of 2013/14. Findings and assessments from these reviews will be conveyed to industry and individual institutions.
 
The remainder of this Chapter outlines supervisory issues and APRA's key supervisory priorities in each of its regulated industries. One issue that straddles the ADI and insurance industries is executive remuneration. In recent years, APRA has met with the Board Remuneration Committees of the largest listed ADIs and insurers to assess the involvement of the board in establishing sound remuneration practices, and has followed up with a detailed review of practices in a number of these institutions. APRA's conclusion from these detailed reviews was that the remuneration policy and practices for senior executives in the institutions concerned were generally sound, but there was room for improvement in aligning risk and reward.
 
The issues raised now form part of APRA's ongoing supervisory activities. APRA's priority is to ensure that executive remuneration arrangements are appropriately structured and meet its prudential requirements on remuneration, which came into force in April 2010. Some particular areas of focus during 2012/13 were the interaction between group-level Board Remuneration Committees for the larger domestically owned groups and senior executives of APRA-regulated institutions within those groups, and interactions between the Australian operations of multinational groups and their head office requirements.
 
Authorised Deposit-Taking Institutions
 
Authorised deposit-taking institutions (ADIs) strengthened their financial position over 2012/13, notwithstanding continued subdued growth in demand for credit. The household sector was restrained in taking on new debt commitments and took advantage of low interest rates to repay debt earlier than required. As a consequence, household credit growth remained around record low rates. In contrast to earlier crisis experience, business credit growth was positive over the year but not strongly so; the business sector has been cautious about its gearing levels in the face of uncertainties about the adjustment path of the Australian economy and the exchange rate, as the mining investment boom recedes.
 
Steady economic growth in 2012/13 nonetheless underpinned improvements in the key barometers of financial health for the ADI industry. Asset quality continued to strengthen, with a decline in non-performing loan ratios, particularly in commercial property exposures, and a slow-down in the rate of newly impaired assets. Profitability was solid, supported by stable net interest margins, a levelling out of bad debt charges and a range of cost savings and productivity enhancing initiatives; these initiatives have pushed cost-to-income ratios for the major banks to low levels by global peer-group standards. For a small number of ADIs, however, the unwinding of impaired commercial property and corporate exposures dented profitability. ADI capital positions also strengthened in quality through the build-up of common equity through profit retention, and a number of ADIs issued non-common equity instruments that meet the stricter eligibility requirements under the Basel III capital framework. Finally, ADIs further strengthened their liquidity and funding positions, taking advantage of strong deposit inflows to reduce the share of wholesale funding.
 
There was little change in the ADI population or its composition in 2012/13. A further three credit unions converted their status to mutually owned banks, and a fourth since year-end. Nine credit unions and one building society, accounting for around 30 per cent of total credit union and building society assets, have converted their status since 2011.
 
Subdued credit growth has been the story of the ADI industry for the past several years. The changing dynamic in this story is the low interest rate environment. Low interest rates can be expected to stimulate the demand for credit, and there are already signs of a pick-up in housing loan approvals that will flow through to credit aggregates. This is the normal transmission mechanism of monetary policy at work, and ADIs can expect to benefit through volume growth, lower debt burdens for borrowers and improved asset quality. If these benefits are to prove enduring, however, it is important that ADIs maintain prudent lending standards and resist the temptation to pursue market share with insufficient regard to the debt-servicing capacity of borrowers over time. Low interest rates might also have an impact on profitability by reducing the funding benefit of low or zero-yielding deposits. Hence, it is also important that ADIs do not respond by diversifying strategies away from core business into unfamiliar territory without robust due diligence and appropriate risk management.
 
The adjustment of ADIs to the low interest rate environment, particularly as it bears on credit quality, has been one of two main areas of APRA supervisory focus during 2012/13. The other area has been the implementation of the new Basel III capital and liquidity frameworks.
 
Credit quality
 
The business models and asset composition of ADIs are predominantly centred on traditional lending activities, particularly lending for housing. For this reason, close monitoring and rigorous assessment of credit risk management is, and has long been, a core element of APRA's supervision of the ADI industry. The experience of banks in countries most affected by the crisis has highlighted the dangers of chasing short-term profitability through relaxing risk appetites and weakening lending standards to acquire borrowers that ultimately prove to be high risk. More recently, advanced countries less affected by the crisis have taken 'macroprudential' measures tomanage emerging pressures in domestic lending markets generated by an extended period of low interest rates.
 
ADI asset quality deteriorated in the first years of the crisis, mainly due to impaired commercial property exposures, but has been on a clear improving trend since then. As noted, that trend continued during 2012/13, although asset quality has yet to regain pre-crisis levels. The non-performing loan ratio in housing lending, already low by historical and international standards, drifted lower again in 2012/13. There was also a further pronounced decline in the share of impaired business and commercial property exposures as ADIs continued to work through legacy problem loans. In contrast, the non-performing loan ratio in personal lending continued to rise. Though personal lending is only a small component of ADI loan portfolios, its performance can serve as a harbinger of household financial stress.
 
Housing loans represent the single largest asset class on ADI balance sheets and this concentration, taken together with the high debt levels of Australian households relative to income, ensures that the management of risks in housing lending receives APRA's continued close supervisory attention. APRA supervisors and credit risk specialists challenge any shifts in risk appetites and lending strategies that hint of short-sightedness, and assess the robustness of governance, lending standards and risk management controls. In recent years, lending standards have also been the subject of APRA communications to ADI boards and the topic for targeted reviews by the external auditors of ADIs. ADI boards bear ultimate responsibility to ensure that prudent lending standards are upheld when competitive pressures are high, and external auditors play a valuable role as another ' line of defence'.
 
In 2012/13, a targeted review by external auditors focussed on the loan serviceability policies that ADIs apply to assess whether borrowers can afford the interest and principal repayments on their housing loans. These policies ('income tests') are important in a housing market where, as in Australia, the high proportion of housing loans with a variable mortgage rate makes borrowers very sensitive to changes in interest rates. The policies assume even more importance in a low interest rate environment, when the ability of new borrowers to afford higher repayments when interest rates ultimately return to more normal levels needs to be rigorously assessed. Against this background, the targeted review asked external auditors of a number of ADIs to evaluate various aspects of loan serviceability policies, including the models adopted to evaluate income and expenses, the role of interest rate buffers and floors, and the nature and frequency of policy 'overrides' and 'exceptions' and how these were monitored and managed.
 
The targeted review findings were released in a recent APRA Insight publication. A number of good practices in the application of loan serviceability policies were identified. These included the clear documentation of policies and procedures, effective governance frameworks and board oversight, regular reviews of policies to align risk appetite with the changing external operating environment, use of an 'interest rate buffer' over the current lending rate in evaluations of loan serviceability, and hindsight reviews of housing loan portfolios. At the same time, the review identified a number of areas where policies could be strengthened, through inclusion of an interest rate floor to assess loan serviceability over at least one interest rate cycle, the assessment of a borrower's actual rather than modelled living expenses, stress testing of other debt commitments, and better monitoring and reporting of policy overrides and exceptions.
 
APRA is following up on identified shortcomings with specific ADIs. In response to the review findings, APRA is also revisiting its expectations for prudent housing lending standards and will outline these expectations in a forthcoming prudential practice guide.
 
Capital
 
ADIs have substantially strengthened their capital positions since the global financial crisis began. This strengthening has been a response, in part, to market pressures to demonstrate an enhanced resilience to shocks and, for ADIs that are rated by credit rating agencies, to board commitments to maintain ratings during a period when many international peers were being downgraded. The strengthening was also, in part, in anticipation of the new Basel III capital standards (see Chapter 3) aimed at raising the quality and quantity of regulatory capital. Basel III gives greater weight to common equity as the highest quality component of capital and it is this component that has grown significantly, through new equity issues but mostly through the retention of profits and contributions from dividend reinvestment programs.
 
Accordingly, ADIs were well placed to meet the new Basel III minimum requirement for common equity (and other tiers of capital) when they were formally implemented by APRA from 1 January 2013, at the early end of the global timetable. ADIs also currently hold more than sufficient common equity to meet the new capital conservation buffer when it comes into effect from 1 January 2016, again at the early end of the global timetable. Following clarification of the eligibility criteria for lesser quality capital instruments under Basel III, ADIs have begun to augment their total capital positions through the issue of non-common equity instruments. Initial industry concerns that these instruments, which are required to convert to common equity or be written-off on a specified 'trigger' event, would be difficult to price and to place have proven unfounded and many issues have been heavily oversubscribed.
 
More recently, ADIs have taken various initiatives that have started to slow the build-up of common equity capital from profit retention. Given the continuing uncertainties in the global and domestic operating environment, ADIs need to be cautious in signalling that the strengthening of capital positions may have run its course. In its supervision of capital positions, APRA has been emphasising that ADIs must do more than meet minimum regulatory requirements. ADIs must build and maintain adequate buffers that give them the capacity to absorb significant losses without relying on potential mitigating actions that may not be deliverable under duress. The setting of these capital buffers is a fundamental part of an ADI's internal capital management, encapsulated in the ICAAP requirement. APRA supervisors focus on understanding and challenging the calibration of these buffers, seeking to ensure that boards and management target prudent levels of capital that are reflective of the ADI's specific risk profile and informed by effective stress testing.
 
APRA has itself committed additional resources to enhance its industry-wide stress testing capabilities and its oversight of ADIs' own stress testing. Frontline supervisors and risk specialists have been examining ADI stress testing frameworks and the critical but complex models that underpin results. Given the long history of relatively stable economic conditions in Australian data-sets and mindsets, stress testing that acknowledges the risk of a harsher reality remains a key priority for ADIs and for APRA.
 
Liquidity
 
As with capital, ADIs have strengthened their liquidity and funding resilience since the crisis began and that trend continued in 2012/13. ADIs added to their holdings of high-quality liquid assets, further increased their share of funding from deposits and reduced their reliance on short-term wholesale funding. Funding tasks were assisted by the significant improvement in sentiment in global funding markets for all but the latter part of the year, which ensured ready access to funds at considerably reduced spreads. The lower risk aversion on the part of investors enabled ADIs to issue steadily in global term debt markets in unsecured form, in place of the secured form of covered bonds that investors had sought the previous year. ADIs have conserved covered bond capacity within legislative limits in case dislocations in global funding markets were to return.
 
Positive investor sentiment also gave a boost to the residential mortgage-backed security (RMBS) market, which in the past has provided a significant source of funding for smaller ADIs. New issuance picked up strongly in 2012/13, spreads fell to their lowest level since the crisis began and participation by the Australian Office of Financial Management was not considered necessary to support the market.
 
Although this strengthening in ADI liquidity and funding positions is welcome, further improvement is necessary. In its recent Financial Sector Assessment Program review of Australia (see page 57), the International Monetary Fund has identified the reliance of the larger ADIs on offshore wholesale funding as one of the 'unique risks' facing the Australian financial system. Improvements to funding structures can come from, amongst other things, increasing the proportion of assets funded by stable retail deposits, reducing short-term wholesale borrowing, increasing the maturity of term debt issues and refining terms and conditions for some products.
 
Promoting such improvements has been a key priority for APRA. APRA's frontline supervisors, working with liquidity risk specialists, routinely review ADI funding positions and funding strategies, including the assumptions on which they are based, through a combination of offsite analysis and onsite prudential risk reviews. APRA maintains regular contact with ADI treasury teams in scheduled and ad hoc meetings to understand and assess market and funding conditions and ADI responses. APRA also routinely benchmarks the larger ADIs against one another and ADIs that are outliers in terms of over-reliance on short-term funding sources, or funding concentration risk, are brought to their board's attention and are subject to targeted supervisory action.
 
Looking ahead, the main catalyst for promoting improved liquidity and funding structures will be the 'all reasonable steps' test that ADIs must meet if they wish to access a secured committed liquidity facility (CLF) from the Reserve Bank of Australia to meet the new Basel III liquidity standard, the Liquidity Coverage Ratio (LCR) (see page 47). The need for such a facility arises from the relatively short supply of high-quality liquid assets in Australia that ADIs subject to the LCR requirement would otherwise need to hold to survive the 30-day funding stress scenario on which the LCR is premised. Access to the CLF is conditional on ADIs demonstrating that they are not relying on the CLF as a 'first resort' but have sought to meet their LCR requirements to the extent possible through their own balance sheet management.
 
From 2014 onwards, APRA supervisors will evaluate requests from ADIs to access a CLF through an annual 'all reasonable steps' assessment. This process will involve a number of stages. These include scrutiny of three-year funding plans, reviewing the robustness of ADI liquidity transfer pricing, and evaluating remuneration incentives for executives responsible for funding and liquidity management. Where APRA determines that an ADI is not taking sufficient steps to reduce its liquidity risk, an appropriate supervisory response may include progressively lowering the amount of the CLF that an ADI can count towards meeting its LCR requirement until a more appropriate liquidity risk profile is reached. To prepare for implementation of the new Basel III liquidity framework, a 'dry run' of the assessment process is being undertaken by APRA in 2013.
 
Operational risk
 
Globally, a series of high-profile events - including the mis-selling of products, trading incidents and manipulation of benchmark interest rates - has confirmed the potential for severe losses and reputational damage if operational risk is not managed appropriately. The ADI industry has not recently faced these types of events in Australia and operational risk losses were relatively stable in 2012/13. Nonetheless, APRA continues to emphasise the need for ADIs to further develop operational risk management frameworks.
 
Operational risks arise in an ADI's normal business activities, through inadequate resilience and response plans for high-visibility payment systems for example, and can take new and complex forms, such as cyber threats. Operational risks also arise in the strategic initiatives that ADIs have been pursuing over recent years in response to the low credit growth environment. Some ADIs have focussed on technological innovation and systems enhancements as a means of strategic differentiation and a driver of increased efficiency and improved productivity. Some ADIs have looked to offshoring and outsourcing (including of technology) as a means of finding efficiency gains. These sorts of strategic initiatives can involve heightened operational risk relating to systems complexity, data security, controls over outsourced service providers and the like, that needs to be subject to rigorous management and board governance processes.
 
ADIs accredited to use the Advanced Measurement Approaches (AMA) to determining operational risk capital have been implementing significant changes to their modelling approaches. These include consideration of structural models to sharpen scenario analysis, and alternative approaches to capture the potential for multiple operational risk events in a single year. These improvements and other enhancements to the overall design and implementation of operational risk management frameworks are welcome. Nonetheless, APRA sees scope for further development and refinement, particularly in addressing potential exposure to low frequency, high impact or 'unexpected' operational risk events. Following a detailed review, APRA raised the operational risk regulatory capital requirements for advanced ADIs from late 2012.
 
General Insurance
 
Profitability in the general insurance industry improved in 2012/13 largely due to a strong performance by underwriters of property risk. The key driver was a lower level of gross claims from natural disasters compared to the previous two years, notwithstanding some severe storm events, floods and bushfires in early 2013. Premiums in property classes of business also increased as insurers sought to recoup the higher cost of property reinsurance in the wake of adverse claims experience from earlier natural disasters. The offsetting impact of an increase in the value of long-tail liabilities from interest rate movements was considerably smaller than in the previous year. Investment income was also a good contributor to industry profitability but less so than the previous year.
 
The aggregate capital ratio of the industry rose to over 1.8 times APRA's prescribed capital requirements. APRA's revised capital framework for general insurers, which came into effect on 1 January 2013, has not had a material impact on capital requirements for the industry overall but the impact on individual insurers has varied. The smooth transition owes in part to an effective consultation process that ensured sufficient time for insurers to undertake any necessary capital initiatives, adjustments to reinsurance programs or other changes ahead of implementation of the new framework.
 
The general insurance population remained largely unchanged in 2012/13. A small number of insurance groups rationalised some of the multiple insurance licenses they held as a result of acquisition activity in prior years.
 
As noted earlier in this Report, a sustained low interest rate environment poses challenges for the general insurance industry. In particular, low interest rates are likely to put upward pressure on premiums, particularly for the long-tail classes of business (compulsory third party (CTP) motor, workers' compensation, professional indemnity and public and product liability insurance). The premium growth needed to offset lower investment income may prove elusive because of strong levels of competition in some market segments, concerns about the affordability of products and state regulatory limitations that may impact on an insurer's ability to reprice quickly. During 2012/13, APRA supervisors met with a number of insurers to gauge the initial impacts of the low interest rate environment on risk appetite and strategy, and on how governance and risk management practices are being applied to assess and manage any emerging challenges. This work is informing APRA's view on appropriate supervisory responses at a broader industry level.
 
The number of insurers offering riverine flood cover in their home and contents policies increased in 2012/13. This response followed the reputational damage some insurers suffered in disputes with policyholders over policy coverage and in associated negative press coverage after the major floods in 2010/11. With the broader coverage, the associated increase in underwriting and pricing risk for riverine flood will need to be carefully managed. Improvements in these processes can be expected to occur as more data are made available and as processes are tested in light of future flood claims experience. Management of these risks was an important part of APRA's reviews of insurers during the year.
 
Strong competition continued in the domestic motor insurance market among the larger insurance groups and a number of smaller insurers that have entered the market in recent years. Price comparison platforms on the internet (known as 'aggregators') still have only a small presence in the home and domestic motor insurance markets but APRA remains watchful of developments. Overseas experience has shown that, because they highlight pricing differences between insurers, aggregators can generate increased customer switching behaviour and this can lead to pressure on insurer profitability.
 
Catastrophe risk management
 
The significant natural disasters in Australia and New Zealand in 2010/11 highlighted two issues: the need for general insurers to have robust reinsurance programmes in place and the overarching importance of strong governance and risk management in determining catastrophe reinsurance needs. These governance processes include the board's and senior management's ability to understand and challenge catastrophe model inputs, assumptions, process and outputs.
 
The adequacy of governance and risk management practices for catastrophe modelling has been an important part of APRA's supervision and was the subject of a thematic review of a sample of insurers in 2012/13. The review found that, for most of these insurers, the level of board engagement in the catastrophe modelling process was either sound or improving. Many used committees of senior management and/or specialists as a forum for challenge when making key decisions in the modelling process, a practice that appeared to work well. The review also found that the level of an insurer's investment in internal modelling expertise heavily influenced its ability to directly engage in the catastrophe modelling process and its outputs, reducing the need to rely on reinsurance brokers or other external experts. Better practice involved insurers taking control of the model assumptions and settings used, with appropriate challenge from business units and/or governance committees. At the same time, the review identified issues with the quality and management of data used in catastrophe modelling and the documentation of assumptions and processes. It was also apparent that, in some cases, undue reliance was placed on model results; there was a lack of appreciation of the weaknesses in the model used and the significant degree of uncertainty in model output.
 
Stronger governance and management of catastrophe risks is needed to properly address these issues. APRA is intent on driving better industry practice in this critical area.
 
Reinsurance counterparty risk
 
The exposure of the general insurance industry to reinsurers is a material source of counterparty risk and that risk is likely to be heightened after major domestic or global catastrophes. In the case of the Christchurch earthquakes, a substantial portion of property claims have yet to be settled because of continuing work on land zoning, land remediation and repair methodologies. For the insurers involved, the reinsurance recoverables associated with these claims, owing from non-APRA-authorised reinsurers, attract a higher capital charge because of the length of time they have been outstanding. This situation will be exacerbated if the insurers involved were to experience further deterioration in these gross claims results. APRA continues to monitor these developments closely.
 
To enhance its understanding of the industry's exposure to individual reinsurance counterparties, APRA outlined proposals in June 2013 to collect reinsurance counterparty data from general insurers and Level 2 insurance groups on a regular basis. APRA had foreshadowed this collection after an earlier ad hoc collection in the wake of the significant natural disasters in 2010/11. The new collection addresses reinsurer downgrade and reinsurer failure. The proposals would enable APRA to determine the impact on an insurer of the downgrade of a reinsurer, based on current reinsurance recoverables. They also require insurers to undertake a forward-looking reinsurance exposure analysis in order to assess the impact of the failure of a material reinsurer. The proposals are intended to be finalised in the latter part of 2013.
 
General insurers have continued to seek out opportunities to access reinsurance capacity through the capital markets or through alternatives to traditional reinsurance products, which in both cases may rely on collateral arrangements. APRA's focus is on ensuring that any such arrangements adequately address prudential requirements, particularly for collateral, and that the prudential requirements keep pace with industry evolution.
 
Reserving risk
 
General insurers (and reinsurers) face the perennial risk of inadequate levels of reserving for their insurance liabilities. This exposes them to the possibility of significant losses if their claims experience, particularly in long-tail insurance business, proves to be worse than estimated. Pressure to sustain short-term profitability in a low interest rate environment may increase the likelihood of unwarranted reserve releases. During 2012/13, APRA undertook a review of the relative reserving strength for particular long-tail classes of business for a peer group of insurers. APRA found that the majority of the insurers had adopted reserving approaches that were not unduly less conservative relative to other insurers in the peer group, but there were some exceptions that APRA has followed up. An outcome of this review has been the development of guidance material and tools to enhance APRA's assessments of insurers' reserving adequacy.
 
Life Insurance and Friendly Societies
 
Notwithstanding the strength of investment markets, the profitability of the life insurance industry declined in 2012/13. Gains in global and domestic equity markets boosted profits on shareholder capital and retained earnings, while income from investment-linked business continued as a relatively stable source of profit. However, profits from risk business fell noticeably, for the second consecutive year. A deteriorating claims experience, particularly for individual income protection business and group insurance, and an increase in voluntary discontinuance ('lapse' rates) mainly explain this fall. Despite the decline in profitability, the capital position of the industry improved a little as insurers replenished capital buffers or took other capital initiatives in anticipation of APRA's revised capital framework for life insurers. Although industry had earlier expressed concerns about capital impacts, the implementation of the revised framework has been managed well, with only a small number of special transition arrangements being approved.
 
Friendly societies as a whole experienced a lift in profitability in 2012/13, due to higher earnings by benefit funds from the strong performance of equity markets. The capital position of friendly societies as a whole also improved moderately.
 
The structure of the life insurance industry was little changed over 2012/13. The industry has broadly coalesced into a number of large diversified groups (including the life insurance subsidiaries of the four major banks), a few prominent group life and investment specialists and some smaller niche participants. For friendly societies, of which only two have assets greater than $1 billion, consolidation pressures will likely continue, especially amongst the smaller societies. Smaller life companies and friendly societies will remain vulnerable to market conditions due to the struggle to maintain a viable scale, the run-off of legacy products and constraints on access to capital.
 
In addition to APRA's revised capital requirements, the life insurance industry has been responding to a range of other regulatory developments that have implications for business strategies and operations, capital management and distribution models. These include the Future of Financial Advice reforms, the Stronger Super reforms, the US Foreign Account Tax Compliance Act and the continuing evolution of International Financial Reporting Standards (for insurance contracts). This has been a substantial workload, which has put pressure on boards and management and has increased operational risk. APRA has been working closely with the industry to ensure that the prudential and other implications of these regulatory developments are fully understood and managed.
 
APRA has also been active in encouraging life insurers and friendly societies to consider the implications of a sustained low interest rate environment and the pre-emptive action that would be needed, if any, to protect policyholder (and shareholder) interests. As noted earlier in this Report, such an environment can put pressure on reserves, profitability from a number of sources and policyholder returns. This is particularly so when business models that are reliant on the continuation of relatively stable interest rates are subject to significant shifts in the interest rate level and structure.
 
From its ongoing supervision, APRA has been well aware of the difficulties facing life insurers in acquiring and retaining skilled resources in the underwriting and claims management areas. Skilled resources have been in limited supply for some time. Apart from enhancing training or seeking support from their reinsurers as they have commonly done, some life insurers have been seeking to recruit from overseas. There are also early signs of the 'offshoring' of certain underwriting/claims processing activities (although not the delegation of decision authorities).
 
Claims experience
 
Earlier indications of deterioration in death and disability claims experience were confirmed over 2012/13, although the picture is not consistent across all life insurers. The deterioration has become particularly evident in products offering income protection, where adverse claims incidence and longer claims duration are reducing product profitability. A major influence at work appears to be the significant downsizing that has taken place in some sectors of the Australian economy, impacting on claims in two ways: increased incidence of stress, depression and related claims, and fewer jobs available for claimants to return to. Improved data collections from 2013 will give APRA a more accurate picture of claims experience.
 
Compounding this problem has been an increase in lapse rates for many life insurers in both death and disability insurance. Contributing factors may be the reduced affordability of premiums and changes in distribution models away from internally sold business to third-party distribution. Directly marketed business has also been prone to high lapse rates in the early years of the product. APRA's particular concern is that life insurers may fail to assume that the lapsing of products is likely to be selective -preferred health risks surrender their policies or take their business elsewhere in search of lower premiums, while poorer risks stay where they are - and possibly underestimate long-term claims costs. This is likely to be exacerbated by any 'churning' of clients by advisers from one insurer to another.
 
To restore profitability, life insurers are looking at a range of responses, including undertaking reviews of product design and pricing, increasing investment in retention programs, tightening underwriting rules, and encouraging earlier claims intervention and accelerated claims closure. Insurers have also given priority to expense control. A small number of insurers particularly affected by adverse claims experience have needed to rebuild capital buffers while the industry, more generally, is seeking to improve returns by more effective utilisation of risk-based capital under APRA's revised capital framework.
 
APRA has been a strong supporter of industry-based death and disability experience studies. These studies, which are now updated every year, provide another perspective and new insights into past trends and their future implications. However, significant delays are involved before results and analysis are completed, and detailed results are embargoed for some time; this makes the studies less useful in monitoring trends. APRA encourages life insurers to participate in these studies, and other industry studies into mortality, morbidity and longevity risk, and provide sufficient resources and quality data to support them.
 
APRA has supported a research project with the University of New South Wales to develop an integrated framework for the economic, actuarial and regulatory aspects of longevity. A further 18 working papers were produced by the project in 2012/13, taking the total to 39 working papers.
 
Group risk insurance
 
Group risk insurance, mainly servicing large superannuation funds, has been a source of concern to APRA for some time, which it has highlighted to individual life insurers and at industry fora. The particular concern has been the sustainability of pricing. A weakening of pricing discipline and foresight, and a significant relaxation of underwriting practices, pushed margins in this business down to unsustainable levels, and pricing assumptions consequently proved to be overly optimistic. The forces behind these developments were the increasing buying power of very large superannuation funds and the drive by some life insurers (together with their reinsurers) to grow market share as quickly as possible without proper regard to pricing and risk issues.
 
The deterioration in claims experience and industry acknowledgement that the bottom of the pricing cycle for group risk insurance had passed saw a strong turnaround in strategies in 2012/13 that made profitability rather than market share the primary strategic driver of this business. Premium rates rose substantially as insurers sought to recover losses and increase prices to a more sustainable basis. APRA welcomes this more realistic approach to pricing.
 
Growth in group risk insurance business had also been encouraged by changes in benefit designs and structure aimed at better meeting the lifestyle needs of superannuation fund members. This strategy may be nearing exhaustion, and trustees now appear to be redirecting their attention to the impact of insurance premiums on members' retirement benefits.
 
APRA has also impressed upon insurers and trustees the need to improve the quality of member and claims data, including data made available to insurers during the tender process for group risk insurance business. A number of questionable practices had begun to emerge in this area, including trustees asking insurers to sign data quality waivers. APRA welcomes indications that insurers are asking more questions than previously about data, claims history and future prospects. The introduction of Prudential Standard SPS 250 Insurance in Superannuation puts the onus for maintaining data quality on superannuation trustees, and this is expected to strengthen the ability of insurers to challenge and reject questionable data. APRA has also released an associated prudential practice guide that provides general guidance to trustees on data management and claims data for tenders. However, there remains an obligation on insurers to ensure that they manage all aspects of their involvement in the group risk insurance market appropriately.
 
Directly marketed business
 
Direct marketing of life insurance to the public (through call centres, the internet and television advertising) continues to grow in popularity. The innovation is not so much in product as in distribution. Product competitiveness appears to play a small role in directly marketed business; the type of direct distribution channel adopted appears to be the main influence on success. To mitigate risks, insurers that are direct selling are attempting to select the best prospects by implicit underwriting and exclusion of certain higher-risk age categories and benefit types. This business carries heightened pricing risk as the largely fixed upfront costs of advertising and promotion need to be covered by sales volumes and ongoing premiums, the latter being prone to high lapse rates. In the case of funeral insurance, in particular, insurers need to fully understand the reputational risks they face from customers subject to substantial premium increases as they age and who may pay more in premiums than they receive in benefits. APRA is closely monitoring the prudential implications of developments in directly marketed business.
 
Superannuation
 
The superannuation industry experienced solid growth over 2012/13, underpinned by a combination of strong overall investment performance and a pick-up in contributions from current members. The rally in global and domestic equity markets, although faltering a little towards year-end, produced double-digit returns on an industry-wide basis. These, in turn, helped restore balances of fund members to pre-crisis levels and improved the financial position of many defined benefit funds. Notwithstanding the pick-up in 2012/13, member contributions were well below pre-crisis rates.
 
Over the year, structural changes associated with the ageing population and consolidation pressures continued to shape the industry. APRA-regulated superannuation funds faced a further increase in outflows, reflecting the exit of members to the self-managed superannuation fund sector and rising benefit payments as the system matures and the population ages. Ongoing consolidation within the industry saw the number of trustees with Registrable Superannuation Entity (RSE) licences decline by 21 to 193 and the number of registered funds under their trusteeship fall by 328 to 3,366.
 
APRA's supervisory efforts over 2012/13 were focussed primarily on implementation of the Stronger Super reforms (see Chapter 3). The second half of the year, in particular, was devoted to authorising MySuper products and assessing the preparedness of trustees for the introduction, from 1 July 2013, of APRA's prudential and reporting standards, a central element of the reforms.
 
In the low interest rate environment, APRA also engaged with those trustees exhibiting an increased investment risk appetite to ensure that they clearly understood and could prudently manage the risks involved. APRA questioned trustees of defined benefit funds on their management of asset-liability mismatch risk and their approaches to revaluing liabilities and adjusting funding plans between triennial valuations.
 
Preparing for Stronger Super
 
The authorisation of MySuper products has been a major supervisory priority for APRA. MySuper is a new superannuation product, with a basic set of product features, that will take the place of existing default funds. APRA must authorise a MySuper product where it is satisfied that a range of statutory requirements will be met, relating to product characteristics, a transition plan, the structure of permitted fees and the fulfilment of enhanced trustee obligations. MySuper is the first product of any kind that has needed to be authorised by APRA. From 1 January 2014, employers will only be able to make Superannuation Guarantee (SG) contributions on behalf of employees who have not chosen a fund into an authorised MySuper product.
 
Most trustees indicated an intention to offer a MySuper product and lodgement of applications to APRA commenced from 1 January 2013. APRA adopted a consultative approach, encouraging engagement with supervisors and draft applications for review and, where appropriate, providing constructive feedback prior to lodgement. The extensive involvement of frontline supervisors has been fundamental. Their institutional knowledge and ongoing dialogue facilitated a more efficient and effective authorisation process and has provided a sound platform for future supervision.
 
As at 1 July 2013, the date from which trustees authorised to do so could offer a MySuper product, APRA had received 75 applications and 48 MySuper products had been authorised. By end September 2013, a further 27 MySuper products had been authorised. APRA has also authorised two trustees to offer eligible rollover funds after 1 January 2014, under revised Stronger Super arrangements.
 
APRA consulted extensively with the industry on the implementation of the new prudential regime in superannuation, built on APRA's prudential standards-making power and new reporting obligations. While many trustees had solid foundations on which to build, some needed considerable effort to close the gaps between their current operations and the requirements of the new prudential standards. In the lead-up to, and following the release of, the final prudential standards, APRA worked closely with trustees to ensure that they were reviewing their existing policies, procedures and processes and making necessary changes in readiness for the new regime. These preparations meant that the industry was generally well placed for the implementation of the prudential standards from 1 July 2013, although further work will be needed to ensure that the standards, and the behaviours they are intended to promote, are fully embedded in industry practice.
 
Similar interaction has taken place on the new reporting obligations. APRA has sought to ensure that trustees were aware of the changes and had considered the adequacy of their systems and processes to meet the obligations. APRA has adopted a phased approach to implementation of the reporting requirements, with some not taking effect until 1 July 2014, and APRA's dialogue with trustees on reporting will continue.
 
Data integrity
 
APRA has continued to stress to industry the importance of data integrity and robust data management in meeting obligations to members. In July 2012, APRA wrote to trustees about data integrity issues, noting that funds still have a way to go before the industry can be considered as handling this issue well. Despite a greater level of industry awareness and some progress towards better management of data, there remains significant scope for improvement. Most trustees appear to lack adequate processes for periodic cleansing and testing of data and remain largely reactive in addressing data issues. The Stronger Super reforms, including the mandating of data and e-commerce standards for superannuation transactions under SuperStream, significantly enhance APRA's ability to drive improvement in data quality within the superannuation industry. APRA will look to leverage off these reforms to encourage greater ownership of data by trustees, particularly in this period of significant systems changes and merger activity. APRA has also released a prudential practice guide on the management of data risk that applies across all APRA-regulated industries, including superannuation (see page 54).
 
Liquidity
 
The continued growth of contributions to superannuation can mask the need for robust management of liquidity risk. Liquidity can be tested by a number of factors, including investment volatility, larger numbers of members moving into the draw-down phase, account consolidation, migration of large balances to the self-managed superannuation fund sector, frozen investments and illiquid asset allocations. In this environment, APRA has encouraged trustees to assess their liquidity needs on an ongoing basis and develop and implement investment strategies that adequately address these needs. Overall, liquidity risk management across the industry has improved since the global financial crisis began, although many trustees continued to lag in the areas of liquidity monitoring, contingency planning and liquidity stress testing. The new Prudential Standard SPS 530 Investment Governance imposes a higher standard of governance in relation to liquidity risk management. Trustees are now required to have a liquidity management plan that incorporates stress testing and actions to be taken in response to adverse liquidity events. APRA will be monitoring how trustees are implementing and embedding the required changes to their liquidity management practices.
 
Many retail superannuation funds continue to hold investments in 'frozen funds' (mortgage and property managed investment schemes) and have sought renewed portability relief under the Superannuation Industry (Supervision) Regulation 1994. Some schemes have been winding up and others re-structuring; however, for many schemes this has been a slow process influenced by underlying impaired assets and valuation concerns. APRA has encouraged trustees to challenge fund managers on the future of these investments and, where appropriate, seek clear timelines for outcomes.
 
Mergers and acquisitions
 
Growing expectations on trustees to reduce costs and demonstrate scale efficiencies are a major driver of consolidation within the industry. The extension of capital gains tax rollover relief for merging APRA-regulated funds during 2012/13 has further fuelled such activity. Mergers give rise to operational and governance risks that need to be carefully managed. In particular, mergers may expose significant weaknesses in data quality and give rise to current or potential conflicts of interest. APRA's engagement with trustees planning mergers also covers the adequacy of the strategic alignment between merging funds, the robustness of due diligence, the equivalency of rights for members and the implications for liquidity and insurance offerings. APRA expects trustees to have effective frameworks to identify, manage and mitigate the risks arising in mergers while ensuring that there is adequate resourcing for ongoing business operations. Trustees involved in mergers have generally been very open with APRA about their plans and have kept APRA informed of any emerging issues.
 
Enforcement Activities
 
APRA seeks to take a collaborative approach to resolving prudential issues with boards and management of APRA-regulated institutions, and this approach generally achieves the desired results. However, APRA is also empowered by legislation to take enforcement action when necessary. APRA's enforcement powers are an important part of its armoury, providing the ability to step in when needed to protect the interests of APRA's beneficiaries (depositors, policyholders and members of superannuation funds).
 
Enforcement options available to APRA include instigating formal investigations into the affairs of an APRA-regulated institution, imposing conditions on an institution's licence, issuing directions related to particular matters, appointing a judicial manager or trustee (as appropriate) to manage an institution's affairs, or accepting enforceable undertakings. APRA can, where necessary, initiate criminal actions or seek to disqualify individuals from holding senior roles within APRA-regulated institutions. APRA can also take action to prevent unlicensed entities from conducting business that can only be conducted by an APRA-regulated institution. Further, as part of the Stronger Super reforms, APRA has been granted the ability to issue infringement notices under the Superannuation Industry (Supervision) Act 1993 (SIS Act) from 1 July 2013.
 
APRA undertook 250 enforcement and related actions during 2012/13. This was a reduction from the 431 actions reported the previous year, due to a decline in the number of formal investigations. The number of complaints APRA received from employees about the failure of employers to remit post-tax employee contributions to their superannuation fund also fell significantly in 2012/13, from 35 to two.
 
APRA's investigation in relation to Trio Capital Limited has continued. Prior to its removal in December 2009, Trio was the trustee of four APRA-regulated superannuation funds and two pooled superannuation trusts. In 2012/13, APRA's investigation resulted in two former directors giving enforceable undertakings to remain out of the superannuation industry for a period of years; another five former Trio directors gave enforceable undertakings to APRA in July 2013. This brought the total number of former Trio directors providing enforceable undertakings to APRA since its investigation commenced to 11. In August 2013, APRA announced that it had commenced disqualification proceedings in the Federal Court of Australia against one former Trio director.
 
In September 2012, the then Minister for Employment and Workplace Relations and Minister for Financial Services and Superannuation announced his decision to grant an additional $16.7 million in financial assistance under Part 23 of the SIS Act in respect of the members of APRA-regulated Trio funds who were affected by loss due to fraud or theft, and to meet further Acting Trustee costs. This brought the total compensation granted to date in respect of the Trio matter to $71.7 million.
 
In April 2013, the then Minister for Employment and Workplace Relations and Minister for Financial Services and Superannuation released the Government's response to the report of the Parliamentary Joint Committee into the collapse of Trio Capital. The response noted that the report 'indicate(s) no systemic issues in the regulation of the superannuation industry'. In line with recommendations made in the report, APRA has reviewed its internal supervision processes in light of issues raised by the Trio collapse. It has also been developing and strengthening its relationships and information-sharing capabilities with other law enforcement agencies, including the Australian Crime Commission, the Australian Securities and Investments Commission (ASIC) and the Australian Taxation Office (see pages 62-66).
 
In the general insurance industry, APRA continued its administration of the Financial Claims Scheme (the Policyholder Compensation Facility), which had been triggered in 2009/10 in relation to a small general insurer, Australian Family Assurance Limited, to which a judicial manager (now liquidator) has been appointed. In conjunction with the liquidator, five claims were finalised in 2012/13. Three claims remain open and APRA continues to work with the liquidator to resolve these as quickly as possible. APRA has also continued to work closely with the judicial manager (now liquidator) to finalise the wind-up of a small general insurer, formerly known as Rural and General Insurance. Pending resolution of a small number of outstanding WorkCover claims, the liquidator expects to be able to wind up the insurer by the end of 2013.
 
In the banking industry, APRA considered 94 matters during 2012/13 relating to the use of restricted words 'bank', 'banker', 'banking', 'credit union' or like names under section 66 of the Banking Act 1959. The increase in the number of such matters (from 76 the previous year) was in part due to ASIC taking over responsibility for the registration of all trading and business names. Previously, this responsibility was shared by ASIC with State Government agencies and requests for registration of restricted words were not always referred to APRA.
 
In November 2011, responsibility for the early release of superannuation benefits was transferred to the Department of Human Services. However, APRA retained responsibility for investigations into three early release of benefit frauds that were in train prior to that date. Two of those matters were resolved in 2011/12. On the third matter, a brief of evidence had been provided to the Commonwealth Director of Public Prosecutions and, during 2012/13, the Court recorded a conviction against the individual concerned. This has finalised APRA's involvement with early release of benefit frauds.
 
Enforcement and related actions1
 
Enforcement Activity ADIs
2012
ADIs
2013
Superannuation
2012
Superannuation
2013
General insurance
2012
General insurance
2013
Life insurance
2012
Life insurance
2013
Friendly societies
2012
Friendly societies
2013
Other2
2012
Other2
2013
Total
2012
Total
2013
Directions and contravention notices3 7 9 157 68 25 5 189 82
Enforceable undertaking 6 2 6 2
Follow-up delayed contributions 35 2 35 2
Investigation action 50 36 50 36
Other actions4 32 31 10 5 44 52 91 83
Prosecution 3 3  
Refer to other agency/police 6 3 12 28 1 1 4 5 23 37
Removal, withdrawal or revocation of license 2 2
Show cause letter 2 4 2 4
Determinations under Financial Claims Scheme 30 4 30 4
Total 45 43 277 140 36 5 0 0 0 0 73 62 431 250
 
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.