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Chapter 2: APRA's supervisory activities in 2011/12

Authorised deposit-taking institutions
Authorised deposit-taking institutions (ADIs) in Australia faced an operating environment in 2011/12 characterised by subdued household and business sentiment and slow credit growth. This picture was little changed from the previous year. The household sector remained prudent about taking on new debt and maintained its stronger savings habit, which provided a benefit to ADIs from a funding perspective. Trading conditions in many parts of the business sector (outside mining-related activities) remained weak, particularly those parts exposed to the high exchange rate, although business credit returned to positive territory in the second half of the year. Overall, credit growth continued at its slowest pace for two decades, the dragging anchor being growth in housing credit at its lowest recorded rate. Notwithstanding this subdued environment and the shadow of global uncertainties, the ADI sector remained in generally healthy condition. Asset quality was sound, with the inflow of newly impaired assets well down from the peaks experienced in 2008/09; however, the slow process of working through impaired assets has left specific provisions elevated. The liquidity and funding positions of ADIs also improved significantly.
The ADI industry remained strongly profitable in 2011/12, particularly when compared with banking systems in many other countries. Profitability was supported by broadly stable net interest margins that underpinned steady core earnings, as well as by containment of costs. The reductions in bad debt expenses that had boosted profitability in the two preceding years appeared to have run their course and, for some mid-sized ADIs, these expenses actually rose. Continued profit retention and dividend reinvestment schemes led to a further strengthening in Tier 1 capital positions. However, this strengthening was not reflected in total capital positions, which have remained broadly steady over the past three years as industry awaited greater clarity on the eligibility criteria for lesser quality capital instruments under Basel III. That clarity has now been provided and total capital positions are expected to increase over the coming period.
Total ADI numbers were little changed in 2011/12. The arrival of new foreign bank branches largely offset a further reduction in credit union numbers through mergers. In addition, five credit unions and one building society, accounting for around 20 per cent of total credit union and building society assets, changed their status to mutually owned banks, having met APRA's substance test to become a bank.
APRA's supervision of the ADI industry during 2011/12 remained focussed on potential vulnerabilities to any further deterioration in the global economic environment, particularly through the direct transmission mechanism of global funding markets. Increasingly, as well, APRA's interactions with ADI boards and senior management have traversed the structural challenges facing ADIs as they seek to maintain shareholder returns without the sustained high asset growth of pre-crisis years.
Liquidity and funding
The larger ADIs continued to strengthen their liquidity and funding positions over the course of 2011/12. They increased their share of funding from deposits and lengthened the maturities of new wholesale funding, in that way reducing their dependence on short-term wholesale debt that is seen as a potential source of vulnerability. The governance, systems and controls around liquidity risk management also improved. In particular, the better managed ADIs now explicitly define their appetite for liquidity and funding risks.
Nonetheless, the acute dislocation in global funding markets in late 2011 again confirmed that liquidity and funding risk requires constant vigilance, by ADIs and APRA alike. At that time, the return of strong risk aversion on the part of investors led to the effective closure of global term unsecured funding markets for banks, whatever their origin. Funding conditions have improved in 2012 and the larger Australian banks have been active issuers in global term debt markets, initially in secured form through covered bonds and later, as risk aversion lessened, in unsecured form. As a consequence, they have moved ahead of schedule in their funding tasks. However, recurring market volatility meant that spreads have only recently returned to mid 2011 levels.
To support its vigilance, APRA has continued to apply additional resources to ensure ADIs are approaching the management of liquidity and funding risk in a prudent manner. The breadth and frequency of APRA's interactions with ADIs in this area ensures that APRA has an extensive understanding of ADI liquidity and funding risk. More recently, these interactions have encompassed ADI planning for the new Basel III liquidity and funding requirements (see Chapter 3). This intensive supervisory stance will be unchanged for some time to come.
The liquidity position of an ADI at any point is a combination of a number of factors but the most important is the funding that the ADI has undertaken in the past. These factors are brought together in an ADI's funding plan, a forward-looking plan with specific quantitative funding targets, which APRA expects to be prepared at least annually and more frequently when material changes occur. APRA's frontline supervisors, working together with its liquidity risk specialists, routinely review and interrogate these funding plans, benchmark projections of forward funding requirements across the industry and scrutinise asset growth targets. A robust understanding of funding plans, and progress in their execution, provides critical insight into emerging liquidity issues.
In addition, supervisors continue to review and analyse base-level ADI liquidity information, including a variety of key metrics such as the average duration of wholesale funding and the level of liquid assets relative to upcoming maturities. Supervisors monitor the 'name crisis' liquidity stress test that larger ADIs are required to meet until the introduction of the new Basel III liquidity standard. Supervisors are also in regular contact, either on a scheduled or ad hoc basis, with ADI treasury staff to understand market and funding conditions. Supervisory engagement on liquidity and funding issues is supplemented by formal on-site reviews. These wide-ranging reviews cover the effectiveness of strategies, policies and systems to measure, monitor and manage liquidity and funding risk in ordinary and stressed operating conditions.
The introduction of covered bonds (see Chapter 3), which are secured debt instruments with continuing recourse to the issuing ADI, was an important structural development in 2011/12, providing ADIs with access to a new source of longer-dated funding. For a time after the late 2011 dislocations, covered bonds were virtually the only instrument attractive to global investors and the larger Australian banks became active issuers, albeit at an elevated cost. The corollary of this investor preference for greater security, however, is that securitisation markets have been slower to recover, particularly for smaller ADIs that have tended to rely on securitisation as a source of funding. New issues of residential mortgage-backed securities (RMBS) have picked-up, supported in some cases by the Australian Office of Financial Management, but spreads are relatively high. Investor appetite for the subordinate tranches of these issues remains weak, in many cases forcing the originating ADIs to retain these tranches. No regulatory capital relief is available to the originating ADIs in these cases, since credit risks associated with a securitisation transaction are concentrated in these subordinated tranches. APRA will be reviewing its prudential framework for securitisation over 2012/13 with the aim of simplifying the framework for market participants and providing more supervisory flexibility.
Credit quality
Close attention to ADI credit quality has been a central element of APRA supervision of the ADI industry long pre-dating the crisis, and it must remain so. Credit quality has proven to be significantly more robust than in most other advanced economies. However, the crisis exposed some weaknesses. Further, as APRA has been warning, the industry faces a key risk that, given subdued credit growth and a competitive retail banking environment, ADIs may seek to gain or maintain market share by relaxing their credit standards.
APRA's supervisory activity involves regular assessments of ADIs' credit risk management frameworks and their implementation, including through on-site prudential reviews. These reviews assess an individual ADI's policies and procedures against those of its peer group as well as against the requirements of APRA's prudential standards. Increasingly, APRA is undertaking more targeted on-site reviews, reflective of the risk-based nature of its supervisory approach and the maturity of the review process. This is most noticeable in the case of credit risk reviews of the larger ADIs.
Credit quality improved over 2011/12, with further falls in the share of impaired assets in business and commercial property lending. Credit quality in housing lending was little changed. That said, non-performing loan ratios overall are still above pre-crisis levels and there has been a relatively constant flow of newly impaired assets, particularly in commercial property lending and certain sectors of business lending. Some ADIs have portfolios of troublesome commercial property loans that will take further time to work out.
In business and commercial property lending, APRA supervisors monitor a range of indicators of credit quality and continue to receive ADIs' own 'watch lists' of difficult credits. In addition to on-site reviews, APRA's supervisors and credit risk specialists have regular discussions with and receive lending survey information from Chief Risk Officers and Chief Credit Officers of the larger ADIs. These discussions also cover, where relevant, credit exposures to European-domiciled counterparties, particularly those counterparties located in the troubled eurozone countries; these latter exposures are relatively small and are being closely managed by ADIs.
In housing lending, APRA's recent supervision of credit risk has been conducted against the background of the high debt levels of Australian households, the concentration of housing lending on ADI balance sheets and some weakness in housing prices in certain areas. APRA's supervisors and credit risk specialists look for any changes in risk appetite and lending strategy of ADIs, variations in credit quality across different geographical regions, and the robustness of governance, credit standards and risk management controls. Broadly speaking, ADIs have reined in their appetite for higher-risk housing lending since the crisis began, although there are signs more recently of a pick-up in high loan-to-valuation ratio lending in response to competitive pressures.
APRA also draws on other 'lines of defence' in its oversight of housing lending risks. Most important are the boards of ADIs, which set the risk appetite for their institution and approve the credit risk framework. Boards of the larger ADIs have provided assurances to APRA that they are actively monitoring housing loan portfolios and are comfortable with their current credit standards. Also important are the external auditors of ADIs, who undertake targeted reviews of particular topics at APRA's behest. The 2011/12 targeted review topic was collateral management and foreclosure management; the 2012/13 topic is housing loan approval standards.
This current targeted review focusses on the income tests that ADIs use to assess whether borrowers can afford the interest and principal repayments on their loans. Loan serviceability criteria are a critical part of the approval process; weaknesses in serviceability policies can quickly lead to increases in the volume of loans defaulting in an economic downturn. In Australia, the very high proportion of variable rate housing lending means that housing credit quality is more sensitive to changes in interest rates than in many other jurisdictions. Further, debt interest payments as a proportion of disposable income, though falling recently, remain quite elevated compared with the experience of earlier decades. The targeted review asks external auditors of the ADIs involved to assess the strengths and weaknesses of the serviceability criteria and serviceability calculators used for housing loan approvals. The assessment will also cover how serviceability policies have worked in practice, including the nature and frequency of policy 'overrides'.
Stress testing
Since the global financial crisis began, there has been an increasing focus globally on the use of stress testing by banking institutions and their supervisors. Consistent with this direction, APRA is investing additional resources in its stress-testing activities as a core area of frontline supervision. In both the ADI and insurance industries, APRA assesses the stress-testing capabilities and analysis of individual institutions to ensure the analysis is robust and factored into decision-making, strategic planning and the institution's Internal Capital Adequacy Assessment Process (ICAAP). APRA also conducts its own stress tests to better understand the vulnerabilities facing individual institutions and industries and the potential for systemic threats. At the individual level, APRA's stress testing can be desk-based by APRA supervisors or by each institution at APRA's request. From time to time, APRA also conducts more comprehensive stress tests at the industry level.
APRA's first comprehensive macroeconomic stress test in the ADI industry was conducted in 2009/10, when the resilience of the 20 largest ADIs was tested against a continued deterioration in global economic conditions that generated a substantial economic downturn in Australia. The stress test confirmed the capital strength of the ADIs involved. As a follow-up, APRA conducted another macroeconomic stress test for five of the largest ADIs in 2011/12. The scenario, developed in conjunction with the Reserve Bank of Australia and the Reserve Bank of New Zealand, involved a sharp slowdown in economic activity in China and a disorderly resolution of sovereign debt problems in Europe, triggering protracted dislocation in global funding markets. Within this context, the scenario envisaged a sharp fall in economic activity in Australia, accompanied by a rapid rise in unemployment and a significant drop in house prices. Despite the severity of this scenario, the stress test showed that none of the five ADIs would have breached the four per cent minimum Tier 1 capital requirement of the Basel II framework but that there was a need to rebuild Tier 2 capital levels, which had been run down ahead of finalisation of the Basel III capital standards.
As part of its 2011/12 Financial Sector Assessment Program review of Australia (see Chapter 3), the IMF conducted a macroeconomic stress test for the five largest ADIs using the same macroeconomic scenario, but taking a 'top-down' modelling approach. The results were consistent with the more granular 'bottom-up' approach of APRA's stress test, providing a cross-check on the process.
Living wills
The concept of 'living wills' arose out of the commitment of global policymakers to strengthen the powers and tools available to supervisory agencies to restructure or resolve financial institutions in crisis. A living will refers to two separate but related matters: recovery planning, in which a financial institution sets out the actions it would take to survive a severe crisis without public sector intervention; and resolution planning, which focusses on measures that would enable a cost-effective resolution of the institution by the authorities where recovery is not possible. The living will concept is central to global reforms designed to ensure that systemically important financial institutions can remain operational in the event of severe distress, in a way that minimises adverse systemic impact and the need for taxpayer assistance.
In the latter part of 2010/11, APRA commenced a pilot program on recovery planning involving a number of the larger ADIs. These institutions were asked to prepare a comprehensive recovery plan identifying a list of possible actions to restore financial soundness in the event of a major depletion of capital and associated liquidity pressures. The recovery actions needed to generate a material improvement in capital and funding within a reasonable period of time, and be credible and realistic. Finalised recovery plans, signed off by the board of each ADI, were received by the end of July 2012.
The recovery plans are comprehensive, with all ADIs involved in the pilot program developing reasonably extensive lists of recovery actions and most providing alternative projections of recovery adopting different selected actions. APRA expects that recovery planning for these ADIs will now be integrated within their existing risk management processes, ensuring that the initial recovery plans are periodically reviewed and updated. APRA also expects these ADIs to challenge their recovery planning with alternative and potentially more severe events, and consider mitigating actions that would ensure effective recovery in a timely manner. In this context, recovery plans need to consider the preparatory steps ('pre-positioning') that could improve the likelihood of recovery, particularly for recovery actions that would have to be taken quickly in need.
The pilot program has provided APRA with a better understanding of the strategic and operational complexities associated with planning and implementing recovery actions and has helped to shape APRA's thinking on the application of recovery planning beyond the larger ADIs. APRA is extending the recovery planning exercise to the next tier of ADIs and is considering its extension to the larger general insurers and life insurers in 2013.
Executive remuneration
During 2011/12, APRA met with the Board Remuneration Committees of a number of the largest listed ADIs and insurers chosen for a detailed review of their executive remuneration arrangements. These were part of a wider group of institutions for which APRA undertook peer group comparisons the previous year. APRA's focus on executive remuneration arrangements is not on the size of executive packages but how they are structured. Its prudential requirements on remuneration, which came into force in April 2010, reflect the lessons of the crisis that poorly structured remuneration arrangements provide incentives for excessive risk-taking, encouraging an accumulation of risk rather than its prudential management.
APRA's conclusions from its detailed review confirmed its views from the earlier peer group comparisons 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.
All of the boards with which APRA met had well established Board Remuneration Committees, with reasonably clear and robust governance arrangements and strong linkages to the Board Risk Committee. In a limited number of cases, however, there seemed to be a degree of tension between the roles of the board, which has ultimate responsibility for the structure and outcomes of remuneration arrangements for senior executives, and of the Chief Executive Officer. Moreover, there appeared some inconsistencies in the extent of board approval of the remuneration of material risk-takers below the senior executive level and of executives in APRA-regulatd subsidiaries within a group. APRA also found that approaches to the use of performance scorecards to determine remuneration varied widely. The design and application of scorecards is critical to ensuring risk and reward are properly aligned. A scorecard based solely on judgment does not provide a sound basis for remuneration decisions while an entirely mechanical or formulaic approach prevents Board Remuneration Committees from providing a sensible overlay where key performance indicators do not present a true measure of an individual's performance. A balance between the two approaches needs to be achieved.
Finally, on the structure of remuneration arrangements, APRA found that almost all institutions with which it met use a combination of short-term and long-term incentives for senior executives. For both types of incentives, there was welcome progress in extending deferment terms, consistent with the intent of APRA's remuneration requirements. However, the ability to clawback unvested payments was not always evident. For some institutions, the scope for withholding unvested payments if, for example, there was subsequent evidence of financial misconduct, was very restricted.
In July 2011, the Basel Committee on Banking Supervision released its Pillar 3 disclosure requirements for remuneration, requiring both qualitative and quantitative disclosure on remuneration by banking institutions. In October 2011, APRA wrote to locally incorporated ADIs encouraging them to include these disclosures in their next annual report or Pillar 3 disclosures. APRA will be consulting with the ADI industry in 2012/13 on the formal inclusion of these disclosure requirements in an expanded version of Prudential Standard APS 330 Capital Adequacy: Public Disclosure of Prudential Information.
Operational risk
The number of material operational risk incidents during 2011/12 was smaller than the previous year, when natural disasters in Queensland as well as security breaches and some serious payment system outages impacted on operations. Though there were incidents of system outages and denial of service attacks, the number of high severity outages fell.
A number of ADIs are in the process of, or are planning for, replacement of their core banking systems. There are considerable risks in doing so, reflecting the age, scale and complexity of these systems. APRA's supervisors and technology risk specialists require regular updates on these core system replacement programs so that they can assess the risks involved. That said, the replacement or upgrading of outdated operating systems, hardware and software must remain a priority if the reliability of banking services, and public and market confidence in ADIs, is to be maintained. APRA and the Reserve Bank of Australia are coordinating efforts to promote greater resilience in ADIs' retail systems, including encouraging continued progress in programs of remediation. APRA's role is to promote the right incentives, governance and transparency to ensure that ADIs are dedicating the necessary effort to the task.
APRA has 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 changes in operational risk profiles. The adequacy of operational risk capital held by banks has become a concern globally and APRA has been participating actively in work on this topic with overseas counterparts, under the auspices of the Basel Committee on Banking Supervision. APRA has concluded that the current models of advanced ADIs generally understate operational risk capital requirements and are not sufficiently sensitive to material changes in operational risk profiles. As a result, APRA has been working closely with these ADIs in pursuing a range of improvements in their operational risk modelling and increases in the capital held against operational risk.
General insurance
The general insurance industry remained profitable and was able to build up its capital position in 2011/12, after the experience of a spate of natural disasters in Australia and New Zealand the previous year. The size and structure of the industry remained relatively stable.
A significant proportion of the industry's premium revenue is generated from underwriting property risks and, hence, the industry's financial performance can be heavily influenced by the occurrence of natural disasters, in terms both of their frequency and their severity. The main influence in 2011/12 was the significantly lower level of gross claims from natural disasters compared to the previous year. The interest rates used in valuing long-tail insurance liabilities fell in 2011/12 and this in turn drove these liabilities higher. However, those falls in interest rates also flowed though to higher investment income in the form of significant realised and unrealised gains on fixed-income securities. The aggregate capital ratio rose over the year to around 1.8 times APRA's minimum capital requirements.
A large portion of the industry's gross property claims from the recent spate of natural disasters have been covered by reinsurance. The consequence, however, has been a general hardening of the reinsurance market, including higher reinsurance premiums and revisions to terms and conditions when insurers sought to renew their property catastrophe reinsurance arrangements in 2011/12. Many insurers responded to the hardening market conditions by reviewing their risk appetites and, in some cases, changing their property catastrophe reinsurance arrangements, particularly by retaining more catastrophe risk on their balance sheets. Insurers also sought to offset the impact of higher reinsurance costs by increasing premium rates in some classes of business. Some insurers reviewed their exposures in geographical regions exposed to catastrophe perils to determine if premiums were commensurate with the risk, leading in some cases to increases in premiums or a withdrawal from underwriting risks in a particular geographic region.
One key outcome of the natural disasters in Australia in 2010/11 has been the prominence given to the availability and affordability of insurance for riverine flood in those communities most at risk. More insurers have made riverine flood insurance available and, increasingly, the cover is mandatory under the policy. However, the challenges involved in pricing riverine flood risk are significant, particularly for small and medium-sized insurers that may not have the volume and range of data that are available to the larger insurers. The Government's intention to provide a central national access point containing all existing flood risk information will be an important resource in assisting all insurers in their pricing of riverine flood risk.
APRA continues to monitor the development of price comparison platforms (known as 'aggregators') in the general insurance market in Australia, which to date have been more prominent in the retail market. These are businesses using the internet to allow consumers to compare the offerings of multiple insurers when purchasing insurance. 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. Thus far, aggregators have had limited impact in the retail market in Australia, mainly because the larger insurers do not offer their products through aggregator sites. It is too early to assess the impact of commercial lines aggregators on the broader commercial insurance market.
Reinsurance counterparty exposure
The exposure of the general insurance industry to reinsurers is a material source of counterparty risk and this risk was heightened in 2010/11 following the spate of natural disasters. APRA's special data collection in that year showed that the industry is well diversified in terms of reinsurance counterparties and that most reinsurers used were rated AA- or A+. The data collection was a valuable addition to APRA's regular data collection on reinsurance counterparty exposure, which has a more insurer-specific focus and, accordingly, is difficult to aggregate across the industry. APRA is currently consulting on whether the regular reporting should be augmented with information similar to that in the special data collection.
Reinsurance placement risk
APRA has been closely monitoring trends and developments in the property reinsurance market, described above, drawing on its frontline supervisors and insurance risk specialists. The work has mainly involved reviews of documentation from individual property insurers, such as their Reinsurance Arrangements Statements and business plans, and assessment of the impacts of changes in their catastrophe reinsurance programs and capital management strategies. The work has also involved examination of industry-wide themes, such as quality of stress testing performed — where there is clearly room for improvement — and the catastrophe modelling used in the determination of reinsurance arrangements. Any general issues identified are communicated to industry through various forums, while feedback specific to individual insurers is provided by frontline supervisors.
Catastrophe modelling processes
The reinsurance arrangements in place during recent natural disasters have been an essential underpinning of the resilience of the industry. A key influence on the structure and nature of reinsurance arrangements is catastrophe modelling, which is used extensively by insurers. Effective risk management and governance practices are important controls in the catastrophe modelling process. Poor practices can lead to inadequate levels and/or structure of reinsurance arrangements, which in turn can have significant impact on insurer risk exposure and profitability, and lead to inappropriate pricing and inadequate capital targets. APRA is concerned that boards and senior management may rely too heavily on catastrophe modelling output and the model's 'black box', without sufficient challenge and debate. In particular, boards and senior management need to recognise the limitations of the models used, and the potential sensitivity of results in the tail of the distribution, when designing their reinsurance requirements. APRA is currently assessing the catastrophe modelling governance practices of a number of insurers to understand the range of industry practices adopted. At a minimum, these findings will inform APRA's supervisory approach to this issue across the industry.
Adequacy of pricing processes
Reviews of the pricing processes and controls of insurers, using its insurance risk and actuarial specialists, form a significant part of APRA's ongoing supervision of the industry. APRA sees heightened risk in this area, not only from increased competition in some classes and the need for improved pricing for riverine flood insurance, but also from the current low interest rate environment. A sustained low interest rate environment is likely to cause upward pressure on premiums, particularly for the long-tail classes of business. Strong competition and subdued demand in some of these classes, however, may hinder an insurer's willingness or ability to obtain the required premium rating to meet profitability requirements for these classes.
Adequacy of reserving
APRA's supervision also focusses closely on reserving risk — the risk of inadequate reserving for insurance liabilities that can expose insurers to significant losses if their claims experience proves to be worse than estimated. Prior-year reserve releases have made a significant contribution to industry profitability in recent years. A key driver of these releases has been insurers' favourable claims experience following tort law reform, which had a significant impact on the compulsory third party (CTP) and liability classes. APRA is concerned that current pressures on industry from natural disasters and other factors may increase the likelihood of unwarranted reserve weakening in order to sustain short-term profitability. APRA is undertaking a review of the relative reserving strength of a range of insurers, concentrating on the underlying reserving assumptions and methodologies used in major classes of business.
Life insurance and friendly societies
Notwithstanding the volatility in global and domestic fixed-income and equity markets, the profitability of the life insurance industry (including friendly societies) was largely unchanged in 2011/12. The nature of the business in force meant that much of the effect of investment volatility was passed on to policyholders and the lower investment income attributable to shareholders was largely offset by underwriting profits from individual risk insurance business. Over the year, life insurance assets increased slightly but the capital position fell a little. Even so, capital adequacy remains around pre-crisis levels and life insurers have the capital resources and robust capital management needed to absorb further shocks, reflecting the priority that APRA and life insurance boards gave to capital strength through the crisis. Nonetheless, life insurance boards and management will need to remain vigilant about their capital positions in these unsettled times. Australian life insurers and reinsurers that have ceded risk to their European parents via reinsurance must be particularly alert to developments in Europe.
There were no major changes to the structure of the life insurance industry over 2011/12, although financial groups continued to rationalise their multiple licences. The size and structure of the friendly society industry was little changed.
The risk insurance business, the major area of activity for life insurers outside their superannuation business, has grown strongly for some years now. This is likely to continue, as much of the growth in premium revenue is due to age increases and indexation of the in-force book. Moreover, while investment markets remain uncertain, financial planners are likely to direct more attention to this market. Competition is largely driven by the need to gain the support of financial planners, and policy features regularly expand and underwriting requirements decline in response. This business has been generally profitable and a number of insurers have specialised in it. However, some poor underwriting and claims practices have emerged in more recent years, which have had a damaging impact on emerging profits. There are some indications that, in response, insurers are starting to adopt a more disciplined approach to their pricing and/ or underwriting. Time will tell how the tension between the need to attract business from financial planners and sensible business practices plays out. This business is coming under increasing APRA scrutiny.
For the life insurance industry, a range of regulatory developments has the potential to cause disruption and require a review of business models. These developments relate to distribution (the Future of Financial Advice reforms), superannuation (the Stronger Super reforms), capital requirements (APRA's life and general insurance capital review), accounting requirements (International Financial Reporting Standards) and operations (the US Foreign Account Tax Compliance Act). APRA continues to work closely with the industry to ensure that it fully understands the operational risks and other prudential implications of these developments.
In its ongoing supervision, APRA has been reviewing the availability of relevant skills for management and boards of life insurers and friendly societies. Skilled resources appear to be in short supply in the areas of underwriting and claims management particularly. Boards need appropriate breadth of relevant skills and industry experience and an understanding of the business, including its operating model, its strategy and its capital and risk management, and should not rely solely on senior management or Appointed Actuaries in these areas. Friendly societies tend to have less complex business models and product offerings, which may be reflected in the skills requirements for boards and management, but they face the same regulatory environment as life insurers and so should be appropriately skilled. APRA has continued to emphasise to boards the importance of strong risk management, including effective risk appetite statements and robust stress testing and scenario testing. APRA intends to provide further guidance in these areas.
Group risk insurance
Group risk insurance, mainly servicing large superannuation funds, now accounts for about one-third of risk insurance business. A small number of insurers, particularly those without a strong brand or distribution capabilities, have been active in this market as a way of building market share. Prudential risks associated with the capital support, operational management and pricing processes for group risk insurance have been of concern to APRA for some time. Some of the practices in this area have been poor. The fact that this business delivers only about 10 to 20 per cent of the profits from risk insurance business confirms a narrowing of profit margins and illustrates the importance of economies of scale for group business. Insurers need to capture and retain large volumes of group business from a range of customers to ensure this business line is sufficiently diversified and robust.
The Stronger Super reforms provide an opportunity to improve practices from the 'demand' side as well as the 'supply' side, since they put an onus on superannuation trustees to ensure that their members are best served by the insurance made available to them through their fund. New prudential standards and guidance will sharpen trustees' focus in this regard.
Directly marketed business
Direct marketing of life insurance has blossomed with the emergence of new distribution channels. These involve marketing of life insurance products directly to the public through call centres, the internet and television advertising, often at high prices. APRA's focus is on the governance associated with this business, the risks such products might pose to the reputation and viability of insurers and whether these risks are being appropriately managed. Many of the concepts in this area are unproven and the market is becoming crowded, which will put pressure on profitability. APRA has also been in discussions with the Australian Securities and Investments Commission (ASIC) over directly marketed business to ensure consistent understanding and coordination of scrutiny in this area.
Claims experience
A recent deterioration in death and disability claims experience has put pressure on the profit margins of some insurers, although the pattern is not consistent across the industry and it is not yet clear whether the deterioration represents the beginning of a trend or is just a short-term fluctuation. The deterioration is particularly evident in products offering income protection, where adverse claims incidence and claims termination are reducing product profitability. This deterioration may be a consequence of weaknesses in some sectors of the Australian economy; it may also reflect the increasing sums insured due to indexation, the changing mix of business from underwritten and guaranteed acceptance (with higher associated claims rates), and/or past relaxation of underwriting requirements. APRA will continue to monitor these developments closely.
APRA has continued its dialogue with the life insurance industry over the importance of industry-based death and disability experience studies and on the quality of data used to produce them. Currently, life insurers are unable to correctly identify the level of underwriting at risk commencement, or even when a policy is on the books because of replacement, continuation or buy-back of cover, meaning that the impact of any raising or waiving of medical requirements is uncertain. APRA welcomes the production of industry lump-sum death/ disability experience studies that cover the majority of the yearly renewable term insurance market. An experience study covering one year of disability income protection has been produced and an analysis of the period 2007-09 has commenced.
APRA continues to support a research project with the University of New South Wales to develop an integrated framework for the economic, actuarial and regulatory aspects of longevity. The four-year project produced a further seven working papers in 2011/12, taking the total to 21 working papers.
Although the superannuation industry continued to grow, the volatility in global and domestic investment markets resulted in returns for superannuation funds that were flat on average in 2011/12. Though lower than the previous year, returns on fixed-income investments helped to offset the decline in equity markets. Continuing net inflows to superannuation provided much of the growth in total industry assets over the year. Trustees are giving greater scrutiny to the structure and cost of investments, with many trustees turning their attention towards delivering good outcomes to members in investment markets that threaten to remain unsettled.
Many defined benefits funds continue to work through funding challenges that have been evident since the global financial crisis began. Overall, however, APRA believes that the solvency of defined benefit funds is being managed appropriately and there is near-universal compliance of employers with funding requirements and rectification plans (where required).
Continuing superannuation fund mergers and consolidation saw the number of trustees with Registrable Superannuation Entities (RSE) licenses fall by 11 to 214, and the number of registered funds under their trusteeship fall by 379 to 3,694.
Anticipation of the Government's Stronger Super reforms (see Chapter 3) has led trustees to examine and evaluate their current products, operations and governance structures. APRA's supervisory efforts during 2011/12 have been focussed on working closely with trustees to determine their strategies and state of preparedness for these reforms. Ongoing issues such as the quality of trustee oversight, the robustness of risk management frameworks (especially those relating to investment risk) and the challenges posed by volatile investment markets have also received close attention from APRA.
Preparing for Stronger Super
Many trustees have begun planning for the Stronger Super reforms and have been assessing possible gaps between their current practices and the new prudential regime. However, a number of trustees are less advanced in their preparations and will need to devote time and resources to this task. APRA supervisors have been working closely with trustees to gain an understanding of their strategy and, in particular, their ability to meet the requirements for offering the new MySuper product. This engagement will intensify as trustees commence submitting draft applications before their formal applications are able to be lodged from 1 January 2013. APRA has been encouraging trustees to work closely with their responsible supervisor to ensure a smooth transition.
The introduction of prudential standards in superannuation will require a heightened level of governance and management for all trustees. Many trustees have a solid base to build on in adapting to the new requirements but others will need to make considerable effort to ensure that they will comply.
While the Stronger Super reforms do not, of themselves, necessitate any need for the merger of superannuation funds, there is a level of ongoing discussion between trustees about potential fund mergers. The Government's proposal to allow an extension of tax loss relief for merging APRA-regulated funds is also likely to facilitate further mergers and consolidation. Although APRA does not have the power to approve or reject mergers, it is ever mindful of the risks to members posed by a poorly performed (or aborted) merger. APRA has been encouraging trustees to conduct thorough due diligence on potential partners and devise their own specific plans, objectives and timeframes before entering into formal arrangements, so as to ensure that when mergers do take place they occur smoothly.
Governance and risk management
A key element in APRA's supervisory framework is its assessment of the adequacy of trustee risk management frameworks. Trustees have been devoting more attention to risk management but further progress is needed to meet APRA's expectations and achieve the level of maturity of other APRA-regulated industries. A general finding from APRA's supervision is that risk management functions suffer from inadequate resourcing; the effectiveness of these functions could also be enhanced through more detailed reporting to and engagement by trustee boards. Another recurring finding is a lack of compliance with trustee policies and procedures. This is particularly prevalent in the case of policies on fitness and propriety of directors and responsible officers, and the management and oversight of outsourced service providers.
Data integrity
APRA has been emphasising to trustees that, if they are to successfully meet their obligations to members, they must have a data management framework that ensures complete, accurate and timely member data. In April 2012, APRA released two prudential practice guides in the area of contribution and benefit accrual standards, and payment standards, that encourage trustees to develop a data reliability framework. In July 2012, APRA wrote to trustees about data integrity issues, noting that funds still have a good way to go before the industry can be considered as handling this issue well. In this context, the introduction of SuperStream, which aims to streamline superannuation transactions, will mandate data and e-commerce standards and allow members to more easily consolidate multiple superannuation accounts.
The superannuation industry continues to benefit from strong net inflows and ongoing momentum in the domestic economy and further increases to the Superannuation Guarantee should see this trend continue. Nonetheless, trustees need to guard against complacency in their overall liquidity management. APRA supervisors regularly liaise with trustees on how they assess liquidity needs in relation to their fund's demographics and liability obligations, the strategies being undertaken to meet these obligations and the impact of investments that became illiquid. APRA has noted an improvement in how trustees conduct liquidity management, including greater use of stress testing.
There has been little tangible improvement in the area of frozen funds, which are predominantly property and mortgage schemes. A number of the underlying schemes are in the process of restructuring or terminating and trustees are working with scheme managers to obtain redemptions or return of capital. APRA continues to assess and, where appropriate, grant applications from portability requirements under the Superannuation Industry Supervision Regulations 1994.
Enforcement activities
APRA's supervisory approach is based on the fundamental premise that the primary responsibility for financial soundness and prudent risk management within an APRA-regulated institution rests with its board of directors and senior management. APRA seeks to work constructively and openly with these parties to address any prudential issues and ensure that institutions can meet their financial promises to beneficiaries (depositors, policyholders and superannuation fund members). However, where that cooperative approach does not resolve any outstanding prudential issues, APRA has available to it a range of graduated remedial actions to protect beneficiaries, culminating if necessary in enforcement action.
Enforcement actions include instigating formal investigations into the affairs of a regulated 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. APRA can, where necessary, initiate criminal actions, seek restraining orders or seek to disqualify individuals from holding senior roles within regulated institutions. APRA can also take action to prevent unlicensed entities from conducting business that can only be conducted by an APRA-regulated institution.
During 2011/12, APRA undertook 431 enforcement and related actions. This was an increase on the 377 actions reported the previous year, reflecting the processing of claims under the Financial Claims Scheme in the general insurance industry and a step-up in the intensity of APRA's major investigations.
APRA continued its investigation in relation to Trio Capital Limited, which was the trustee of four superannuation funds and two pooled superannuation trusts prior to its failure in December 2009. APRA's investigation has resulted in six former Trio directors giving enforceable undertakings to remain out of the superannuation industry for periods ranging from four to 15 years. These undertakings related to the failure of the directors to meet the high standards expected of them as trustee directors and not acting in the best interests of members, including in relation to investments in offshore hedge funds. APRA's investigation in relation to Trio is now focussing on former Trio directors who had been involved in Trio's operations before its collapse in late 2009.
In May 2012, the Parliamentary Joint Committee on Corporations and Financial Services reported on the collapse of Trio. In response to the Committee's recommendations, APRA is undertaking activities in four main areas:
  • giving consideration, in conjunction with the Government, to legislative gaps that may need to be addressed;
  • reviewing APRA's internal supervision processes in light of issues raised by the Trio collapse;
  • enhancing APRA's approach to intelligence gathering and analysis, in cooperation with the Australian Federal Police, the Australian Crime Commission and other agencies; and
  • enhancing APRA's information sharing with the Australian Securities and Investments Commission (ASIC) and the Australian Taxation Office.
APRA is cooperating with other agencies undertaking criminal investigations of key figures responsible for defrauding Trio.
In April 2011, the then Assistant Treasurer announced his decision to grant financial assistance of $55 million under Part 23 of the Superannuation Industry (Supervision) Act 1993 (SIS Act) in respect of the members of the APRA-regulated Trio superannuation funds who were affected by loss due to fraud or theft. In February 2012, the Acting Trustee of Trio paid compensation totalling $52.4 million to these members. In May 2012, the Acting Trustee lodged a further application for financial assistance to provide additional compensation to members and meet further Acting Trustee costs.
During 2011/12, APRA received 35 complaints relating to the failure by employers to remit employees' voluntary post-tax employee superannuation contributions to their superannuation fund. 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.
In the general insurance industry, APRA continued the 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 had been appointed. During 2011/12, an amount of around $1.3 million was paid out under the Scheme to eligible policyholders. The scheme was closed to new claimants from October 2011. APRA continues to work through the small number of remaining claims applications with the judicial manager (now liquidator) to finalise the liquidation of the insurer.
APRA has continued working closely with the judicial manager (now liquidator) appointed in June 2010 to another small general insurer, formerly known as Rural and General Insurance Limited. The liquidator has now declared a dividend in the liquidation and determined that there will be no eligible policyholder shortfall in the liquidation.
In the banking industry, APRA considered 76 matters during 2011/12 relating to the use of restricted words 'bank', 'banker', 'banking' or like names under s66 of the Banking Act 1959. A substantial proportion of these related to the use of the restricted words by entities outside the financial services industry.
In November 2011, responsibility for the early release of superannuation benefits was transferred to the Department of Human Services. However, APRA continued to finalise three remaining investigations into early release of benefit frauds. The briefs of evidence on these matters have been provided to the Commonwealth Department of Public Prosecution. As a result, two matters have been heard (resulting in two guilty verdicts) and the final matter will shortly go to court.
Enforcement and related actions1
  ADIs Superannuation General insurance Life insurance Friendly societies Other2 Total
  2011 2012 2011 2012 2011 2012 2011 2012 2011 2012 2011 2012 2011 2012
Directions and contravention notices3 9 7 164 157 2           5 25 180 189
Enforceable undertaking       6                   6
Follow-up delayed contributions     40 35             2   42 35
Investigation action     73 50                 73 50
Other actions4 37 32 13 10   5         11 44 61 91
Prosecution       3                   3
Refer to other agency/police 1 6 15 12   1         5 4 21 23
Removal, withdrawal or revocation of license       2                   2
Show cause letter       2                   2
Determinations under Financial Claims Scheme           30               30
Total 47 45 305 277 2 36 0 0 0 0 23 73 377 431
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.