APRA appreciates the opportunity to contribute to this SIA seminar.
In July this year, the second most significant reform in Australian general insurance history - after the 1973 introduction of the original Insurance Act - took effect in the form of a revamped Insurance Act and modernised set of APRA prudential standards.
To add force to this regulatory reform, APRA is now paying more regard to early warning signs and to prompt intervention in our operational approach to the ongoing surveillance and supervision of the industry.
Before outlining some key aspects of our new approach to general insurance regulation and supervision, it might be useful to reiterate where APRA sits in the broad scheme of Australian financial regulation.
Under the Government’s 1998 financial sector reforms following the Wallis Inquiry, safety and soundness requirements for general insurers - codified in the Insurance Act - are the responsibility of APRA.
In particular, APRA’s role is to help keep insurance companies solvent into the future, so they can continue to pay claims. At the same time, we are required in safeguarding policyholder interests to avoid unduly detracting from competition in the industry.
In practice, competition has never been an issue. There are still well over 100 general insurers competing for new business in the local market, even though we recently upgraded the entry barrier.
Indeed, it has been frequently and reasonably observed that the Australian general insurance market tends to be over-serviced and under-priced.
The community also needs to be aware of the limits to our mandate. For example, APRA does not have a commission to guarantee claims or to regulate premiums.
And consumer matters in general insurance - including product disclosure, sales conduct and complaints handling - are the responsibility of the conduct and disclosure regulator, ASIC.
The general insurance industry has been in pressing need of major regulatory reform and better commercial management, for some time.
Recent years have seen large losses in the industry - conceivably over $7 billion in total - largely due to the failure of four long-tail companies: HIH, New Cap Re, ReAC and GIO Re.
Even then, industry problems have been understated as a result of unusually strong investment returns during the 1990s, which had the effect of masking some massive underwriting losses.
Underwriting losses have averaged over $1 billion per year since the mid 1990s, a result that is simply unsustainable in the longer-term.
In July 1998, when APRA started, we inherited an outdated Insurance Act and set about developing proposals for major reform. These were subsequently enacted by Parliament in August 01, and took effect from July 02.
As a result, the industry is now under a strong regulatory discipline to assess risks more accurately, price products more commercially and set provisions more prudently.
In addition, APRA resolved to conduct its ongoing supervision of the industry in a more forceful and less accommodating manner than had been traditional in the past.
For our part, we have clearly made mistakes and are keen to learn from that experience. APRA can do better, and we intend to do better.
There are four aspects to our contemporary regulation and supervision of general insurance that I wish to highlight today:
- the role of the actuary and safety margin in liability valuation;
- The increased capital requirement for higher risk companies;
- APRA’s upgraded internal risk rating system; and
- the dangers of unregulated insurance.
Prior to July this year, general insurers had far too much discretion in how they set their technical provisions - that is, brought their policy liabilities to book.
This provided the potential for the technical provisions to be manipulated for various commercial purposes, with potentially adverse consequences for policyholders, creditors and shareholders.
The most glaring gap was the lack of a mandatory safety margin in that key item in an insurer’s balance sheet, the policy liabilities.
The silence of general insurance Accounting Standard 1023 on the question of a safety margin for policy liability estimates has been, in APRA’s view, quite unhelpful in this regard.
The concept of setting insurance provisions according to a central estimate plus safety margin has been around for 20 years. And we now have evidence that companies that get into trouble are more likely to be those that have dispensed with a safety margin.
APRA‘s new Liability Valuation Standard seeks to improve the reliability, consistency and risk sensitivity of the technical provisions by mandating a safety margin and actuarial advice.
General insurers are now required to have an Approved Actuary who can demonstrate professionalism, honesty, and freedom from conflicts of interest.
The intention of the Approved Actuary requirement is to ensure that the Board of an insurer has the benefit of objective, expert advice when valuing policy liabilities.
The Board has the power to override the Actuary’s advice, but will have to report and defend any such decision to the regulator and to the market. We would be surprised to see that.
In any event, compliance with the Liability Valuation Standard is compulsory; and APRA also has the right to require a company to increase its technical provisions in the interests of policyholders, if we consider that to be prudent and appropriate in the circumstances.
In practice, companies will be under intense market pressure to accept the advice of their Approved Actuary.
An insurer’s technical provisions set at the fair value of its policy liabilities provide some comfort for policyholders, but not enough.
Capital is also needed to the absorb the unusual and extreme shocks that are not expected in the normal course of business, but which can emerge out of nowhere at any time to buffet the fortunes of a company and threaten the interests of its policyholders.
Small companies need to meet a significant threshold size or entry hurdle to operate in what is an inherently risky industry, and the absolute minimum capital requirement for general insurers has risen from $2 million to $5 million, compared to $10 million for life companies.
Above the $5 million floor, an insurer’s regulatory capital requirement is calibrated to its risk profile. For example, companies writing long-tail liability insurance need more capital - to meet the greater uncertainty they face - than do companies writing short-tail property insurance.
Asset side risks were overlooked in the old regime, and insurers with significant investment risks now face a higher capital requirement. This will hopefully deter companies from responding to the end of a bull market with an imprudent, higher risk investment strategy.
While average regulatory capital requirements rose on 1 July by a significant margin, the industry at an aggregate level continued to hold a significant buffer over APRA requirements.
For example, the six or so major general insurance companies - accounting for around 80% of direct underwriting premium - were already well placed to readily meet the new requirements.
At an individual company level, however, some marginal insurers were forced to raise new capital, merge with a stronger competitor, or go into run-off. Where exits have occurred, these have been orderly, and at no cost to policyholders.
For the first time, general insurance companies are now permitted - as banks have been for some time - to have a mix of Tier 1 and Tier 2 funding, where Tier 1 is higher quality capital such as owners’ equity, and Tier 2 is lower quality capital such as subordinated debt.
From a regulatory perspective, Tier 1 capital provides more comfort, and at least half of the minimum capital requirement must take this form; but from a commercial perspective, Tier 2 capital can be cheaper to raise after tax, and should benefit the industry bottom line.
A prudential regulator like APRA needs not only to develop a strong set of minimum standards, but also to supervise regulated entities on a regular basis to monitor their performance and enforce regulatory compliance.
APRA uses a risk based approach to supervision that draws on our internal rating system for scoring each entity in the regulated population, so that its supervision can be tailored to its risk profile.
During the last year, we upgraded this system to a new one called the Probability And Impact Rating System, or PAIRS for short, that takes into account the impact of failure, as well as the probability of failure.
The PAIRS system borrows from the risk rating models of our Canadian and British counterparts, but also incorporates a local innovation by indexing and combining the respective probability and impact measures to create a single, numerical Attention Index.
The probability component of the rating system is a systematic and structured measure of each entity’s inherent risk profile, minus the mitigating effect of its risk controls and capital support.
The impact component of the system currently reflects the size of an entity - that is, the larger the entity, the greater the potential threat - although more sophisticated measures of impact are being considered.
The composite Attention Index is a non-linear measure of the threat an entity poses to the safety of the regulated financial sector. As probability of failure and impact of failure rise, the composite Attention Index rises at an increasing rate.
Thus, the Attention Index ranges from a minimum score of one for a low probability/low impact entity, to a maximum of 56,250 for an extreme probability/extreme impact entity - this involves some mathematics that are too mysterious for me to attempt to outline here today.
Once an entity is assigned a rating, a commensurate strategy is designed to align the intensity of the supervision with the scale of the threat. It is not intended to publicly disclose these ratings, but the regulated entities will be in no doubt as to how we view them.
Our objectives in developing such a complex, structured and disciplined risk rating system are:
- to help gauge the scale of APRA’s overall supervisory task,
- to identify priority areas within the regulated population,
- to allocate resources according to degree of risk,
- to monitor market trends in risk profiles,
- to increase the objectivity and consistency of ratings, and
- to create a documented audit trail for accountability purposes.
APRA is concerned that - in an environment of escalating insurance premiums - small businesses, professional associations and community groups seeking insurance protection may look to alternative, unregulated providers, without fully understanding the potential consequences.
Such providers might have the attraction of significantly lower premium charges. This particularly applies to public liability and professional indemnity cover, which by nature lie at the high end of the insurance risk spectrum and are likely to be priced accordingly by regulated insurers.
Unregulated insurance is not in the public interest, because the average consumer is in no position to understand the complexities, uncertainties and limitations of the cover provided, and in particular, the possibility of the provider not still being around and upright when the time comes to pay a claim.
Accordingly, advanced countries (and many others) go to some considerable length to license and regulate their domestic insurance sector. The International Association of Insurance Supervisors promotes high quality insurance regulation on behalf of some 100 jurisdictions world-wide.
In Australia, consistent with best international practice in financial regulation, it is an offence for a person to carry on insurance business unless authorised under the Insurance Act and thereby subject to the Act’s capital requirements and the regulator’s prudential standards.
These requirements are not designed to be heavy handed, but rather to promote the levels of competence, honesty, prudence and openness that companies following commercial best practice would already be close to meeting.
The two main forms of unregulated and (we would argue) unreliable insurance are the products provided by unauthorised foreign insurers and discretionary mutual funds.
Foreign insurers wishing to operate in Australia can and should apply for a local licence, and submit themselves to the rigours and disciplines that this entails, and most do.
Unfortunately, some fringe foreign insurers prefer to use lightly regulated jurisdictions as a base from which to distribute their products into countries with higher standards, such as Australia and its OECD peers.
This activity is aimed at misinformed consumers who buy purely on headline price, without understanding the greater risk involved.
While the Financial Sector Reform Act allows insurance brokers and registered foreign insurance agents to distribute insurance products underwritten by foreign insurers not authorised in Australia, there is clearly an obligation on the insurance broker or foreign agent to inform local consumers of the foreign insurer’s unregulated status in Australia, and to point out that dealing with an unauthorised insurer will take them well into caveat emptor territory.
A prospective policyholder would be well advised to check whether a locally unauthorised foreign insurer is licensed and regulated in its home country, and has the financial capacity to pay claims into the future, particularly in the case of long tail public liability and professional indemnity products.
They should also check their policy to determine which legal jurisdiction would apply in the event of a dispute, to avoid potential difficulties in enforcing rights in an overseas jurisdiction. Even better would be to avoid unauthorised foreign insurers altogether.
Discretionary mutual funds are mutual aid schemes in which members pool resources to provide coverage to the membership on a ‘discretionary’ basis. They are not licensed or regulated under the Insurance Act because there are no contractual terms and conditions governing the payment of a claim. Claims are paid at the discretion of the scheme and only if there is sufficient capital at the time.
Mutual aid schemes have been established over many years in various sectors of the economy by groups seeking to reduce the cost of insurance through forms of cover that escape State stamp duties and fire levies, and the stringent capital requirements of the Insurance Act.
An example is the discretionary quasi insurance product offered by medical defence organisations and certain legal indemnity and (more recently) home warranty schemes. Some of these schemes have significant funding and competent management; and some do not. Many are sponsored by respectable and well intentioned parties; but the risk remains.
While they sometimes appear to work effectively, APRA views unregulated mutual aid schemes as being inherently flawed, potentially under-funded and ultimately unsustainable in an environment of rising community standards and expectations.
The first problem is that such schemes only work if the common interests of the members result in consistently below-average claims experience, which is increasingly rare. The second problem is the natural incentive to keep subscriptions at unsustainably low levels. And a third problem is that pay-outs are by definition individually uncertain and collectively unpredictable, particularly in periods of volatile claims trends.
At the end of the day, the cost of insurance is driven by the scale of the risk involved, and not by the institutional structure of the party assuming the liability.
The local industry is substantial, accounting for more than 1% of world-wide general insurance business, and giving Australia a ranking in the top dozen countries.
And as we know now better than ever - after some notable failures - the industry’s safety is important not only for the protection of individual policyholders, but also for stability and confidence in the wider economy.
If we had to choose two key indicators of a financial institution’s long-term viability and prospects, they would likely be capital adequacy and management quality. Indeed, financial sector failures can almost always be attributed to a combination of under-capitalisation and poor management.
APRA’s new regulatory framework and upgraded supervision approach are aimed at preventing under-capitalisation and discouraging poor management in general insurance.
In combination, this should significantly reduce the likelihood of failures, although absolute safety is of course neither attainable nor desirable in a risk-taking economy.