GPS 114 Capital Adequacy: Asset Risk Charge - frequently asked questions
Updated: 6 June 2019
These Frequently asked questions (FAQs) are for clarification purposes only and are not legal advice. APRA encourages you to obtain professional advice about the application of any legislation or prudential standard to your particular circumstances. You should also exercise skill and care when relying on any material contained in these FAQs. APRA disclaims any liability for any loss or damage arising out of any use of or reliance on these FAQs. The FAQs may include links to external websites that are beyond APRA’s control. APRA accepts no responsibility for the accuracy, completeness or currency of any externally linked or referenced material in these FAQs.
Note: the numbering of these questions is fixed and will not change as new questions are added. The following frequently asked questions (FAQs) provide further information to assist general insurers and Level 2 insurance groups (GIs) in the interpretation of Prudential Standard GPS 114 Capital Adequacy: Asset Risk Charge (GPS 114). In particular, these FAQs provide guidance around the use of collateral, guarantees and letters of credit (LOCs) in respect of reinsurance recoverables from non-APRA-authorised reinsurers. GIs are encouraged to contact APRA where they have questions regarding the interpretation of GPS 114.
1.1 How can GIs ensure that the collateral provides effective security against liabilities arising under the relevant reinsurance contract?
For the purposes of paragraph 6(b) of Attachment B to GPS 114, the collateral must ‘provide effective security against liabilities arising under the reinsurance contract’. The collateral must provide effective security not only when the non-APRA-authorised reinsurer is solvent, but also when it is insolvent.
If the GI does not have access to the collateral ahead of all other creditors upon the insolvency of the non-APRA authorised reinsurer, APRA considers that it will not provide effective security and will not satisfy paragraph 6(b) of Attachment B of GPS 114.
Effective security against insolvency of the reinsurer
Paragraph 6(c) of Attachment B to GPS 114 specifically requires that the collateral ‘is not available for distribution to creditors of the reinsurer other than the insurer in the event of insolvency of the reinsurer’. The collateral is first required to meet all outstanding liabilities due to the GI under the relevant reinsurance contracts. Only once these liabilities are met should other creditors be given access to any residual collateral. In particular, APRA considers that the rights of any administrator or liquidator of the non-APRA authorised reinsurer to the collateral should be subordinate to the rights of the GI until all liabilities under the relevant reinsurance contracts have been discharged.
APRA expects that appropriate legal and supporting operational arrangements be put in place to achieve this:
- In respect of assets held under trust (paragraph 6(a)(i) of Attachment B to GPS 114), APRA will only recognise the collateral if the assets are held by the trustee for the sole benefit of the GI. APRA expects that the trust deed includes a term that provides that the non-APRA-authorised reinsurer will not have access to the assets required to meet outstanding liabilities due to the GI under the relevant reinsurance contracts until all the relevant liabilities of the GI have been discharged. In addition, APRA expects that the trustee will not be a related body corporate of either the GI or the non-APRA-authorised reinsurer.
- In respect of amounts held on deposit by the GI (paragraph 6(a)(ii) of Attachment B to GPS 114), APRA expects that a formal agreement executed by the GI and the non-APRA-authorised reinsurer is in place which governs this arrangement. APRA expects that there be satisfactory segregation of collateral funds within the GI’s investments such as by way of either a separate bank account or a sub-account with a custodian in respect of the relevant investment holdings. The investments held as collateral are expected to be readily identifiable and distinguishable from the other funds of the GI in the event of the insolvency of the GI. This is important as reinsurance recoveries receivable during the winding up of a GI are required to be paid directly to relevant policyholders under section 562A of the Corporations Act 2001 (Corporations Act). Additionally, APRA expects that funds will only be repayable to the non-APRA-authorised reinsurer where they are in excess of the outstanding liabilities due to the GI under the relevant reinsurance contracts.
APRA expects GIs to obtain legal advice in relation to the above matters, so that the GI and APRA can be satisfied that the collateral meets the requirements of paragraphs 6 (a), (b) and (c) of Attachment B to GPS 114.
Effective security against winding up of the insurer
APRA considers that effective security around collateral arrangements needs to involve arrangements that secure the collateral for its intended purpose in the event of the insolvency of the GI.
As collateral is intended to be drawn upon when a payment from a reinsurer cannot otherwise be made, the collateral must perform a similar function in the winding up of the GI and the reinsurer at the same time. Where the winding up of the GI commences, section 562A of the Corporations Act ensures that any amount received by the GI under a contract of reinsurance must be held for the benefit of relevant policyholders. APRA expects that the collateral also operates in the same way. This means that collateral held by a GI is expected to be held for the purpose of making payments to policyholders to discharge liabilities under the contracts of insurance and is not to be available to meet the claims of:
- creditors of the reinsurer other than the GI (until such time as the liabilities due to the GI under the underlying contracts of reinsurance have been fully discharged); and
- creditors of the GI other than the GI’s policyholders (the collateral is held for the exclusive benefit of the GI’s policyholders until such time as the liabilities due to the GI under the underlying contracts of reinsurance have been fully discharged).
APRA considers appropriate legal protection against this risk can be achieved through a Deed Poll or the documentation governing the collateral arrangement. APRA expects that collateral funds are held for the benefit of the relevant policyholders, quarantined from the other funds of the GI, and reserved to pay losses under the relevant reinsurance contracts as and when they fall due. If this additional Deed Poll or relevant documentation is not in place, the rights of the GI’s policyholders to the collateral will be put at risk and may potentially lose the protection which section 562A of the Corporations Act is intended to secure in respect of reinsurance recoveries received from a reinsurer.
1.2: What other forms of collateral may APRA approve and recognise in Attachment B paragraph 6(a)(iv)?
APRA may approve and recognise any form of collateral that satisfies the requirements of paragraphs 6(b) and (c) of Attachment B to GPS 114. For example, certain ‘funds withheld’ arrangements may be acceptable in circumstances where the GI has obtained expert advice and is satisfied that the collateral will not be available to creditors of the non-APRA-authorised reinsurer other than the GI in the event of the insolvency of the reinsurer.
APRA considers that certain ‘funds withheld’ arrangements may involve the non-APRA-authorised reinsurer retaining a registrable security interest in the collateral. Where this occurs, it is important that the GI be granted a security interest over the reinsurer’s interest so that the collateral is retained to discharge policy liabilities in any winding up of the reinsurer. Without adequate security, the GI may find that the collateral is available to other creditors and this will defeat the purpose of the collateral. APRA also expects GIs to register their security interest in these circumstances to protect the interests of its policyholders.
Consistent with the principles in Question 1, where a GI proposes to hold collateral under a ‘funds withheld’ arrangement in the form of securities purchased from amounts held in a ‘funds withheld’ account, APRA expects that the securities will either be held separately from the other investments of the GI or be identifiable in the books and records of the GI, as being securities held for the benefit of meeting policy liabilities reinsured under the relevant reinsurance contracts.
In respect of other forms of collateral under paragraph 6(a)(iv) of Attachment B to GPS 114, APRA will only recognise the collateral if the asset holdings and dealings are fully detailed in formal agreements. As APRA approval is necessary under this paragraph, GIs should seek APRA’s views on the adequacy of such arrangements before the arrangements are executed.
Guarantees and LOC’s
2.1: What is expected to be included in a guarantee or LOC?
The guarantee or LOC must meet all the criteria in paragraph 8 of Attachment to GPS 114. APRA also expects that the guarantee or LOC include:
- a pro forma sight draft (or other pro forma payment demand) and that any reference to a demand for payment in the guarantee or LOC refers to the pro forma sight draft; and
- the sight draft description of the payment event to correspond with the LOC or guarantee description of the payment event.
2.2: Is it acceptable for the parent or non-operating holding company of the GI to be nominated as the beneficiary of the guarantee or LOC?
No, paragraph 8 of Attachment B to GPS 114 requires that the GI must possess the guarantee or LOC in respect of reinsurance recoverables due from a non-APRA-authorised reinsurer. The GI must be the beneficiary as it alone (on behalf of its policyholders) is intended to benefit from the reinsurance.
2.3: Is it appropriate for payments by the issuer under the guarantee or LOC to be made to the GI outside of Australia or directly to a foreign insurer’s head office?
No, paragraph 8(c) of Attachment B to GPS 114 requires that the guarantor or issuer of the LOC is obliged to pay the GI in Australia. APRA expects that the sight draft is to be presented to a nominated branch or office of the ADI in Australia and that this requirement is explicitly stated in the LOC or guarantee and reflected in the sight draft.
2.4: Is it acceptable for the GI to be required to prove that the reinsurer is in breach of its obligations under the reinsurance contracts before payment is made on the guarantee or the LOC?
No, paragraph 8(b) of Attachment B to GPS 114 requires that the guarantee or LOC must be unconditional. In order to avoid delays in payment by the guarantor or issuer, the guarantee or LOC is expected to state that the guarantor or issuer will not conduct any inquiry into the sight draft other than for the purpose of ascertaining whether it is in the required form. However, the demand for payment may be required to state both the existence and nature of the breach by the reinsurer of its obligations under the relevant reinsurance contracts.
2.5: What is expected by the requirement in GPS 114 for guarantees and LOCs to be irrevocable?
APRA expects that the guarantees and LOCs do not provide for the guarantor or issuer of the LOC to cancel its undertaking before the expiry date. In addition, to ensure the credit support is available to the GI when required, APRA expects that any right for the GI (beneficiary) to cancel the guarantee or LOC before its expiry be subject to prior consultation with APRA.
2.6: How should the guarantee or LOC be specifically linked to performance of the reinsurance contract under which the reinsurance recoverables arise, as required by GPS 114?
APRA expects that the guarantee or LOC sets out that the credit support is confined to the reinsurance arrangements specified in the guarantee or LOC. This involves clear and unambiguous identification of the relevant reinsurance contracts in the guarantee or LOC. Where appropriate, the reinsurance contract numbers and dates to which the guarantee or LOC relates are expected to be included in the guarantee or LOC to avoid any ambiguity.
3.1: Is APRA’s formal approval required for collateral, guarantees or LOCs under GPS 114?
Other than those arrangements referenced under paragraph 6(a)(iv) of Attachment B to GPS 114, formal APRA approval of the arrangements set out in paragraphs 6(a)(i) to (iii) of Attachment B to GPS 114 is not required. However, seeking APRA’s views on the adequacy of those arrangements before they are executed will be in the interest of any GI considering these options, to ensure the GI is not excluded from capital relief when APRA reviews such arrangements as part of its ongoing supervision.
The following supporting information will assist APRA’s consideration in regard to collateral proposals:
- documentation that establishes and governs the collateral arrangement (including the details of the reinsurance arrangements for which the collateral is to be provided and the methods used to monitor and adjust the amounts due under the reinsurance contracts for which the collateral is to act as security);
- the arrangements over the collateral (to safeguard the collateral from other creditors in the event of the insolvency of the non-APRA-authorised reinsurer);
- legal advice received by the GI on the proposed form of collateral (including whether the GI will have exclusive access to the collateral notwithstanding an insolvency of the reinsurer and whether the collateral will be held exclusively for the benefit of the GI’s policyholders in the event of the insolvency of the GI); and
- any other information which the GI believes is relevant to satisfying APRA that the collateral proposal complies with paragraphs 6, 7 and 10 of Attachment B to GPS 114. This may include processes to be used by the GI to monitor the collateral arrangement (e.g. keeping track of the value of the collateral and adjustments in the amount of the liabilities which are secured by the collateral arrangement).
For proposals around guarantees or LOCs, draft documentation establishing the arrangement should be provided to APRA.
4.1: How does a GI calculate and report the capital treatment of any eligible collateral, LOCs and/or guarantees?
The lodgement of eligible collateral, or the operation of acceptable LOC or guarantee arrangements, reduces the asset risk charge for the relevant reinsurance recoverables from the counterparty grade of the reinsurer to that of the collateral, the issuer of the LOC or the guarantor.
Collateral should be reported in Section 4A of Reporting Form GRF 114.3 Credit Support Received (GRF 114.3). Additionally, APRA expects certain forms of collateral to be reported on the balance sheet of GIs. Most commonly, this is in the form of deposit collateral. For reporting purposes, it is APRA’s expectation that deposit collateral is reported on the balance sheet with an offsetting liability to the reinsurer. On balance sheet deposit collateral assets will also be reported in Reporting Form GRF 300.0 Statement of Financial Position. These assets will attract an asset risk charge and effectively be risk charged twice. Accordingly, the GI should record an adjustment for the amount of the asset risk charge on the collateral assets in item 6 of Reporting Form GRF 114.0 Asset Risk Charge. It should be noted that in practice, often the type of ‘on balance sheet’ collateral provided to support an asset is cash deposited at an Authorised Deposit-Taking Institution (ADI) or equivalent. This will attract a risk charge of zero and therefore a deduction or adjustment is not needed.
Guarantees and LOC’s should be reported in Section 4B of GRF 114.3.
Capital Treatment of Market Neutral Strategies
5.1: What is APRA’s capital treatment of long and short equity portfolios under GPS 114?
Equity stress is addressed in paragraphs 44-46 of GPS 114, and measures the impact on the capital base of a fall in equity and other asset values. This applies to listed and unlisted equities. An exchange listed equity index futures contract would be treated as listed equity, and positive and negative positions are offset when assessing capital charges, with the same approach applying to individual stocks as well as index futures. Generally, the standard approach set out in GPS 114 can be used where GIs hold diversified portfolios and are not taking materially offsetting long and short term positions. Where such positions are material, the standard approach to assessing risk could lead to inadequate capital being applied.
APRA expects a GI that has, or is considering taking, a material offsetting long and short position, to approach APRA with a suitable bespoke capital treatment. The treatment would depend on the specific circumstances of the GI and its portfolio and would require the GI to work with APRA to determine a suitable arrangement.