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APRA Senior Manager, Policy Development, Peter Kohlhagen - Speech to the Private Healthcare Australia conference

Thursday 15 November 2018

Resilience, capital and culture: building defences against the rising tide

Peter Kohlhagen, Senior Manager, Policy Development - Private Healthcare Australia conference, Gold Coast

Good afternoon everyone.
It’s my pleasure to be here today at beautiful Surfers Paradise to speak about resilience, capital and culture.
Before we get into the detail, I’d like to spend a little bit of time talking about my hometown, the regional NSW town of Wagga Wagga. You can see it from the air on this slide.[i] You’ll see that the town sits alongside the Murrumbidgee River that is snaking its way through the centre of the slide.
Like many parts of Australia, Wagga Wagga is exposed to the risk of natural disasters, particularly flooding. And so, in common with many other towns and cities around Australia, mitigation measures are in place. Trained emergency workers are available, pumps installed, but the centrepiece is a levee bank.
We can see the impact of the levee on the next slide – the photo is from 2012.
The river is in heavy flood, but the levee protects the town. In my grandparents’ time, the main street and many surrounding houses flooded regularly with devastating consequences for the residents and business owners. But forward-looking planning eventually led to the investment of money and resources into the building of the levee bank. That investment has paid dividends in the form of a city that is much more resilient. While I can recall the floodwater lapping at the rear fence at my parent’s farm as a child, I didn’t have any fear that the city would be flooded.
Building resilience doesn’t just happen – someone needs to recognise the threat, and invest time, money and resources into building and maintaining appropriate mitigation measures. We need to continually assess and re-assess the adequacy of our defences in light of new information. Maintaining the necessary focus can be challenging as the memory of the last crisis fades. In the natural disaster context, the insurance industry has been an admirably strong advocate for mitigation and resilience for exactly that reason.
My experience as a child, in a town that has worked together to become more resilient to threats, resonates with my experience as a regulator. In both cases, we invest resources in the good times when there is no imminent threat – we build risk management capabilities, sound governance arrangements and strong financial buffers. Then when bad times happen (as they inevitably do), we’re ready to withstand the challenge.
Today I’m going to build on APRA’s views on resilience and sustainability, by exploring two main themes:
  • first, financial buffers in the form of capital that help protect against losses; and
  • second, the cultural underpinnings that are needed to support good risk management, governance and capital management.
As a prudential regulator, APRA is deeply concerned with risks that can threaten the soundness of an institution or the stability of the system. Capital is one of the primary tools we use to manage those risks. However, as APRA’s Chair Wayne Byres has noted, governance, culture and accountability are also key: “Traditional prudential requirements for adequate financial resources may not be sufficient when an institution suffers from poor governance, weak culture, or ineffective risk management.”[ii]  In other words, sound capital levels are necessary, but not sufficient – they cannot safeguard an insurer with poor risk culture.
Building resilience continues to be key to the long-term sustainability of the private health insurance industry. APRA has spoken extensively about the challenges facing the industry and the sustainability of insurer business models. I’ve also spoken about the cultural challenge of avoiding complacency, as a prolonged period of relative calm gives way to emerging challenges. Those challenges continue to be front of mind for APRA, and should be front of mind for insurers and their boards.


A review of capital standards is Phase Three in the Prudential Policy Roadmap. I last spoke on the subject at the Health Insurance Summit in May this year.[iii]
With the completion of Phases One and Two of the Roadmap, APRA is now actively progressing Phase Three. I’m pleased to announce that APRA will today release a letter to industry setting out a roadmap for the review.
APRA has consistently stated that it doesn’t consider that capital levels in the industry are too high or should be reduced. Capital is an important prudential protection, and capital levels are not a material driver of premium increases in the longer term. The fundamental driver of premiums is changes in the claims costs experienced by insurers, in turn driven by changes in the costs and utilisation of health care.
Consistent with APRA’s ongoing focus on resilience, the objective of the review is to ensure that the capital standards applying to private health insurers are fit for purpose. In short, to make sure that they provide an appropriate level of protection for policyholders by making sure insurers are financially resilient. APRA does not approach the review with the objective of increasing or decreasing capital levels. We aim to make sure capital requirements are sufficient to protect the insurer and its policyholders against the risks facing the insurer.

Overall approach to the capital standards

At the Health Insurance Summit, I spoke about the differences between the current capital framework for private health insurers and the capital framework for other APRA-regulated insurers (commonly known as the Life and General Insurance Capital, or LAGIC, framework). I noted that our review would consider those differences.
APRA has decided to consult on using the LAGIC framework as the basis for a revised capital framework for health insurers.
The LAGIC framework reflects APRA’s overall approach to capital and is consistent with international best practice. Consistency of capital frameworks across the insurance sectors facilitates a common language on capital and supports better quality discussions on capital between APRA and insurers.
This does not mean that APRA will apply standards designed for life insurers or general insurers unchanged to private health insurers. There are important differences in risk profiles and business models that must be recognised in the capital framework. APRA will carefully design appropriate modifications to the LAGIC framework to reflect these differences. This is consistent with the approach taken for other insurers, where there is a consistent overall framework but clear allowance for different risks within it. An example is the treatment of insurance risk, where the standards for general insurers have a highly customised treatment of catastrophe risks.
It may assist if I unpack some of the implications of moving to a framework based on LAGIC. APRA will consult on all these aspects next year.
The fundamental requirement of LAGIC is that each insurer must have available capital (or capital base) greater than the minimum required capital (called the Prudential Capital Requirement or PCR) at all times. Starting with the capital base, the current capital standards generally start with values determined under Australian accounting standards. Adjustments to those values are necessary to make sure they are sufficiently prudent. This approach would continue under the new framework, with some strengthening of the prudential adjustments. Importantly, prudential regulators worry when assets that would not be available to pay claims in times of stress are counted as capital. Accordingly, the capital base under the LAGIC framework does not ascribe any value to deferred tax assets, goodwill and other intangibles, deferred acquisition costs and a range of other similar assets. Similarly, for the value of liabilities, we would calculate the base value using the forthcoming new insurance accounting standard "AASB 17 Insurance Contracts", with appropriate adjustments.
Underpinning the quality of the capital base, the LAGIC framework specifies which capital instruments can be included. Only instruments that are able to protect policyholders by acting as a buffer against losses in times of stress are included. The framework considers capital instruments in two broad tiers of capital, each with differing requirements and limits according to their quality.
Turning to the PCR, a key difference between the two frameworks is the targeted level of resilience. The current private health insurance capital framework targets a 98 per cent probability of sufficiency over a 12-month period. The LAGIC framework targets a more conservative 99.5 per cent probability of sufficiency over a 12-month period. All else being equal, a change from the current basis to align with the LAGIC basis would result in higher capital requirements.
Also on the PCR, the current capital framework generally allows for much more discretion in the calculation than the LAGIC framework. While some discretion can be appropriate for parts of the calculation that are highly insurer-specific, we favour a more standardised approach to narrow the differences between insurers that have similar risk profiles. This is particularly the case for risks that would affect all insurers similarly, such as asset risks.
So in summary, all aspects of the capital framework are in scope for the review. This includes the capital base, the PCR and requirements for the capital management policy (in LAGIC terminology, the Internal Capital Adequacy Assessment Process, or ICAAP).
Overall, APRA’s view is the above factors indicate that minimum capital requirements may increase as we improve the alignment of capital to risk, at least in theory. That doesn’t mean that all insurers would need to raise more capital – many have buffers that would be sufficient to absorb the change. Some insurers with thinner buffers may need to source additional capital if capital requirements increase. The impact of any change to capital requirements will differ from insurer to insurer, depending on their business model and current capital structure.

Process for the review

The letter released today outlines in some detail the process for the review. The process will come as no surprise to those who have participated in Phases One and Two of the Roadmap, and will include extensive consultation.
APRA intends to hold workshops for insurers and other interested stakeholders over the coming six months. The feedback we get from the consultation process is invaluable to help us understand the issues and the potential impacts. We all have an interest in getting the policy settings right so I encourage all of you to engage openly as we undertake the review.
The next formal step in the process will be the release of a discussion paper that outlines the proposed framework for health insurer capital at a principles level. This will include industry-specific adjustments where assessed as appropriate and necessary. We are planning to release the paper in the second quarter of next year.

Transitional arrangements

Before leaving the capital framework, I will make a few remarks on APRA’s approach to transition. We know that insurers value clarity about APRA’s approach, to inform the decisions they need to make about capital management.
As a general principle, APRA wants to see orderly transition when making any regulatory change. We expect to use a combination of industry-wide and insurer-specific transitional arrangements in support of that aim. An orderly transition will be undermined if insurers take capital management decisions while the review is underway that make them less prepared for a new framework. APRA is likely to look less favourably on transition applications where an insurer has taken such decisions. On capital instruments specifically, APRA will look more favourably on applications for additional transitional arrangements where an insurer has made good faith attempts to align to the LAGIC rules while still meeting the current rules. For transparency though, APRA does not typically grandfather non-complying capital instruments when the framework changes. Insurers should centre their expectations around transition to the next call date for the instrument rather than permanently.

Update on Phases One and Two

Before leaving the policy roadmap, it would be remiss of me not to emphasise some important messages regarding implementation of the recent risk management and governance changes for health insurers. In general, APRA sees an ongoing need for attention to implementation of the Phase One and Phase Two requirements. APRA will continue to work with private health insurers to facilitate an orderly transition, but insurers need to continue to invest in their capabilities in the risk management and governance space. The key point is that there needs to be an uplift in the maturity of processes over time.


Insurers often ask how APRA thinks about culture in the private health insurance context. That’s natural given that private health insurers join us on this journey some way after other institutions regulated by APRA. I hope my remarks today will assist.
There are many possible definitions of risk culture. Former APRA Deputy Chair Ian Laughlin’s definition is my favourite. Ian said that if culture is ‘the way we do things around here’, then risk culture is ‘the way we do risk around here’.[1]
APRA has spoken extensively on risk culture in recent years, with good reason. Increasingly since the GFC, prudential regulators around the world have recognised and highlighted the importance of culture in driving the right prudential outcomes. Culture influences all aspects of an insurer’s operations. Without a sound culture, no amount of policy or procedure can protect an insurer.
Questions of culture, conduct, governance, remuneration and accountability are not only of substantial interest to APRA, they are also central to many of the matters that have been drawn into such sharp relief by the ongoing Royal Commission into Misconduct in the Banking, Superannuation and Financial Services Industry. Further lessons will emerge, and private health insurers should engage with them notwithstanding that private health insurers are not within the terms of reference for the Commission.
APRA first introduced requirements around risk culture in 2015, when Prudential Standard CPS 220 Risk Management came into effect for authorised deposit-taking institutions and other insurers. APRA then extended it to health insurers from 1 April 2018. The requirement is quite simple, but far-reaching:
“The Board must ensure that: […] it forms a view of the risk culture in the institution, and the extent to which that culture supports the ability of the institution to operate consistently within its risk appetite, identifies any desirable changes to the risk culture and ensures the institution takes steps to address those changes.”
APRA wanted to put the question of risk culture squarely on the agenda for boards of APRA-regulated institutions. Quite deliberately, the standard doesn’t prescribe what the culture of an institution should be – that is properly a matter for the institution and its board. APRA’s observation is that the requirement for the board to form a view has succeeded in starting this challenging but important discussion at board level within institutions.
For its part, APRA has been active in considering risk culture, and related questions of governance, accountability and remuneration across APRA-regulated industries:
  • In October 2016, APRA released an information paper on risk culture. The paper noted that poor risk culture can lead to weak risk management and excessive or ill-considered risk taking. In turn, this can lead to significant losses and has, in some cases, led to the failure of institutions.
  • In April 2018, APRA released an information paper on remuneration practices.  The Information Paper noted, “Remuneration frameworks and the outcomes they produce are important barometers and influencers of an organisation’s risk culture, providing insights into the extent that risk-taking is likely to be conducted within reasonable bounds.”
  • Accountability, and particularly the detrimental impacts of unclear accountabilities, has been recognised in the introduction of the Banking Executive Accountability Regime (or BEAR) for authorised deposit-taking institutions. APRA has observed that the process of developing accountability statements and accountability maps can add significant value. Accountability statements clearly specify the accountabilities of key executives. Accountability maps set out the lines of accountability through an organisation, helping to make sure that there are no overlapping or underlapping accountabilities.
  • The final report of the Prudential Inquiry into the Commonwealth Bank of Australia (CBA) had a number of key findings, including that financial success had ‘dulled the senses of the institution’ particularly in relation to non-financial risks.[iv] The report noted that ‘two critical voices became harder to hear, leaving CBA vulnerable to missteps’. One was the ‘voice of risk’ the other was the ‘customer voice’.
None of this material is specifically addressed to private health insurers. It would represent a significant lost opportunity, though, if insurers and their boards didn’t reflect on the lessons arising and challenge themselves to make changes where needed. Indeed, APRA has asked a range of larger regulated institutions to undertake a self-assessment against the findings of the CBA prudential inquiry.
Ultimately, a sound risk culture cannot be regulated into existence. It requires ongoing attention from executives and boards – to appropriately balance risk and reward, and operate the business in a sustainable way over the long run. Everyone in the industry and the broader system has a role to play.
It is clear that there is a lot of activity in this space, and insurers can expect matters around governance, culture, conduct, remuneration and accountability to be an ongoing focus for APRA, through both supervision and future policy development.


In closing, APRA’s ongoing focus on resilience continues as we progress through the private health insurance policy Roadmap. We do all of this so that we are prepared when hard times come. I touched in my opening on the ongoing vigilance and foresight needed to make sure we build and maintain readiness. To revisit (and hopefully not belabour) the levee analogy – we need to make sure that our levee is thoughtfully engineered and built to withstand the relevant risk. In insurance terms, that we have the right level and quality of capital. But we also need to vigilantly maintain the levee and check it for weak points. That is, we need to have a culture that supports us in managing risk appropriately.
At the end of the day, I think we’d all agree that when floodwaters inevitably rise, we’d like to be high and dry behind a strong levee bank. Certainly, that is preferred to needing to scramble to respond. Being prepared necessitates sound policies and procedures for risk management, governance and capital, supported by a sound risk culture that drives insurers to embed those policies and procedures in their day-to-day operations.
Thank you and I’m pleased to take your questions.

The Australian Prudential Regulation Authority (APRA) is the prudential regulator of the financial services industry. It oversees banks, credit unions, building societies, general insurance and reinsurance companies, life insurance, private health insurers, friendly societies, and most members of the superannuation industry. APRA currently supervises institutions holding $6 trillion in assets for Australian depositors, policyholders and superannuation fund members.