John Trowbridge, Executive Member - Insurance Council of Australia Regulatory Update Seminar
This is my third regulatory update since becoming Executive Member of APRA.
- In April 2007, I outlined APRA’s general philosophy and approach to supervision and regulation, and noted APRA’s regulatory agenda. Although I was still adapting to the role at that time, after six months or so at APRA, I can say that the agenda has changed little since then.
- In February 2008, twelve months ago, I elaborated on various parts of APRA’s agenda which was then dominated by the refinements package that followed the DOFI legislation of 2007. The global financial crisis had begun by this time last year but at that stage it had no visible effect on the general insurance industry. Stock markets had retreated perhaps 10 or 15% from their peaks and interest rates were at levels that are very different from today.
But what a year 2008 became! Where to begin?
In Australia the economic effects are at an earlier stage than in some other countries and our financial system is holding up well. That is because of the prosperity over the last decade or so, in which the now collapsed commodities boom played a major part. It is also due to the relative conservatism of Australian banks and, dare I say, a high-quality effort by APRA and the Reserve Bank in recent years in their regulatory, supervisory and financial stability activities.
We have, however, a world of financial instability. And that instability has some deep roots in the global evolution of banking, saving, investing and trading activities.
You have all done your own reading and have your own knowledge and understanding of the global financial crisis and the emerging global economic recession. I will give you my version of those aspects of it which affect general insurance markets and market participants, i.e. the industry, and also the prudential regulation and supervision of those markets. I will then outline the likely future direction of insurance regulation in response to some weaknesses that have been identified during the current instability. I will also explain the APRA agenda in the context of this global direction.
- In 2009 it is a new world. The general insurance industry is less affected by the financial crisis so far than the banking industry, the life insurance and superannuation industries and many others. APRA, however, is affected because we are an integrated regulator and have been working hard to support stability in the banking sector and to see that the life insurance industry also remains stable and well capitalised.
- We have seen excess credit and easy money in some countries and excess savings in some other countries for some years. Poor credit standards in the US during the 90s and the low interest rate policy of the US Fed contributed to both the asset price inflation and the high leverage that has emerged in the last decade. The unwinding of this leverage will take quite some time and will be painful, for it will suppress economic growth.
- There are major debt imbalances. The heavy debt or leverage in the US, the UK and some other countries has been funded from large savings in China, Japan and the oil exporting countries and has fuelled asset price inflation.
Effects on the industry
- The deleveraging that has begun will affect interest rates and investment markets for some time to come.
- Hence, in managing investments, insurers need to work hard on their knowledge, understanding and interpretation of investment markets, including planning for low interest rates and weak asset prices for some time to come.
- The good news is that the industry is generally invested conservatively, and this is so not only in Australia but in many other countries as well.
- There will also be increased balance sheet volatility which might lead to adjustments to the capital base of companies and which in some cases could be problematic. We will need to see careful financial management by these companies and careful examination by the regulators.
- Changes in the competitive landscape, in ways that are not predictable, as government support for banks and others continues and then eventually is wound back and out.
- government equity stakes in banks and others such as AIG create another variable in the business environment
- some changes may look unfair, as if the playing field is being tilted - governments are not deliberately intending that, but it can happen. Support for the US car industry is but one example. Governments also risk being protectionist in their efforts to bolster their own economies and insulate them from others’ problems.
- Weaker economic conditions will lead to differences in underwriting assessments, claims experience including fraud and other adverse outcomes in some classes of business, the credit worthiness of insureds etc.
- Constraints on the ability of insurance companies, among others, to raise capital and consequential limitations on insurance and reinsurance capacity
- Reduction in activity in many segments of the financial sector, affecting the availability of catastrophe bonds, securitisations and some other financial products that have become important to some insurers.
- Scrutiny and reconsideration of what is insurance, what should be regulated and how. Monolines may be affected and certain other products such as credit default swaps and other forms of financial guarantee – in Australia, LMI has operated very effectively, but not so in the US.
- Models: greater caution and scepticism over the use of financial models, including capital models in banking and insurance as well as modelling for pricing and management of financial products.
- Different views towards rating agencies and some differences in methods of operation of those agencies.
- Weaknesses in regulatory and supervisory arrangements that have become evident in some countries through problems in a number of companies including some monolines and some with investment problems, and in some groups, for example AIG and also, Fortis, ING, RBS and HBOS, which all have major businesses in both banking and insurance. The lessons from these experiences will lead to a range of regulatory initiatives in insurance that will include, in time –
- either more effective supervision of specialist insurance groups and cross-sectoral financial groups, or restrictions on the scope of activities of specialist insurance groups.
- continuing interest in and development of accounting standards and audit practices in insurance
- greater supervisory interest in remuneration practices of groups, and
- greater emphasis on and scrutiny of governance and risk management practices in all financial institutions.
So the main international supervisory agenda in this environment relates to:
- group supervision, including capital and solvency
- risk management and governance
- executive remuneration
- accounting standards.
I will talk about each of these topics as well and as insurer performance, foreign insurers, the NCPD and catastrophe reporting.
There is a clear consensus around the world that an important factor contributing to the global financial turmoil was remuneration practices that encouraged inappropriate risk-taking.
APRA issued a press release on the subject in January, outlining our approach on executive remuneration. We are developing a principles-based framework for executive remuneration structures that will apply to APRA-regulated institutions. APRA is also represented on the task force of the Financial Stability Forum that is developing the international initiative for the G20. Charles Littrell is our representative and I am the APRA member with responsibility for the executive remuneration initiative.
APRA will concentrate on the structure of executive remuneration and, in particular, on the incentives built into these arrangements. We will issue a discussion paper by mid year and, after considering submissions received, we will issue a response paper along with draft principles and guidance to be applied by the boards of APRA-regulated institutions. As usual, this second set of published material, more detailed than the first, will give another opportunity for submissions before APRA finalises its approach, expected to be during the second half of 2009.
The Australian general insurance industry has - to date - negotiated the GFC without any material adverse impacts.
This is primarily due to:
- Strong levels of capitalisation
- Conservative approach to investments (so no material write downs) – less than 10% equity investments across the industry, with many having nil exposure; generally high quality fixed interest investments
- Generally close matching of assets and liabilities to mitigate effects of changes in interest rates on balance sheets.
Industry MCR coverage was 2.04xMCR at Dec 2007 but had reduced to 1.75 at 30 September 2008. The estimated effect of the new capital requirements for equities and property introduced last year is shown on the accompanying slide. The industry MCR would have been 1.84 without these changes. We are likely to witness lower figures again at 31 December 2008.
Incidentally, the current financial environment demonstrates the importance of these capital changes, instituted by APRA last year.
Underlying performance has been, and will continue to be, under pressure due to adverse claims experience from both large claims (weather-related and other events) plus general increases in underlying attritional losses which are emerging in some classes of business.
This is coupled with the impact of the pricing cycle, which has seen significant downward pressure on premium rates for the last few years. Note that the dotted red line in the charts below represents inflation, so the lines below it are an approximate indication of falling prices. Householders and domestic motor have risen a little faster than inflation across the four years but the other classes have just matched inflation or fallen short. This is only now starting to change direction, with rate increases being seen across personal lines and also starting to occur in commercial lines.
Sept 2008 quarterly stats indicate that:
- Net premium revenue at $23.1bn was up for the year to Sept 2008 by 3.9%
- Net incurred claims increased significantly in 2008 cf 2007 (29.2%)
- Loss ratios therefore also up significantly (70.6% for 2008 cf 56.7% for 2007)
- Hence underwriting result is substantially lower for the year to Sept 2008 than for the previous year.
Capital will be more scarce and expensive to obtain, placing more emphasis on capital management and internal capital generation to maintain financial strength. Investment returns have been falling. The 10 year bond rate at December was 4% compared with about 6.5% in June.
Even where insurers reasonably closely match assets and liabilities, valuation changes can impact the financial position and therefore MCR coverage.
Incidentally, there is the occasional surprise. The industry reported $1.9 billion in investment income in the September 2008 quarter, compared with $500 million in the June 2008 quarter, including some $800 million in unrealised gains and $1.1 billion in realised investment income.
Overseas holdings in direct interest investments contributed to the large unrealised gains in the September 2008 quarter. The Trade Weighted Index (TWI) fell 13.6 per cent and significant unrealised gains occurred on direct interest investments as market prices of these investments reflected market expectations of lower interest rates.
Following the DOFI amendments to the Insurance Act effective 1 July 2008, foreign insurers wanting to operate in Australia needed to become authorised by APRA. Six new insurers and reinsurers have been authorised in the last year and there may be another two or three who were included under transition arrangements that enabled these insurers to continue operating while going through the authorisation process.
We welcome these new companies who have added useful capacity to the market, mostly in specialist areas.
The aim of the NCPD is to provide insurers, the community and the government with a better understanding of public and product liability and professional indemnity insurance. It also aims to help make these products more affordable and available by providing insurers with detailed information to help them assess risks and premiums for these insurance products.
The level of confidentiality protection sought by the insurance industry significantly undermines the achievement of these aims.
NCPD Discussion Paper
APRA is in the process of clarifying and deciding upon the future of the National Claims and Policies Database (NCPD). The first stage of the process was the recent release of a discussion paper that seeks feedback on the level of confidentiality of data contained in future level 2 reports from the NCPD. The paper was released to NCPD contributors on 26 November last year and the submission period has just closed.
The proposal relates to APRA’s impending release of level 2 reports from the NCPD. The reports will be released with one of three options for the level of confidentiality protection applied to these reports:
Confidentiality protection options:
||Full confidentiality protection
||All level 2 reports will be subject to full confidentiality protection and will contain appropriate masking.
||Full policy confidentiality protection, no claim masking
The level 2 policy reports will be subject to full confidentiality protection and will contain appropriate masking.
The level 2 claim reports will be released with no confidentiality masking.
||All level 2 reports will be released with no confidentiality masking.
In exploring these options, APRA’s goal is to find a balance between the desire of some companies (but not all) to protect confidentiality and the wider public interest in the availability of useful output from the NCPD.
As the second stage of considering the future of the NCPD, APRA is keen to get responses from a wider range of stakeholders in relation to their current or potential use of the data collected. A further round of consultation will soon take place to determine if there are any prospective changes to the content or scope of the database. This consultation will involve Federal and State Governments, ACCC, Professional Standards Council, actuarial and accounting firms, the various law bodies and others.
It is notable that:
APRA has full access to all NCPD data irrespective of what is made available publicly.
Level 2 reports still do not make available on all the information collected – there is scope for a Level 3.
Lloyds does not contribute full data but we are currently investigating this matter with Lloyds.
APRA has not had the mandate or the resources to analyse all the data in the NCPD. However, APRA is beginning to utilise the data for its own supervisory purposes. We will use NCPD data to assist in assessing actuarial liability valuations and we believe it is in the best interests of the industry that insurers also have access to the full range of data that are available to APRA to perform this analysis.
At present APRA receives no special reporting from insurers during and after major weather events but the Insurance Council does have such an arrangement in place with individual insurers.
Last year APRA approached the Insurance Council with a view to working with the Council to arrange for reporting of such events through the Council. It is possible for APRA to establish its own mandatory reporting of this kind but, given particularly the need for frequent and prompt reporting of claims during the weeks immediately following a weather event, we believe it would be a better solution for everyone concerned if APRA’s needs could be met by means of a cooperative approach between the insurers, the Council and APRA. We are expecting to have some arrangements in place during 2009.
APRA reporting, accounting standards and solvency standards
Internationally, there continue to be slow and difficult discussions on accounting standards involving such groups as the IASB, IAIS and IAA.
The US and the EU rarely agree. Meanwhile the Europeans are pressing on relentlessly with Solvency II and the world waits to see whether there really will be movement in the United States.
In Australia, APRA has committed to reconsidering the reporting framework for general insurers in order to achieve two key outcomes:
- Improved performance measurement of general insurers, including alignment with accounting standards and industry accepted measures of performance;
- Reduced compliance effort and costs in filling out APRA returns.
In pursuing these aims, APRA does not intend to change the prudential outcome of its reporting framework, which for each individual company is encapsulated in the MCR coverage ratio. That is, we do not intend that reporting changes alone will result in a change to the MCR or a change to the recognised capital base of insurers.
We are commencing this year an MCR recalibration exercise that will separately consider whether changes need to be made to MCR. This is a longer term project.
The current approach to reporting requires the balance sheet and income statement to be reported on an APRA prospective accounting basis. This means that the balance sheet and income statement submitted to APRA do not align with the balance sheet and income statement that are required to be produced by insurers under AASB 1023. Along with the prospective nature of APRA’s requirements, which does not allow deferral and matching of revenue and income items, the point of recognition of assets and liabilities can also be different under APRA reporting.
The diagram encapsulates the existing approach and the proposed approach. The dotted lines and boxes represent the way we intend to revise our approach. The part in red will no longer exist.
The AASB balance sheet to which the APRA balance sheet is currently reconciled annually will be the new basis for the reporting framework. This will mean that the income statement will also be on a AASB 1023 basis.
Prudential adjustments will be performed outside of the balance sheet. For instance, insurance liabilities will continue to be reported at 75% probability of adequacy in separate forms. Hence, while this should meet the objectives of improved performance measurement and some reduction in compliance cost, the fundamentals of APRA’s prudential capital framework will not change as a result of these developments.
Although there has been a significant amount of conceptual development to get us to this point, we are still only at the beginning of the implementation process which will need to go through the usual rounds of consultation, drafting and system development. But I’m hopeful that a solution along these lines will be in place later this year or early next year.
There are usually three benefits that insurers look for from group supervision. They are mobility of capital, recognition of diversification benefits and reduced or streamlined regulatory requirements.
There are also three goals that regulators have in undertaking group supervision. They are based around protection for policyholders from contagion risks within the group, and the main such risks are:
- Inappropriate capital or ownership arrangements at group level (e.g. debt financing or short term ownership, as are often the case with private equity investors)
- Unregulated entities in the group that can compromise the solvency of the group.
- Intra-group transactions such as loans, guarantees, double leveraging, etc.
APRA aims to achieve all of these supervisory goals while also facilitating mobility of surplus capital. We already recognise some diversification benefits in claims liability valuations and we have gone out of our way to simplify the reporting required of insurance groups.
APRA’s new standards on Level 2 supervision were released in December and become effective on 31 March 2009.
The Standards broadly define a Level 2 insurance group in a way designed to include all entities in the group conducting insurance and related business both locally and internationally.
As a starting point, this will follow the consolidation requirements in the Australian Accounting Standards, but with investments in non-insurance controlled entities being de-consolidated and the investment deducted from capital. The Standards give APRA the ability to determine which entities should be consolidated and which should not.
APRA has been in discussion with insurers that it expects will be affected by the new arrangements, to determine how their groups should be defined for this purpose. Our objective will be to include all insurance or insurance related businesses that have potential to affect the policyholders of the regulated insurer.
At this stage some 30 possible groups have been identified and are being evaluated. These include a wide array of corporate structures – from the simple: perhaps only one NOHC and an insurer, or one insurer and a subsidiary – to the complex: multiple insurers, operating both locally and internationally; or insurers which are part of more widely diversified conglomerate groups.
In most of these groups (28) the head company in Australia is a Non-operating Holding company, although in about half (16), this NOHC is not currently authorised by APRA.
To ensure both competitive equity and supervisory effectiveness, we are engaging with these groups, generally with the expectation that these NOHCs will become authorised, and the resulting Level 2 group then supervised. From a supervisory perspective, one of APRA’s objectives with group supervision is to ensure that capital support for the Australian business is and continues to be structured to provide the necessary financial support for the business.
A discussion on group supervision would be incomplete without referring again to the international dimension. I noted earlier that we are destined to see either more effective supervision of specialist insurance groups and cross-sectoral financial groups, or restrictions on the scope of activities of specialist insurance groups. This is because the global financial crisis has brought to light the need to examine further such topics as –
- unregulated entities
- vulnerability of some lines of business
- limits on the mobility or fungibility capital, and
- clearer understanding of the power of solo supervision in stress situations, which has, for example protected AIG policyholders despite the travails of the parent.
Let me return before finishing to the global financial crisis –
Firstly, an interesting aspect of its genesis.
Banks have been able to securitise pools of loans, taking them totally off the bank balance sheet - equivalent to 100% quota share reinsurance? -- with all of the risk being transferred to a combination of specialised insurers, unregulated entities (investors) other banks and sometimes another arm of the same bank! In some cases these entities have underestimated or misunderstood the risks involved.
By comparison, insurers who wish to transfer risk generally do so by way of reinsurance, and generally the reinsurers require the insurers to retain a material interest in the risk. Furthermore, reinsurers are now supervised in most jurisdictions in the same way as are direct insurers.
This ability of banks to transfer the risk with no apparent residual interest in the risk often comes as a surprise to insurers. But for the same reason many of you, I am sure, are not surprised that this aspect of banking practice and supervision of credit risk, particularly sub-prime mortgages and credit default swaps in the United States, has led to accumulated losses in a way that most insurers find unthinkable in the insurance context. Herein lies one of the great lessons of this global financial crisis.
Secondly, the community and business impact –
There is a squeeze emerging across both the banking sector and the insurance sector. Risk quality declines in a receding economy and so banks underwrite more carefully, giving less access to credit for some. Similarly, insurers underwrite more carefully, giving less access and/or higher prices and more stringent conditions. The squeeze occurs because reducing risk quality generates a need for greater capital but capital has become a scarce commodity. While straightforward enough at the institutional level, this becomes a conundrum at government level, because of a desire to see increased confidence, risk-taking and economic activity at the very time that bankers and insurers are at their most defensive.
That completes my tour of the regulatory landscape. Finally, I’d like to thank Kerrie Kelly for the efforts she has made in maintaining and building the liaison between APRA and the Insurance Council and its members. We greatly value that liaison.
I’d also like to congratulate Terry Towell and Mike Wilkins on their recent appointments as President and Deputy President respectively of the Council. I wish you both well in what is certain to be a testing time for the industry over the next couple of years.