John Trowbridge, Executive Member - Insurance Council of Australia, Sydney
This is my fourth regulatory update since becoming Executive Member of APRA in 2006 and it is my last in this role. Today I intend to reflect on the changes that have occurred in the industry over the last decade or so and I will begin with a retrospective on the industry. I will then describe the state of play in the industry as I see it today and take you through APRA's current regulatory agenda. I will conclude with some comments on international developments.
To set the scene I will give you a retrospective in three parts.
The ‘cycle trough’
The first part could be called the cycle trough, in the pre-HIH era, from the mid 90s to 2001.
The industry was very competitive, with HIH leading prices down, generally to unprofitable levels, especially in liability and other commercial classes of insurance. HIH appeared to be profitable but it was not. And other insurers had poor results in the late 1990s because HIH had pushed prices down for some years and simultaneously the costs of liability claims were increasing noticeably.
APRA was established on 1 July 1998 so this period embraces APRA's establishment phase. The ISC solvency regime, inherited at that time by APRA, was weak, not because the capital requirement itself was weak, as primitive as it was (the higher of 20% of premiums and 15% of outstanding claims) but because of the formula for eligible capital. Eligible capital is the capital APRA counts for solvency purposes. It was net assets measured as gross assets less the company's own measure of liabilities, and it was okay to measure the liabilities as a central estimate, discounted, with no risk margin. So the lower the liabilities shown in the accounts, the higher the capital appeared to be. This was the genesis of the HIH failure. In other words there were no robust APRA standards or actuarial standards at that time for assessing claims liabilities.
The end of this period was signalled by HIH failing in 2001, and we also had the failure in 2000 of UMP, the medical indemnity organisation, for similar reasons. Incidentally UMP and the other medical indemnity organisations were unregulated at that time because technically they were not insurers but were discretionary mutuals.
The ‘golden period’
The next period might be referred to as the post-HIH period but I will call it the golden period, from 2002 to 2006.
Several momentous changes occurred in the two or three years after the failures of UMP and HIH. Insurers put prices up, especially in the liability classes, because HIH, as the maverick low price player, had made its exit. Prices increased so much in liability that we had the "insurance liability crisis". Do you remember that? Many buyers of insurance, especially smaller businesses and not-for-profit groups, saw the new prices as unaffordable. Some insurers simply withdrew from the market, not willing to underwrite the business at any price. Anzac Day marches and school fetes were cancelled, scout halls and garden clubs stopped operating and, in relation to medical indemnity, many doctors retired or withdrew their services.
And so the politicians began to react -
- The government rescued medical indemnity organisations but insisted that they become licensed insurers regulated by APRA.
- Tort reform occurred. It was a rather amazing partnership between a conservative Federal government and six State Labor governments. It was an historic alignment, led by Sen Helen Coonan for the Federal government in Canberra and by Premier Bob Carr and Treasurer Michael Egan in Sydney. It led to substantial reforms of tort law in every Australian State.
Also APRA, having been jolted by the HIH failure and castigated by the Royal Commission, was restructured by the government. It proceeded to fix the solvency requirements. The single most important change was in the assessment of claims liabilities, which were required to be measured as the central estimate plus a risk margin at 75% probability of sufficiency, irrespective of the numbers that companies might insert in their published accounts. Also the measurement had to be made by a suitably qualified actuary working to professional standards issued by the Institute of Actuaries of Australia. This was a breakthrough and I believe it is the single most important regulatory reform ever made by APRA in general insurance.
APRA also did other things. It disqualified a number of people associated with the failure of HIH. It introduced risk management requirements, including the compulsory preparation of business plans and financial projections. And most importantly, especially in light of the GFC, it began to build up its supervisory capabilities and activities - but more of this later.
The industry went through a golden period because prices were able to be increased, tort reform was effective so claims costs fell in some classes of business, we had a very strong economy including buoyant investment returns, and we had benign weather conditions, marked essentially by low rainfall, all of which contributed to record profits for the industry. The more optimistic in the industry even pronounced the death of the underwriting cycle! Those of us who challenged those voices were drowned out at the time but the naiveté of that view is now evident.
So in this period, wherever you looked, whether in liability classes, personal lines, mortgage insurance, or even commercial property, loss ratios were low and profits were high.
The ‘sober period’
The third period, from 2007 to the present, I will label the sober period.
Slowly but surely as the first decade of the century wore on, price competition began to filter back into the industry, some adverse weather events occurred, some insurers began to take extra risks in underwriting or in business expansion (usually through acquisition of other insurers or of underwriting agencies) and profits began to decline.
Loss ratios by accident year began to increase and the reserve releases which had been substantial in the previous three or four years began to diminish.
There had been few major weather events during the first half of the decade. The Canberra bushfires in 2003 were perhaps the worst in that period, at some $350 million, but several larger events occurred in 2006, 07, 08 and 09. They included Cyclone Larry in March 2006 ($540 million), the Hunter Valley storms in June 2007 ($1,450 million), storms in Sydney, Brisbane and Mackay in 2007 and 2008 (around $400 million each) and the Victorian bushfires just over one year ago in February 2009 ($1,070 million).
And simultaneously the financial and economic environment was changing. The stock market peaked in October 2007 and its subsequent decline through 2008 to its nadir in March 2009 marks the toughest period in the financial sector in living memory. To relieve pressure the government stabilised our banking system and the economy by introducing in October 2008 the wholesale funding and large deposit guarantee. This kind of action was unprecedented.
The general insurance industry was less affected than many other industries but declining interest rates, increasing credit spreads, difficulties in equity and property markets, reduced economic growth and some increases in claims costs have all contributed to a more difficult time.
And what was APRA doing during this period? It introduced several new sets of regulations, the more significant of which were –
- governance requirements, especially around board composition
- refinements associated with the DOFI legislation, and
- group requirements for risk management and governance.
But most importantly it was building the capabilities and the modus operandi of its supervisory teams.
And that brings us to where we were this time last year. The seminar was held only days before the Victorian bushfires of 8 February 2009, the stock market was still falling and governments around the world were announcing and introducing very substantial stimulus packages.
Cast your mind back, for it is easy to forget. No one knew how bad it would become before getting better, and stories of corporate meltdowns and personal financial disasters were hitting the press every day. Insurers were troubled because interest rates were falling, calling for higher prices, and asset values, even for fixed interest securities, were also falling.
The good news is that almost everything today, in the economy and in financial markets, is better than a year ago and considerably better than many people expected. Confidence has returned, employment and investment markets seem to be stable and we are again able to talk of economic growth. We remain cautious of course, but so far so good.
State of play in the general insurance industry
I have already spoken of pricing and profitability. We now look briefly at capital and solvency.
The capital base of the industry has been growing steadily, at between about 4% and 6% per annum (depending on the precise measurement period), during the seven years that APRA has been operating the current data collection. Industry solvency has fallen slightly in recent years to a little under two times the industry aggregate MCR but has been and remains strong.
In this same period, industry gross premium income has grown at just 2% pa, rising from $29 billion for the year to June 2004 to $32 billion for the year to 30 June 2009.
This low growth rate in aggregate premiums, at less than the rate of increase in GDP, is further evidence of price competition over this period.
Underwriting performance is a little more difficult to understand properly from the APRA returns. The quarterly returns show the following financial year loss ratios-
APRA analysis of its statistical data and FCRs indicates that reserve releases have made a significant contribution to industry profitability since around 2005. Clearly industry profits over recent years would have been lower and loss ratios higher without the boost from prior year reserve releases.
To better understand the industry‟s financial performance it is necessary to examine the underlying accident year loss ratios. APRA‟s internal analysis of insurers‟ loss ratios shows that these have been deteriorating on an accident year basis since around 2005. This observation is in line with market commentary that competitive forces have resulted in falling premium rates and more liberal terms and conditions. On the claims side, there is evidence of the emergence of superimposed inflation in some long tail classes and adverse weather conditions have affected loss ratios for the short tail classes.
However, on a more positive note for the industry, there is some evidence of increasing premium rates over the past year or so, particularly in the personal lines classes.
On industry structure, there are currently 134 licensed insurers, of whom 27 are in run-off and 107 are active. Of these latter, 49 are owned locally, 18 are subsidiaries of foreign insurers and 40 are branches of foreign insurers. Also there are 20 insurance groups which collectively hold 43 individual licences. On the whole this represents a healthy competitive market place.
APRA's current regulatory agenda
The overall APRA agenda is now substantial, partly due to the aftermath of the GFC. The G20 and the Financial Stability Board have extended our agenda but, to this audience, I am pleased to say that most of the extensions relate to banks and other deposit taking institutions. The main issues for these institutions revolve around capital and liquidity.
In general insurance, we currently have six projects under way that affect the industry, at various stages of preparation or implementation. They are:
- Group Supervision
- APRA reporting
- Capital review
- NCPD (national claims and policies database)
- Event reporting
And there is one project that affects brokers but not insurers.
1. Group supervision
Full group supervision for general insurers was introduced from 31 March 2009, when we extended the scope beyond risk management and governance to include group capital and solvency. It has been a surprisingly tortuous process because the range of corporate structures, legal and financial, has exceeded not just our expectations but also our imaginations!
One unexpected but positive outcome is that some groups have simplified their structures, to the benefit not only of APRA but also of their own boards and in some cases their own management. Simpler structures tend to increase transparency within the group, reduce complexity and reduce risk.
2. APRA reporting
APRA has recently consulted on proposals to change the prudential reporting framework. These changes will align APRA reporting closely with statutory reporting under AASB1023 and thereby deliver four important benefits. They will:
- simplify reporting by general insurers to APRA, because of the alignment with accounting standards
- give APRA more effective information for assessing insurer performance, because we will be seeing the same management information as the companies use themselves
- as a result, enhance the quality of dialogue between APRA and individual insurers on their performance, and
- give APRA better and earlier warning of deteriorating performance of any individual general insurers.
Importantly, the changes will allow improved performance analysis and a clearer view of profitability for APRA at a level of detail previously not available through the APRA returns.
Consultation on these proposals closed just last week. The submissions show that there are several matters of detail to be worked through but nevertheless the general reaction to the proposals has been positive and it appears that insurers recognise that, once operational, these changes will indeed benefit both insurers and APRA.
3. Capital review
APRA is presently conducting a review of the general insurance and life insurance capital standards. The objectives are to:
- improve the risk-sensitivity and appropriateness of the standards;
- improve the alignment of the standards between industries; and
- consider the standards in light of international developments.
APRA does not intend to „rebuild‟ its prudential standards from first principles but rather intends to adjust the current standards in the light of experience to date with the existing standards. Nonetheless, this is a significant project.
The proposals will include modest changes to the capital adequacy framework for general insurers. There will be more substantial changes for life insurers. It is intended that the new capital prudential standards will be implemented in 2012.
A discussion paper will be released shortly, probably in March. APRA will then initiate a quantitative impact study toward the middle of this year that all insurers will be encouraged to undertake.
Last November, APRA finalised its position on the prudential requirements for remuneration. Extensions to the governance standard (GPS 510) and a prudential practice guide (PPG 511) were published.
The industry broadly supported APRA‟s approach, accepting that poorly structured remuneration practices may result in excessive risk-taking by individuals and undermine the risk management systems of prudentially regulated institutions.
The revised governance standard comes into effect on 1 April 2010. By this date, APRA requires that the Board Remuneration Committee, with appropriate composition and charter, be established and a suitable Remuneration Policy be in place.
Please note that any licensed insurer that has difficulty in fully meeting the requirements need to advise APRA before 1 April 2010 if transitional arrangements need to be considered.
5. NCPD (national claims and policies database)
APRA has undertaken two consultations in the last year or so on the NCPD. The first, at the end of 2008, was to contributing insurers and the second, during 2009, was to all other interested parties.
The NCPD is a child of the liability insurance crisis and its aim is to provide insurers, the community and governments around the country 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.
APRA has now completed its consideration of the 36 submissions received, including many from outside the industry, and APRA's response paper to these two consultations is soon to be published. It will formally state APRA's decisions on the NCPD, which are that all premium data will be published in future in Level 1 and Level 2 reports with no masking, and that all claims data will also be published without masking except for those data items that need to be protected for privacy reasons. The technique for doing the latter, i.e. privacy masking, is still under consideration.
These decisions around confidentiality are something of a breakthrough for the NCPD and in future will extend substantially the published data on public and product liability and professional indemnity insurance.
6. Event reporting
The Insurance Council has been doing an excellent job for many years in collecting and publicising industry data on major weather events, the most recent of which was the Victorian bushfire disaster this time last year.
APRA has a strong interest in this information, for several reasons, and has considered in the past undertaking a formal data collection itself. However it was always going to be better for everyone concerned, for timeliness and flexibility, if APRA could draw on the industry's own voluntary data collection. Agreement on how to do this has recently been reached between the Board of the Insurance Council and APRA. The next step is to extend the communication and understanding of this agreement to all individual insurers, with a view to APRA in future receiving data from insurers more or less simultaneously with the Insurance Council receiving the same data from insurers.
These are the six items on APRA's agenda which affect general insurers. And then there is the broker data collection.
Broker data collection
Associated with the legislation enacted in 2008 to require foreign insurers to be licensed in Australia, if they wish to operate here, is the exemption regime administered by the Treasury that allows insurance in certain circumstances still to be placed offshore. An important part of administering this exemption regime is a mechanism for brokers to report all insurances that they arrange that are underwritten offshore.
Regulations were put in place by the Minister in December 2009 to establish a suitable data collection. The data collection is essentially a joint venture between ASIC and APRA on behalf of the Treasury. All licensed brokers in Australia will be required to report to APRA on their total business and on their offshore business from 1 May this year. The first data collection will be for the two months to 30 June 2010 and will be on a "best endeavours" basis. Thereafter brokers will need to send returns to APRA twice yearly, for each six-month period to 30 June and 31 December.
This data collection will achieve two very valuable outcomes. It will enable the Treasury to understand and assess how the exemption regime is operating, and it will also generate a public understanding of the nature and scale of activities of the whole insurance broking industry in Australia.
The international scene - financial stability, regulation and insurance
Ever since the visibility of the sub-prime crisis in the US and the failures of Bear Stearns and Lehman Bros in 2008, there has been widespread concern about financial stability. It has been accompanied by enormous interest in the causes of the instability and initiatives that might be taken to protect the financial system and prevent future instability.
The G20 leaders have driven their governments and regulators to look closely at what can be done and the Financial Stability Board has emerged as a kind of international overseer of the progress of the financial stability agenda of governments and regulators around the world.
The most significant financial stability issues are in the banking sector. They relate not only to credit quality or quality of lending but also to systemic risk and the ability of individual banks to keep operating if one or more other banks in the system cease to operate. The attention has been on capital and liquidity, supported by considerable efforts to work out how to avoid pro-cyclical behaviour where one or more institutions in trouble can effectively bring down the whole financial system and thereby cause great damage to the economy.
There are also some important financial stability issues that the insurance sector needs to consider. The IAIS, in which APRA participates actively and on whose executive committee I represent APRA, has established a Financial Stability Task Force and has been exploring the insurance related aspects of financial stability.
Initial thinking was about insurance interactions with the GFC but that would be a narrow view. If one thing is certain, it is that the next financial crisis will be different from the last.
So what are the lessons for the insurance industry and its regulators from the GFC? One thing we know is that, if one or more major insurers fails, there can be instability. Q.v. bond insurers and mortgage insurers in the US. But we know more than that. The economy depends on the availability of insurance so that if there is a market failure of any kind, financial instability may ensue. A failing insurance company may not cause a market failure but we do have several examples of market failure to draw from in the last decade.
- In Australia, HIH's demise led to a market failure in the form of the „insurance liability crisis‟ and economic stability was threatened.
- UMP's failure led to doctors withdrawing services i.e. another market failure that seriously affected economic activity and the community
- in 2001, after 9/11, reinsurers withdrew terrorism cover, bringing to a standstill commercial property lending in Australia - another market failure.
- In 2008, an unregulated subsidiary of AIG in the US needed financial support from its parent, which was forthcoming only because of support given by the US government. Without this support, it is likely that the AIG group would have collapsed, leading to unknown adverse financial and economic consequences
- In 2008, some bancassurance groups, notably ING and Fortis in Europe, discovered that problems in their banking arms risked the failure of their insurance arms, leading in these cases to dismemberment of the groups.
The first two of these examples (HIH and UMP) point to the need for high-quality regulation and supervision of solo insurers. The good news in the AIG case is that this level of regulation and supervision seems to have existed around the world in 2008 and 2009 because no policyholders of AIG insurance subsidiaries have suffered from the problems of the parent.
The third, withdrawal of some cover by reinsurers, points to the inevitable gaps that occur from time to time in insurance markets where insurers or their reinsurers conclude that certain risks are uninsurable. We have witnessed this problem in Australia in earlier times, for example in CTP and workers compensation insurance. In these cases, governments generally have to step in to protect related economic activities.
In the fourth and fifth cases (AIG, ING, Fortis - and there are some others) illustrate the importance of effective group regulation and supervision. They also illustrate that such regulation and supervision were not universally in place in 2008. As I see it, this is the number one task or challenge for the world's insurance regulators in the next period:-
- to ensure firstly that they have the legislative powers they need for effective group supervision,
- secondly that they have designed and implemented suitable regulations,
- and thirdly that they have the supervisory wit, capability and resources to oversee such groups effectively.
And if they are not able to meet all of these conditions, they or their governments need to consider restricting the scope of the commercial activities of groups that contain insurance companies in a way that limits the contagion risks within groups, in order to protect both financial stability and policyholders.
In Australia APRA believes it is on top of this problem of group regulation and supervision. In many countries, however, not only are the regulators trying to come to terms with the problem but in many cases the legislative powers they need do not yet exist.
And that brings me to my final point about lessons for the GFC. It is, to quote Jaime Caruano of the BIS, speaking last week at an international meeting of the Joint Forum in Melbourne, in relation to the relevance of the supervision activities of regulators. "The strength of supervision mattered, not just the rule-setting, as demonstrated by Australia and Canada. Contrary to the notion that strict regulation restricts competiveness, the crisis shows that the financial systems of countries with strict supervision came out better." APRA‟s approach to supervision is more intrusive than in some other jurisdictions, but I think we can take this as an endorsement of our approach.
APRA, the Insurance Council and the industry
Finally it is worth mentioning the valuable and effective liaison that is occurring between the Insurance Council and APRA. From APRA's perspective, an industry association is only as good as its ability to draw together the voices and interests of its members in a way that facilitates APRA‟s interaction with the industry. The Insurance Council is currently doing that effectively and we have a very good example in the recent event reporting exercise. There are also other examples such as this very seminar.
I can only encourage all Insurance Council staff, industry executives and my APRA colleagues to continue effective dialogue in this direction because it is clearly in the mutual interest and, through that interest, to the benefit of the community at large.