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Some thoughts on insurance

Monday 21 May 2012

Ian Laughlin, Executive Member - Financial Services Accountants Association, Gold Coast

Thank you for the opportunity to talk with you again.

Here are the topics I will be discussing today, some of which will be developments of comments I made last year.

First, let me comment briefly on the environment for the two insurance industries.

The global economy and investment markets remain in an extraordinary state of uncertainty and volatility. The situation varies considerably by geographic area, as highlighted by the sharp contrast between Europe and Asia. Australia has done well economically and is well placed to benefit from Asia’s growth, but we are not immune to problems elsewhere in the world. This poses direct risks to insurers’ balances sheets and to business performance more generally.

With this backdrop, APRA remains on heightened alert and we are closely monitoring our industries and institutions.

LAGIC (Life and General Insurance Capital review)

LAGIC is very topical of course, as we are entering the home stretch of the long development process for our proposals, the final versions of which come into force on 1 January 2013.

First, some recent history:

You will recall that, in December 2011, we released a paper to industry setting out APRA’s response to submissions made as part of our second round of consultation, together with 14 draft prudential standards.

We have been considering the various submissions on that consultation and will provide APRA’s response this month as planned. At the same time we will release final versions of the majority of prudential standards that were released in draft form in December – also as planned.

On 14 March, we wrote to general insurers advising that the formal implementation of one aspect of the insurance concentration risk charge (the horizontal requirement) would be deferred until 1 January 2014. More on this shortly.

On 30 March, we wrote to life insurers with APRA’s proposals for an illiquidity premium for the risk free Interest rate for discounting certain liabilities, including draft prudential standard wording. Submissions on this proposal close on 1 June.

I will now touch briefly on some of the key areas that generated responses to the December package.

In addition to those on the ICRC, there was a series of questions and comments were received about the ICAAP (Internal Capital Adequacy Assessment Process) and Pillar 2 capital adjustments. There also were a number of comments on our proposals on composition of capital.

These are all important issues and I will comment on each of them in a minute.

Submissions made various other points as shown on this slide.

I won’t go into APRA’s responses, but each point has been considered carefully. In some cases we have agreed with the argument and in others no change is going to be made. In all cases our final position will be clear.

ICRC (Insurance Concentration Risk Charge)

APRA has received considerable feedback from general insurers on the ICRC - in particular on the impact of the horizontal requirement, the component of the ICRC that is intended to address a series of material catastrophe events over a year. The key concerns raised include that it is overly conservative, that reinsurance to offset the requirement is expensive and not readily available. There also were strong arguments that more time was needed for insurers to determine and implement a suitable strategy for meeting the horizontal requirement and to obtain appropriate reinsurance cover or raise additional capital. Our decision to defer the introduction of the horizontal component (see above) has relieved much of the concern expressed. Appropriate transition arrangements (more on this shortly) will help address other issues raised.


Let me now turn to ICAAP.

ICAAP was explained in our previous consultation papers, and in the draft prudential standards issued in December 2011. We have had a number of requests for more information on ICAAP and what APRA expects of insurers. To help with this APRA intends to expand the section on ICAAP in the final version of the prudential standard to be issued this month. We also intend to issue a Prudential Practice Guide (PPG) in September. Let me now explain ICAAP in a little more detail.

APRA already expects insurers to have in place a process for assessing overall capital adequacy and setting capital targets, and a strategy for maintaining capital levels. The proposed ICAAP requirements therefore build on APRA’s current capital management requirements and guidance for insurers, and the existing requirements for capital management plans will be subsumed into the ICAAP requirements. The ICAAP is fundamentally an internal process that must be overseen by the insurer’s Board and adapted to the specific nature of that insurer’s business and structure. At a minimum the ICAAP must include the items on this slide:

APRA’s guidance will assist insurers, but will not replace the need for management and Boards to give serious consideration to how best to develop and implement the ICAAP requirements for their company. Many insurers will already be doing much of what would be required in a well-developed ICAAP in their current capital management processes, and so will have a solid foundation. Insurers who are more advanced in their implementation work have already taken steps such as development of detailed project plans, engagement of Board and senior management in the process (e.g. through board workshops) and discussion with APRA.

The December package distinguished two documents that need to be produced: the ICAAP summary statement and the ICAAP report. The ICAAP summary statement is intended to be a roadmap, briefly describing and summarising the capital assessment and management processes of the insurer. This document is expected to be developed and available to APRA from 1 January 2013. The ICAAP report is an annual report that will summarise the outcomes from the operation of the ICAAP over the last year and give an overview of expected capital management actions and issues for the coming period. It should include details of actual capital levels and capital management actions during the previous period, and projected capital levels and planned capital management actions. It should also summarise any changes to capital targets or other aspects of the ICAAP. The first ICAAP report will be due four months after the first balance date after 1 January 2013 - at the end of October 2013 for June balancers and in April 2014 for December balancers.

APRA expects that the ICAAP will be developed by the insurer’s senior management with input from relevant areas and experts. However, the ICAAP is fundamentally the responsibility of the Board: the Board should be actively engaged in the development of the insurer’s ICAAP and its implementation, and must ultimately approve the ICAAP.

We strongly encourage insurers to ensure they are well prepared for the ICAAP commencement date of 1 January 2013. We recognise that the ICAAP itself and the required documentation may undergo refinement over the first 12-24 months and we expect that practice in relation to ICAAP will improve over time as industry gains experience with the requirements.

APRA acknowledges that some insurers may wish to complete their annual ICAAP report at a date other than year end. Therefore, the prudential standard has been amended to give insurers the flexibility to complete their ICAAP report at a time other than year end, for example, as part of the annual business planning cycle.

APRA expects stress and scenario testing to be used both in setting the insurer’s risk appetite and in the insurer’s ongoing capital management. It therefore should be an integral part of the insurer's ICAAP. It should also play a key role in determining an insurer’s reinsurance strategy. Rigorous, forward-looking stress testing supports capital and reinsurance management by assessing the impact of severe events, including a series of compounding events or changes in market conditions that could adversely impact the insurer.

APRA reviews the approach taken by insurers to stress and scenario testing as part of its regular supervision activities. APRA has also previously undertaken surveys of industry practice in this area. There is a range of practice from poor to quite good. Some of the areas for improvement include the nature of the stresses and scenarios considered, in particular their severity and the adequacy of the reporting to the board. APRA intends to develop cross-industry guidance on stress testing in due course. In the meantime, requirements and guidance on stress testing are being included as part of ICAAP.

Finally, insurers should not await the release of APRA’s PPG on ICAAPs before engaging with their Board and with APRA.

Pillar 2

A number of insurers have expressed concern about the possible impost of additional capital requirements by APRA under Pillar 2. To remind you: Pillar 2 is the supervisory review process which includes APRA’s assessment of the risk management and capital management practices of insurers.

Under Pillar 2, APRA may increase the prescribed capital determined under Pillar 1 if we are of the view that this amount does not adequately account for all of an insurer’s risks. Such an adjustment may increase the total required capital amount and/or strengthen the composition of the insurer’s capital base (i.e. the insurer may have to hold an increased proportion of higher quality capital).

Because of the risk-sensitive nature of LAGIC and its fairly comprehensive coverage of types of risks, we do not expect many insurers will need a Pillar 2 adjustment just because of the peculiar nature of the risks to which they may be exposed. However, there may be other reasons for such an adjustment. All supervisory adjustments will be made in the context of a supervision and decision-making process that insurers are already familiar with. The power to require a supervisory adjustment to capital is one tool in a broader supervisory toolkit for addressing prudential concerns.

If an insurer currently has an increased capital requirement imposed by APRA, we will consider whether there is an ongoing need for that adjustment under LAGIC. Some adjustments will be in place to address risks which will now be adequately captured under the standard method for calculating the prescribed capital amount. In such cases, there may be no ongoing need for the adjustment. Insurers should also note that APRA is unlikely to apply a supervisory adjustment to capital just because the ICAAP and its documentation are being refined during 2013, so long as a well-considered and developed ICAAP is in place from 1 January 2013.

Pillar 2 provides a powerful tool for APRA to reflect an insurer’s inadequate quality of risk management in its capital requirements if needed. Insurers are encouraged to discuss the application of the Pillar 2 process with their APRA supervisor.

Composition of capital

APRA outlined in the December response paper its proposed criteria and limits for the composition of the capital base of insurers. The proposals are intended to substantially align these requirements with the proposed requirements for authorised deposit-taking institutions (ADIs) under APRA’s implementation of the Basel III capital framework. APRA’s practice for many years has been to maintain consistency of capital definitions for ADIs and general insurers.

The proposed criteria for capital instruments to qualify as Common Equity Tier 1, Additional Tier 1 and Tier 2 capital are the same as proposed for ADIs. The proposed limits are expressed as a percentage of required, rather than total, capital. This is consistent with the proposed limits for ADIs which are expressed as minimum percentages of risk-weighted assets rather than as a proportion of capital base. The proposed limits for insurers have also been set to broadly align with the proposed minimum requirements for ADIs, so that the proportion of minimum required capital represented by the different components of capital is similar.

Some insurers are concerned that the limits are unduly constraining, will require changes to the mix of capital instruments issued and will increase the cost of capital for the industry. Some insurers have also raised questions in relation to the treatment of current capital instruments that do not meet the revised criteria for regulatory capital. We have considered these issues closely and will respond to them later this month. In the meantime, APRA is happy to discuss any concerns, and appropriate transitional arrangements, with individual insurers.

Transition arrangements

Which brings me to the topic of transition more generally. We understand that a number of insurers are likely to seek transition arrangements. This may be because they may be affected by the new requirements on quality of capital as just discussed or because they will have increased minimum capital requirements under LAGIC. As we have previously indicated, we are open to requests for transition arrangements on a case-by-case basis where insurers have compelling arguments supported by capital projections. We encourage insurers to initiate discussions with their supervisor as early as possible and well before the cut off date of 30 Sept. In the meantime APRA will continue over 2012 to work to the plan outlined in the December 2011 Response Paper.

The remaining key milestones in the project timetable for this year are shown on this slide. The new capital framework will be effective from 1 January 2013.

Customer interests – APRA’s approach

The primary responsibility for looking after the interests of customers rests with the insurer – its board and management - and not, in particular, with APRA. In meeting this responsibility, the insurer must address three core issues:

  • Capital management – the more capital the better the protection for customers
  • Risk Management – the better the RM, the better the protection for customers; and
  • Governance - a robust foundation of good governance is critical.

Now, while the primary responsibility for customer interests lies with the board and management, in its Mission APRA sets out to ensure that “under all reasonable circumstances, financial promises made by institutions we supervise are met”. So of course APRA takes a very keen interest in how management and board tackle their responsibilities in the three areas of capital management, risk management and governance. And this is reflected in our prudential standards.

Most of APRA’s prudential standards can be broadly grouped into these three areas, thus aligning our focus with the company’s responsibilities to look after customer interests. However, APRA does much more than just set prudential standards. In particular, we actively supervise our industries. In doing so, we rely on a strong understanding of our industries and their evolving risks, together with a thorough working knowledge of each of our entities. And we adopt a risk-based approach to our supervision.

Risk-based supervision is a structured and methodical process. It is designed to identify and assess those areas of greatest risk to a regulated institution (or to the financial system as a whole) and then direct supervisory resources and attention to those risks. Under this approach, more supervisory resources are devoted to those regulated institutions that have higher risk profiles or identified risk management weaknesses, or that pose a potential systemic threat.

A successful risk-based approach is characterised by high-quality and astute analysis leading to the early identification of key risks and issues, a capacity to escalate the intensity of supervision rapidly, and the ability and willingness to intervene promptly and assertively as and when required.

The essential building blocks of APRA’s risk-based approach to supervision are set out in the APRA Supervision Blueprint (published in January 2010). In summary, the building blocks are:

  • A forward-looking supervisory action plan for each regulated institution that addresses the key risks facing the institution;
  • A structured risk assessment and decision-making process to ensure that the risk judgments that underpin supervisory action plans are rigorous and consistent, and that supervisory interventions are targeted and timely; and
  • A ‘thematic’ or industry-wide approach to the analysis of risks that identifies the main emerging risks and supervisory issues for each APRA-regulated industry.

One important aspect of APRA’s supervision is its engagement with boards. Boards have primary responsibility for ensuring the prudent management of regulated institutions and APRA’s prudential standards make boards accountable for a range of prudential matters. In recent times APRA has increased its engagement with boards on matters such as risk appetite and remuneration. As APRA has learned, direct access to the board, and an effective relationship built on mutual trust and respect in good times, can be crucial in managing situations when times turn sour. More face-to-face contact helps to strengthen relationships and, at the same time, allows APRA to properly test board capabilities and director contributions.

Assurances, assessments, attestations etc.

In addition to supervision, APRA relies on assessments or assurances from experts (and management) in a number of areas. APRA receives assessments or assurances from:

  • Appointed Actuary – who has specific roles and responsibilities for insurers. In particular, the Appointed Actuary provides an assessment of the overall financial condition of the company, advice on the valuation of its policy liabilities and an assessment of the suitability and adequacy of the risk management framework.
  • External audit - who perform the external audit and provide the audit report which indicates the extent APRA can rely on the accounts for its capital requirements. They also review and test systems, processes and controls designed to address compliance with prudential requirements. And they perform routine and non-routine engagements for APRA on a range of matters.
  • Internal audit – who evaluate the effectiveness of the risk management framework and control processes.

APRA also requires CEO and CFO attestations as part of its risk management arrangements.

I want to stress the importance of these assessments and assurances. They can add greatly to our understanding of an institution and its issues. But there is room for improvement. For example,

  • we would like to get far more insight into issues external auditors may find in their work (it is worth noting that qualifications from external auditors are rare); and
  • the assessment of the risk management framework by appointed actuaries in many cases could be more comprehensive and informative.

So we will be working with auditors (internal and external) and actuaries to improve the value to us of the work they perform.

Risk appetite – are we there yet?

The Board is primarily responsible for an insurer’s risk management framework and risk management strategy. An integral part of this is setting the company’s risk appetite, which should be a clear statement of the degree of risk the insurer is willing and able to take in pursuing its objectives. A clear and considered risk appetite statement sets robust foundations for the company’s overall risk management. At this conference last year, I set out the approach APRA was intending to take in assessing insurers’ formulation and management of risk appetite. You might recall that following a review of a range of risk appetite statements we decided there was a need for significant improvement. As a first step we decided to use 16 principles in our assessments of insurers’ practices. This seems to have been an effective catalyst, and we are quite pleased with the progress that has been made across much of the insurance industry. Many of the boards we have met with have been quite engaged in their risk appetite work, and improvements have been marked in the quality of the statements themselves. Nonetheless, we are not there yet, and much work still needs to be done. Those that are well advanced should continue this development work; those that have done little work to date must give the matter serious attention.

APRA expects there to be a clear link between an insurer’s risk appetite and its risk and capital management frameworks, including the target capital levels determined as part of the insurer’s ICAAP. APRA expects that target capital levels will be set in accordance with the insurer’s risk appetite and not solely by reference to APRA’s minimum capital requirements.

APRA is also continuing to provide feedback to insurers and intends to issue industry guidance on this topic in due course.

Board support

We sometimes get feedback from boards that we are expecting too much of them. They argue that they’re being over-burdened with regulatory requirements and we’re confusing the role of the board with that of senior management.

Under LAGIC it might be argued that the board’s responsibilities are becoming even more demanding. However the role of the board in protecting policyholders’ interests is critical. We believe, therefore, that the obligations placed on boards through APRA’s prudential standards are entirely appropriate. We also believe that APRA’s prudential standards empower boards because they give a frame of reference for good practice. Management too has a role to play here. It has an obligation to recognise the difficult role the board has and to make it as easy as possible for the board to meet its responsibilities. There is much that management can and should do to support boards in meeting their regulatory responsibilities. This includes:

  • ensuring the board is well aware of their regulatory obligations – perhaps through simple and readily accessible summaries;
  • ensuring regulatory obligations are woven into normal management, governance and board reporting;
  • helping the board think ahead, with a plan to meet regulatory requirements; and
  • providing tools to complement reports - for example sensitivity tables or graphs in capital management considerations.

Stronger support of boards by management will give APRA more confidence that boards are meeting their regulatory obligations and lead to lower intensity of supervision by APRA.

This approach, in turn, helps APRA and we get a virtuous circle like that shown on the chart.

Remuneration – is it worth it?

As you may recall, in April 2010 APRA introduced new requirements in relation to remuneration. The requirements aim to ensure that regulated institutions’ remuneration arrangements promote prudent risk-taking in the management of their business, and that there is effective governance of remuneration matters. Since then, APRA’s supervision teams have monitored progress on implementation as part of their normal ongoing activities. APRA has also met with the Board Remuneration Committees of a number of large institutions to discuss their oversight of remuneration arrangements for senior executives and how policy is translated into practice.

Generally we were quite pleased with the processes adopted by these institutions. However, APRA did identify a number of issues warranting further consideration. Based on this experience, we then wrote to all ADIs, general insurers and life insurers asking them to consider specific questions to see whether improvements could be made to current remuneration policies and practices. Some of the issues to be considered included those shown on this slide:

We expect to see industry remuneration practices evolve over time, partly in response to these considerations, and will continue to engage with boards and senior management to ensure ongoing improvement.

International developments


There continues to be much work underway internationally on the identification of global systemically important financial institutions and appropriate regulatory and supervision measures for such institutions. This work is being driven by the Financial Stability Board (FSB). Banks were the initial centre of attention, but much work has now been done on insurers. This has proved to be quite a challenging issue in the insurance world with the industry arguing vigorously that there is no such thing as a systemically important insurer. Nonetheless, the IAIS is currently considering various possible methodologies and scenarios for the determination of global systemically important insurers (G-SIIs for short). The intention is to publish final G-SII methodologies and appropriate policy measures in late 2012.

It is quite unlikely that there will be any Australian G-SIIs. However, as is the case in banking, it is likely that this work will flow in due course to consideration of domestic SIIs and appropriate policy measures for them. APRA will continue to actively participate in the work of the IAIS in this area and consider its implications for Australia as it develops.


Work also has continued at the IAIS on the development of what is called “ComFrame”. This is a common framework for the supervision of internationally active insurance groups (or IAIGs for short) – that is, those that operate in more than one jurisdiction. Australia probably will have some IAIGs. The intention here is that there is a consistent and co-operative approach to the regulation of insurers that operate internationally. Much of this work will also be complete by the end of 2012. This will influence our approach to regulation of such companies in due course.

Living wills

In recent years, in the wake of the GFC and at the instigation of the Financial Stability Board (FSB), the concept of living wills for financial institutions has evolved. There are two components to living wills:

  • Recovery plans, which are measures that would enable a financial institution to survive a destabilising event (e.g. strategies for raising additional capital or disposing of a core business). The Recovery Plan is the institution’s responsibility.
  • Resolution plans, which are measures that would enable a cost-effective resolution to be implemented by the authorities where recovery is not possible (e.g. simplifying complex group structures to facilitate resolution). The Resolution Plan is the supervisor’s responsibility.

We are currently looking closely at the role living wills could play in our supervisory activities. While it is difficult to argue with the concept of recovery and resolution plans, not all regulated institutions are the same and so the scope, complexity and value of living wills will vary. APRA supervises large banks, credit unions and building societies, foreign banks subsidiaries, foreign bank branches, large life and general insurers, specialist insurers, branch insurers, reinsurers, and superannuation trustees of various shapes and sizes (public offer, corporation etc).

Our challenge is to decide how the living will concept should be applied. And a second challenge is to decide how comprehensive and detailed a plan needs to be. Inevitably, a resolution plan will be executed when a recovery plan has failed, but we need to understand how recovery plans might unfold to be able to adequately plan for a resolution. There is no point assuming that a failed institution can be resolved by, for example, selling a major business arm to recapitalise the remaining business if that business arm has already been sold as part of the (inadequate) recovery efforts.

So work on institution-specific resolution plans inevitably follows from developing good recovery plans.

APRA has begun its own work in this area. Our initial priority is recovery planning in the ADI industry. In the latter part of 2010/11, APRA established a pilot program for a number of the larger ADIs, requiring them to prepare a comprehensive recovery plan that  sets out the specific actions they would take to restore themselves to a sound financial condition in the face of a major depletion of capital and associated liquidity pressures.

Finalised plans for these ADIs will be required by mid-2012 and APRA intends to extend its recovery planning program to a wider set of ADIs in 2012/13. Recovery planning is also likely to be extended to the larger general insurers and life insurers in due course, modified to suit the nature of their business. APRA will also be undertaking an assessment of institution-specific resolution planning, but only after it is satisfied that substantial progress has been made on recovery planning.

This slide shows how ICAAP and living wills relate to each other using the earlier diagram.

The box on the right shows how the Living Will would complement the LAGIC capital requirements and the ICAAP process. Clearly the insurer’s ICAAP, Recovery Plan and Resolution Plan would have to be consistent with each other.

IFRS: Review of insurance contracts standard

The IASB and FASB continue to work towards a common Insurance Contracts model with considerable attention devoted to the measurement of the insurance contract liability. A review draft or a revised Exposure Draft (ED) is expected in the second half of this year at the earliest. The current proposals suggest this standard is not likely to represent a significant change to Australian insurers’ practices, and in any event there is likely to be a long lead time for implementation.

The slide shows how the IASB is approaching the measurement of the insurance contract liability in the Insurance Contracts project, as outlined in its July 2010 Insurance Contracts Exposure draft.

The FASB supports the use of a single composite margin. Any differences in the two approaches are likely to be addressed through disclosures. There are other refinements to the previous proposals. For example, the discount rate is expected to be a current rate that is updated each reporting period (i.e. not a “locked in” rate for each insurance contract). There is also further consideration being given to the use of other comprehensive income for presenting the effects of changes in certain assumptions on the insurance contract liability.

Life industry issues

In the current uncertain economic and investment environment, the Life industry continues to undergo significant change. Forces at work include:

  •  FOFA;
  •  Stronger Super;
  •  Merger and acquisition activity; and
  •  APRA’s LAGIC and associated changes to prudential standards.

At the same time, we have some specific areas of concern. APRA has been expressing concern about the group life market for some time. I mentioned it at this conference last year. There are a few reasons for this:

  •  a very competitive market, which puts pressure on pricing and underwriting and operational practices;
  •  poor data for pricing;
  •  some poor pricing practices; and
  •  an inadequate skills base (e.g. claims management) in a growing market.

There are some signs of poor claims experience emerging – possibly because of these points. We are seeing some signs of improvement in practices (eg in pricing by some insurers, with better governance, justification of assumptions etc), but the industry can do much better.

We are therefore maintaining our focus on this business. We have taken a number of steps so far:

  • discussions with industry committees;
  • discussions with all Appointed Actuaries (through the Actuaries Institute);
  • discussions with individual insurers, with strong messages to boards and senior management; and
  • in superannuation prudential standard SPS250 , a specific requirement for trustees to maintain good quality data so that the incumbent insurer and insurers involved in a tender have a robust foundation for pricing.

We are also considering the need for guidance on tendering processes.

We are looking for significant improvement over the next one to two years.

Morbidity experience appears to be worsening but, anecdotally at least, this does not appear to be across the board. So only some insurers seem to be impacted. Why is this? Is it poor or liberal underwriting? Or perhaps it is poor claims management. Or could it be the regular addition of product features, often at no cost? Whatever the reason, each insurer needs to carefully analyse, understand and actively manage their disability business.

For the first time in many years, we are seeing some evidence of deteriorating mortality experience. As with disability experience, it could be due to any of underwriting, claims management or terms and conditions, but it is not at all clear what the driving force is.

Again, each insurer should be carefully analysing and understanding its own experience. Unfortunately, for some insurers this will be difficult because of inadequate data (for example, original underwriting terms for each insured).

Direct life insurance business has been growing at a high rate and is now a significant proportion of the retail market. We are concerned that the quality of the products and of the business being written may be poor in some cases. We see example of expensive products and high discontinuance rates. This raises concerns about governance and reputational risk – for the company and for the industry and we are actively discussing this with boards. There are also issues with market conduct, about which we have had discussions with ASIC.

General insurance issues

The General Insurance industry has been through an extraordinary period, with a debilitating series of natural disasters and associated political backlash. Even though it has been subject to criticism for its flood coverage and its claim handling, the industry by and large has managed its way through this situation well. Its strong capital position and comprehensive reinsurance arrangements have stood it in good stead, and it has remained in good financial health. It has responded promptly to the various criticisms with a series of changed practices.

As this graph shows, the general insurance industry remains well capitalized. At 31 December 2011 the industry held close to 1.8 times the minimum capital requirements set by APRA and surplus capital of close to $12bn. Capital coverage of the industry did reduce a little over 2011 but still remains very strong. The industry has also maintained its profitability over the last four years, notwithstanding the pressures it has faced on underwriting results and from lower investment returns. However pressures remain and it will be challenging for insurers to sustain their profitability and maintain a sound financial position over the coming years. This continuing uncertain environment heightens the need for sound risk and capital management by insurers so that they are well positioned to respond to developments as they unfold.

APRA will, as always, maintain its proactive and risk-based approach to supervision, to ensure that it is on top of the material factors that will impact the strength and performance of the industry. There are, however, some areas on which APRA will be placing particular focus over the coming year or so. Some of these areas were also on APRA’s radar in 2010 and 2011, while others are coming into sharper focus for 2012. Reinsurance is, not surprisingly, an area that we have been monitoring closely for the last few years given its importance to the financial strength of the industry.

Reinsurance counterparty risk

In early 2011, APRA undertook a data collection to assess whether the failure or significant downgrade of a major reinsurer was a material risk for the industry. Pleasingly, the information provided showed that the industry is well diversified in terms of reinsurance counterparties from a geographical standpoint and across APRA and non-APRA authorised reinsurers. In excess of 90% of the reinsurers utilised are also rated APRA grade 3 (S&P A-rated) or higher. APRA is considering whether to make this data collection permanent so that it can more readily monitor reinsurer counterparty exposure.

Placement risk

The catastrophe events in Australia and New Zealand in 2010 and 2011 led to some reinsurers reducing or restructuring the cover they are willing to provide in the region, or requiring significant price increases for some types of cover. Consequently, some insurers may retain greater catastrophe risk on their balance sheet, in turn increasing the volatility of their capital position and also their capital requirements. For insurers with material property exposures, APRA has been undertaking targeted reviews of their reinsurance strategy and its alignment with their risk and capital management strategy. APRA will continue its targeted reinsurance reviews throughout 2012 and provide feedback to individual insurers and the industry on the outcomes. APRA has also been looking at changes made to reinsurance arrangements and capital triggers, the robustness of stress-testing for catastrophe events and the use of catastrophe models. These reviews are intended to provide APRA with a better overall view of the impact on industry from the recent catastrophe events and the changes occurring in the reinsurance market. It is also highlighting areas of good practice and where there is room for improvement.

Reinsurance and the use of modelling

One such area is in relation to catastrophe models where poor governance practices in the use of these models can have a significant impact on an insurer. The series of catastrophe events over 2010/2011 and into 2012 had, and will continue to have, a significant impact on the general insurance industry. The events highlighted several issues that warrant close attention from both industry and APRA.

For example, each insurer needs to better articulate in their Reinsurance Arrangement Statement (RAS) what their actual reinsurance arrangements are and how they operate, including worked examples. The schematics in the RAS need to accurately reflect the words (and vice versa). Also, insurers should make greater use of stress testing as part of establishing their reinsurance arrangements. In particular, APRA has suggested that insurers should consider the potential impact of a series of events similar to those of 2010/2011, the erosion of lower layers and back up covers, and further reinstatements being unavailable.

As you know, APRA sets a minimum standard based on 1 in 250 (soon to be 1 in 200) probability. Obviously it is not a simple matter to assess the cover to meet this standard, and models are used extensively for this purpose. However, we are concerned that there may be an over-dependence on these models in setting reinsurance catastrophe cover. Some insurers accept the model outputs blindly and use this for the purchase of their catastrophe cover. Others rely heavily on their reinsurance brokers and their models to the same extent. Some insurers use multiple models to set their cover. But they may then choose the lowest of the results produced. The models can be something of a black box to the insurers of course, which might encourage this blind acceptance of the model’s results. Our concern stems from the degree of error in the models and whether boards and management understand this and take it into account in setting their cover.

All models have limitations. The output is dependent on the data provided, the assumptions in the model, the reliance on known history, which perils are modelled, the sophistication of the modelling engine etc. The relevance of the result of course is then subject to the vagaries of the real world (e.g. an unknown earthquake fault!). The net result is that at best a model gives an estimate and its results are subject to a significant margin of error. It is dangerous to ignore this.

And so we are urging management and boards to recognise the limitations of models, and to challenge and debate the model outputs and in the process to recognise the inherent errors in these outputs. They should then consider their risk appetite for having inadequate catastrophe cover, and set their cover taking all of this into account. APRA’s minimum requirement - and it is just a minimum - should be only one factor in this consideration. APRA is currently considering whether we could provide some guidance for boards and management on this issue. In the meantime we are reviewing catastrophe modelling reports of a number of insurers to better understand the processes followed.

Pricing processes

Sound pricing practices and processes are fundamentally important for insurers for the maintenance of a sound and profitable business. Review of insurer pricing processes and controls forms a core part of APRA’s supervision activities, and we see heightened risk in this area at present for a number of reasons. These include increased competition within the industry (including from aggregators), likely increases in reinsurance retentions and costs, low interest rates and the deterioration in the profitability of some classes of business that may have been masked by the release of reserves in recent years.

Further, APRA’s reviews of pricing processes and controls suggest that there is room for improvement in the development of technical prices, and in the management of actual versus technical prices.

Adequacy of reserving

Reserve releases have been a feature of general insurers’ results in recent years and, as noted above, have the potential to mask deterioration in profitability. This is also an area that is looked at on a regular basis by APRA. However the current challenging environment for the industry heightens the risk of reserve releases being used to boost apparent profitability.

APRA is undertaking an internal review of the reserving strength of a range of insurers, focusing on the underlying assumptions and methodologies used across key classes of business. APRA will look to provide specific feedback to individual insurers once the review is completed and will also consider publishing any general observations on industry practice that may emerge from the review.


Let me finish now. I have covered a lot of ground this morning and hopefully given you some insights into our current thinking and concerns.

Thank you for your time.

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.