Prudential reform of general insurance

The local general insurance industry is substantial, accounting for over 1 per cent of worldwide general insurance business, and giving Australia a ranking in the top dozen countries. The industry’s safety is important not only for the protection of individual policyholders, but also for stability and confidence in the wider economy.

Under the Government’s financial sector reforms following the Wallis Inquiry, safety and soundness requirements for general insurers - codified in the Insurance Act 1973 - are the responsibility of APRA.

By the time of APRA’s inception in July 1998, the old Insurance Act had long been overtaken by market and regulatory developments, and was badly in need of significant reform. The emergence of some substantial losses in the industry during this period served to reinforce the case for reform, in order to increase public confidence.

After several years of policy development and industry consultation, APRA’s reform proposals were approved by the Government in November 2000, and legislated by the Parliament in August 2001. The final standards were tabled in Parliament in February 2002, and took effect on 1 July 2002.

There are three key aspects of the general insurance reform that will improve public confidence in industry soundness. These are:

1. The shift to upgraded, risk-based capital adequacy requirements;
2. The checks and balances created by stronger governance standards; and
3. The universal ‘health check’ on all companies under the re-authorisation process.

Liability valuation

General insurers previously had too much discretion in how they valued their policy liabilities and set their technical provisions. APRA’s new Liability Valuation Standard seeks to improve the reliability, consistency and risk sensitivity of the technical provisions by mandating actuarial advice and a prudential margin. An insurance company’s Board will have the power to override the Actuary’s advice, provided they disclose this, but compliance with the Liability Valuation Standard is mandatory.

In any event, APRA will have the right - on a case by case basis - to require a company to increase its technical provisions in the interests of policyholders, if that is considered to be prudent and appropriate in the circumstances.

Capital Adequacy

Capital provides a buffer to absorb unusual or extreme shocks - that would otherwise damage policyholder interests - and should be commensurate with each company’s risk profile.

Small companies need to meet a significant threshold size or entry hurdle to operate in what is an inherently risky industry, and the absolute minimum capital requirement for general insurers has risen from $2m to $5m, in order to provide for a prudent base level of internal infrastructure and risk management.

Above the $5m floor, the regulatory capital requirement is risk based. Thus, insurers writing liability and reinsurance lines need more capital to meet the greater uncertainty they face - due to the potential time lag between premium and claim - than insurers writing property business.

Asset side risks were overlooked in the old regime. Insurers with significant investment risks face a higher capital requirement.

The new regulatory capital standards are designed to increase regulatory requirements by on average 50% - more for higher risk companies, less for lower risk ones. At an overall level, the industry already holds a significant buffer over current requirements, and actual capital levels for the industry overall will continue to be adequate. At a company level, however, some marginal insurers have been forced to raise new capital, find someone stronger to merge with, or go into run-off.

For many companies at the small end, under-capitalisation has not been a major issue because they have a parent with ample capacity to re-capitalise the subsidiary, restructure the group or sell the business. In such cases - e.g. captives of industrial groups or local arms of foreign insurance groups - it has been simply a matter of the parent determining the optimum strategy.

Reinsurance

A general insurer’s Board now needs to develop a high level Reinsurance Management Strategy that should at a minimum:

• be submitted to APRA for approval, and regularly updated;
• pay regard to counterparty diversification & creditworthiness;
• include controls on the use of financial reinsurance; and
• set out clear processes for reinsurance decision-making.

There should also be controls in place to ensure financial reinsurance is used for bona fide purposes only.

Risk Management

The Board and CEO of an insurer should develop a Risk Management Strategy aimed at mitigating all its material financial and operational risks.

To meet APRA’s risk management expectations, an insurer’s internal checks and balances should include, for example:

• no shareholder should have disproportionate representation on the Board;
• a non-executive Chair and non-executive majority of the Board;
• an Audit Committee of the Board with a non-executive majority;
• `fit & proper’ tests for directors, managers and advisers;
• clearly defined roles for managers and advisers.

Directors will have to provide annually to APRA a written Declaration of the Board certifying that collectively they have:

• complied with all relevant prudential requirements;
• identified and managed all material risks;
• and propagated a strong risk control culture across the company.

With its upgraded insurance review capacity, APRA will encourage the boards and management of insurers to propagate a stronger risk control culture across the company.

Re-authorisation

Re-authorisation of every general insurer seeking a licence to operate after 30 June 2002 was required by the legislation, and was not just a technical formality. From APRA’s viewpoint, re-authorisation was an additional opportunity to take stock of each company’s soundness, and a useful discipline on companies to put in the spadework needed to meet the new requirements.

The vast majority of general insurers transitioned successfully to meet the new requirements. APRA’s reauthorisation process involved a rigorous assessment of each general insurer’s situation, business practices and business plans. The reforms include significantly increased capital requirements, stricter corporate governance requirements and far greater emphasis on the role of company actuaries.

APRA did not grant full reauthorisation to a small number of general insurers. These insurers are inadequately capitalised or were otherwise unable to satisfy APRA’s authorisation criteria. APRA has restrained these general insurers from writing new policies or renewing existing policies. APRA will supervise the orderly run-off of policies these insurers have in force.

Conclusion

Insurance company failures can almost always be attributed to a combination of under-capitalisation and poor management. The two technical standards in the new regime - covering liability valuation and capital adequacy respectively - are intended to prevent under-capitalisation in general insurance. While the two governance standards - covering reinsurance and risk management, respectively - are aimed at discouraging poor management in general insurance.

In combination, the new prudential standards should significantly reduce the likelihood of failures in the general insurance sector.

Frequently asked questions

What are the new requirements?

The new legislation (General Insurance Reform Act 2001) places stringent conditions on general insurance companies so that the prudential ‘bar’ for general insurers is now set very high. In fact, policyholder safety is now much stronger than it has ever been.

The new prudential standards are much more comprehensive and more discriminating in addressing general insurance risks. General insurance companies are now subject to much more demanding internal risk controls and governance and greater responsibility is now placed on directors, auditors and actuaries. The minimum capital requirements for general insurance companies rose by more than 50 per cent on average across the industry.

Specifically, the three key conditions in the General Insurance Reform Act designed to improve public confidence in the industry are:

• A shift to upgraded, risk-based capital adequacy requirements;
• Checks and balances created by stronger governance standards; and
• Universal ‘health check’ on all companies under the re-authorisation process.

In summary, the two technical standards in the new regime – covering liability valuation and capital adequacy respectively – are intended to prevent under-capitalisation in general insurance. While the two governing standards – covering reinsurance and risk management, respectively – are aimed at discouraging poor management in general insurance.