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The Actuary The magazine of the Institute & Faculty of Actuaries

Prudential standards in Australia

The Australian Prudential Regulation Authority (APRA) was established in 1998 and one of its key objectives has been the finalisation of work that will lead to the introduction of a new prudential framework for the general insurance sector. APRA has proposed a three-layered system of regulation: the revised Insurance Act, prudential standards, and guidance notes. In September 1999 APRA issued a discussion paper detailing the broad shape of the proposed prudential framework. Since this initial paper there have been extensive discussions with industry, together with a ‘road test’ of the proposed standards on a representative sample of general insurers.
In November 2000 the federal government announced that it would proceed with amendments to the Insurance Act 1973 necessary to implement APRA’s proposed standards. Final versions of the new prudential standards and supporting guidance notes were issued in November 2001. The new prudential regime will come into force on 1 July 2002 and encompasses many issues that will need to be addressed by members of the actuarial profession.
The most important proposals are as follows.

Role of the actuary
APRA proposes that each insurer be required to appoint a valuation actuary where:
– total insurance liabilities of the insurer at the last reporting date exceeded A$20m; or
– insurance liabilities comprise a material amount of long-tail business; or
– the insurer is unable to satisfy APRA that actuarial advice is not warranted.
The actuary would provide the board with advice on the valuation of insurance liabilities in accordance with the new liability valuation standard. At the same time, the insurer’s board has ultimate responsibility for setting the provisions, and can override the actuary’s advice, but must then disclose and explain this decision to APRA and to the market through the published annual accounts. It is proposed that the revised Insurance Act will provide for the imposition of whistle-blowing rights and responsibilities and accompanying privilege on the directors, auditor, and valuation actuary of a company authorised under the Act.
Some have noted that the role of the valuation actuary as prescribed was too onerous for any one person to fill, both in terms of the overall workload required, and in relation to the proposed whistle-blowing obligations. APRA acknowledged that, in practice, the actuary will need to co-ordinate, and rely upon, work undertaken by other employees or contractors of the insurer, but argued that this would not detract from the usefulness of the role. To the extent that many large insurers already operate with a chief actuary or similar role, this merely replicates existing practice.

Valuation of liabilities
Under the present regulatory framework, there is a considerable degree of flexibility in the valuation of insurance liabilities. APRA’s aim is to achieve a more objective, reliable, and consistent valuation of insurance liabilities than currently occurs. As a result, APRA has recommended that valuation of liabilities, both outstanding claims and premium, must comprise a central estimate value and risk margin that reflects the inherent uncertainty in each of the central estimates. The risk margin should be established such that the sum of the central estimate and the risk margin provides a 75% probability of sufficiency and the risk margin should be no less than one-half of the coefficient of variation. The calculation of the 75th percentile should not rely only on statistical techniques but also on knowledge of the business and judgement.
While there is little disagreement that risk margins over and above the central estimate are a necessary component of valuing insurance liabilities, there is considerable disagreement that the 75th percentile is necessarily the appropriate level to mandate. There is also debate concerning the calculation and reporting of the diversification margin.
Other key proposals under the liability valuation standard include:
– Premiums liability concept The existing arrangement is a retrospective basis through the use of the unearned premium provision and deferred acquisition costs (DAC). Now the proposal is for the premium liabilities to be valued on a fully prospective basis. Concern has been raised regarding the complexity of the calculation, the requirement for a prudential risk margin, and the fact that the existing method of estimating premium liabilities may produce a more conservative estimate. In response, APRA has included suggested methodologies for the calculation which acknowledge that a high degree of complex analysis may not always be warranted, and allow the actuary to exercise professional judgement as to whether simple methods suffice.
– Prescribed discount rate The rate to be used in discounting the expected future claim payments for a class of business is the gross redemption yield, as at the valuation date, of a portfolio of government bonds matching the liabilities by term and currency. In contrast, the existing regime directs that the rate must be determined by reference to market-determined risk-adjusted rates of return appropriate to the insurer. This is viewed as ambiguous and open to interpretation.
– An emerging international accounting framework Concerns have been raised as to the establishment of a consistent accounting framework and approach under the liability valuation standard for both regulatory and financial reporting purposes. There is ongoing consultation with both the International and Australian Accounting Standards Boards.

Capital adequacy
The 1991 changes to the Australian Insurance Act introduced a minimum solvency margin of the greatest of A$2m, 20% of net written premiums, and 15% of net outstanding claims provisions. APRA’s objective is to ensure that each insurer holds sufficient capital to reduce to a minimal level the possibility of failing to meet its obligations. To this end, APRA proposes a risk-based approach to the measurement of capital adequacy of all general insurers.
The new minimum capital requirement (MCR) may be determined using either:
– an internal model developed by the company to reflect the circumstances of its business;
– the standardised (or prescribed) framework;
– a combination of the above, as appropriate to the mix of business of the company.
Regardless of the outcome of the model calculations, an insurer’s MCR cannot fall below A$5m. There is a two-year transition period for insurers unable to meet the new capital adequacy requirements on 1 July 2002. However, insurers who intend to take advantage of these transitional arrangements will need to agree an appropriate transition plan with APRA.
For insurers using the prescribed method, the MCR will be determined as the sum of capital charges for:
– Insurance risk The risk that the true value of net insurance liabilities could be greater than the value determined under the liability valuation standard. This capital charge has two components: a charge in respect of outstanding claims risk and a charge in respect of premiums liability risk.
– Investment risk The risk of an adverse movement in the value of the insurer’s assets and/or off-balance sheet exposures. The investment risk charge is determined as the sum across all assets of the value of each investment multiplied by the relevant capital factor for that investment. An insurer may be required to hold additional capital for investment concentration risk.
– Concentration risk The risk associated with an accumulation of exposures to a single catastrophic event. The concentration charge is set equal to the insurer’s maximum event retention (MER) the largest loss to which an insurer will be exposed (taking into account the probability of that loss) as a result of a concentration of policies, after netting out any reinsurance recoveries. The MER should allow for the cost of one reinstatement premium for the insurer’s catastrophe reinsurance.
There has been little opposition to the broad ideas introduced within the capital adequacy framework. The overall impact on the industry is to increase minimum capital requirements by around 50% on average.

As a consequence of the new regulatory proposals, insurers will be required to formally reapply to APRA for authorisation under the new regime. Authorisation will require, inter alia, production of strategy documents for reinsurance and risk management, in addition to a comprehensive three-year business plan.

Strategy documents
As part of the authorisation process within the new regulatory regime, each insurer is required to have in place a reinsurance management strategy and a risk management strategy, approved by the board and appropriate to the size, business mix, and complexity of operations of the insurer. Both strategies must be submitted to APRA. The strategies should be reviewed regularly and the insurer must consult with APRA if it intends to undertake a material deviation from either proposed strategy. The approach APRA will use to assess the adequacy and appropriateness of each strategy is set out in two respective prudential standards.
The reinsurance standard aims to ensure that an insurer has in place reinsurance arrangements contributing to a high likelihood it will be able to meet its obligations to policyholders.
The risk management standard aims to ensure that an insurer is well managed, has access to appropriate independent expertise, and has systems for identifying, managing, and monitoring risks that may threaten the ability of the insurer to meet its obligations to policyholders. APRA considers that at a minimum balance sheet and market risk, credit risk, and operational risk categories should be addressed in an insurer’s risk management strategy.
The general insurance arena must heed the words of APRA’s chief executive officer, Graeme Thompson, on 29 August 2001: ‘There is a good deal of work to be done in a short space of time’.