Insurance (prudential standard) determination No. 7 of 2006 - Prudential Standard GPS 110 - Capital Adequacy (Cth)
Insurance (prudential standard) determination No. 7 of 2006
Prudential Standard GPS 110 Capital Adequacy
Insurance Act 1973
I, John Roy Trowbridge, Member of APRA, a delegate of APRA, under subsection 32(1) of the Insurance Act 1973 (the Act) and subsection 33(3) of the Acts Interpretation Act 1901:
REVOKE Prudential Standard GPS 110 Capital Adequacy for General Insurers (and related guidance notes) made on 7 February 2002 as varied ; and
MAKE Prudential Standard GPS 110 Capital Adequacy in the form set out in the Schedule, which shall apply to general insurers.
This instrument takes effect from the later of 1 January 2007 and the date of registration on the Federal Register of Legislative Instruments.
Dated 25 September 2006
[Signed]
John Trowbridge
Member
Interpretation
In this instrument:
APRA means the Australian Prudential Regulation Authority.
general insurer has the meaning given in section 11 of the Act.
Note 1 A general insurer that does not comply with a standard may be issued with directions by APRA under paragraph 36(1)(a) of the Act. Non-compliance with a direction is an offence attracting a penalty of up to 300 penalty units (currently $33,000). Officers of the general insurer and other individuals may also be criminally liable (see section 37).
Note 2 Prudential Standard GPS 110 Capital Adequacy for General Insurers was made on 7 February 2002 by Legislative Instrument F2006B01543 on the Federal Register of Legislative Instruments.
Schedule
Prudential Standard GPS 110 Capital Adequacy comprises the 78 pages commencing on the following page.
Prudential Standard GPS 110
Capital Adequacy
| Objective and key requirements of this Prudential Standard This Prudential Standard aims to ensure that the security of policyholder obligations of all insurers is established at an appropriate level by requiring that each general insurer maintain at least a minimum amount of capital. Capital is the cornerstone of a general insurer’s strength. It provides a buffer against losses that have not been anticipated and, in the event of problems, enables the general insurer to continue operating while those problems are addressed or resolved. In this way, the maintenance of an adequate capital base can engender confidence, on the part of policyholders, creditors and the market more generally, in the financial soundness and stability of the general insurer. Beyond the minimum levels of capital specified by this Prudential Standard, it is the responsibility of a general insurer’s Board and senior management to ensure that the general insurer’s capital base is appropriate to the size, business mix, complexity and risk profile of its business. Accordingly, the general insurer must have suitable systems in place to identify, manage and monitor the risks associated with its business activities, and to hold capital commensurate with its overall risk profile. Such capital must, of course, be no less than the minimum specified by this Prudential Standard. The key requirements of this Prudential Standard are: · A general insurer may choose one of two methods for determining its Minimum Capital Requirement. General insurers with sufficient resources are permitted to develop an in-house capital adequacy model to determine their own Minimum Capital Requirement (this is referred to as the Internal Model Based Method). Use of this method will, however, need APRA’s approval and the Treasurer’s agreement and will require a general insurer to satisfy a range of qualitative and quantitative criteria. General insurers that do not use the Internal Model Based Method must use the Prescribed Method described in this Prudential Standard. · Regardless of which method is used to calculate the Minimum Capital Requirement, a general insurer’s Minimum Capital Requirement is determined having regard to a range of risk factors that may threaten the ability of the general insurer to meet policyholder obligations. Under the Prescribed Method, these fall under three broad types: insurance risk (the risk that the actual value of net insurance liabilities could be greater than the value determined under Prudential Standard GPS 310 Audit and Actuarial Reporting and Valuation); investment risk (the risk of an adverse movement in the value of a general insurer’s assets or off-balance sheet exposures); and concentration risk (the risk associated with an accumulation of exposures to a single catastrophic event or multiple catastrophic events if a whole of portfolio approach to catastrophe risk is applied). A general insurer using the Internal Model Based Method will be expected to include at least these risks, but also all other relevant risk factors, within its method of calculation. · A general insurer must, at all times, maintain a capital base in excess of its Minimum Capital Requirement. To achieve this APRA expects the general insurer to maintain a buffer above the Minimum Capital Requirement. An insurer’s capital base is comprised of Tier 1 and Tier 2 capital. · Foreign incorporated general insurers authorised to operate in Australia as branches have slightly different requirements from those applied to locally incorporated general insurers. Specifically, foreign incorporated general insurers are required to maintain assets in Australia that exceed their liabilities in Australia, by an amount that is greater than their Minimum Capital Requirement. For the definition of assets in Australia, refer to the Insurance Act 1973 and Prudential Standard GPS 120 Assets in Australia. · Disclosure and transparency are important allies of the supervisory process. To improve policyholder and market understanding of its capital adequacy position, a general insurer must disclose, in its published annual report, details of its capital base and Minimum Capital Requirement. |
Index
This document consists of the following:
Prudential Standard GPS 110 Capital Adequacy
Attachment A – Measurement of Capital Base
Attachment B – Internal Model Based Method
Attachment C – Insurance Risk Capital Charge
Attachment D – Investment Risk Capital Charge
Attachment E – Concentration Risk Capital Charge
Attachment F – Concentration Risk Capital Charge for Lenders Mortgage Insurers
Attachment G – Reductions in Capital
Attachment H – Transition Provisions
Authority
This Prudential Standard is made under section 32 of the Insurance Act 1973 (the Act).
Application
This Prudential Standard applies to general insurers (insurers) authorised under the Act.F[1]F
[1] Refer to sections 32 and 35 of the Insurance Act 1973 (the Act).
Further details of the requirements outlined below are specified in the Attachments to this Prudential Standard.
Subject to any specific transition rules set out in Attachment H, an insurer must:
(a)comply with this Prudential Standard from 1 January 2007 (effective date); and
(b)continue to comply with:
(i) Prudential Standard GPS 110 Capital Adequacy for General Insurers made on 7 February 2002 (previous GPS 110);F[2]F
[2] Amended on 15 December 2004.
(ii) Guidance Note GGN 110.1 Measurement of Capital Base made on 7 February 2002 (GGN 110.1);
(iii) Guidance Note GGN 110.2 Internal Model Based Method made on 7 February 2002 (GGN 110.2);
(iv) Guidance Note GGN 110.3 Insurance Risk Capital Charge made on 7 February 2002 (GGN 110.3);
(v) Guidance Note GGN 110.4 Investment Risk Capital Charge made on 7 February 2002 (GGN 110.4);F[3]F
[3] Amended on 29 June 2004 and 15 December 2004.
(vi) Guidance Note GGN 110.5 Concentration Risk Capital Charge made on 7 February 2002 (GGN 110.5); and
(vii) Guidance Note GGN 110.6 Concentration Risk Capital Charge for Lenders Mortgage Insurers made on 6 September 2005 (GGN 110.6)
until the effective date.
As a consequence of the key role played by capital in the financial health of an insurer, every insurer must maintain sufficient capital to enable its insurance obligations to be met under a wide range of circumstances. This required level of capital for regulatory purposes is referred to as the Minimum Capital Requirement (MCR).
Interpretation
By operation of subsection 13(1) of the Legislative Instruments Act 2003, terms not defined in this Prudential Standard but which are defined in the Act have the same meaning as in the Act.
Definition of capital base
In assessing the adequacy of an insurer’s capital base, attention must be paid not only to the types of events or problems that it might encounter, but also to the quality of the support provided by various types of capital instruments. The following matters are relevant to whether a capital instrument is adequate for supervisory purposes, namely the extent to which each instrument:
(a)provides a permanent and unrestricted commitment of funds;
(b)is freely available to absorb losses from business activities;
(c)does not impose any unavoidable servicing charges against earnings; and
(d)ranks behind the claims of policyholders and creditors in the event of the winding-up of the insurer.
Not all types of capital instruments meet these criteria equally. Due to the need to ensure that the capital base of an insurer provides adequate support, APRA imposes some restrictions on the composition of capital eligible to meet the MCR. The capital instruments deemed eligible for inclusion in an insurer’s capital base, and the conditions as to their inclusion, are specified in Attachment A.
An insurer’s balance sheet may contain certain assets (such as deferred tax assets, goodwill and other intangibles) that are acceptable from an accounting perspective, but for supervisory purposes are either generally not available, or of questionable value, should the insurer encounter difficulties. Insurers are therefore required to deduct from their capital base any holdings in these types of assets. Details of these deductions are provided in Attachment A.
An insurer must maintain a capital base sufficient to enable its insurance obligations to be met under a range of circumstances. An insurer must, at all times, hold eligible capitalF[4]F (after deductions) in excess of its MCR. Where an insurer proposes any reduction in its capital base, it must obtain APRA’s prior written consent (refer to Attachment H).
[4]For further detail regarding the types of eligible capital, refer to Attachment A.
Foreign insurers
By the nature of its Australian balance sheet, a foreign general insurer (foreign insurer) will not typically have capital instruments of the type specified in Attachment A. Foreign insurers are nevertheless required to meet a variant of the MCR. Specifically, foreign insurers are required to maintain assets in AustraliaF[5]F that exceed their liabilities in AustraliaF[6]F, by an amount that is greater than the MCR determined by this Prudential Standard.
[5] In this context, “assets in Australia” are those within the meaning of sections 28 and 116A of the Act and Prudential Standard GPS 120 Assets in Australia.
[6]In this context, “liabilities in Australia” are those:
References to the capital base of an insurer elsewhere in this Prudential Standard are, where they are intended to apply to a foreign insurer, to be read as referring to ‘net assets in Australia’ of that insurer.
For further detail regarding the treatment of foreign insurers, refer to Prudential Standard GPS 120 Assets in Australia.
Minimum Capital Requirement (MCR)
An insurer’s capital base must be adequate for the size, business mix, complexity and risk profile of its business. To this end, this Prudential Standard establishes a risk-based approach to the measurement of capital adequacy of an insurer. The MCR is intended to be broadly commensurate with the full range of risks to which an insurer is exposed (including risks relating to insurance claims, investments, counterparty default, asset-liability mismatches, catastrophic events, and operational errors and problems).
The MCR may be determined using either:
(a)an internal model developed by the insurer to reflect the circumstances of its business - the Internal Model Based (IMB) Method;F[7]F
[7] The internal model will need to be implemented by way of a modification to this Prudential Standard, as it applies to the particular insurer. The modification will be made under subsection 32(3A) of the Act, and APRA must first obtain the Treasurer’s written agreement to this under subsection 32(3E) of the Act.
(b)the standardised framework detailed in this Prudential Standard – the Prescribed Method; or
(c)a combination of the methods specified in subparagraphs (a) and (b).
Regardless of the outcome of the method used for determining the MCR, an insurer’s MCR cannot be less than $5 million.
APRA recognises that any measure of the adequacy of an insurer’s capital base involves judgement and estimation, and requires the quantification of risks that may be difficult to quantify. As a result, APRA may adjust an insurer’s MCR where it believes that the amount determined under this Prudential Standard does not adequately reflect the risk profile of the insurer.F[8]F In exercise of this discretion to adjust an insurer’s MCR, APRA will have regard to the following:
[8]Under subsection 32(3D) of the Act, prudential standards may provide for APRA to adjust prudential requirements.
(a)the length of time the insurer has been operating;
(b)whether the insurer is in or appears likely to be in financial or operational difficulty;
(c)whether the insurer is deemed by APRA to have a disproportionate exposure to a particular type of risk;
(d)whether particular risks faced by an insurer are adequately dealt with by the prudential standards; and
(e)any other relevant matters.
In the normal course of business, an insurer must have in place capital management processes. These must be set out in the insurer’s Risk Management Strategy (RMS) in accordance with Prudential Standard GPS 220 Risk Management.
Internal Model Based Method
Insurers with sufficient resources are permitted to develop an in-house capital measurement model to calculate the MCR. Use of the IMB Method will be conditional on APRA’s approval and the Treasurer’s agreementF[9]F and will require insurers to satisfy a range of criteria, as detailed in Attachment B. As is the case for prudential standards covering other supervised industries, APRA must be satisfied that the insurer’s methodology for capital assessment is suitably rigorous and broadly consistent with comparable segments of the industry, that the model is well designed, the analysis and assumptions used are sound, and that the results of applying the model are reasonable from a prudential viewpoint. Insurers which do not develop a model that meets the criteria specified in Attachment B must use the Prescribed Method described below.
[9] Refer to subsections 32(3A) and 32(3E) of the Act.
Prescribed Method
For insurers using the Prescribed Method, the MCR will be determined as the sum of the capital charges for:
(a)insurance risk;
(b)investment risk; and
(c)concentration risk.
Insurance risk
The Insurance Risk Capital Charge relates to the risk that the actual value of net insurance liabilities is greater than the value determined under Prudential Standard GPS 310 Audit and Actuarial Reporting and Valuation (GPS 310). The method for determining the Insurance Risk Capital Charge is set out in Attachment C.
This capital charge has two components: a charge in respect of outstanding claims risk (Outstanding Claims Capital Charge); and a charge in respect of premiums liability risk (Premiums Liability Capital Charge). The Outstanding Claims Capital Charge relates to the risk that the value of the net outstanding claims liabilities is greater than the value determined under GPS 310. The Premiums Liability Capital Charge relates to the risk that premiums relating to post calculation date exposures, including premiums written before but incepting after the calculation date, are insufficient to fund the liabilities arising from that business.
The Outstanding Claims Capital Charge is determined as the sum, over all classes of business of the insurer, of the value of the net outstanding claims liabilities for each class (determined using GPS 310), multiplied by the appropriate Outstanding Claims Capital Factor for that class.
The Premiums Liability Capital Charge is determined as the sum, over all classes of business of the insurer, of the net premiums liabilities for each class (determined using GPS 310), multiplied by the appropriate Premiums Liability Capital Factor for that class.
If an insurer securitises insurance liabilities, the net insurance liabilities may reduce. The insurer must consult APRA prior to entering into the securitisation transaction in order to be able to reduce the Insurance Risk Capital Charge and the Concentration Risk Capital Charge.
Investment risk
The Investment Risk Capital Charge relates to the risk of adverse movements in the value of an insurer’s assets or off-balance sheet exposures or both. Investment risk can be derived from a number of sources, including market risk and credit risk.
Subject to paragraphs 28 to 31, the Investment Risk Capital Charge is determined as the sum, across all assets and certain off-balance sheet exposures, of the value of each investment multiplied by the relevant Investment Capital Factor for that investment. For the purposes of this Prudential Standard, assets and exposures must be valued according to the relevant reporting standards made under the Financial Sector (Collection of Data) Act 2001 (Collection of Data Act). The method for determining the Investment Risk Capital Charge is set out in Attachment D.
This capital charge may reduce through the reduction in investment risk arising from the availability of risk mitigants (e.g. collateral security or guarantees), subject to the criteria detailed in Attachment D.
An insurer must hold additional capital, in the form of an Investment Concentration Charge, if its exposure to a particular asset or counterparty exceeds the thresholds set out in Attachment D.
In certain circumstances, an insurer may choose to hold assets in a special purpose vehicle (SPV), rather than on its own balance sheet. Where APRA has approved the inclusion of a SPV as part of the insurer’s Extended Licensed Entity (ELE),F[10]F the insurer is able to “look through” the legal structures involved, to determine its Investment Risk Capital Charge (and any Investment Concentration Charge) based on the individual assets of the SPV, rather than simply on its direct exposure to the entity.
[10]Under paragraph 10 of Attachment D. Criteria that APRA will consider are set out in paragraph 11 of that Attachment.
If an insurer securitises assets, the insurer must consult APRA prior to entering into the securitisation transaction in order to be able to reduce the Investment Risk Capital Charge.
Concentration risk
At a minimum, the Concentration Risk Capital Charge relates to the risk associated with an accumulation of exposures to a single catastrophic event at a single site. However, APRA will require a whole of portfolio approach to be implemented by an insurer where APRA assesses that the single event approach is inadequate in evaluating that insurer’s reinsurance needs. If this is required of an insurer and it does not comply with the requirement, the insurer’s MCR may be increased in accordance with paragraph 17. The method for determining the Concentration Risk Capital Charge is set out in Attachment E. For lenders mortgage insurers, additional requirements for calculating the Concentration Risk Capital Charge are set out in Attachment F.
The Concentration Risk Capital Charge is set equal to the insurer’s Maximum Event Retention (MER), plus the cost of one reinstatement of the catastrophe reinsurance cover in cases where the reinstatement reinsurance cover has not been pre-paid by the insurer. APRA will monitor an insurer’s calculation of its MER and may, where it is not satisfied with the methodologies or assumptions used, require adjustments to be made to the calculation.F[11]F
[11]Exercising the power under paragraph 18 of Attachment E.
In calculating the MER, an insurer must not take into account potential recoveries from a reinsurance arrangement unless the reinsurance arrangement:
(a)complies with the two month rule and six month rule imposed under Prudential Standard GPS 230 Reinsurance Management (GPS 230); or
(b)fails to comply with those rules as at the date of the relevant deadline but:
(i) subsequent to the deadline specified under the two month rule, the reinsurance arrangement is documented in accordance with the other requirements of the two month rule (in which case the reinsurance recoveries from the reinsurance arrangement may be taken into account for the purposes of calculating the MER until the reinsurance arrangement fails to comply with the six month rule); or
(ii) subsequent to the deadline specified under the six month rule, the reinsurance arrangement is documented in accordance with the other requirements of the six month rule; or
(c)has been treated by APRA, under GPS 230, as complying with the two month rule and six month rule.
Disclosure
Disclosure and transparency are important allies of the supervisor. To improve policyholder and market understanding of its capital adequacy position, an insurer must disclose, in its published annual report, the following items:
(a)the amount of eligible Tier 1 capital, with separate disclosure of each of the items specified in Attachment A;
(b)the aggregate amount of any deductions from Tier 1 capital;
(c)the amount of eligible Tier 2 capital, with separate disclosure of each of the items specified in Attachment A;
(d)the aggregate amount of any deductions from Tier 2 capital;
(e)the total capital base of the insurer derived from the items (a) to (d);
(f)the MCR of the insurer; and
(g)the capital adequacy multiple of the insurer (item (e) divided by item (f)).
Attachment A
Measurement of Capital Base
This Attachment sets out the range of capital instruments that are eligible for inclusion in the capital base of an insurer, required deductions from an insurer’s capital base and the process for obtaining approval for reductions in capital by an insurer.
The definitions and the qualifying criteria detailed in this Attachment are applicable to all locally incorporated insurers. As outlined in this Prudential Standard, a different measure of capital adequacy applies to foreign insurers. This reflects the nature of a foreign insurer’s Australian balance sheet, which does not generally include separately identifiable capital instruments.
Interpretation
Any reference in this Attachment to:
(a)Auditing and Assurance Standards is a reference to the Auditing and Assurance Standards issued by the Auditing and Assurance Standards Board as may be amended from time to time;
(b)Australian Accounting Standards is a reference to the Australian Accounting Standards issued by the Australian Accounting Standards Board as may be amended from time to time;
(c)associates is a reference to associates as defined in the Australian Accounting Standards and is to be read as also applying to joint ventures unless otherwise indicated;
(d)cash flow hedges is a reference to cash flow hedges as defined in the Australian Accounting Standards;
(e)the earnings or retained earnings of an insurer in this Attachment is a reference to the earnings or retained earnings of the insurer determined in a manner consistent with the insurer’s prudential reporting to APRA under the Collection of Data Act rather than in accordance with Australian Accounting Standards as required for statutory financial reporting under the Corporations Act 2001 (Corporations Act); and
(f)subsidiary is a reference to a subsidiary as defined under the Corporations Act.
Capital base
Capital, for supervisory purposes, is considered in two tiers. Tier 1, or core capital, comprises the highest quality capital elements that fully meet all the essential characteristics of capital described in paragraph 7 of this Attachment. Tier 2, or supplementary capital, includes other instruments that, to varying degrees, fall short of the quality of Tier 1 capital but nonetheless contribute to the overall financial strength of an insurer.
For capital adequacy purposes, a locally incorporated insurer’s capital base is defined as the sum of Tier 1 and Tier 2 capital, net of all deductions specified in this Attachment, subject to the various limits specified in paragraph 44 of this Attachment that apply. An insurer must ensure that its capital base exceeds its MCR at all times.
In assessing whether an instrument is eligible as Tier 1 or Tier 2 capital, APRA will have regard to both the form and substance of the instrument. An insurer must:
(a)provide APRA with copies of documentation associated with the issue of the instrument; and
(b)where the terms of the instrument depart from established precedent, consult APRA and provide APRA with adequate time to review the instrument in advance of issuance to ensure the eligibility of the instrument for inclusion in the insurer’s capital base.
Tier 1 capital
Tier 1 capital comprises the highest quality capital elements which fully satisfy all of the following essential characteristics:
(a)provide a permanent and unrestricted commitment of funds;
(b)are freely available to absorb losses;
(c)do not impose any unavoidable servicing charge against earnings; and
(d)rank behind the claims of policyholders and creditors in the event of winding-up.
For the purposes of calculating an insurer’s capital base, Tier 1 capital is divided into the following:
(a)Fundamental Tier 1 capital, which is the highest form of capital, consists of:
(i) paid-up ordinary shares;
(ii) reserves;F[12]F
[12] Excluding asset revaluation reserves.
(iii) retained earnings;
(iv) current year’s earnings net of expected dividends and tax expenses; and
(v) technical provisions in excess of those required by GPS 310.F[13]F
[13]Where technical provisions in excess of those required by Prudential Standard GPS 310 Audit and Actuarial Reporting and Valuation (GPS 310) are included as Tier 1 capital, they must be net of expected reinsurance recoveries and other recoveries. They must then be reduced to take account of tax effects.
(b)Residual Tier 1 capital, which consists of all other items qualifying for Tier 1 status, is divided into:
(i) Non-innovative Residual Tier 1 capital – comprising perpetualF[14]F non-cumulative preference shares that satisfy the relevant criteria set out in this Attachment; and
[14]For the purposes of this Attachment, an instrument is perpetual where it does not have a maturity date.
(ii) Innovative Tier 1 capital – comprising all other Residual Tier 1 capital instruments that satisfy the relevant criteria set out in this Attachment.
Reserves are created after tax and include, but are not limited to:
(a)reserves from equity-settled share-based payments (shares or share options) granted to employees as part of their remuneration package provided that:
(i) the shares or share options granted relate only to the ordinary shares of the insurer itself; and
(ii) there are no circumstances in which such remuneration can be converted into another form (e.g. cash).
Any other reserves associated with share-based payments must be excluded from capital; and
(b)cumulative unrealised gains or losses on cash flow hedges offsetting gains or losses included in Tier 1 capital (e.g. movements in the currency value of foreign currency denominated hedging instruments which offset movements in foreign currency denominated items recognised in the foreign currency translation reserve).
Residual Tier 1 capital
To qualify as Residual Tier 1 capital, an insurer must ensure that an instrument satisfies the following criteria:F[15]F
[15]Capital instruments approved by APRA for Tier 1 status prior to 1 July 2006 are deemed to comply with the criteria set out in paragraph 10 of this Attachment.
(a)the instrument is unsecured and paid up:
(i) any partly paid issue is eligible only to the extent that it has been paid up. Subject to paragraph 15 of this Attachment, unpaid perpetual non-cumulative preference shares issued through “stapled” structures are permitted (to the extent that they are paid up); and
(ii) only the proceeds of the issue that have been received by the issuer are permitted to count as capital;
(b)the instrument is perpetual:
(i) the instrument is not redeemable at the option of the holder and has no provisions which require future redemption by the issuer; and
(ii) redemption at the option of the issuer is permitted, provided the redemption or call option is subject to APRA’s written approval at the time of exercise and it does not operate in conjunction with any other feature that creates or signals a de facto tenor of the instrument. Should this occur, APRA will consider the instrument to be a dated instrument and ineligible for inclusion as Tier 1 capital. Issue documentation must give clear and prominent notice to prospective investors that the issuer’s right to exercise any such option to redeem or purchase the instrument is subject to APRA’s prior written approval;
(c)the instrument imposes no fixed servicing costs on the issuer:
(i) dividend or interest payments to the holders of the instrument is at the discretion of the issuer. The issuer is able to waive any dividend or interest payments on the instrument and alter the timing of payments;
(ii) any unpaid dividends or interest to the holders of the instrument is non-cumulative (i.e. not required to be made up by the issuer at a later date). The instrument, both in form and substance, does not provide for cumulative dividend or interest payments. For example, the instrument does not provide for payment of a higher dividend or interest rate if dividend or interest payments are not made on time nor a reduced dividend or interest rate if such payments are made on time. Any special or optional dividends or interest payments on the instrument outside of normal scheduled payments require APRA’s prior written approval;
(iii) the non-payment of a dividend or interest on the instrument does not trigger any restrictions on the issuer other than its ability to pay dividends on ordinary shares, or purchase shares (outside normal trading operations) or retire other shares;
(iv) the instrument does not provide for payment of any form of compensation to investors other than by way of a distribution of profits. Any such profit distribution is in the form of a cash dividend or interest payments. Payment in kind is not permitted;
(v) dividend or interest payments on the instrument are not linked to the credit standing of the issuer. However, linking dividend or interest payments on the instrument to movements in general market indices is permitted; and
(vi) the rate of dividends or interest on the instrument, or the formulae for calculating dividend or interest payments on the instrument, are predetermined and set out in the issue documentation;
(d)the instrument is able to absorb losses incurred by the issuer on a going concern basis and in the winding-up of the issuer, including satisfying the criteria specified in paragraph 13 of this Attachment;
(e)the instrument is subordinated in right of repayment of principal, interest and dividends to all policyholders and creditors of the issuer, with issue documentation that clearly:
(i) indicates the subordinated nature of the instrument to prospective holders, and
(ii) precludes the exercise of any contractual rights of set-off between the instrument and any claims by the issuer on the holders of the instrument;
(f)the instrument does not contain any terms, covenants or restrictions that could inhibit the issuer’s ability to be managed in a sound and prudent manner, particularly in times of financial difficulty, or restrict APRA’s ability to resolve any problems encountered by the issuer (e.g. clauses preventing further senior debt issues are prohibited). There are no cross-default clauses in the documentation of any debt instruments of the issuer linking the issuer’s obligations under the instrument to default by another party (related or otherwise); and
(g)the instrument is marketed in line with its prudential treatment, and does not include any “repackaging” arrangements which have the effect of compromising the permanency of capital raised. If the prospectus or other offering documentation or marketing of the instrument suggests to investors that the instrument has attributes of a lower level of capital than claimed for prudential treatment, APRA will treat the instrument as an instrument falling into that lower level of capital for prudential purposes.
Where an instrument is subject to the laws of a jurisdiction other than a state or territory of Australia, the insurer must also ensure that the instrument complies with and is enforceable under the laws of that jurisdiction. APRA may require the insurer to provide confirmation by way of an independent legal opinion addressed to APRA by a firm or practitioner of APRA’s choice, at the expense of the insurer.
An insurer must inform APRA of any subsequent modification of the terms or conditions of the instrument. In assessing whether the subsequent modification of the terms or conditions of the instrument affects its eligibility to continue qualifying as Non-innovative Residual Tier 1 capital or Innovative Tier 1 capital, APRA will have regard to both the form and substance of the instrument as modified. An insurer must:
(a)provide APRA with copies of documentation associated with the modification of the instrument; and
(b)where the terms and conditions of the instrument as modified depart from established precedent, consult APRA and provide APRA with adequate time to review the instrument in advance of the modification to ensure the eligibility of the instrument for inclusion in the insurer’s capital base.
For the purposes of subparagraph 10(d) of this Attachment, the issuer must ensure that:
(a)the instrument (both principal and any unpaid dividends or interest) is treated as a specific class of share capital or member’s interest of the issuer. The contractual rights of the holders of the instrument to receive and enforce any payments under the instrument must be consistent with the intention that the instrument functions as if it constituted a specific class of share capital or member’s interest of the issuer;
(b)the issuer does not have any liability to make a dividend or interest payment on the instrument if making the payment would result in the issuer becoming, or being likely to become, insolvent for the purposes of the Corporations Act or, where the issuer is incorporated in a foreign jurisdiction, for the purposes of equivalent corporate insolvency law of that jurisdiction; and
(c)issue documentation makes explicit that:
(i) payment of dividends or interest on the instrument is at the discretion of the issuer;
(ii) failure of the issuer to make a dividend or interest payment on the instrument does not constitute an event of default;
(iii) holders have no right to apply for the winding-up or administration of the issuer, or cause a receiver, or receiver and manager, to be appointed in respect of the issuer on the grounds that the issuer fails to make, or is or may become unable to make, a dividend or interest payment under the instrument; and
(iv) holders of the instrument will have no offsetting rights or claims on the issuer in the event that the issuer cancels or suspends dividend or interest payments on the instrument.
Non-innovative Residual Tier 1 capital
To qualify as Non-innovative Residual Tier 1 capital, an insurer must ensure that perpetual non-cumulative preference shares satisfy both the criteria set out in paragraph 10 of this Attachment and the following criteria:
(a)the preference shares have not been issued indirectly through an SPV. An indirect issue is not eligible for inclusion in Non-innovative Residual Tier 1 capital although the preference shares may be included in Innovative Tier 1 capital provided they also satisfy the criteria set out in paragraph 45 of this Attachment;
(b)the preference shares do not provide for any step-up in dividends. A conversion from fixed to floating rate (or vice-versa) or a switch in index basis, where there is no change in the effective margin included in the rate of dividend is not considered a step-up;
(c)conversion of the preference shares into ordinary shares is permitted, subject to the following criteria:
(i) conversion cannot occur at the option of the holder;
(ii) the conversion formula for determining the number of ordinary shares received upon conversion of a preference share is fixed in the issue documentation and includes a cap on the maximum number of ordinary shares that holders will receive upon conversion;
(iii) for the purposes of sub-subparagraph (ii), the maximum number of ordinary shares received upon conversion of each preference share does not exceed the ratio of the price of the preference share at issue divided by 50 per cent of the price of the ordinary share at time of issue of the preference shares. For these purposes, in calculating the ordinary share price at time of issue, adjustments may be made for subsequent ordinary share splits, bonus issues and similar transactions;
(iv) the conversion is not structured in a way that would effectively provide for a return of capital or compensation for unpaid dividends; and
(v) any exercise of the conversion option by the issuer is subject to APRA’s prior written approval. Approval is not required for any mandatory conversions whose terms were agreed to by APRA prior to issuance of the preference shares; and
(d)perpetual non-cumulative preference shares issued through “stapled” structures are permitted, subject to the conditions specified in paragraph 15 of this Attachment; and
(e)adequate internal policies and controls are in place such that the unstapling procedures are correctly followed.
For the purposes of sub-subparagraph 10(a)(i) and subparagraph 14(d) of this Attachment:
(a)the preference shares are issued directly by the insurer and are “stapled” to securities (the stapled securities) issued directly by an overseas branch of the insurer. The stapled structure must not involve any use of SPVs and must be simple and transparent;
(b)either or both of the preference shares and the stapled securities are paid up. Any partly paid preference shares or stapled securities are eligible only to the extent that they have been paid up;
(c)the preference shares and the stapled securities are not traded separately and are stapled together unless and until an “unstapling event” occurs;
(d)the terms and conditions of the stapled securities mirror substantially those of the preference shares such that the stapled securities operate effectively as if they were the preference shares. Accordingly, the terms and conditions of the stapled securities do not compromise the Tier 1 qualities of the underlying preference shares;
(e)“unstapling” of the preference shares and the stapled securities at the option of the issuer is permitted. The instrument documentation must clearly stipulate the events that will cause the preference shares to be “unstapled” with the stapled securities being extinguished and the holders of the stapled securities holding the preference shares instead. “Unstapling” must take place where:
(i) proceedings for the liquidation of the insurer commence; or
(ii) APRA revokes the authorisation of the insurer pursuant to subsection 15(1) of the Act;
(f)issue documentation requires holders of the stapled securities to hold the underlying preference shares upon the occurrence of an unstapling event. Where necessary, APRA may require the insurer to provide an independent legal opinion confirming this result addressed to APRA by a firm or practitioner of APRA’s choice, at the expense of the insurer. To reduce the inherent legal risk associated with unstapling of the structure, the insurer must ensure the clarity, consistency and certainty with which the contractual terms and conditions are specified in the issue documentation, in particular that:
(i) all entities involved in the stapled structure have the capacity and power needed to issue the relevant instruments and perform obligations under them;
(ii) the rights and obligations created by the preference shares and the stapled securities are legal, valid, binding and enforceable on all relevant parties in all relevant jurisdictions; and
(iii) the unstapling mechanism will take effect as contemplated in the issue documentation even if the insurer or other entity has become, or is likely to become insolvent, including where it is in administration, receivership, winding up, or where APRA has revoked the authorisation of the insurer pursuant to subsection 15(1) of the Act.
Innovative Tier 1 capital
To qualify as Innovative Tier 1 capital, an insurer must ensure that an instrument satisfies the criteria set out in paragraph 10 of this Attachment and the following criteria:
(a)where the instrument provides for a “step-up” in dividends or interest, the terms of the step-up is limited, fixed at the time of issue and subject to APRA’s prior written approval (refer to paragraph 35 of this Attachment for further detail);
(b)a step-up in dividends or interest or an equity conversion is permitted in conjunction with an issuer call option, provided the step-up or equity conversion meets all relevant criteria and, where the application of a step-up or equity conversion is optional, the issue cannot mandate the exercise of the call option if the step-up or equity conversion is not applied;
(c)where the instrument provides for a mandatory conversion or an option to the holders or the issuer to convert into another form of eligible Tier 1 capital instrument, the instrument must not contain any conversion feature that effectively provides for a return of capital or compensation for unpaid dividends or interest. The rate of conversion in all circumstances must be fixed (e.g. by way of a formulae) at the time of issue; and
(d)where the instrument is issued indirectly through an SPV, it satisfies the criteria set out in paragraph 45 of this Attachment.
Tier 2 capital
Tier 2 capital includes other elements which, to varying degrees, fall short of the quality of Tier 1 capital stated in Hparagraph H7 of this Attachment but nonetheless contribute to the overall strength of an insurer as a going concern, and is divided into:
(a)Upper Tier 2 capital – comprising elements that are essentially permanent in nature, including some forms of hybrid capital instruments; and
(b)Lower Tier 2 capital – comprising instruments which are not permanent i.e. dated or limited life instruments.
Upper Tier 2 capital
Upper Tier 2 capital consists of the following items that satisfy the relevant criteria set out in this Attachment:
(a)perpetual cumulative preference shares;
(b)perpetual cumulative mandatory convertible notes;
(c)perpetual cumulative subordinated debt;
(d)any other hybrid capital instruments of a permanent nature approved by APRA, including any capital amounts otherwise meeting APRA’s requirements for Tier 1 capital instruments (specified in this Attachment) that are ineligible for inclusion as Tier 1 capital as a result of the limits specified in paragraph 44 of this Attachment;
(e)45 per cent of pre-tax revaluation reserves of each of the following:F[16]F
[16]This amount includes cumulative unrealised gains or losses on effective cash flow hedges. Where a revaluation is calculated net of hedges, the amount of hedges concerned must be excluded from reported Tier 1 capital, that is, the gains or losses on hedges must be deducted from or added back to Tier 1 capital.
(i) property not held at fair value; and
(ii) investments in subsidiaries not held at fair value, other than subsidiaries that APRA deems part of an Extended Licensed Entity (ELE) (refer to Attachment D).F[17]F
[17]This amount excludes any reserve recognised from the revaluation of the goodwill component of investments in subsidiaries not held at fair value.
The amount recognised must be net of any fair value gains and losses and any gains or losses on hedges offsetting revaluations included in reserves; and
(f)45 per cent of the post-acquisition reserves of associates as defined in the Australian Accounting Standards. This includes, under equity accounting, the insurer’s share of undistributed profits, plus any share of asset revaluations in associates or any other revaluation of investments in associates. The amount recognised must be net of fair value gains and losses and any gains or losses on hedges offsetting revaluations of investments in associates included in reserves.F[18]F
[18]Refer to footnote 16.
Where an insurer is aware that a particular asset is impaired and a loss arises, such a loss must be reflected in Tier 1 capital. However, where a particular asset belongs to a class of assets for which asset revaluation reserves are included in Upper Tier 2 capital and the asset has been identified as impaired and losses arise, the losses may be offset against any existing revaluations of the asset or class of revalued assets.
If an asset revaluation reserve included in Upper Tier 2 capital is negative after adjustment for revaluations of assets included in the reserve, losses due to impairment of assets covered by the reserve and any gains or losses on hedges offsetting revaluations of assets included in the reserve, the amount of deficit in the reserve must be reported as a deduction from Tier 1 capital.
Lower Tier 2 capital
Lower Tier 2 capital consists of the following items that satisfy the relevant criteria set out in this Attachment:
(a)term subordinated debt;
(b)limited life redeemable preference shares; and
(c)any other similar limited life capital instruments.
Upper Tier 2 capital
Asset revaluation reserves
Only revaluation reserves arising from the revaluation of property and investments in subsidiaries not held at fair value, other than subsidiaries that APRA deems part of an ELE, and associates referred to in paragraphs 23 to 25 of this Attachment can be included in the capital of an insurer.
Reserves arising from the revaluation of property can only be included in Upper Tier 2 capital if the following conditions are met:
(a)the property is owned by the insurer;
(b)the property represents only land and buildings;
(c)the reserves are shown as a component of equity in the published audited financial accounts of the insurer;
(d)the revaluations are prudent, in accordance with Australian Accounting Standards and subject to audit or review consistent with Auditing and Assurance Standards; and
(e)the amount of reserves incorporates the full effect of any fair value gains and losses and any gains or losses on hedges offsetting revaluations of property not held at fair value included in the reserves.
Reserves, including any share of undistributed profits in subsidiaries otherwise included in earnings, arising from the revaluation of investments in subsidiaries not held at fair value, other than subsidiaries that APRA deems to be part of an ELE, are to be included in Upper Tier 2 capital subject to the following conditions:
(a)an insurer is able, if required by APRA, to demonstrate that a reliable fair value can be credibly inferred to the subsidiary. This could include demonstrating recent prices received for the sale of entities with similar business profiles, or reliable estimates of the fair value of assets and liabilities of a subsidiary or values derived from other sound valuation practices;
(b)the amounts included in the reserves are shown as a component of equity in any published audited financial accounts of the insurer;
(c)the revaluations are prudent, in accordance with Australian Accounting Standards, and subject to audit or review consistent with Auditing and Assurance Standards; and
(d)the amount of reserves incorporates the full effect of any fair value gains and losses and any gains or losses on any hedges offsetting revaluations of the investments in subsidiaries not held at fair value.
Reserves representing an insurer’s share of profits in associates or revaluation of assets in associates under equity accounting plus any reserves otherwise arising from the revaluation of investments in associates are to be included in Upper Tier 2 capital subject to the following conditions:
(a)where reserves simply reflect investments in associates and are revalued, an insurer is able, if required by APRA, to demonstrate that a reliable fair value can be credibly inferred to the investment in the associate. This could include demonstrating recent prices received for the sale of an equity interest in the associate or by way of sale of entities with similar business profiles, or reliable estimates of the fair value of assets and liabilities of the associate or values derived from other sound valuation practices;
(b)the amounts included in the reserves are shown as a component of equity in any published audited financial accounts of the insurer;
(c)any revaluations are prudent, in accordance with Australian Accounting Standards, and the amounts reported in the reserves are subject to audit or review consistent with Auditing and Assurance Standards; and
(d)the amount of reserves incorporates the full effect of any fair value gains and losses and any gains or losses on any hedges offsetting revaluations of the investments in associates.
Hybrid Capital Instruments
To qualify as Upper Tier 2 capital, an insurer must ensure that an instrument satisfies the following criteria:F[19]F
[19]Capital instruments approved by APRA for Upper Tier 2 status prior to 1 July 2006 are deemed to comply with the criteria set out in paragraph 26 of this Attachment.
(a)the instrument is unsecured and paid up:
(i) any partly paid issue is eligible only to the extent that it has been paid up; and
(ii) only the proceeds of the issue that have been received by the issuer are permitted to count as capital.
(b)the instrument is perpetual:
(i) the instrument is not redeemable at the option of the holder and has no other provisions which require future redemption by the issuer; and
(ii) redemption at the option of the issuer is permitted, provided the redemption or call option is subject to APRA’s written approval at the time of its exercise and it does not operate in conjunction with any other feature that creates or signals a de facto tenor of the instrument. Should this occur, APRA will consider the instrument to be a dated instrument and ineligible for inclusion as Upper Tier 2 capital. Issue documentation must give clear and prominent notice to prospective investors that the issuer’s right to exercise any such option to redeem or purchase the instrument is subject to APRA’s prior written approval;
(c)cumulative dividend or interest payments on the instrument are permitted subject to paragraph 29 of this Attachment;
(d)the instrument is able to absorb losses incurred by the issuer on a going concern basis and in the winding-up of the issuer, including satisfying the criteria specified in paragraph 30 of this Attachment;
(e)the instrument is subordinated in right of repayment of principal, interest and dividends to all policyholders and creditors of the issuer, except those creditors (not policyholders) expressed to rank equally with or behind the holders of the instrument, including that issue documentation clearly:
(i) indicates the subordinated nature of the instrument to prospective holders; and
(ii) precludes the exercise of any contractual rights of set-off between the instrument and any claims by the issuer on the holders of the instrument;
(f)the instrument does not provide for any accelerated repayment of principal, except in the event of liquidation or winding-up of the issuer. The winding-up must be irrevocable i.e. either by way of a court order or an effective resolution by shareholders or members. The making of an application to wind-up, or the appointment of a receiver, administrator, or official with similar powers, including the exercise of APRA’s powers under subsection 15(1) of the Act, are not sufficient to accelerate repayment of the instrument;
(g)where the instrument provides for a mandatory conversion or an option to the holders or the issuer to convert into share capital of the issuer, the instrument does not contain any conversion feature that effectively provides for a return of capital or compensation for unpaid dividends or interest. The rate of conversion is fixed (e.g. by way of a formulae) at the time of issue;
(h)where the instrument provides for a “step-up” in dividends or interest, the terms of the step-up are limited, fixed at the time of issue and subject to APRA’s prior written approval (refer to paragraph 35 of this Attachment for further detail);
(i)a step-up in dividends or interest or an equity conversion is permitted in conjunction with an issuer call option, provided the step-up or equity conversion meets all relevant criteria and, where the application of a step-up or equity conversion is optional, the issue cannot mandate the exercise of the call option if the step-up or equity conversion is not applied;
(j)the instrument does not contain any terms, covenants or restrictions that could inhibit the issuer’s ability to be managed in a sound and prudent manner, particularly in times of financial difficulty, or restrict APRA’s ability to resolve any problems encountered by the issuer (e.g. clauses preventing further senior debt issues). There are no cross-default clauses in the documentation of any debt instruments of the issuer linking the issuer’s obligations under the instrument to default by another party, related or otherwise;
(k)the instrument is marketed in line with its prudential treatment, and does not include any “repackaging” arrangements which have the effect of compromising the permanency of capital raised. If the prospectus or other offering documentation or marketing of the instrument suggests to investors that the instrument has attributes of a lower level of capital than claimed for prudential treatment, APRA will treat the instrument as an instrument falling into that lower level of capital for prudential purposes; and
(l)where the instrument is issued indirectly through an SPV, it also satisfies the criteria set out in paragraph 45 of this Attachment.
Where the instrument is subject to the laws of a jurisdiction other than a state or territory of Australia, an insurer must also ensure that the instrument complies with and is enforceable under the laws of that jurisdiction. APRA may require the insurer to provide confirmation by way of an independent legal opinion addressed to APRA by a firm or practitioner of APRA’s choice, at the expense of the insurer.
An insurer must inform APRA of any subsequent modification of the terms or conditions of the instrument. In assessing whether the subsequent modification of the terms or conditions of the instrument affects its eligibility to continue qualifying as Upper Tier 2 capital, APRA will have regard to both the form and substance of the instrument as modified. An insurer must:
(a)provide APRA with copies of documentation associated with the modification of the instrument; and
(b)where the terms and conditions of the instrument as modified depart from established precedent, consult APRA and provide APRA with adequate time to review the instrument in advance of the modification to ensure the eligibility of the instrument for inclusion in the insurer’s capital base.
For the purposes of subparagraph 26(c) of this Attachment:
(a)the instrument must allow the issuer an option to defer servicing obligations where profitability does not justify a dividend or interest payment (refer to paragraph 37 of this Attachment);
(b)where perpetual cumulative preference shares do not provide the issuer with the option to defer or reduce dividends when profitability does not justify payment, such shares are to be treated as a Lower Tier 2 capital instrument;
(c)although any unpaid dividends or interest to the holders of the instrument can be accumulated, they must not be compounded. For example, the instrument must not provide for payment of a higher dividend or interest rate if dividend or interest payments are not made on time, nor a reduced dividend or interest rate if such payments are made on time;
(d)the instrument must not provide for payment of any form of compensation to investors other than by way of a distribution of profits. Any such profit distribution must be in the form of a cash dividend or interest payments. Payment in kind is not permitted;
(e)dividend or interest payments on the instrument must not be linked to the credit standing of the issuer. However, linking dividend or interest payments on the instrument to movements in general market indices is permitted; and
(f)the rate of dividends or interest on the instrument, or the formulae for calculating dividend or interest payments on the instrument, are predetermined and set out in the issue documentation.
For the purposes of subparagraph 26(d) of this Attachment, the issuer must ensure that:
(a)the instrument (both principal and any unpaid dividends or interest) is treated as a specific class of share capital or member’s interest of the issuer in the event that the issuer’s retained earnings become negative. The contractual rights of the holders of the instrument to receive and enforce any payments under the instrument must be consistent with the intention that the instrument functions as if it constituted a specific class of share capital or member’s interest of the issuer in this situation;
(b)the issuer does not have any liability to make a scheduled dividend or interest payment on the instrument if making the payment would result in the issuer becoming, or being likely to become, insolvent for the purposes of the Corporations Act or, where the issuer is incorporated in a foreign jurisdiction, for the purposes of equivalent corporate insolvency law of that jurisdiction; and
(c)issue documentation makes explicit that:
(i) the issuer has the right to defer dividend or interest payments on the instrument;
(ii) failure of the issuer to make a scheduled dividend or interest payment on the instrument does not constitute an event of default; and
(iii) holders have no right to apply for the winding-up or administration of the issuer, or cause a receiver, or receiver and manager, to be appointed in respect of the issuer on the grounds that the issuer fails to make, or is or may become unable to make, a scheduled dividend or interest payment under the instrument.
Lower Tier 2 capital
To qualify as Lower Tier 2 capital, an insurer must ensure that an instrument satisfies the following criteria:
(a)the instrument is unsecured and paid up:
(i) any partly paid issue is eligible only to the extent that it has been paid up; and
(ii) only the proceeds of the issue that have been received by the issuer are permitted to count as capital;
(b)the instrument has a minimum term of five years. Where the instrument is drawn down in a series of tranches, the minimum original maturity of each tranche is five years from the date of drawdown (refer to paragraph 34 of this Attachment for further detail);
(c)issue documentation makes explicit that all scheduled dividend or interest payments on the instrument are conditional upon the issuer being solvent at the time of payment and no payment may be made unless the issuer is solvent immediately afterwards. Failure of the issuer to make any scheduled dividend or interest payments in this case does not constitute an event of default;
(d)the instrument does not provide for payment of a higher dividend or interest rate if dividend or interest payments are not made on time, nor a reduced dividend or interest rate if such payments are made on time;
(e)dividend or interest payments on the instrument are not linked to the credit standing of the issuer. However, linking dividend or interest payments on the instrument to movements in general market indices is permitted;
(f)the rate of dividends or interest on the instrument, or the formulae for calculating dividend or interest payments on the instrument, are predetermined and set out in the issue documentation;
(g)where the instrument provides for a “step-up” in dividends or interest, the terms of the step-up are limited, fixed at the time of issue and subject to APRA’s prior written approval. Paragraph 36 of this Attachment provides further detail in relation to step-ups;
(h)a step-up in dividends or interest is permitted in conjunction with an issuer call option, provided the step-up meets all relevant criteria and, where the application of a step-up is optional, the issue cannot mandate the exercise of the call option if the step-up is not applied. Otherwise, the instrument is deemed to mature on the date at which the step-up provisions take effect;
(i)the instrument is subordinated in right of repayment of principal, interest and dividends to all policyholders and creditors of the issuer, except those creditors (not policyholders) expressed to rank equally with or behind the holders of the instrument, including that issue documentation clearly:
(i) indicates the subordinated nature of the instrument to prospective holders, and
(ii) precludes the exercise of any contractual rights of set-off between the instrument and any claims by the issuer on the holders of the instrument;
(j)in the event that the issuer defaults under the terms of the instrument, remedies available to the holders are limited to actions for specific performance, recovery of amounts currently outstanding or the winding-up of the issuer;
(k)the instrument does not provide for any accelerated repayment of principal, except in the event of liquidation or winding-up of the issuer. The winding-up must be irrevocable i.e. either by way of a court order or an effective resolution by shareholders or members. The making of an application to wind-up, or the appointment of a receiver, administrator, or official with similar powers, including the exercise of APRA’s powers under section 15(1) of the Act, are not sufficient to accelerate repayment of the instrument;
(l)the instrument does not contain any terms, covenants or restrictions that could inhibit the issuer’s ability to be managed in a sound and prudent manner, particularly in times of financial difficulty, or restrict APRA’s ability to resolve any problems encountered by the issuer (e.g. clauses preventing further senior debt issues). There are no cross-default clauses in the documentation of any debt instruments of the issuer linking the issuer’s obligations under the instrument to default by another party (related or otherwise);
(m)where the instrument is issued indirectly through an SPV, it must also satisfy the criteria set out in paragraph 45 of this Attachment.
Where the instrument is subject to the laws of a jurisdiction other than a state or territory of Australia, an insurer must also ensure that the instrument complies with and is enforceable under the laws of that jurisdiction. APRA may require the insurer to provide confirmation by way of an independent legal opinion addressed to APRA by a firm or practitioner of APRA’s choice, at the expense of the insurer.
An insurer must inform APRA of any subsequent modification of the terms or conditions of the instrument. In assessing whether the subsequent modification of the terms or conditions of the instrument affects its eligibility to continue qualifying as Lower Tier 2 capital, APRA will have regard to both the form and substance of the instrument as modified. An insurer must:
(a)provide APRA with copies of documentation associated with the modification of the instrument; and
(b)where the terms and conditions of the instrument as modified depart from established precedent, consult APRA and provide APRA with adequate time to review the instrument in advance of the modification to ensure the eligibility of the instrument for inclusion in the insurer’s capital base.
For the purposes of subparagraph 31(b) of this Attachment:
(a)where the instrument provides holders with the right or option to demand repayment prior to maturity, the first possible repayment date is regarded as the effective maturity date of the instrument;
(b)where the instrument offers the issuer a redemption or call option prior to maturity, issue documentation must give clear and prominent notice to prospective investors that the issuer’s right to exercise any such option to repay, purchase, or otherwise redeem the instrument is subject to APRA’s prior written approval; and
(c)the amount of the instrument eligible for inclusion in Lower Tier 2 capital is to be amortised on a straight line basis at a rate of 20 per cent per annum over the last four years to maturity as follows:
Years to Maturity Amount Eligible for Inclusion in Lower Tier 2 Capital More than 4 100 per cent Less than and including 4 but more than 3 80 per cent Less than and including 3 but more than 2 60 per cent Less than and including 2 but more than 1 40 per cent Less than and including 1 20 per cent
Step-up in dividends or interest
Tier 1 and Upper Tier 2 instruments
For the purposes of subparagraphs 16(a) and 26(h) of this Attachment:
(a)a step-up in dividends or interest includes the following events:
(i) a change in margin on a floating rate instrument;
(ii) a change in rate on a fixed rate instrument;
(iii) a conversion from fixed to floating rate (or vice versa), with a change in the effective margin included in the rate of dividend or interest of the instrument; or
(iv) a switch in the index basis (e.g. from a 3-month to 6-month floating rate or from a 3-month LIBOR to a 3-month BBSW) with a change in the effective margin included in the rate of dividend or interest of the instrument;
(b)moderate step-up in the rate of dividends or interest is permitted, provided the increase in dividends or interest is no greater than either:
(i) 100 basis points, less the swap spread between the initial index basis and the stepped-up index basis; or
(ii) 50 per cent of the initial credit spread, less the swap spread between the initial index basis and the stepped-up index basis;
(c)the issue documentation specifies which of the two measures specified in subparagraph (b) is to apply to the instrument;
(d)switching between the two measures specified in subparagraph (b) is not allowed;
(e)where the step-up involves a conversion from fixed to floating rate (or vice versa), as set out in subparagraph (a) or a switch in index basis, the swap spread must be fixed as at the pricing date and reflect the differential in pricing on that date between the initial reference rate and the stepped-up reference rate;
(f)any step-up in dividends or interest must not be operative within the first 10 years from drawdown; and
(g)in principle, only one step-up in dividends or interest is permitted over the life of the instrument. Exceptions for step-ups to be undertaken on multiple occasions (or for variable amounts) may be approved by APRA in writing at the time of issuing the instrument.
Lower Tier 2 instruments
For the purposes of subparagraph 31(g) of this Attachment:
(a)a step-up in dividends or interest includes the following events:
(i) a change in margin on a floating rate instrument;
(ii) a change in rate on a fixed rate instrument;
(iii) a conversion from fixed to floating rate (or vice versa), with a change in the effective margin included in the rate of dividend or interest of the instrument; or
(iv) a switch in the index basis (e.g. from a 3-month to 6-month floating rate or from a 3-month LIBOR to a 3-month BBSW) with a change in the effective margin included in the rate of dividend or interest of the instrument;
(b)moderate step-up in the rate of dividends or interest is permitted, provided the increase in dividends or interest is no greater than:
(i) 50 basis points, less the swap spread between the initial index basis and the stepped-up index basis, for an issue with a maturity up to 10 years;
(ii) 100 basis points, less the swap spread between the initial index basis and the stepped-up index basis, for an issue with a maturity of more than 10 years; or
(iii) 50 per cent of the initial credit spread, less the swap spread between the initial index basis and the stepped-up index basis;
(c)the issue documentation specifies which of the three measures specified in subparagraph (b) is to apply to the instrument;
(d)switching among the three measures mentioned in subparagraph (b) is not allowed;
(e)where the step-up involves a conversion from fixed to floating rate (or vice versa), as set out in subparagraph (a), or a switch in index basis, the swap spread must be fixed as at the pricing date and reflect the differential in pricing on that date between the initial reference rate and the stepped-up reference rate;
(f)any step-up in dividends or interest must not be operative within the first five years from drawdown; and
(g)in principle, only one step-up in dividends or interest is permitted over the life of the instrument. Exceptions for step-ups to be undertaken on multiple occasions (or for variable amounts) may be approved by APRA in writing at the time of issuing the instrument.
Dividend and interest payments on Tier 1 and Upper Tier 2 capital instruments
Unless otherwise approved, in writing, by APRA:F[20]F
[20]Refer to paragraph 2 of Attachment G for the approval requirement.
(a)the aggregate amount of dividend payments on ordinary shares must not exceed an insurer’s after-tax earnings, after taking into account any payments on more senior capital instruments, in the financial year to which they relate; and
(b)dividend or interest payments, whether whole or partial, paid on Upper Tier 2, Innovative Tier 1 and Non-innovative Residual Tier 1 capital instruments must not exceed an insurer’s after-tax earnings, after taking into account any payments made on more senior capital instruments, calculated before any such payments are applied in the financial year to which they relate.
For these purposes, “financial year” refers to the last four quarters for which the insurer was required to submit quarterly returnsF[21]F to APRA preceding the date of the proposed payment of interest or dividend.
[21] In accordance with reporting standards made under the Financial Sector (Collection of Data) Act 2001 (Collection of Data Act).
Holding of shares in insurer by special purpose vehicle (SPV)
Direct investments in shares of an insurer, by an SPV (e.g. trust) established under a share-based employee remuneration scheme, may only be included in the insurer’s Tier 1 capital where:
(a)the shares issued to the SPV represent ordinary shares of the insurer;
(b)the amount included in Tier 1 capital is matched by an equivalent charge to the profit and loss of the insurer for expensing the issue or funding the acquisition of ordinary shares by the SPV; and
(c)the ordinary shares issued cannot be converted to payment in another form (e.g. cash).
Deductions from an insurer’s capital base
Deductions from Tier 1 capital
The amount of Tier 1 capital to be included in an insurer’s capital base will be net of the following deductions:
(a)goodwill;F[22]F
[22]This includes that component of investments in controlled entities which represents purchased goodwill (i.e. current value less value of identifiable net tangible assets).
(b)other intangible assets;
(c)deferred tax assets net of deferred tax liabilities;F[23]F
23 Where the amount of deferred tax liabilities exceeds the amount of deferred tax assets, the excess cannot be added to Tier 1 capital (i.e. the net deduction is zero). This item also excludes any amounts associated with surpluses in any insurer employer-sponsored superannuation funds.
(d)any portion of current year earnings or retained earnings which represents any amount deriving from the insurer’s share of undistributed profit or loss in an associate, under equity accounting. This amount must be included in Upper Tier 2 capital;
(e)any surplus, net of deferred tax liabilities, in any insurer employer-sponsored defined benefit superannuation fund, unless otherwise approved, in writing, by APRA. Any excluded surplus must reverse any associated deferred tax liability from Tier 1 capital;
(f)any deficit in an insurer employer-sponsored defined benefit superannuation fund that is not already reflected in Tier 1 capital;
(g)all holdings of own Tier 1 capital instruments;
(h)any negative movement over the amount available in the respective revaluation reserves for the following items, to the extent not already accounted for in current year earnings or retained earnings:
(i) property not held at fair value;
(ii) investments in subsidiaries not held at fair value; or
(iii) investments in associates, including any excess of the share of losses in associates under equity accounting;
(i)any identified impairment of an asset not forming part of a class of assets, to which an asset revaluation reserve in Upper Tier 2 capital applies and where the impairment has not already been taken into account in the profit and loss;
(j)unrealised fair value gains, or, where applicable, adding back unrealised fair value losses, arising from changes in an insurer’s own creditworthiness;
(k)any amounts included in revaluation reserves in Upper Tier 2 capital which would otherwise have been included in Tier 1 capital;
(l)cumulative fair value gains and losses on effective cash flow hedges reflected in retained earnings or reserves included in Tier 1 capital which do not offset gains or losses on revaluations in reserves included in Tier 1 capital;F[24]F
[24]Any gains on hedges are to be deducted and any losses on hedges are to be added back.
(m)during the first and second transition periods, all reinsurance recoveriesF[25]F receivable on each reinsurance arrangement where the insurer has not reached the threshold levels of reinsurance documentation specified in Attachment H;
[25] For the purposes of this Prudential Standard, “reinsurance recoveries” refers to the reinsurance recoveries net of doubtful debts.
(n)after the second transition period, reinsurance recoveries receivable under each reinsurance arrangement that does not meet the reinsurance documentation test in paragraph 2 of Attachment H; and
(o)for inwards reinsurance business, the premium receivables deduction on any portfolio of proportional reinsurance treaties calculated in accordance with paragraph 40 of this Attachment.
For each portfolio of proportional reinsurance treaties underwritten by an insurer carrying on inwards reinsurance business where underlying risks have not yet been accepted by the direct insurer, the following equation applies in determining the deduction under subparagraph 39(o) of this Attachment:
Premium receivables deduction = [(Net premium receivablesF[26]F - net premiums liabilitiesF[27]F) * (1 –tax rateF[28]F)] – [(net premiums liabilities * premiums liability risk capital factor * capital buffer factor (if applicable))]
[26] For the purposes of this equation, “net premium receivables” is the premium receivables net of doubtful debts, premiums paid or payable for retrocession and exchange commissions.
[27] For the purposes of this equation, “net premiums liabilities” is the premiums liabilities net of expected recoveries.
[28] The tax rate is the corporate taxation rate applying to the proportional reinsurance contract (in Australia or a foreign country).
An insurer may apply to APRA for a capital buffer factor to be used in the determination of its premium receivables deduction. APRA will consider the application and may determine an appropriate capital buffer factor in writing.
Each item in this equation relates only to the relevant fractionF[29]F of the portfolio of proportional reinsurance treaties for which underlying risks have not yet been accepted by the direct insurer. A negative premium receivables deduction is not to be taken into account for the purposes of subparagraph 39(o) of this Attachment. Any deferred tax liability generated in relation to the relevant fraction of the portfolio of proportional reinsurance treaties may not be used to reduce the deferred tax asset deduction required under subparagraph 39(o) of this Attachment.
[29] The relevant fraction is: (expected direct premium under the treaty until the next review date less direct premium written under the treaty) divided by expected direct premium under the treaty until the next review date. The relevant fraction cannot be less than zero.
For the purposes of subparagraph 39(e) of this Attachment, an insurer may make representations to APRA to include a surplus as an asset (and hence include the surplus in Tier 1 capital) where the insurer employer-sponsor is able to demonstrate unequivocal and unrestricted access to a fund surplus in a timely manner. Where APRA is satisfied regarding such access, an insurer may include the surplus in its assets subject to an Investment Capital Factor of 10 per cent (refer to Attachment D). This surplus will no longer be required to be deducted from Tier 1 capital.
Deductions from Upper or Lower Tier 2 capital
The amount of Upper and Lower Tier 2 capital to be included in an insurer’s capital base will be net of all holdings of own Upper and Lower Tier 2 capital instruments respectively.
Own instrument purchases
An insurer may not, without obtaining APRA’s prior written approval, enter into an arrangement where it may purchase, or provide financial assistance with a dominant purpose of facilitating the purchase by another party of, its own Tier 1 or Tier 2 capital instruments. Any such purchases will be subject to a limit agreed with APRA. APRA will require an amount of capital equal to that limit to be deducted from Tier 1 or Tier 2 capital as appropriate (depending on whether the prospective purchases relate to Tier 1 or Tier 2 capital instruments).
Issues affecting the level of MER
In determining the level of MER for a given portfolio, the insurer must consider:
(a)the classes of business in which the insurer is engaged;
(b)the types of catastrophic risk which need to be addressed;
(c)the level of capital available to the insurer;
(d)the geographical zones in which the insurer transacts business;
(e)the effects of combined risks, e.g. where an insurer provides coverage for both workers’ compensation business and building insurance in the same geographical area;
(f)how the geographical zones will be grouped for calculation purposes; and
(g)the insurer’s overall risk appetite and desired probability of ruin.
An insurer must at a minimum adopt an MER which relates to an accumulation of exposures to a single event. However, an insurer with a complex portfolio of insurance risks may be required by APRA to estimate its MER using a whole of portfolio approach.
When calculating the MER, an insurer must have regard to the documentation of reinsurance contracts it has in place. To determine the extent to which reinsurance recoveries expected from reinsurance contracts may be used to offset the PML calculated, refer to paragraph 34 of this Prudential Standard.
Specialist insurers
Specialist insurers, such as providers of medical indemnity, may not be exposed to large losses from natural catastrophes. They may, however, still be exposed to large losses arising from groups of claims resulting from a common dependent source. For example, a medical insurer may face a large number of claims arising from a class action related to a faulty medical procedure.
Determining the level of the MER
The insurer must base the calculation of its MER on:
(a)the relevant area of concentration (e.g. geographic region);
(b)which peril produces the greatest MER;
(c)the return period of the relevant catastrophe and the sensitivity of the MER to changes in the return period;
(d)results produced by modelling the insurer’s own past experience; and
(e)any external, commercially available data and modelling facilities, bearing in mind the appropriateness of these data to the insurer’s portfolio of risks.
The MER must be calculated in a manner consistent with the processes for setting, monitoring and altering the MER outlined in the insurer’s Reinsurance Management Strategy (REMS), as required under GPS 230.
It is common practice for an insurer to use computer-based modelling techniques, developed either in-house or by external providers, to estimate likely losses under different catastrophe scenarios. Where an insurer uses such a model, the model must be conceptually sound and capable of consistently producing realistic calculations of the MER. APRA will expect the insurer to be able to demonstrate an understanding of the model used in estimating the MER. This understanding will include:
(a)the type of data and assumptions used in the model;
(b)the methodology used to incorporate the data and assumptions into the model; and
(c)the sensitivity of the resulting MER figure to changes in the model’s assumptions.
An insurer must be able to demonstrate that they have thoroughly researched the model and tested at least several different scenarios of return period for each type of catastrophic event that may affect their portfolio of risks. Similarly, an insurer must calculate its MER using data that is consistent, accurate and complete. Where an insurer lacks access to the relevant data, it must be able to explain the rationale for, and details of, any estimates of data that it uses. This would include analysis of the sensitivity of the results to changes in the estimates and assumptions.
In setting an appropriate level of MER, the Board must consider the insurer’s claims history, capital availability and reinsurance arrangements.
The MER for a lenders mortgage insurer must be determined by reference to Attachment F.
Reporting
APRA will review and agree with each insurer the adequacy and appropriateness of the methodology for setting its MER. Where APRA is not satisfied with the methodologies or the assumptions used, it may require the insurer to make adjustments to the calculation of its MER.
An insurer must inform APRA of any changes to its MER arising as a result of changes in its REMS, risk profile, classes of business underwritten or reinsurance program.
Attachment F
Concentration Risk Capital Charge for Lenders Mortgage Insurers
This Attachment applies to a Lenders Mortgage Insurer (LMI), meaning an insurer that has written or reinsured, or proposes to write or reinsure, policies of lenders mortgage insurance. For these purposes, lenders mortgage insurance has its ordinary commercial meaning and includes insurance under a policy which protects a lender from losses in the event of borrower default on a loan secured by mortgage over residential or other property. This Attachment outlines the methodology for the calculation of the MER, and the applicable Concentration Risk Capital Charge, for an LMI that uses the Prescribed Method to determine its MCR. Consistent with this Prudential Standard and Attachment E, the Concentration Risk Capital Charge is set equal to an LMI’s MER, plus the cost of one reinstatement of the catastrophe reinsurance cover in cases where the reinstatement reinsurance cover has not been pre-paid by the insurer.
An LMI must also meet the requirements of Attachment E. Should there be any inconsistency between this Attachment and Attachment E, the requirements in this Attachment take precedence in relation to an LMI.
Definitions
The MER is the largest loss to which an insurer will be exposed (taking into account the probability of that loss) due to a concentration of policies, after netting out any reinsurance recoveries.
PML is the largest loss to which an insurer will be exposed (within the realms of possibility) due to a concentration of policies, without any allowance for reinsurance recoveries. For the purpose of this Attachment, the PML is assumed to arise from a catastrophic event that is expected to re-occur, on average, once in every 250 years.
Loans, as referred to in this Attachment, are loans secured by an insured mortgage over residential or other property.
Sum insured is the original exposure amount for an LMI as stated in the mortgage insurance policy. Further information on sum insured is provided in paragraph 29 of this Attachment.
Loan-to-Valuation Ratio (LVR) is the ratio of the amount of the loan to the value of the secured residential property, as at the date of origination of the loan. Where the mortgage insurance premium is capitalised in the loan amount, the LVR must be calculated including the premium; that is, the loan amount must be increased by the amount of the capitalised premium. The inclusion of a First Home Owners Grant (FHOG) in the deposit for a mortgaged property will not otherwise increase the LVR of a loan. Further information on LVR is provided in paragraph 29 of this Attachment.
Age is the length of time from the date of origination of the loan to the date of calculation. Further information on age is provided in paragraph 29 of this Attachment.
Loan type refers to whether the loan is a standard, non-standard or commercial loan. Further information on loan types is provided in paragraphs 23 to 28 of this Attachment.
Coverage type refers to whether the insurance provided is for 100 per cent of the loan amount, or less than 100 per cent of the loan amount (top cover), or is coverage in respect of a pool of loans (pool mortgage insurance).
Premiums Liabilities, as referred to in this Attachment, relate to future claim payments arising from future events insured under existing policies, gross of expected reinsurance recoveries and valued at a 75 per cent level of sufficiency.
Outstanding Claims Provision (OCP), as referred to in this Attachment, relates to all claims incurred prior to the calculation date, whether or not they have been reported to the insurer, gross of expected reinsurance recoveries and valued at a 75 per cent level of sufficiency.
Background
Although an LMI may not be exposed to the possibility of large losses due to natural perils, such as those faced by most other general insurers, it will be exposed to large losses resulting from a severe economic or property downturn.
Most natural peril catastrophes are localised and occur at a particular point in time. In contrast, an economic or property downturn can be a prolonged, nationwide event, which may have an impact over several years. APRA considers that a three-year downturn is appropriate for determining the MER of an LMI.
MER model for LMIs
The MER model for LMIs assumes a three-year economic or property downturn. The modelled losses must be allocated in the proportion of 25 per cent to year one, 50 per cent to year two and 25 per cent to year three, of the downturn. These losses are in addition to future claim payments provisioned for as Premiums Liabilities.
An LMI’s MER is calculated by:
(a)working out the PML (which will comprise the total of all the amounts worked out by applying paragraphs 17 to 22 of this Attachment);
(b)deducting the amount of allowable reinsurance, worked out in accordance with paragraphs 30 to 37 of this Attachment, from the PML; and
(c)adding an allowance of five per cent of the PML for claims handling expenses.
Where an LMI has written one or more policies covering standard or non-standard loans (other than by way of a policy of pool mortgage insurance, or by way of a policy of top cover), its PML will include an amount calculated by:
(a)multiplying the sum insured under each such policy by the appropriate Probability of Default (PD), Loss-Given-Default (LGD) and seasoning factors set out in the Table of this Attachment; and then
(b)adding together the amounts calculated for each policy under subparagraph (a) to produce a total.
Where an LMI has written one or more policies of top cover in respect of standard or non-standard loans, its PML will include an amount calculated by:
(a)multiplying the sum insured under each such policy by:
(i)the appropriate PD factor set out in the Table of this Attachment;
(ii)the appropriate LGD factor set out in the Table of this Attachment, adjusted to reflect the proportion of insurance in place by dividing the LGD percentage by the percentage of top cover (refer to Example below), up to a maximum of 100 per cent; and
(iii)the appropriate seasoning factor set out in the Table of this Attachment; and then
(b)adding together the amounts calculated for each policy under subparagraph (a) to produce a total.
Example: 30 per cent top cover for a loan with an LVR of 65 per cent is subject to an LGD of 67 per cent (which is equal to 20 per cent divided by 30 per cent).
Where an LMI has written one or more policies of pool mortgage insurance covering standard or non-standard loans, its PML will include an amount calculated by:
(a)multiplying the total sum insured under each such policy by the appropriate PD, LGD and seasoning factors (as set out in the Table of this Attachment); and then
(b)adding together the amounts calculated for each policy under subparagraph (a) to produce a total.
For the purposes of subparagraph (a), the PD and seasoning factors are the factors set out in the Table of this Attachment that correspond to the weighted-average LVR and weighted-average age of the pool, and the LGD is 100 per cent.
Where an LMI has written one or more policies covering commercial loans, its PML will include an amount calculated by:
(a)multiplying the sum insured under each such policy by a factor of eight per cent (irrespective of the LVR and age of the loan); and then
(b)adding together the amounts calculated for each policy under subparagraph (a) to produce a total.
Where a policy has characteristics of more than one coverage type, or the insured loan or loans have characteristics of more than one loan type, then the relevant exposure must be recognised in the category which produces the highest PML for that exposure. If paragraphs 17, 18, 19 or 20 of this Attachment do not readily apply to the policy or the loan type, APRA may determine, by instrument in writing, a formula for the calculation of the PML in relation to that exposure (being a formula that is appropriate to the policy or loan type and is broadly consistent with the prudential approach taken in this Attachment).
In calculating the PML in accordance with paragraphs 17 to 21 of this Attachment, the LMI MER model assumes a constant sum insured over the three-year scenario. This recognises that, although the sum insured may decrease as a result of the expiration of existing policies, this may be offset by the LMI writing new business over the three-year scenario. However, for an LMI no longer writing new business (i.e. in run-off), the sum insured is expected to decrease over the three-year scenario. Accordingly, it may be appropriate for an LMI in run-off to adjust its PML downwards in years two and three of the scenario for the purpose of calculating its MER. The methodology for adjusting an LMI’s PML must be approved, by APRA, by an instrument in writing.
Criteria for standard loans, non-standard loans and commercial loans
Loans predominantly secured by residential property are generally classified as standard or non-standard. For the purpose of the LMI MER model, a standard loan must meet the following criteria:
(a)the LMI or lender has formally verified the borrower’s income and employment; and
(b)the borrower passes standard credit checks and income requirements as documented in the LMI or lender’s underwriting or credit policies and procedures.
Loans to borrowers with non-saved deposits (e.g. borrowers with deposits partially generated under the FHOG scheme), are to be classified as standard loans, except where the loans do not otherwise meet the criteria in paragraph 23 of this Attachment.
Loans which are predominantly secured by registered mortgage over residential property, but do not meet the criteria set out in paragraph 23 of this Attachment, are to be classified as non-standard loans.
APRA may also, by instrument in writing, direct an LMI to classify a loan as a non-standard loan where APRA considers the PD factors for standard loans do not reflect the inherent risk of the loan.
All loans which are not predominantly secured by registered mortgage over residential property must be classified as commercial loans.
APRA may, by instrument in writing, direct an LMI to reclassify:
(a)a particular standard or non-standard loan; or
(b)each standard or non-standard loan of a particular kind
as a commercial loan. APRA may do this if it is satisfied that the PML that would otherwise apply to the loan would not reflect the inherent risk relating to the loan or related mortgage.
Direction relating to sum insured, LVR and age
Despite paragraphs 6, 7 and 8 of this Attachment, APRA may, by instrument in writing, direct an LMI to assume that the sum insured, LVR or age of:
(a)a particular standard or non-standard loan; or
(b)each standard or non-standard loan of a particular kind
is the sum insured, LVR or age specified in APRA’s direction, or is the sum insured, LVR or age worked out by applying instructions contained in APRA’s direction. APRA may do so if it is satisfied, having regard to the nature of the loan (or kind of loan), that working out the sum insured, LVR or age by applying paragraph 6, 7 or 8 of this Attachment would produce a result that fails to reflect the risks relating to the loan (or kind of loan).F[46]F
[46] For example, APRA may give such a direction in relation to a reverse mortgage (where the amount outstanding increases over the life of the loan).
Reinsurance
Reinsurance arrangements must be in place for at least a full year in advance, and be fully documented, to be recognised in determining the MER. For example, where an LMI has two and a half years of reinsurance cover remaining, it can only recognise reinsurance in the first two years of the three-year scenario for the purpose of the MER model.
APRA recognises that, as Premiums Liabilities are apportioned over the term of the loan, a proportion of an LMI’s Premiums Liabilities will be recognised as claim payments in the same period as the modelled downturn. Accordingly, for the purpose of calculating available reinsurance for the MER calculation, an LMI with aggregate excess-of-loss or stop-loss reinsurance may assume an appropriate proportion of Premiums Liabilities as being incurred in addition to its PML (refer to paragraphs 32 to 35 of this Attachment).
For an LMI with a quota share reinsurance arrangement, the level of Premiums Liabilities will not impact on the amount of available reinsurance for the MER calculation.
An LMI with aggregate excess-of-loss or stop-loss reinsurance on a claims year basisF[47]F may assume claim payments of up to a maximum of 60 per cent of reported Premiums Liabilities as at the MER calculation date, in determining the amount of available reinsurance for determining the MER.F[48]F A maximum of 15 per cent of Premiums Liabilities may be allocated to year one, 30 per cent to year two and 15 per cent to year three, of the modelled downturn.
[47] This includes both claims made reinsurance, which relates to all claims made in a particular year on policies written in previous years as well as the current year, and claims incurred reinsurance, which relates to all claims incurred in a particular year.
[48] Technical provisions in excess of a 75 per cent level of sufficiency must not be recognised.
Consistent with the assumption of a constant sum insured over the three-year scenario (refer to paragraph 22 of this Attachment), an LMI (that is not in run-off) with aggregate excess-of-loss or stop-loss reinsurance on a claims year basis must assume that the attachment points of reinsurance in years two and three of the modelled downturn are the same as the attachment point determined in year one.
An LMI with aggregate excess-of-loss or stop-loss reinsurance on an underwriting year basisF[49]F may:
[49] Underwriting year reinsurance relates to claims on all policies written in a particular year, irrespective of when claims are made or incurred.
(a)determine PML for individual underwriting years by applying the model separately to the sum insured in each underwriting year or allocating total PML (over the three-year scenario) back to each underwriting year in the same proportion as the sum insured for those years;
(b)recognise claims that have already been paid, 90 per cent of OCP and 90 per cent of Premiums Liabilities in calculating the amount of available reinsurance for the MER calculation; and
(c)allocate OCP and Premiums Liabilities to each underwriting year in accordance with a methodology outlined in the LMI’s REMS (refer to paragraph 39 of this Attachment).
An LMI with reinsurance arrangements which are not detailed in paragraphs 32 to 35 of this Attachment must seek APRA’s written approval of the methodology proposed for the calculation of available reinsurance.
The amount of allowable reinsurance to be deducted from the PML in determining the MER is limited to a maximum of 60 per cent of the PML, irrespective of the amount available under paragraphs 30 to 36 of this Attachment.
Reinsurance Management Strategy
An LMI must outline in its REMS all assumptions that have been made in the determination of its MER (as might particularly be the case for LMIs in run‑off), the methodology used in calculating its allowable reinsurance and how allowable reinsurance is applied to its PML in determining its MER.
An LMI with reinsurance on an underwriting year basis must detail in its REMS the reasoning and methodology it has adopted in allocating OCP and Premiums Liabilities to individual underwriting years (refer to paragraph 35 of this Attachment).
Table
The aggregate PD and LGD factors by LVR, over the three-year scenario, for standard loans are:
| LVR | PD factor | LGD factor |
| Greater than 100% | 14.0% | 40% |
| 95.01 – 100% | 8.0% | 40% |
| 90.01 – 95% | 5.0% | 40% |
| 85.01 – 90% | 3.2% | 30% |
| 80.01 – 85% | 1.6% | 30% |
| 70.01 – 80% | 1.2% | 30% |
| 60.01 – 70% | 0.8% | 20% |
| Less than 60.01% | 0.6% | 20% |
The aggregate PD and LGD factors by LVR, over the three-year scenario, for non‑standard loans are:
| LVR | PD factor | LGD factor |
| Greater than 100% | 21.0% | 40% |
| 95.01 – 100% | 12.0% | 40% |
| 90.01 – 95% | 7.5% | 40% |
| 85.01 – 90% | 4.8% | 30% |
| 80.01 – 85% | 2.4% | 30% |
| 70.01 – 80% | 1.8% | 30% |
| 60.01 – 70% | 1.2% | 20% |
| Less than 60.01% | 0.9% | 20% |
The seasoning factors by age are:
| Age of loan | Seasoning factor |
| Less than 3 years | 100% |
| 3 years to less than 5 years | 75% |
| 5 years to less than 10 years | 25% |
| 10 years or more | 5% |
Attachment G
Reductions in Capital
A reduction in an insurer’s capital includes, but is not limited to:
(a)share buybacks;
(b)the redemption, repurchase or early repayment of any qualifying Tier 1 and Tier 2 capital instruments issued by the insurer or an SPV;
(c)trading in the insurer’s own shares or capital instruments (refer to paragraph 43 of Attachment A); or
(d)payment of dividends on ordinary shares that exceeds an insurer’s after-tax earnings, after including any payments on more senior capital instruments, in the financial yearF[50]F to which they relate;
[50]Refer to paragraph 37 of Attachment A for the meaning of “financial year”.
(e)dividend or interest payments (whether whole or partial) on Upper Tier 2, Innovative Tier 1 and Non-innovative Residual Tier 1 capital that exceed an insurer’s after-tax earnings, including any payments made on more senior capital instruments, calculated before any such payments are applied in the financial yearF[51]F to which they relate.
[51]Refer to TfootnoteT 50.
An insurer must seek APRA’s written approval before making a reduction in its capital. APRA’s approval may be subject to conditions.
Where APRA’s approval is required under paragraph 2 of this Attachment, the insurer must provide APRA with a capital plan extending for at least three years. The insurer will need to satisfy APRA, on the basis of the capital plan provided, that the company’s capital base after the proposed reduction will remain adequate for its future needs. In deciding whether or not to approve a reduction in capital, APRA will have regard to all relevant considerations, including whether the insurer’s capital plan shows that the insurer will maintain an adequate level of capital, taking account of factors such as:
(a)the immediate capital position;
(b)commitments to raise capital; and
(c)core profitability.
Interpretation
Any reference to the earnings or retained earnings of an insurer in this Attachment is a reference to the earnings or retained earnings of the insurer determined in a manner consistent with the insurer’s prudential reporting to APRA under the Collection of Data Act rather than in accordance with Australian Accounting Standards issued by the Australian Accounting Standards Board as required for statutory financial reporting under the Corporations Act.
Reductions in capital for insurers in run-off
This paragraph applies to an insurer which is not writing new business at the time of a request for a reduction in capital and is running off its existing insurance liabilities. The insurer must submit to APRA:
(a)documents clearly setting out and evidencing its current financial position; and
(b)a capital plan required under paragraph 3 of this Attachment with insurance liabilities valued in accordance with the methodology set out in GPS 310, except that the valuation must demonstrate that the tangible assets of the insurer, after the proposed capital reduction, are sufficient to cover its insurance liabilities to a 99.5 per cent level of sufficiency, plus any other liabilities, as calculated by an Approved ActuaryF[52]F as defined under GPS 310.
[52] Where an insurer does not have an Approved Actuary as defined under GPS 310, the insurer must seek APRA’s prior consent to the actuary engaged to provide this valuation.
Foreign insurers
Any repatriation of assets in Australia, whether direct or indirect, by a foreign insurer that will result in a reduction in its net assets in Australia must be subject to APRA’s prior approval consistent with the requirements of paragraphs 1 to 3 of this Attachment.F[53]F
[53] For example, the head office of a foreign insurer might cause a liability of another offshore branch to become a liability of the foreign insurer in Australia. If this change is unfunded, there will effectively be a reduction in net assets in Australia of the foreign insurer but not an actual direct repatriation of assets. APRA will view this as amounting to an indirect repatriation of assets from Australia.
Paragraph 6 of this Attachment does not apply to any repatriation of assets in Australia out of the current year profits of a foreign insurer where the assets being repatriated to the head office of the foreign insurer or any other branch or related entity of the head office of the foreign insurer do not exceed the foreign insurer’s after-tax earnings in the year to which they relate (i.e. a repatriation of assets not wholly or partly funded from retained earnings).
Attachment H
Transition Provisions
Transition rules relating to deductions from Tier 1 capital
For the purposes of subparagraphs 39(m) and 39(n) of Attachment A:
(a)the key dates in the transition periods, in relation to an insurer, are as follows:
| Balance Dates | 30 June | 30 September | 30 November | 1 December | 31 December | 31 March |
| First day of first transition period | 30 June 2007 | 30 September 2007 | 30 November 2007 | 1 December 2007 | 31 December 2007 | 31 March 2008 |
| Last day of first transition period | 29 June 2008 | 29 September 2008 | 29 November 2008 | 30 November 2008 | 30 December 2008 | 30 March 2009 |
| First day of second transition period | 30 June 2008 | 30 September 2008 | 30 November 2008 | 1 December 2008 | 31 December 2008 | 31 March 2009 |
| Last day of second transition period | 29 June 2009 | 29 September 2009 | 29 November 2009 | 30 November 2009 | 30 December 2009 | 30 March 2010 |
(b)the threshold levels of reinsurance documentation are as follows:
| Threshold level of reinsurance documentation | Application period |
| 60 per cent of reinsurance recoveries receivable by value must be derived from reinsurance arrangements that meet the reinsurance documentation test (see paragraph 2 of this Attachment) | First transition period |
| 80 per cent of the reinsurance recoveries receivable by value must be derived from reinsurance arrangements that meet the reinsurance documentation test (see paragraph 2 of this Attachment) | Second transition period |
For the purposes of subparagraph 1(b) of this Attachment and subparagraphs 39(m) and (n) of Attachment A, a reinsurance arrangement meets the reinsurance documentation test if the arrangement:
(a)complies with the two month rule and six month rule under GPS 230;
(b)fails to comply with those rules as at the date of the relevant deadline but:
(i) subsequent to the deadline specified under the two month rule, the reinsurance arrangement is documented in accordance with the other requirements of the two month rule (in which case the reinsurance arrangement is treated as meeting the reinsurance documentation test until the reinsurance arrangements fail the six month rule); or
(ii) subsequent to the deadline specified under the six month rule, the reinsurance arrangement is documented in accordance with the other requirements of the six month rule; or
(c)is otherwise treated by APRA under GPS 230 as complying with the two month rule and six month rule.
Transition rules relating to LMIs
Where an LMI’s capital base does not adequately cover its MCR, and any additional capital requirements imposed by APRA, as a result of the requirements in Attachment F, then the LMI may apply to APRA for a determination (by way of an instrument in writing) allowing the LMI a transition period during which:
(a)the LMI will be required to undertake the calculations and modelling required by Attachment F but will not be required to hold some or all of the capital (as specified in APRA’s determination) which it would otherwise be required to hold because of the application of this Prudential Standard; and
(b)the LMI will be required to take such steps, and meet such interim requirements as are specified in APRA’s determination approving the transition period, to ensure that the LMI satisfies the capital requirements of this Prudential Standard by the end of the transition period.
APRA may make a determination in the terms sought in the LMI’s application under this Attachment, or make a determination on such terms as APRA considers appropriate, or decline to make a determination granting the LMI a transition period.F[54]F
[54] During a transition period, the LMI will be required to ignore any transitional relief granted under this Attachment or under the old Guidance Note and assume that it is required to hold capital in accordance with Attachment F, for the purposes of reporting to APRA under reporting standards made under section 13 of the Collection of Data Act.
An application under this Attachment must be supported by a capital management plan demonstrating how the LMI will meet its capital requirements before the expiry of the requested transition period. APRA will consider the capital management plan, and any other relevant circumstances, in determining the LMI’s eligibility for a transition period and, if granted, the length of the transition period. Any transition period granted by APRA may not extend beyond 31 December 2008.
IFRS transition arrangements
For the purposes of Attachment A, an insurer may include a specific dollar amount, as agreed upon by APRA, in writing, in its Tier 1 capital or Upper Tier 2 capital or both during the transition period from 1 January 2007 to 31 December 2007. The dollar amount of the adjustment will be based on the difference between the insurer’s total capital base as at 31 December 2006 under the pre-IFRS requirements and its total capital base at 1 January 2007 as would otherwise be reportable under Attachment A. The dollar amount of the adjustment will remain constant over the transition period and will cease to apply on 1 January 2008.
For the purposes of Attachment A, APRA may grant transition relief in writing to an insurer that does not extend beyond 1 January 2010 where its dollar amount of innovative capital instruments exceeds the 15 per cent limit at 1 January 2008. An insurer may include an excess amount agreed upon by APRA as eligible Innovative Tier 1 capital during the transition period. In determining the excess amount for transition, APRA will limit the amount to the difference between the dollar amount of the insurer’s Innovative Tier 1 capital instruments as at 31 August 2005 and the dollar amount of Innovative Tier 1 capital that the insurer would otherwise be entitled to hold had the 15 per cent limit applied to the insurer’s Tier 1 capital as at 1 January 2007. The actual excess amount for transition will be agreed upon with APRA, in writing, based on the insurer’s estimated capital base as at 1 January 2008 and any other factors, including other capital management measures undertaken by the insurer.
Determinations made under the previous standard and guidance notes
An approval, determination, direction or requirement made by APRA under a provision specified in Column 1 of the following table that is in operation immediately prior to the commencement of this Prudential Standard is taken, on and from the effective date, to have been made under the provision of this Prudential Standard specified in the same row of Column 2 of the table.
| Column 1: Provision of previous standard or guidance note | Column 2: Provision of this Prudential Standard |
| Paragraph 10 of previous GPS 110: adjust an insurer’s MCR | Paragraph 17 of this Prudential Standard |
| Paragraph 24 of previous GPS 110: require adjustments to calculation of MER | Paragraph 19 of this Prudential Standard |
| Paragraph 6 of GGN 110.1, footnote 1: approve mutual insurer to be exempt from requirement that Tier 1 capital make up 50% of capital base | Subparagraph 44(c) of Attachment A |
| Paragraph 10 of GGN 110.1: approve dividend or interest payments out of retained earnings. | Paragraph 2 of Attachment G |
| Paragraph 19 of GGN 110.1: approve purchase of insurer’s own Tier 1 or Tier 2 capital. | Paragraph 43 of Attachment A |
| Paragraph 21 of GGN 110.1: approve reduction in capital base. | Paragraph 2 of Attachment G |
| Paragraph 5A of GGN 110.4: determination regarding method of calculation of Investment Risk Capital Charge. | Paragraph 6 of Attachment D |
| Paragraph 8 of GGN 110.4: approve a related entity as part of insurer’s ELE. | Paragraph 10 of Attachment D |
| Subparagraph 22(b) of GGN 110.4: approve surety bonds as insurance risk. | Subparagraph 29(b) of Attachment D |
| Paragraph 28 of GGN 110.4: require insurer to hold additional capital. | Paragraph 17 of this Prudential Standard |
| Paragraph 29 of GGN 110.4: agree upon capital treatment of derivative transactions. | Paragraph 17 of this Prudential Standard |
| Last paragraph of Attachment 2 to GGN 110.4: approve rating agency. | Last paragraph under Table 2 of Attachment D |
| Paragraph 18 of GGN 110.5: review and agree with insurer the adequacy of methodology for setting MER. | Paragraph 18 of Attachment E |
| Paragraph 21 of GGN 110.6: determine a formula for calculating PML | Paragraph 21 of Attachment F |
| Paragraph 22 of GGN 110.6: approve downward adjustment to PML | Paragraph 22 of Attachment F |
| Paragraph 26 of GGN 110.6: direct classification of loan as non-standard loan | Paragraph 26 of Attachment F |
| Paragraph 28 of GGN 110.6: direct reclassification of loan as commercial loan | Paragraph 28 of Attachment F |
| Paragraph 29 of GGN 110.6: direct LMI to assume sum insured, LVR or age of loan | Paragraph 29 of Attachment F |
| Paragraph 36 of GGN 110.6: approve methodology for calculation of available insurance | Paragraph 36 of Attachment F |
| Paragraph 42 of GGN 110.6: determine a transition period | Paragraph 4 of Attachment H |
(a)within the meaning of subsections 116A(2) and (3) of the Act;
(b)that would be a liability located in Australia under the common law; and
(c)within the meaning of subsection 116A(4) of the Act that are, by operation of subparagraph (a) or (b) of this footnote, a liability in Australia.
(a)a high cost claim indemnity as defined under the Medical Indemnity Act 2002 (Medical Indemnity Act); and
(b)amounts payable under the High Cost Claims Protocol as defined under the Medical Indemnity Act.
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