Insurance (prudential standard) determination No. 7 of 2010 Prudential Standard GPS 114 Capital Adequacy: Investment Risk Capital Charge (Cth)
Insurance (prudential standard) determination No. 7 of 2010
Prudential Standard GPS 114 Capital Adequacy: Investment Risk Capital Charge
Insurance Act 1973
I, John Roy Trowbridge, a delegate of APRA:
(a)under subsection 32(4) of the Insurance Act 1973 (the Act), REVOKE Prudential Standard GPS 114 Capital Adequacy: Investment Risk Capital Charge made by Insurance (prudential standard) No. 4 of 2008 as amended by Insurance (prudential standard) No. 1 of 2009; and
(b)under subsection 32(1) of the Act, DETERMINE Prudential Standard GPS 114 Capital Adequacy: Investment Risk Capital Charge in the form set out in the Schedule, which applies to all general insurers.
This determination takes effect from 1 July 2010.
Dated 18 June 2010
[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.
Schedule
Prudential Standard GPS 114 Capital Adequacy: Investment Risk Capital Charge comprises the 21 pages commencing on the following page.
Prudential Standard GPS 114
Capital Adequacy: Investment Risk Capital Charge
| Objective and key requirements of this Prudential Standard This Prudential Standard sets out the calculation of the Investment Risk Capital Charge under the Prescribed Method of calculating the Minimum Capital Requirement applicable to a general insurer. Credit risk, market or mismatch risk and liquidity risk may all cause adverse movements in the value of assets recorded by a general insurer or may cause adverse movements in certain off-balance sheet exposures. The Investment Risk Capital Charge attempts to cover these risks by requiring general insurers to hold an amount of capital against each asset that is proportional to the value of that asset. The Prescribed Method of calculating the Investment Risk Capital Charge is carried out using a simple approach of applying a factor to the value of an asset or off-balance sheet exposure. The factors that apply to particular assets or exposures are set out at Attachment A. This Prudential Standard forms part of a comprehensive set of prudential standards that deal with the measurement of a general insurer’s capital adequacy. |
Authority
This Prudential Standard is made under section 32 of the Insurance Act 1973 (the Act).
Application
This Prudential Standard applies to insurers authorised under the Act.[1]
[1] Refer to sections 32 and 35 of the Act.
Subject to any specific transition rules, this Prudential Standard applies to insurers from 1 July 2010 (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
Unless otherwise defined in this Prudential Standard, expressions in bold are defined in Prudential Standard GPS 001 Definitions.
For the purposes of this Prudential Standard, a related entity is an entity which is a ‘related party’ within the meaning of the relevant Australian Accounting Standards.
Investment Risk Capital Charge
This Prudential Standard sets out the calculation of the Investment Risk Capital Charge for an insurer using the Prescribed Method to determine its MCR.
The capital charge for investment risk relates to the risk of an adverse movement in the value of an insurer’s on-balance sheet assets or certain off-balance sheet obligations. Investment risk derives from a number of sources. These include:
(a)credit risk - the risk of an adverse movement in the value of an asset owing to changes in the credit quality of the issuer of that asset (including the default of the issuer);
(b)market or mismatch risk - the risk of an adverse movement in the value of an asset, which is not offset by a corresponding movement in the value of liabilities; and
(c)liquidity risk - the risk that the reported asset value will not be readily realised in certain circumstances.
It is not possible to devise a simple capital framework that takes all of these risk factors into account in an accurate fashion. The capital charge for investment risk attempts to cover these risks by requiring insurers to hold an amount of capital against each asset that is proportional to the value of that asset. The investment capital factors assigned to assets are broad and for capital adequacy purposes only, and must not be taken as a substitute for individual company assessments of the risks associated with particular assets. Over and above the MCR required by GPS 110, the Board and senior management of an insurer have responsibility for ensuring that adequate systems are in place to individually assess the risks in an insurer’s operations, to allocate the appropriate amount of capital to cover those risks and to suitably value the transactions that give rise to those risks.
Subject to paragraph 11, to calculate the capital charge for investment risk, each of an insurer’s assets (and certain off-balance sheet exposures) is assigned to various categories. The Investment Risk Capital Charge is determined by multiplying the balance sheet value of each asset by the appropriate Investment Capital Factor for its category (subject to any thresholds in the case of assets exceeding the thresholds specified in this Prudential Standard). The total capital charge for investment risk is the sum of the Investment Risk Capital Charges for each individual asset. The Investment Capital Factors to be applied to each asset are presented in Table 1 at Attachment A.
Different treatment is accorded to certain reinsurance recoverables due from a non-APRA-authorised reinsurer as set out at Attachment A.
For the purpose of applying the Investment Capital Factors, debt obligations refers to all loans, deposits, placements, interest rate securities and other receivables. Where reference is required to credit or counterparty ratings, these must be applied in accordance with the table at Attachment B.
APRA may determine in writing that the Investment Risk Capital Charge for a specified asset, or an asset of a specified class, of a particular insurer is to be calculated by applying:
(a)an Investment Capital Factor of zero; or
(b)an Investment Capital Factor specified in the determination (being greater than zero but lower than the Investment Capital Factor provided for in Table 1 at Attachment A for the asset)
if the conditions in paragraph 14 are satisfied. APRA’s determination shall apply for a period specified in the determination or until APRA revokes the determination. Upon the determination ceasing to apply, the Investment Risk Capital Charge for an asset covered by the determination must be calculated by applying the Investment Capital Factor specified in Table 1 at Attachment A for that asset. For the avoidance of doubt, a determination in relation to a particular insurer may cover more than one asset, or more than one class of assets, of that insurer, and a determination may make different provision in respect of different assets or classes of assets.
APRA may only make a determination under paragraph 13 in relation to an asset, or an asset of a particular class, if:
(a)the asset, or each asset in the class, is:
(i) a reinsurance asset, due from a reinsurer with a counterparty rating of Grade 1, 2, 3 or 4; or
(ii) an unpaid premium that is less than six months overdue; and
(b)the party liable for the relevant payment (the obligor) is a general insurer authorised under section 12 of the Act; and
(c)the obligor is a related body corporate of the general insurer that holds the relevant asset; and
(d)APRA considers that it is appropriate to make the determination, having regard to relevant prudential matters within the meaning of section 3 of the Act.
Extended Licensed Entity (ELE)
In certain circumstances, an insurer may choose to hold assets in an SPV or other related entity, rather than on its own balance sheet. Where an insurer receives approval under paragraph 17, the insurer will be able to determine its Investment Risk Capital Charge (and any Investment Concentration Capital Charge) based on the individual assets of the related entity, rather than simply on the insurer’s direct exposure to that entity.
The extent to which the risk of an insurer’s exposure to a related entity is commensurate with the underlying holdings of that entity depends on the insurer’s extent of control over, and integration with, the entity as well as on the existence of any third party liabilities of the entity. Potential complications under a scenario where underlying asset holdings must be liquidated during financial stress must also be considered.
Subject to the specific requirements set out in paragraph 18, an insurer may apply to APRA to have one or more related entities approved as part of its ELE. Once approved, APRA will allow the insurer to ‘look through’ the legal structures involved, and to ‘consolidate’ the balance sheet of the related entity with its own for the purposes of determining the Investment Risk Capital Charge. In effect, this allows the insurer to treat its own balance sheet and that of the approved related entity as a single entity for the purpose of calculating that charge.
In deciding whether to approve an entity as part of an insurer’s ELE, APRA will have regard to the following criteria in respect of the relationship between the insurer and the related entity:
(a)the related entity must be wholly owned and controlled by the insurer, with a Board of directors/trustees that is comprised entirely of members of the insurer’s Board or senior management;
(b)the insurer must demonstrate to APRA that there are no legal or regulatory barriers (including cross-border issues for a branch or if the proposed ELE is not an Australian entity) to the transfer of the assets back to the insurer;
(c)the insurer’s risk management systems and controls must be fully extended to the operations of the related entity. The senior management of the insurer must be in a position to monitor the operations of the related entity to the same extent as the operations of the insurer itself. Systems for monitoring and control over the related entity must be included within the internal and external audit programs of the insurer;
(d)the insurer must be able to furnish stand-alone accounting records for the related entity, and provide APRA with full and unfettered access to this information at any time (including during on-site visits);
(e)where the related entity borrows on behalf of the insurer, all funds must be on-lent directly to the insurer;
(f)the related entity must not conduct any business that the insurer would otherwise be prevented from doing under the Act; and
(g)where the related entity holds or invests in assets on behalf of the insurer, the related entity must have no material third party liabilities, other than exempt tax liabilities and employee entitlements.
Treatment of collateral and guarantees as risk mitigants
The capital charge for investment risk may be reduced where the insurer holds certain types of collateral against an asset, or where the asset has been guaranteed, as a means of reducing risk. Where the assets in question are reinsurance recoverables due from non-APRA-authorised reinsurers, different rules regarding treatment of collateral and guarantees apply (refer to paragraphs 23 to 26).
Collateral
Where an insurer possesses recognised collateral against an asset (other than reinsurance recoverables due from non-APRA-authorised reinsurers), it may apply the Investment Capital Factor relevant to the collateral to the value of the asset (instead of applying the Investment Capital Factor that would otherwise apply to the asset). For the purposes of this paragraph, collateral is recognised only to the extent that it takes the form of a charge, mortgage or other security interest in, or over, an Eligible Collateral Item. Eligible Collateral Items are cash, government securities, or debt obligations (as defined in paragraph 12) where the obligor has a counterparty rating in Grade 1, 2 or 3. The Eligible Collateral Item must also be held for the period for which the asset is held. Where the fair value of the collateral does not cover the full value of the asset, only that part of an asset that is covered by collateral may be assigned the Investment Capital Factor applicable to the collateral.
Guarantees
Assets (other than reinsurance recoverables due from non-APRA-authorised reinsurers) that have been explicitly, unconditionally and irrevocably guaranteed for their remaining term to maturity by a guarantor with a counterparty rating (or for governments, the long-term foreign currency credit rating) in Grades 1, 2 or 3 may be assigned the Investment Capital Factor that would be applicable to the guarantor.
Guarantees provided to an insurer by its own parent or a related entity are not eligible for this treatment.
Collateral, guarantees and letters of credit in respect of reinsurance recoverables due from non-APRA-authorised reinsurers
Where an insurer possesses recognised collateral in Australia against reinsurance recoverables due from a non-APRA-authorised reinsurer, it may apply the Investment Capital Factor relevant to the collateral to the value of the reinsurance recoverables (instead of applying the Investment Capital Factor that would otherwise apply to the reinsurance recoverables). For the purposes of this paragraph, collateral is recognised only:
(a)to the extent that it takes the form of:
(i) assets held in Australia which form part of a trust fund maintained by a trustee resident in Australia;
(ii) deposits held by the insurer in Australia made by the non-APRA-authorised reinsurer;
(iii) a combination of the two forms of collateral specified in paragraphs (a) and (b); or
(iv) any other form of collateral as may be approved by APRA in writing in a particular case;
(b)if it provides effective security against liabilities arising under the reinsurance contract; and
(c)if it is not available for distribution to creditors of the reinsurer other than the insurer in the event of insolvency of the reinsurer.
Where the fair value of the collateral does not cover the full value of the reinsurance recoverables, only that part of the value of the reinsurance recoverables that is covered by collateral may be assigned the Investment Capital Factor applicable to the collateral.
Where an insurer possesses a guarantee or letter of credit in respect of the reinsurance recoverables due from a non APRA authorised reinsurer, the Investment Capital Factor to be used is that applicable to the guarantor or the issuer of the letter of credit, as the case may be. This paragraph applies only if:
(a)the guarantor or issuer of the letter of credit is an authorised deposit-taking institution[2] or, in the case of a Category E insurer, its parent entity or other related entity provided the entity has a counterparty rating of Grade 1, 2 or 3;
[2] For the avoidance of doubt, this refers to a deposit-taking institution authorised by APRA under the Banking Act 1959 (Banking Act) and includes foreign ADIs as defined in the Banking Act.
(b)the guarantee or letter of credit is explicit, unconditional and irrevocable;
(c)the guarantor or issuer of the letter of credit is obliged to pay the insurer in Australia; and
(d)the obligation of the guarantor or issuer of the letter of credit to pay the insurer is specifically linked to performance of the reinsurance contract or contracts under which the reinsurance recoverables arise.
Except in the case of a Category E insurer, a guarantee or letter of credit provided to an insurer by its parent entity or other related entity is not eligible for the treatment provided for in this paragraph.
The collateral, guarantee or letter of credit referred to in paragraphs 23 and 25 must be effective for the expected period for payment of claims under the reinsurance contract under which the reinsurance recoverables arise. If this is impractical, the collateral, guarantee or letter of credit must be effective for at least 2 years but be renegotiable each year to allow at least a year to identify alternative arrangements if the collateral, guarantee or letter of credit cannot be renegotiated.
Charged and encumbered assets
Subject to paragraph 28, assets of the insurer that are under a fixed or floating charge[3], mortgage or other security are subject to an Investment Capital Factor of 100 per cent, to the extent of the indebtedness secured on those assets. This will replace the Investment Capital Factor that would otherwise apply to the secured assets.
[3] ‘Charge’ as defined in the Act.
Where the security referred to in paragraph 27 exclusively supports an insurer’s insurance liabilities, the Investment Capital Factor of 100 per cent is applicable only to the amount by which the fair value of the charged assets exceeds the insurer’s supported insurance liabilities. These insurance liabilities are to be valued at a 75 per cent level of sufficiency according to Prudential Standard GPS 310 Audit and Actuarial Reporting and Valuation (GPS 310).
Investment Concentration Charge
For the purposes of calculating the Investment Concentration Charge, two or more counterparties will form a group of related counterparties if they are linked by:
(a)cross guarantees;
(b)common ownership or management;
(c)the ability of a counterparty to exercise control (defined in accordance with Australian Accounting Standards) over the other(s), where direct or indirect;
(d)financial interdependency such that the financial soundness of any of them may affect the financial soundness of the other(s); or
(e)other connections or relationships which, according to an the insurer’s assessment, identify the counterparties as constituting a single risk.
An insurer may be exposed to an additional risk arising from an excessive exposure (both on-balance sheet and off-balance sheet) to a particular asset, counterparty or group of counterparties (including in relation to reinsurance assets). Subject to paragraph 31, to address the risk associated with excessive exposure, an insurer must hold additional capital in those cases where an insurer’s exposure to a particular asset, counterparty or group of related counterparties exceeds the thresholds set out in paragraph 32. The aggregation of exposures to individual counterparties must be undertaken for an insurer and any entities approved as part of its ELE (refer to paragraphs 15 to 18).
APRA recognises that an insurer may make loans to its parent company or related companies. If such a loan is not made on commercial terms, the entire exposure from the loan is accorded an Investment Capital Factor of 100 per cent and this Investment Capital Factor applies regardless of the counterparty rating of the parent company or related company.
The thresholds referred to in paragraph 30 are based on the credit rating[4] of the counterparty[5] and are as follows:
[4]For the purposes of the Investment Concentration Charge, investments in equity or subordinated debt must be regarded as having the same rating as unsecured debt obligations of the issuer. For unit trusts, the Investment Concentration Charge applies to the underlying assets. Direct investments in real property are treated as Grade 4.
[5]Where paragraphs 20 and 23 apply, the obligor referred to in those paragraphs represents the counterparty and, where paragraphs 21 and 25 apply, the guarantor or issuer of a letter of credit, as the case may be, referred to in those paragraphs represents the counterparty.
Counterparty Rating | Threshold as a Percentage of Capital Base |
| Grades 1, 2 or 3 | no limit |
| Grade 4 | 50% |
| Grade 5 | 25% |
If a large claim or aggregation of claims arising from a catastrophic event causes the outstanding reinsurance assets of an insurer to temporarily exceed the thresholds set out in paragraph 32, the insurer may apply to APRA to suspend the application of the thresholds for a specified period of time. APRA may grant written approval for such suspension subject to conditions and may specify any period of time for such suspension.
An insurer must apply the relevant Investment Capital Factor to an asset or assets up to the value of the threshold, and apply a 100 per cent Investment Capital Factor to the value in excess of this level to calculate the Investment Concentration Charge. In the case of exposures (both on-balance and off-balance sheet) to a group of related counterparties, exposures are aggregated both against counterparties of the same grade and upwards through the rating grades, with the threshold for each grade applying to aggregate exposures summed for that grade and all lower quality grades, excluding any exposures which are already subject to a 100 per cent Investment Capital Factor. Paragraph 35 describes the method to be applied in greater detail.
Exposures to a group of related counterparties at the Grade 5 level are aggregated to determine the amount in excess of the Grade 5 threshold to which the 100 per cent Investment Capital Factor is applied. Those exposures to a group of related counterparties at the Grade 5 level (up to the Grade 5 threshold) are then aggregated with all exposures to that group of related counterparties at the Grade 4 level to determine the amount in excess of the Grade 4 threshold to which the 100 per cent Investment Capital Factor is applied.
The following must not be taken into account in determining the Investment Concentration Charge:
(a)premium receivables and reinsurance assets to which an Investment Capital Factor of zero per cent is applied; and
(b)assets to which an Investment Capital Factor of 100 per cent is applied.
Off-balance sheet transactions
An insurer can be exposed to various investment risks through transactions or dealings other than those reflected on its balance sheet.
As a general rule, an insurer must not be exposed to an obligor for an unlimited amount and any exposure must be for a finite period. An exception to this rule is where a potential credit exposure results from reinsurance of an insurance contract that is required by law to be unlimited. If an insurer does enter into an arrangement with an obligor that does not have appropriate limits, it must:
(a)notify APRA;
(b)explain how this arrangement complies with its Risk Management Strategy; and
(c)explain how it will be valued for the purposes of capital adequacy calculations.
Such an exposure may cause APRA to review the insurer’s MCR and adjust the insurer’s MCR in accordance with paragraph 17 of GPS 110.
Direct credit substitutes
To the extent that an insurer has issued:
(a)guarantees (including written put options serving as guarantees);
(b)letters of credit; or
(c)any other credit substitute (other than insurance) in favour of another party,
the insurer is exposed to risk of having to make payment on these instruments should the guaranteed party default or fail to deliver.
An insurer must set aside capital to cover the risk of such events occurring. Within the Prescribed Method, this is to be achieved by applying, to the face value of the credit substitute, the Investment Capital Factor that would be applied to the obligation or asset over which the credit substitute has been written. Where the credit substitute is supported by collateral or a guarantee, the provisions of paragraphs 20 to 22 may be applied.
A different approach to that set out in paragraphs 39 and 40 is available for surety bonds issued by the insurer. The insurer has the choice of either:
(a)treating any surety bonds the insurer has issued as a type of direct credit substitute. In this case, the insurer must determine 25 per cent of the value of the surety bond, and apply to that amount the Investment Capital Factor that would be applied to the obligation or asset over which the surety bond has been written. Where the surety bond is supported by a risk mitigation arrangement, the applicable Investment Capital Factor will be that assigned to the counterparty to that arrangement, but only to the extent that the risk mitigation arrangement applies; or
(b)seeking written approval from APRA to treat any surety bonds the insurer has issued as if they were an insurance risk (for the purposes of meeting the requirements of prudential standards only). This would require the insurer to include surety bond exposures within the insurer’s assessment of insurance liabilities, as determined under GPS 310, and to apply the relevant capital factors specified in Prudential Standard GPS 115 Capital Adequacy: Insurance Risk Capital Charge.[6] For the purpose of calculating net outstanding claims liabilities and net premiums liabilities (as determined under GPS 310) the insurer may treat any risk mitigation arrangement as if it were reinsurance. An insurer seeking APRA’s approval for this approach would need to include with its application a confirmation from the company’s Appointed Actuary that that person is able to appropriately measure the risk of the surety bond business within the insurer’s insurance liabilities.
[6]Surety bond business treated in this manner must be classed as an ‘other’ line of business in Table 1 at Attachment A to GPS 115.
The insurer must use the same approach for all surety bonds issued by it, and apply that approach consistently over time.
For the purposes of paragraph 41, a surety bond means an undertaking given by an insurer at the request of a person (Customer) pursuant to an agreement (Surety Agreement) between the insurer and the Customer made in the following circumstances:
(a)the Customer enters into the Surety Agreement in order to enable the Customer to meet a requirement of another agreement (Principal Agreement) between the Customer, or a person associated with the Customer, and a person other than the insurer (Principal);
(b)under the surety bond, the insurer undertakes to make a payment to, or perform an obligation for the benefit of, the Principal or another person nominated by the Principal (Beneficiary) in the circumstances specified in the surety bond;
(c)the surety bond is issued to the Principal or the Beneficiary in relation to or in connection with an obligation owed by the Customer, or a person associated with the Customer, to the Principal under the Principal Agreement being an obligation which:
(i) is a performance obligation or contains an element of performance on the part of the Customer, or a person associated with the Customer; and
(ii) does not relate solely to the payment of money by the Customer, or a person associated with the Customer, to the Principal; and
(d)under the Surety Agreement, the Customer is liable to the insurer if the insurer makes a payment or incurs a liability to the Principal or the Beneficiary under the surety bond.
Derivatives
Derivatives include forwards, futures, swaps, options and other similar contracts. Derivatives expose insurers to the full range of investment risks, even though in many cases there may be no, or only a very small, initial outlay. An insurer must set aside capital to cover the investment risk of these transactions, particularly in instances where the derivatives are used for reasons other than to hedge an underlying physical position. Under the Prescribed Method, an insurer is required to hold capital against derivatives using the method described below. For the avoidance of doubt:
(a)the paragraphs in this Prudential Standard relating to derivatives apply to both covered and uncovered derivative positions; and
(b)a short position in any traded instrument is taken to be a derivative for the purposes of this Prudential Standard and paragraph 27 does not apply to any collateral arrangement associated with the short position.
The Investment Risk Capital Charge for a derivative is determined as the sum of three components:
(a)the equity market risk component;
(b)the equity basis risk component; and
(c)the counterparty risk component.
The components in paragraphs (a) and (b) are applicable only to derivatives over listed equities. Paragraphs 47 to 50 set out the application of the counterparty risk component.
Where an insurer holds derivatives over listed equities, the Investment Risk Capital Charge applicable to all holdings of listed equities under paragraph 10 is to be replaced with the equity market risk component. The equity market risk component is equal to 16 per cent of the absolute value of the net exposure to listed equities and derivatives over listed equities (where the derivatives exposure for options is calculated on a delta-weighted basis).
The equity basis risk component applies only to derivatives over listed equities for which the notional equity position is negative, and will be a specified percentage of the absolute value of the notional equity position. The percentage is the lesser of eight per cent and 16 x (100 per cent - overlap percentage). The overlap percentage measures the effectiveness of the hedge between the derivative and the physical portfolio it is being used to hedge and is equal to the sum of the lesser of A and B for each stock in that portfolio where:
(a)A is the stock's proportionate weight in the portfolio; and
(b)B is the stock's proportionate weight in the index on which the derivative is based.
A derivative that is not being used to hedge a portfolio will have a basis risk percentage of eight per cent. A portfolio may consist of one or more stocks.
The counterparty risk component does not apply to:
(a)foreign exchange (except gold) contracts which have an original maturity of 14 calendar days or less; and
(b)instruments traded on futures and options exchanges which are subject to daily mark-to-market and margin payments.
The counterparty risk component for each derivative contract is based on its ‘asset equivalent value’. The asset equivalent value is the sum of the positive mark-to-market value (or replacement costs) of the contract and a potential exposure add-on.
The potential exposure add-on is determined by multiplying the notional principal amount[7] of the derivative contract (regardless of whether the contract has a zero, positive or negative fair value) by the relevant credit conversion factor specified in the table below according to the nature and residual maturity of the instrument.[8]
[7]The notional principal amount of a contract is the reference amount used to calculate payment streams between counterparties to a contract.
[8]Potential future credit exposure must be based on effective rather than apparent notional amounts. In the event that the stated notional amount of a contract is leveraged or enhanced by the structure of the transaction, an insurer must use the effective notional amount when calculating potential future credit exposure. For example, an interest rate swap with stated notional amount of $1 million, but with payments calculated at two times LIBOR, would have an effective notional amount of $2 million.
Residual Maturity Interest Rate Contracts Foreign Exchange & Gold Contracts Equity Contracts Precious Metal Contracts (except Gold) Other Contracts Less than 1 year Nil 1.0% 6.0% 7.0% 10.0% 1 year to less than 5 years 0.5% 5.0% 8.0% 7.0% 12.0% 5 years or more 1.5% 7.5% 10.0% 8.0% 15.0%
The asset equivalent value of each derivative must then be multiplied by the Investment Capital Factor applicable to a debt obligation of the counterparty to the derivative contract to determine the counterparty risk component.
Where:
(a)an insurer enters into significant derivative transactions (defined for the purposes of this Prudential Standard as contributing greater than five per cent of the insurer’s total Investment Risk Capital Charge or, in relation to exchange traded derivatives, where the notional principal amount of these instruments is greater than the capital base of the insurer); or
(b)an insurer is otherwise making extensive use of derivatives for speculative purposes,
APRA may require the insurer to hold additional capital[9] against these positions.
[9]By adjusting the insurer’s MCR pursuant to paragraph 17 of GPS 110.
An insurer must not generally enter into derivative contracts at off-market prices. This includes historical rate rollovers on foreign exchange contracts. If an insurer undertakes any derivative contracts at off-market prices, the insurer must contact APRA to discuss the reasons for such actions and the consequences for the insurer’s MCR.
In relation to paragraphs 39 to 52, any amounts recorded on an insurer’s balance sheet at fair value in relation to these transactions must not be taken into account for determining the Investment Risk Capital Charge. The Investment Risk Capital Charge for these transactions must only be calculated in accordance with paragraphs 39 to 52.
An insurer must consult with APRA prior to entering into derivative contracts other than those over:
(a)equities;
(b)interest rates; and
(c)foreign exchange.
APRA will, as part of the consultation, determine an appropriate capital treatment for such contracts.
Determinations made under previous GPS 114
An approval, determination, direction or requirement made by APRA or taken to have been 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 Prudential Standard GPS 114 Capital Adequacy: Investment Risk Capital Charge made on 23 June 2008 as amended by Insurance (prudential standard) No. 1 of 2009 made on 11 May 2009 | Column 2: Provision of this Prudential Standard |
| Paragraph 13: determine calculation of Investment Risk Capital Charge for a specified asset or an asset of a specified class. | Paragraph 13 |
| Paragraph 17: approve a related entity as part of an insurer’s ELE. | Paragraph 17 |
| Paragraph 33: suspend the application of thresholds relating to Investment Concentration Charge for a period of time following a catastrophic event. | Paragraph 33 |
| Paragraph 41(b) of previous GPS 110: approve surety bonds as insurance risk. | Paragraph 41(b) |
| Attachment B, Paragraph 6: approve use of rating determined by a rating agency not included in the table of Attachment B, Paragraph 1. | Attachment B, Paragraph 6 |
Attachment A
This Attachment sets out the manner in which Investment Capital Factors are to be determined in order to calculate the Investment Risk Capital Charge in accordance with paragraph 10 of this Prudential Standard.
For assets of an insurer or its ELE held under a trust (other than a cash management trust[10]), the insurer may apply the Investment Capital Factor applicable to the underlying assets (including derivatives) of the trust if the insurer has information on the underlying assets. For the purpose of determining the Investment Risk Capital Charge, the Investment Capital Factors specified in Table 1 must be applied to the insurer’s share of the underlying assets of the trust as though the insurer held those assets directly.
[10] For the purposes of this Attachment, a cash management trust is defined as a trust which invests in highly liquid money market securities and which makes no material utilisation of derivatives, e.g. bills of exchange, promissory notes, government and semi-government bonds with a maturity of less than six months.
An insurer must consult APRA on the Investment Capital Factor applicable to hybrid instruments with both equity and debt features (e.g. embedded derivatives) in calculating the Investment Risk Capital Charge. In particular, APRA may require the insurer to apply different Investment Capital Factors to different components of a hybrid instrument.
Table 1 - Investment Capital Factors
| Asset | Investment Capital Factor | |
| 1. | Cash (notes and coins) · the Commonwealth Government; · an Australian State or Territory government; or · the national government of a foreign country where: - the security has a Grade 1 counterparty rating; or, if not rated, - the long-term, foreign currency counterparty rating of that country is Grade 1 Assets in respect of anticipated recoveries from the Commonwealth Government or from an Australian State or Territory government | 0.5% |
| 2. | Any debt obligation that matures or is redeemable in less than one year with a counterparty rating of Grade 1 or 2 (excluding subordinated debt[11] and debt obligations of government dealt with specifically in this Table) | 1% |
| 3. | Any other debt obligation (that matures or is redeemable in one year or more) with a counterparty rating of Grade 1 or 2 (excluding subordinated debt and debt obligations of government dealt with specifically in this Table) | 2% |
| 4. | Reinsurance assets in relation to non-APRA-authorised reinsurers with a counterparty rating of Grade 1 or 2 except for reinsurance recoverables specified under paragraph 5 of this Attachment | 3% |
| 5. | Unpaid premiums due less than 6 months previously (subject to any determination by APRA under paragraph 13 of this Prudential Standard) | 4% |
| 6. | Any other debt obligation with a counterparty rating of Grade 4 (excluding subordinated debt) | 6% |
| 7. | Any other debt obligation with a counterparty rating of Grade 5 (excluding unlisted subordinated debt) Unpaid premiums due more than 6 months previously Cash management trusts with a counterparty rating of Grade 5 | 8% |
| 8. | Reinsurance assets in relation to non-APRA-authorised reinsurers with a counterparty rating of Grade 4 except for reinsurance recoverables specified under paragraph 5 of this Attachment | 9% |
| 9. | Unlisted subordinated debt | 10% |
| 10. | Reinsurance assets in relation to non-APRA-authorised reinsurers with a counterparty rating of Grade 5 except for reinsurance recoverables specified under paragraph 5 of this Attachment | 12% |
| 11. | Listed equity instruments Listed trusts except where otherwise provided for in this Attachment | 16% |
| 12. | Direct holdings of real estate | 20% |
| 13. | Loans to directors of the insurer or directors of related bodies corporate (or a director’s spouse) Unsecured loans to employees exceeding $1,000 | 100% |
| 14. | Amounts required to be deducted from an insurer’s capital base under Prudential Standard GPS 112 Capital Adequacy: Measurement of Capital Amounts recorded on the balance sheet in relation to instruments subject to paragraphs 39 to 54 of this Prudential Standard | 0% |
[11] For the purposes of this Attachment, subordinated debt is any debt instrument issued by a company (whether Australian or foreign) that constitutes debt subordination within the meaning of subsection 563C(2) of the Corporations Act 2001 but with the references in the subsection to ‘company’ to be read as including foreign companies not registered under that Act. This definition does not apply to debt instruments issued by an SPV set up for the purpose of securitising an asset or a pool of assets. Any debt instruments issued by such an SPV are to be treated as ordinary debt instruments with the Investment Risk Capital Charge applied according to the issue-specific counterparty rating.
Transition for reinsurance assets due from non APRA-authorised reinsurers
Reinsurance assets due from non-APRA-authorised reinsurers are treated as if they were reinsurance assets due from APRA-authorised reinsurers for the purposes of calculating the Investment Risk Capital Charge up to and including 31 December 2008.
Treatment of certain reinsurance recoverables from non-APRA-authorised reinsurers
This paragraph applies to reinsurance recoverables from non-APRA-authorised reinsurers arising under reinsurance contracts incepting on or after 31 December 2008. For reinsurance recoverables from non-APRA-authorised reinsurers, the Investment Capital Factors specified in Table 2 apply (in replacement of those specified in Table 1) to each reinsurance recoverable on and from the second annual balance date after the event giving rise to the reinsurance recoverable.[12] This treatment applies only to the extent that the reinsurance recoverables are not supported by collateral, a guarantee or a letter of credit as specified in paragraphs 23 to 26 of this Prudential Standard.[13]
[12] For a claims made policy, this refers to reinsurance recoverables on and from the second annual balance date after a claim notification was made.
[13]For the avoidance of doubt, the Investment Capital Factors specified in Table 2 apply to the amount of relevant reinsurance recoverables that exceeds the amount of available collateral, guarantee or letter of credit.
Table 2 - Investment Capital Factors for reinsurance recoverables due from non-APRA-authorised reinsurers
| Counterparty Grade | Investment Capital Factor |
| 1 | 20% |
| 2 | 40% |
| 3 | 60% |
| 4 | 100% |
| 5 | 100% |
Notwithstanding anything else in this Attachment, with effect from 1 January 2009, an Investment Capital Factor of 100 per cent applies to a reinsurance recoverable due from non-APRA-authorised reinsurers if:
(a)the recoverable has become a receivable (i.e. it is due and payable); and
(b)the receivable is overdue for more than six months since a request for payment has been made to the reinsurer; and
(c)there is no formal dispute between the insurer and reinsurer in relation to that receivable.[14]
[14] Any dispute between the insurer and reinsurer in relation to a receivable arising from a reinsurance recoverable would have been taken into account in the valuation processes provided for under GPS 310.
For the purposes of determining the amount of a reinsurance recoverable, if there is an offsetting arrangement between the insurer and the reinsurer that results in premium being withheld by the insurer in lieu of claim payments, the withholding of that premium is taken to be payment. However, if there is a requirement for offsets to be approved by the reinsurer the date of the offset request is taken to be the date of the request for payment.
Attachment B
This Attachment sets out the manner in which counterparty grades are to be assigned for the purposes of this Prudential Standard. The table below sets out the general approach to be followed but there are exceptions as specified below.
Counterparty grades
| Grade | Standard & Poor’s | Moody’s | AM Best | Fitch |
| 1 | AAA | Aaa | A++ | AAA |
| 2 | AA+ AA AA- | Aa1 Aa2 Aa3 | A+ | AA+ AA AA- |
| 3 | A+ A A- | A1 A2 A3 | A A- | A+ A A- |
| 4 | BBB+ BBB BBB- | Baa1 Baa2 Baa3 | B++ B+ | BBB+ BBB BBB- |
| 5 | BB+ or below | Ba1 or below | B or below | BB+ or below |
Unrated assets or exposures must be classified as Grade 4.
Where APRA supervises a consolidated insurance group[15], APRA may, at the request of an insurer within the group, determine the counterparty grade of a non-APRA-authorised reinsurer which:
[15]This refers to a Level 2 insurance group to be defined when prudential standards providing for consolidated group supervision by APRA become effective. Consequently, APRA’s power to determine a counterparty grade under this paragraph becomes effective only upon the effective date of the prudential standards providing for consolidated group supervision.
(a)has no external credit rating; and
(b)is a member of the group.
An insurer must, in general, use the same rating agency for determining counterparty grades. An insurer may depart from this general rule where there are good reasons for doing so, such as under the following circumstances:
(a)where the rating agencies usually monitored by the insurer do not issue a solicited credit rating for a particular debt obligation and only one other rating agency issues a solicited credit rating for that debt obligation, the insurer may use that solicited credit rating; or
(b)where the rating agencies usually monitored by the insurer do not issue a solicited credit rating for a particular debt obligation, the credit ratings issued by all other rating agencies listed in the table above must be reviewed and the rule in paragraph 5 of this Attachment must be used to determine which rating agency will be used to determine the counterparty grade and therefore the Investment Capital Factor to be applied; or
(c)the rule in paragraph 5 of this Attachment may also be applied where the insurer monitors multiple rating agencies that provide different solicited credit ratings for a particular debt obligation.
Rule: Where a counterparty or debt obligation has solicited credit ratings from multiple rating agencies, the following guidelines will be followed in determining the rating to be used for determining the Investment Capital Factor:
(a)if there are two solicited ratings which correspond to different Investment Capital Factors, the higher Investment Capital Factor must be used to determine the Investment Risk Capital Charge of the debt obligation; or
(b)if there are three or more solicited ratings that correspond to different Investment Capital Factors, the ratings corresponding to the second-lowest of those Investment Capital Factors must be used to determine the Investment Risk Capital Charge of the debt obligation.
APRA’s written approval must be sought if an insurer wishes to use the rating determined by a rating agency not included in the table above.
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