Insurance (Prudential Standards) Determination No. 1 of 2005 - Variation of Prudential Standard GPS 110 (Cth)

Insurance (Prudential Standards) Determination No.1 of 2005

Variation of Prudential Standard GPS 110

Insurance Act 1973

I, Stephen Somogyi, a delegate of APRA, under paragraph 32(1)(a) of the Insurance Act 1973 and subsection 33(3) of the Acts Interpretation Act 1901, VARY Prudential Standard GPS 110 by inserting, after Guidance Note GGN 110.5, Guidance Note GGN 110.6, which is set out in the attached Schedule.

Under subsection 32(4) of the Act, this Determination takes effect on 1 January 2006.

Dated 6 September 2005

[Signed]

Stephen Somogyi

Member

Interpretation

In this Notice

APRA means the Australian Prudential Regulation Authority.

Schedule

Guidance Note GGN 110.6

Concentration Risk Capital Charge for Lenders Mortgage Insurers

1.       This Guidance Note applies to a Lenders Mortgage Insurer (LMI) meaning a general insurer (as defined in the Insurance Act 1973) 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 and/or other property. This Guidance Note outlines the methodology for the calculation of the Maximum Event Retention (MER), and the applicable Concentration Risk Capital Charge, for an LMI that uses the Prescribed Method to determine its Minimum Capital Requirement (MCR).

2.       An LMI must also meet the requirements of Guidance Note GGN 110.5 Concentration Risk Capital Charge. Should there be any inconsistency between this Guidance Note and GGN 110.5, the requirements in this Guidance Note take precedence in relation to an LMI.

Definitions

3.       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. The MER must include an allowance for the cost of one reinstatement premium for the insurer’s catastrophe reinsurance.

4.       Probable Maximum Loss (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 Guidance Note, the PML is assumed to arise from a catastrophic event that is expected to re-occur, on average, once in every 250 years.

5.       Loans, as referred to in this Guidance Note, are loans secured by an insured mortgage over residential and/or other property.

6.       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.

7.       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 should be calculated including the premium; that is, the loan amount should 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.

8.       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.

9.       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.

10.     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).

11.     Premiums Liabilities, as referred to in this Guidance Note, 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.

12.     Outstanding Claims Provision (OCP), as referred to in this Guidance Note, 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

13.     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 and/or property downturn.

14.     Most natural peril catastrophes are localised and occur at a particular point in time. In contrast, an economic and/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

15.     The MER model for LMIs assumes a three-year economic and/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. 

16.     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);

(b)     deducting the amount of allowable reinsurance, worked out in accordance with paragraphs 30 to 38 and Attachment 2, from the PML;

(c)      adding an allowance of five per cent of the PML for claims handling expenses; and

(d)     adding the cost of one full reinstatement of reinsurance cover (if applicable).

17.     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 Attachment 1; and then

(b)     adding together the amounts calculated for each policy under subparagraph (a) to produce a total.

18.     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 Attachment  1; and

(ii)the appropriate LGD factor set out in Attachment 1, adjusted to reflect the proportion of insurance in place by dividing the LGD percentage by the percentage of top cover (see the Example below), up to a maximum of 100 per cent; and 

(iii)the appropriate seasoning factor set out in Attachment 1; 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 (= 20 per cent divided by 30 per cent).

19.     Where an LMI has written one or more policies of  pool mortgage insurance covering standard and/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 below); 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 Attachment 1 that correspond to the weighted-average LVR and weighted-average age of the pool, and the LGD is 100 per cent.

20.     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.

21.     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 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 Guidance Note).

22.     In calculating the PML in accordance with paragraphs 17 to 21, 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

23.     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.

24.     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.

25.     Loans which are predominantly secured by registered mortgage over residential property, but do not meet the criteria set out in paragraph 23, are to be classified as non-standard loans.

26.     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.

27.     All loans which are not predominantly secured by registered mortgage over residential property must be classified as commercial loans.

28.     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

29.     Despite paragraphs 6, 7 and 8, 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 would produce a result that fails to reflect the risks relating to the loan (or kind of loan).

Note: 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

30.     Reinsurance arrangements must be in place for at least a full year in advance, and be fully documented, to be recognised in the MER calculation. 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.

31.     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 paragraphs 32 to 35 and Attachment 2).

32.     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 (refer Attachment 2).

33.     An LMI with aggregate excess-of-loss or stop-loss reinsurance on a claims year basis[1] 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 the MER calculation.[2] 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.

[1]           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.

[2]           Technical provisions in excess of a 75 per cent level of sufficiency should not be recognised.

34.     Consistent with the assumption of a constant sum insured over the three-year scenario (refer paragraph 22), an LMI (that is not in run-off) with aggregate excess-of-loss or stop-loss reinsurance on a claims year basis should 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.

35.     An LMI with aggregate excess-of-loss or stop-loss reinsurance on an underwriting year basis[3] may:

[3]           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 Reinsurance Management Strategy (REMS) (refer paragraph 40).

36.     An LMI with reinsurance arrangements which are not detailed in paragraphs 32 to 35 must seek APRA’s approval (which APRA may provide by instrument in writing) of the methodology proposed for the calculation of available reinsurance.

37.     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.

38.     Examples of determining allowable reinsurance for the arrangements outlined in this section are provided in Attachment 2.

Reinsurance Management Strategy

39.     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.

40.     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 paragraph 35).

Transitional arrangements

41.     This Guidance Note will apply on commencement to all 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 this Guidance Note, then the LMI may apply to APRA for a determination (by way of an instrument in writing) allowing the LMI a transitional period during which:

(a)      the LMI will be required to undertake the calculations and modelling required by this Guidance Note 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 Guidance Note (read with Prudential Standard GPS 110 Capital Adequacy for General Insurers); 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 transitional period, to ensure that the LMI satisfies the capital requirements of this Guidance Note (read with GPS 110) by the end of the transitional period.

42.     APRA may make a determination in the terms sought in the LMI’s application under paragraph 41, or make a determination on such terms as APRA considers appropriate, or decline to make a determination granting the LMI a transitional period.

Note: During a transitional period the LMI will be required to ignore any transitional relief granted under paragraph 42, and assume that it is required to hold capital in accordance with this Guidance Note, for the purposes of reporting to APRA under reporting standards made under section 13 of the Financial Sector (Collection of Data) Act 2001.

43.     An application under paragraph 41 must be supported by a capital management plan demonstrating how the LMI will meet its capital requirements before the expiry of the requested transitional period. APRA will consider the capital management plan, and any other relevant circumstances, in determining the LMI’s eligibility for a transitional period and, if granted, the length of the transitional period. The maximum transitional period that APRA will grant to an LMI is three years from the commencement date of this Guidance Note.

ATTACHMENT 1

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 2

A. MER calculation for an LMI with quota share reinsurance (as described in paragraph 32)

Assume that:

-   aggregate PML over three years (using the model) is $100;

-   claims handling expenses are $5, i.e. 5 per cent of PML; and

-   there are no reinstatement costs.

If an LMI cedes 70 per cent of risk through a quota share reinsurance arrangement, available reinsurance is $70 (i.e. 70 per cent of the PML).

However, the amount of available reinsurance ($70) breaches the limit of 60 per cent of the PML ($60) outlined in paragraph 37. Hence, only $60 can be recognised as allowable reinsurance in the MER calculation.

The MER for the LMI is:

MER   = PML – allowable reinsurance + claims handling expenses +

reinstatement costs

= $100 - $60 + $5 + $0

= $45

B. MER calculation for an LMI with aggregate excess-of-loss or stop-loss reinsurance on a claims year basis (as described in paragraphs 33 and 34)

Assume that:

-   aggregate PML over three years (using the model) is $100;

-   Premiums Liabilities are $100;

-   claims handling expenses are $5, i.e. 5 per cent of PML; and

-   there are no reinstatement costs

If an LMI has aggregate excess-of-loss reinsurance on a claims year basis, where the lower limit of reinsurance (retention) for each year is $45 and the upper limit is $90, available reinsurance is determined by:

(a)      allocating aggregate PML ($100) in the proportion of 25 per cent in years one and three of the downturn and 50 per cent in year two;

(b)     distributing 60 per cent of Premiums Liabilities ($60) across the three-year scenario in the same proportion as PML;

(c)      determining total losses as the sum of PML and 60 per cent of Premiums Liabilities; and

(d)     calculating available reinsurance in each year using total losses, given the LMI’s lower limit ($45) and upper limit ($90) of reinsurance.  

Year of downturn	PML	60 per cent of Premiums Liabilities	Total losses	Available reinsurance
(a)	(b)	(c)	(d)
Year 1	$25	$15	$40	$0
Year 2	$50	$30	$80	$35
Year 3	$25	$15	$40	$0
Total	$100	$60	$160	$35

The amount of available reinsurance ($35) does not breach the limit of 60 per cent of the PML ($60), hence allowable reinsurance is $35.

The MER for the LMI is:

MER   = PML – allowable reinsurance + claims handling expenses +

reinstatement costs

= $100 - $35 + $5 + $0

= $70

C. MER calculation for an LMI with aggregate excess-of-loss or stop-loss reinsurance on an underwriting year basis (as described in paragraph 35)

Assume that:

-   aggregate PML (using the model) is $100;

-   Premiums Liabilities are $100 and OCP is $20;

-   claims paid over the period 2001 to 2004 is $12;

-   claims handling expenses are $5, i.e. 5 per cent of PML;

-   there are no reinstatement costs; and

-   the LMI has only been writing lenders mortgage insurance since 2001 (and has therefore only been reinsuring in respect of that insurance since then).

If an LMI has aggregate excess-of-loss reinsurance on an underwriting year basis, where the lower limit of reinsurance (retention) for each underwriting year is $45 and the upper limit is $90, available reinsurance is determined by:

(a)      allocating aggregate PML to each underwriting year in the same proportion as sum insured for those years, e.g. the PML in 2001 ($10) is 10 per cent of the total PML ($100). Alternatively, the MER model may be applied separately to each underwriting year;

(b)     allocating claims paid ($12), 90 per cent of Premiums Liabilities ($90) and 90 per cent of OCP ($18) to individual underwriting years using a methodology that is documented in the LMI’s REMS;

(c)      determining total losses as the sum of PML, claims paid, 90 per cent of OCP and 90 per cent of Premiums Liabilities in each underwriting year; and

(d)     calculating available reinsurance in each underwriting year using total losses, given the LMI’s lower limit ($45) and upper limit ($90) of reinsurance.

Underwriting year	Sum insured ($)	Sum insured (%)	PML	Claims paid + 90% of Premiums Liabilities + 90% of OCP	Total losses	Available reinsurance
(a)	(b)	(c)	(d)
2001	$100	10%	$10	$30	$40	$0
2002	$200	20%	$20	$25	$45	$0
2003	$300	30%	$30	$30	$60	$15
2004	$400	40%	$40	$35	$75	$30
Total	$1000	100%	$100	$120	$220	$45

The amount of available reinsurance ($45) does not breach the 60 per cent limit of the PML ($60), hence allowable reinsurance is $45.

The MER for the LMI is:

MER   = PML – allowable reinsurance + claims handling expenses +

reinstatement costs

= $100 - $45 + $5 + $0 = $60