Banking (prudential standards) determination No. 2 of 2005: new Guidance Note AGN 112.1 applying to ADIs
EXPLANATORY STATEMENT
Issued by the authority of the Australian Prudential Regulation Authority (‘APRA’)
Banking Act 1959, subsection 11AF(3)
Acts Interpretation Act 1901, subsection 33(3)
Under subsection 11AF(1) of the Banking Act 1959, APRA has power to make prudential standards applying to authorised deposit taking institutions (‘ADIs’). Under subsection 11AF(3), APRA has power to vary a prudential standard.
Subsection 33(3) of the Acts Interpretation Act 1901 provides that a power to make an instrument shall be taken to include a power to revoke such an instrument in like manner.
Banking (prudential standards) determination No 2 of 2005 (‘the Determination’) varies Prudential Standard APS 112 – Capital Adequacy: Credit Risk (which originally came into effect on 1 October 2000) to update related Guidance Note AGN 112.1 Risk-weighted On-balance Sheet Credit Exposures.
The Determination revokes an earlier variation to APS 112, and thereby effectively revokes the current version of AGN 112.1 (which had come into effect on 1 October 2004), so that it can in substance be replaced by the updated AGN 112.1 which is attached to the Determination.
The revocation will take place, and the new version of AGN 112.1 will come into effect, on 1 January 2006.
Background
Prudential Standard APS 112 aims to ensure that all ADIs incorporated in Australia adopt a uniform approach to the measurement of their on- and off-balance sheet credit exposures for capital adequacy purposes. It does this by requiring those ADIs to risk-weight those exposures according to certain risk categories. Each on-balance sheet and off-balance sheet transaction is assigned to one of four categories of risk weight, those categories being 0, 20, 50 and 100 per cent. Related prudential standard APS 110 provides that, broadly speaking, an ADI must hold eligible capital equal to 8 per cent of its risk weighted liabilities.
Prudential Standard APS 112, then, is concerned with the process of risk-weighting liabilities. It refers to, and incorporates by reference, a number of ‘Guidance Notes’, which flesh out details of the risk-weighting process.
Of these, AGN 112.1 addresses the risk-weighting of on-balance sheet exposures. Attachment C to AGN 112.1 is specifically concerned with the risk-weighting of an ADI’s exposures to residential mortgages.
Paragraph 11 of Attachment C provides (and, in the new version, will continue to provide) that residential mortgages are subject to a concessional risk weight of 50 per cent under certain circumstances. Broadly speaking, the Attachment requires a loan to valuation ratio of no greater than 80 per cent (or no greater than 60 per cent if certain criteria are not met).
However, an ADI may still be entitled to the concessional risk weight of 50 per cent, despite the ratio exceeding the relevant percentage, if the loan is ‘100 per cent mortgage insured’ through an acceptable lenders mortgage insurer (LMI).
APRA has conducted an examination of the use of lenders mortgage insurance, with attention to both the prudential risks to ADIs and those to LMIs. As a result, a number of reforms are proposed that focus on strengthening and standardising the capital framework, and amending the definition of acceptable mortgage insurance for ADIs claiming capital concessions on mortgage-insured loans.
The amendments aim to further increase the risk-sensitivity of the capital framework, thereby ensuring that capital requirements are appropriately aligned to risk.
Moreover, the reforms aim to reduce regulatory inconsistencies between LMIs and ADIs, and ensure that similar risks are treated in a similar manner.
The amendments are part of an ongoing process by APRA to enhance its supervision of regulated financial institutions, and provide more effective protection to the beneficiaries of these institutions.
The Determination
The Determination amends Prudential Standard APS 112 by inserting a footnote in paragraph 3 after the first reference to AGN 112.1. This footnote will provide that, where APS 112 makes reference to AGN 112.1, that reference shall be taken to be a reference to a new version of AGN 112.1, which is attached to the Determination.
For example, paragraph 3 of APS 112 refers to AGN 112.1 for details of the four categories of risk weight. This shall be taken to mean the new version of AGN 112.1.
Therefore the new version of AGN 112.1 will be incorporated by reference into APS 112.
The new version of AGN 112.1
The new version of AGN 112.1 is substantially the same as the existing version, with the exception of certain amendments to Attachment C to the Guidance Note.
These amendments concern lenders mortgage insurance. The general rule will continue to be set out in paragraph 11 of Attachment C, with broadly the same requirements as those contained in the old Attachment C. If a loan meets the lending criteria in paragraphs 1 to 10 of Attachment C, then it will be eligible for the concessional risk weight if the loan to valuation ratio does not exceed 80 per cent or the loan is 100 per cent mortgage insured through an acceptable LMI. If, but for a failure to meet one or more the criteria in paragraphs 2, 3, 6, 7 or 8, the loan would meet the lending criteria in paragraphs 1 to 10, then it will be eligible for the concessional rate if the loan to value ratio is 60 per cent or the loan is 100 per cent mortgage insured through an acceptable LMI.
The general concept of ‘100 per cent mortgage’ insurance will remain the same, ie it will continue to include cover for realised losses with respect to the full value of an outstanding loan balance (see paragraph 17 of Attachment C to the new AGN 112.1).
However, there will be a number of differences between the old and new Attachment C.
First, there will be greater detail, and some changes, in the definition of what constitutes an acceptable LMI in the new Attachment C. Paragraph 17 of the old Attachment C requires the LMI to have a credit rating of ‘A’ or higher, and that it be subject to supervision by an approved insurance regulator. Paragraph 18 in the new version provides that the LMI must either be authorised by APRA under section 12 of the Insurance Act 1973, or APRA must have determined that APRA is satisfied that it is subject to comparable prudential regulation (in another jurisdiction) and be otherwise an acceptable LMI. New paragraphs 21 to 25 of Attachment C set out detailed criteria governing the circumstances in which APRA may make such a determination.
Accordingly, the new requirements, while broadly similar in intent, will make clearer precisely what is expected of the LMI if the relevant ADI is to obtain a concessional risk weight of 50 per cent. The new requirements remove the focus on the credit rating of the LMI and make it clear that the LMI must be prudentially supervised, either by APRA or a foreign regulator.
Secondly, paragraph 19 of the new Attachment C provides that a loan will not be regarded as 100 per cent mortgage insured through an acceptable LMI where the LMI or reinsurer for the policy has contractual recourse to the ADI, or a member of the ADI’s consolidated group (except where the contractual recourse is to a member of the ADI’s group that is itself an LMI that is wholly or partly owned by the ADI). Nor will a loan be regarded as 100 per cent mortgage insured through an acceptable LMI where the reinsurer for the policy is (i) wholly or partly owned by the ADI and (ii) neither authorised under the Insurance Act nor subject to comparable prudential regulation in another jurisdiction (see again paragraphs 21 to 25 of the new Attachment C).
This differs from the approach taken in paragraph 18 of the old Attachment C, which has provided that a captive LMI, though unrated, may qualify as an acceptable LMI where it is able to demonstrate (to APRA) a claim paying ability of ‘A’ or higher. This required APRA to consider non-rated associated LMIs on a case-by-case basis. Under the new Attachment C the emphasis will shift to whether the LMI is regulated by either APRA (or, if APRA determines, a foreign regulator).
The attached Regulation Impact Statement contains further information on the changes to Attachment C.
Commencement and transitional arrangements
The new Guidance Note is to come into effect on 1 January 2006. Paragraph 26 of Attachment C confirms, for the avoidance of doubt, that the new paragraphs 18, 19, 21, 22, 23, 24 and 25 of Attachment C (which contain most of the new requirements) will come into effect on that date. (Paragraph 20 of the new Attachment C is not mentioned as it is in the same form as paragraph 19 of the old Attachment C.)
Paragraphs 27 to 30 of the new Attachment C set out certain transitional arrangements. Where an ADI does not meet its capital requirements as a result of the new paragraphs (because it has ceased to be eligible for the concessional 50 per cent risk weighting in respect of a loan or loans), it may apply to APRA for a determination in writing granting the ADI a transitional period (of up to 2 years) in which to meet some or all of the requirements. Paragraph 28 sets out details of when transitional relief may be granted. Paragraph 29 specifies the material with which APRA must be provided in support of an application for transitional relief.
Consultation
APRA has consulted publicly on these proposals on two separate occasions as well as engaging in regular dialogue with ADIs in relation to the proposed reforms. APRA has taken into account the views of industry in formulating its proposals while ensuring that our prudential objectives continue to be met.
The consultation process is more fully described in the Regulation Impact Statement.
Regulation Impact Statement
A Regulation Impact Statement is attached.
Regulation Impact Statement
This Regulation Impact Statement covers:
- GPS 110 – Capital Adequacy for General Insurers; and
- APS 112 – Capital Adequacy: Credit Risk.
Background
Lenders Mortgage Insurers (LMIs) protect lenders from losses in the event of borrower default on loans secured by mortgages[1]. Currently, 13 LMIs are authorised under the Insurance Act 1973 subject to the condition that they only conduct mortgage insurance business. Of the 13 LMIs, six LMIs are captive insurers[2] of Authorised Deposit-taking Institutions (ADIs), while four LMIs are in run-off and are restricted from writing new or renewal mortgage insurance business. In addition, two captive LMIs are domiciled in Singapore and are regulated by the Monetary Authority of Singapore. As at December 2003, LMIs had $2.9 billion in total assets and more than $200 billion worth of loans insured, including loans made by ADIs and unregulated lenders and insurance contracts on securitised portfolios. The LMI industry is highly concentrated, with the market share of the two major LMIs being 70 per cent.
LMIs are regulated under the general insurance framework administered by the Australian Prudential Regulation Authority (APRA) and comprising the Insurance Act 1973 and the General Insurance Reform Act 2001, Prudential Standards and Guidance Notes. LMIs are also required to comply with Reporting Standards made under the Financial Sector (Collection of Data) Act 2001.
There are currently 254 ADIs authorised under the Banking Act 1959, holding approximately $504.2 billion in deposits. ADIs, in aggregate, insure around 20 per cent of their on-balance sheet residential mortgage loans with LMIs. There are three principal reasons for which ADIs obtain mortgage insurance. Primarily, it transfers credit risk from their loan books. Secondly, ADIs obtain a concessional risk weight of 50 per cent on high Loan-to-Valuation Ratio (LVR) loans (defined as loans with an LVR of greater than 80 per cent), provided that such loans are mortgage insured by an approved LMI. Without mortgage insurance, high LVR loans attract a 100 per cent risk weight. Finally, ADIs use mortgage insurance as a credit enhancement tool to gain access to wholesale funding through the mortgage-backed securitisation market. Hence, ADIs use LMIs for risk transfer and to efficiently manage capital.
The prudential framework for ADIs comprises the Banking Act 1959 and Prudential Standards made under that Act. APRA also administers additional Guidance Notes.
Problem Identification
During 2003, APRA conducted a stress test involving 120 ADIs in order to assess whether they could withstand a substantial correction in the housing market without materially impacting on prudential requirements. The results demonstrated that ADIs would remain solvent under the stress scenario, and that more than 90 per cent of ADIs would do so without falling below their regulatory minimum capital requirements. A significant proportion of ADI counterparty default risk for housing loans is transferred to LMIs. This raised the question of whether LMIs could survive a severe housing downturn, given the higher risk of their portfolios. Hence, in late 2003, APRA extended the stress test to LMIs and conducted a broader review of the LMI industry including reinsurance arrangements, parental support, reporting requirements and relationships with ADIs.
Maximum Event Retention and Risk Charge for LMIs
The stress test of LMIs indicated that a majority of LMIs would have had difficulties managing a substantial deterioration in the housing market without materially impacting on their capital and solvency requirements, or alternatively requiring capital injections from their parents. Given this finding, APRA undertook to reassess the capital framework for LMIs.
The Minimum Capital Requirement (MCR) for an LMI, like other general insurers, is comprised of an insurance risk charge, investment risk charge, and concentration risk charge[3] or Maximum Event Retention (MER). However, unlike other general insurers, the concentration risk charge accounts for the greater part of an LMI’s MCR. [4] Hence, the review of the current capital framework for LMIs centred on the concentration risk charge.
GGN 110.5 – Concentration Risk Capital Charge defines MER as the largest loss to which a general insurer expects that it could be exposed (over a 250 year period) due to a concentration of policies, after netting out any reinsurance recoveries. LMIs currently use a model recommended by APRA to calculate MER. The results of the stress test on LMIs suggested that the standard APRA model is inadequate and inconsistent with the general insurance standards on MER. That is, it results in a capital charge that is inadequate to support the losses arising from a probable maximum event. If the MER model is not strengthened, LMIs operating close to the current APRA minimum capital requirements are likely to have inadequate levels of capital to support the risks associated with their activities, during a significant housing downturn.
Further, the MER model for LMIs is not publicly available, leading to a lack of transparency of LMIs’ capital requirements to market participants. Moreover, there are inconsistencies in the way that the MER model is applied by different LMIs with some issues requiring further clarification.
Further, the current capital framework for LMIs has resulted in capital arbitrage between ADIs and LMIs. There is a large discrepancy between the levels of capital that ADIs and LMIs are required to hold for the same risk.[5] This creates an incentive for ADIs to transfer risk to LMIs and also take an ownership interest in LMIs, resulting in a system which is undercapitalised relative to its total risk. If the current capital requirements for LMIs are not strengthened, capital arbitrage between ADIs and LMIs will persist.
Finally, in recent years there has been significant demand for riskier and more innovative loan products, such as low-doc loans and high leverage loans. This may have increased the overall riskiness of loan books and as a result. APRA is proposing tighter capital requirements for these exposures within ADIs. However, the current concentration risk charge for LMIs does not differentiate loans by product type, and hence does not adequately reflect the risks associated with new loan products. If the MER model is not updated, LMIs will not be required to hold additional capital to reflect these risks.
Eligibility Criteria for the Concessional Risk Weight on Mortgage Insured Loans
ADIs receive a concessional risk weight of 50 per cent on loans above 80 per cent LVR that are mortgage insured through an acceptable LMI. This recognises that the risk of borrower default on such loans is transferred to LMIs. AGN 112.1 – Risk-Weighted On-Balance Sheet Credit Exposures defines an acceptable LMI as an LMI that has a rating that is ‘A’ or higher and is subject to supervision by an approved insurance regulator. An unrated captive LMI may also qualify as an acceptable LMI where it is able to demonstrate claims paying ability of rating ‘A’ or higher; APRA considers this on a case-by-case basis. These requirements lack clarity and have resulted in inconsistencies in the prudential supervision of both LMIs and ADIs.
The ‘A’ level rating requirement for LMIs is not strictly and formally enforced as ADIs that insure with unrated LMIs can also qualify for capital concessions. This has created inconsistencies in the treatment of mortgage insurance from non-captive LMIs, which are mostly rated, and captive LMIs, which are mostly unrated.
The requirement that LMIs have to be supervised by an approved insurance regulator has also led to inconsistent treatment. Off-shore LMIs are subject to different and potentially less stringent regulatory regimes that may be inconsistent with APRA’s prudential requirements. However, the ADIs that mortgage insure with off-shore LMIs still qualify for the 50 per cent concessional risk weight.
Some captive LMIs have reinsurance arrangements in place that have potential recourse to the ADI parent. For example, the ADI could be required to make payments to the reinsurer if its captive LMI does not meet minimum premium requirements, or the ADI could be required to make payments to its captive LMI if the LMI’s reinsurance is exhausted. An ADI still qualifies for the 50 per cent concessional risk weight even when mortgage insurance does not provide a complete transfer of risk. This treatment is clearly contrary to the policy intent of the capital concession granted to ADIs for transferring risk to LMIs.
Objectives
The objectives of the proposed amendments to the prudential framework for LMIs and ADIs are to:
- increase the protection provided to policyholders and other beneficiaries of mortgage insurance policies through the prudential supervision of LMIs;
- ensure that LMIs’ capital requirements are more risk sensitive, and that their ability to withstand a severe downturn is enhanced;
- adopt a consistent approach in the prudential supervision of both LMIs and ADIs;
- clarify existing prudential requirements and provide additional guidance for LMIs and ADIs; and
- increase the transparency of LMI prudential requirements to market participants.
Identification of options
Maximum Event Retention and Risk Charge for LMIs
Option 1 – Introduce a new Guidance Note and amend existing Prudential Standard GPS 110 and Guidance Note GGN 110.5
Under this option, a new Guidance Note would be introduced for the concentration risk charge for LMIs. GPS 110 – Capital Adequacy for General Insurers and GGN 110.5 – Concentration Risk Capital Charge would be amended in accordance with the new Guidance Note. The new Guidance Note would prescribe a standard model for determining the concentration risk charge for LMIs which is consistent with the general insurance standards. The model would specify standard frequency and severity factors by LVR, age and product type based on a three year housing downturn. It would also specify how LMIs should apply the model to their exposures.
Option 2 – Retain Prudential Standard GPS 110 and Guidance Note GGN 110.5 without amendment
This option would retain the existing general insurance capital framework for LMIs without amendment.
Eligibility Criteria for the Concessional Risk Weight on Mortgage Insured Loans
Option 1 – Review and amend existing Prudential Standard APS 112 and Guidance Note AGN 112.1
Under this option, APS 112 – Capital Adequacy: Credit Risk and AGN 112.1 – Risk-Weighted On-Balance Sheet Credit Exposures would be amended to clarify existing requirements, and to tighten the eligibility requirements for ADIs claiming the 50 per cent concessional risk weight on mortgage insured loans.
As before, loans above 80 per cent LVR that are 100 per cent mortgage insured through an acceptable LMI would qualify for a 50 per cent concessional risk weight. However, the definition of an acceptable LMI would be amended to be an LMI, whether rated or unrated, that is supervised by APRA and complies with minimum regulatory requirements. Further, the 50 per cent concessional risk weight would not apply to loans that are reinsured by off-shore captives of APRA-regulated ADIs, even if they are mortgage insured by acceptable LMIs. Finally, any mortgage insurance that has potential recourse to the ADI would not be eligible for capital concessions.
Option 2 – Retain Prudential Standard APS 112 and Guidance Note GGN 112.1 without amendment
This option would retain the existing prudential framework for ADIs without amendment.
Impact Analysis
Maximum Event Retention and Risk Charge for LMIs
Impact group identification
APRA, LMIs, policyholders (including ADIs, unregulated lenders and securitisation vehicles) and consumers are likely to be affected by the proposed amendments to the capital framework for LMIs.
Assessment of costs and benefits
Option 1 – Introduce a new Guidance Note and amend existing Prudential Standard GPS 110 and Guidance Note GGN 110.5
APRA
Benefits
By strengthening the capital requirements for LMIs, APRA would ensure that LMIs’ capital requirements are more risk sensitive and that their ability to withstand a severe downturn is enhanced. It would also discourage inappropriate risk transfer and capital arbitrage between ADIs and LMIs. This, in turn, would strengthen the safety and soundness of LMIs and the financial system overall, allowing APRA to better protect policyholders’ interests.
By clarifying existing prudential requirements, APRA would be able to remove inconsistencies in the application of capital requirements to all LMIs. The new capital requirements would also ensure consistency with the current standards on MER for other general insurers. By enabling consistency in supervision, APRA would address a fundamental goal of prudential regulation, which is to ensure regulatory fairness and competitive neutrality across all regulated entities. Further, by updating prudential requirements to reflect changes in the market, APRA would be better able to ensure that the capital framework is relevant and appropriate to the supervision of LMIs.
Costs
APRA would incur modest costs in implementing the new and amended prudential requirements, including the costs of training staff (estimated at 12 person days), and using additional resources in the supervision of LMIs during the transitional phase when the industry moves to compliance with the new requirements. APRA would also incur costs in monitoring the compliance of LMIs with the new requirements.
Under this option, APRA would still have to accommodate a certain level of capital arbitrage between LMIs and ADIs as arbitrage opportunities would not be completely eliminated. Hence, APRA’s ADI regulation would be less effective than if there was no capital arbitrage as ADIs could easily transfer the risk of high LVR lending to LMIs, which are less stringently regulated.
LMIs
Benefits
Amending the capital framework for LMIs would ensure that LMIs have adequate capital to support the risks of their business activities and increase the likelihood that they operate their business in a prudent manner. This would also increase their ability to withstand a severe housing downturn. In particular, LMIs operating at the new minimum would be able to withstand a downturn corresponding to a 0.8 per cent loss rate, which is twice as severe as that under the current requirements. Further, the proposed capital requirements are more risk sensitive, which implies that LMIs would hold more capital for loans at greater risk of default in a housing downturn.
Updating the requirements to reflect market developments would ensure that LMIs have to comply with standards that are relevant and appropriate to their risk profile. By clarifying existing requirements and providing additional guidance, LMIs would gain a better understanding of the prudential requirements that they have to comply with. Moreover, the changes would lead to greater regulatory transparency and certainty for LMIs.
Costs
The proposed amendments would approximately double the existing MCR for LMIs. However, the amount of additional capital or reinsurance that LMIs would have to obtain would be significantly less than this, as they currently have a large capital buffer in aggregate. Hence, the proposal would formalise the capital requirement for some LMIs while increasing the requirement for others. Four LMIs would have to raise additional capital and/or strengthen their reinsurance arrangements to meet the new MCR, and a further three LMIs would have to increase capital and reinsurance to provide them with a buffer above the regulatory requirement.
Further, LMIs would incur costs in training staff and changing systems to comply with the new requirements. These costs would be minor as most of this information is already collected by LMIs.
The new capital requirements would also require a higher capital commitment from potential entrants. However, it is not expected to discourage LMIs from entering the market if they charge premiums which ensure that they earn an adequate return on capital.
The precise nature of the costs that would be incurred by LMIs if this option were to proceed is not yet known.
Policyholders
Benefits
The new prudential requirements to strengthen the capital levels of LMIs would benefit policyholders, which includes ADIs, unregulated lenders and securitisation vehicles. Policyholders would benefit from premiums that are more risk sensitive, and would obtain increased protection through a higher level of safety and soundness in the industry and enhanced supervision of LMIs. This, in turn, would strengthen the positions of policyholders.
The new requirements would increase the transparency of LMI capital requirements in the market. Improved disclosure would create greater confidence by policyholders that LMIs are being supervised according to a comprehensive and sound prudential framework, which promotes safety in the financial system.
Costs
Holding all else constant, higher minimum capital requirements may lead to an increase in premiums. It should be noted, however, that premium pricing is generally based on economic capital and not regulatory capital, and although the new requirements significantly raise the minimum regulatory requirements, the effect on economic capital is much lower. This is because LMIs currently hold capital well in excess of the regulatory minimum – a signal that the market may view the current regulatory minimum as too lenient.
The new model has attempted to match market pricing practices (e.g. premiums vary with LVR and loan type). Nevertheless, it is likely that the regulatory requirements would differ from market practice in some cases, and therefore influence premium pricing. This is most likely to occur for high LVR loans.
The level of market competition would also affect premium pricing. As the market is open to new entrants (both captive and non-captive), any excessive premium increases would encourage new entrants. The level of premium increases should not exceed those which ensure an adequate return on capital.
Consumers
Benefits
Consumers that are depositors with ADIs would benefit if the capital levels of LMIs are strengthened as ADIs would receive added protection and assurance that the obligations of LMIs would be met.
In addition, consumers that are investors in mortgage-backed securities, including retail and institutional investors such as superannuation funds and insurance companies, would also benefit for the same reasons. Overall, it would promote the market’s confidence in the financial system.
Costs
Consumers, namely borrowers, may be adversely impacted if the changes to the capital framework lead to costs which LMIs pass on via increased premiums. In particular, the cost of borrowing at LVRs above 80 per cent could increase, which may discourage some consumers, who are on the margin of affordability, from borrowing.
Option 2 – Retain Prudential Standard GPS 110 and Guidance Note GGN 110.5 without amendment
APRA
Benefits
If the current prudential framework for LMIs was retained, APRA would avoid the costs that would have otherwise been incurred if changes to the framework were made.
Costs
APRA would lack a comprehensive and sound prudential system to appropriately supervise LMIs if the current standards and guidance notes were retained. The capital framework would continue to promote inadequate levels of capital, inappropriate risk transfer and capital arbitrage. This would affect APRA’s ability to protect policyholders and beneficiaries, especially in the event of a severe downturn.
Inconsistencies in the supervision across LMIs, and between LMIs and other general insurers would continue. In addition, prudential requirements would not adequately reflect changes in the LMI market and the changing risk profiles of LMIs.
LMIs
Benefits
If APRA were to retain the current prudential framework for LMIs, LMIs would be subject to no additional supervisory requirements, and hence would incur no additional costs associated with increasing capital and reinsurance, training staff and changing systems to ensure compliance.
Costs
Under this option, some LMIs would continue to lack sufficient capital to fully meet policyholder obligations in the event of a significant correction in the housing market. Under the current requirements, LMIs operating at the regulatory minimum would not survive a housing downturn which results in a less than 0.5 per cent loss rate. This risk would continue unless LMIs adopt a more prudent capital policy.
If the current framework was retained, LMIs would be subject to inconsistent supervision across the industry. Inconsistent supervision may lead to some captive LMIs having a competitive advantage over their rivals.
Policyholders
Benefits
Under this option, the benefits to policyholders would be unchanged. LMIs would incur no additional costs as a result of new capital requirements which could affect premiums and therefore policyholders.
Costs
If the current prudential framework for LMIs is retained, policyholders would lack adequate protection of their interests. Policyholders would face the increased risk that LMIs would be unable to fully meet their obligations in a severe downturn. Hence, policyholders may lack confidence in the safety and soundness of the LMI industry.
Consumers
Benefits
As LMIs would not be required to comply with any additional requirements, no additional costs would be incurred that could potentially be passed on to consumers through increased premiums.
Costs
Under this option, in the event of a severe downturn, LMIs may lack sufficient capital to fully meet their obligations to ADIs and securitisation vehicles. This lack of adequate protection would have a negative impact on depositors of ADIs and investors in mortgage-backed securities.
Eligibility Criteria for the Concessional Risk Weight on Mortgage Insured Loans
Impact group identification
APRA, ADIs, LMIs and consumers are likely to be affected by the proposed amendments to the eligibility requirements for ADIs to receive the concessional risk weight on mortgage insured loans.
Assessment of costs and benefits
Option 1 – Review and amend existing Prudential Standard APS 112 and Guidance Note AGN 112.1
APRA
Benefits
The amendments to the existing framework would eliminate ambiguity in the current standards by clarifying and strengthening requirements for concessional risk-weighting. This would lead to a better understanding of the prudential requirements and enable APRA to apply consistent requirements across the industry.
Currently, the claims paying ability of unrated captives needs to be assessed by APRA to determine whether ADIs with unrated captives are eligible for capital concessions. Hence, by removing the rating requirement, APRA would have reduced monitoring and assessment costs.
By restricting capital concessions available to ADIs for loans mortgage insured by APRA-regulated entities, should encourage risk transfer to LMIs under APRA’s jurisdiction, enabling closer monitoring and oversight of LMIs. APRA would not have to place undue reliance on assessments by rating agencies and regulators of off-shore LMIs. This would lead to APRA being better placed to protect depositors of ADIs with significant exposure to LMIs.
Further, by removing capital concessions for mortgage insurance that has potential recourse to the ADI, the amendments would ensure that the capital saving to ADIs is matched by an appropriate and complete transfer of risk from ADIs.
Costs
Costs would be incurred as a result of changes to prudential requirements. These would include the cost associated with training staff (estimated at seven person days), monitoring compliance and additional supervisory resources in the short term as the industry moves to compliance with the new requirements.
ADIs
Benefits
ADIs would benefit from increased clarity and guidance with respect to the eligibility criteria for capital concessions on mortgage insured loans.
As policyholders, ADIs would have added protection if captive LMIs and reinsurers currently located off-shore are brought under APRA’s more stringent supervision as a result of amendments to the prudential requirements.
Increased protection to ADIs would also result if potential recourse to ADIs in a severe downturn is discouraged.
Costs
Four ADIs have mortgage insurance arrangements that do not meet the new eligibility requirements, and hence would not qualify for capital concessions under this option. However, given the significant benefit they receive from capital concessions, these ADIs are likely to source and establish primary contractual mortgage insurance relationships with acceptable LMIs in order to qualify. It is likely that ADIs would be able to form these relationships at minimal cost as they currently have established relationships with acceptable LMIs for securitisation purposes. In addition, the impact of proposed reforms is likely to be minimised via transition arrangements, which implies that mainly new business will be affected.
LMIs
Benefits
The new requirements would benefit LMIs by ensuring that there is consistent treatment of mortgage insurance across the industry for capital concession purposes.
Captive LMIs would obtain cost savings from not having to establish and maintain formal ratings for capital concession purposes. Compliance costs would also be minimised as captive LMIs would not be subject to both regulatory and rating agency requirements. It should be noted, however, that non-captive LMIs would continue to maintain ratings for other purposes, for example securitisation, and hence would not realise these cost savings.
Costs
If the proposed requirements lead to the two off-shore LMIs coming on-shore, they would incur significant costs in relocating and meeting APRA requirements, as the off-shore regulatory requirements are less stringent.
If the new requirements discourage recourse to ADIs, some of the smaller captive LMIs may have difficulties in obtaining reinsurance, or would incur a higher cost for their reinsurance.
The precise nature and level of costs that might be incurred by LMIs under this option is not known with certainty.
Consumers
Benefits
Consumers that are depositors of ADIs would benefit from increased protection to ADIs under this option due to the reduced possibility of calls on the ADI parents of captive LMIs.
Costs
If changes to ADI regulation impose costs on captive LMIs (such as relocating their operations on-shore or sourcing new reinsurance arrangements), LMIs may pass these costs on to new borrowers via higher premiums. However, premium increases may be constrained by the level of competition in the LMI industry.
The likelihood of increased costs for consumers due to the proposed reforms is not known with certainty.
Option 2 – Retain Prudential Standard APS 112 and Guidance Note GGN 112.1 without amendment
APRA
Benefits
If the current framework was retained, APRA would not incur costs associated with amending prudential requirements.
Costs
Under this option, APRA would continue to apply prudential requirements that lack clarity and guidance. APRA would also have minimal information and oversight of off-shore LMIs that are subsidiaries of APRA-regulated ADIs.
If APRA were to retain the existing prudential requirements, it would be unable to prevent inappropriate and incomplete risk transfer arrangements. This would adversely affect APRA’s ability to protect policyholders of ADIs affected by the proposals.
ADIs
Benefits
The benefits to ADIs would be unchanged if the current framework was retained. ADIs would continue to receive capital concessions on mortgage insured loans, irrespective of the level of regulation to which the LMI is subject and whether there is potential recourse to the ADI.
Costs
ADIs would lack a complete understanding of the prudential requirements if the guidelines remain unclear.
LMIs
Benefits
LMIs that are located off-shore would avoid costs that might have otherwise been incurred if the current framework was amended, such as the costs of relocating their off-shore operations on-shore. They would also continue to receive tax and capital relief in overseas jurisdictions.
Additionally, if potential recourse to ADIs is not discouraged, some small captives would continue to obtain reinsurance at a lower cost.
Costs
The cost to LMIs from retaining the existing prudential requirements is the inconsistencies in the treatment of mortgage insurance in the industry that would be retained. This would be particularly evident in the treatment of mortgage insurance from captive LMIs compared to non-captive LMIs.
Consumers
Benefits
The benefits would remain unchanged if the current framework was retained. As ADIs and LMIs would not be required to comply with additional requirements, no additional costs would be incurred that could potentially be passed on to consumers via increased premiums.
Costs
Consumers that are depositors would lack adequate protection that ADIs would fully meet their obligations if potential contractual recourse to the ADI is not discouraged.
Consultation
APRA has consulted extensively on proposed changes to reporting requirements for LMIs. The consultation process involved the release of a consultation paper in August 2004 that proposed a standard model for LMIs to calculate the concentration risk charge, additional reporting requirements for LMIs, and changes to the eligibility requirements for mortgage insured loans for capital concession purposes. These changes are designed to address inadequacies in the current prudential framework that were identified by the stress test of LMIs and a broader review of LMI risk issues. A second consultation paper along with a draft reporting standard and the proposed draft reporting forms were released in February 2005. There has also been extensive direct consultation with industry involving meetings and other forums for discussion on the proposed new requirements.
Nine of the thirteen LMIs who operate in the Australian market provided responses on the proposals. A further two submissions were received from other parties.
Following is a summary of the main issues raised in submissions and an explanation as to APRA’s response to these matters.
- Submissions argued that APRA’s proposed cap on reinsurance for the purposes of calculating the MER does not take into account factors such as the credit rating of the reinsurer and whether the reinsurer itself is an APRA-regulated institution. APRA acknowledges that such factors are relevant in determination of such a cap. This is a matter with implications for all general insurers, not just LMIs. APRA intends to maintain the cap as proposed but will be looking at the matter as part of a broader review of reinsurance arrangements in the future.
- Submissions argued that APRA’s proposed 5% claims handling expense (CHE) charge for inclusion in the calculation of the MER for the purpose of covering the cost of administrative expenses associated with claims handling is excessive. APRA’s research indicates that the long-run CHE is typically in the order of 15%, falling to approximately 7-8% for catastrophic events. APRA took a liberal view in setting the CHE and further reduction of the CHE on this basis would not be appropriate.
- Numerous submissions argued that the commencement date of the new requirements, being 1 October, should be moved back to 1 January 2006. APRA has agreed to make the commencement date 1 January 2006. Industry have been consulted with on the proposals and have had time to prepare for them. Where appropriate, individual LMIs will be able to avail themselves of the transition period.
- As part of its proposal APRA has allowed for a transition period of three years for eligible LMIs. A number of submissions argued for a four year transition period, but many also acknowledged that a longer transition period would negate the intended effect of the proposals. APRA does not see merit in extending the transition period. The deficiencies identified by APRA with respect to the prudential regulation of LMIs do require that the changes be implemented without unreasonable delay. Further, the current downturn in the housing market does necessitate that we continue with the timetable for implementation as consulted upon.
- Questions were raised as to why APRA would not restrict the new requirements to only apply to new business written from the time the proposed requirements take effect. Adopting such an approach would constitute a form of ‘grandfathering’ and would serve to significantly undermine the objectives of the proposals as it would take many years before any significant proportion of business was subject to the new proposals. This would mean that the underlying matters that the proposals seek to rectify would remain for some considerable period.
- In the original proposal, APRA had calibrated the MER model to a 1-in-250-year loss rate, which is similar to requirements at a Standard and Poor’s (S&P) ‘BBB+’ level. Industry noted that the S&P event includes total losses and not just losses due to a catastrophic event. As catastrophic losses are assumed to occur in addition to normal working losses, and the MER model is only expected to address capital implications of a catastrophic event, APRA re-calibrated the MER model to capture only catastrophic losses, rather than total losses, at the 1-in-250-year loss rate. This was achieved by adjustments to the model parameters in line with other industry recommendations.
The major issue raised during consultation with industry on proposed reforms is the treatment of premium liabilities (PL) within the proposed MER model. Premium liabilities are set aside mainly to cover future normal working losses, whereas the MER risk charge is expected to cover catastrophic losses. As such, the request from the industry to recognise PL as an alternative capital resource to meet MER claims was not accepted. However, APRA has allowed PL to be recognised in determining recoveries from aggregate excess-of-loss (also known as stop-loss) reinsurance arrangements.
Aggregate excess-of-loss reinsurance covers total losses, including both catastrophic and normal working losses. However, in such arrangements, reinsurance will only cover losses incurred by the insurer in ‘excess’ of a pre-determined amount. Losses up to that pre-determined limit, which could include normal working losses, are retained by the insurer. As normal working losses incurred during the event (provisioned for in premium liabilities) would also be counted towards this ‘excess’ calculation, APRA has proposed that LMIs with aggregate stop-loss reinsurance should be able to count 60% of their premium liabilities in determining reinsurance recoveries in the MER scenario. This is based on the industry estimation that approximately 60% of future normal working losses will be incurred in the next three years, which is the modelled catastrophic (MER) period. This is expected to provide some capital relief to the LMIs in their MER calculations. This approach is consistent with the regulations applied to other specialist insurers, such as medical indemnity insurers.
Conclusion and recommended option
Maximum Event Retention and Risk Charge for LMIs
Option 1 is the preferred option
This option will provide the most effective protection to policyholders and other beneficiaries of mortgage insurance policies by ensuring that LMI capital requirements are set at an appropriate level and are more risk sensitive. It will also discourage inappropriate risk transfer and capital arbitrage between ADIs and LMIs. Hence, it will lead to a higher level of safety and soundness in the LMI industry and greater confidence in the financial system. In addition, this option will update prudential requirements to reflect changes in the market so that they remain relevant and appropriate to the supervision of LMIs, clarify existing requirements, and ensure consistency and transparency in the supervision of LMIs.
APRA will incur modest costs from the changes to the prudential requirements. LMIs will also incur costs in raising capital and/or reinsurance to meet the new requirement or obtain a buffer above the regulatory requirement. Consumers of high risk loans may be impacted upon if LMIs pass on these costs through increased premiums. The changes may also discourage consumers on the margin of affordability from borrowing, however this is not inconsistent with the stated objectives as such borrowers are likely to represent a higher risk for ADIs, and hence LMIs.
Overall, the benefits arising from the enhanced supervision of LMIs, the reduced incentive for other ADIs to take advantage of current capital arbitrage opportunities, a higher level of safety and soundness in the industry, increased stability in the financial system, and enhanced protection to policyholders and consumers are expected to outweigh the costs incurred.
Option 2 does not meet all of the stated objectives. It does not provide adequate protection to policyholders as it retains inadequacies in the LMI capital model, inappropriate risk transfer and capital arbitrage. Moreover, the current capital framework lacks clarity and transparency, and promotes inconsistency in the treatment of LMIs.
Eligibility Criteria for the Concessional Risk Weight on Mortgage Insured Loans
Option 1 is the preferred option
This option increases the protection provided to policyholders through enhanced and consistent prudential supervision, while also eliminating ambiguity in the current standards. This will lead to a better understanding of the prudential requirements. It will enable APRA to enforce appropriate risk transfer arrangements, and closely monitor LMIs that provide insurance cover to ADIs.
APRA will incur costs in the short-term as the industry moves to compliance with the new requirements. Some LMIs and ADIs may incur costs in complying with the additional prudential requirements. However, the benefits of additional protection to policyholders, increased clarity and a consistent approach in supervision are likely to more than compensate for any costs incurred. Moreover, without further amendment, even greater costs will be incurred as the incentive remains for other ADIs to take advantage of the current system by setting up inappropriate structures and risk transfer arrangements.
Option 2 does not meet all of the stated objectives. It does not enable APRA to closely monitor off-shore LMIs or prevent inappropriate risk transfer arrangements. Hence, it does not allow APRA to adequately protect policyholders or treat mortgage insurance provided by LMIs consistently.
Implementation and review
It is proposed that APRA amend:
- GPS 110 – Capital Adequacy for General Insurers under the Insurance Act 1973 through the addition of a new guidance note; and
- APS 112 – Capital Adequacy: Credit Risk under the Banking Act 1959 through the addition of a new attachment to guidance on the prudential standard.
These changes are intended to take effect on 1 January 2006. APRA also proposes to determine a new Reporting Standard for Maximum Event Retention and Risk Charge for LMIs under the Financial Sector (Collection of Data) Act. These reporting requirements have been dealt with separately in the Regulation Impact Statement covering the reporting standards in relation to this proposal.
The Prudential Standards for LMIs and ADIs outlined above will be reviewed, in three years to ensure that they remain appropriate for the industry and meet the supervisory needs of APRA.
[1] Although mortgage insurance protects lenders, the cost is borne by the borrower.
[2] A captive insurer provides insurance to companies within the same corporate group and does not solicit business from third parties.
[3] The insurance risk charge reflects the risk that the true value of net insurance liabilities could be greater than that estimated, the investment risk charge captures the risk of an adverse movement in the value of assets and off-balance sheet exposures, and the concentration risk charge reflects the risk associated with an accumulation of exposures to a single catastrophic event.
[4] The concentration risk charge accounts for around 70 per cent of an LMI’s MCR.
[5] ADIs save approximately $2.5 billion in capital by insuring with LMIs. In comparison, LMIs, as a group, hold only $1.5 billion in capital.