Financial Sector (Collection of Data) (reporting standard) determination No. 90 of 2006 - Reporting Standard GRS 440.0 (2007) Claims Development Tables

Financial Sector (Collection of Data) (reporting standard) determinations Nos. 63-91 of 2006

EXPLANATORY STATEMENT

Prepared by the Australian Prudential Regulation Authority (APRA)

Financial Sector (Collection of Data) Act 2001 (the Act), paragraph 13(1)(a) and section 15

Acts Interpretation Act 1901, subsection 33(3)

Under paragraph 13(1)(a) of the Financial Sector (Collection of Data) Act 2001 (the Act), APRA may, by writing, determine reporting standards with which financial sector entities must comply.  Such standards relate to reporting financial or accounting data and other information regarding the business or activities of the entities.  Section 15 of the Act gives APRA power to make a formal declaration of the date when reporting standards begin to apply.  Subsection 33(3) of the Acts Interpretation Act 1901 gives APRA the power to revoke reporting standards so made. 

Financial Sector (Collection of Data) (reporting standard) determinations Nos. 63-91 of 2006 revoke all existing reporting standards applying to general insurers regulated by APRA and replace them with new reporting standards which are similarly titled, save for the year reference. For example, Financial Sector (Collection of Data) (reporting standard) determination No. 63 revokes Reporting Standard GRS 110.0 (2005) Minimum Capital Requirement and replaces it with Reporting Standard GRS 110.0 (2006) Minimum Capital Requirement. The existing reporting standards were determined on 21 June 2005 to have effect from 1 July 2006 (save for Reporting Standard GRS 170.1 (2005) Maximum Event Retention and Risk Charge for LMIs, which was determined on 14 November 2005 to have effect from 1 January 2006).

Under subsection 15(1) of the Act, APRA has determined that Financial Sector (Collection of Data) (reporting standard) determinations Nos. 63-91 of 2006 will come into force on the later of 1 January 2007 and the date of registration on the Federal Register of Legislative Instruments.

1.    Background

This Explanatory Statement explains the changes being made by APRA to the reporting framework for general insurers in response to Australian equivalents to international financial reporting standards (AIFRS).  General insurers have adopted AIFRS for reporting periods beginning on or after 1 January 2005.

The changes to Australian accounting standards that flow from the adoption of AIFRS, if left unadjusted, would automatically flow through to APRA’s reporting framework.  APRA’s objective in its approach to AIFRS is to align its reporting standards with Australian accounting standards and principles to the extent practicable, as the latter provide a widely accepted basis for the recognition and measurement of assets, liabilities, equity, revenue and expenses.

In certain circumstances, however, APRA’s prudential reporting framework will depart from accounting standards. APRA’s prudential framework and supervisory approach are forward-looking and risk-based, while accounting standards primarily focus on verification and reporting of past transactions and events. The focus on prospective rather than past outcomes and the fact that risk assessment is a forward-looking concept is an important point of departure from accounting standards.

The adoption of AIFRS could have significant implications for a general insurer’s regulatory capital base if allowed to flow through fully to the prudential framework. There are also other areas where the full adoption of AIFRS in the APRA prudential and reporting frameworks would have unintended and undesirable prudential outcomes. APRA has therefore departed from accounting standards where necessary to preserve the intent and integrity of the prudential framework.  The new reporting standards simply align the reporting requirements with prudential requirements already adjusted to accommodate the impact of AIFRS .

Changes arising from the adoption of AIFRS have also created an opportunity for APRA, as part of the general insurance Stage 2 reforms, to make technical amendments to capital requirements for general insurers.  In this respect, changes have already been made to Prudential Standard GPS 110 Capital Adequacy and Prudential Standard GPS 120 Assets in Australia (determined on 25 September 2006). The new reporting standards  have been aligned with these prudential standards.

The new reporting standards also resolve a problem arising in relation to the lodgement of data with APRA.  Under the current standards, only officers of an insurer are permitted to submit data to APRA either electronically or in paper form.  This does not allow insurers to appoint an agent to submit data to APRA on their behalf.  The current requirement does not reflect the administrative positions of some insurers, particularly captive insurers and insurers in run off.  The new reporting standards provide insurers with increased flexibility to comply with their reporting requirements by allowing an agent of an insurer to submit data to APRA.

2.      Purpose of the instrument

The purpose of each instrument is to revoke the existing reporting standards applying to general insurers and replace them with corresponding standards which incorporate appropriate adjustments.  APRA considered that it would be clearer and more effective to consolidate the necessary changes within new standards.  For that reason, APRA decided to revoke and replace affected reporting standards rather than to amend them.

3.      Operation of the instruments

Financial Sector (Collection of Data) (reporting standard) determinations Nos. 63-91 of 2006 revoke all existing general insurance reporting standards and determine new standards.

Each reporting standard comprises:

• the body of the reporting standard itself (which includes details about when returns under the standards must be lodged with APRA);
• one or more reporting forms which must be completed by general insurers covered by the reporting standard; and
• a set of detailed technical instructions regarding completion of the form.

The new reporting standards incorporate changes to capital requirements as part of the general insurance Stage 2 reforms, which include:

• adjustments to the calculation of the Investment Risk Capital Charge, a component of the Minimum Capital Requirement;
• adjustments to the calculation of deductions from the capital base of general insurers; and
• refinement of the application of the assets in Australia test in Prudential Standard GPS 120 Assets in Australia.

The forms and instructions within the reporting standards have been revised taking account of the impact of AIFRS. The core changes are as follows:

• Terminology changes – use of AIFRS and prudential terminology (e.g. deferred tax liability replaced with provision for deferred tax);

• New items –  new AIFRS items (e.g. derivative financial instruments, defined benefit assets and liabilities, loan loss provisioning);

• Prudential Policy changes – these changes reflect AIFRS revised prudential treatments for Tier 1 capital, securitised assets, fair value measurement, provisions, cash flow hedges, property and employer-sponsored defined benefit funds, treatment of impaired facilities and available for sale reserves.

The new standards also provide increased flexibility to comply with reporting requirements by allowing agents of an insurer to submit data to APRA.  Specifically, the new standards permit insurers to outsource the lodgement of their data returns to an agent, subject to certain requirements designed to ensure that data returns lodged by an agent are appropriately authorised by the insurer.

4.      Consultation

Private consultation was undertaken with the insurance industry prior to the release of the discussion paper, Proposed Changes to General Insurance Reporting Framework to be Effective from 1 January 2007 (the discussion paper).  Submissions were invited in response to the discussion paper during the 6 week period from 19 May 2006 to 30 June 2006.

5.      Regulation Impact Statement

A regulation impact statement is attached. 

Regulation Impact Statement

Introduction

This Regulation Impact Statement (RIS) addresses proposed changes to the prudential and reporting framework for general insurers. The changes arise from the introduction of Australian equivalents to International Financial Reporting Standards (AIFRS).  General insurers have adopted AIFRS for reporting periods beginning on or after 1 January 2005.

The Australian Prudential Regulatory Authority (APRA) is primarily responsible for ensuring the safety and soundness of prudentially regulated financial institutions so that they can meet their financial promises to depositors and insurance policyholders (beneficiaries).    The introduction of AIFRS has implications for how APRA carries out these responsibilities and requires amendments to Prudential Standard GPS 110 Capital Adequacy (GPS 110) and associated reporting standards.

The amendments in response to the adoption of AIFRS have also given APRA the opportunity to make technical changes to GPS 110, Prudential Standard GPS 120 Assets in Australia (GPS 120) and associated reporting standards.  These technical amendments form part of the General Insurance Stage 2 reforms (Stage 2 reforms) which are intended to refine and upgrade the prudential regime for general insurers implemented from 1 July 2002.

Background

Australian reporting entities have adopted AIFRS for reporting periods beginning on or after 1 January 2005.  The adoption of AIFRS changed the Australian generally accepted accounting principles (AGAAP) in place prior to that date in relation to the recognition and measurement of assets, liabilities, equity, revenue and expenses.  As a result of the adoption of AIFRS, general insurers now use these new accounting standards as the basis for their financial reports prepared in accordance with the Corporations Act 2001 (general purpose financial reports). 

APRA’s prudential requirements are aimed at protecting the interests of beneficiaries, particularly in adverse circumstances.  General purpose financial reports focus on evaluating the interests of the economic owners of an institution on a going‑concern basis.  Because of these differing objectives, prudential reporting requirements sometimes differ from accounting requirements, though APRA seeks to align its prudential and reporting standards with Australian accounting standards to the extent practicable.  Similar changes to those proposed for general insurers have already been made to the prudential and reporting framework for authorised deposit-taking institutions (ADIs).[1]

Changes arising from the adoption of AIFRS have also created an opportunity, as part of the Stage 2 reforms, for APRA to make amendments to capital requirements for general insurers.  Other components of Stage 2 reforms, which have now been introduced, comprise enhancements to the prudential requirements for risk management, reinsurance management and audit and actuarial valuation and reporting.[2]  The current capital requirements have applied since 1 July 2002 and, since that time, issues have arisen with the application and interpretation of these requirements.  In addition, the application of capital requirements and the ‘assets in Australia’ test[3] have not always produced logical outcomes.  APRA is therefore proposing some technical adjustments to refine the application of capital requirements and the ‘assets in Australia’ test. 

Consequent changes to reporting requirements are necessary to bring them into line with the changes to prudential standards flowing from the adoption of AIFRS and Stage 2 reforms.

The proposed changes affect 133 general insurers currently authorised under the Insurance Act 1973, with approximately $82 billion in assets (as at 31 December 2005).

Problem identification

AIFRS has changed the basis for accounting recognition and measurement, particularly of assets, equity and costs.  While major liability and revenue items for general insurers are unaffected, APRA’s prudential and reporting framework will need minor adjustments to take account of the AIFRS changes.  The most significant changes will be to deduct some items from capital to accurately reflect the availability of a general insurer’s capital base to support the insurer in distress.

The principal prudential impact from the adoption of AIFRS, if allowed to flow through fully to the prudential framework, would be in relation to a general insurer’s regulatory capital base.  AIFRS introduces a stricter definition of equity that, on initial adoption, could result in certain financial instruments currently classified as equity being reclassified as liabilities.   The immediate impact on the general insurance industry would be minimal as authorised insurers have not traditionally sought to raise capital in the form of hybrid securities.  However, if left unadjusted, general insurers would not be able to recognise certain hybrid securities as Tier 1 capital and, over time, this would adversely affect their cost of capital.  APRA has ‘decoupled’ the definition of capital instruments eligible for Tier 1 capital from Australian accounting standards in the case of ADIs.  If it did not do so for general insurers, this industry would be at a disadvantage compared to the ADI industry when seeking additional capital from the market.

Since the July 2002 reforms, APRA has observed that though the regulatory capital framework for general insurers is adequate, the calculations involved have not always produced logical outcomes.  In particular:

• the minimum capital requirement (MCR)[4] of general insurers needs to be more accurately risk-based than is currently the case.  Anomalies have been found where imprudent decisions were not being penalised in the calculation of the MCR and prudent behaviour was being penalised.  These issues occur at the periphery of the calculations but are still of concern, particularly where general insurers maintain a minimal buffer over MCR;
• some amounts that are included in the capital base of a general insurer and reported to APRA as part of retained earnings are not appropriate for inclusion in regulatory capital.  This may compromise the function of capital as a buffer against any unexpected losses suffered by general insurers, by allowing them to continue operating while addressing problems that may arise in their normal operations; and  
• a number of technical queries have been raised by industry indicating a need to clarify the intent and application of GPS 120[5].   

General insurance reporting requirements need to be revised due to:

• the introduction of AIFRS;

• the need to align reporting requirements with Stage 2 reforms; and

• industry feedback regarding the need for improvements to the forms and instructions (introduced in 2002) in order to make the submission of data easier and more reliable.

Objectives

Recognising that APRA has no choice but to deal with the potential impacts of IFRS, APRA’s primary objective is to establish, maintain and enforce prudential standards and practices which ensure that, under all reasonable circumstances, financial promises made by general insurers are met within a stable, efficient and competitive financial system.  Consistent with this, APRA’s approach to AIFRS is to align its prudential and reporting framework as closely as possible with accounting standards, except where this would have an adverse impact on the intent and integrity of APRA's prudential framework.

APRA’s other objectives in making amendments to capital requirements and associated reporting requirements are to:

• reduce, as much as possible, potential disruption to general insurers caused by AIFRS; 
• clarify and provide guidance about APRA’s prudential policies as a result of the adoption of AIFRS; 
• improve the quality of capital held by general insurers to ensure greater protection for policyholders in times of financial stress would provide;
• provide an incentive for general insurers to obtain legal certainty in their reinsurance arrangements; and
• clarify the application of GPS 120 and make more certain that, in the event of a liquidation of a general insurer,  its assets in Australia would be considered by the courts as assets in Australia and thus available to meet claims of policyholders in Australia.

Identification of options

Option 1: Maintain existing prudential and reporting framework to preserve AGAAP and not incorporate either AIFRS or Stage 2 reforms (status quo)

Under this option, APRA’s prudential and reporting framework would be kept in its current form and any references to Australian accounting standards in APRA’s requirements would be to those standards existing prior to 1 January 2005.  This would mean that, for APRA’s prudential purposes, AGAAP would be preserved.  Unlike prudential reporting for ADIs, prudential reporting for general insurers already diverged in significant respects from general purpose financial reporting prior to 1 January 2005.  With the adoption of AIFRS, maintaining the status quo for prudential reporting would mean that general purpose financial reporting and prudential reporting would diverge even further.  This option would also mean that the existing GPS 110 and GPS 120 remain unchanged.  General insurers would continue to comply with capital requirements as they have done since 2002 without having to meet any new or clarified capital requirements.  In addition, the reporting framework for general insurers would remain unchanged.

Option 2: Align the prudential and reporting framework with AIFRS, unless there are strong prudential reasons for departure

Under this option, APRA would align its prudential and reporting framework with AIFRS, except where this would not be consistent with the intent and integrity of the prudential framework.  The major points of departure are:

Tier 1 capital

APRA would de‑couple the definition of capital instruments eligible for Tier 1 capital from Australian accounting standards.  This would allow certain instruments classified as liabilities under AIFRS to be included in capital for prudential purposes.  At the same time, APRA would more clearly specify the definitions of Tier 1 capital and bring the Tier 1 limits into line with the approach adopted for ADIs, clarify the loss absorption qualities applicable to eligible Tier 1 instruments and introduce more flexibility for general insurers to issue innovative instruments.

Securitised assets

APRA would de-couple the assessment of securitised assets of general insurers for capital adequacy purposes from the accounting treatment of these assets.

Fair value measurement

General insurers would be required to eliminate for regulatory capital purposes any unrealised fair value gains and losses arising from changes in their own creditworthiness.

Cash flow hedges

APRA would exclude cumulative gains and losses on cash flow hedges that are recognised directly in equity from the definition of Tier 1 and Tier 2 capital.

Property

APRA would introduce a consistent regulatory capital treatment for property not held at fair value.  An amount of 45 per cent of pre-tax revaluation reserves on property not held at fair value would be allowed in Upper Tier 2 capital.

Employer sponsored defined benefit superannuation funds

APRA would not recognise a defined benefit superannuation fund surplus as an asset for capital purposes, unless an employer sponsor is able to demonstrate unrestricted and unfettered access to the fund surplus in a timely manner.

APRA would revoke the current GPS 110 (and associated guidance notes) and determine a new GPS 110 under the Insurance Act 1973 to refine and clarify its capital requirements.  In addition, APRA would revoke the current GPS 120 and determine a new GPS 120 under the Insurance Act 1973 to refine the test for assets in Australia.  In particular, changes arising from Stage 2 reforms include:

• adjustments to the calculation of the Investment Risk Capital Charge, a component of the MCR;
• adjustments to the calculation of deductions from the capital base of general insurers; and
• refinement of the application of the assets in Australia test in GPS 120.

Further, the reporting framework would be amended to ensure alignment with the new requirements for capital and assets in Australia, as set out above.

APRA also considered a third option, which would be to amend the prudential and reporting framework to allow AIFRS to flow through fully.  This option would involve APRA amending its prudential and reporting framework so that it would reflect all changes associated with the adoption of AIFRS.  Given the existing differences between AGAAP and prudential reporting, this option would fundamentally change the calculation of the MCR and a general insurer’s capital base.   

The prudential and reporting framework would align with a general insurer’s general purpose financial reports. 

On the basis of a preliminary assessment, however, this option was dismissed as clearly not feasible or appropriate in the context of general insurers. Prudential reporting for general insurers was already divergent in significant respects from general purpose financial reporting before AIFRS adoption in contrast to the case for ADIs, where prudential reporting did not deviate too substantially from general purpose financial reporting prior to 1 January 2005.  Allowing AIFRS to flow through fully would mean that the entire process for calculating the MCR and the capital base would need to be revisited. APRA views the existing basis of prudential reporting as fundamental to a risk-based MCR and capital base calculation, the costs to the community of moving away from this basis, in terms of financial safety, would be significant. 

Impact analysis

Impact group identification

APRA anticipates that the following groups would be affected by amendments to the prudential and reporting framework for general insurers in light of the adoption of AIFRS:

• APRA;
• general insurers;
• policyholders; and
• external users of prudential data, including Government, the Australian Bureau of Statistics (ABS) and ratings agencies.

Assessment of costs and benefits

Neither APRA nor the industry has the data to perform a quantitative cost-benefit analysis.  The following analysis is based on APRA’s own assessments, taking into account information supplied by the industry.  Some general views on costs and benefits are discussed below but it is not possible to provide a quantitative estimate with any precision and any attempt to do so would be misleading.

The impact groups cannot be considered as mutually exclusive groups (except for external users of prudential data) because there are mechanisms to pass costs from one impact group to another.  Costs imposed on APRA are passed to general insurers via the levies imposed on general insurers to fund APRA. 

General insurers operate in a competitive market though certain lines of business in ‘niche’ segments may be subject to less competition.  Where costs are imposed on all general insurers equally there is potential for costs to be passed on to policyholders via increased premiums.  If some general insurers bear higher costs in complying with the enhanced capital requirements and satisfying the ‘assets in Australia’ test, the likely effect is that those costs will be retained by general insurers as the competitive environment they operate in would constrain their ability to pass these costs on.

Option 1: Maintain existing prudential and reporting framework to preserve AGAAP and not incorporate either AIFRS or Stage 2 reforms (status quo)

Benefit

APRA

APRA would incur no direct costs under this option, because changes would not be required to its existing prudential and reporting framework.  Since APRA’s regulatory capital requirements for general insurers would remain unchanged, the integrity of the prudential framework would be unaffected and beneficiaries would continue to receive the protection afforded by current levels of capital.  APRA would not incur the costs of introducing the new requirements under the Stage 2 reforms which would require some internal training and administration.

 Insurers

Maintaining the status quo would not require general insurers to revise existing prudential reporting systems in response to AIFRS.  This may reduce potential disruption to a general insurer who has already had to make significant system changes to accommodate new AIFRS general purpose financial reporting requirements. 

As regulatory capital requirements would remain unchanged, those general insurers that would have been affected by Stage 2 reform proposals would not incur the costs outlined in Option 2 below. 

The need to commit additional resources for training, documentation, business strategy and reporting would be avoided as the prudential and reporting framework would remain unchanged.

Policyholders

As noted above, policyholders would continue to receive the same levels of prudential protection afforded under the existing regime.  There is no benefit to policyholders under this option beyond the benefits offered by the current prudential framework.

External users of prudential data

As the basis for APRA's published data would be unchanged under this option, users would not incur costs associated with revising their analytical reports.  Users would also not have to familiarise themselves with new APRA reports.

Costs

One-off and ongoing costs would differ in quantum, nature and frequency for the different impact groups under this option. In many instances, quantification of impacts would be unreliable.  In these situations, APRA has instead illustrated the effects in qualitative terms. 

APRA

APRA would unlikely incur any direct costs, since the existing prudential and reporting framework would remain unchanged.  However, it is likely that significant ongoing indirect costs may result from not being able to achieve the benefits envisaged under Option 2.  For example, APRA would not be able to improve the targeting of its supervisory resources because the MCR would not be made more sensitive to the risks faced by general insurers.

Insurers

As pointed out above, there was already a significant divergence between prudential reporting and financial reporting for general insurers prior to 1 January 2005.  Maintaining the status quo would, therefore, involve greater differences between prudential reporting and financial reporting under AIFRS, leading to a significant administrative burden on general insurers in having to continue to comply with two very divergent reporting frameworks.  General insurers would have a one-off build cost to differentiate prudential reporting from AIFRS and incur ongoing maintenance costs for this dual reporting environment.  In addition, general insurers would incur increased costs associated with compliance, audit and accounting controls.  APRA believes that one-off costs may be material to an entity but that ongoing costs would only be marginal in comparison to an entity’s current operating costs.  However, the quantum of these costs would depend on the unique circumstances of each general insurer. 

The requirement to complete two sets of reports would raise the possibility of confusion for those in the general insurer responsible for preparing the reports.  As a result, the general insurer may incur significant one-off training costs.

Maintaining the current ‘assets in Australia’ test without the proposed refinements would mean that general insurers may incur administrative costs in consulting APRA in attempting to apply the current GPS 120 without the refinements.  The same would be true for the current reporting requirements if certain reporting forms and instructions were left unclarified.

Policyholders

There is potential for general insurers to pass on the costs identified above as these costs would be incurred by the whole industry and would affect cost bases in similar ways. 

Policyholders would not benefit from the greater security in claims payments which would result from the implementation of Stage 2 reforms.

External users of prudential data

As explained above, there was already a significant divergence between prudential reporting and financial reporting for general insurers prior to 1 January 2005.  This option would involve greater differences between prudential reporting and financial reporting.  Users of prudential data would have to incur training costs to understand the differences and how they impact on the data being used. 

The data collected by APRA may also be inappropriate for the purposes of the ABS since the data would be based on the superseded AGAAP accounting standards.  This would result in additional one‑off and ongoing costs associated with the need to manipulate the data from APRA, and could reduce the consistency of ABS reports.

Option 2: Align the prudential and reporting framework with AIFRS, unless there are strong prudential reasons for departure

Benefits

APRA

Under this option, APRA would align its prudential and reporting framework as closely as possible with AIFRS, except where this would not be consistent with the intent and integrity of the prudential framework.  The major points of departure were summarised above. 

This option would allow APRA to meet its objective of basing its prudential and reporting framework on AIFRS, while maintaining a sound and robust prudential and reporting framework that meets both its statutory objectives and recognises the realities of the general insurance industry.  The minimisation of differences between financial and prudential reporting would reduce the need for industry to consider, and APRA supervisors to deal with, differences in the APRA reporting framework.  Proposed changes to reporting requirements would result in a more refined and efficient reporting process which would reduce the costs to APRA of having to clarify parts of forms or instructions. 

With a reduction in the need to divert supervisory resources to interpretation, this option would lead to better targeting of supervisory resources in the general insurance industry.  Adjustments to a general insurer’s capital base, in the form of changes to Tier 1 capital and to deductions from Tier 1 capital, would provide a more appropriate measure of regulatory capital.  Adjustments to MCR components, in particular the Investment Risk Capital Charge, would ensure that a general insurer’s capital base more accurately reflects the level of risk to which the insurer is exposed.  Adjustments to deductions from Tier 1 capital would also provide incentives for general insurers to manage their business more prudently, obviating the need for APRA to engage in supervisory action to achieve the same outcome.  Proposed refinements to GPS 120 to clarify the assets in Australia test would reduce the need for general insurers to liaise with APRA when applying the test, freeing-up APRA resources as a consequence. 

Insurers

This option would ensure that general insurers would be able to continue operating in a sound regulatory environment, enhancing public confidence in the prudential regime.  It would also reduce the burden of reporting to APRA.  While general insurers had to deal with financial and prudential reporting frameworks which diverge in significant respects prior to 1 January 2005, bringing the frameworks closer together would enable general insurers to avoid the higher costs described under Option 1.

This option would also allow general insurers to issue hybrid capital instruments, the features of which lower the cost of raising capital.  To date, general insurers have not issued a significant amount of hybrid capital instruments as they have not required additional capital resources beyond that grown through profits. Since the revised prudential regime was put in place in 2002, profits have been sufficient to fund both growth and the strengthening of capital resources.  This position cannot be guaranteed, and allowing hybrid capital instruments to be counted as a form of Tier 1 capital would enable general insurers to reduce their cost of capital when future needs for additional capital arose.

A more risk-based capital base would also mean the lower likelihood of a general insurer holding excessive capital which might adversely affect its investment policy and development. 

Policyholders

Policyholders would benefit from the protection of a sound and robust prudential framework that has dealt with the main adverse impacts of AIFRS. 

In relation to Stage 2 reforms, the more appropriate calculation of the capital base and of the MCR would strengthen the ability of general insurers to meet policyholder claims.  This would reduce the risk of failure and give policyholders greater confidence in the financial soundness and stability of general insurers. 

Refinements to the ‘assets in Australia’ test would serve to enhance the position of policyholders in Australia if a general insurer were to go into liquidation.

External users of prudential data

As the prudential and reporting framework would be more in line with AIFRS, external users of APRA’s prudential data would avoid the training costs of understanding the effect of further divergences in reporting frameworks.

Costs

One-off and ongoing costs would differ in quantum, nature and frequency for the different impact groups under this option.  In many instances, quantification of impacts would be unreliable.  In these situations, APRA has instead illustrated the effects in qualitative terms. 

APRA

APRA would incur one-off costs associated with amending the prudential and reporting requirements to incorporate the points of departure from AIFRS.  This option would involve one-off costs in training for APRA staff to ensure that the new requirements are appropriately applied.  These costs would be easily absorbed in APRA’s current budget.  The time spent on this training would simply divert resources being used to train staff on existing requirements.  New and existing staff can be trained at the same time to apply the new requirements.

Implementing the proposed changes for the Stage 2 reforms would impose only minimal additional costs on APRA.  APRA would use existing resources to train supervisory staff to implement the revised framework.  Frontline supervisors may be required to expend some effort to administer the transition by general insurers to the new standards and, for a short period, to respond to a likely higher number of queries from regulated entities.  This one-off cost will divert existing supervisory resources but no additional resources would be employed as a result.

The additional supervisory effort required for monitoring compliance with the new requirements will be built into APRA’s existing supervisory methodology and review processes. 

Insurers

Under this option, general insurers would incur additional one-off costs associated with compliance with APRA’s new requirements, including staff training, amendments to information systems and changes to procedures and controls.  APRA believes that the costs associated with this option will be significantly less than under Option 1, because general insurers would only have to supplement their information systems in those areas where the reporting framework diverges from AIFRS.

In the case of the Stage 2 reforms, changes in deductions from Tier 1 capital would affect only those general insurers which are not achieving contract certainty in reinsurance arrangements.  Also, adjustments to MCR are likely to have little or no impact on most general insurers.  For those insurers which have structured their business in a way that exposes them to higher risk than indicated by their current MCR, the adjustments would have some impact.  The refined ‘assets in Australia’ test would not require general insurers to acquire more assets to satisfy the test but merely to change the form in which assets are held; any resulting costs would be minor.

Policyholders

Policyholders would only incur direct costs if general insurers increased premiums to offset the expense of complying with the new requirements.  Even if general insurers did so, compliance costs are a small part of a general insurer’s overall costs and the impact on premiums would be negligible.  Those general insurers that need to incur more substantial costs than others would be placed at a competitive disadvantage if they chose to pass on any significant costs. 

This option would also provide offsetting cost savings for general insurers, as outlined above.  Hence, the net effect of this option could be a reduction in overall costs for general insurers.

For those reasons, APRA does not expect premiums to increase in a material way, if at all, if this option were to be implemented.  Further, the compliance costs involved are likely to be one-off and are less likely to be passed on to policyholders compared to ongoing costs.

External users of prudential data

External users of prudential data would have to expend some effort in understanding the changes made.  However, the benefits of narrowing the differences between the financial reporting and prudential reporting frameworks would significantly offset any new costs.

Consultation

APRA undertook extensive consultation on its approach to AIFRS across the ADI and general insurance industry over an 18-month period.  This extensive consultation process was aimed at ensuring that APRA’s approach to AIFRS would maintain the integrity of the prudential regime, was communicated clearly to industry and took into account practical implementation issues.

Five public consultation papers on AIFRS were released over an 18-month period:

• November 2004: Adoption of IFRS – Prudential Implications provided an overview to assist APRA-regulated institutions in assessing the prudential impact and associated risks of IFRS;
• February 2005 – Adoption of International Financial Reporting Standards: Prudential Approach 1. Fair value and other issues outlined how APRA proposed to address the prudential implications of a number of specific AIFRS-related changes;
• August 2005 - Adoption of International Financial Reporting Standards: Prudential Approach 2. Tier 1 Capital and Securitisation; dealt with the treatment of eligible Tier 1 capital instruments and securitisation in the context of AIFRS;
• November 2005 – Response to Submissions: Adoption of International Financial Reporting Standards Prudential Approach 1. Fair Value and Other Issues addressed issues raised by respondents on APRA’s proposed prudential approach to fair value and other AIFRS issues.  This paper was accompanied by draft prudential standards, guidance notes and reporting standards for ADIs which provided details of the proposed changes, with indications of the changes that would be introduced for general insurers; and
• April 2006 – Response to Submission: Adoption of International Financial Reporting Standards: Prudential Approach 2. Tier 1 Capital and Securitisation addressed issues raised by respondents on APRA's proposed prudential response concerning Tier 1 capital and securitisation.  This paper was also accompanied by draft prudential standards and guidance notes for ADIs detailing the proposals, with an indication that similar changes would be introduced for general insurers.

The detailed feedback received from industry was particularly useful in ensuring that APRA’s approach to AIFRS was appropriate to the realities of industry.  Industry generally supported APRA’s proposal to de-couple the definition of capital instruments eligible for Tier 1 capital as well as securitisation transactions from the AIFRS treatment.   At the same time, it raised issues about APRA's proposed changes to the limits on Tier 1 capital and about the detail of some of the draft requirements.  APRA considered these issues in the development of the final requirements.  Submissions also made additional proposals on certain items, which were accepted by APRA. 

In addition, APRA consulted on changes to the prudential and reporting framework for general insurers with the Insurance Council of Australia (ICA) which referred the matter to a working party of insurance company representatives.  ICA made comments relating to technical issues arising under GPS 110, which APRA has taken into account in finalising GPS 110. 

APRA has also undertaken a comprehensive and rigorous program of consultation with industry on its Stage 2 reforms since the release of the initial discussion paper in November 2003 (Prudential Supervision of General Insurance: Stage 2 Reforms).  A further discussion paper outlining proposed changes to requirements on capital adequacy and assets in Australia was issued in October 2005 (Prudential Supervision of General Insurance – Stage 2 Reforms: Capital, Assets in Australia and, Custodian Requirements) along with draft prudential standards.  Ten submissions were received in response to this discussion paper.  The general insurance industry was generally supportive of the changes proposed, but made a number of technical suggestions for amendments to certain items, which were considered by APRA. 

After reviewing the submissions, APRA developed revised drafts of the prudential standards and undertook further consultation with the ICA.  Further comments from the ICA were considered by APRA in finalising the revised standards.

APRA undertook public consultation on the proposed changes to reporting requirements. In May 2006 it issued a consultation paper (Proposed Changes to General Insurance Reporting Framework to be Effective from 1 January 2007) outlining the changes, along with draft updated forms and instructions.  APRA will take into account the technical comments received.

Conclusion and recommended option

Option 2 is the preferred option

Option 2 most effectively meets APRA’s objectives.  APRA believes that this option would result in a more robust prudential regime that better protects the interests of policyholders.  It is a measured approach that ensures that APRA aligns its prudential and reporting framework closely with AIFRS. This would minimise the differences between financial and prudential reporting and, consequently, the dual reporting burden for a general insurer, while ensuring that there are no substantial adverse prudential implications for a general insurer’s capital base.  Option 2 contemplates the future issuance by general insurers of hybrid capital instruments and allows such instruments to be counted as a form of Tier 1 capital.  This should  reduce the cost of capital for general insurers when they need to raise capital.  In APRA’s view, this benefit outweighs the additional administrative costs that general insurers would incur under Option 2.

Adjustments to the way in which a general insurer’s capital base and MCR is calculated would ensure that a general insurer’s regulatory capital more accurately reflects the level of risk to which the insurer is exposed.  It would also enable better targeting of supervisory resources by APRA, resulting in more efficient and effective supervision.  APRA believes that this increase in the quality of supervision also outweighs the additional administrative costs under Option 2.

The refinements to capital requirements proposed in Option 2 would increase the likelihood of policyholder claims being met by general insurers under a wide range of circumstances, particularly in situations of financial distress.   It would ensure that general insurers can continue operating while unanticipated problems are being addressed and resolved.    Option 2 also provides incentives for general insurers to manage their business more prudently.  These also lower the risk of failure of general insurers and engender confidence in the financial soundness and stability of the general insurance industry.  The refinement of the ‘assets in Australia’ test would create greater certainty that there are assets available for distribution to policyholders in the event of a general insurer being placed into liquidation. 

At the same time, a more risk-based capital base would also make it less likely that a general insurer held excessive capital which may hinder its investments and development.  Tier 1 capital changes would also ensure a lower cost of capital for general insurers by allowing them to issue hybrid capital instruments when the need to raise capital arises. 

These various benefits would, in APRA’s view, also outweigh the additional costs to APRA under Option 2, compared to Option 1. These costs, involve the commitment of APRA’s resources to amending the current and reporting framework and to training staff to ensure that the new requirements are appropriately applied.

Option 1 does not meet APRA’s stated objectives.  General insurers would not incur the costs of implementing Option 2 but also would not receive the indirect benefits it provides.  As explained above, there was already a significant divergence between prudential reporting and financial reporting for general insurers prior to 1 January 2005.  Option 1 would impose a significant administrative burden on general insurers in having to comply with two reporting regimes that would be even more divergent.  The consequence for general insurers would be increased costs associated with compliance, audit and accounting controls and the possibility of confusion for those responsible in preparing APRA reports unless comprehensive training is provided. 

While current capital requirements provide strong protection to policyholders, Option 1 retains existing inefficiencies in the application of both GPS 110 and GPS 120 and does not provide the various benefits associated with Stage 2 reforms, as discussed above.

Implementation and review

Changes to APRA’s prudential and reporting framework to incorporate its approach to AIFRS, and Stage 2 reforms relating to capital requirements and assets in Australia, are intended to take effect from 1 January 2007.  Transition arrangements will be available for all general insurers affected by the changes. 

APRA will provide guidance and clarification to general insurers to ensure that they are aware of the requirements that they need to meet and the implementation process.  Final reporting standards for general insurers are intended for release in the third quarter of 2006 and will apply to regulatory returns for reporting periods ending after 1 January 2007. 

The prudential and reporting framework for general insurers will be subject to ongoing review and amendments will be made where warranted, and after industry consultation.

[1] This is covered by a separate Regulation Impact Statement addressing the changes proposed to the prudential and reporting framework for authorised deposit-taking institutions.

[2]  Prudential Standard GPS 220 Risk Management, Prudential Standard GPS 230 Reinsurance Management and Prudential Standard GPS 310 Audit and Actuarial Reporting and Valuation which have been dealt with by separate Regulation Impact Statements.

[3]  Refer GPS120

[4] The MCR is the required minimum level of capital which every general insurer must hold to ensure that it maintains sufficient capital to enable its insurance obligations to be met under a wide range of circumstances.

[5] Section 28 of the Insurance Act 1973 gives APRA the ability to determine, via a prudential standard, that assets which might otherwise qualify at law as being assets in Australia will not be regarded as such.