Transitional Prudential Standard GPS 900

Early Approvals of Auditors and Actuaries

Transitional Prudential Standard

1. This Standard is made under Item 3 of Schedule 2 to the GI Reform Act and section 32 of the new Insurance Act.

Commencement

2.             This Standard comes into effect on the day it is determined.[1]

Application

3.             This Standard applies to a body corporate (“the insurer”) which:

(a)          intends to become authorised as a general insurer under Part III of the new Insurance Act; and

(b)         in preparation for that, wishes to:

(i)           appoint, before 1 July 2002, an auditor and/or an actuary under section 39 of the new Insurance Act and Item 3 of Schedule 2 to the GI Reform Act (“Item 3”); and

(ii)        have such an appointment approved by APRA, before 1 July 2002, under section 40 of the new Insurance Act and Item 3,

on the basis that the appointment, or appointments, are to take effect on or after 1 July 2002.

Early appointment

4.             An insurer may appoint an Approved Auditor and/or an Approved Actuary, prior to 1 July 2002, in accordance with this Transitional Prudential Standard. 

5.             A person can only hold such an appointment if they have first been  approved by APRA in accordance with paragraphs 6 to 10 below.[2]

The early approval process

6.             The new Insurance Act requires that APRA approve the insurer’s appointment of an auditor and actuary.  For this purpose, an application for approval of an auditor or actuary must be submitted in writing by the insurer to APRA.  An application must include the following details:

(a)          the name, address and telephone number of the person to be appointed;

(b)         whether the person is an employee of the insurer, or if not, the name of any firm that the person is an employee or partner of;

(c)          details on the eligibility criteria set out in paragraph 8 below;

(d)         details on the criteria for fitness and propriety set out in paragraph 16 below;

(e)          a statement of the pecuniary interests which the person, or a related person, has in the insurer, or a related body corporate of the insurer, for instance:

(i)           a security in, or contract with, the insurer or a related body corporate; and

(ii)        the receipt of any remuneration, specified by type of service, from the insurer or a related body corporate.

A related person of the Approved Auditor or Approved Actuary means a spouse, or a dependent child, or a business partner, or an employer (other than the insurer), or a firm of which the Approved Auditor or Approved Actuary is a director or partner.

(f)           in the case of a proposed Approved Auditor, an attestation from the auditor that he/she complies with Statement of Auditing Practice AUP 32 “Audit Independence”.  Where there is non-compliance, details of that must be provided.

7.             In addition, the proposed Approved Auditor or Approved Actuary must provide APRA with a written undertaking that he or she will perform his or her functions in accordance with all prudential requirements issued by APRA and standards issued by relevant professional bodies.

Eligibility criteria for Approved Auditors and Approved Actuaries

8.             In addition to the general requirements of fitness and propriety outlined in paragraph 16, APRA can only approve the appointment of an Approved Auditor and Approved Actuary if the person concerned meets the following eligibility criteria:[3]

(a)          the person has appropriate formal qualifications and is a member of a suitable professional body; 

(b)         the person has a minimum of 5 years’ experience in the general insurance industry; and

(c)          the person is ordinarily resident in Australia.

9.             APRA may approve individuals, on a case-by-case basis, who do not meet the eligibility criteria in paragraph 8 if the insurer can demonstrate to the reasonable satisfaction of APRA that exceptional circumstances exist as to why the person should be approved as an Approved Auditor or Approved Actuary.

10.        Reflecting the importance of the positions, and in order to demonstrate independence and avoid potential conflicts of interest, a person is not eligible to be appointed as both an Approved Auditor and Approved Actuary to the same insurer.

Fitness and Propriety

11.        Insurers must ensure that Approved Actuaries and Approved Auditors have the degree of probity and competence commensurate with their responsibilities. 

12.        For this purpose, insurers should have in place policies and procedures to address fitness and propriety.  These policies and procedures should at a minimum address the criteria for fitness and propriety that APRA uses to assess fitness and propriety set out in paragraph 16. 

13.        Insurers must assess proposed and existing Approved Auditors and Approved Actuaries, and must notify APRA immediately if an Approved Auditor or Approved Actuary no longer complies with the tests of fitness and propriety established by the insurer.

14.        APRA may conduct a review of the fitness and propriety of an individual.  Where APRA conducts such a review, APRA will allow access to the information collected as part of the review where the provider of the information has granted permission for the information to be released.  APRA will not release information where it is prohibited from doing so under any agreement with the provider of the information or under any law.

15.        The criteria for fitness and propriety[4] are as follows:

(a)          the person has not been convicted of an offence against or arising out of the Insurance Act or the Financial Sector (Collection of Data) Act 2001;

(b)         the person has not been convicted of an offence against or arising out of a law in force in Australia, or the law of a foreign country, if

the offence concerns dishonest conduct or conduct relating to a financial sector company within the meaning of the Financial Sector (Shareholdings) Act 1998;

(c)          the person has never been bankrupt, has not applied to take the benefit of a law for the relief of bankrupt or insolvent debtors, or has not compounded with his or her creditors;

(d)         the person has no actual or potential conflicts of interest that are likely to influence their ability to carry out their role and functions with appropriate probity and competence;

(e)          the person has adequate experience and demonstrated competence and integrity in the conduct of business duties;[5] 

(f)           the person is not of bad repute within the business and financial community;

(g)         in the case of an Approved Auditor:

(i)           the person is not a director or employee of the insurer or of a related body corporate within the meaning of section 50 of the Corporations Act 2001; and

(ii)         the person is registered as an auditor under the Corporations Act 2001;

(h)         in the case of an Approved Actuary, the person is not the Chief Executive or a director of the insurer, or of a related body corporate within the meaning of section 50 of the Corporations Act 2001 (except where that related body corporate is a subsidiary of the insurer).

Revocation of approval and disqualification

16.        APRA may revoke the approval of a person’s appointment as an Approved Auditor or Approved Actuary,[6] and disqualify a person from holding an appointment as an Approved Auditor or Approved Actuary,[7] where APRA finds that the person:

(a)          has failed to perform adequately and properly the functions and duties of such an appointment; or

(b)         otherwise does not meet one or more of the criteria for fitness and propriety; or

(c)          does not meet the eligibility criteria for such an appointment.

17.        An individual affected by a decision made by APRA referred to in paragraph 17 may request that APRA review that decision.  If APRA confirms or varies the decision, or fails to do either within 21 days, the person affected may then make an application to the Administrative Appeals Tribunal.  The appeal process is set out in Part VI of the new Insurance Act.

Prudential Standard GPS 110

Capital Adequacy for General Insurers

Prudential Standard

1. This Prudential Standard, made under section 32 of the Insurance Act 1973 (the Act), applies to all general insurers authorised under the Act.
2. As a consequence of the key role played by capital in the financial health of an insurer, APRA requires that each insurer maintain sufficient capital to enable its insurance obligations to be met under a wide range of circumstances.  This required level of capital for regulatory purposes is referred to as the Minimum Capital Requirement (MCR).

Definition of Capital Base

3.             In assessing the adequacy of an insurer’s capital resources, attention must be paid not only to the types of events or problems that it might encounter, but also the quality of the support provided by various types of capital instruments.  The following matters are relevant to whether a capital instrument is adequate for supervisory purposes, namely the extent to which each instrument:

(a)          provides a permanent and unrestricted commitment of funds;

(b)         is freely available to absorb losses from business activities;

(c)          does not impose any unavoidable servicing charges against earnings; and

(d)         ranks behind the claims of policyholders and other creditors in the event of the winding-up of the insurer.

4.             Not all types of capital instruments meet these criteria equally.  Due to the need to ensure that the capital base of an insurer provides adequate support, APRA imposes some restrictions on the composition of capital eligible to meet the MCR.  The capital instruments deemed eligible for inclusion in an insurer’s capital base, and the conditions as to their inclusion, are outlined in Guidance Note GGN 110.1 Measurement of Capital Base.

5.             An insurer’s balance sheet may contain certain assets - such as future income tax benefits, goodwill and other intangibles - that are acceptable from an accounting perspective, but for supervisory purposes are either generally not available, or of questionable value, should the insurer encounter difficulties.  Insurers are therefore required to deduct from eligible capital any holdings in these types of assets.  Details of these deductions are provided in Guidance Note GGN 110.1.

6.             An insurer must, at all times, hold eligible capital (after deductions) in excess of its MCR.  Where an insurer proposes any reduction in its capital, it must obtain APRA’s prior written consent - see Guidance Note GGN 110.1.

Minimum Capital Requirement (MCR)

7.             An insurer’s capital resources must be adequate for the size, business mix and complexity of its business.  To this end, APRA adopts a risk-based approach to the measurement of capital adequacy of all insurers.  The MCR is intended to be broadly commensurate with the full range of risks to which an insurer is exposed (including risks relating to insurance claims, investments, counterparty default, asset-liability mismatches, catastrophes, and operational errors and problems).

8.             The MCR may be determined using either:

(a)          an internal model developed by the company to reflect the circumstances of its business  Internal Model Based (IMB) Method;[8]

(b)         the standardised framework detailed in this Standard and accompanying Guidance Notes – the Prescribed Method;  or

(c)          a combination of (a) and (b) as appropriate to the mix of business of the company.

9.             Regardless of the outcome of calculations made under paragraph 8, an insurer’s MCR cannot be less than $5 million.

10.        It is recognised that any measure of the adequacy of an insurer’s capital involves considerable judgement and estimation, and requires the quantification of risks even where it is extremely difficult to do so.  As a result, APRA may adjust an insurer’s MCR where it believes that the amount determined under this Standard does not adequately reflect the risk profile of an individual insurer.[9]  That is, an individual insurer may be required by APRA to maintain a specified level of eligible capital in excess of that calculated using one of the risk measurement methodologies outlined in paragraph 8.  This might be the case, for example, for a newly established insurer, an insurer that has encountered financial or operational difficulties, or for an insurer that is deemed by APRA to have a disproportionate exposure to a particular type of risk.

11.        In the normal course of business, an insurer must have in place capital management processes to monitor and ensure its continual compliance with the MCR.  These processes should be consistent with the insurer’s overall business plan and must include actions and procedures to avert any breaches of the MCR.

(i) Internal Model Based Method

12.        Insurers with sufficient resources are encouraged to develop an in-house capital measurement model to calculate the MCR.  Use of the IMB Method will be conditional on APRA’s and the Treasurer’s prior approval[10] and will require insurers to satisfy a range of criteria, as detailed in Guidance Note GGN 110.2 Internal Model Based Method.  As is the case for Prudential Standards covering other supervised industries, APRA must be satisfied that the insurer’s capital calculation methodology is suitably rigorous and broadly consistent with comparable segments of the industry.  Insurers unable or unwilling to develop a model that meets the criteria specified by APRA must use the Prescribed Method outlined below.

(ii) Prescribed Method

13.        For insurers using the Prescribed Method, the MCR will be determined as the sum of the capital charges for:

(a)          insurance risk;

(b)         investment risk; and

(c)          concentration risk.

- Insurance Risk

14.        The Insurance Risk Capital Charge is in response to the risk that the true value of net insurance liabilities could be greater than the value determined under Prudential Standard GPS 210 Liability Valuation.  The methodology for determining the Insurance Risk Capital Charge is set out in Guidance Note GGN 110.3 Insurance Risk Capital Charge.

15.        The capital charge has two components: a charge in respect of outstanding claims risk; and a charge in respect of premiums liability risk.  The capital charge for outstanding claims risk is in response to the risk that the true value of the outstanding claims liabilities could be greater than the value determined under GPS 210.  The capital charge for premiums liability risk is in response to the risk that premiums relating to

post calculation date exposures, including premiums written after the calculation date, could be insufficient to fund the liabilities arising from that business.

16.        The Outstanding Claims Capital Charge is determined as the sum, over all classes of business of the insurer, of the value of the net outstanding claims liabilities for each class (determined using GPS 210), multiplied by the appropriate Outstanding Claims Capital Factor for that class.

17.        The Premiums Liability Capital Charge is determined as the sum, over all classes of business of the insurer, of the net premiums liabilities for each class (determined using GPS 210), multiplied by the appropriate Premiums Liability Capital Factor for that class.

- Investment Risk

18.        The capital charge for investment risk is in response to the risk of an adverse movement in the value of an insurer’s assets and/or off-balance sheet exposures.  Investment risk can be derived from a number of sources, including market risk and credit risk.  The methodology for determining the Investment Risk Capital Charge is set out in Guidance Note GGN 110.4 Investment Risk Capital Charge.

19.        Subject to paragraphs 20 to 22, the Investment Risk Capital Charge is determined as the sum, across all assets and certain off-balance sheet exposures, of the value of each investment multiplied by the relevant Investment Capital Factor for that investment.  For the purposes of this Standard, assets and exposures should be valued according to Australian Accounting Standards.

20.        The capital charge may be adjusted to recognise any reduction in investment risk arising from the availability of risk mitigants (eg collateral security or guarantees), subject to the criteria detailed in Guidance Note GGN 110.4.

21.        An insurer may be required to hold additional capital, in the form of a capital charge for Investment Concentration Risk, if its exposure to a particular asset or counterparty exceeds the thresholds set out in Guidance Note GGN 110.4.

22.        In certain circumstances, an insurer may choose to hold assets in a special purpose vehicle, rather than on its own balance sheet. APRA may allow the insurer to “look through” the legal structures involved, and determine its Investment Risk Capital Charge (and any Investment Concentration Capital Charge) based on the individual assets of the special purpose vehicle, rather than simply on its direct exposure to the entity.  APRA will have regard to the criteria outlined in paragraph 9 of GGN 110.4 in exercising this discretion.

- Concentration Risk

23.        The capital charge for concentration risk is in response to the risk associated with an accumulation of exposures to a single catastrophic event.  The methodology for determining the capital charge is set out in Guidance Note GGN 110.5 Concentration Risk Capital Charge.

24.        The Concentration Risk Capital Charge is set equal to the insurer’s Maximum Event Retention.  APRA intends to monitor an insurer’s calculation of its Maximum Event Retention and may require adjustments to be made to the calculation where APRA is not satisfied with the methodologies and/or assumptions used.

Foreign Insurers

25.        By the nature of its Australian balance sheet, a foreign-incorporated insurer authorised under the Act to operate in Australia as a branch (a foreign insurer) will not typically have capital instruments of the type specified in Guidance Note GGN 110.1.  Foreign insurers are nevertheless required to meet a variant of the MCR.  Specifically, foreign insurers are required to maintain assets in Australia[11] in excess of their liabilities in Australia, of an amount at least equal to the MCR determined by this Standard.

26.        Further detail regarding the treatment of foreign insurers can be found in GPS 120 Assets in Australia.

Disclosure

27.        Disclosure and transparency are important allies of the supervisor.  To improve policyholder and market understanding of its capital adequacy position, an insurer should disclose, in its published annual accounts, the following items:

(a)          the amount of eligible Tier 1 capital, with separate disclosure of each of the items specified in GGN 110.1;

(b)         the aggregate amount of any deductions from Tier 1 capital;

(c)          the amount of eligible Tier 2 capital, with separate disclosure of each of the items specified in GGN 110.1;

(d)         the aggregate amount of any deductions from Tier 2 capital;

(e)          the total capital base of the insurer derived from the items (a) to (d);

(f)           the MCR of the insurer;  and

(g)         the capital adequacy multiple of the insurer (item (e) divided by (f)).

Guidance Note GGN 110.1

Measurement of Capital Base

1. An insurer must maintain a capital base sufficient to enable its insurance obligations to be met under a range of circumstances.  In particular, an insurer must maintain, at a minimum, a capital base in excess of its Minimum Capital Requirement (MCR) at all times.  This Guidance Note sets out the range of capital instruments that are eligible for inclusion in the capital base of an insurer.
2. An insurer is advised to consult APRA in advance of issuing any capital instrument (whether that instrument is to be issued by the insurer, or through an associate or special purpose vehicle) in order to avoid any dispute over eligibility.
3. The definitions and the qualifying criteria detailed in this Guidance Note are applicable to all locally-incorporated insurers.  As outlined in paragraph 25 of GPS 110 Capital Adequacy, a different measure of capital adequacy applies to foreign-incorporated insurers operating in Australia as branches (foreign insurers).  This reflects the nature of a foreign insurer’s Australian balance sheet, which does not generally include separately identifiable capital instruments.

Capital Base

4.             Capital, for supervisory purposes, is considered in two tiers.  Tier 1, or core capital, comprises the highest quality capital elements that fully meet all the essential characteristics of capital described in paragraph 3 of GPS 110.  Tier 2, or supplementary capital, includes other instruments that, to varying degrees, fall short of the quality of Tier 1 capital but nonetheless contribute to the overall financial strength of an insurer.

5.             A locally-incorporated insurer’s capital base is defined as the sum of Tier 1 and Tier 2 capital, less the deductions specified below.  An insurer must ensure that its capital base exceeds its MCR, as defined under GPS 110, at all times.  An example illustrating the calculation of an insurer’s capital base is included as Attachment 1.

Tier 1 Capital

6.             Tier 1 capital comprises the highest quality capital elements, including the proceeds of instruments that are both permanent and non-cumulative in nature.  Tier 1 capital (net of deductions set out in paragraph 18 below) must constitute at least 50% of an insurer’s capital base.[12]

7.             Tier 1 capital comprises:

(a)          paid-up ordinary shares;

(b)         general reserves;

(c)          retained earnings;

(d)         current year’s earnings net of expected dividends and tax expenses;

(e)          technical provisions in excess of those required by GPS 210 Liability Valuation;[13]

(f)           non-cumulative irredeemable preference shares; and

(g)         other “innovative” capital instruments (issued by the insurer or through special purpose vehicles).

8.             Items (a) to (e) in paragraph 7 may be included as part of the insurer’s capital base without the need for APRA’s prior approval.  If an insurer wishes to have instruments covered by items (f) and (g) of paragraph 7 included in its Tier 1 capital, this will require APRA’s approval.  APRA may revoke its approval in relation to an instrument if it becomes aware that the instrument does not meet the relevant criteria.

9.             A capital instrument is not eligible for inclusion in Tier 1 capital to the extent that its inclusion will result in the aggregate amount of items (f) and (g) in paragraph 7 exceeding 20% of aggregate Tier 1 capital (before deductions).  Any amount ineligible for inclusion as Tier 1 capital as a result of this limit will be eligible for inclusion as Upper Tier 2 capital. 

10.        Unless otherwise approved by APRA, an insurer’s total servicing obligations on Tier 1 capital instruments must not exceed the insurer’s after-tax earnings in the year to which they relate.  That is, there should be no dividend or interest payments out of retained earnings without APRA’s prior approval (see paragraphs 20-22).

Tier 2 Capital

11.        Consistent with paragraph 6, Tier 2 capital is limited to a maximum of 100% of an insurer’s Tier 1 capital (net of deductions).

12.        Tier 2 capital consists of instruments that, to varying degrees, fall short of the quality of Tier 1 capital but nonetheless contribute to the overall strength of an insurer.  Such instruments include some forms of hybrid capital instruments that have the characteristics of both equity and debt.  Tier 2 capital is divided into Upper Tier 2 and Lower Tier 2 capital.

13.        Upper Tier 2 instruments include:

(a)          cumulative irredeemable preference shares;

(b)         mandatory convertible notes and similar capital instruments;

(c)          perpetual subordinated debt;  and

(d)         any other hybrid (debt/equity) capital instruments of a permanent nature (eg capital amounts that are ineligible for inclusion as Tier 1 capital as a result of the limit referred to in paragraph 9.)

14.        Lower Tier 2 instruments include:

(a)          term subordinated debt;

(b)         limited life redeemable preference shares; and

(c)          any other similar limited life capital instruments.

15.        All capital instruments that an insurer wishes to include in Tier 2 capital will require APRA’s approval.  APRA may revoke its approval in relation to an instrument if it becomes aware that the instrument does not meet the relevant criteria.

16.        A capital instrument is not eligible for inclusion in Tier 2 capital to the extent that its inclusion will result in the aggregate amount of Lower Tier 2 capital exceeding 50% of eligible Tier 1 capital (net of deductions).

17.        Capital instruments with a limited life (ie Lower Tier 2 Capital) must have an original maturity greater than 5 years.  These instruments will also be subject to amortisation over the last four years of their life according to the following schedule:

Deductions from an Insurer’s Capital Base

(i) Deductions from Tier 1 Capital

18.        The amount of Tier 1 capital to be included in an insurer’s capital base will be net of the following deductions:

(a)          goodwill;

(b)         other intangible assets; and

(c)          future income tax benefits (net of provisions for deferred income tax liabilities).[14]

(ii) Own Instrument Purchases

19.        An insurer may not, without obtaining APRA’s prior approval, enter into an arrangement where it may purchase, or provide financial assistance with a dominant purpose of facilitating the purchase by another party of, its own Tier 1 or Tier 2 capital instruments.  Any such purchases will be subject to a limit agreed with APRA.  APRA will require an amount of capital equal to that limit to be deducted from Tier 1 or Tier 2 capital as appropriate (depending on whether the prospective purchases relate to Tier 1 or Tier 2 capital instruments). 

Reductions in Capital

20.        A reduction in an insurer’s capital includes, but is not limited to: share buybacks; the redemption, repurchase or early repayment of any eligible capital instruments issued by the insurer or a special purpose vehicle; trading in own shares (see paragraph 19); or where aggregate interest and dividend payments on Tier 1 capital exceed the insurer’s after-tax earnings in the year to which they relate (ie dividend and interest payments on Tier 1 capital wholly or partly funded from retained earnings). 

21.        An insurer must seek APRA’s prior approval before making a reduction in its capital base.  APRA’s approval may be subject to conditions.

22.        Where APRA’s prior approval is required under paragraph 21, the insurer should provide APRA with a capital plan extending for at least two years.  The insurer will need to satisfy APRA, on the basis of the capital plan provided, that the company’s capital base after the proposed reduction will remain adequate for its future needs.  In deciding whether or not to approve a reduction in capital, APRA will have regard to all relevant considerations, including whether the insurer’s capital plan shows that the insurer will maintain an adequate level of capital, taking account of factors such as the immediate capital position, commitments to raise capital, and core profitability.

Attachment 1

Determining an Insurer’s Capital Base

Assume an insurer has the following balance sheet:

The insurer’s capital base would be calculated as follows:

Guidance Note GGN 110.2

Internal Model Based Method

1. The Internal Model Based (IMB) method is intended to allow an insurer to calculate its Minimum Capital Requirement (MCR) based on the output of its in-house capital allocation model.  Hence, each insurer will have the flexibility to develop a methodology that is best suited to its business, provided that the model chosen is comprehensive, rigorous and broadly consistent with comparable segments of the industry.  Use of the IMB method will, however, be strictly conditional on APRA’s and the Treasurer’s approval.[15]
2. To ensure that the MCRs calculated by insurers using the IMB method are sufficiently prudent, comparable and consistent across the industry, model approval will require that the insurer’s risk management system and the methodology underlying the capital calculation meet certain criteria.  APRA will, in consultation with industry, refine these criteria over time to ensure that they are consistent with the evolution of industry modelling capabilities.  In broad terms, however, the insurer should satisfy the quantitative and qualitative requirements outlined in this Guidance Note.
3. Each insurer will have discretion to determine the precise nature of its modelling approach.  However, an insurer must be able to demonstrate that its internal model:

(a)          operates within a risk management environment that is conceptually sound and supported by adequate resources;

(b)         is based on a set of quantitative parameters specified in this Guidance Note, including a required probability of default and a modelling time horizon over which that probability is to be measured.  These parameters will be set at a level that ensures insurers achieve and maintain a minimum level of financial soundness;

(c)          addresses all material risks to which the insurer could be reasonably expected to be exposed and is commensurate with the relative importance of those risks, based on the company’s business mix;

(d)         is closely integrated into the day-to-day risk management process of the insurer; and

(e)          is supported by appropriate audit and compliance procedures.

In addition to the quantitative and qualitative requirements of this Guidance Note, insurers seeking approval to use the IMB method must have in place adequate processes for validating the accuracy of the capital measurement model, and for monitoring and assessing its on‑going performance.  A proven track record of reasonable accuracy in measuring risk will also be required.

Qualitative Factors

4.             It is important that insurers using the IMB method have risk management systems and capital measurement models that are conceptually sound and implemented with integrity.  Accordingly, there are a number of qualitative criteria that APRA will have regard to in deciding whether to approve an internal model for capital adequacy purposes.

5.             The qualitative criteria are:

(a)          The insurer should have an independent risk management unit that is responsible for the design and implementation of the insurer’s capital measurement model.  This unit could form part of the insurer’s actuarial function, its financial control division, or other appropriate group within the insurer’s organisational structure that is separate from the insurer’s general business units.  It is not APRA’s intention to mandate a particular organisational structure for insurers, provided the designated unit has adequate independence, appropriate skills and resources, and direct reporting access to the senior management of the insurer.  Amongst other things, this unit should produce and analyse the periodic results of the capital measurement model and conduct regular validation of the model against the actual experience observed by the insurer.

(b)         The insurer’s Board and senior management should be actively involved in the risk control process and must regard risk control as an essential aspect of the business to which significant resources need to be devoted.  The periodic reports and validation results produced by the independent risk management unit must be reviewed by a level of management with sufficient seniority and authority to enforce restrictions on the insurer’s overall risk exposure.

(c)          The capital measurement model must be closely integrated into the day-to-day risk management process of the insurer.  Accordingly, the output of the models should be an integral part of the process of planning, monitoring and controlling the insurer’s risk profile.

(d)         An independent review of the capital measurement model should be carried out periodically as part of the insurer’s own internal audit process. A review of the overall risk management process should take place at regular intervals (ideally not less than once a year) and should specifically address, at a minimum:

(i)           the scope of the risks captured by the capital measurement model;

(ii)         the integrity of the management information system;

(iii)      the verification of the consistency, timeliness and reliability of data sources used to run internal models, including the independence of such data sources;

(iv)       the accuracy and appropriateness of volatility, correlation and distributional assumptions;

(v)         the verification of the model’s accuracy through periodic back testing or other validation process;

(vi)       the validation of any significant change in the capital measurement model;

(vii)    the adequacy of the documentation of the capital measurement model and accompanying risk management systems and processes;

(viii)  the organisation of the risk management unit; and

(ix)       the integration of the capital measurement model into the broader risk management framework of the insurer.

Quantitative Standards

6.             The insurer’s capital measurement model should calculate an amount of capital sufficient to reduce the insurer’s probability of default over a one year time horizon to 0.5% or below[16].

7.             An insurer may measure its capital requirement over a different combination of probability of default and time horizon, provided the insurer can demonstrate to APRA that the alternative parameters are appropriate for its business mix and produce a result which is consistent with the benchmark set in paragraph 6.

Specification of Risk Factors

8.             An important part of an insurer’s internal capital measurement model is the specification of an appropriate set of risk factors, ie the risks that impact on the value of the insurer’s assets and liabilities.  The risk factors contained in the capital measurement model must be sufficient to capture the risks inherent in the insurer’s portfolio.  Although insurers will have some discretion in specifying the risk factors for their internal models, the criteria specified in paragraphs 10-13 should generally be taken into account.

9.             The risks specified in paragraphs 10-13 are intended to provide guidance to insurers on the sorts of risk factors that should be incorporated into capital measurement models.  However, the list is not intended to be exhaustive:  there may be additional factors specific to an individual insurer’s activities that will need to be built into any internal model before it can be used to calculate the insurer’s MCR.  Similarly, there may be factors included in paragraphs 10-13 which are irrelevant or immaterial to a particular insurer’s business or modelling technique.  In these cases, the insurer will not be required to devote significant modelling resources where this is clearly unwarranted.

(i) Investment Risks

10.        An insurer’s capital measurement model must consider the risk that the amount or timing of the cash flows connected with the insurer’s assets will differ from expectations or assumptions as of the valuation date.  Factors that should be considered include:

(i)           default/counterparty failure;

(ii)         the future market value of assets;

(iii)      the liquidity of assets; and

(iv)       the impact of changes in interest rates on the value of asset cash flows (this includes cash flows from bonds, mortgages, real estate and dividends).

(ii) Insurance Risks

11.        An insurer’s capital measurement model must consider the risk that the amount or timing of cash flows connected with the insurer’s obligations will differ from expectations or assumptions as at the valuation date.  Factors that should be considered include:

(a)        outstanding claims risk - the risk that the actual cost of claims for obligations incurred before the calculation date will differ from expectations or assumptions due to factors such as:

(i)           unexpected inflation in claim costs;

(ii)         changes in interest rates;

(iii)      changes in the legal environment in which claims will be resolved, including the environment in which claims are pursued by policyholders or third parties;

(iv)       changes to the basic premises underlying the provisions for a particular coverage (such as has occurred with environmental impairment liability);

(v)         patterns of pricing adequacy which affect the payment of claims or the adequacy of case reserves;

(vi)       currency fluctuations which affect the costs of losses when expressed in local currency;

(vii)    the randomness of the claims process itself;  and

(viii)  incompleteness of databases.

(b)        premiums risk - the risk that premiums relating to post calculation date exposures, including premiums written after the calculation date, could be insufficient to fund the liabilities arising from that business due to changes in factors including:

(i)           changes in interest rates;

(ii)         competitive pressures that do not allow the insurer to achieve assumed levels of exposure and/or rate adequacy;

(iii)      regulatory intervention that restrains premium increases or decreases or requires business to be underwritten that would not be underwritten in the absence of such intervention;

(iv)       retrospective premiums or dividends that differ from assumptions; and

(v)         amounts collectible from agents that differ from assumptions.

(c)        loss projection risk - the uncertainty regarding assumptions about future claims costs.  Loss projection risk is a function of the factors that affect reserve risk and also of the uncertainty regarding factors such as:

(i)           unanticipated changes in loss costs and exposures from the historical experience period;

(ii)         loss costs for the mix of new policies being underwritten, including the effect of adverse selection;  and

(iii)      loss adjustment practices in the future that may differ from those in the past.

(d)        concentration risk - the uncertainty regarding the cost of catastrophic events.  Concentration risk can be considered a component of loss projection risk, and is a function of factors such as:

(i)           the coverages being written;

(ii)         the concentration of insured values in specific geographic areas or legal jurisdictions;  and

(iii)      uncertainty regarding the frequency, severity and nature of catastrophic events.

(e)        reinsurance risk - uncertainty regarding the price and availability of desired reinsurance, and of the uncertainty regarding the collectability of reinsurance recoverables arising from the financial condition of the reinsurer or ambiguity about coverages provided.  Reinsurance risk recognises how reinsurance responds under stress, such as a large catastrophe or other strain on collectability, aggregates, reinstatements and other reinsurance parameters. 

(f)         expense risk -  the risk that expenses will differ from projections due to factors such as:

(i)           contingent commissions to agents;

(ii)         marginal expenses of adding new business;  and

(iii)      overhead costs, including the risk that overhead costs will be changed by regulatory intervention, and the risk that there may be periods of changing premium during which overhead costs will not change in proportion to premium.

(iii) Operational Risk

12.        As well as accurately measuring financial risks, an insurer’s model for measuring capital adequacy must take into account the various operational risks that it also faces, ie the risk of financial loss occurring through error, fraud or failure to perform activities in a timely manner as a result of breakdown of people or systems, internal controls, corporate governance and external events.  These risks, although difficult to quantify, have the potential to impose significant costs upon, and possibly seriously jeopardise, the financial soundness and on-going business of the insurer.   An insurer’s capital measurement model will therefore need to include a measure of operational risk within its capital calculation.

(iv) Correlation Between Risk Classes

13.        An insurer’s capital measurement model must estimate the effects of the risks specified in paragraphs 10-12 individually on the financial position of the insurer, and evaluate the interrelationships between these risks and other risks.

Stress Testing

14.        Stress testing is an important component of any modelling approach.  Insurers that use the IMB method for determining their MCR must have in place a comprehensive stress testing program to supplement their capital measurement calculations.

15.        APRA will not impose standard stress scenarios on insurers, but will expect insurers using the IMB method to have developed a comprehensive range of scenarios against which its capital calculations can be compared.  It is important that these scenarios are tailored to the particular circumstances of the insurer, and reflect low‑probability but potentially high-impact events that might adversely affect the insurer’s financial position.  These scenarios will include, but should not be limited to, sensitivity analysis on the assumptions made within the capital measurement model, as well as the assessment of the impact of plausible stress scenarios (eg major catastrophe events or extreme market conditions).

16.        Stress testing results should be incorporated into model validation procedures, and included as part of regular management reporting.

Partial Models

17.        APRA will consider applications by insurers to use the IMB method to calculate elements of its MCR, and to use the Prescribed Method for those parts  of  the  insurer’s  business  for  which  it  does  not  have an internal

model.  However, recognising that there is a range of factors which are not explicitly addressed within the Prescribed Method (eg operational risk), APRA may impose an additional capital requirement on the results of any partial model to compensate for this.

Model Review Process

18.        An insurer must obtain APRA’s prior approval before it will be able to use its internal capital measurement model to determine its MCR.  Approval will be subject to the outcome of a comprehensive model review process including:

(a)          completion of a detailed questionnaire about the model and accompanying risk control environment; and

(b)         one or more on-site visits to discuss the detail of the model, risk management systems, and surrounding organisational structure and controls.

Once APRA is satisfied with the extent to which  the insurer has met the criteria outlined in this Guidance Note, APRA will (subject to obtaining the Treasurer’s consent) approve the model.[17]  Any conditions on which the approval is granted will also be specified.

19.        APRA will require, as a minimum condition of its model approval, that the insurer undertake to advise APRA in advance of any material changes to its capital measurement model or surrounding controls, and that APRA be provided with any information necessary to satisfy itself that the insurer continues to meet the criteria outlined in this Guidance Note.

20.        Once an insurer has commenced using the IMB method for the measurement of its MCR, the insurer will be required to continue using this method of capital measurement unless:

(a)          APRA revokes model approval and directs the insurer to use the Prescribed Method for calculating its MCR; or

(b)         the insurer seeks and receives approval from APRA to return to the Prescribed Method.

Guidance Note GGN 110.3

Insurance Risk Capital Charge

1. This Guidance Note details the calculation of the Insurance Risk Capital Charge for an insurer using the Prescribed Method to determine its Minimum Capital Requirement (MCR).

2.             The Insurance Risk Capital Charge is in response to the risk that the true value of net insurance liabilities is greater than the value determined under GPS 210 Liability Valuation.  It has two components: a charge in respect of Outstanding Claims Risk and a charge in respect of Premiums Liability Risk.  The total Insurance Risk Capital Charge is the sum of the capital charge for each of the two components.

Outstanding Claims Risk

3.             The capital charge for Outstanding Claims Risk is in response to the risk that the true value of the net outstanding claims liabilities is greater than the value determined under GPS 210.

4.             For the purposes of the Prescribed Method, Outstanding Claims Risk is considered to be broadly proportional to the value of the net outstanding claims liabilities.  Because the extent of Outstanding Claims Risk will vary by class of business, a separate capital charge for Outstanding Claims Risk must be calculated for each class of business.

5.             The capital charge for each class of business is calculated by multiplying the net outstanding claims liabilities for that class (as determined under GPS 210) by the relevant Outstanding Claims Risk Capital Factor.  For these purposes, APRA classes of business have been divided into three categories with respect to direct insurance business and a matrix of three classes with four types of business with respect to inwards reinsurance (as set out in Tables 1 and 2 below).  Classes of business within the same category are regarded as having broadly similar levels of Outstanding Claims Risk.  The total capital charge for Outstanding Claims Risk is the sum of the capital charges for each class of business.

Premiums Liability Risk

6.             The capital charge for Premiums Liability Risk is in response to the risk that premiums relating to post calculation date exposures, including premiums written after the calculation date, will be insufficient to fund the liabilities arising from that business.  The need for a capital charge which relates, in part, to new business arises because of the time delay between calculation date and the time at which APRA is able to process information and take any action which may be necessary.

7.             The value of the net premium liabilities, as determined under GPS 210, is taken as the base value for the liabilities upon which the capital charge for Premiums Liability Risk is calculated.

8.             For the purposes of the Prescribed Method, Premiums Liability Risk is considered to be broadly proportional to the value of the net Premiums Liabilities.  As for Outstanding Claims Risk, the extent of Premiums Liability Risk will vary by class of business.  However, in a stable portfolio, Premiums Liability Risk is likely to be greater than Outstanding Claims Risk for the same class of business.  A separate capital charge for Premiums Liability Risk therefore needs to be calculated for each class of business.

9.             The capital charge for each class of business is calculated by multiplying the net premium liabilities for that class (as determined by GPS 210) by the relevant Premiums Liability Risk Capital Factor (using the same categories as for Outstanding Claims Risk – see Tables 1 and 2 below).  Classes of business within the same category are regarded as having broadly similar levels of Premiums Liability Risk.  The total capital charge for Premiums Liability Risk is the sum of the capital charges for Premiums Liability Risk for each class of business.

Business Covering Multiple Classes

10.        Where an insurer writes inwards reinsurance business and is unable to split this business into the classes and types listed below, they are to use the highest casualty factors on their outstanding claims liabilities and their premiums liabilities.

11.        Where an insurer writes inwards reinsurance which spans multiple classes and the insurer cannot readily split the contract between classes, APRA suggests that the contract should be allocated using one of the following methods:

(a)        allocate the contract to the category which represents the greatest exposure; or

(b)        allocate the contract to the category representing the greatest premium income.

An insurer that writes inwards reinsurance is free to choose which of the above methods it uses, or may use another appropriate method, provided the same method is used for all contracts and all subsequent periods.

Table 1:  Direct Insurance

Table 2:  Inwards Reinsurance

Guidance Note GGN 110.4

Investment Risk Capital Charge

1. This Guidance Note details the calculation of the Investment Risk Capital Charge for an insurer using the Prescribed Method to determine its Minimum Capital Requirement (MCR).
2. The capital charge for investment risk is in response to the risk of an adverse movement in the value of an insurer’s on-balance sheet assets and/or certain off-balance sheet obligations.  Investment risk derives from a number of sources.  These include:

(a)          credit risk  the risk of an adverse movement in the value of an asset owing to changes in the credit quality of the issuer of that asset (including the default of the issuer);

(b)         market/mismatch risk  the risk of an adverse movement in the value of an asset, which is not offset by a corresponding movement in the value of liabilities; and

(c)          liquidity risk  the risk that the reported asset value will not be readily realised in certain circumstances.

3.             It is not possible to devise a simple capital framework that takes all of these risk factors into an account in an accurate fashion.  The capital charge for Investment Risk attempts to cover these risks by requiring insurers to hold an amount of capital against each asset that is proportional to the value of that asset.  The capital factors assigned to assets reflect broad judgements by APRA for capital adequacy purposes only, and should not be taken as a substitute for individual company assessments of the risks associated with particular assets.  Over and above the minimum capital requirements required by this Standard, the Board and senior management of an insurer have primary responsibility for ensuring that adequate systems are in place to individually assess the risks in an insurer’s operations, to allocate the appropriate amount of capital to cover that risk and to suitably value the transactions that give rise to that risk.

4.             To calculate the capital charge for Investment Risk, each of an insurer’s assets (and certain off-balance sheet exposures) is assigned to one of nine categories.  The Investment Risk Capital Charge is determined by multiplying the balance sheet value of each asset by the appropriate Investment Capital Factor for its category (subject to any thresholds in the case of assets exceeding the specified thresholds detailed in paragraphs 16-18).  The total capital charge for Investment Risk is the sum of the Investment Risk Capital Charges for each individual asset.  The Investment Capital Factors to be applied to each asset are presented in Attachment 1 to this Guidance Note.

5.             For the purpose of applying the capital factors, the term ‘debt obligations’ refers to all loans, deposits, placements, interest rate securities and other payables. Where reference is required to credit/counterparty ratings, these should be applied in accordance with Attachment 2.

Extended Licensed Entity

6.             In certain circumstances, an insurer may choose to hold assets in a special purpose vehicle or other related entity, rather than on its own balance sheet.  Subject to meeting the conditions outlined below, APRA may allow an insurer to determine its Investment Risk Capital Charge (and any Investment Concentration Capital Charge) based on the individual assets of the related entity, rather than simply on the insurer’s direct exposure to that entity.

7.             The extent to which the risk of an insurer’s exposure to a related entity is commensurate with the underlying holdings of that entity depends on the insurer’s extent of control over, and integration with, the entity as well as on the existence of any third party liabilities of the entity.  Potential complications under a scenario where underlying asset holdings must be liquidated during financial stress must also be considered.

8.             Subject to the specific requirements set out in paragraph 9, an insurer may apply to APRA to have one or more related entities approved as part of its Extended Licensed Entity (ELE).  Once approved, APRA will allow the insurer to “look through” the legal structures involved, and to “consolidate” the balance sheet of the related entity with its own for the purposes of determining the Investment Risk Capital Charge.  In effect, this allows the insurer to treat its own balance sheet and that of the approved entity as a single entity for the purpose of calculating that charge.

9.             In deciding whether to approve an entity as part of an insurer’s ELE, APRA will have regard to the following criteria in respect of the relationship between the insurer and the related entity:

(a)          the related entity must be a wholly-owned and controlled by the insurer, with a Board of directors/trustees that is comprised entirely of members of the insurer’s Board or senior management;

(b)         the insurer must demonstrate to APRA that there are no legal or regulatory barriers (including cross-border issues for a branch or if the proposed ELE is not an Australian entity) to the transfer of the assets back to the insurer;

(c)          the insurer’s risk management systems and controls must be fully extended to the operations of the related entity.  The senior management of the insurer must be in a position to monitor the operations of the related entity to the same extent as the operations of the insurer itself.  Systems for monitoring and control over the related entity must be included within the internal and external audit programs of the insurer;

(d)         the insurer must be able to furnish stand-alone accounting records for the related entity, and provide APRA with full and unfettered access to this information at any time (including during on-site visits); 

(e)          the related entity must not conduct any business that the insurer would otherwise be prevented from doing under the Insurance Act 1973; and

(f)           where the related entity holds or invests in assets on behalf of the insurer, the related entity must have no material third party liabilities (APRA will exempt tax liabilities and employee entitlements from this requirement).

Treatment of Collateral and Guarantees as Risk Mitigants

10.        The capital charge for Investment Risk may be reduced where the insurer holds certain types of collateral against an asset, or where the asset has been guaranteed, as a means of reducing risk.

(i) Collateral

11.        Where an insurer possesses recognised collateral against an asset, it may apply the Investment Risk Capital Factor relevant to the collateral to the value of the asset (instead of applying the capital factor that would otherwise apply to the asset).  Collateral will be recognised only to the extent that it takes the form of a charge, mortgage or other security interest in, or over, an Eligible Collateral Item.  Eligible Collateral Items are cash, Government securities, or debt obligations (as defined in paragraph 5) where the obligor has a counterparty rating in Grade 1, 2 or 3.  The Eligible Collateral Item must also be held for the period for which the asset is held.  Where the market value of the collateral does not cover the full value of the asset, only that part of an asset that is covered by collateral may be assigned the Investment Capital Factor applicable to the collateral.

(ii) Guarantees

12.        Assets that have been explicitly, unconditionally and irrevocably guaranteed for their remaining term to maturity by a guarantor with a counterparty rating (or for governments, the long-term foreign currency credit rating) in Grades 1, 2 or 3 may be assigned the Investment Capital Factor that would be applicable to the guarantor.

13.        Guarantees provided to an insurer by its own parent or a related entity[18] are not eligible for this treatment.

Charged and Encumbered Assets

14.        Subject to paragraph 15, assets of the insurer that are under a fixed or floating charge, mortgage or other security are subject to an Investment Capital Factor of 100%, to the extent of the indebtedness secured on those assets.  This will replace the Investment Capital Factor that would otherwise apply to the secured assets.

15.        Where the security supports an insurer’s insurance liabilities, the Investment Capital Factor of 100% is applicable only to the amount by which the market value of the charged assets exceeds the insurer’s supported liabilities.

Investment Concentration Charge

16.        An insurer may be exposed to an additional risk arising from an excessive exposure to a particular asset (including reinsurance recoveries).  To address the risk associated with excessive asset concentration, an insurer must hold additional capital in those cases where an insurer’s holdings of an asset or exposure to a particular obligor (or group of related obligors) exceeds the thresholds set out below.  The aggregation of exposures to individual counterparties must be undertaken for an insurer and any entities approved as part of its ELE (see paragraphs 6-9).

17.        The thresholds referred to in paragraph 16 are based on the credit rating[19] of the counterparty, and are as follows:

18.        For holdings of assets in excess of the thresholds, an insurer must apply the relevant Investment Capital Factor to the asset up to the value of the threshold, and apply a 100% Capital Factor to the value in excess of this level.

Off-Balance Sheet Transactions

19.        An insurer can be exposed to various Investment Risks through transactions or dealings other than those reflected on its balance sheet.

(i) Direct Credit Substitutes

20.        To the extent that an insurer has issued:

(a)          guarantees (including written put options serving as guarantees);

(b)         letters of credit; or

(c)          any other credit substitute (other than insurance) in favour of  another party;

the insurer is exposed to risk of having to make payment on these instruments should the guaranteed party default or fail to deliver.

21.        Insurers must set aside capital to cover the risk of such events occurring.  Within the Prescribed Method, this is to be achieved by applying, to the face value of the credit substitute, the Investment Capital Factor that would be applied to the obligation or asset over which the credit substitute has been written.  Where the credit substitute is supported by collateral or a guarantee, the provisions of paragraphs 11-13 may be applied.

22.        A different approach to that contained in paragraphs 20-21 is available for surety bond business.  Insurers have the choice of either:

(a)          treating any surety bonds the insurer has issued as a type of direct credit substitute.  In this case, the insurer must determine 25% of the value of the surety bond, and apply to that amount the Investment Capital Factor that would be applied to the obligation or asset over which the surety bond has been written.  Where the surety bond is supported by a risk mitigation arrangement, the applicable Investment Capital Factor will be that assigned to the counterparty to that arrangement, but only to the extent that the risk mitigation arrangement applies;  or

(b)         seeking written approval from APRA to treat any surety bonds the insurer has issued as if they were an insurance risk (for the purposes of meeting the requirements of the Prudential Standards only).  This would require the insurer to include surety bond exposures within the insurer's assessment of insurance liabilities, as determined under GPS 210 Liability Valuation, and to apply the relevant capital factors within GGN 110.3.[20]  For the purpose of calculating net outstanding claims liabilities and net premium liabilities (as determined under GPS 210) the insurer may treat any risk mitigation arrangement as if it were reinsurance.  An insurer seeking APRA's approval for this approach would need to include with its application a confirmation from the company's Approved Actuary that that person is able to appropriately measure the risk of the surety bond business within the insurer's insurance liabilities.

Insurers must use the same approach for all surety bond business, and apply that approach consistently over time.

(ii) Derivatives

23.        Derivatives include forwards, futures, swaps, options and other similar contracts.  Derivatives expose insurers to the full range of investment risks, even though in many cases there may be no, or only a very small, initial outlay.  Insurers must set aside capital to cover the Investment Risk of these transactions, particularly in instances where the derivatives are used for reasons other than to hedge an underlying physical position.  Under the Prescribed Method, insurers are required to hold capital against derivatives using the method described below.

24.        The requirements set out below do not apply to:

(a)          foreign exchange (except gold) contracts which have an original maturity of 14 calendar days or less; and

(b)         instruments traded on futures and options exchanges which are subject to daily mark-to-market and margin payments.

25.        The capital charge for each derivative contract is based on its ‘asset equivalent value’.  The asset equivalent value is the sum of the current mark-to-market exposure of the derivative (where positive) and a potential exposure add-on.

26.        The potential exposure add-on is determined by multiplying the notional principal amount of the derivative contract (regardless of whether the contract has a zero, positive or negative mark-to-market value) by the relevant credit conversion factor specified in the table below according to the nature and residual maturity of the instrument.[21]

27.        The asset equivalent value of each derivative must then be multiplied by the Investment Capital Factor applicable to a debt obligation of the counterparty to the derivative contract to determine the Investment Risk Capital Charge.

28.        APRA acknowledges that the method of measuring the risk of derivative positions outlined in paragraphs 23-27 is simple, and may not always reflect the underlying risk to which the insurer is exposed.  However, given the limited usage of derivatives within the general insurance industry, APRA is of the view that a simple method will be adequate for the vast majority of Australian insurers.  Where an insurer enters into significant derivative transactions – defined for the purposes of this Standard as contributing greater than 5% of the insurer’s total Investment Risk Capital Charge or, in relation to exchange traded derivatives, where the notional principal amount of these instruments is greater than the capital base of the insurer – or where the insurer is otherwise making extensive use of derivatives for speculative purposes, APRA reserves the right to require the insurer to hold additional capital against these positions using a method that APRA will prescribe.

29.        Insurers should not generally enter into derivative contracts at off-market prices.  This includes historical rate rollovers on foreign exchange contracts.  If any derivative contracts are undertaken at off-market prices, insurers must contact APRA to discuss the reasons for such actions and to agree the capital (and other prudential) treatment of these transactions.

Attachment 1

Investment Capital Factors

Attachment 2

Counterparty Grades

Unrated assets or exposures should be classified as Grade 4.

Insurers should, in general, use the same rating agency for determining counterparty gradings.  Where the insurer has counterparties with multiple ratings from two or more of the rating agencies in the table above, the insurer should consistently choose the ratings of a single agency whenever possible.  For example, an insurer may have a number of counterparties that are rated by Standard & Poor’s and AM Best.  In this case, the insurer should choose a single agency that will be consistently used whenever the individual ratings conflict.

APRA’s approval must be sought if an insurer wishes to use the rating determined by a rating agency not included in the table above.

Guidance Note GGN 110.5

Concentration Risk Capital Charge

1. This Guidance Note details the calculation of the Concentration Risk Capital Charge for an insurer using the Prescribed Method to determine its Minimum Capital Requirement (MCR).  Specifically, it sets out the issues that an insurer should consider in setting its Maximum Event Retention (MER) for catastrophe purposes.  It is the responsibility of the insurer’s Board and senior management to ensure that the MER is set at a level which is consistent with the insurer’s risk profile and its reinsurance program.

Definitions

2.             The MER is the largest loss to which an insurer will be exposed (taking into account the probability of that loss) due to a concentration of policies, after netting out any reinsurance recoveries.  The MER must include an allowance for the cost of one reinstatement premium for the insurer’s catastrophe reinsurance.

3.             Probable Maximum Loss (PML) is the largest loss to which an insurer will be exposed (within the realms of possibility) due to a concentration of policies, without any allowance for reinsurance recoveries.

4.             Return Period is the expected average period within which a particular catastrophic event will re-occur.  For the purposes of this Guidance Note, insurers will be required to assume a return period of 1 in 250 years, or greater.

Background

5.             Insurers are exposed to the possibility of very large losses arising from their portfolios as a result of various natural catastrophes or other causes of large losses eg earthquakes, fires, storms etc.  These catastrophic events will occur only rarely and yet their financial impact on an insurer can be very significant, possibly even resulting in the failure of an insurer.

6.             Theoretically an insurer can calculate the maximum limit of its catastrophic losses in a particular geographical region as the total of the individual sums insured under all of its policies. Clearly, however, such an approach would require prohibitively large amounts of capital.

7.             In practice, insurers use the concept of MER to estimate their exposure to catastrophic events. The use of MER allows insurers to:

(a)          calculate the level of reinsurance cover which the insurer requires;

(b)                       apportion reinsurance costs fairly among different segments of business; and

(c)                        control exposures to geographical zones or business types, where the risks of catastrophic loss are higher than acceptable, having regard to the insurer’s risk profile.

Issues affecting the level of MER

8.             In determining the level of MER for a given portfolio, the insurer should consider:

(a)          the classes of business in which the insurer is engaged;

(b)         the types of catastrophic risk which need to be addressed;

(c)          the level of capital available to the insurer;

(d)         the geographical zones in which the insurer transacts business;

(e)          the effects of combined risks eg where an insurer provides coverage for both workers’ compensation business and building insurance in the same geographical area;

(f)           how the geographical zones will be grouped for calculation purposes;  and

(g)         the insurer’s overall risk appetite and desired probability of ruin.

Specialist Insurers

9.             Specialist insurers, such as providers of medical indemnity or mortgage lender’s insurance, may not be exposed to large losses from natural catastrophes.  They may, however, still be exposed to large losses arising from groups of claims resulting from a common source.  For example, a medical insurer may face a large number of claims arising from a class action related to a faulty medical procedure, while a mortgage insurer might be most exposed to a period of severe economic downturn.

Determining the level of the MER

10.        The insurer should base the calculation of its MER on:

(a)          the relevant area of concentration (eg geographic region);

(b)         which peril produces the greatest MER;

(c)          the return period of the relevant catastrophe and the sensitivity of the MER to changes in the return period;

(d)         results produced by modelling the insurer’s own past experience; and

(e)          any externally, commercially available data and modelling facilities, bearing in mind the appropriateness of these data to the insurer’s portfolio of risks.

11.        The MER must be calculated in a manner consistent with the processes for setting, monitoring and altering the MER outlined in the insurer’s Reinsurance Management Strategy (REMS), as required under GPS 230 Reinsurance Arrangements. 

12.        It is common practice for insurers to use computer-based modelling techniques, developed either in-house or by external providers,to estimate likely losses under different catastrophe scenarios.  Where an insurer uses such a model, the model must be conceptually sound and capable of consistently producing realistic calculations of the MER. APRA will expect the insurer to be able to demonstrate an understanding of the model used in estimating the MER.  This understanding will include:

(a)          the type of data and assumptions used in the model;

(b)         the methodology used to incorporate the data and assumptions into the model; and

(c)          the sensitivity of the resulting MER figure to changes in the model’s assumptions.

13.        Insurers must be able to demonstrate that they have thoroughly researched the model and tested at least several different scenarios of return period for each type of catastrophic event that may affect their portfolio of risks.  Similarly, an insurer must calculate its MER using data that is consistent, accurate and complete.  Where an insurer lacks access to the relevant data, it must be able to explain the rationale for, and details of, any estimates of data that it uses.  This would include analysis of the sensitivity of the results to changes in the estimates and assumptions.

14.        In setting an appropriate level of MER, the Board must consider the insurer’s claims history, capital availability and reinsurance arrangements.  While the MER will ultimately be governed by the insurer’s particular portfolio, some simple methods could be used to guide the decision.  For example, insurers who have determined that their maximum event would be a natural catastrophe could apply the standard PML factors produced by the Insurance Council of Australia to their aggregate exposures.  This will provide an estimate of the gross loss to which the insurer is exposed.  The insurer could then apply their reinsurance protections to this amount to obtain their MER.

15.        Similarly, the MER for a mortgage insurer will ultimately depend on the insurer’s portfolio of risks.  However, as a general guide, the insurer could use the relevant part of the Standard & Poor’s model for calculating capital at the BBB level.  This would involve assessing the insurance in force of the mortgage insurer, and applying the standard frequency and severity factors by LVR band.

Board and Management Oversight

16.        GPS 230 requires insurers to have a REMS approved by the Board (or in the case of foreign insurers, a senior officer from outside Australia with requisite Board delegation) and by APRA.  An insurer’s REMS must include details of the insurer’s systems for the setting, monitoring and altering of its MER. Guidance Note GGN 230.1 Reinsurance Management Strategy sets out matters that each insurer’s REMS must detail:

(a)          the insurer’s willingness to take on catastrophic risks;

(b)         how the insurer’s financial resources cover its calculated MER;

(c)          the regular process by which the policies are reviewed by senior management, and (if relevant) by the Approved Actuary, in the light of the insurer’s results by class of business and geographical region, as well as current market conditions eg availability of adequate catastrophe reinsurance cover;

(d)         the regular process by which the policies are approved by the directors; and

(e)          the regular process by which the insurer’s compliance with its policies is independently reviewed.

17.        Regardless of the methodology used, the Board should periodically seek the advice of its Approved Auditor, Approved Actuary, or other relevant expert, to review the calculation of the MER, and ensure that it is established at an appropriate level.

Reporting

18.        APRA will review and agree with each insurer the adequacy and appropriateness of the methodology for setting its MER as part of APRA’s review of the insurer’s REMS.

19.        An insurer must inform APRA of any changes to its MER arising as a result of changes in its REMS, risk profile, classes of business underwritten or reinsurance program.

Prudential Standard GPS 120

Assets In Australia for General Insurers

Prudential Standard

1. This Prudential Standard, made under section 32 of the Insurance Act 1973 (the Act), applies to all general insurers authorised under the Act.

Requirement to Maintain Assets Inside Australia

2.             The Act sets out a number of assets and liabilities which are to be treated as assets or liabilities in Australia.[23]  However, the Act does not provide an exhaustive definition.  This Standard specifies additional requirements for that purpose.

Assets not included as in Australia

3.             The prudential standards may specify assets that are not considered as assets in Australia.[24]  For this purpose, the following assets are excluded (in addition to goodwill[25]):

(a)          other intangible assets;

(b)         future income tax benefits (net of provisions for deferred income tax liabilities);

(c)          assets under a fixed or floating charge, mortgage or other security (to the extent of the indebtedness secured by such assets);  and

(d)         assets otherwise excluded under paragraphs 4-17 below.

(i) Chattels and real property

4.             In relation to a locally-incorporated insurer, an asset comprising a chattel or real property, or an asset that is an equitable interest in a chattel or real property, will not be regarded as an asset in Australia unless:

(a)          either:

(i)           the legal title is held by the insurer or the insurer’s custodian (and that custodian is incorporated in Australia); and

(ii)         the physical asset is located in Australia; or

(b)         the asset is an equitable interest, or an interest in a managed investment scheme, the interest is held by a person mentioned in sub-paragraph (a)(i), the interest is covered by paragraphs 10-16, and is not excluded from being an asset in Australia under those paragraphs.

5.             In relation to a foreign insurer, an asset comprising a chattel or real property, or an asset that is an equitable interest in a chattel or real property, will not be regarded as an asset in Australia unless:

(a)          either:

(i)           the legal title is held by the foreign insurer’s agent in Australia,[26] or by a custodian appointed by the foreign insurer’s agent in Australia and that custodian is incorporated in Australia (to ensure that the foreign insurer’s agent has control over the asset); and

(ii)         the physical asset is located in Australia; or

(b)         the asset is an equitable interest, or an interest in a managed investment scheme, the interest is held by a person mentioned in sub-paragraph (a)(i), the interest is covered by paragraphs 10-16, and is not excluded from being an asset in Australia under those paragraphs.

(ii) Loans and amounts due (including debentures)

6.             In relation to a locally-incorporated insurer, an asset which is a loan to, or amount due from, another person (including an investment, such as a debenture, held with Austraclear or RITS), or an asset which is an equitable interest in such a loan or amount due, will not be regarded as an asset in Australia, unless:

(a)          either:

(i)           the creditor, or owner of the asset, is the insurer or the insurer’s custodian and that custodian is incorporated in Australia; and

(ii)         the outstanding amount is payable in Australia and the debtor is physically located in Australia;

(b)         or:

(i)           the asset is held on a securities system in Australia (eg Austraclear or RITS) and can be readily sold in Australia; and

(ii)         the account in which the asset is held in the securities system is controlled by the insurer or the insurer’s custodian and that custodian is incorporated in Australia; or

(c)          the asset is an equitable interest, or an interest in a managed investment scheme, the interest is held by a person mentioned in sub-paragraph (a)(i), the interest is covered by paragraphs 10-16, and is not excluded from being an asset in Australia under those paragraphs.

7.             In relation to a foreign insurer, an asset which is a loan to, or amount due from, another person (including an investment, such as a debenture, held with Austraclear or RITS), or an asset which is an equitable interest in such a loan or amount due, will not be regarded as an asset in Australia, unless:

(a)          either:

(i)           the creditor, or owner of the asset, is the agent in Australia of the foreign insurer or a custodian appointed by the foreign insurer’s agent in Australia and that custodian is incorporated in Australia (to ensure that the foreign insurer’s agent in Australia has control over the asset); and

(ii)         the outstanding amount is payable in Australia and the debtor is physically located in Australia;

(b)         or:

(i)           the asset is held on a securities system in Australia (eg Austraclear or RITS) and can be readily sold in Australia; and

(ii)         the account in which the asset is held in the securities system is controlled by the agent in Australia of the foreign insurer or a custodian appointed by the foreign insurer’s agent in Australia and that custodian is incorporated in Australia (to ensure that the foreign insurer’s agent in Australia has control over the asset); or

(c)          the asset is an equitable interest, or an interest in a managed investment scheme, the interest is held by a person mentioned in sub-paragraph (a)(i), the interest is covered by paragraphs 10-16, and is not excluded from being an asset in Australia under those paragraphs.

(iii) Shares

8.             In relation to a locally-incorporated insurer, an asset held by the insurer which is a share, or an equitable interest in a share, will not be regarded as an asset in Australia unless:

(a)          it is registered within Australia, and is under the direct control of the insurer or its custodian and that custodian is incorporated in Australia; or

(b)         the asset is an equitable interest, or an interest in a managed investment scheme, the interest is held by a person mentioned in sub-paragraph (a) and the share is registered in Australia, the interest is covered by paragraphs 10-16, and is not excluded from being an asset in Australia under those paragraphs.

9.             In relation to a foreign insurer, an asset held by the insurer which is a share, or an equitable interest in a share, will not be regarded as an asset in Australia unless:

(a)          it is registered within Australia, and is under the direct control of the foreign insurer’s agent in Australia or a custodian appointed by the foreign insurer’s agent in Australia and that custodian is incorporated in Australia (to ensure that the foreign insurer’s agent in Australia has control over the asset); or

(b)         the asset is an equitable interest, or an interest in a managed investment scheme, the interest is held by a person mentioned in paragraph (a) and the share is registered in Australia, the interest is covered by paragraphs 10-16, and is not excluded from being an asset in Australia under those paragraphs.

(iv)   Units in unit trusts

10.        A unit in a unit trust will not be regarded as an asset in Australia except where the trustee and, if applicable, the responsible entity is (if a natural person) resident in Australia or (if incorporated) is incorporated in Australia.

11.        A unit in a unit trust will not be regarded as an asset in Australia if the underlying assets would not be assets in Australia if held by the insurer itself (or, in the case of a foreign insurer, the foreign insurer’s agent in Australia).

12.        However, APRA may in its discretion determine that paragraph 11 does not apply to the interest of a particular insurer in a diversified trust which contains some assets that are not regarded as assets in Australia within the meaning of the Act or this Standard.

13.        A unit in a unit trust will not be regarded as an asset in Australia if, under the trust deed, the trustee has the right to suspend or delay the redemption of the unit pending sale of any of the trust’s property outside Australia. 

(v) Assets held  on trust other than through a unit trust, or held through a managed investment scheme

14.        An asset held on trust, other than through a unit trust, or an interest in a managed investment scheme, will not be regarded as an asset in Australia except where the trustee and, if applicable, the responsible entity is (if a natural person) resident in Australia or (if incorporated) is incorporated in Australia.

15.        An equitable or similar interest of an insurer in an asset (the “underlying asset”) held on trust, other than through a unit trust,[27] or under a managed investment scheme, will not be regarded as an asset in Australia if the underlying asset would not be an asset in Australia if held by the insurer itself (or, in the case of a foreign insurer, the foreign insurer’s agent in Australia).

16.        However, APRA may in its discretion determine that paragraph 15 does not apply to the interest of a particular insurer in a diversified trust which contains some assets that are not regarded as assets in Australia within the meaning of the Act or this Standard.

(vi) Reinsurance

17.        The Act permits certain reinsurance assets to be regarded as assets in Australia.  Before these assets are accepted as assets in Australia, an insurer must be able to demonstrate to APRA that the assets meet the criteria specified in section 116A of the Act, by providing appropriate evidence to APRA.

Foreign Insurers

18.        As set out in GPS 110 Capital Adequacy, foreign insurers do not typically have capital instruments of the type specified in Guidance Note GGN 110.1 Measurement of Capital Base.  Foreign insurers are nevertheless required to meet a variant of the MCR.  Specifically, foreign insurers are required to maintain assets in Australia in excess of their liabilities in Australia, of an amount at least equal to their MCR. 

19.        For the purposes of meeting this requirement, APRA will use the same criteria for assessing what is an asset in Australia as is used for complying

with section 28 of the Act (ie see paragraphs 3-17 above, and section 116A of the Act).

Prudential Standard GPS 210

Liability Valuation for General Insurers

Prudential Standard

1. This Prudential Standard, made under section 32 of the Insurance Act 1973 (the Act), applies to all general insurers authorised under the Act.
2. In determining the value of insurance liabilities, not all insurers will be required to have an Approved Actuary.[28]  However, irrespective of whether actuarial advice is sought or required, an insurer’s liabilities must be valued in accordance with the principles of this Standard.

The Role of the Approved Actuary in Valuing Insurance Liabilities

3.             Subject to certain exceptions set out in Guidance Note GGN 220.1 Governance, an insurer must appoint an actuary (Approved Actuary) in accordance with the Act, and have this appointment approved by APRA.  As well as any other responsibilities that may be assigned by APRA, the Approved Actuary must provide written advice to the Board of the insurer on the value of insurance liabilities in accordance with this Standard.  Unless APRA provides written approval for less frequent advice, this must at a minimum occur on an annual basis to coincide with the preparation of the insurer’s yearly statutory accounts.  The Board of an insurer is free to seek more frequent advice if it believes this is to be appropriate.

Valuation of Insurance Liabilities

4.             Where an insurer includes in its accounts a value for insurance liabilities which is inconsistent with the advice received from the Approved Actuary, or is not determined in a manner consistent with the principles of this Standard, the insurer must notify APRA in writing, and should include within its published annual financial accounts:

(a)          the reasons for not accepting the Approved Actuary’s advice, or for not determining the insurance liabilities in a manner consistent with this Standard; and

(b)         details of the alternative assumptions and methodologies used for determining the value of the insurance liabilities.

5.             In determining the value of its insurance liabilities, an insurer (after taking advice from its Approved Actuary, where necessary) must determine a value for both its Outstanding Claims Liabilities and its Premiums Liabilities for each class of business.[29]

6.             The Outstanding Claims Liabilities relate to all claims incurred prior to the calculation date, whether or not they have been reported to the insurer.  The most significant component of the insurance liabilities for long tail business is the Outstanding Claims Liabilities.  The value of the Outstanding Claims Liabilities must include an amount in respect of the internal expenses that the insurer expects to incur in settling these claims.  The Outstanding Claims Liabilities are to be determined both net and gross of expected reinsurance recoveries.

7.             The Premiums Liabilities relate to future claim payments arising from future events insured under existing policies.  For short tail business, the Premiums Liabilities are of greater relative significance.  The value of the Premiums Liabilities must include an amount in respect of the internal expenses that the insurer expects to incur in administering the policies and settling the relevant claims.  The Premiums Liabilities are to be determined on a fully prospective basis; both net and gross of expected reinsurance recoveries (as a result, there is no need to separately report a deferred acquisition cost asset).

8.             Subject to the requirements of this Standard, the valuations of an insurer’s Outstanding Claims Liabilities and its Premiums Liabilities must be realistic estimates, determined having regard to considerations of consistency with the basis for valuing assets, and the requirements of relevant Australian Accounting Standards.

9.             The valuation of insurance liabilities for each class of business must comprise:

(a)          a central estimate value of the Outstanding Claims Liabilities;

(b)          a central estimate value of the Premiums Liabilities; and

(c)          risk margins that relate to the inherent uncertainty in each of these central estimate values.

The value of the insurance liabilities (for both Outstanding Claims Liabilities and Premiums Liabilities) is the sum of the central estimate and the risk margin.

10.        The valuation of insurance liabilities should reflect the individual circumstances of each insurer.  Notwithstanding this, to ensure that valuation processes are consistent and sufficiently rigorous across the industry, the risk margin should be established on a basis that is intended to secure the insurance liabilities of the insurer at a given level of sufficiency – that level is 75 per cent.

11.        Due to the highly skewed nature of some insurance distributions, the level of sufficiency established in paragraph 10 may result in a value regarded as insufficient for prudent purposes.  Therefore, the risk margin should not be less than one half of the coefficient of variation for the insurance liabilities of the insurer.

Determination by Class of Business

12.        The principles for determining the central estimate values of the Outstanding Claims Liabilities and the Premiums Liabilities are, subject to considerations of materiality and the professional judgement of the Approved Actuary, to be applied to each class of business of the insurer.

13.        For the purpose of disclosing the values of the insurance liabilities in the accounts, risk margins should be shown separately in relation to the Outstanding Claims Liabilities and the Premiums Liabilities.  Risk margins should also be shown separately for each class of business.

14.        Where the Approved Actuary thinks it appropriate, allowance for diversification and/or reinsurance should be made in determining the risk margin.  The justification for and method of determining such diversification allowance and reinsurance recoveries should be clearly documented and reported by the Approved Actuary.

15.        The value of the insurance liabilities (both for Outstanding Claims Liabilities and Premiums Liabilities) reported by the insurer will be the aggregate of the liabilities determined for each class of business.

16.        In practice, the process of determining the central estimate values of the insurance liabilities should be undertaken on the basis of a class of business.  However, this should not prevent the Approved Actuary from undertaking the necessary analysis on a basis which is more suitable, taking into account the nature of the data and the particular circumstances of the insurer.

The Central Estimate

17.        For the purposes of paragraph 9, the central estimate is intended to reflect the mean value in the range of possible values for the outcome (that is, the mean of the distribution of probabilistic outcomes).  The determination of the central estimate should be based on assumptions as to future experience which reflect the experience and circumstances of the insurer and which are:

(a)          made using judgement and experience;

(b)         made having regard to reasonably available statistics and other information; and

(c)          neither deliberately overstated nor deliberately understated.

18.        It should be recognised that where experience is highly volatile, model parameters estimated from the experience can also be volatile. The intention is for the central estimate to reflect as closely as possible the likely future experience of the insurer.  To this end, judgement may be required to limit the volatility of the assumed parameters to that which is justified in terms of the credibility of the experience data.

19.        The central estimate will generally be measured as the present value of the future expected payments.  This measurement process will involve prospective calculations and modelling techniques, and will require assumptions in respect of the expected future experience, taking into account all factors which are considered to be material to the calculation, including:

(a)          discount rates (see paragraphs 29-31);

(b)         claims escalation;

(c)          claims expenses; and

(d)         the pattern of claims run-off.

This is equally applicable to the determination of the gross insurance liabilities and the estimation of reinsurance recoveries.

20.        In establishing the central estimate assumptions, due regard should be had to the materiality of:

(a)          the class of business being considered; and

(b)         the effect of particular assumptions on the determined result.

21.        Many of the assumptions should be consistent for the estimation of the Outstanding Claims Liabilities and the Premiums Liabilities. Where there are differences, the reasons must be clearly documented.

The Risk Margin

22.        For the purposes of paragraph 9, the risk margin is the component of the value of the insurance liabilities that relates to the inherent uncertainty in the central estimate.  The risk margin does not relate to the risk associated with the underlying assets, including asset-liability mismatch risk.  As the risk margin represents an additional component of the liability value, it is therefore aimed at ensuring that the value of the insurance liabilities is established at an appropriate and sufficient level (as defined in paragraphs 10-11).

23.        Risk margins should be determined on a basis that reflects the experience of the insurer. Professional judgement will be needed to determine the risk margins for the insurer as a whole, and for each class of business.  In determining risk margins, regard should be had to the objective of this Standard, any other guidance or any relevant professional standards.

24.        In considering the methodology and assumptions to be used in determining the risk margin for a class of business, regard should be had to a range of factors, including:

(a)          the robustness of the valuations models;

(b)         the reliability and volume of the available data;

(c)          past experience of the insurer and the industry; and

(d)         the particular characteristics of the class of business.

25.        Estimation of the coefficient of variation may, itself, present technical difficulties with some components of the uncertainty in the central estimate not permitting statistical analysis.  Generally, estimation of the coefficient of variation will require judgement as well as technical analysis.  As with other aspects of this Standard, regard should be had to the intent underlying the valuation of insurance liabilities in making these judgements.

26.        The risk margin should normally be determined having regard to the uncertainty of the net insurance liabilities, but consideration should also be given to any additional uncertainty related to the estimate of reinsurance recoveries.

27.        While the risk margin plays a role in achieving an appropriate pattern of profit emergence for a class of business, it is not appropriate to use the risk margin as a tool for smoothing the effect of changes in assumptions or valuation methods.

28.        From year to year, risk margins would generally be a constant percentage of the central estimate for each class of business, unless there has been a material change in uncertainty.  Such changes may include changed reinsurance arrangements, changes in the insurer’s gross risk profile or volume of business, or structural changes, eg legislative requirements.

The Discount Rate

29.        The value of an insurer’s liabilities is typically independent of the value of the underlying assets.  For this reason, a discount rate that is observable, market-based and objective is most appropriate.

30.        The rate to be used in discounting the expected future claims payments for a class of business is the gross redemption yield, as at the calculation date, of a portfolio of sovereign risk securities with a similar expected payment profile to the insurance liabilities for that class (eg Commonwealth Government securities for Australian dollar liabilities).

31.        Where the expected payment profile of the liabilities cannot be matched - for example, because the duration is too long - a discount rate regarded as consistent with the intention of this Standard should be assumed.

Methodologies for the Valuation of Insurance Liabilities

32.        It is not the purpose of this Standard to be prescriptive in terms of the methods to be adopted for the valuation of the insurance liabilities.  The appropriateness of any methodology will depend on:

(a)          the class of business;

(b)         the nature, volume and quality of the available data;

(c)          the circumstances of the insurer; and

(d)         considerations of materiality.

33.        Where an Approved Actuary provides advice on the valuation of insurance liabilities, it is considered necessary that, subject to considerations of materiality, comprehensive actuarial analyses and modelling techniques will be employed.  While the principles of establishing the central estimate and risk margin in respect of each class of business are described in this Standard, it remains the professional responsibility of the Approved Actuary to determine an appropriate methodology.  Guidance Note GGN 210.1 Actuarial Opinions and Reports on General Insurance Liabilities contains a range of suggested methodologies that may help the Approved Actuary in calculating insurance liabilities.  GGN 210.1 should be used as interim guidance until the Institute of Actuaries of Australia releases its own professional standards and guidance notes in this area.

34.        Approximate methods may be employed in the valuation of the insurance liabilities, subject to the principles of this Standard and where the result so produced is not material or not materially different from that which would result from a full valuation process.  Short tail business, for example, may justify the use of approximate methods to the extent that future expected claims are not discounted.  Similarly, an approximate method which Mortgage Lenders insurers might adopt in the valuation of insurance liabilities, is to establish case estimates for reported claims, and to construct a premium earning pattern designed to hold back premium so that it is earned in line with expected claims reporting patterns.

35.        An insurer may use an approximate method to assess if its Unearned Premium Provision (UPP), less the value of its Deferred Acquisition Expense (DAC), is a reasonable approximation of its Premiums Liabilities.  If the assessment suggests that the insurer’s Premiums Liabilities would not be materially higher from a more detailed investigation then the insurer may use its UPP less its DAC as the central estimate of its total Premiums Liabilities after adjusting for the profit margin in the UPP.  For the purposes of this assessment, materiality should be judged in terms of the impact on the balance sheet and solvency of the insurer.  In considering the appropriateness of such an approach, the Approved Actuary should have regard to, among other things:

(a)          any recent assessments of outstanding claims undertaken by the Approved Actuary since the previous calculation date of the insurer;

(b)         trends in, and the stability of, the insurer’s net combined ratios and net loss ratios over the previous three accident years, including the current year, relative to the level the insurer needs in order to achieve its required return on capital.  The Approved Actuary should make adequate allowance for working losses, large claims and catastrophes;

(c)          trends in, and the stability of, the insurer’s profits over the previous three financial years, including estimates of the likely profit for the current year.  The Approved Actuary should make adequate  allowance for working losses, large claims and catastrophes;

(d)         the insurer’s experience with respect to premium rate changes over the previous three years per unit of exposure, eg significant premium rate increases in classes that have had historically high loss ratios.  The Approved Actuary should also consider the impact of major changes to the insurer’s underwriting and claims management systems;

(e)          trends in the rate of growth in exposure for the insurer over the previous three years. The Approved Actuary should analyse premium growth arising from increases in exposure, adjusted for acquisitions, divestment of portfolios, new classes etc;

(f)           recent trends and likely developments in the insurer’s reinsurance arrangements and rates; and

(g)         proper allowance for claims handling, policy administration and other management expenses.

36.        The onus for justification of the appropriateness of any approximate method rests with the Board of the insurer and, where relevant, the Approved Actuary.  Where an Approved Actuary has been involved in the valuation of the insurance liabilities, then the Approved Actuary must report in his/her written advice on the reasons for, and the effect of, any approach to the determination of risk margins other than one consistent with paragraphs 22-28.

Estimation of Reinsurance Recoveries

37.        Reinsurance refers to arrangements where some part of individual or aggregate insurance risks are ceded to another insurer or insurers.  This includes cessions of direct writing insurers to reinsurers or other direct writing insurers, as well as retrocessions of reinsurers to their parent insurers or other reinsurers.  Reinsurance recoveries are amounts expected to be recovered under arrangements in relation to the Outstanding Claims Liabilities and the Premiums Liabilities.

38.        The valuation of net (of reinsurance) insurance liabilities is to be determined in accordance with the principles of this Standard.  The principles of this Standard should be applied with similar robustness to the valuation of gross (of reinsurance) insurance liabilities.

39.        In practice, the estimation of the value of the insurance liabilities may be either undertaken on a gross basis, with a separate estimate of the value of reinsurance recoveries, or on a net basis.  Where the process is undertaken on a net basis, it is still necessary to value separately estimates of the gross liability and the recovery amounts.

40.        In determining the estimate of reinsurance recoveries, the principles of this Standard must be complied with.  Where the advice of an Approved Actuary is required in regard to the valuation of the insurance liabilities, the Approved Actuary should also consider the estimation of reinsurance recoveries.  Actuarial judgement should be used in the application of the principles of this Standard in those circumstances.

41.        The estimation of the value of reinsurance recoveries would normally be undertaken on the basis of a class of business.  However, there are certain forms of reinsurance where recoveries depend on the combined claims experience of several classes.

Claims Escalation

42.        Appropriate allowance must be made for future claims escalation when determining the central estimates of both the Outstanding Claims Liabilities and the Premiums Liabilities.  Future claims payments may increase over current levels as a result of either or both of:

(a)          wages or price increases (inflation); or

(b)         court awarded interest, other environmental or economic causes (superimposed inflation),

and appropriate allowance must be made in both respects.  Claims payments include third party costs incurred in settling those claims such as investigation, medical and legal fees, etc.

Non-Reinsurance Recoveries

43.        Non-reinsurance recoveries are amounts that may be recovered under arrangements other than reinsurance arrangements.  These would include salvage, subrogation and sharing agreements.  The treatment of non-reinsurance recoveries should be consistent with that required by relevant Australian Accounting Standards.

Materiality

44.        Particular values are considered material to the overall result of a calculation when their misstatement or omission would cause the result to be misleading to the users of the information.  Materiality tests assess the significance of the particular value by relating it to the amount of the overall result (the base amount) to which it contributes.

45.        Materiality will always be a matter requiring exercise of judgement.  It should be recognised that the level at which a difference becomes material can be considerably lower than a statistically significant difference.  In these circumstances, careful exercise of judgement is required.

Reporting Requirements

46.        Paragraphs 25 to 31 of Guidance Note GGN 220.1 set out details on the content of an Approved Actuary’s report on liabilities. 

Guidance Note GGN 210.1

Actuarial Opinions and Reports on General Insurance Liabilities

Status

This Guidance Note has been issued by APRA as preliminary guidance for insurers and actuaries when determining the value of general insurance liabilities under GPS 210 Liability Valuation.  The Institute of Actuaries of Australia (IAAust) is developing a professional standard and guidance notes on this issue, and it is intended that this Guidance Note will be replaced by the standards of the IAAust as they are developed.

Introduction

1. In April 2000, APRA released a policy discussion paper entitled Proposed Reforms to the Prudential Supervision of General Insurance Companies in Australia.  This paper provided some detailed proposals for modernising prudential supervisory requirements that were first explored in policy discussion papers issued in September 1999.  APRA has subsequently released Prudential Standards on a range of issues; this Guidance Note is intended to support GPS 210 Liability Valuation.
2. With respect to insurance liabilities, it was noted in the policy discussion papers that prudential regulation requires consistency, rigour and robustness in the estimation of such liabilities.  Inconsistencies in the application of Accounting Standard AASB1023 compromise the integrity of the capital adequacy framework.  These inconsistencies arise because of the standard’s silence on the issue of prudential margins.  Industry practice with respect to prudential margins has been quite varied and depended on each insurer’s assessment and attitude towards risk, taxation and profit and loss implications.
3. The Insurance Act 1973 (the Act) contains a requirement that general insurers appoint an Approved Actuary.[30]  The Approved Actuary has the responsibility of advising the Board and senior management of the insurer on the value of insurance liabilities that is consistent with GPS 210.
4. The nature of the advice required from the Approved Actuary, and from other actuaries assisting in the preparation of insurance liabilities for inclusion in this opinion, places a high level of responsibility on the actuarial profession.  Actuaries accepting an appointment as an Approved Actuary, or being delegated the function of preparing an estimate of the value of insurance liabilities for inclusion in the Approved Actuary’s opinion, must consider in relation to the IAAust Professional Code of Conduct whether they have sufficient and relevant experience to justify acceptance.  In addition, the actuary should have regard to this Guidance Note and any other relevant guidance issued by APRA or the IAAust.

Relationships

5.             The relationships between Boards, management, auditors, internal actuaries and consulting actuaries can be very complex.  It is the responsibility of the Approved Actuary to clarify the relationship between these parties for the purpose of preparing advice on the value of a company’s insurance liabilities consistent with GPS 210.  The extent to which any information is obtained from, or work undertaken by, other parties must be disclosed in the Approved Actuary’s report.

6.             It is the role of the Approved Actuary to make it clear that he or she may require access to and information from management, underwriters, other employees of the company and the company’s auditors.  Approved Actuaries must, however, take full responsibility for their advice and reports and must therefore be satisfied as to the validity of information provided to them or work undertaken for them.

7.             In providing a report under GPS 210, the Approved Actuary has a legal responsibility to provide advice that complies with the Act and GPS 210, and a professional responsibility to provide advice that complies with this Guidance Note and the professional standards of the IAAust.  These responsibilities override any responsibility as an employee of, or consultant to, the insurer.

Scope

8.             It is the responsibility of an actuary valuing insurance liabilities for the purpose of compliance with GPS 210 to be conversant with the requirements of the Standard and its implications for the preparation of an opinion and report.

9.             An actuary should seek further instruction as to the scope of the opinion and report from the Board, management, other company staff or the Approved Actuary as appropriate.  This is particularly important where the actuary has a delegation to form an opinion on some, but not all, of the value of a company’s insurance liabilities, thereby requiring another party to integrate the opinion with others to form an opinion for the company as a whole that complies with GPS 210.

10.        GPS 210 specifies that when an Approved Actuary has been requested to prepare an opinion on the value of insurance liabilities, that opinion must at least include:

(a) a central estimate value of the Outstanding Claims Liabilities;

(b) a central estimate value of the Premiums Liabilities; and

(c) risk margins that relate to the inherent uncertainty in each of those central estimate values.

Data

11.        An actuary should be familiar with the administration and accounting procedures for policies and claims for the part of the company for which an opinion is required.

12.        An actuary should be conversant with the characteristics of the insurance policies and claim processes that may materially impact upon the estimation of insurance liabilities.  This may include familiarity with the:

(a)          nature of coverage;

(b)         underwriting strategy and the nature and mix of risks underwritten;

(c)          benefits payable under policy terms or by virtue of legislation, including deductibles and limits; and

(d)         reinsurance arrangements.

13.        An actuary should also be familiar with economic, technological, medical, legal and social trends within the broader community that may impact upon the value of insurance liabilities.

14.        It is an actuary’s responsibility to ensure that the data used gives an appropriate basis for estimating the insurance liabilities.  This includes the insurer’s own exposure and claim experience data, but should extend to industry data, where the insurer’s own data is not sufficient to reduce uncertainty to an acceptable level.  Where even industry data is sparse, it may be necessary to rely, to a greater or lesser extent, on subjective assessment.  The appropriate compromise between the cost of better data and the benefit, in terms of more reliable estimation, is a matter for actuarial judgement, which should take into account the materiality of the reduction in uncertainty that might result.

15.        An actuary should take reasonable steps to verify the consistency, completeness and accuracy of the data collated, against the company’s financial records.  The degree to which an actuary relies upon the data provided by the company or upon earlier or later testing of the data by the company’s auditors, and the resulting limitations that this reliance places on the actuary’s confidence in the data, should be commented upon in the report.

16.        In order to meet reporting deadlines, an actuary may be asked to value insurance liabilities as at a valuation date prior to the reporting date.  It may be intended either to use this valuation as if it were at the reporting date, or to update it to the reporting date.  Another approach is to develop a model based on analysis of data up to an earlier date, applied to data as at the valuation date.  This practice is acceptable, provided that the actuary does not have reason to believe, on the basis of the data emerging since the full analysis, that a full valuation using more recent data would give significantly (in the technical statistical sense) different results.  The actuary should comment in the report on any features of the subsequent data that might materially affect the result and quantify the difference.

The Central Estimate

- Class of Business

17.        The estimation of insurance liabilities for a company is likely to require subdivision of risks into classes or sub-classes of business with similar characteristics.  This subdivision requires an appropriate balance between homogeneity and statistical reliability.

18.        It is the responsibility of the actuary to determine the most appropriate subdivision for the purpose of analysis and projection.  However, the value of insurance liabilities must be assessed and reported for each class of business specified by APRA.

- Analysis

19.        Policy and claim experience should be analysed on an individual policy or claim basis or on the basis of cohorts of similar claims.  Depending on the nature of the class of business being examined and the availability and reliability of data, this analysis should consider the development over time of claim payments in relation to some or all of the following measures of exposure:

(a)          number of policies;

(b)         earned premium;

(c)          numbers of claims:

(i)                reported;

(ii)             continuing;

(iii)           settled;

(iv)           finalised; and

(v)              reopened etc.

(d)         prior payments;

(e)          case estimates; and

(f)           reported incurred costs.

20.        It may be necessary for some models to analyse and consider the development of these exposure items.

21.        The claim experience need not necessarily be analysed in a fashion that distinguishes claims of different status such as reported, IBNR and reopened.

22.        In some cases, it may be necessary for an actuary to estimate future, or unclosed, premiums for policies underwritten up to the reporting date.  The actuary should consider the delay between when the business is underwritten and when premiums are received and factors that influence this delay.  The division between the amount of unclosed premium that is earned and unearned should also be considered. The principles in this Guidance Note with respect to Outstanding Claim Liabilities also apply, where relevant, to unclosed premiums.

23.        The focus of GPS 210 is for estimates of insurance liabilities that are net of reinsurance and other recoveries.  Ordinarily, analysis and valuation of outstanding claims will be on a gross basis, with separate estimates for reinsurance and other recoveries.  The analysis of reinsurance and other recoveries should be appropriate to the circumstances.  The estimation of reinsurance recoveries may require separate deterministic or stochastic analysis of large claims, large events or aggregate costs that approach or exceed reinsurance retentions.  In some circumstances, however, it may be more suitable for the analysis and valuation to consider the net of reinsurance experience and add an allowance for reinsurance recoveries to arrive at the gross estimate.

24.        The actuary should initially assume that reinsurance recoveries will be made in full. Under the capital adequacy framework, the risk that recoveries will not be received from the reinsurer is part of the investment risk for the company.  Where there is a known material risk that one or more reinsurers will fail to meet their obligations, the actuary should separate reinsurance recoveries into amounts recoverable from each of those reinsurers to enable the appropriate investment and concentration risk charges to be made as prescribed by GPS 110 Capital Adequacy.  If material, the actuary should also assess the potential range of amounts unrecoverable from reinsurers, based on the uncertainty of individual and aggregate gross losses.

25.        The analysis should consider factors both internal and external to the company that may have influenced the observed patterns in historical experience.  Such factors, and changes to them, may include, but are not limited to:

(a)          underwriting strategies;

(b)         mix of business;

(c)          policy coverage, including deductibles, limits and exclusions;

(d)         legislation;

(e)          economic and social trends;

(f)           claim management procedures;  and

(g)         reinsurance programs.

Valuation Model

26.        The actuary is responsible for the selection of an appropriate valuation model, having regard to the availability and reliability of the data and the key drivers of claim cost as revealed by the data analysis or consistent with the nature of the class of business.

27.        The actuary may investigate more than one valuation model for the estimation of insurance liabilities, then select one or blend the results from more than one as considered most appropriate.

- Claim Experience Assumptions

28.        The selection of claim experience assumptions should have regard to the adopted valuation model or models and the analysis of experience.  These assumptions should include trends, other than inflation as measured by standard economic indicators, in claim experience considered suitable for the projection of outstanding claim payments.  These trends include the impact of social, economic, environmental, legislative and court precedent factors; often referred to as superimposed inflation.

29.        Escalation due to wage or price inflation should also be allowed for.

30.        Models vary depending on whether certain trends are explicit in the model or are implicitly allowed for by other assumptions.  Where trends are implicit, this should be discussed in the report.

31.        Where a sequence of explicit inflation or superimposed inflation rates are used, or where different inflation or superimposed inflation rates are used in different parts of the model, the equivalent single, level rate should be stated in the report.

32.        In some cases, there may be an insufficient amount of claim experience data on which to reliably base assumptions for the selected model or models.  The actuary may give partial or full weight to assumptions drawn from industry data, if satisfied that such an approach is appropriate.  For classes where claims are reported slowly, or where there is little early information about the severity of claims, it may be appropriate to give partial or full weight to some or all of the premium assumptions or, if there are no such assumptions explicit, to assumptions based on expected actuarial loss ratios applied to the premiums charged.

33.        All claim experience assumptions should be reviewed with each valuation of insurance liabilities and updated, if necessary, as considered appropriate.  The actuary should be satisfied that the claim experience assumptions adopted at each valuation are realistic in the context of data known at that time.  Changes required to assumptions must not be spread over more than one valuation, but this does not prevent the actuary from placing appropriate credibility on the claim experience that has emerged since the previous valuation, when determining such changes.

- Discount Rate

34.        GPS 210 prescribes how the discount rate assumption is to be determined.  This discount rate is the gross effective yield on a portfolio of sovereign fixed coupon and redemption value securities, in the currency of, and with a payment profile matching as far as possible, the expected payment profile.  For all Australian insurance liabilities, the fixed interest securities to be used are Commonwealth Government Treasury notes and bonds.  It is acceptable to use either the average rate or a series of discount rates taken from the corresponding yield curve.

35.        Sovereign fixed interest securities are typically not available to exactly match projected payments.  There are usually gaps in the maturity dates available and the longest dated such security may not be long enough.  It is appropriate to smooth, interpolate and extrapolate from the observed yields in the sovereign bond market.

36.        If the actuary applies a sequence of discount rates for future periods, the corresponding average discount rate should be calculated for each class of business and stated in the report.  The discounted mean term for each class of business should also be stated in the report.

37.        Where the value and timing of unclosed premiums have been projected, discounting should also be applied.

38.        Discounting may be disregarded where the effect of discounting does not materially change the resulting central estimate.

- Claim Administration Expenses

39.        An appropriate allowance should be made for the future costs of claim administration that are not allocated to individual claims and, therefore, not included in the data on which the claim experience assumptions were based.  The allowance for claim administration expenses should be made after consideration of historical levels of claim administration expenses, organisational structure, internal and outsourced functions and future administrative developments.  It should be noted that expenses are incurred in the making of gross payments as well as making recoveries.  It should also be noted that expense levels are often higher for older, more complex claims.  While this may be encompassed in an average rate for an active portfolio, allowance for escalating expenses may be needed for a closed portfolio.  The complexity of the approach used to determine an appropriate allowance for claim administration expenses should be commensurate with its likely materiality.

- Central Estimate

40.        The actuary is responsible for ensuring that the valuation calculations are carried out accurately.  The actuary must also be satisfied that the overall valuation process and estimates are reasonable. The actuary should quantify the impact of any changes to the valuation basis since the previous actuarial valuation conducted for the purpose of compliance with GPS 210.  Explanation of the impact of material changes should be included in the actuary’s report.

41.        GPS 210 requires that a central estimate of the Outstanding Claim Liabilities be reported.  For the purpose of GPS 210, this should be thought of as a requirement for the mean of a notional probability distribution of outcomes, without regard to whether the insurer has sufficient capital to meet all of the possible outcomes.  Where the actuary is of the view that the estimate is not such a notional mean, the reasons for this should be explained in the report, and an alternative central estimate should be provided and explained.  Such explanations will usually be in the context of the analysis of uncertainty.  It should be noted that, in the context of general insurance, the mean is typically larger than either the median or the mode, so that reporting either the median or the mode is likely to result in underestimation.  These differences are usually larger for gross than for net estimates.

Premium liabilities

42.        The actuary is also required by GPS 210 to provide an opinion on the value of Premiums Liabilities.  These are defined as insurance liabilities which relate to claim payments arising from future events insured under existing policies up until their next renewal.

43.        The general procedures and principles described in the section above for valuing Outstanding Claim Liabilities also apply to valuing Premiums Liabilities.  However, it is recognised that, as a full actuarial valuation of Premiums Liabilities is essentially a re-underwriting of the portfolio, it may not be appropriate or even possible to undertake as complete a valuation as is appropriate for Outstanding Claim Liabilities.

44.        If the premiums charged are based on actuarial advice, it will normally be appropriate to base the central estimate of the Premiums Liability on that advice, modified as appropriate for subsequent information and with current inflation and discount rate assumptions.

45.        For a reasonably homogeneous and stable portfolio, it will usually be possible to extend the outstanding claim valuation model on the basis of claim frequencies and numbers of policies, or some similar measure of exposure.

46.        For a relatively stable portfolio, it will often be possible to apply an actuarial loss ratio, based on historical performance as revealed by the outstanding claim estimates, to the unexpired premium.  If this, or the approach in paragraph 45 is taken, the actuary should investigate and, if appropriate, adjust the selected assumptions for any:

(a)          differences in nature between the unexpired risk exposure and the exposure from which the models and claim experience assumptions developed for the valuation of outstanding claim liabilities were derived;

(b)         changes in underwriting standards and premium rates or levels; and

(c)          environmental and other differences that might affect the estimated liability.

47.        In certain cases where premiums charged are not based on actuarial advice, it may not be possible to do more than assume that the premiums charged were appropriate to the risk.  In such a case it may be necessary to assume a loss ratio based on subtracting reasonable expense and profit margins.  These cases may include, but are not limited to those where:

(a)          a large element of underwriting judgement is required in relation to unique risks;

(b)         there is little past experience for the class; or

(c)          there is insufficient or no information relating to the pricing or underwriting of the risks.

48.        As a result of these investigations and considerations, the actuary should set out in the report for each class of insurance:

(a)          the nature of the unexpired risk exposure relative to recent exposure;

(b)         an explanation of the particular difficulties associated with a full valuation or re-underwriting of Premium Liabilities for material classes of business;

(c)          a description of the approach adopted in order to reach an opinion on the value of Premiums Liabilities; and

(d)         a discussion of the limitations of the approach adopted versus undertaking a full valuation of Premiums Liabilities.

49.        The complexity of the selected approach should have regard to the materiality and uncertainty of the Premiums Liabilities in the context of the total insurance liabilities for each particular class of business and the insurance liabilities for the company as a whole.

50.        There should ideally be a high degree of continuity between the following as progressively more information becomes available:

(a)          the estimation of Premiums Liabilities;

(b)         the estimation of IBNR liabilities; and

(c)          the estimation of reported claims.

Uncertainty

51.        The value of insurance liabilities is uncertain.  Sources of this uncertainty include, but are not limited, to the following:

(a)          the valuation model or models adopted for analysis and projection are unable to fully capture the complexities of an actual claim process;

(b)         fluctuations in observed claim experience result in uncertainty in selecting suitable assumptions for the valuation model;

(c)          errors in the claim data result in errors in selecting assumptions;

(d)         future economic and environmental factors that impact upon future claim payments are uncertain;

(e)          projected payments relating to Premiums Liabilities relate to events that are yet to occur; and

(f)           there is uncertainty in the projected payments, even if the true claim experience assumptions could be found for a perfect model.

52.        Although the analogy is not exact, it is useful to think of the true value (which can only be known, in hindsight, after all claims are settled and, even then, only imperfectly) as a random variable, drawn from a probability distribution of possible outcomes.  This notional probability distribution has an expected value and shape that can be quantified in terms of its second and higher moments.  The aim of the actuarial estimation process is to arrive at an estimate of the notional expected value.  It is also possible to think in terms of this estimate having a standard error, skewness, etc.

53.        The actuary is required to quantify the uncertainty, which will generally require use of one or more of the following:

(a)          statistical analysis;

(b)         sensitivity analysis, changes to claim experience assumptions or the valuation models;

(c)          comparison with previous valuations;

(d)         analysis of scenarios; and

(e)          judgement.

54.        In this quantification, it may be useful to think in terms of two components of uncertainty, independent and systemic:

(a)          Independent variation arises out of factors that have an isolated impact on individual policies or claims.  If there is a sufficient body of data, it is susceptible to rigorous statistical analysis.  It can be controlled by diversification and reinsurance.  Its relative importance is inversely proportional to the square root of the size of the portfolio; and

(b)         Systemic uncertainty arises out of factors that affect the portfolio as a whole. Because of the nature of many of these factors, it is not easily susceptible to statistical analysis, if at all.  Even where a reasonable body of past data is available for analysis, it can often be argued that the conditions observed in the past are unlikely to continue unchanged in the future.  Most assessments of systemic uncertainty rely heavily on actuarial judgement.

55.        The above split is, of course, an oversimplification.  Actual experience is driven by factors that range between these two extremes.  Most real world variables are partially correlated, rather than perfectly correlated or perfectly independent.  The split does, however, provide a useful framework for discussing and assessing overall uncertainty.

56.        GPS 210 requires the actuary to estimate uncertainty in terms of the 75th percentile, and half the coefficient of variation, of the net insurance liability, excluding investment and operational risks, and assuming a matched portfolio of sovereign risk assets.  The risk of reinsurance default should be included in this assessment (see paragraph 24).

57.        Where classes of business are valued separately, uncertainty should be assessed for each class separately, as if that class stands alone.  The actuary should initially assess the 75th percentile of the combined Outstanding Claim Liabilities and Premiums Liabilities.  This should then be split between Outstanding Claim Liabilities and Premium Liabilities.  In the absence of any better basis, it is acceptable to assume this split is in proportion to the respective central estimates.  If the actuary is concerned that the distribution of the total liability is particularly skewed, the actuary should form a view as to whether the 75th percentile is less than half the coefficient of variation above the mean and substitute the higher value.  For less extreme distributions, while it may be helpful, an explicit estimate of the coefficient of variation is not required.

58.        While it may be helpful for the actuary to form a view as to the approximate shape of the notional probability distribution, this is not necessary.  All that is required, is for the actuary to adopt a figure which is intended to be the higher of the 75th percentile and half the coefficient of variation more than the mean.  Where the actuary does work in terms of a particular notional probability distribution, this should be described in the report, along with the reasons why it is considered appropriate.  Where this is not done, the actuary should discuss the reasoning behind the figure chosen.

59.        As it will be necessary to allow for the benefits of diversification across the company as a whole, the actuary should also discuss the way in which the uncertainties, of the class of business being valued, might interact with the other business of the company.  This can be done in terms of a discussion of the independent and systemic components of the assessed uncertainty.  Where this is not feasible or considered appropriate, the actuary should indicate the extent of uncertainty, as if the insurance liabilities for the class of business being assessed were of the size of the likely total insurance liabilities for the company as a whole.

60.        The actuary should describe, in a qualitative fashion, the key drivers of uncertainty for the class of business or portfolio being valued.  Material changes in these key drivers, or uncertainty generally, since the previous valuation, should be discussed and, if appropriate, quantified.

61.        Material changes, since the previous valuation, in the probability distribution of insurance liability outcomes by class of business must be explained in the report.

62.        The actuary also has a general responsibility to explain the practical consequences of the uncertainty of the estimates presented.  In many cases, the range of reasonable uncertainty will be very large.  The conclusions that may be drawn, near the ends of this range, may be totally different, for example, in terms of large profits versus insolvency.  In addition to providing the information required under GPS 210, the actuary should attempt to explain uncertainty in terms that will be understood by the insurer.

Risk margins

63.        GPS 210 calls for a risk margin intended to give a 75% probability that an insurer’s insurance liabilities will prove adequate, but not less than half of the coefficient of variation of the combined central estimate.  This margin must be reported separately for Premiums and Outstanding Claim Liabilities within each class of business, and where the actuary deems it appropriate, allowance for diversification and/or reinsurance should be made in determining the risk margin.  Such an allowance will normally be appropriate.  Where the actuary takes the view that it is not appropriate, the reasons for adopting this view should be given.

64.        The derivation of the risk margins in the context of the assessed uncertainty, and how this complies with the requirements of GPS 210, should be described in the report.  Normally, the risk margin, as a proportion of the central estimate, should not change greatly between valuations.  Where there is a change, the reasons for the change should be explained.

65.        The approach adopted by the actuary who adjusts the risk margins for diversification and reinsurance should be clearly documented.  Normally, the actuary should consider the impact of the size of the insurance liabilities for the company as a whole and the extent of less than full correlation of potential outcomes between classes of business.  As the uncertainties involved in assessing risk margins are even greater than those of central estimates, it will usually be appropriate for the actuary to base conclusions mainly on the extent of correlation between classes of business for the entire market, but regard should also be given to any observed correlations for the company.

66.        The actuary should apportion the diversification benefit between classes of business.  While this is an essentially arbitrary allocation that is performed for reporting purposes, the approach adopted should be documented.  Approaches such as a proportional reduction to the amounts of risk margin or to the probability of adequacy by class of business would usually be considered suitable.

Involvement of more than one actuary

67.        Larger insurers underwriting numerous and sizeable classes of business are likely to require the services of more than one actuary to assess the value of Outstanding Claim Liabilities and Premiums Liabilities as well as the risk margins.  In these circumstances, the Approved Actuary has responsibility for coordinating the valuations and summarising the results into one opinion for delivery to the insurer’s Board and senior management.

68.        In preparing the summary opinion for the insurance liabilities for the company, the Approved Actuary should be satisfied as to the suitability of central estimates, risk margins and diversification benefits prepared by other actuaries for inclusion in the opinion.  Where the Approved Actuary is not satisfied as to the suitability of a particular item for inclusion in the opinion, then an alternative figure is to be provided.  Justification for varying the figure from the original is to be included in the summary report.

69.        While the assessment of central estimates for Outstanding Claim Liabilities and Premiums Liabilities, uncertainty and risk margins for various classes of business in isolation is a relatively independent exercise capable of delegation to separate actuaries, the assessment of diversification benefits for the company is unlikely to be.  The Approved Actuary is responsible for ensuring that the diversification benefit is assessed on a holistic basis for the company.

70.        Some forms of reinsurance may be dependent upon the aggregate claim experience of a number of classes of business.  Where an actuary is undertaking the valuation of classes of business completely encompassed by such a reinsurance arrangement, then the impact of the reinsurance on the central estimate of Outstanding Claim Liabilities and risk margin should be considered and included as part of the report.  Where separate actuaries are valuing classes of business within such a reinsurance arrangement, it is the responsibility of the Approved Actuary to ensure that the impact of the reinsurance arrangement on the central estimates and risk margins is appropriately assessed and documented.

71.        In order to meet reporting deadlines for published accounts, it may be necessary to invert the natural sequence and determine diversification adjustments before the individual classes of business valuations are completed.  It will normally be acceptable for individual portfolio reports to show risk margins based on analysis of diversification benefits at the most recent previous valuation.  If this is done, the continued appropriateness of those adjustments should be discussed.

Reporting

72.        Although referred to in the singular throughout this Guidance Note, it is likely that two styles of report may be required: an insurance liabilities report and a risk margin diversification report.  This is particularly the case where more than one actuary is involved.  The actuary should prepare, date and sign a written final report. For both styles of report, the actuary should include the following items:

(a)          who commissioned the report and the addressee.  Where other actuaries prepare separate reports, the addressee should be the Approved Actuary.  At least a summary opinion is to be prepared by the Approved Actuary, addressed to the insurer’s Board.  This report should disclose the actuaries who have undertaken the valuations by class of business;

(b)         the name of the actuary and the capacity in which the actuary is acting;

(c)          purpose of the report and terms of reference which, as a minimum, are to advise the values of Outstanding Claim Liabilities and Premiums Liabilities and the corresponding risk margins in compliance with GPS 210.  It should be made clear that the report should not be used for purposes for which it is not suitable or intended;

(d)         extent of compliance with this Guidance Note and reasons for not complying fully with it; and

(e)          definition of terms and expressions used in the report that may be ambiguous or subject to wide interpretation.

73.        The two styles of report are distinct.  Each should deal with the items indicated below for the respective reports.

(a)          Insurance liabilities report should include:

(i)           classes of business for which a valuation has been undertaken;

(ii)         nature, appropriateness, accuracy and interpretation of data;

(iii)      analysis of policy and claim experience, highlighting significant aspects of recent experience;

(iv)       valuation model or models and the claim experience assumptions adopted for the projection of the Outstanding Claim Liabilities and Premiums Liabilities;

(v)         changes to the approach, model or models and claim experience since the previous report of this nature;

(vi)       comparisons of actual experience, for both Outstanding Claim Liabilities and Premiums Liabilities with that expected under the assumptions of the previous report of this nature;

(vii)    approach to the assessment of uncertainty, 75th percentile and/or coefficient of variation and derivation of the risk margin that complies with GPS 210; and

(viii)  results of the valuation that clearly identify:

• the central estimate of Outstanding Claim Liabilities by class of business;
• the central estimate of Premiums Liabilities by class of business;
• the coefficient of variation (if applicable) and risk margins (before diversification) by class of business, separately for Outstanding Claim Liabilities and Premiums Liabilities; and
• if diversification adjustments based on a previous valuation have been applied, the adjusted risk margins.

(b)         Risk margin diversification report should include:

(i)           summary of Outstanding Claim Liabilities, Premiums Liabilities, 75th percentiles and/or coefficient of variation (where applicable) and risk margins by class of business for the entire company;

(ii)         approach, model or models and assumptions, particularly with respect to correlations, for allowing for diversification across the classes of business within the company;

(iii)      changes to the model or models and assumptions since the previous report of this nature;

(iv)       results of the risk margin diversification report that clearly identifies the diversification benefit; and

(v)         if diversification adjustments based on a previous valuation have been used in individual liability reports, the continued appropriateness of those adjustments.

74.        In all cases, the approach and model or models adopted should be clearly described and the derivation of assumptions clearly explained with reference to the analysis of data.  Any limitations should also be stated.

75.        Where the principal requires the actuary to use specific assumptions or the actuary is relying on the interpretation of legislation, standards or rulings supplied by the principal or its other advisers, the actuary must clearly state the circumstances, discuss whether or not the assumptions are reasonable and consistent with this Guidance Note, GPS 210 and other relevant professional standards, and discuss the implications of any divergence from this Guidance Note, GPS 210 and professional standards.

Prudential Standard GPS 220

Risk Management for General Insurers

Prudential Standard

1. This Prudential Standard, made under section 32 of the Insurance Act 1973 (the Act), applies to all general insurers authorised under the Act.

Governance

Fitness and Propriety

2.             Insurers must ensure that persons occupying key positions within the insurer have the degree of probity and competence commensurate with their responsibilities. 

3.             For this purpose, insurers should have in place policies and procedures to address fitness and propriety.  These policies and procedures should at a minimum address the criteria for fitness and propriety that APRA uses to assess fitness and propriety set out in paragraph 6.

4.             For locally-incorporated insurers, persons occupying key positions  means:

(a)          directors;

(b)         senior managers;[31]

(c)          the insurer’s auditor appointed under the Act and approved by APRA (Approved Auditor);[32] and

(d)         the insurer’s actuary appointed under the Act and approved by APRA (Approved Actuary),[33] where relevant.

5.             For foreign-incorporated insurers operating in Australia as branches (foreign insurers), persons occupying key positions means:

(a)          senior managers of the Australian operations;

(b)         the foreign insurer’s agent in Australia appointed under the Act;[34]

(c)              the foreign insurer’s Approved Auditor;  and

(d)             the foreign insurer’s Approved Actuary, where relevant.

6.             The criteria for fitness and propriety[35] are as follows:

(a) the person has not been convicted of an offence against or arising out of the Act or the Financial Sector (Collection of Data) Act 2001;

(b) the person has not been convicted of an offence against or arising out of a law in force in Australia, or the law of a foreign country, if the offence concerns dishonest conduct or conduct relating to a financial sector company within the meaning of the Financial Sector (Shareholdings) Act 1998;

(c)               the person has never been bankrupt, has not applied to take the benefit of a law for the relief of bankrupt or insolvent debtors, or has not compounded with his or her creditors;

(d)              the person has no actual or potential conflicts of interest that are likely to influence their ability to carry out their role and functions with appropriate probity and competence;

(e)               the person has adequate experience and demonstrated competence and integrity in the conduct of business duties;[36] 

(f)                the person is not of bad repute within the business and financial community;

(g)              in the case of an Approved Auditor:

(i) the person is not a director or employee of the insurer or of a related body corporate within the meaning of section 50 of the Corporations Act 2001; and

(ii) the person is registered as an auditor under the Corporations Act 2001; and

(h)       in the case of an Approved Actuary, the person is not the Chief Executive or a director of the insurer, or of a related body corporate within the meaning of section 50 of the Corporations Act 2001 (except where that related body corporate is a subsidiary of the insurer).

7.             A person may not act as a director, a senior manager or an agent in Australia if that person is a disqualified person.[37]  The disqualification criteria are set out in the Act.[38]

Eligibility Criteria for Approved Auditors and Approved Actuaries

8.             In addition to the general requirements of fitness and propriety outlined in paragraph 6, APRA can only approve the appointment of an Approved Auditor and Approved Actuary if the person concerned meets the following eligibility criteria:[39]

(a) the person has appropriate formal qualifications and is a member of a suitable professional body; 

(b) the person has a minimum of 5 years’ experience in the general insurance industry; and

(c)          the person is ordinarily resident in Australia.

9.             APRA may approve individuals, on a case-by-case basis, who do not  meet the eligibility criteria in paragraph 8 if the insurer can demonstrate to the reasonable satisfaction of APRA that exceptional circumstances exist as to why the person should be approved as an Approved Auditor or Approved Actuary.

10.        Reflecting the importance of the positions, and in order to demonstrate independence and avoid potential conflicts of interest, a person is not eligible to be appointed as both an Approved Auditor and Approved Actuary to the same insurer.

11.        Further detail in relation to these eligibility criteria and the particulars required for an application are set out in Guidance Note GGN 220.1 Governance.

12.        APRA may direct that an insurer remove a person occupying a key position (other than an Approved Auditor or Approved Actuary)[40] where APRA finds that the person:

(a)          is a disqualified person under the Act;[41] or

(b)         does not meet one or more of the criteria for fitness and propriety.

13.        APRA may revoke the approval of a person’s appointment as an Approved Auditor or Approved Actuary,[42] and disqualify a person from holding an appointment as an Approved Auditor or Approved Actuary,[43] where APRA finds that the person:

(a) has failed to perform adequately and properly the functions and duties of such an appointment; or

(b) otherwise does not meet one or more of the criteria for fitness and propriety; or

(c)          does not meet the eligibility criteria for such an appointment.

14.        Individuals affected by a decision made by APRA referred to in paragraphs 12-13 may request that APRA review that decision.  If APRA confirms or varies the decision, or fails to do either within 21 days, the person affected may then make an application to the Administrative Appeals Tribunal.  The appeal process is set out in Part VI of the Act.

Roles and Obligations of Key Positions

(i) Boards

15.        The Board has ultimate responsibility for the safety and soundness of an insurer.  Accordingly, the Board should have responsibility for approving and reviewing business strategies and significant policies of the insurer.  The Board must use its best endeavours to identify and understand the major risks faced by the insurer.  The Board must ensure that an appropriate, adequate and effective system of risk management and internal control is established and maintained, and must use its best endeavours to ensure that senior management monitors the effectiveness of the risk management and control system.

16.        Given the Board’s responsibilities, it is essential that a shareholder (or a group of associated shareholders) of an insurer is not in a position to exercise undue or disproportionate control or influence over that insurer’s Board, policies or operations.

17.        As a guide, holdings under 15 per cent of an insurer’s voting shares should have representation of no more than one on a Board of six or less and no more than two on a Board of seven or more.  Where shareholdings over 15 per cent have been approved under the Financial Sector (Shareholdings) Act 1998, the shareholder’s Board representation can be higher, but should remain broadly proportionate to the shareholding concerned.

18.        In addition, at all times, the Board of a locally-incorporated insurer must have:

(a)          a minimum of five directors;

(b)         a non-executive Chair;  and

(c)          a majority of non-executive directors.

At least two directors of the insurer must be Australian residents, one of whom must be a non-executive.  Further detail, including guidance for foreign-owned locally-incorporated insurers, is set out in Guidance Note GGN 220.1.

19.        Insurers must provide APRA with details of all newly appointed directors, including their name, principal business associations and curriculum vitae, within 14 days of their appointment.  In addition, insurers must provide APRA with an updated annual statement listing all of its directors (including details of any changes to business associations) no later than at the time which the insurer lodges its yearly statutory accounts.

20.        The Board of a locally incorporated insurer must establish appropriate Board Committees, including at a minimum a Board Audit Committee. The Board Audit Committee must be made up of a majority of non-executive directors and its function shall be to monitor compliance with the Board’s policies, as well as prudential and statutory requirements.  The Chair of the Board must not also be the Chair of the Audit Committee.  Where the insurer is part of a larger corporate group, APRA may allow the insurer to use the Group Audit Committee as a Board  Audit Committee where it is demonstrated that the Group Audit Committee can effectively address the needs of the insurer (provided the Group Audit Committee has a majority of directors who are non-executives of the insurer).  Further detail in respect of Board Audit Committees is set out in Guidance Note GGN 220.1.

(ii)    Senior Management

21.        Senior managers comprise persons employed by an insurer who exercise senior management responsibilities.  Senior management responsibilities[44] means having primary responsibility for one or more of the following:

(a)          high level decision making;

(b)         implementing strategies and policies approved by the Board;

(c)          developing processes that identify, manage and monitor risks incurred by the insurer; and

(d)         monitoring the appropriateness, adequacy and effectiveness of the risk management system.

22.        Insurers must provide APRA with a list of senior management positions and the responsibilities of those positions.  Details of the individuals who occupy these positions, including their name and curriculum vitae, must also be submitted within 14 days of their appointment.  In addition, insurers must provide APRA with an updated annual statement listing all senior management positions, and names of persons occupying those positions, no later than at the time which the insurer lodges its yearly statutory accounts.

(iii) Senior Officer from Outside Australia (Foreign Insurers)

23.        As in the case of locally incorporated insurers, the ultimate responsibility for the safety and soundness of a foreign insurer resides with its Board.  However, for practical purposes, APRA will allow a foreign insurers’ Risk Management Strategy (refer paragraphs 40-44) and Reinsurance Management Strategy (see GPS 230 Reinsurance Arrangements) and the Board Declaration (refer paragraphs 54-55) to be approved by a senior officer outside Australia with delegated authority from the Board.  The senior officer must have responsibility for overseeing the Australian branch operation.

24.        At the time of nominating a senior officer from outside Australia, foreign insurers must provide APRA with details of that person, including their name and curriculum vitae. These details must be resubmitted to APRA within 14 days when there is any change in the senior officer from outside Australia.  The foreign insurer must ensure that the designated senior officer meets the standards of fitness and proprietary set out in this Standard.

(iv) Approved Auditor

25.        The Approved Auditor must audit the annual accounts of an insurer as required under the Act.[45]  The Approved Auditor must provide a certificate to the insurer, and that certificate must be submitted by the insurer to APRA together with the yearly statutory accounts.  The certificate must fulfil the requirements set out in Guidance Note         GGN 220.1.

26.        The Act requires that an insurer must make arrangements to enable the Approved Auditor to undertake his/her functions.[46]  These arrangements would normally include ensuring that the Approved Auditor is fully informed of APRA’s prudential requirements for the insurer (such as conditions on authorisation, variations to prudential standards, determinations and exemptions), as well as any other information that APRA has provided to the insurer that may assist the Approved Auditor in performing his/her duties.

27.        In addition, the insurer must ensure that its Approved Auditor has access to all relevant data and people which the Approved Auditor reasonably believes is necessary to fulfil his/her obligations under the Act, Insurance Regulations 1974, Prudential Standards and the Financial Sector (Collection of Data) Act 2001 and Reporting Standards.

28.        An Approved Auditor may also be required to undertake other functions specified by APRA in consultation with the insurer.  Accordingly, APRA may, in consultation with an insurer, request a specific review of a particular aspect of the insurer’s operations or risk management system. The cost of specific reviews will be borne by the insurer.

29.        The specific reviews will be conducted along the lines of an “Engagement to Perform Agreed-Upon Procedures” (refer Auditing Standard 904).[47]  The report of such reviews must be submitted to APRA and the insurer simultaneously, within 3 months after the review is commissioned.

(v) Approved Actuary

30.        The Approved Actuary must prepare a report in accordance with GPS 210 Liability Valuation and provide this report to the insurer’s Board.  The insurer must submit this report to APRA at the same time as it submits its yearly statutory accounts.  An Approved Actuary may also be required to provide other information to APRA on request.[48]

31.        The Act requires that an insurer must make arrangements to enable the Approved Actuary to undertake his/her functions.[49]  These arrangements will normally include ensuring that the Approved Actuary is fully informed of APRA’s prudential requirements for the insurer (such as conditions on authorisation, variations to Prudential Standards, determinations and exemptions), as well as any other information that APRA has provided to the insurer that may assist the Approved Actuary in performing his/her duties.

32.        In addition, the insurer must ensure that its Approved Actuary has access to all relevant data and people which the Approved Actuary reasonably believes is necessary to fulfil his/her obligations under the Act, Insurance Regulations 1974 and Prudential Standards.

Non-routine Reporting by Approved Auditors and Approved Actuaries

33.        Approved Auditors and Approved Actuaries are required to make non-routine reports in certain circumstances.  This might be where APRA requests specific information, or where the information available to the Approved Auditor or Approved Actuary is of material interest to APRA.[50]  Additional detail on the nature of non-routine reporting is set out in Guidance Note GGN 220.1.

Meetings with Approved Auditors and Approved Actuaries

34.        Liaison with an insurer’s Approved Auditor or Approved Actuary will normally be conducted under trilateral arrangements involving APRA, the insurer, and its Approved Auditor or Approved Actuary.  Any one of these three parties can initiate meetings or discussions when considered necessary.  Notwithstanding the trilateral relationship, APRA and an insurer’s Approved Auditor or Approved Actuary may meet on a bilateral basis where either party deems this to be necessary.

Risk Management

35.        A system of effective risk management and control is critical to the safety and soundness of the operations of insurers.  The Board and senior management of an insurer must develop, implement and maintain a sound and prudent Risk Management Strategy that identifies the insurer’s policies and procedures, processes and controls that comprise the insurer’s risk management and control systems.  These systems should be appropriate to the size, business mix and complexity of the insurer’s operations and address all material risks, financial and non-financial, likely to be faced by the insurer.

36.        The Board is charged with the responsibility to instil a strong risk control culture throughout the insurer, so that material risks and potential problems that emerge can be identified, managed and promptly resolved in the normal course of business operations.

37.        No matter how well designed and operated, risk management and control systems will be subject to some inherent limitations.  Nonetheless, risk management and control systems should provide the Board (and APRA) with a reasonable assurance that an insurer’s business is appropriately controlled and that its risks are being prudently and soundly managed.

38.        At a minimum, the risk management and control systems must include:

(a)          a comprehensive written Risk Management Strategy approved by the Board (or in the case of foreign insurers, approved by an appropriate senior officer from outside Australia with requisite Board delegation);

(b)         sound risk management policies and procedures to identify, manage, monitor and report on the key risks of the insurer; and

(c)          clearly defined managerial responsibilities and controls.

39.        These elements will be considered by APRA when evaluating insurers’ risk management and control systems.

Risk Management Strategy (RMS)

40.        Each insurer is required to maintain at all times a written RMS, approved by the Board (or in the case of foreign insurers, a senior officer from outside Australia with requisite Board delegation).[51]  The RMS should be appropriate to the size, business mix and complexity of operations of the insurer and must define and document the insurer’s objectives and strategy for risk management and internal control.

41.        An insurer’s RMS must be submitted to APRA within 14 days of its being approved by the Board.

42.        Each insurer must review its RMS regularly (at least annually) to ensure it provides an adequate framework to monitor the operating circumstances that may impact on the insurer’s risk profile. The RMS must be reviewed (and if necessary, amended) where there is material change to the operations of an insurer.  An updated, Board approved, copy must be provided to APRA within 14 days after Board approval.

43.        An insurer must substantially adhere to its RMS at all times and must advise APRA if it intends to undertake activities in a manner that represents a material deviation from its RMS.  Any such activities should first be approved by the Board.  Should the RMS then require amendment, a revised RMS must be approved by the Board and submitted to APRA within 14 days of Board approval.

44.        The RMS must cover both the Australian and, where relevant, the overseas operations of the insurer.  Further detail on the content of the RMS is contained in Guidance Note GGN 220.2 Risk Management Systems.

Processes for Risk Identification and Assessment

45.        An effective risk management system identifies, manages, monitors and continually assesses the material risks that could adversely affect the operations of an insurer.

46.        Whilst the risk management systems of an insurer must address all material risks, APRA considers that at a minimum the following categories must be addressed in an insurer’s risk management systems: balance sheet and market risk (including investment risk, insurance risk, product design and pricing risk, underwriting and liability risk, liquidity risk, risk arising from claims management and derivatives risk); credit risk; and operational risk (including legal and reputational risks). 

47.        In addition, an insurer’s risk management systems should also take into account the potential risks arising out of the insurer’s reinsurance arrangements.  That is, there must be a clear link between the insurer’s Reinsurance Management Strategy (as required by GPS 230) and the insurer’s risk management systems.

Control Activities

48.        Control activities are the policies and procedures that help ensure Board and senior management directives are carried out.  In this way, action can be taken to adequately address risks faced by the insurer.  Control activities should be reflective of the size and operations of the insurer.

49.        Control activities would normally include: reviews by Board and senior management; activity controls for each division or department; physical controls; the establishment of underwriting limits and checking compliance with limits; a system of approvals and authorisations; verifications and reconciliations; and segregation of duties.  Guidance Note GGN 220.2 sets out some further examples.

Information and Communication

50.        Pertinent information should be identified, captured and communicated in a form and timeframe that will enable the responsibilities of the insurer to be met.  An insurer’s information systems must be capable of producing financial, operational and compliance data, and of dealing with external market information about events and conditions that are relevant to decision making.  Internal information systems must be secure and supported by adequate contingency arrangements.

51.        Effective communication should occur throughout the insurer to ensure that all staff fully understand and adhere to policies and procedures affecting their duties and responsibilities and that other relevant information is reaching the appropriate personnel.

Processes for Monitoring Risks

52.        The overall effectiveness of the insurer’s risk management and control systems must be monitored.  Depending on the size and complexity of operations of an insurer, risk management systems may be monitored on an ongoing or periodic basis. At a minimum, there must be periodic internal audits with results being reported promptly to the Board or the Board Audit Committee and to senior management.

53.        Where deficiencies are identified as part of the monitoring process or internal audit, these must be reported in a timely manner to the appropriate management and addressed.  Material deficiencies must be reported to the Board or the Board Audit Committee and senior management.  For this purpose, a material deficiency can result not only from a single deficiency, but from a number of small deficiencies that, when considered together, amount to a material deficiency.

Board Declaration

54.        An insurer must provide APRA with a Board Declaration signed by 2 directors, or in the case of a foreign insurer, by a senior officer from outside Australia delegated the requisite authority from the Board, at the same time it lodges its yearly statutory accounts.

55.        The purpose of the Board Declaration is to ensure the Board undertakes a regular informed assessment of all key risks.  The Board Declaration is to certify that strategies have been put in place to monitor those risks.  Broadly, the Board is required to confirm that the insurer has systems in place to ensure compliance with legislative and prudential requirements, and that the Board has satisfied itself as to the adequacy of, and compliance with, the insurer’s risk management and reinsurance arrangements.  Details of the Board Declaration are set out in Guidance Note GGN 220.2.

Business Plan

56.        A business plan is an important management and control tool that enables a company to communicate its strategic direction and objectives, identify opportunities in the market place, forecast results and establish benchmarks.  A sound business plan also needs to consider the impact of differing assumptions or scenarios on the insurer’s financial position.

57.        Each insurer must at all times maintain a business plan approved by the Board that is revised in response to developments in the insurer’s operational environment.  This plan must be submitted to APRA annually (as well as whenever material changes to the plan are made).

Other Reporting Requirements - Insurance Business Outside Australia

58.        Where an insurer conducts insurance business outside Australia, it must notify APRA in writing if its right to conduct that business ceases, or if the insurer’s right to conduct insurance business has been limited or otherwise materially affected under a law of the jurisdiction in which the business is being conducted.  Notification must be provided within 14 days of the event occurring.

Guidance Note GGN 220.1

Governance

1. The internal governance structure of an insurer is critical to ensuring that the interests of policyholders are protected.  For an internal governance structure to be effective, the Board, senior management and appointed experts of an insurer must have the probity and competence necessary to develop, monitor and review sound systems for managing risk.
2. In addition, risk management and control systems should be supported by a strong and fully informed Board, the use of Board Audit Committees and independent experts.

Fitness and Propriety

3.             In accordance with paragraphs 2-3 of GPS 220 Risk Management, insurers must ensure that persons occupying key positions within the insurer have the degree of probity and competence commensurate with their responsibilities.  For this purpose, insurers should have in place policies and procedures to address fitness and propriety.  Accordingly, insurers must assess all new persons filling key positions, and those of existing staff, and should review these assessments at least annually.

4.             An insurer should notify APRA immediately if a key person no longer complies with the tests of fitness and propriety established by the insurer.

5.             APRA may conduct a review of the fitness and propriety of an individual.  Where APRA conducts such a review, APRA will allow access to the information collected as part of the review where the provider of the information has granted permission for the information to be released.  APRA will not release information where it is prohibited from doing so under any agreement with the provider of the information or under any law.

Roles and Obligations of Key Positions

(i) Boards

6.             Paragraphs 17-18 of GPS 220 set out the requirements for the composition of an insurer’s Board.  The Board of an insurer must collectively possess appropriate skills and experience to understand the risks of that insurer’s business.  This could include (but is not limited to) actuarial, accounting, finance, insurance business and legal expertise.

7.             In the case of a foreign-owned locally-incorporated insurer, non-executive directors (including the Chair) of the local Board may include Board members or senior management of the parent company (including insurance subsidiaries of the foreign parent).  APRA will also accept a Board member or senior manager of the parent company to be the Chair of the Australian insurer provided the Chair is available to consult with APRA if required.

8.             Non-executive directors are persons not part of the management of the insurer, nor of any related body corporate[52] of the insurer.[53]

9.             The Board must provide the Approved Auditor and Approved Actuary of the insurer with the opportunity to raise matters directly with the Board.  This includes instances where the matters have already been raised with senior management or the Board Audit Committee, but have not been dealt with to the satisfaction of the Approved Auditor or Approved Actuary.

(ii) Board Audit Committees

10.        Audit Committees play an important role in establishing, maintaining and developing the control systems and compliance culture within an insurer. Locally incorporated insurers must have a Board Audit Committee.

11.        Where the insurer is part of a larger corporate group, APRA may allow the insurer to use the Group Audit Committee as its Board Audit Committee where it is demonstrated that the Group Audit Committee can effectively address the needs of the insurer.  In addition, the Board of the insurer must retain the authority to commission the Group Audit Committee to undertake work on behalf of the insurer.  The Board of the insurer must also be able to arrange meetings with the Group Audit Committee in order to determine matters particular to the business of the insurer.

12.        The Audit Committee should, at a minimum, oversee the insurer’s financial reporting, internal and external audits, the appointment of the Approved Auditor, and generally assist the Board in providing an objective, non-executive review of the effectiveness of the insurer’s financial reporting and risk management and control processes.

13.        The Audit Committee must review the Approved Auditor’s engagement every year, including evaluating the Approved Auditor’s independence in accordance with Statement of Auditing Practice AUP 32 “Audit Independence”.[54]

14.        While some duties placed on directors may be delegated to the Audit Committee, the Board retains ultimate responsibility for ensuring that those duties are performed. The insurer must make such arrangements and give the Audit Committee sufficient powers to enable it to obtain all information necessary for the performance of its functions.

15.        The Audit Committee must invite the Approved Auditor and Approved Actuary of the insurer to the meetings of the Audit Committee and, where necessary, provide the Approved Auditor and Approved Actuary with the opportunity to bring matters to the attention of that Committee without reference to the other directors or senior management of the insurer.

(iii) Approved Auditors and Approved Actuaries

16.        An insurer must appoint an auditor (Approved Auditor) in accordance with the Act, and have this appointment approved by APRA.[55] 

17.        Subject to paragraph 19, an insurer must appoint an actuary (Approved Actuary) in accordance with the Act, and have this appointment approved by APRA.[56] 

18.        The Approved Auditor’s primary role is to provide an independent and objective view on the truth and fairness of financial statements, and the Approved Auditor may also provide an assessment of the internal controls and processes within an insurer.  The Approved Actuary’s primary role to provide advice on the valuation of insurance liabilities.

19.        An insurer will be exempt from the requirement to have an Approved Actuary where:

(a)          the total insurance liabilities of the insurer are less than $20 million, and do not include a material amount in respect of a class of business which is long tail business.  Long tail business refers to those classes of business where the claims are typically settled one year or more after the date of occurrence of the event that gives rise to the claim;  or

(b)         the insurer is able to satisfy APRA that actuarial advice is not warranted (in these cases, APRA will also need to seek the approval of the Treasurer for such an exemption).[57]

20.        An insurer seeking to take advantage of the exemption granted under paragraph 19(a) must inform APRA, and provide evidence that the criteria have been met.  APRA may request that the insurer provide additional information at any time to ensure that the insurer still meets  the criteria for an exemption.

21.        Notwithstanding any exemption available under paragraph 19, APRA may at its discretion still require the insurer to have an independent actuarial review undertaken.[58]

- The approval process

22.        The Act requires that APRA approve the insurer’s appointment of an auditor and actuary.  For this purpose, an application for approval of an auditor or actuary must be submitted in writing by the insurer to APRA.  An application must include the following details:

(a) the name, address and telephone number of the person;

(b) whether the person is an employee of the insurer, or if not, the name of any firm that the person is an employee or partner of;

(c)          details on the eligibility criteria set out in paragraph 8 of GPS 220;

(d)         details on the criteria for fitness and propriety set out in paragraph 6 of GPS 220;

(e)          a statement of the pecuniary interests which the person, or a related person, has in the insurer, or a related body corporate of the insurer, for instance:

(i) a security in, or contract with, the insurer or a related body corporate; and

(ii) the receipt of any remuneration, specified by type of service, from the insurer or a related body corporate;

A related person of the Approved Auditor or Approved Actuary means a spouse, or a dependent child, or a business partner, or an employer (other than the insurer), or a firm of which the Approved Auditor or Approved Actuary is a director or partner.

(f)           in the case of an Approved Auditor, an attestation from the proposed auditor that he/she complies with Statement of Auditing

Practice AUP 32 “Audit Independence”.  Where there is non-compliance, details of that must be provided.

23.        In addition, the proposed Approved Auditor or Approved Actuary must provide APRA with a written undertaking that he or she will perform his or her functions in accordance with all prudential requirements issued by APRA and standards issued by relevant professional bodies.

Routine Reporting

(i) Approved Auditor

24.        The Approved Auditor must audit the yearly statutory accounts of an insurer as required by the Act.[59]  The Approved Auditor must provide a certificate to the insurer specifying whether, in the Approved Auditor’s opinion:

(a)          the insurer has adequate systems and procedures in place to ensure it observes all the prudential standard requirements APRA has set for the insurer;

(b)         the statistical and financial data provided by the insurer to APRA in its yearly statutory accounts are reliable;

(c)          the insurer has adequate systems and procedures in place to ensure it complies with statutory general insurance requirements, any conditions on the authority to carry on insurance business, and any other conditions imposed by APRA in relation to an insurer’s operations; and

(d)         there are any matters which will, or are likely to, adversely affect the interests of insurer’s policyholders.

Where the Approved Auditor is unable to satisfy these requirements (for example, if there are accounting records that have not been appropriately kept, transactions that appear irregular or that have not been accurately or properly recorded, requests for information and explanation that have not been met, or aspects to the accounts that do not truly represent the transactions and financial position), the certificate should contain details of these matters.

(ii) Approved Actuary

25.        The Approved Actuary must prepare a report in accordance with this Guidance Note, GPS 210 Liability Valuation and any other guidance or any relevant professional standards at the end of each financial year of the insurer.

26.        The report must provide:

(a)          written advice in respect of the value of the insurer’s liabilities in accordance with GPS 210; and

(b)         whether there are any matters arising out of the preparation of this advice which will, or are likely to, adversely affect the interests of the insurer’s policyholders.

27.        In particular, the report must provide details of, in respect of each class of business:

(a)          an estimate of the value of insurance liabilities determined in accordance with GPS 210 (where necessary, this might also include an indication of the conceivable range of values, between which the true value of the insurance liabilities might lie);

(b)         assumptions used in the valuation process;

(c)          availability and appropriateness of the data;

(d)         significant aspects of the recent experience;

(e)          the model(s) used;

(f)           the approach taken to estimate the coefficient of variation where this is used;

(g)         an indication of the uncertainty in the estimate of the coefficient of variation;  and

(h)         the sensitivity analyses undertaken.

28.        For each calculation date, the Approved Actuary must reassess the appropriateness of the assumptions and valuation methods the insurer uses to determine its insurance liabilities.  Where a change in assumptions or method is made by the Approved Actuary or the insurer, the effect of that change on the value of the insurance liabilities must emerge in the current calculation period – it is not appropriate that the effects of such a change be spread over future calculation periods.

29.        In addition, where there has been a change in assumptions or in valuation method from that adopted at the previous valuation, the effect of these changes must be disclosed in the written advice.

30.        In general, care should be taken to ensure that results are not presented in a way that gives the impression of greater reliability than is actually the case.  This applies, in particular, in situations where materially different results could reasonably be justified.

31.        Abbreviated details are appropriate for a class of business that is not material.

32.        The Approved Actuary must provide the report to the insurer’s Board within such time as to give the Board a reasonable opportunity to consider and use the report in preparing the insurer’s yearly statutory accounts for that financial year.

33.        The insurer must submit the Approved Actuary’s report to APRA on or before the day that the insurer’s yearly statutory accounts are required to be given to APRA under the Financial Sector (Collection of Data) Act 2001.

34.        Where an insurer includes in its accounts a value for insurance liabilities which is inconsistent with the advice received from the Approved Actuary, or is not determined in a manner consistent with the principles of GPS 210, the insurer must notify APRA in writing, and should include within its published annual financial accounts:

(a) the reasons for not accepting the Approved Actuary’s advice, or for not determining the insurance liabilities in a manner consistent with GPS 210; and

(b) details of the alternative assumptions and methodologies used for determining the value of the insurance liabilities.

Non-routine Reporting by Auditors and Actuaries

35.        The Act specifies a number of instances in which an Approved Auditor or Approved Actuary is obliged to report to APRA on a non-routine basis.[60]

36.        In fulfilling this obligation, Approved Auditors and Approved Actuaries are not required to actively seek out instances where prudential requirements may be breached or policyholder interests may be threatened, but must report any such instances when identified in the course of fulfilling their functions.  That said, should an Approved Auditor or Approved Actuary come across such a matter during the course of undertaking an activity not specifically required by APRA, the Approved Auditor or Approved Actuary must still provide that information to APRA.

37.        In assessing whether the interests of policyholders may be materially prejudiced, an Approved Auditor and Approved Actuary should consider not only a single activity or single deficiency.  Policyholder interests may be materially prejudiced by a number of activities or deficiencies that may not of themselves result in a material threat to policyholder interests but, when considered in total, do amount to a material threat.  In such cases, an Approved Auditor or Approved Actuary should provide such information to APRA.

38.        In most cases, matters reported to APRA by the Approved Auditor or Approved Actuary should also be reported by that person to the insurer.  However, the Approved Auditor or Approved Actuary does not need to notify the insurer where that person considers that by doing so the interests of the policyholders would be jeopardised, or, where there is a situation of mistrust between the Approved Auditor or Approved Actuary and the Board or senior management of the insurer.

39.        An Approved Auditor or Approved Actuary that provides information to APRA in the course of non-routine reporting is not excused from giving the information to APRA on the grounds that doing so would tend to incriminate that person or make them liable to a penalty.  Protection is provided under the Act[61] to Approved Auditors or Approved Actuaries that supply information to APRA in these circumstances.

40.        In addition, an Approved Auditor or Approved Actuary is encouraged to provide information to APRA if that person considers it will assist APRA in the performance of its functions under the Act or the Financial Sector (Collection of Data) Act 2001.[62] 

Other Functions of Approved Auditors and Approved Actuaries

41.        An Approved Auditor may also be required to undertake other functions specified by APRA.  In addition, insurers may also seek the advice of the Approved Auditor in relation to other matters, for instance the adequacy of the insurer’s risk management and control framework, should the insurer consider this appropriate.

42.        An Approved Actuary may also be required to undertake other functions specified by APRA.  Insurers may also seek the advice of the Approved Actuary in relation to other matters, for instance the adequacy of the insurer’s reinsurance arrangements, should the insurer consider this appropriate.

Guidance Note GGN 220.2

Risk Management Systems

1. Risk management and control is the process of identifying, monitoring, controlling and reporting all internal and external sources of risk that could have a material impact on an insurer’s operations.  This includes both the financial and non-financial (or operational) risks associated with conducting business.
2. APRA follows a systems-based approach in supervising risk management of insurers.  This approach recognises primary responsibility for risk management rests with the Board and senior management of an insurer, and focuses on the quality of the processes and controls adopted by that insurer.  While the Board retains the primary responsibility for risk management and control, it may, of course, also seek the advice of its Approved Auditor, Approved Actuary or other relevant expert in relation to the appropriateness, adequacy and effectiveness of its risk management and control systems.
3. APRA recognises that the scope of risk management systems will vary among insurers depending on the size, business mix and complexity of their operations.

Risk Management Strategy (RMS)

4.             The RMS must document, in detail, the strategy adopted for managing risk.  The RMS should define and document the insurer’s objectives and strategy for risk management and control and should identify the individuals responsible for approval, and ongoing oversight, of the risk management framework.  The RMS should identify the insurer’s broad risk management and control systems (including at a minimum the systems in place to address balance sheet and market risk, credit risk, operation risks and risks arising out of reinsurance arrangements), in particular its policies and procedures including:

(a)          processes for the identification and assessment of risks;

(b)         control processes and mechanisms;

(c)          management information systems and communication processes; and

(d)         processes for monitoring risk.

5.             The RMS must include provisions to review these systems regularly (at least annually) to take account of changes in an insurer’s business profile and other available information.  In addition, where there are institutional or other developments relating to the insurer’s operations in Australia that materially affect the risk profile of the insurer, the insurer should first consult APRA.  Examples of such developments include proposals relating to the establishment of subsidiaries, major modifications to, or the re-organisation of, the functions of the insurer, any changes in the operations of the insurer or the Group to which the insurer is a part, and any other activities that involve new risks, for example new business lines or new off-balance sheet exposures.  Any such developments would need to be incorporated into the insurer’s RMS.

6.             Foreign insurers should identify in their RMS where responsibility resides for monitoring the risk profile of their operations.  Where control mechanisms for risk are in place, and these include reporting to home office or are the responsibility of home office, the RMS should also identify these mechanisms and detail the reporting arrangements.

7.             If the insurer in Australia is part of a global insurance group or operates as a foreign insurer, APRA expects the RMS to include information on the global risk management policy.  This may include policy objectives and strategies in respect of risk management, but would particularly include the reporting arrangements between Australian and overseas operations, the monitoring of Australian operations by the overseas parent or home office and the home regulator’s supervisory arrangements regarding risk management.  Where elements of the RMS are controlled by an overseas office, these should be identified and detailed.

8.             If the insurer in Australia is part of an Australian insurance group, APRA expects the RMS to include information on the group’s risk management policy.  This may include policy objectives and strategies in respect of risk management, but would particularly include the reporting arrangements between the insurer’s operations and the monitoring of operations by the parent of the group.  Where elements of the RMS are controlled by another company in the group, for instance the parent, these should be identified and detailed.

9.             As part of its normal supervisory activities, APRA will review the appropriateness, adequacy and effectiveness of an insurer’s RMS having regard to the size, business mix and complexity of the insurer’s operations, covering both domestic and (where relevant) overseas activities.

Processes for Risk Identification and Assessment

10.        An insurer must have in place processes to identify and assess the range of risks that could adversely affect the operations of the insurer. 

11.        Whilst the risk management systems of an insurer should address all material risks, APRA considers that, at a minimum, an insurer must have risk management systems to address: 

(a)          balance sheet and market risk (see Guidance Note GGN 220.3);

(b)         credit quality risk (see Guidance Note GGN 220.4); 

(c)          operational risk (see Guidance Note GGN 220.5); and

(d)         risks arising out of reinsurance arrangements (see GPS 230 Reinsurance Arrangements).

12.        There are a number of techniques available to insurers to enable the assessment and quantification of risks and their impact on the insurer’s operations, including, for example, stress testing and scenario analysis.  Where appropriate, an insurer should consider using such techniques.

Control Activities

13.        An insurer should have appropriate control mechanisms in place to ensure that the policies and procedures established for risk management are adhered to at all times.

14.        Control mechanisms would normally include:

(a)          clearly defined management responsibilities;

(b)         adequate segregation of duties;

(c)          a risk committee or audit function to establish and maintain the control processes;

(d)         a system of approvals, limits, authorisations and reporting lines;

(e)          policies to document the insurer’s procedural controls;

(f)           activity controls for each division or department;

(g)         verifications of activities such as underwriting, pricing and claims management, and reconciliations;

(h)         reviews by Board, senior management and internal audit; and

(i)           physical controls.

Information and Communication

15.        As part of an insurer’s risk management and control systems, comprehensive management information systems should be established, maintained and utilised to assist in the management, communication and reporting of risk issues and outcomes.

16.        An effective and comprehensive management information system needs to ensure that relevant, accurate and timely information is reported to appropriate persons, so to enable the insurer to identify, quantify, assess and monitor business activities, exposure to risk, financial position and performance.  The information system should also allow the insurer to monitor the effectiveness of, and compliance with, its control mechanisms and report any exceptions that arise.

17.        Management information systems need to be reviewed regularly to assess the current relevance of information generated and the adequacy, quality and accuracy of the system’s performance over time.

Processes for Monitoring Risk

18.        An insurer’s risk management and control systems should be monitored to assess the quality of the systems’ performance.  This can be accomplished through ongoing monitoring activities, separate evaluations or a combination of the two.  The advantage of ongoing monitoring is that deficiencies in the systems can be detected and corrected quickly. Alternatively, separate evaluations enable the insurer to periodically assess the effectiveness of a system.  Separate evaluation involves a more comprehensive analysis and allows an insurer to assess the quality of the system as a whole as opposed to a case-by-case approach to ongoing monitoring.

19.        Within any quality assessment, there should be clearly defined roles for both internal and external audits.  At a minimum, there must be periodic internal audits (with a clear methodology in place to determine the frequency of review for major business or activities or risk sources), with results being reported to the Board or the Board Audit Committee and to senior management.

20.        Any deficiencies identified as part of the monitoring process or internal audit must be reported to those persons responsible in order that they can be addressed.  Material deficiencies must be reported to the Board and senior management.  A material deficiency can result not only from a single deficiency, but from a number of small deficiencies that, when considered together, amount to a material deficiency.

Board Declaration

21.        The Board is required to confirm that the insurer has systems in place to ensure compliance with legislative and prudential requirements, and that the Board has satisfied itself as to the adequacy of, and compliance with, the insurer’s risk management and reinsurance arrangements.  Specifically, each insurer must provide APRA with a Board Declaration, at the same time it lodges its yearly statutory accounts, that, for the last financial year:

(a)          the insurer has systems in place to ensure compliance with the Insurance Act 1973, Insurance Regulations 1974, Prudential Standards, authorisation conditions and directions;

(b)         the Board and senior management have identified the key risks facing the insurer and have a Risk Management Strategy in place to manage and monitor those risks;

(c)          the insurer has in place a Reinsurance Management Strategy for selecting and monitoring reinsurance programs;

(d)         the insurer has substantially complied with its Risk Management Strategy and Reinsurance Management Strategy and that they are operating effectively in practice, having regard to the risks they are designed to control; and

(e)          copies of its Risk Management Strategy and Reinsurance Management Strategy provided to APRA are accurate and current.

22.        Should the Board wish to qualify the Board Declaration, the qualified Board Declaration must include a description of any material deviation from its obligations, and steps taken to remedy those breaches.

23.        Key risks facing an insurer include all matters capable of influencing the risk profile of an insurer, taking into account the size, business mix and complexity of an insurer’s operations.  Where appropriate, an insurer may address key risks by setting and requiring adherence to a series of prudential limits and timely reporting processes.

24.        An insurer is not required to have the Board Declaration audited since the Board should have considered the advice of independent experts in making the Board Declaration.

Guidance Note GGN 220.3

Balance Sheet and Market Risk

1. The Board and senior management of an insurer must develop, implement and maintain a risk management and control system to address balance sheet and market risks.  Balance sheet and market risks include, but are not limited to, insurance and investment risks, and the risks associated with underwriting, claims management, product design and pricing, liquidity management and the use of derivatives.  Some of these risks have been discussed in detail elsewhere in GPS 220 Risk Management and the guidance notes. This Guidance Note brings together some of that discussion, and provides guidance on some of the balance sheet and market risks that an insurer’s risk management and control systems need to address.

Insurance

2.             Insurance risk is the risk that the true value of insurance liabilities, both outstanding claims liability and premiums liability, will be greater than the estimated value of insurance liabilities.  Insurance risk is one of the most significant risks to which an insurer is exposed.  To this end, an insurer’s risk management and control system must include a process for ongoing review and appraisal of the liability valuation framework (ie assumptions made, reinsurance recoveries estimated, etc).  In conducting this review, consideration should be given to emerging pricing and claim payment trends.

Investment

3.             Investment risk refers to the possibility of an adverse movement in the value of an insurer’s on-balance sheet assets and/or certain off-balance sheet obligations.  Investment risk derives from a number of sources, including market risk (eg equity, interest rate and foreign exchange risk), credit risk, investment concentration risk and asset and liability mismatch risk. 

4.             An insurer’s risk management system should document clearly the investment decision making framework, and include information on the process for monitoring, controlling and reporting investment exposures (eg asset allocations, liability portfolio matching criteria, limit structures and dealing authorities, and performance analysis).  Requirements in respect of credit risk, concentration risk, liquidity risk and derivatives risk are provided elsewhere in this Guidance Note and Guidance Note      GGN 220.4 Credit Quality.

Underwriting

5.             Underwriting is the process by which an insurer determines whether and under what conditions to accept a risk.  Weaknesses in the controls and systems surrounding the underwriting process can expose an insurer to the risk of unexpected losses which may threaten the capital position of the insurer.

6.             At a minimum the risk management and control system for underwriting must consist of policies and procedures including:

(a)          a statement of the insurer’s willingness and capacity to accept risk;

(b)         the classes and characteristics of insurance business that the insurer is prepared to underwrite including:

(i)           geographical areas;

(ii)        the types of risks that may be underwritten; and

(iii)      criteria for the use of policy exclusions and reinsurance;

(c)          a formal evaluation process for the effective assessment of risks underwritten including:

(i)           the criteria for assessing risk;

(ii)        the method for monitoring emerging experience; and

(iii)      the method by which emerging experience is taken into account in updating the underwriting process;

(d)         appropriate approval authorities and limits to those authorities that are definitive and specific (including controls surrounding delegations given to intermediaries of the insurer);

(e)          concentration limits; and

(f)           methods for monitoring compliance with underwriting policies and procedures such as:

(i)           internal audit;

(ii)         peer review of policies underwritten;

(iii)      assessments of brokers’ procedures and systems to ensure the quality of information provided to the insurer is of a suitable standard; and

(iv)       in the case of reinsurers, audits of ceding companies to ensure that reinsurance assumed is in accordance with treaties in place.

Claims Management

7.             Claims management is the process by which insurance companies fulfil their contractual obligations to policyholders.  When a loss occurs under an insurance policy the insurer must:

(a)          verify the contractual obligation to pay the claim;

(b)         make an assessment of the claims liability, including loss adjustment expenses; and

(c)          manage the claim settlement process.

8.             Weaknesses in the controls and systems surrounding the claims management process can expose an insurer to the risk of unexpected losses.  These losses may threaten the capital position of the insurer.

9.             At a minimum, the risk management system for claims management must consist of policies and procedures including:

(a)          clearly defined and appropriate levels of delegations of authority;

(b)         claim settlement procedures, including claim determination and investigation procedures and the criteria for accepting or rejecting claims;

(c)          loss estimation procedures (including estimated reinsurance recoveries);  and

(d)         methods for monitoring compliance with claims management processes and procedures such as:

(i)           internal audit;

(ii)         peer review of claims paid;

(iii)      assessments of brokers’ procedures and systems to ensure the quality of information provided to the insurer is of a suitable standard;  and

(iv)       in the case of reinsurers, audits of ceding companies to ensure that the value of claims paid is in accordance with treaties in place.

Product Design and Pricing

10.        The pricing of an insurance product involves the estimation of claims and costs arising from that product and the estimation of investment income arising from the investment of premium income attaching to the product.  Pricing risk may occur where the claims, costs or investment returns arising from the sale of a product are inaccurately calculated.

11.        At a minimum the risk management system for product design and pricing must consist of policies and procedures including:

(a)          product lines that the insurer is prepared to engage in or has chosen not to engage in;

(b)         clearly defined and appropriate levels of delegation for approval of all material aspects of product design and pricing;

(c)          processes for assessing risks, including, risks arising from: inflation; anti-selection; technology changes; catastrophes; legal decisions; changes in government policy; and investment returns;

(d)         requirements for limiting risk through, for example, diversification, exclusions and reinsurance;

(e)          processes to ensure that policy documentation is adequately drafted to give legal effect to the proposed level of coverage under the product;

(f)           how emerging experience is to be reflected in price adjustments; 

(g)         how the insurer’s product pricing responds to competitive pressures; and

(h)         methods for monitoring compliance with product design and pricing policies and procedures.

Liquidity

12.        An insurer should have sufficient liquidity to meet all cash outflow commitments to policyholders (and other creditors) as and when they fall due.  The nature of insurance activities means that the timing and amount of cash outflows are uncertain.  This uncertainty may affect the ability of an insurer to meet its obligations to policyholders or may require insurers to incur additional costs through, for example, raising additional funds at a premium on the market or through the sale of assets.

13.        At a minimum the risk management system for liquidity must consist of policies and procedures including consideration of:

(a)          the level of mismatch between expected asset and liability cash flows under normal and stressed operating conditions;

(b)         the liquidity and realisability of assets;

(c)          commitments to meet insurance and other liabilities;

(d)         the uncertainty of incidence, timing and magnitude of insurance liabilities;

(e)          the level of liquid assets held by the insurer;  and

(f)           other sources of funding including reinsurance, borrowing capacity, lines of credit and the availability of intra-group funding.

Derivatives

14.        Derivative transactions are financial contracts and include a wide assortment of instruments such as forwards, futures, swaps, options and other similar transactions. 

15.        At a minimum, the risk management and control system must consist of policies and procedures including:

(a)          a statement of the insurer’s objectives in using derivatives;

(b)         the risk tolerances of the insurer and a limit framework consistent with those risk tolerances;

(c)          appropriate lines of authority and responsibility for transacting derivatives, including trading limits; and

(d)         consideration of worst case scenarios and sensitivity analysis and reporting of that analysis.

Guidance Note GGN 220.4

Credit Quality

1. The Board and senior management of an insurer must develop, implement and maintain a risk management and control system to address credit quality risks. 

Credit Exposures

2.             Credit exposures can increase the risk profile of an insurer and adversely affect financial viability.  A credit exposure for the purpose of GPS 220 Risk Management and this Guidance Note includes both on-balance sheet and off-balance sheet exposures (including guarantees, derivative financial instruments and performance related obligations) to single and related counterparties.

3.             At a minimum the risk management system for credit exposures must consist of policies and procedures including:

(a)          limits for credit exposures to:

(i)           single counterparties and groups of related counterparties;

(ii)         intra-group asset exposures (to subsidiaries and related entities);

(iii)      single industries; and

(iv)       single geographical locations;

at both an individual and consolidated level;

(b)         a process for approving requests for temporary increases in limits and a process to ensure excesses are brought within the pre-approved limits within a set timeframe;

(c)          processes for reducing or cancelling limits to a particular counterparty where the counterparty is known to be experiencing problems;

(d)         a process in place to monitor and control credit exposures against pre-approved limits;

(e)          a process to review credit exposures (at least annually but more frequently in cases where there is evidence of a deterioration in credit quality);

(f)           a management information system that is capable of aggregating exposures to any one counterparty (or group of related counterparties), asset class, industry or region in a timely manner;  and

(g)         a process of reporting to the Board and senior management:

(i)           any breaches of limits; and

(ii)         large exposures and other credit risk concentrations.

4.             For these purposes, APRA would normally regard a large exposure as an exposure to an asset or counterparty (including related entities) of greater than 10% of the insurer’s capital base.

Guidance Note GGN 220.5

Operational Risks

Operational Risk

1. The Board and senior management of an insurer must develop, implement and maintain a risk management and control system to address the non‑financial or operational risks of that insurer.  This covers, but is not limited to, issues such as technology risk (including processing risks), reputational risk, fraud, compliance, outsourcing, business continuity planning, legal risk and key person risk.
2. Some of these risks can be mitigated by adopting the principles outlined in Guidance Note GGN 220.2 Risk Management Systems.  For example, the risk of fraud can be reduced through segregation of duties, authorisation and reconciliation procedures.  This Guidance Note addresses the particular risks associated with outsourcing and disruptions to business continuity.

Outsourcing

3.             Many insurers outsource some parts of the administration of their business to a third party service provider.  Insurers should ensure that they retain ultimate control over the outsourced operations and that the division of risks and responsibility is clear and mutually understood.

4.             At a minimum, the risk management system for outsourcing must consist of policies and procedures including:

(a)          procedures to assess the controls of the service provider;

(b)         procedures for entering into outsourcing agreements including:

(i)           the formation of a business case outlining the benefits and risks of outsourcing the activity, including: an outline of the processes to be outsourced; the services required; the quality and timeframe requirements; together with detail on how the insurer intends monitoring, measuring and managing the relationship and the intended controls;

(ii)         due diligence on the service provider, including: the capacity of the service provider (financial, technical and otherwise) to fulfil duties, deal with disruptions in business continuity and to meet any indemnities or penalties; and

(iii)      conflicts of interest.

5.             All outsourcing arrangements must be undertaken using a written, legally binding agreement.  The agreement should:

(a)          clearly outline the responsibility of each party to the contract;

(b)         set out the ways in which the insurer and the service provider will monitor performance under the agreement;

(c)          establish procedures for problem resolution;

(d)         include termination clauses (including requirements for the ownership and delivery of records from the service provider to the insurer) and transitional arrangements;

(e)          define the consideration together with penalties to be incurred by either party for non-performance;  and

(f)           set out requirements for the service provider to hold relevant insurance.

6.             In addition, the insurer must ensure that:

(a)          adequate security and confidentiality is provided over sensitive information; and

(b)         records held by the insurer and the service provider are adequate for audit trail purposes and that those records held by the service provider are readily available at all times to the insurer and, where APRA considers it necessary, to APRA.

7.             The insurer must ensure that adequate contingency plans exist, including back-up facilities if appropriate, to cover a breakdown in the operations of the service provider or in circumstances where the service provider or the insurer exercises a right to terminate the contract.  These plans should be tested regularly (annually at a minimum) and the results of these tests should be made available to the insurer.

8.             Where the service provider is related to the insurer (for example, part of the same corporate group), the insurer must have in place risk management and control systems similar to those in place for external service providers.  In addition, the contingency plan should consider the possibility of accessing external service providers at a similar cost in the case of an inability of the related entity to continue to provide contracted services.

Business Continuity

9.             Disruptions in an insurer’s business can lead to unexpected losses of both a financial and non-financial nature (eg data, premises, reputation, etc.).  Disruptions may occur as a result of events such as power failure, denial of access to premises or work areas, systems failure (computers, data, building and/or equipment), fire, fraud, and loss of key staff.

10.        At a minimum the risk management system for business continuity must consist of policies and procedures including:

(a)          a process for identifying:

(i)           events that may lead to a disruption in business continuity;

(ii)         the likelihood of those events occurring;

(iii)      the processes most at risk;  and

(iv)       the consequence of those events.

(b)         a business continuity plan (BCP) describing:

(i)           procedures to be followed if business continuity problems arise;

(ii)         detailed procedures for enacting the BCP, including manual processes, the activation of an off-site recovery site (if needed) and the person(s) responsible for activating the BCP;

(iii)      a communications strategy (including a media strategy) and contact information for relevant staff, suppliers, regulators, market authorities (including exchanges), major clients, the media and other key people;

(iv)       a schedule of critical systems covered by the BCP and the timeframe for restoring those systems;

(v)         the pre-assigned responsibilities of staff and procedures for training staff on all aspects of the BCP;

(vi)       procedures for regular testing and review of the BCP; and

(c)          procedures for backing up important data on a regular basis (preferably daily) and storing the information off-site.

Prudential Standard GPS 230

Reinsurance Arrangements for General Insurers

Prudential Standard

1. This Prudential Standard, made under section 32 of the Insurance Act 1973 (the Act), applies to all general insurers authorised under the Act.
2. The prime responsibility for the sound and prudent management of an insurer rests with the Board of Directors (Board) and senior management of that insurer.  The Board and senior management of an insurer must develop, implement and maintain a Reinsurance Management Strategy, appropriate for the operations of that insurer, to ensure that the insurer has sufficient capacity to meet obligations as they fall due.

Reinsurance Management

3.             Reinsurance management refers to the selection, monitoring, review and control of reinsurance arrangements – that is, where some part of individual or aggregate insurance risks are ceded to other insurers, including from direct writing insurers to reinsurers or other direct writing insurers (cessions) as well as from reinsurers to their parent companies or other reinsurers (retrocessions).  For this purpose, reinsurance arrangements will also extend to cover financial reinsurance and alternative risk transfer products.  Reinsurance management is a critical component of an insurer’s ability to meet its obligations to policyholders.

4.             An insurer must inform APRA immediately if there is a likelihood of a problem arising with its reinsurance arrangements that is likely to materially detract from its current or future capacity to meet its obligations, and discuss with APRA its plans to redress this situation.

Reinsurance Management Strategy (REMS)

5.             Each insurer is required to maintain at all times a written REMS that has been:

(a)          approved by the Board (or in the case of foreign insurers, by a senior officer from outside Australia with requisite Board delegation);[63] and

(b)         approved by APRA.

The REMS must be appropriate to the size, business mix and complexity of operations of the insurer and must define and document the insurer’s objectives and strategy for reinsurance management.

6.             Each insurer must review its REMS regularly (at least annually) to take account of changing operating circumstances.  The REMS must also be amended where material change to the operations of an insurer warrants modification.  An updated copy of the REMS, approved by the Board, must be provided to APRA for approval within 14 days after Board approval.

7.             An insurer must substantially adhere to its REMS at all times and must advise APRA if it intends to undertake activities in a manner that represent a material deviation from its REMS.  Any such activities must first be approved by the Board.  Should the REMS then require amendment, a revised REMS must be approved by the Board and submitted to APRA for approval within 14 days of Board approval.

8.             An insurer’s REMS must, at a minimum, include the following elements:

(a)          sound systems for selecting and monitoring reinsurance programs;

(b)         clearly defined managerial responsibilities and controls;  and

(c)          clear methodologies for determining all aspects of a reinsurance program, including:

(i) identification and management of aggregations of risk;

(ii) identification and management of upper bounds of programs; and

(iii) selection of participants including consideration of diversification and creditworthiness.

9.             The REMS must cover both the Australian and, where relevant, the overseas operations of the insurer.  Further detail on the content of the REMS is contained in Guidance Note GGN 230.1 Reinsurance Management Strategy.

Guidance Note GGN 230.1

Reinsurance Management Strategy

1. Insurers may purchase reinsurance to provide security and liquidity, and to increase their own capacity to underwrite new insurance business.  Weaknesses in an insurer’s reinsurance arrangements may therefore impair that company’s capital or liquidity position.
2. APRA follows a systems-based approach in supervising the reinsurance arrangements of insurers.  This approach recognises that primary responsibility for reinsurance management rests with the Board and senior management of an insurer, and focuses on the quality of the processes and controls adopted by that insurer.  While the Board retains the primary responsibility for reinsurance management, it may also seek the advice of its Approved Auditor, Approved Actuary, or other relevant expert, in relation to the appropriateness, adequacy and effectiveness of its reinsurance arrangements.
3. APRA recognises that the scope of the Reinsurance Management Strategy (REMS) will vary among insurers depending on the size, business mix and complexity of their operations. 
4. The REMS must document in detail the strategy adopted for managing reinsurance. 
5. Foreign insurers should identify in their REMS where responsibility resides for monitoring the reinsurance arrangements of their operations.  Where control mechanisms for reinsurance are in place, and these include reporting to home office or are the responsibility of home office, the REMS should also identify these mechanisms and detail the reporting arrangements.
6. If the insurer in Australia is part of a global insurance group or operates as a foreign insurer, APRA expects the REMS to include information on the global reinsurance policy.  This may include policy objectives and strategies in respect of reinsurance management, but would particularly include the reporting arrangements between Australian and overseas operations, the monitoring of Australian operations by the overseas parent or home office and the home regulator’s supervisory arrangements regarding reinsurance.  Where elements of the REMS are controlled by home office, these should be identified and detailed.
7. If the insurer in Australia is part of an Australian insurance group, APRA expects the REMS to include information on the group’s reinsurance policy.  This may include policy objectives and strategies in respect of reinsurance management, but would particularly include the reporting arrangements between the insurer’s operations and the monitoring of operations by the parent of the group.  Where elements of the REMS are controlled by another company in the group, for instance the parent, these should be identified and detailed.
8. As part of its normal supervisory activities, APRA will review the appropriateness, adequacy and effectiveness of an insurer’s REMS.  In doing so, APRA will distinguish between insurers having regard to:

(a)  the size, business mix and complexity of the insurer’s operations, including both domestic and (where relevant) overseas activities;

(b)  the classes of insurance business in which the insurer is engaged;

(c)  the availability and resilience of intra-group funding;

(d)         staff expertise and depth; and

(e)          the quality of policies and systems for managing reinsurance arrangements.

9.             In addition, APRA will take into account those elements of an insurer’s risk management system that address the potential risks arising out of the insurer’s reinsurance arrangements.

Systems for Selecting Reinsurance Programs

10.        An insurer, as part of its REMS, must put in place sound systems for the selection of reinsurance programs. 

11.        While the sophistication of an insurer’s systems is specific to the insurer, at a minimum the system must consist of policies and procedures that:

(a)          identify the insurer’s tolerance for risk;

(b)         identify the level of cessions appropriate to the insurer’s tolerance for risk (for direct insurers and reinsurers, APRA would normally allow an insurer to cede up to 60% of the insurer’s total business underwritten.  In the case of  captive insurers, APRA would typically allow an insurer to cede up to 90%);

(c)          determine what type of reinsurance arrangements are most appropriate to limit risks to the company’s level of tolerance (separately documenting traditional reinsurance contracts, financial reinsurance and alternative risk transfer products);

(d)         set out principles for the selection of reinsurance counterparties including formal evaluation procedures to assess the diversification and creditworthiness of reinsurance counterparties;

(e)          set out how liquidity will be managed where there is a timing mismatch between the payment of claims and the receipt of reinsurance recoveries; and

(f)           set concentration limits for credit risk exposure to reinsurance counterparties and appropriate systems for monitoring these exposures.

12.        The REMS must include provisions to regularly review these systems to take account of changes in business profile and other available information.

Systems for Setting the Maximum Event Retention

13.        An insurer, as part of its REMS, must put in place sound systems for the setting, monitoring and altering of its Maximum Event Retention (MER).  At a minimum, these systems must consist of policies and procedures that detail: