Insurance (prudential standard) determination No. 1 of 2010 - Prudential Standard GPS 116 - Capital Adequacy - Concentration Risk Capital Charge

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Legislation au F2010L00673 Not in force Legislative Instrument

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Insurance (prudential standard) determination No. 1 of 2010

EXPLANATORY STATEMENT

Prepared by the Australian Prudential Regulation Authority (APRA)

 

Insurance Act 1973, paragraphs 32(1)(a) and (b) and subsection 32(4)

 

 

Paragraphs 32(1)(a) and (b) of the Insurance Act 1973 (“the Insurance Act”) provides that APRA may determine, in writing, standards relating to prudential matters that must be complied with by general insurers and authorised NOHCs.  Pursuant to subsection 32(5A) of the Insurance Act and paragraph 6(d) of the Legislative Instruments Act 2003, such Prudential Standards are legislative instruments for the purposes of the Legislative Instruments Act 2003 (“the Legislative Instruments Act”).  Subsection 32(4) of the Insurance Act gives APRA the power to vary Prudential Standards so determined.

 

  1.         Background

 

General Insurance Prudential Standard GPS 116 Capital Adequacy: Concentration Risk Capital Charge (GPS 116) forms part of a comprehensive set of prudential standards that deal with the measurement of a general insurer’s capital adequacy.  GPS 116 sets out the calculation of the Concentration Risk Capital Charge under the Prescribed Method of calculating the Minimum Capital Requirement (MCR) applicable to a general insurer.  There are specific requirements for this calculation for lenders mortgage insurers (LMIs) detailed in Attachment A of GPS 116.

 

The Concentration Risk Capital Charge is the component of the MCR that takes into account the highest aggregation of risks of an insurer.  It is calculated as the addition of the insurer’s Maximum Event Retention (MER) after taking into account acceptable reinsurance arrangements, plus the cost of one reinstatement of those reinsurance arrangements.  GPS 116 sets out issues that affect an insurer’s MCR that must be taken into account in the calculation of the MER. 

 

In September 2008, APRA released the discussion paper Maximum Event Retention for Lenders Mortgage Insurers. The discussion paper made six proposals in relation to the determination of the MER for LMIs. The discussion paper was accompanied by a draft GPS 116 Attachment A and a quantitative impact study (QIS).

 

The changes are intended to achieve two objectives:

  • to clarify the intention of GPS 116 Attachment A; and
  • to reduce prescription in the technical application of GPS 116 Attachment A.

 

Four of the original six proposals are implemented by this instrument.  Two have been postponed.


2.            Purpose of the Instrument

 

This instrument makes changes to GPS 116 Attachment A to implement the following proposals:

 

  1. Reinsurance principles

 

GPS 116 Attachment A has been amended to reduce the prescriptive instructions regarding the calculation of allowable reinsurance for the MER calculation. Instead, it now requires an LMI to apply a principles-based approach to this calculation. This approach enables an LMI to consider the impact of the prescribed stress scenario on its overall reinsurance arrangements and take account of the relevant financial impacts, such as reinstatement premium and reversal of experience bonuses.  Changes have been made to GPS 116 Attachment A to reflect the principles-based approach and paragraphs 3, 13, 14, 30, 31, 32, 33, 34, 35, 36, 39 and 40 have been removed.

 

2.      Capitalised premium

 

APRA requires capitalised premium to be included in the Loan-to-Valuation Ratio (LVR) calculation for PML purposes, irrespective of whether or not the premium is insured. This reflects that the probability of default on the loan by the borrower is dependent on the total quantum of the loan and not the amount of protection which the LMI has extended to the lender. The words ‘irrespective of whether the premium is insured’ have been inserted into GPS 116 Attachment A at paragraph 5 for the avoidance of doubt.

 

3.        PML for pooled policies

 

GPS 116 Attachment A has been amended to clarify the calculation of probable maximum loss (PML). The following changes to GPS 116 Attachment A have been implemented:

  • defining more clearly the product types and coverage types at paragraphs 13 and 14;
  • clarifying the seasoning factor to be used when additional loans are extended to existing borrowers at paragraph 26;
  • clarifying the PML calculation for non-proportional reinsurance at paragraph 25;
  • requiring an LMI to consult with APRA where it is not clear how to calculate the PML for any of its business at paragraph 27; and
  • advising that an LMI cannot use summarised information by applying a weighted average LVR to determine PML for pooled mortgage insurance at paragraph 26.

 

 

 

 

 

 

4.      Reinsurance cover for new business

 

APRA requires an LMI to consider its new business volumes and the extent to which these volumes are protected by reinsurance. APRA is allowing LMIs to base the MER calculation on the current business in force. Changes have been made to GPS 116 Attachment A to require an LMI to describe in its Reinsurance Management Strategy (REMS) how it manages exposure to and the mitigants in place for the risk in relation to future reinsurance arrangements at paragraph 39.

 

3.            Operation of the Instrument

 

This instrument is to take effect from 1 May 2010.

 

4.   Consultation

 

Section 17 of the Legislative Instruments Act 2003 requires consultation when a rule-maker makes a legislative instrument. The changes to prudential standard General Insurance Prudential Standard GPS 116 Capital Adequacy: Concentration Risk Capital Charge (GPS 116) have been subject to an external consultation process since September 2008.

 

Overview

The Insurance (prudential standard) determination No. 1 of 2010 was enacted by the Australian Prudential Regulation Authority (APRA) in accordance with the Insurance Act 1973, aiming to address gaps in the regulatory framework for general insurers and authorised non-operating holding companies (NOHCs) by setting prudential standards. These standards are intended to ensure the financial stability and soundness of the insurance sector. APRA, as the regulator, has the authority to determine and vary these prudential standards to manage risks and maintain the integrity of the insurance market. This legislative instrument is designed to refine the calculation of the Concentration Risk Capital Charge, which is part of the Minimum Capital Requirement (MCR) for general insurers, particularly for lenders mortgage insurers (LMIs). The policy objective behind these changes is to clarify the application of prudential standards and reduce prescriptiveness while enhancing the resilience of insurers against concentration risks.

Scope and Application

The Insurance (prudential standard) determination No. 1 of 2010 applies to general insurers and authorised non-operating holding companies (NOHCs) as specified under the Insurance Act 1973. The Act empowers the Australian Prudential Regulation Authority (APRA) to establish and vary prudential standards that these entities must adhere to, ensuring they maintain sufficient capital to mitigate risks, particularly concentration risks. The legislation is a legislative instrument under the Legislative Instruments Act 2003, and it extends across the Commonwealth of Australia. It sets out detailed requirements for calculating the Minimum Capital Requirement (MCR), specifically the Concentration Risk Capital Charge, for general insurers. The changes implemented in GPS 116 Attachment A primarily affect lenders mortgage insurers (LMIs) by refining the principles-based approach to calculating allowable reinsurance for the Maximum Event Retention (MER) and clarifying the probable maximum loss (PML) calculation for pooled policies. APRA's authority to modify these standards allows for adjustments through subordinate instruments, ensuring that the prudential framework remains responsive to evolving market conditions and risks.

Key Provisions

The Insurance (Prudential Standard) Determination No. 1 of 2010, under the Insurance Act 1973 (sections 32(1)(a), 32(1)(b), and 32(4)), allows the Australian Prudential Regulation Authority (APRA) to establish and modify prudential standards for general insurers and authorised non-operating holding companies (NOHCs). This determination, effective from 1 May 2010, specifically revises General Insurance Prudential Standard GPS 116, which pertains to the capital adequacy of general insurers, particularly focusing on concentration risk. The changes are designed to enhance clarity and reduce prescriptiveness in the application of the standard. General insurers and authorised NOHCs governed by this Act must adhere to the new requirements set out in GPS 116. These entities are now required to adopt a principles-based approach in calculating allowable reinsurance for Maximum Event Retention (MER). They must ensure that their Loan-to-Valuation Ratio (LVR) calculations include capitalised premiums, regardless of whether the premium is insured. Additionally, insurers must clarify their probable maximum loss (PML) calculations, especially concerning pooled policies, and must consult with APRA if there is uncertainty about the PML calculation for any business. These changes aim to ensure that insurers maintain adequate capital to cover potential losses. Breach of the provisions outlined in this determination can lead to significant consequences. While the Act does not explicitly state penalties for non-compliance, failure to adhere to prudential standards can result in regulatory action by APRA, including enforcement actions, fines, or other penalties. The severity of the consequences will depend on the nature and extent of the non-compliance and the impact on the insurer's ability to meet its financial obligations. The Act's overarching goal is to ensure the financial stability and soundness of general insurers, thus protecting policyholders and the broader financial system.

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