Insurance (prudential standard) determination No. 2 of 2006 - Prudential Standard GPS 230 - Reinsurance Management

Insurance (prudential standard) determination No. 2 of 2006: Prudential Standard GPS 230 Reinsurance Management

Explanatory Statement

Issued by the authority of the Australian Prudential Regulation Authority (“APRA”)

Insurance Act 1973, paragraph 32(1)(a)

Acts Interpretation Act 1901, subsection 33(3)

Legislative background

Paragraph 32(1)(a) of the Insurance Act 1973 (“the Act”) provides that APRA may determine (in writing) standards relating to prudential matters that must be complied with by general insurers.  Pursuant to subsection 32(5) of the 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.  Subsection 33(3) of the Acts Interpretation Act 1901 gives APRA power to revoke Prudential Standards so determined.

Prudential Standard GPS 230 Reinsurance Arrangements for General Insurers deals with requirements relating to reinsurance management for general insurers. 

The Determination

Insurance (prudential standard) determination No 2 of 2006 will revoke Prudential Standard GPS 230 Reinsurance Arrangements for General Insurers (made on 7 February 2002 under paragraph 32(1)(a) of the Act) (“the old Standard”) and makes the new Prudential Standard GPS 230 Reinsurance Management (“the new Standard”).

The old Standard (and the associated Guidance Note which forms part of the old Standard) aims to ensure that a general insurer has in place prudent reinsurance arrangements, contributing to a high likelihood that the general insurer is able to meet its obligations to policyholders.  The new Standard will aim to ensure that a general insurer has a framework to manage the selection, implementation, monitoring, review, control and documentation of reinsurance arrangements that are used to contribute to the general insurer’s ability to meet its obligations to policyholders.

Background to the Changes

Since 1 July 2002, general insurers have been required to comply with a prudential regime under the Act (involving prudential standards and guidance notes) administered by APRA.  These prudential requirements are complemented by a comprehensive reporting framework for general insurers via reporting standards made under the Financial Sector (Collection of Data) Act 2001.

The prudential regime significantly strengthened and modernised the supervisory framework applying to general insurers in Australia, such that the industry is now subject to much higher operational standards than has been the case in the past.  As with all elements of the prudential framework, APRA intends to update these initial requirements for general insurers as it recognises that it requires greater rigour to adequately protect policyholders.  Sufficient time has now passed to assess the effectiveness of the original framework.

The results of the implementation of the old Standard since July 2002 have been mixed.  While the old Standard and the associated guidance notes, which formed part, were quite prescriptive, APRA observed a wide variation in the application of the old Standard through its supervisory activities.  As a result, the quality of reinsurance management of some general insurers was insufficient to meet APRA’s expectations for a prudently managed institution.  Although the old Standard is prescriptive, it lacks sufficient clarity about APRA’s expectations on reinsurance management. Industry expressed concerns, in particular during on-site supervision activities, that it is difficult for general insurers to implement suitable approaches to compliance.

Inconsistent treatment of prudential requirements between general insurers is an issue.  For example, the quality of reinsurance management documentation and monitoring processes differs greatly between insurers.  The level of prescription in the old standards and guidance notes is such that the requirements cannot be easily tailored to meet the particular circumstances of individual insurers. According to the Insurance Council of Australia (ICA), ‘APRA’s role should be to ensure that each insurer has an appropriate strategy; the details of that strategy could be discussed with each insurer.’  APRA agrees.  Prescribing a set of standards that are ‘one size fits all’ does not achieve the outcome that both the industry and APRA desires.  The tendency with a prescriptive approach is that both insurers and APRA focus too much on compliance with individual elements reducing focus on the effectiveness of the risk management framework in place.

APRA’s supervision of general insurers since 2002 has revealed the following elements relating to reinsurance management as being crucial to the prudent management of a general insurer and APRA’s ability to effectively prudentially supervise the general insurer:

• the presence of an effective framework for reinsurance management, which is documented in a Reinsurance Management Strategy (“REMS”), and includes sound reinsurance management policies and procedures and clearly defined managerial responsibilities and controls.  The key issue here is that the framework must exist and the REMS should describe the framework rather than the REMS being a document for regulatory compliance.  The REMS must be lodged with APRA on a regular basis to ensure compliance with APRA’s prudential aims;
• the way in which a general insurer’s reinsurance arrangements meet the strategy set out in the REMS must be easily understandable.  Senior managers with responsibility for reinsurance within a general insurer must be able to explain where differences occur between the strategic objectives and the outcomes of actual reinsurance arrangements;
• the general insurer has in place sufficient documentation for their reinsurance arrangements as soon as possible after the inception of those arrangements; and
• Limited Risk Transfer Arrangements, including financial reinsurance, are appropriately used within the reinsurance management framework of the general insurer and are appropriately disclosed.

In April 2003, Justice Owen, Commissioner of the HIH Royal Commission, handed down his findings and recommendations on the failure of HIH Insurance. In Recommendation 30, Justice Owen recommended:

That APRA develop mechanisms for investigating the reinsurance arrangements of authorised general insurers on a random but frequent basis.

APRA has made significant internal improvements towards meeting Recommendation 30 of the HIH Royal Commission through its mechanisms for supervising insurers but the old framework makes this process less than optimal because APRA does not receive regular information about insurers’ actual reinsurance arrangements. 

APRA’s powers are in the Act and the Prudential Standards.  The quality of the Prudential Standard on reinsurance management must, therefore, be sufficient to provide APRA with the necessary powers to carry on its supervisory work.  To this end, APRA needs appropriate requirements in the new Standard such as the following:

• To require lodgement of the REMS with APRA on a regular basis but not to require approval of the REMS by APRA (as is currently required) as this is an unnecessary intrusion into a general insurer’s management decision making;
• To require submission of a statement setting out a general insurer’s actual reinsurance arrangements and the effect of these arrangements;
• To require regular attestation by senior managers of a general insurer that the general insurer’s reinsurance arrangements are appropriately documented; and
• To require approval by APRA of the treatment of Limited Risk Transfer Arrangements due to the history of these arrangements being improperly used by Australian general insurers (including HIH) and general insurers overseas to misrepresent their financial positions.

The objectives of amending the reinsurance management prudential framework for general insurers are to:

• Foster a stronger and more flexible reinsurance management regime that allows tailoring of requirements according to the size, business mix and complexity of individual insurers, and which is capable of adapting to market developments and improvements in supervisory techniques over time.  Components of this regime would be:
  • The focus of management is on the creation and maintenance of a framework for prudent, risk driven reinsurance management rather than creating a REMS for compliance purposes;
  • Clear linkages between reinsurance management strategies and actual reinsurance programs;
  • Encouragement for insurers to seek legal certainty in their reinsurance arrangements; and
  • ensure LRTA are not used to misrepresent the financial position of insurers.
• Ultimately increase the protection provided to policyholders.

Detailed Changes

APRA will revoke the old Standard (and associated guidance note) and determine the new Standard under the Act to govern reinsurance management.  The mandatory detail in the guidance note will be retained in the form of technical appendices in the new Standard.  Rather than redetermine the guidance note as part of this new Standard, APRA will release a Prudential Practice Guide (“PPG”).  The PPG will provide guidance to general insurers on the development of a REMS.  The PPG will not be legally enforceable but will be an indication of good reinsurance management practice and help with their compliance with the new Standard.

The new Standard reflects some existing requirements but also implements a range of additional obligations for insurers using a more principles-based approach to supervision, but does not attempt to prescribe in all cases how an insurer must operate to comply with the new Standard.  Specifically, the regime under the new Standard will do the following:

• clarify APRA’s expectations for a general insurer’s reinsurance management framework summarised in a REMS.  The reinsurance management framework will document reinsurance management policies and procedures and clearly define managerial responsibilities and controls and the REMS will be submitted to APRA on an annual basis;
• require insurers to lodge with APRA, on an annual basis, a Reinsurance Arrangements Statement that provides the implemented detail;
• require from an insurer an annual declaration from the insurer’s Chief Executive Officer or Chief Reinsurance Officer that the insurer has in place binding documentation two months and six months after the inception of those arrangements; and
• require general insurers to seek APRA’s approval for the treatment of Limited Risk Transfer Arrangements as reinsurance or financing arrangements before entering into such arrangements.

This new Standard would reinforce the principle that the insurer must have in place at all times a rigourous reinsurance management framework to impose greater certainty about its reinsurance arrangements.  The new Standard will provide a logical structure for the management of a general insurer’s reinsurance arrangements, characterised by the REMS.

Implementation

The old Standard will be revoked with effect from 1 October 2006.  The new Standard will take effect from 1 October 2006.  Between the date of Insurance (prudential standard) determination No 1 of 2006 and 1 October 2006, a general insurer must continue to comply with the old Standard. 

However, there are special transition rules set out in an attachment to the new Standard.  These deal with the submission of various documentation required under the new Standard and other transitional matters.

Consultation

APRA has undertaken a comprehensive and rigorous program of consultation with industry since the release of the initial discussion paper outlining the proposed changes to reinsurance management (among other things) in November 2003.  A large number of submissions were received in response to this discussion paper, many of which expressed concerns about the prescriptive nature of the proposals concerning reinsurance management.

To provide a forum for further discussion about the proposals, APRA and the Insurance Council of Australia (“ICA”) held a Joint Forum in June 2004, where APRA presented its proposals and comments on the submissions received to date.  This also provided an opportunity for members of the industry to voice their concerns and to foster a useful debate about the proposals.  Subsequent to this Joint Forum, APRA also met with insurers on an individual basis to further discuss the specific impact of the proposals on their operations

APRA then released a further discussion paper and draft prudential standards and guidance notes for industry comment in May 2005, incorporating changes based on the submissions received from, and discussions held with, industry.  APRA and ICA held another Joint Forum in June 2005 where further discussions around the detail of the proposals took place.  At both this forum and in the submissions received (during the six-month consultation period), similar concerns about the proposed level of prescription and the lack of relevance of some of the proposals to differing types of general insurers were again raised.

As a result of the cumulative effect of these submissions, APRA decided to propose significant changes to its overall prudential framework for general insurers to allow for greater flexibility with a more tailored and certain supervision framework.  These proposals, including the introduction of PPGs, were presented to the ICA and contributors of significant submissions in October 2005.

Once the proposed standards and PPGs were in a near final form, APRA held a private consultation with an ICA Working Party to ensure that APRA’s approach adequately reflected their input.

Throughout the overall consultation process, APRA also held Auditor Liaison meetings, where the proposals relating to the responsibilities of auditors were discussed with representatives from the profession. 

The response from all participants in the final consultation processes was very positive.  The industry was pleased with option 1 in general terms because of its greater flexibility in structure and the significantly reduced prescription.  The remaining resistance to particular proposals by individual insurers concerned the impact of the particular proposals on those insurers which could not be appropriately addressed while meeting the objectives of the proposals.

Regulatory Impact Statement

A Regulation Impact Statement is attached to this Explanatory Statement.

Regulation impact statement

GPS 230 Reinsurance Management

This Regulation Impact Statement (RIS) addresses APRA’s determination of Prudential Standard GPS 230 Reinsurance Management and the creation of a new prudential framework characterised by the introduction of non-enforceable guidance material.

Background

There are currently 133 private sector companies authorised under the Insurance Act 1973 (the Act), managing (as at 30 September 2005) approximately $82 billion in assets. Since 1 July 2002, general insurers have been required to comply with an upgraded prudential regime under the Act (involving prudential standards and guidance notes) administered by the Australian Prudential Regulation Authority (APRA).  These prudential requirements are complemented by a comprehensive reporting framework for general insurers via reporting standards made under the Financial Sector (Collection of Data) Act 2001.

The current prudential regime significantly strengthened and modernised the supervisory framework applying to general insurers in Australia, such that the industry is now subject to much higher operational standards than had been the case in the past.  As with all elements of the prudential framework, APRA intended to update these initial requirements for general insurers as it recognised that it required greater rigor to adequately protect policyholders.  Sufficient time has now passed to assess the effectiveness of  the current framework.

In order to measure the impact on the operating costs of insurers of this updated package we examined the impact on the cost base of insurers of the extensive changes implemented on 1 July 2002.  If the compliance costs of prudential regulation were significant, then the reforms implemented in 2002 should have been accompanied with a large increase in operating costs (other expenses and underwriting expenses).  APRA’s analysis indicates that the added costs of the 2002 reforms were not significant as the inflation in operating costs of the largest four insurers continued at about the same rate as the increase in the assets and the gross written premium of those insurers.  Refer to the graph on the following page which shows the four major insurers’ operating costs and a comparison of operating costs to total assets and gross written premium.  

If operating costs are compared to premium income, then the first year of the implementation of the reforms coincided with a significant decrease in expenses compared to gross written premium.  This effect was caused by a significant increase in premium rates.  There were a number of drivers of increased premiums at that time including: a greater focus on underwriting results due to low inflation and weak equity markets; loss of capacity in the industry particularly due to the exit of HIH; and increased pressure from reinsurance costs following the September 11 terrorist attacks. The result was that in 2003 for the first time in five years the industry made an underwriting profit.

The trend in increasing costs in actual dollar terms from 2001 to 2004 is relatively stable.  Whilst this analysis does not definitively indicate the absence of additional compliance costs, it does demonstrate that a significant reform of the general insurance industry was not accompanied by a significant increase in operating costs.  APRA believes that this is evidence that compliance costs are not significant and any increase in compliance costs as a result of this package of further reforms, which are less comprehensive than those implemented in 2002, will therefore not be significant.

 The standard that is the subject of this RIS, is part of a package of standards known as the General Insurance Stage 2 reform – risk and financial management package.  Other components of that package are reforms to the prudential requirements for risk management and audit and actuarial reporting and valuation.  The reforms implemented as at 1 July 2002 were far more extensive than proposed under the Stage 2 reforms. 

In April 2003, Justice Owen, Commissioner of the HIH Royal Commission, handed down his findings and recommendations on the failure of HIH Insurance. In Recommendation 30, Justice Owen recommended:

That APRA develop mechanisms for investigating the reinsurance arrangements of authorised general insurers on a random but frequent basis.

Problem identification

APRA has made significant internal improvements towards meeting Recommendation 30 of the HIH Royal Commission through its mechanisms for supervising insurers but the existing framework makes this process less than optimal because APRA does not receive regular information about insurers’ actual reinsurance arrangements.  This results in APRA’s scarce supervision resources not being used in the best possible way as key information is not available to refine the risk assessment APRA applies to parts of an entity’s operations and to each entity as a whole.  APRA has to organise a prudential review at the offices of the insurer to obtain this information. These must be programmed carefully to maximise the use of APRA’s scarce resources and to prevent constant interference with the business operations of the insurer.  If regular information was available regarding the reinsurance arrangements, APRA’s expertise in reinsurance could be targeted to the right companies and APRA could devote more focus to the non-reinsurance operations of insurers, where  warranted.

APRA’s supervision of general insurers since 2002 has revealed the following issues with the reinsurance requirements currently in place:

• There is a focus on the Reinsurance Management Strategy (REMS) being a document for regulatory compliance rather than a document that helps focus on risk issues by the Board and management of the company.  The focus on regulatory compliance means that the reinsurance management framework is not necessarily adequate for the effective management of reinsurance within an insurer leading to decisions by the Board and management that may not always be in the best interests of the insurer.
• It has been difficult for some insurers to explain the link between their REMS and the actual reinsurance arrangements put in place when APRA has been conducting prudential reviews.  It is expected that similar difficulties in understanding the link between strategy and implementation would be faced by the  relevant senior management, Boards, actuaries and auditors. 
• Past industry practice has seen few timely reinsurance arrangements with certainty of the contract terms.  Many were not completed until a significant period after the inception date of the contract, in some cases contract certainty was never achieved.  This potentially exposes insurers to significant legal risk if there is not a true meeting of minds between an insurer and a reinsurer about the detailed terms of the contract.  In the extreme situation, this may lead to a reinsurer denying a claim that the insurer believes is covered.  While the ‘duty of good faith’ has operated reasonably well in such situations in the past, there is a clear growing tendency in international insurance markets for litigation over the terms of contracts.  Consequences may be discounting of claim payment or refusal to reinstate cover after a claim leading to significant additional costs in obtaining alternative cover.  There is a possibility of the extreme outcome of the reinsurer denying a claim leading to consequences which could be extremely serious for the insurer – perhaps even leading to insolvency if it was a significant catastrophe claim.  Whilst the industry recognises this problem and its serious consequences it is difficult for any single insurer to change industry practice.
• Limited Risk Transfer Arrangements (LRTAs), including financial reinsurance have been inappropriately used to distort reported financial performance.  It is clear that senior management and boards of insurers where LRTAs have been inappropriately used have not sufficiently understood the effect of these complex transactions.

Inconsistent treatment of prudential requirements between insurers is a key issue.  For example, that the quality of reinsurance documentation and monitoring processes differs greatly between insurers.  The level of prescription in the current prudential standard is such that the requirements cannot be easily tailored to meet the particular circumstances of individual insurers.  According to the ICA, ‘APRA’s role should be to ensure that each insurer has an appropriate strategy; the details of that strategy could be discussed with each insurer.’  APRA agrees.  Prescribing a set of standards that are ‘one size fits all’ does not achieve the outcome that both the industry and APRA desires.  The tendency with a prescriptive approach is that both insurers and APRA focus too much on compliance with individual elements reducing focus on the effectiveness of the reinsurance management framework in place.

The prescriptive approach to general insurance regulation was deemed appropriate in 2002, in light of the failure of HIH and the general consensus that the industry needed to improve its approach to reinsurance management.  Through implementing the prescriptive requirements via the current standard, industry practice has matured and it is now more appropriate to use principles-based supervisory methods.

Further, there is a lack of alignment between APRA’s requirements and international regulatory developments with regard to the treatment of reinsurance arrangements and, in particular, LRTA.   There has been focus on misleading reinsurance arrangements, particularly by US regulators and the impact on disclosed financial reports.  In Australia, these problems were experienced with the reinsurance arrangements of HIH and there have been other instances since then where APRA has been involved in enforcement action.  Enforcement action is difficult in the absence of specific standards which should assist the industry to identify inappropriate practices and prevent them before they occur. 

Objectives

The objectives of amending the reinsurance management framework for general insurers are to:

• Foster a stronger and more flexible reinsurance management regime that allows tailoring of requirements according to the size, business mix and complexity of individual insurers, and which is capable of adapting to market developments and improvements in supervisory techniques over time.  Components of this regime would be:
  • The focus of management is on the creation and maintenance of a framework for prudent, risk driven reinsurance management rather than creating a REMS for compliance purposes;
  • Clear linkages between reinsurance management strategies and actual reinsurance programs;
  • Encouragement for insurers to seek legal certainty in their reinsurance arrangements; and
  • ensure LRTA are not used to misrepresent the financial position of insurers.
• Ultimately increase the protection provided to policyholders.

Identification of options

Option 1: Determine a prudential standard to impose new reinsurance management requirements on general insurers

Under this option, APRA would revoke the current standard (and associated guidance note), and determine a new prudential standard under the Act to govern reinsurance management.  The mandatory detail in the guidance note would be retained in the form of technical appendices in the prudential standard.  Rather than maintain legally binding guidance notes, APRA would release a Prudential Practice Guide (PPG).  The PPG would provide guidance to insurers in the implementation of good reinsurance management practices and help with their compliance with the new prudential standard.  The PPG would not be legally enforceable, but would be an indication of good practice which could be used as a benchmark by APRA supervisors when assessing the reinsurance arrangements of an insurer.  If an insurer chooses an alternative approach to the development of a REMS more suited to its business model, it would have to demonstrate how the alternative met the required standard.  A failure by an insurer to implement such practice would be considered in APRA’s holistic assessment of the insurer, via its Probability and Impact Rating System (PAIRS) framework.   The determination of APRA’s supervisory stance and allocation of resources is based on the Probability Rating and Impact Rating for each rated institution.

APRA has four supervisory stances: ‘Normal’, ‘Oversight’, ‘Mandated Improvement’ and ‘Restructure’.

• A 'Normal' mode means APRA each quarter collects and analyses data and makes regular  routine on-site visits.
• 'Oversight' means a significant step-up in information collection and inspection intensity. APRA may increase minimum capital requirements for ‘Oversight’ institutions, if the additional risk profile warrants such a change.
• 'Mandated Improvement' means the institution is operating in an unsustainable way in the medium term. APRA will direct these institutions to present and execute a remediation plan that addresses the area of identified weakness and restored financial stability. At this level, APRA allows the regulated institution to retain control of its destiny, but clearly signals that improvements must be made. APRA may issue directions and take other enforcement actions at this level.
• 'Restructure' institutions are in serious danger of failure to deliver their financial promises to beneficiaries. To these institutions, APRA applies its full enforcement powers, including issuing directions to replace persons and service providers and/or to restrict business activities. APRA's paramount concern in this situation is to quarantine the entity from further deterioration and minimise losses to depositors, policyholders and superannuation fund members.

APRA’s supervisory stances relate to an institution’s PAIRS Probability and Impact ratings as follows:

Failure to adequately manage reinsurance arrangements will lead to an increase in the probability of failure rating.  Depending on how close an insurer is to the threshold for increased supervision will determine the effect on the insurer.  The reinsurance management framework is only one part of an insurer’s overall risk management framework and the impact of the quality of the risk management framework on the overall probability rating will depend on the insurer’s inherent risks, its management capabilities and its capital resources available to absorb losses.   

The new prudential standard reflects some existing requirements but also implements a range of additional obligations for insurers using a more principles-based approach to supervision, but does not attempt to prescribe in all cases how an insurer must operate to comply with the standard.  Specifically, the regime under this prudential standard would do the following:

• clarify APRA’s expectations for an insurer’s reinsurance management framework summarised in a REMS.  The reinsurance management framework would document reinsurance management policies and procedures and clearly define managerial responsibilities and controls and the REMS would be submitted to APRA on an annual basis;
• require insurers to lodge with APRA, on an annual basis, a Reinsurance Arrangements Statement that provides the implemented detail;
• require from an insurer an annual declaration from the insurer’s Chief Executive Officer or Chief Reinsurance Officer that the insurer has in place binding documention for their reinsurance arrangements two months and six months after the inception of those arrangements; and
• require insurers to seek APRA’s approval for the treatment of LRTA as either reinsurance or financing arrangements before entering into such arrangements.

This new standard would reinforce that the insurer must have in place at all times a rigourous reinsurance management framework to impose greater certainty about its reinsurance arrangements.  The prudential standard would provide a logical structure for the management of an insurer’s reinsurance arrangements, characterised by the REMS.

Option 2: Amend existing prudential standard and guidance notes

Under this option, APRA would amend only the content of the existing prudential framework.  That is, the current standard and its associated enforceable guidance notes would be updated to clarify the new reinsurance management framework and related requirements, impose requirements relating to the Reinsurance Arrangements Statement and Reinsurance Declaration and require more rigourous treatment of LRTAs.  Insurers would have to comply with these prescribed new requirements, as the character of the enforceable framework surrounding these requirements would not change.

Option 3: Retain existing reinsurance management requirements without amendment

Under this option, the current standard would remain unchanged.  Insurers would continue to manage their reinsurance arrangements as they have done since 2002 without having to meet any new or clarified requirements.

Impact analysis

Impact group identification

It is expected that APRA, insurers and policyholders would be affected by the implementation of the options relating to reinsurance management outlined above.

Assessment of costs and benefits

APRA does not have data to perform a detailed quantitative cost-benefit analysis.  The following analysis is based on anecdotal evidence provided from within APRA which is influenced by information supplied by the industry.  Some general views on costs and benefits have been recorded but this does not indicate an ability to accurately determine a quantitative estimate.  Any attempt to provide a quantitative estimate would be misleading.

The impact groups are not mutually exclusive because there are mechanisms to pass costs from one impact group to another.  Costs imposed on APRA are passed to insurers via the levies imposed on insurers that fund APRA.  If costs are to be incurred by either insurers or APRA then an issue to consider is which would be the most effective and efficient at carrying out that task.

Insurers operate in a relatively competitive market.  There is potential, where costs are imposed on all insurers equally, for costs to be passed on to policyholders via increased premiums.  If some costs are incurred disproportionately by some insurers more than others the likely effect is that those costs will be retained by insurers as the competitive environment they operate in would not allow these costs to be passed on.

As shown in the background section analysis, compliance costs for insurers is not significant when compared to the overall operating costs of an insurer.  This is based on the experience of implementing very significant reforms in 2002 when no significant trend in increased costs emerged.

Option 1: Determine a prudential standard to impose new reinsurance management requirements on general insurers

Benefits

APRA

Under this option, insurers would be subject to more stringent requirements governing their reinsurance arrangements than those which currently exist but which apply more appropriately to the individual circumstances of the insurer.  The most important benefit flowing from this option is that APRA’s supervision methodology would better target supervision of individual insurers, whilst retaining sufficient rigour.  The new standard would impose the set of standardised requirements with which all insurers must comply.  Rather than having to apply only a prescriptive set of prudential requirements that may not be relevant to the operations of an insurer, APRA would also be able to rely on guidance material which can be interpreted in the context of the insurer’s business.  This approach would also provide a structure that allows for a better focus on the real structure of the reinsurance arrangements of an insurer, rather than simply taking a ‘one-size-fits-all’ approach to compliance and supervision.  The introduction of the new standard and separate PPGs would clarify those elements of APRA’s supervision framework that are enforceable and those that are purely guidance.  The tailoring of the prudential framework would also create closer ties between APRA’s supervision activities and the current PAIRS assessment framework for risk-based supervision of regulated institutions.

The rigour of the prudential framework would not be diminished as all insurers would have to comply with standard requirements across the industry.  Further, insurers would also be expected to explain how their practices meet the requirements.  

The improvements to the supervisory tools relating to the reinsurance arrangements of insurers would assist APRA to fulfil its obligations in meeting Recommendation 30 of the HIH Royal Commission, and assist Government policy in this area.

On a more practical level, the replacement of guidance notes with PPGs would provide sufficient flexibility for APRA to update this guidance material as required.  This would allow the PPGs to appropriately respond to industry developments without having to redetermine new legislative instruments.

APRA would derive benefits from specific proposals in the following ways:

• APRA’s supervision resources would be targeted towards companies with greater prudential issues because better information would be available via the Reinsurance Arrangements Statement
• APRA would cease to incur administrative costs in approving REMS;
• APRA would be involved in less enforcement (which is extremely resource intensive) in relation to LRTAs as inappropriate LRTAs would not be approved by APRA.  This proposal would also result in greater focus on the high risk activity by insurers as APRA would need to consider approvals of LRTAs

Insurers

Under the new standard and PPG, insurers should incur a lesser compliance burden as the requirements would better reflect the structures and operations of individual insurers.  Insurers would benefit from the provision of clearer and more appropriate requirements in the new standard, and would be able to use the PPG as the basis for their reinsurance management frameworks without having to comply with unnecessary elements.  This option would remove some of the existing prescription and inflexibility in the application of the reinsurance management requirements through the creation of the principles based set of minimum criteria.  This flexibility would ensure that any increase in compliance costs are kept to a minimum by reducing legal/compliance risk for insurers.

This option would give insurers a new ability to operate within a stronger reinsurance management framework (that better aligns with international approaches to prudential supervision and this is important because of the international nature of the reinsurance market) without an unnecessary level of prescription.  Insurers would be subject to clarified requirements governing their reinsurance management practices with better information about the context for regulation; insurers should undertake continual processes for monitoring reinsurance arrangements (via a more rigourous REMS, the new Reinsurance Arrangements Statement and the Reinsurance Declaration) rather than focusing only on the initial stages of such arrangements, or when reinsurance is called upon. For a number of insurers, who have not implemented a reinsurance management framework, there will be significant benefits from the better decision making that will flow from implementing these requirements. 

Insurers would be required to appropriately account for LRTAs.  Note that insurers using LRTAs are a minority of insurers. The failure by some insurers in the past to account appropriately for such arrangements has been a well publicised issue in Australia (including in relation to the HIH collapse) and internationally.  Failure to account appropriately for LRTAs has caused significant damage to the reputation of some insurers and the misrepresentation of the financial position of insurers caused through the misuse of these arrangements has meant that significant financial problems have remained hidden for much longer than necessary.  Avoiding such issues will be a significant benefit to insurers, to APRA and to the industry.  For instance, insurers will be able to avoid costly and public enforcement actions given that issues with LRTAs can be dealt with in consultation with APRA through the approval process.  Overall the benefits to a small number of insurers will be less risk to reputation and their financial position.

A key benefit from the proposals is that insurers would have greater legal certainty about their reinsurance arrangements through the requirement to document those reinsurance arrangements in a timely manner. Contract certainty will lead to fewer disputes regarding reinsurance arrangements and decrease legal costs in the long run.

Insurers which cannot currently effectively communicate how their reinsurance arrangements operate to external parties generally have the same problem internally. Hence, key decision makers within the insurer are not appropriately informed.  Those insurers that need to significantly improve the description of their reinsurance arrangements and how they work as well as how they fit with the REMS will benefit from improved decision making by senior management and the Board.  It is APRA’s view that these benefits will be significant compared with the costs of implementing this requirement.

Policyholders 

Policyholders with those insurers that need to improve the management of their reinsurance arrangements would benefit from these more rigorous processes being in place.  A sound framework for the management of reinsurance arrangements within an insurer would minimise the risk of unforeseen events materially affecting the financial soundness of the insurer.  Further, it should encourage the development of better systems for identifying, managing and monitoring the risks associated with entering into reinsurance contracts that may improve the ability of the insurer to meet its obligations to policyholders when called upon to pay claims.  This will lead to greater certainty that insurers will be able to fulfil their obligations under an insurance contract.

The benefits experienced by insurers from the streamlining of compliance requirements may be passed on to policyholders.

Costs

APRA

Implementing the proposed changes would only impose minimal additional costs on APRA.  APRA would use existing resources to train supervisory staff to implement the altered framework.  Frontline supervisors may be required to expend some additional effort during the transition period to supervise the transition by companies to the new standards.  As industry would be unfamiliar with the new structure incorporating PPGs, supervisors may also have to respond in the short term to a higher number of queries from regulated institutions than is currently the case.  However, existing resources would be used to carry out these tasks and no additional resources would be employed. This one-off cost will divert existing supervisory resources, however there will be an offsetting reduced focus on supervising current requirements.

Any additional supervisory effort required for monitoring compliance with the new requirements will be built into the existing supervisory methodology and review processes.  Supervisory resources will be required to administer the new requirements including reviewing Reinsurance Arrangements Statements, assessing reinsurance declarations (only significant work will be on an exception basis where qualifications are made) and approving LRTAs (likely to be infrequent).  In mitigation, it is proposed that APRA will no longer have to expend administrative resources on approving REMS.  The additional information provided to APRA through the Reinsurance Arrangements Statement will result in better targeting of supervisory resources, the cost saving from this better targeting of resources will offset any increase in administrative tasks, resulting in no requirement for additional supervisory resources. 

Insurers

As with any new regulatory approach, it is anticipated that insurers would face initial compliance costs under this option associated with amending their internal systems to meet the new reinsurance management requirements.  APRA does not, however, expect that any increase in compliance costs would be onerous longer term.  There will be a trade off between the costs of complying with new more flexible requirements compared to cost savings from a lesser compliance burden with prescriptive requirements.  This trade off will differ between insurers. 

Changes to the REMS to be a description of a reinsurance management framework covering specific minimum requirements largely reflect existing arrangements in place by those insurers that are appropriately addressing their reinsurance management.  APRA anticipates that only a significant minority of insurers are not fully meeting APRA’s requirements about reinsurance management at present.  This significant minority is concentrated among the smaller specialist insurers who often have not yet appropriately developed their risk management frameworks.  The majority of the major insurers largely meet the new requirements.  So, only those insurers with inadequate frameworks commensurate with the risks faced by their business would incur initial costs to set up additional systems.   

In relation to reinsurance documentation, the practices across the insurance industry have not been at an acceptable standard and the requirements being imposed will require an industry wide response to improving the timeliness of documentation completion.  The costs of implementing such a change are difficult to calculate as all that is required is for insurers and intermediaries to complete the documentation in a more timely manner.  An issue is that insurers typically arrange their reinsurance at the end of June and the end of December each year, creating two peaks in workload in the industry.  Additional resources may be required in these two peak seasons in order to complete documentation in a timely manner or the industry could choose to spread its workload more evenly through the year.  It is likely that the bulk of the costs will be incurred in the implementation period (3 years) because changes in processes will need to be introduced.

There may also be costs for insurers to put in place management reporting processes that will enable the annual reinsurance declaration to be made.  Any initial costs of complying with this requirement should be offset by the lower costs associated with fewer legal disputes about reinsurance arrangements due to greater contract certainty.  This is a problem that has been difficult for individual insurers to deal with as seeking contract certainty from the reinsurance market requires a change in the standard procedures of the industry.

APRA expects that most which choose to enter into LRTA would already have in place processes for ensuring that any such arrangements are accounted for appropriately.  Such companies will incur minimal compliance costs (only costs associated with the APRA Approval process).  Companies can always choose not to enter into such arrangements and would therefore incur no compliance costs under this proposal.  Where an insurer does wish to make use of LRTAs because they provide the most effective solution in particular circumstances, then the benefits of putting in place policies to ensure the effect of the arrangements are appropriately understood by senior management and the board of an insurer and properly disclosed would far outweigh the costs of compliance with the new requirements.

The implementation of the Reinsurance Arrangement Statement is expected to come at minimal cost to insurers with adequate systems to inform senior management, the board, auditors (internal and external) and the actuary of how reinsurance arrangements are used and how they relate to the insurer’s REMS.  This proposal aims to formalise all of the necessary information in one document which is submitted to APRA.  The costs of implementing this initiative will be the costs of bringing together the information concerning how an insurer’s actual reinsurance arrangements operate, a cost that is incurred when a third-party such as the insurer’s Approved Actuary, Approved Auditor or APRA require this information.  Insurers will be able to structure this Reinsurance Arrangements Statement to satisfy both the APRA requirements and the needs of other users, potentially streamlining the provision of information.  There will be insurers that will incur significant costs to implement the reinsurance arrangements requirements.  These are the same insurers likely to experience significant benefits from the proposal.

Policyholders

Policyholders will only suffer direct costs if insurers increase premiums to offset the expense of complying with the new formalised requirements. Note that this would mean that the costs borne by insurers would reduce or be offset if this occurred so the costs to insurers and policyholders are alternatives and are not to be added together. APRA expects, however, that insurers will not increase their premiums and will instead fund any increased compliance from their profits, due to market forces.  The one proposal that will result in the entire industry incurring costs is the reinsurance contract certainty proposal.  However, if insurers did choose to pass on the costs, compliance costs are a small part of an insurer’s overall costs and the impact on premiums would be negligible.  Given market forces, APRA expects that premiums would not increase in a material way, if at all.

Option 2: Amend existing prudential standard and guidance notes

Benefits

APRA

This option would allow the prudential framework for reinsurance management to be updated to clarify APRA’s expectations for a strong reinsurance management framework and  assist APRA to meet its obligations under Recommendation 30 in a more effective way.   The familiarity of the standard and guidance notes under this option would also mean that training costs for supervision staff and the time spent educating the industry about the new requirements would be kept to a minimum.

The benefits identified for option 1 with respect to the specific proposals would apply under this option as well.

Insurers

The only benefit to insurers under this option would be that they would operate under a more robust reinsurance management framework with the features outlined above.

Policyholders

Policyholders would have the benefit of better prudential protection under this option than currently in place (similar to Option 1 outlined above).  This should minimise the chance of losses arising through unforseen events where the insurer cannot pay claims because of the inadequacy of its reinsurance arrangements.

Costs

APRA

APRA would incur similar direct costs as those outlined for Option 1 above as this option would involve amendments to the prudential framework on a similar scale.  The staff training costs associated with this option would not be as great as the framework would retain the same essential character. 

APRA would, incur significant indirect costs under this option.  Essentially, APRA’s costs under this option are the benefits derived from the new framework for prudential standards and guidance noted under Option 1.  Most importantly, the inefficiencies in the existing framework that have been identified would remain in place.  This means that APRA would continue to face the problems associated with imposing a fixed structure framework onto insurers with often vastly different operations.   The framework would remain unresponsive to developments in the industry and APRA’s framework would continue to reflect an overly prescriptive approach.

Insurers

This option would result in the greatest increase in compliance costs for insurers as they would have to comply with additional reinsurance management requirements in a system that has been identified as being prescriptive, inefficient and inflexible.  The costs of complying with this new framework would be associated with the development of new systems and training of staff and the provision of additional material to APRA. Essentially, the difference between this option and option 1 is that any offsetting benefits in terms of cost reductions through streamlining of compliance would not be realised.

Policyholders

The increased compliance costs faced by insurers under this option could flow through to increased premiums, which would impose a cost that is disproportionate to the level of increased protection that policyholders would receive through the more rigourous framework.  Increased compliance costs among insurers is likely to be more prevalent and therefore it is more likely that market forces would allow some of that cost to be passed on to policyholders through higher premiums.

Option 3: Retain existing reinsurance management requirements without amendment

Benefits

APRA

APRA would not incur the staff training costs or any potential costs from administering the requirement for a reinsurance statement and reinsurance declaration and authorisation of LRTAs.

Insurers

As the existing reinsurance management requirements would remain unchanged under this option, insurers would not have to expend extra resources complying with new requirements.

Policyholders

There is no real benefit to policyholders under this option beyond the benefits offered by the current environment.

Costs

APRA

Whilst APRA would incur no direct policy development and implementations costs associated with this option, as the prudential framework would remain unchanged, it would actually experience significant ongoing indirect costs.  Firstly, APRA would not be able to improve the targeting of its supervision resources as the information supplied to it would remain the same.  The problems previously identified associated with LRTAs would also continue, meaning that, due to lack of transparency, the level of capital held by an insurer may not be appropriate to the risks it holds on its books leading to greater likelihood of failure or financial distress.  Secondly, APRA would not be able to fully implement recommendation 30 of the HIH Royal Commision as it would continue to have to apply a supervisory framework that has been identified as partially inadequate.  This is contrary to the Government’s decision to implement this recommendation.

The benefits to APRA of the specific measures noted would not be realised if this option was implemented.

Insurers

Insurers would be disadvantaged under this option as the existing inflexible and prescriptive reinsurance management framework would continue to operate.  This is in spite of the fact that APRA’s consultation about the proposals has revealed that the current framework does not appropriately reflect the developing and varied nature of insurance company operations.  Existing inefficiencies arising from APRA’s framework would remain in place meaning that insurers would continue to expend resources on compliance measures that have insufficient direct benefit in terms of their safety and soundness.

Policyholders

Whilst policyholders would not face additional financial costs if the framework remained in its current form, they would not benefit from improved security in the supervisory arrangements that would result from improved reinsurance management requirements.  Necessary levels of protection would not be provided to policyholders as the identified inadequacies in the current framework would continue.

Consultation

APRA has undertaken a comprehensive and rigourous program of consultation with industry since the release of the initial discussion paper outlining the proposed changes to reinsurance management (amongst others) in November 2003.  These proposals were essentially option 2 above. A large number of submissions were received in response to this discussion paper, many of which expressed concerns about the scope and prescriptive nature of the proposals concerning reinsurance management.

To provide a forum for further discussion about the proposals, APRA and the Insurance Council of Australia (ICA) held a Joint Forum in June 2004, where APRA presented its proposals and comments on the submissions received to date.  This also provided an opportunity for members of the industry to voice their concerns and to foster a useful debate about the proposals.  Subsequent to this Joint Forum, APRA also met with insurers on an individual basis to further discuss the specific impact of the proposals on their operations.  Again all the discussion was essentially about option 2.

APRA then released a further discussion paper and draft prudential standards and guidance notes for industry comment in May 2005, incorporating changes based on the submissions received from, and discussions held with, industry.  The discussion paper represented an updated option 2.  APRA and the ICA held another Joint Forum in June 2005 where further discussions around the detail of the proposals took place.  At both this forum and in the submissions received (during the six-month consultation period), similar concerns about the proposed level of prescription and the lack of relevance of some of the proposals to differing types of insurers were again raised.

As a result of the cumulative effect of these submissions, APRA decided to propose significant changes to its overall prudential framework for general insurers (refer Option 1 above) to allow for greater flexibility with a more tailored and certain supervision by APRA.  These proposals, including the introduction of PPGs, were presented to the ICA and contributors of significant submissions in October 2005.

Once the proposed standards and PPGs were in a near final form, APRA held a private consultation with an ICA Working Party to ensure that APRA’s approach adequately reflected their input.

Throughout the consultation process, APRA also held Auditor Liaison meetings, where the proposals relating to the responsibilities of auditors were discussed with representatives from the profession. 

The response from all participants in the final consultation processes was very positive.  The industry was pleased with option 1 in general terms because of its greater flexibility in structure and the significantly reduced prescription.  The remaining resistance to particular proposals by individual insurers concerned the impact of the particular proposals on those insurers which could not be appropriately addressed while meeting the objectives of the proposals.

Conclusion and recommended option

Option 1 is the preferred option

Option 1 fulfils APRA’s stated objective of a balanced prudential framework which accommodates both increased protection to policyholders and fosters a flexible regime for insurers. 

This option increases protection to policyholders by emphasising that rigorous reinsurance management should be an ongoing concern for general insurers.  This is achieved by requiring insurers to establish a reinsurance management framework which is summarised in the form of a REMS approved by the Board.  A reinsurance arrangements statement is then required to be provided by senior management to show how they have gone about implementing the strategy set out in the REMS.  Senior management are also required to certify, via the Reinsurance Declaration, that reinsurance arrangements have been documented in a timely fashion.  LRTAs are required to be approved by APRA as either reinsurance arrangements or financing arrangements, based on their character.  This step is necessary due to the significant problems that have emerged from the use of these arrangements by certain parts of the industry in Australia and overseas.  These measures taken together will assist APRA to implement Recommendation 30 of the HIH Royal Commission.

It will remedy the significant concerns expressed by the insurance industry about the overly prescriptive nature of the original proposals which are represented by option 2 and the associated high compliance costs.  APRA would be able to tailor its supervisory practices to the particular nature of an insurer’s business, and insurers would be able to refer to significant guidance in developing and maintaining their reinsurance management framework, without having to prove compliance with elements that are irrelevant to their business.  Finally, it allows APRA to implement, in principle, Recommendation 30 of the HIH Royal Commission.

Option 2 does not entirely meet the objective stated above.  Whilst the additional reinsurance management elements are added to the existing framework, under this option, the framework would retain the current inflexibility which prevents appropriate and tailored supervision of insurers.  Policyholders would be adequately protected under the reinsurance management framework, but would face the risk of having to pay higher premiums flowing from increased compliance costs for insurers.

Option 3 falls short of meeting APRA’s stated objectives.  It neither assists APRA to fulfil its obligation to implement Recommendation 30 of the HIH Royal Commission nor provides sufficient levels of protection for policyholders.  It retains inefficiencies in the framework that have been acknowledged as limiting the appropriate supervision of insurers, and which impose an unacceptable compliance burden on the industry.

The table on the following pages shows the analysis of all the benefits and costs from Option 1 to each impact group.  It also shows where significant costs can be passed from one impact group to another.

Implementation and review

APRA intends that the new GPS 230 and PPG will be released in February 2006, with an effective date of 1 October 2006.  In the intervening months, insurers will have the time to put in place internal changes to comply if they are not already operating at a level that would meet the requirements of the new standard. 

APRA will assess the adequacy of the prudential supervisory requirements proposed under the GPS 230 on an ongoing basis, to ensure that they effectively address the character of the reinsurance arrangements entered into by insurers.  APRA expects that the current arrangements will undergo a formal review after three years of operation, with the next review due to commence in late 2009.