Insurance (prudential standard) determination No. 3 of 2006 - Prudential Standard GPS 310 - Audit and Actuarial Reporting and Valuation

Insurance (prudential standard) determination No. 3 of 2006: Prudential Standard GPS 310 Auditor and Actuarial Reporting and Valuation

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 210 Liability Valuation for General Insurers deals with requirements relating to actuarial liability valuation for general insurers and Prudential Standard GPS 220 Risk Management for General Insurers deals with requirements relating to the roles and responsibilities of a general insurer’s Approved Auditor and Approved Actuary.  The Approved Auditor and Approved Actuary are auditors and actuaries of general insurers who have been approved by APRA as required under the Act. 

The Determination

Insurance (prudential standard) determination No 3 of 2006 will revoke Prudential Standard GPS 210 Liability Valuation for General Insurers (made in July 2002 under paragraph 32(1) of the Act) (“the old GPS 210”) and makes the new Prudential Standard GPS 310 Audit and Actuarial Reporting and Valuation (“the new Standard”).

The old GPS 210 (and the associated Guidance Note which forms part of the old GPS 210) establishes a set of principles for the consistent measurement and reporting of the insurance liabilities for all general insurers.  The new Standard will aim to ensure that the Board and senior management of a general insurer are provided with impartial advice in relation to the operations, financial condition and insurance liabilities of the general insurer.  This advice is designed to assist the Board and senior management in carrying out their responsibility to ensure the sound and prudent management of the general insurer.  Accordingly, the new Standard will outline the roles and responsibilities of a general insurer’s Approved Auditor and, where the general insurer is required to have one, its Approved Actuary, and the obligations of a general insurer to make arrangements to enable its Approved Auditor and Approved Actuary to fulfil their responsibilities.  The new Standard will also establish a set of principles and practices for the consistent measurement and reporting of insurance liabilities for all general insurers.  Existing requirements relating to the roles and responsibilities of a general insurer’s Approved Auditor and Approved Actuary are set out in Prudential Standard GPS 220 (made on 7 February 2002 under paragraph 32(1) of the Act) (“the old GPS 220”), which will be revoked by Insurance (prudential standard) determination No 1 of 2006.

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 key change implemented with the current prudential regime relevant to the topic of audit and actuarial reporting and valuation was the requirement for insurance liabilities to be valued by an Approved Actuary with a prudential margin applied utilising as a base the professional standard promulgated by the Institute of Actuaries of Australia (IAAust).  This has improved the reliability, consistency and risk sensitivity of the technical provisions for insurance liabilities.

As with all elements of the prudential framework, APRA has intended to update these initial changed requirements for general insurers recognising the need for greater rigour to adequately protect policyholders.  Sufficient time has now passed to assess the effectiveness of the current framework.

The results of the implementation of the old GPS 210 and the old GPS 220 since July 2002 have been mixed.  The approach to liability valuation has been working well, however peer review of insurance liability valuations would assist in maintaining and, if required, improving the quality and consistency of liability valuation reports.  Unlike auditors, rotation of actuaries is not proposed or appropriate because many Approved Actuaries are employed in-house by insurance companies and this has been common practice in the industry.  This situation has developed because the principal role of an actuary is to provide advice to the Board and management in addition to their statutory functions.  However, APRA and others do place reliance on an actuary’s work particularly the actuary’s liability valuations used in financial reports.  Therefore, there is a need to enhance the independence of the actuarial role.

Implementing peer review of actuarial reports is in line with the suggestion of Justice Owen in the HIH Royal Commission report in his commentary on Recommendation 16 where he indicated that peer review would often be a worthwhile exercise but he was not inclined to recommend a formal process of peer review of the actuary’s report be made mandatory.  It would be difficult not to apply peer review comprehensively as there are costs involved in implementing peer review and requiring it on a case by case basis could lead to issues of equity in the application of the requirement.  It is notable that this suggestion from the HIH Royal Commission was made pursuant to the IAAust’s view that it was desirable that the approved actuary’s insurance liability valuation report (ILVR) be subject to independent review by another actuary.  Therefore the professionals that this peer review applies to believe it would be a desirable addition to the prudential framework.

As identified by Justice Owen in Recommendation 41 of the HIH Royal Commission report, the role of actuaries should be extended to reviewing the overall financial condition of insurers. 

There is a need to amend the audit scope from that contained in the old GPS 220.  Auditors have been producing audit reports at a standard lower than that prescribed in the old GPS 220 as it was found when implementing the requirements that in practice auditors could not economically provide the level of assurance required.  As a result, APRA worked with the auditing profession to develop a compromise solution to the issues covered by the audit report.  It is not desirable for auditors to be operating outside of the prudential standard requirements due to a practical issue with compliance even if it is an agreed position with APRA.

Under the old GPS 220, only auditors were required to perform specific reviews.  There are matters on which APRA may require reports where the actuary may be better qualified to give the report rather than the auditor.  The ability to require a specific report from an actuary would therefore be a useful enhancement to APRA’s ability to effectively supervise insurers.

The criteria for exemption from the requirement to have an approved actuary are not forward looking.  This means that an insurer can reach the threshold test before the need to begin the process of appointing an Approved Actuary.  Appointment of an Approved Actuary is not a fast process as the relevant actuary must be identified from a limited pool of actuaries in Australia with relevant experience, subject to the insurer’s fit and proper requirements and then the application must be provided to APRA.  In this period, ostensibly the insurer no longer meets the exemption requirement but still does not have an Approved Actuary and so this is an uncertainty that needs to be addressed. 

The objectives of amending the audit and actuarial requirements for general insurers are to:

• increase the protection provided to policyholders and the beneficiaries of general insurance policies through the prudential supervision of general insurers;
• enhance the focus on the financial strength of insurers;
• Enhance the independence and quality of insurance liability valuations by actuaries;
• Ensure that the exemption from the requirement to have an Approved Actuary is applied appropriately; and
• Clarify existing prudential requirements relating to audit reports.

Detailed Changes

APRA will revoke the old GPS 210 and the old GPS 220 (and associated guidance notes) and determine the new Standard under the Act to govern audit and actuarial reporting and valuation.  The new Standard will incorporate technical appendices to retain the mandatory detail relating to the insurance liability valuation report (“ILVR”).  Detailed requirements for an FCR will be set out in a professional standard issued by the Institute of Actuaries of Australia.  

The new prudential standard reflects some existing requirements, but also implements a range of additional obligations for insurers using a principles-based approach to supervision.  Such an approach mandates compliance with a range of core elements (or ‘principles’), 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:

• continue the existing roles of the auditor and actuary including the actuary’s production of an ILVR (with requirements in an attachment to the standard rather than a guidance note) and the auditor’s certification of an insurer’s yearly statutory accounts;
• clarify the scope of the auditor’s review and testing of the insurer’s systems, processes, and controls;
• require an FCR to be completed for all insurers required to have an approved actuary with the basic scope prescribed in the prudential standard but the detailed requirements covered by a professional standard issued by the IAAust;
• require an insurer’s ILVR to be peer reviewed by an independent actuary
• provide for APRA to be able to request the Approved Actuary to carry out a specific review which would occur if APRA was concerned about a specific aspect of an insurer’s operations the review of which is within an actuary’s field of expertise (e.g. pricing decisions being made by an insurer); and
• refine the criteria for exemption from the requirement to appoint an Approved Actuary so that an insurer will have to provide documentary evidence that it meets the criteria for exemption and must also attest to APRA that it will continue to meet the criteria for the coming year.

Implementation

The old GPS 210 will be revoked with effect from 1 October 2006.  The old GPS 220 will be revoked by General Insurance (prudential standard) determination No 1 of 2006 with effect from 1 October 2006.  The new Standard will take effect from 1 October 2006.  Between the date of Insurance (prudential standard) determinations Nos 1 and 3 of 2006 and 1 October 2006, a general insurer must continue to comply with the old GPS 210 and old GPS 220. 

However, there are special transition rules set out in an attachment to the new Standard.  These deal with transitional arrangements in relation to the following matters:

• exemptions from the requirement for a general insurer to appoint an Approved Actuary where the general insurer is required to do so;
• peer review of ILVRs;
• preparation of the audit report and audit certificate by an Approved Auditor; and
• submission of trial FCRs by some general insurers to enable these general insurers to familiarise themselves with the new requirements relating to FCRs under the new Standard and to enable actuaries to develop processes to deal with matters falling within the scope of these new requirements.

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 audit and actuarial reporting and valuation (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 risk 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.

There have been extensive consultations with the Institute of Actuaries of Australia which have had the opportunity to review drafts of the new Standard.  APRA has also had the opportunity to review drafts of professional standards of the Institute of Actuaries of Australia on FCRs and peer review of ILVRs.  This process of consultation has ensured congruence between the professional standards and the new Standard. 

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 310 Audit and Actuarial Reporting and Valuation

This Regulation Impact Statement (RIS) addresses APRA’s determination of Prudential Standard GPS 310 Audit and Actuarial Reporting and Valuation.

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 reinsurance management.  The reforms implemented as at 1 July 2002 were far more extensive than proposed under the Stage 2 reforms. 

Problem identification

The key change implemented with the current prudential regime relevant to the topic of audit and actuarial reporting and valuation was the requirement for insurance liabilities to be valued by an Approved Actuary with a prudential margin applied utilising as a base the professional standard promulgated by the Institute of Actuaries of Australia (IAAust).  This has improved the reliability, consistency and risk sensitivity of the technical provisions for insurance liabilities.

As with all elements of the prudential framework, APRA has intended to update these initial changed requirements for general insurers recognising the need for greater rigour to adequately protect policyholders.  Sufficient time has now passed to assess the effectiveness of the current framework.

The results of the implementation of GPS 210 Liability Valuation for General Insurers (the old GPS 210) and GPS 220 Risk Management for General Insurers (the old GPS 220 – the two collectively referred to as the old standards) since July 2002 have been mixed.  The approach to liability valuation has been working well, however peer review of insurance liability valuations would assist in maintaining and, if required, improving the quality and consistency of liability valuation reports.  Unlike auditors, rotation of actuaries is not proposed or appropriate because many Approved Actuaries are employed in-house by insurance companies and this has been common practice in the industry.  This situation has developed because the principal role of an actuary is to provide advice to the Board and management in addition to their statutory functions.  However, APRA and others do place reliance on an actuary’s work particularly the actuary’s liability valuations used in financial reports.  Therefore, there is a need to enhance the independence of the actuarial role.

Implementing peer review of actuarial reports is in line with the suggestion of Justice Owen in the HIH Royal Commission report in his commentary on Recommendation 16 where he indicated that peer review would often be a worthwhile exercise but he was not inclined to recommend a formal process of peer review of the actuary’s report be made mandatory.  It would be difficult not to apply peer review comprehensively as there are costs involved in implementing peer review and requiring it on a case by case basis could lead to issues of equity in the application of the requirement.  It is notable that this suggestion from the HIH Royal Commission was made pursuant to the IAAust’s view that it was desirable that the approved actuary’s insurance liability valuation report (ILVR) be subject to independent review by another actuary.  Therefore the professionals that this peer review applies to believe it would be a desirable addition to the prudential framework.

As identified by Justice Owen in Recommendation 41 of the HIH Royal Commission report, the role of actuaries should be extended to reviewing the overall financial condition of insurers.  In summary, the reasons for this recommendation were:

• A report on the overall financial condition of insurers would provide a complete review of the insurer’s financial position and
• There would be consistency with the life insurance companies which are required to have a financial condition report (FCR) prepared annually as Justice Owen noted that ‘general insurers face similar and arguably more volatile operating conditions than life companies yet there is no similar requirement applied to general insurers under current prudential standards.’

 Implementation of recommendations of the HIH Royal Commission is stated government policy.

There is a need to amend the audit scope from that contained in the old GPS 220.  Auditors have been producing audit reports at a standard lower than that prescribed in the old GPS 220 as it was found when implementing the requirements that in practice auditors could not economically provide the level of assurance required.  As a result, APRA worked with the auditing profession to develop a compromise solution to the issues covered by the audit report.  It is not desirable for auditors to be operating outside of the prudential standard requirements due to a practical issue with compliance even if it is an agreed position with APRA.

Under the old GPS 220, only auditors were required to perform specific reviews.  There are matters on which APRA may require reports where the actuary may be better qualified to give the report rather than the auditor.  The ability to require a specific report from an actuary would therefore be a useful enhancement to APRA’s ability to effectively supervise insurers.

The criteria for exemption from the requirement to have an approved actuary are not forward looking.  This means that an insurer can reach the threshold test before the need to begin the process of appointing an Approved Actuary.  Appointment of an Approved Actuary is not a fast process as the relevant actuary must be identified from a limited pool of actuaries in Australia with relevant experience, subject to the insurer’s fit and proper requirements and then the application must be provided to APRA.  In this period, ostensibly the insurer no longer meets the exemption requirement but still does not have an Approved Actuary and so this is an uncertainty that needs to be addressed. 

Objectives

The objectives of amending the audit and actuarial requirements for general insurers are to:

• increase the protection provided to policyholders and the beneficiaries of general insurance policies through the prudential supervision of general insurers;
• enhance the focus on the financial strength of insurers;
• Enhance the independence and quality of insurance liability valuations by actuaries;
• Ensure that the exemption from the requirement to have an Approved Actuary is applied appropriately; and
• Clarify existing prudential requirements relating to audit reports.

Identification of options

Option 1: Determine a prudential standard that consolidates audit and actuarial requirements and imposes new obligations that meet the objectives

Under this option, APRA would revoke the old standards (and associated guidance notes), and determine a new prudential standard under the Act to govern audit and actuarial reporting and valuation.  This prudential standard would incorporate technical appendices to retain the mandatory detail relating to the ILVR.  Detailed requirements for an FCR would be contained in a professional standard of the Institute of Actuaries of Australia (IAAust).  It would be preferable for this approach to be taken with the ILVR but the IAAust will not be able to complete development of its relevant professional standard in time to be implemented with the new prudential standard.  Once the IAAust has developed its professional standard for ILVR it is intended that the new prudential standard would be amended to remove the detailed requirements for ILVR.

The new prudential standard reflects some existing requirements, but also implements a range of additional obligations for insurers using a principles-based approach to supervision.  Such an approach mandates compliance with a range of core elements (or ‘principles’), 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:

• continue the existing roles of the auditor and actuary including the actuary’s production of an ILVR (with requirements in an attachment to the standard rather than a guidance note) and the auditor’s certification of an insurer’s yearly statutory accounts;
• clarify the scope of the auditor’s review and testing of the insurer’s systems, processes, and controls;
• require an FCR to be completed for all insurers required to have an approved actuary with the basic scope prescribed in the prudential standard but the detailed requirements covered by a professional standard issued by the IAAust;
• require an insurer’s ILVR to be peer reviewed by an independent actuary
• provide for APRA to be able to request the Approved Actuary to carry out a specific review which would occur if APRA was concerned about a specific aspect of an insurer’s operations the review of which is within an actuary’s field of expertise (e.g. pricing decisions being made by an insurer); and
• refine the criteria for exemption from the requirement to appoint an Approved Actuary so that an insurer will have to provide documentary evidence that it meets the criteria for exemption and must also attest to APRA that it will continue to meet the criteria for the coming year. 

Transition arrangements allowing insurers to attain compliance with the new standard would be provided.

Option 2: Retain existing audit and actuarial reporting and valuation requirements without amendment

Under this option, the old standards would remain unchanged.  Insurers would continue to manage their audit and actuarial reporting and valuation 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 audit and actuarial reporting and valuation outlined above.

Assessment of costs and benefits

APRA does not have data to perform a 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 cannot be considered as mutually exclusive groups 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. 

Insurers operate in a relatively competitive market although it is acknowledged that certain lines of business in isolated segments may be subject to less competition.  There is potential where costs are imposed on all insurers equally for costs to be passed on to policyholders via increased premiums.  If some insurers bear more costs due to a greater need to improve their audit and actuarial processes, the likely effect is that those costs will be retained by insurers as the competitive environment they operate in would constrain their ability to pass these costs 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 that consolidates audit and actuarial requirements and imposes new obligations that meet the objectives

Benefits

APRA

Under this option, insurers would be subject to additional requirements governing their audit and actuarial reporting and valuation than currently exist though some insurers also impose these requirements voluntarily.  An analysis of the benefits flowing from this option is:

• It would allow flexibility in requiring a specific review to be undertaken by either the auditor or the actuary which would result in more efficient targeting of specific reviews.  It is difficult to precisely estimate the benefit of this proposal as the need for specific reviews by actuaries will vary with developments in the industry.  However, if only auditors could carry out such reviews then they could only do so by employing their own actuaries.  This would significantly narrow the field of available actuaries and therefore unnecessarily increase the cost of the reviews.  The alternative would be for APRA to employ actuaries with equivalent experience and knowledge to Approved Actuaries to carry out the specific reviews as required and would effectively transfer costs from insurers to APRA.  It is notable that as APRA’s is funded by levies from the industries it regulates, insurers would ultimately bear these costs anyway.  However, it is unlikely that such a central pool approach would be able to tailor each company review appropriately to the circumstances.
• A significant increase in the information available about the financial condition of an insurer through the FCR which will lead to greater efficiency in targeting APRA’s supervisory resources where they are most needed.  The benefits of such targeting are difficult to quantify as it is not likely to lead to a reduction in supervisory staff but an increase in the quality of supervision and the early anticipation of insurers increasing risk profile.  ;
• ILVRs will improve in quality and reliability through the implementation of peer review.  The quantification of such benefits is difficult because the benefit is in the form of an increase in the quality of information available to APRA which will lead to a higher quality of supervision.
• Ensuring that the exemption from the requirement to have an Approved Actuary is applied appropriately means there will be an increase in the quality of information available to APRA as an actuary’s reports on a company’s liabilities and financial condition provide higher quality information than management reports alone.  This benefit will only be marginal as the change to the exemption criteria will only have the impact of identifying companies that should have an actuary earlier in their growth phase than under the current requirements.

Insurers

APRA submitted to the HIH Royal Commission that an FCR would be a valuable tool for management and directors by providing a complete review of the insurer’s financial position.  Justice Owen agreed noting that an FCR similar to that required for life insurers would be useful.  This enhancement of the quality of information supplied to management and directors should lead to greater quality in decision making.  For those insurers which currently only receive the minimum ILVR information, the benefits may be substantial through a significant increase in the information available about the financial condition of an insurer.  This should lead to a more comprehensive understanding by the Board and management of that insurer of its risk profile and capital constraints going forward.  This will lead to insurers being better able to anticipate the risk of failure to meet obligations to policyholders more effectively and efficiently.

Peer review of ILVRs will be an advantage to insurers due to the quality control that this process will apply to ILVRs.  This will mean that the information supplied to the board and management will be more reliable and generally of a higher quality.  This will not be a universal benefit across the industry as it is not anticipated that all ILVRs need to be improved to meet the requirements of peer review, only those ILVRs that are not currently of a high quality will need to be improved.  There is a benefit from competitive neutrality because ILVRs of differing quality mean that similar insurance risks may be differentially valued leading to competitive disadvantage for those insurers subject to a higher liability valuation.  Peer review will be useful to individual insurers because the Board and management will know that an external, market driven view will also be taken into account.  Additionally, it will increase the general quality control over ILVRs in the industry. 

There will be significant advantages from the new scope for audit reports for insurers.  Currently, confusion is caused because of the difference between the APRA prudential standard requirements and the auditing professions view of what assurance it can provide as outlined in Auditing Guidance Statement AGS 1064.  Essentially, the audits performed since the introduction of the old GPS 220 have not been able to conform to the prudential standard requirements as the prudential standard requirements were not practically possible to implement.  This is an untenable position for insurers and their auditors and the refinement of the scope which has been discussed with insurance company auditors will be a significant benefit to the auditors and insurers through the reduction in uncertainty regarding their compliance obligations. 

Policyholders

The proposals relating to actuarial reports and the changes to the exemption of insurers from the requirement to have an actuary will lead to greater financial soundness of insurers directly benefiting policyholders.  This will mean greater certainty that insurers will be able to meet their obligations to policyholders to pay claims as they occur.  The proposal relating to the scope of audit reports will have the effect of increasing the reliability of financial reporting and policyholders (along with other industry stakeholders such as investors/shareholders) will be able to place greater reliance on publicly available financial reports issued by insurers.

Costs

APRA

Implementing the proposed changes would impose only 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 effort to administer the transition by companies to the new standards.  As industry would be unfamiliar with the new requirements, supervisors may also have to respond to a higher number of queries from regulated entities than is currently the case for a short period.  However, existing resources would be used to carry out these tasks and no additional resources would be employed as a result.  This one off cost will divert existing supervisory resources. However, there will be an offsetting reduced focus on administering current requirements which will be superseded.

The additional supervisory effort required for monitoring compliance with the new requirements will be built into the existing supervisory methodology and review processes.  On the face of it supervisory resources will be diverted into administering the new requirements including reviewing FCRs which is the principal ongoing administrative task.  However, as the additional information provided to APRA is likely to result in better targeting of supervisory resources this cost saving will offset the increase in administrative tasks.  This trade-off is discussed further in the conclusion. 

Insurers

Direct costs will be imposed on insurers due to peer review of ILVRs.  The costs of peer review of  ILVRs will significantly vary across insurers depending on the complexity of the insurer’s operations.  It would therefore be misleading to give an indicative cost or even a range of costs in this regulation impact statement.  Peer review has not been previously a standard process and the IAAust has only just finalised its peer review professional standard.  Whilst APRA does not believe the costs will be significant it has no point of comparison to make a meaningful estimate of the cost.  Obtaining an estimate from industry or the actuarial profession would also be difficult as the variables across insurance groups and the variance of expectations of work load prior to any meaningful experience would make any range of costs misleading in the context of individual insurers.  The peer review of ILVRs is not expected to result in a significant increase in costs as the peer review of the ILVR will cost much less than the actual ILVR itself.  It is arguable that the ILVR is a compliance cost as well run insurance companies would likely carry out an ILVR in the absence of a regulatory requirement to do so.  In addition, most auditors hire review actuaries to provide assurance for the audit sign off for the ILVR amounts in the accounts.  The peer review process has been specifically designed to allow the review actuary to be the same person as the peer review actuary making the cost of the peer review, in APRA’s opinion, an immaterial addition to the existing costs of compliance.

The proposed scope of audit reports represents a reduction in scope compared with the current prudential requirements.  The feedback received from insurers and the auditing profession was that if APRA enforced compliance with the old GPS 220 requirement the cost would be prohibitive if auditors would agree to the engagements at all.  Therefore, the proposed scope of the audit report could be considered to represent a very significant potential cost saving to insurers.  In practical effect, auditors have been performing their role in accordance with AGS 1064 with APRA’s consent. 

The impact on costs of the change in audit scope is therefore arguable.  In practical terms, there is likely to be an increase in costs arising from the implementation of the new audit scope, however this is in comparison with audits that have not been performed in compliance with the old GPS 220 for practical reasons.  In comparison with the AGS 1064 requirements which are couched in terms of the insurer complying with its RMS in relation to a prescriptive set of matters, it is difficult to say with absolute certainty that the scope in the new prudential standard will represent an increase or a decrease in scope although auditors of insurers, in general, believe the new prudential standard requirement will represent an increase in scope due to the focus on the adequacy and effectiveness of financial reporting controls.  The position reached with the scope of the audit report is considered to be an appropriate compromise between the audit scope contained in the old GPS 220 and the current professional guidance.  It is notable that APRA has liaised with and taken on board the auditing professions representations in reaching this compromise.  In comparison with the old GPS 220 requirements, rather than requiring an Approved Auditor to give an opinion about whether the insurer has adequate systems and procedures in place to ensure it observes statutory requirements placed on insurers, the scope has been reduced to confirming the existence of controls and the requirement to certify adequacy and effectiveness only applies to financial reporting controls.  Once again it would be misleading to ascribe a value to the cost of this proposal because it will vary across insurers, however it is not expected to be significant compared to the cost bases of insurers.

The change in criteria for exemption from the requirement to appoint an Approved Actuary will not affect most insurers. It will only affect a few insurers which marginally meet the existing criteria.  The basic criteria are no long-tail liabilities and no more than $20 million of insurance liabilities.  The new requirement will most likely trigger an earlier need for an insurer to obtain an actuary if in its business plan it expects to increase insurance liabilities beyond $20m or if it intends to expand into long-tail business in the next 12 months.  The most likely impact is that for small insurers experiencing growth, it will bring forward the requirement to appoint an approved actuary because of the requirement for management to annually certify that the company will continue to meet the exemption criteria for the 12 months following the certification.  The cost to those few insurers affected will be substantial as it will result in incurring the costs of an ILVR, the peer review of that ILVR and also an FCR.  However, a significant feature of the regulation of insurers since 2002 has been the requirement for actuarial valuation of insurance liabilities.  The exemption from this requirement must be carefully and equitably applied to ensure that the exemption is applied only in appropriate circumstances where the costs derived from the requirement to appoint an Approved Actuary would likely exceed the benefits.  Therefore, in general there will be no costs from this proposal except for a few small but fast growing insurers where the costs are likely to be significant.  

The cost of an FCR is difficult to estimate because of the wide variety of insurance companies in the market.  Life insurance companies of all sizes would appear to be able to provide an indication of the cost of an FCR.  However, FCRs for many life insurers were implemented at the same time a liability valuation standard was imposed and as such the incremental cost of an FCR is not easily discernable.  In addition, a life company has at least one statutory fund as well as the shareholders’ fund and so the FCR is carried out on a different basis effectively considering the financial soundness of more than one entity.

Large, complex insurers may already have the resources to produce an FCR and the FCR will likely represent an opportunity cost as other work performed by their actuarial departments is given lower priority.  Most of the work required for an FCR should already be performed by insurers’ actuaries.  In particular, the ILVR will form a significant input to or component of the FCR.  For such sophisticated insurers, the incremental cost of an FCR may be quite minimal as the FCR will involve drawing together and formalising existing work.  Smaller entities, particularly those who employ external actuarial services are likely to experience a direct cost as the consulting fees charged by Approved Actuaries increases due to the requirement to provide an FCR. 

In summary, compared to the cost bases of insurers the proposals individually and collectively are not expected to be significant compared with the cost bases of the insurers.  There may be an exception for certain small insurers to which the exemption from the requirement to have an Approved Actuary will no longer apply, but this proposal will essentially bring forward costs that will otherwise be incurred later.  The comparison to the overall cost bases of insurers is an important point because of the ability of insurers as an industry to pass on costs to policyholders.  Where the impact on some insurers is greater than others, it is likely that the costs will be borne by those insurers with the greater incremental costs due to their inability to pass on costs in a competitive market.

Policyholders

Under this option, policyholders will only suffer direct costs if insurers increase premiums to offset the expense of complying with the new requirements.  Note that this would mean that the costs borne by insurers would reduce if this occurred so the costs to insurers and policyholders are alternatives and are not to be added together.  In relation to most lines of business, APRA expects that insurers may not necessarily increase their premiums and may instead fund any increased compliance from their profits due to market forces constraining their ability to pass on costs.  Insurers that are price leaders may have a greater ability to pass on costs to policyholders.  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.  As indicated above, those insurers that need to incur more substantial costs than others would be placed at a competitive disadvantage when compared with the rest of the industry if they chose to pass on any significant costs.  It is for this reason that APRA expects that premiums would not increase in a material way, if at all, if this option were to be implemented.

Option 2: Retain existing audit and actuarial reporting and valuation requirements without amendment

Benefit

APRA

APRA would not incur the costs of introducing the new requirements which would require internal training and ongoing administration.

 Insurers

As the existing audit and actuarial reporting and valuation requirements would remain unchanged under this option, insurers would not have to expend extra resources complying with new requirements outlined above under Option 1. 

Policyholders

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

Costs

APRA

In comparison with option 1, APRA would receive substantially less valuable information to monitor the status of insurers, their ability to meet their obligations to policyholders and their ability to meet their capital requirements with sufficient certainty. Firstly, APRA would not be able to require the production of a Financial Condition Report.  The result would be that APRA could not implement Recommendation 41 of the HIH Royal Commission.  As noted under the benefits section for option 1, the alternative would be for APRA to employ actuaries with equivalent experience and knowledge to Approved Actuaries to carry out the specific reviews as required and that would effectively transfer costs from insurers to APRA.  It is likely that APRA would be competing with insurers for actuaries with sufficient knowledge

Secondly, peer review of ILVRs would not occur and this would mean that APRA would have to devote additional resources to dealing with the quality of ILVRs where that quality was not appropriate and information contained in ILVRs may not be optimal in its usefulness to APRA. 

Thirdly, APRA would continue to face difficulty in determining the appropriate scope of audit reports because it currently cannot practically enforce the requirements in the old GPS 220. 

Fourthly, APRA would not be able to request an Approved Actuary to undertake a specific review even if that specific review fell within the Approved Actuary’s capabilities rather than the Approved Auditor’s capabilities. 

Fifthly, the exemption from the requirement to appoint an Approved Actuary would not be clarified and strengthened resulting in there being insurers which would benefit from the professional services of an Approved Actuary not being required to have an Approved Actuary.

In summary, the problem identified would not be dealt with and as a result the information provided to APRA would not be improved and existing inefficiencies in prudential supervision would continue. 

Insurers

There would be no direct costs to insurers under this option.  However, some insurers would not gain the benefits of better understanding their risk profile and be less confident of meeting their future capital obligations.

Insurers that choose not to obtain an FCR would continue to incur indirect costs of not having an independent view of the financial position of the insurer presented to the board and management, therefore decreasing the tools for decision making within insurers compared to Option 1.  Insurers would have the option of obtaining an FCR voluntarily where insurers considered the benefits outweighed the costs.  As explained under option 1 above, many of the components of an FCR are already available within prudently managed insurers so the costs of this option would be skewed towards those insurers who do not obtain FCR type information.

Similarly, insurers could voluntarily have ILVRs peer reviewed.  However, this would not universally occur across the industry leading to a disincentive to incur the additional cost.  There would be an indirect cost to insurers as this impetus to improve the quality of ILVRs would be removed and the quality of this significant input to decision making would be diminished.

There are potential serious cost implications from not changing the scope of audit reports.  As explained under Option 1, the current prudential standard requires an audit report to cover a scope that would be very expensive if carried out by an auditor.  APRA to date has recognised this and has been allowing the professional auditing guidance to determine a lesser scope to the audit report.  However, as the scope is open to interpretation it is possible that the scope of an audit report could be significantly increased to reduce the compliance risk of an insurer and its Approved Auditor.   The reduced audit scope will create certainty for insurers as to the costs of audit.  However, in practical terms the costs of audits for insurers may increase as the scope proposed under the standard is not directly comparable with the scope provided for in professional guidance.

For those insurers that are at the margin of the current criteria for exemption from the need to appoint an Approved Actuary, they will not incur direct costs as soon as they might under Option 1.  However, they will incur the indirect costs of not having appropriate actuarial advice as input to managerial decision making and may therefore make suboptimal decisions.

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 audit and actuarial reporting and valuation requirements.  Necessary levels of protection would not be provided to policyholders as the identified current inadequacies in the framework would continue.

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 audit and actuarial reporting and valuation (amongst others) in November 2003.  A large number of submissions were received in response to this discussion paper.

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 the ICA held another Joint Forum in June 2005 where further discussions around the detail of the proposals took place. 

There was some opposition to the imposition of FCRs although this was not universal with some insurers and actuaries accepting the findings of the HIH Royal Commission would result in FCRs being required.  Those insurers who did express opposition indicated that the cost of the FCR would outweigh the benefits for them.  APRA has carefully considered these comments but since the negative views were from a minority of insurers it was considered that across the industry and taking into account other stakeholders benefits and costs that the implementation of the FCR requirement is still valid.

Peer review was also opposed by some insurers on the basis of the cost of implementation.  One suggestion made to partially address the cost imposition was to allow an actuary who is part of the Approved Auditor’s firm to conduct the peer review and address it to the Approved Auditor.  Approved Auditors typically call on internal actuarial expertise in their assessment of the disclosure of insurance liabilities in financial statements and for prudential reporting purposes and therefore using this resource for peer review will result in only incremental costs.  To ensure continuing independence of the audit opinion, it was considered appropriate for the peer review in such circumstances to be allowed to be addressed to the Approved Auditor.

Throughout the overall consultation process, APRA held Auditor Liaison meetings, where the proposals relating to the responsibilities of auditors were discussed with representatives from the profession.  Feedback from this group was invaluable because APRA’s original proposal was still considered to impose significant costs on the insurance industry and was modified as a result of the feedback.

There have been extensive consultations with the IAAust and they have reviewed drafts of the new standard and APRA has had the opportunity to review drafts of their professional standards on FCRs and peer review.  This process of consultation has ensured congruence between the professional standards and the new prudential standard.

Conclusion and recommended option

Option 1 is the preferred option

Option 1 fulfils APRA’s stated objectives including the vital objective of implementing government policy in respect of the HIH Royal Commission’s recommendation to require FCRs.  The increase in quality of APRA’s supervision that will be a result of the better information available to it is considered to outweigh the additional administrative costs imposed on APRA.  In fact, the better targeting of supervisory resources is likely to lead to administrative cost savings which are considered likely to offset any increase in administrative costs.  Therefore, the quality of APRA’s supervision will improve and it is expected that no additional resources will be required.

This option comes at some cost to insurers which is difficult to estimate and will vary among individual insurers.  However, the costs are not expected to be significant compared to the overall cost base of insurers with the possible exception of those small, fast growing insurers who will be required to appoint an Approved Actuary under the new standard bringing forward costs that will otherwise be incurred later.  The benefits to insurers are indirect but significant.  The improvement to understanding their risk profile and their ability to meet future capital requirements as a result of implementing an FCR will ensure Boards and senior management of insurers will be better able to steer their companies going forward.  The improvement in the quality of ILVRs via the peer review process will ensure high quality information about insurance liabilities is used as an input to board and management decision making.  The impact of the change in audit scope is difficult to determine because the new prudential standard will achieve a compromise between the current prudential standard requirement which auditors and insurers cannot comply with and the current scope of audit reports actually being done.  Greater compliance certainty with regard to audit reports will be a significant benefit to insurers.

All of the proposals under Option 1 will lead to greater financial soundness of insurers which is in policyholders interests.  It is not expected that, in general, additional costs will be passed on to policyholders but if they are this does not increase the overall cost to the community but merely transfers it from the insurers to the policyholders.

The implementation of Option 1 can be summarised in the following table.  The proposal to enable actuaries to carry out specific reviews has been omitted from the table as this will not have an ongoing effect, only when additional information is required by APRA.  In effect, this mechanism allows APRA to transfer costs from itself to the insurance industry and a cost/benefit analysis will be conducted each time that decision is made.  The basic presumption is that in certain circumstances the expertise available to insurers through their Approved Actuary will enable information to be provided to APRA more efficiently than if APRA was to employ the resources directly.  It must be noted that APRA’s costs are passed on to the industry via the levies imposed on the industry to pay for APRA’s supervision so any costs incurred by APRA are ultimately payed by insurers.

The implementation of Option 1 can be summarised in the following table which provides an analysis of benefits and costs relative to the current position which is Option 2:

Option 2 does not meet APRA’s stated objectives.  It neither fulfils APRA’s obligation to implement recommendations of the HIH Royal Commission nor provides sufficient levels of protection for policyholders.  Insurers would not incur the costs of implementing Option 1 but also would not receive the indirect benefits of Option 1.

Implementation and review

APRA intends that the new prudential standard will be released in February 2006, with an effective date of 1 October 2006.  The IAAust will also release a professional standard on FCRs and peer review of ILVRs which will be effective by 1 October 2006.  In the intervening months, insurers will have the time to put in place procedures to ensure compliance with the new requirements.

APRA will assess the adequacy of the prudential supervisory requirements proposed under the new prudential standard on an ongoing basis.  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.