Life insurance (prudential standard) determination No. 1 of 2006: Prudential Standard LPS 520 Fit and Proper

EXPLANATORY STATEMENT

Prepared by the Australian Prudential Regulation Authority

Life Insurance Act 1995, paragraph 230A(1)(a)

Under paragraph 230A(1)(a) of the Life Insurance Act 1995 (the Act), APRA has the power to determine (in writing) standards in relation to prudential matters to be complied with by life companies.

Life insurance (prudential standard) determination No. 1 of 2006 makes Prudential Standard LPS 520 Fit and Proper, which will come into effect on 1 October 2006.

1.      Background

LPS 520 is intended to ensure that life companies prudently manage the risk that persons acting in positions of responsibility for their institution may not be fit and proper.  Much international and Australian experience has demonstrated that institutions can become financially unstable and, in extreme cases, collapse as a result of incompetence or impropriety on the part of responsible persons. 

Together with Prudential Standards APS 520 Fit and Proper and GPS 520 Fit and Proper for authorised deposit-taking institutions and general insurers, respectively, LPS 520 forms part of a harmonised approach to fitness and propriety which is consistent across APRA-regulated institutions (with the exception of superannuation which is subject to separate fit and proper requirements in regulation 4.14 of the Superannuation Industry (Supervision) Regulations 1994[1]).

2.      Operation of LPS 520

LPS 520 requires a life company to have a written policy on the fitness and propriety of responsible persons which has been approved by the Board of directors (Board) or, in the case of an eligible foreign life insurance company as defined in the Act, by the Compliance Committee (see generally paragraphs 2 to 5 of LPS 520).  The policy must set out processes for assessing fitness and propriety and criteria against which persons must be assessed (see paragraphs 20 to 30 for the assessment processes).  The primary responsibility for ensuring the fitness and propriety of responsible persons rests with the Board.  APRA has certain powers under the Act which reinforce this system of institutional self-assessment (these are outlined below).

Where a responsible person (generally defined to include directors, senior managers, certain auditors and actuaries and certain persons performing activities for subsidiaries of the institution – see paragraphs 6 and 7)[2] is assessed as not fit and proper, the institution must take steps to ensure that the person does not remain in the position (see paragraph 37).  They must also notify APRA (see paragraph 40) so that APRA can ensure that the person is removed where the institution is unable or unwilling to act. 

LPS 520 supplements the legislative framework in the Act under which APRA has certain powers (although these powers differ from the schemes in the Insurance Act 1973 and the Banking Act 1959).  That framework may be summarised as follows:

Auditors

• section 84 provides that only an individual who is an approved auditor may hold an appointment as the auditor of a life company;
• section 85 provides that APRA may approve a person as an auditor of life companies (or of either friendly societies or non-friendly society life companies) if the person is a registered company auditor for the purposes of the Corporations Act 2001 and the person has such experience as to render him or her suitable for appointment as the auditor of life companies of that kind;
• section 86 provides that APRA may revoke a person’s appointment as an auditor of life companies if the person has ceased to be a registered company auditor within the meaning of the Corporations Act 2001 or has failed to perform adequately and properly the functions and duties of an auditor under the Life Insurance Act;

 Actuaries

• subsection 93(1) provides that a life company must have an actuary appointed by the company, and subsection 93(3) provides that the person must be eligible for such appointment;
• subsection 93(4) provides that to be eligible for such appointment, an actuary must be ordinarily resident in Australia and have been a Fellow of the Institute of Actuaries of Australia for at least 5 years (although APRA can, under subsection 93(6), approve a person who does not satisfy one or more of these requirements if it is satisfied that the person has actuarial qualifications and experience that fit him or her to perform the functions of the appointed actuary of the company);
• subsection 94(1) provides that a person ceases to be an actuary of a life company if (inter alia) they cease to be eligible for such appointment, and in this regard subsection 94(3) provides that APRA may, in writing, declare that a person is not eligible for appointment as a life company's actuary if the person has failed to perform adequately and properly the functions and duties of an appointed actuary under the Act;

Disqualified persons

• section 245 provides that a person who has become bankrupt or has committed an offence of a certain kind is disqualified from being a director, principal executive officer or appointed actuary of a life company registered under the Act;

Directions power

• section 230B gives APRA power to give certain directions where (inter alia) necessary in the interests of policy holders or prospective policy holders, including a direction to remove a director, secretary, executive officer, employee, auditor or actuary.

LPS 520 differs from GPS 520 and APS 520 in that it does not prescribe matters (e.g. criteria for fitness and propriety, eligibility criteria or senior management responsibilities) for any specific provision of the Life Insurance Act.  The criteria for fitness and propriety set out in paragraphs 16 to 18, and the senior management responsibilities set out in paragraphs 13 and 14, are specified primarily for the purposes of LPS 520 itself (although they may relevant when APRA is considering whether to exercise a power under the Act).  This reflects a difference between the legislative scheme in the Life Insurance Act on the one hand and the Banking and Insurance Acts on the other. 

3.      Consultation

APRA has undertaken two rounds of public consultation on the proposed LPS 520, APS 520 and GPS 520 and has redrafted LPS 520 to take account of industry concerns as appropriate.  Thirty-nine submissions were received from regulated entities in the first round consultation (commencing March 2004) and thirty-five in the second round of consultations (commencing June 2005).  APRA conducted information sessions for regulated institutions following the second round consultations.  During these sessions APRA briefed industry on the amendments it had made to the proposals in response to industry concerns.

4.      RIS

A Regulation Impact Statement is required for LPS 520.  It has been prepared and is attached to this Explanatory Statement.

Regulation Impact Statement

Introduction

This Regulation Impact Statement (RIS) covers proposed amendments to fit and proper requirements for authorised deposit-taking institutions (ADIs), general insurers (insurers) and life companies regulated by APRA.[3]

APRA is primarily responsible for ensuring the safety and soundness of prudentially regulated institutions so that they can meet their financial promises to depositors and policyholders (their ‘beneficiaries’).  As part of its mandate, APRA has implemented a multi-layered prudential framework that encompasses the industry Acts it administers, prudential standards that set out specific requirements to which institutions must adhere, and guidance notes designed to clarify APRA’s expectations with regard to prudential requirements.

Background

The failure of institutions to take steps to manage the risk that persons acting in positions of responsibility are not fit and proper for their roles may ultimately result in financial stress or collapse, where those responsible for managing the institution prove to be incompetent, reckless or dishonest.  Depositors and policyholders face an asymmetry of information problem in that they lack sufficient information with which to assess the quality of responsible persons.

APRA relies on Boards and senior management to run regulated institutions prudently and with appropriate regard for the interests of beneficiaries.  APRA also relies on auditors and actuaries to provide assurance to both institutions and APRA that regulated institutions are prudently run.  The fitness and propriety of these responsible persons has the potential to impact significantly on the financial soundness and stability of APRA-regulated institutions.  These institutions must give due regard to the fitness and propriety of responsible persons to ensure the ongoing safety and stability of the institutions and to engender the confidence of beneficiaries, and the public generally. 

Fit and proper requirements form part of international standards for prudential regulation.  The Core Principles for Effective Banking Supervision[4] specify that banking supervisors should, as part of their licensing process and ongoing supervision of ADIs, evaluate directors and senior management as to expertise and integrity.[5]  Further, the Insurance Core Principles[6] (which apply to life and general insurance) state that the significant owners, board members, senior management, auditors and actuaries of an insurer should be fit and proper to fulfil their roles.  This requires that they possess the appropriate integrity, competency, experience and qualifications.[7]  These core principles provide an internationally accepted benchmark of minimum supervisory standards against which the quality of a country’s prudential supervision system can be measured and assessed.

As at June 2005, there were 236 ADIs authorised under the Banking Act 1959 (the Banking Act), 133 general insurers and 10 NOHCs authorised under the Insurance Act 1973 (Insurance Act) and 37 life companies and 29 friendly societies authorised under the Life Insurance Act 1995 (Life Insurance Act).

Problem identification

The problems APRA seeks to address are twofold. Firstly, the fit and proper requirements applying to APRA-regulated institutions are not consistent, hence APRA’s expectations in this area are not always clear or are not able to be applied. Secondly, deficiencies in fit and proper practices of regulated institutions have been identified as part of APRA’s routine supervision.

While general insurers are required to ensure that directors, senior managers, auditors and actuaries meet minimum standards of fitness and propriety, these standards do not cover the full range of matters now considered necessary and appropriate for determining whether a person is fit and proper to serve in a responsible role within these institutions.[8]

For ADIs there is no explicit test of fitness and propriety. The Banking Act contains an explicit power that allows APRA to remove a person from the position of director or senior manager if APRA is satisfied that the person does not meet one or more of the criteria for fitness and propriety set out in the prudential standards. As stated, there are currently no such criteria set out in a prudential standard for this purpose.

For life companies and friendly societies there is no explicit test of fitness and propriety.

APRA has identified the need to clarify its expectations as to the standards of fitness and propriety that should reasonably be applied to responsible persons of regulated institutions, and to ensure that the assessment processes for responsible persons are applied in a consistent manner. 

In addition to the lack of harmonisation of fit and proper requirements across APRA-regulated industries, deficiencies have also been identified in the application of fit and proper tests by regulated institutions, as set out below.

Inconsistent and inadequate approach to self regulation - Responsibility for assessing the fitness and propriety of responsible persons rests in the first instance with APRA-regulated institutions.  APRA’s review of fit and proper assessments of responsible persons indicates that the type and form of fit and proper assessments are, in a number of cases, less than adequate. A key reason for this is that there are no explicit requirements for regulated institutions, other than general insurers, to have formal policies on fitness and propriety. This creates the risk that standards of fitness and propriety applied by some institutions may fall short of acceptable levels. Even in those cases where fit and proper tests are in place, the tests vary from institution to institution and there is no clear standard that sets out minimum expectations of such a policy.  

APRA has seen a number of cases where the absence of clear fit and proper risk management has jeopardised the safety of an institution or has had the potential to cause material losses to the institution. 

Enforcement issues – While APRA has a range of fit and proper powers under its various industry Acts, the powers are not harmonised.   The use of APRA’s fit and proper powers under the Superannuation Industry (Supervision) Act 1993 (the SIS Act) highlights the potential inadequacies in the regimes for other APRA-regulated institutions.  To date, APRA has disqualified some 60 persons under the fit and proper powers in the SIS Act, with further cases under present consideration.  A number of these individuals have been disqualified because they have failed to exercise a reasonable degree of care and diligence in carrying out their trustee duties, and have therefore failed the ‘fitness and propriety’ test under the SIS Act.  By applying a minimum standard APRA was able to remove individuals who were not fit and proper from holding positions of responsibility within the superannuation industry.  Clearly, other APRA-regulated industries could benefit from explicit criteria that prevents   similarly unsuitable individuals from holding positions of responsibility in those industries.

The general insurance industry has been subject to explicit fit and proper requirements since 1 July 2002.  The Insurance Act provides APRA with powers to remove and/or disqualify directors and senior managers where they are found to be not fit and proper and APRA may also revoke the approval of an auditor or actuary where they are found to be not fit and proper.  GPS 220 establishes the fit and proper criteria upon which these powers can be exercised and requires insurance companies to develop their own fit and proper policies. APRA last year disqualified 23 persons using these powers. However, developments in this area since 2002, including public expectations as to the behaviour of persons who hold responsible person positions in APRA-regulated institutions, has highlighted that the fit and proper requirements applicable to general insurers have fallen below these expectations as well as more recent international standards dealing with this issue.  

The Banking Act was amended by the Financial Sector Legislation Amendment Act (No. 1) 2003 to give APRA powers in respect of the fitness and propriety of directors and senior managers akin to those provided in the Insurance Act. These changes include a power that allows APRA to remove a person from a position of director or senior manager if APRA is satisfied that the person does not meet one or more of the criteria for fitness and propriety set out in the prudential standards.[9]  Rather than APRA undertaking to monitor the fitness and propriety of all responsible persons, as would otherwise be required under the Banking Act, APRA believes that this obligation should rest with the ADIs themselves. 

In summary

APRA does not have an adequate level of assurance that regulated institutions currently have appropriate fit and proper policies and procedures.  The lack of a rigorous approach to ‘fit and proper’ assessments of responsible persons by APRA-regulated institutions may expose depositors and policyholders to greater risk of mismanagement and fraud in these institutions and, in the worst cases, may result in financial failures.

In addition, existing requirements across these industries are not harmonised. In some cases, the lack of explicit standards of fitness and propriety may limit APRA’s ability to remove directors and senior management who are not fit and proper.  Similarly, APRA may be hampered in its ability to revoke the approval of an auditor or actuary or direct their removal on the basis of their being not fit and proper to carry out their role. 

Further, without a framework for fitness and propriety, Australia would not meet international best practice standards in this area, including those set out in the Basel Core Principles and Insurance Core Principles outlined above. APRA endeavours to meet international standards where it assists in the protection of depositors and policyholders. APRA believes that adherence to the Basel Core Principles and Insurance Core Principles would mean that responsible persons of locally regulated financial institutions would be held to the same standards as their international counterparts.

Objective

The principal objective of harmonised fit and proper prudential requirements is to promote confidence in the financial system by reducing the likelihood of instability or financial stress that could result from mismanagement or misconduct in APRA-regulated institutions.  More specifically, APRA’s framework for fitness and propriety is intended to:

• clarify that ‘fit and proper’ risk management is primarily a task for the regulated institution, and provide minimum benchmarks for achieving this task;
• strengthen requirements applying to responsible persons, such as directors, senior managers, auditors and actuaries, to ensure that these persons meet minimum standards of fitness and propriety;
• increase the protection provided to beneficiaries by ensuring that persons known to fall short of minimum standards of fitness and propriety are not placed in positions of responsibility;
• establish a harmonised framework for assessing responsible persons across APRA-regulated industries; and
• meet internationally accepted benchmarks of minimum supervisory standards for fitness and propriety.

Identification of options

Option 1 – Introduce new prudential standards on fit and proper

Under this Option, APRA would seek to introduce three new Fit and Proper prudential standards.

For the general insurance industry, existing fit and proper requirements would be removed from GPS 220, and placed in a new prudential standard that captures all matters that would bear on the fitness and propriety of responsible persons.  ADIs and life insurance companies would be subject to new harmonised prudential standards outlining fit and proper requirements.  Requirements for Non-Operating Holding Companies (NOHCs) of ADIs would be included in the ADI standard and requirements for NOHCs of general insurers would be included in the general insurance standard.

Under this harmonised framework, regulated institutions would be required to develop a fit and proper policy that meets minimum criteria for assessing the fitness and propriety of responsible persons.  These minimum criteria would be central to the fit and proper framework and would be set out in the prudential standards.  Institutions would be required to form a prudent judgement about whether a person meets the minimum criteria.  They would apply the fit and proper policy to all their responsible persons and ensure that only persons meeting the minimum requirements are appointed to, or remain in, responsible person positions. 

Assessments by institutions would be supported by the existing legislative framework that enables APRA to remove and/or disqualify persons who are not fit and proper (under the Banking and Insurance Acts).  Additionally, APRA could also direct an institution to remove a person that APRA considers is not fit and proper.

APRA’s supervisory framework requires assessment of an institution’s fit and proper policies and their application.  Where deficiencies are identified, APRA has a range of enforcement powers it can exercise to ensure these deficiencies are addressed.  Institutions would also be required to inform APRA, in writing, where any responsible person no longer meets the fit and proper criteria to facilitate enforcement action by APRA.

Option 2 – Retain the existing prudential standards on fit and proper without amendment

Under this Option, no new Fit and Proper prudential standards would be introduced for the ADI, general insurance and life insurance industries.  General insurance would continue to be the only APRA-regulated industry subject to specific fit and proper requirements, as contained in GPS 220.[10]

Impact analysis

Impact group identification

The groups that will be affected by any proposed changes to prudential standards with respect to fitness and propriety include APRA, APRA-regulated institutions, responsible persons of APRA-regulated institutions, and depositors and policyholders.

Assessment of costs and benefits

Option 1 – Introduce new prudential standards on fit and proper requirements

Australian Prudential Regulation Authority

Benefits

Introducing new requirements covering fit and proper will assist APRA’s prudential supervision of regulated institutions. It would significantly reduce the risk of institution failure due to incompetent, reckless or improper risk management by responsible persons.  By incorporating fit and proper requirements in prudential standards, APRA would be able to ensure the requirements remain relevant to industry and reflect good practice in this area.  This would also provide the basis for more appropriate and targeted supervision.  By setting out its minimum expectations for fitness and propriety in prudential standards, APRA would increase the transparency of its requirements. 

The introduction of harmonised standards across APRA-regulated industries should also result in reduced administration, supervision and enforcement costs and ensure consistency of supervisory treatment across these industries. While these benefits cannot be readily quantified, the benefits to APRA are expected to be moderate.

Further, new prudential standards containing requirements for fitness and propriety would allow Australia to meet international benchmarks in respect of these matters for ADIs and insurers. As discussed previously, this would ensure that local institutions are held to the same standards as their overseas counterparts, and afford increased protection to beneficiaries through the reduced risk of loss from the actions of persons who are not fit and proper to hold responsible person positions.  

Costs

Introducing harmonised fit and proper prudential standards will require APRA to incur some costs in updating its supervisory approach and framework.  These costs are nominal as the APRA supervision framework already requires APRA supervisors to assess of fit and proper policies and procedures and this would typically be completed in conjunction with a scheduled review of an institution.

APRA would also incur costs in assessing the policies and procedures of regulated institutions on an ongoing basis.  However, this would be built into existing supervisory activities and processes.  Collecting additional information, and associated supervision and compliance monitoring, will also be accommodated by APRA’s existing systems and supervisory processes.  In brief, APRA would not expect to incur substantial costs from introducing new standards on fitness and propriety.  APRA’s experience in introducing fit and proper requirements for general insurers in 2002 indicates that the costs of administering such requirements do not add materially to the existing costs of supervision.

There will be minimal systems expenditure associated with this proposal. The systems are already in place for data collection. The information required under this Option would require the development of one short APRA statistical form.

APRA-regulated institutions

Benefits

Improving the fitness and propriety of responsible persons in APRA-regulated institutions will provide greater certainty as to their ongoing safety and stability. 

Requiring regulated institutions to have comprehensive fit and proper policies will help to ensure that responsible persons have the necessary probity, competence and independence to manage an institution in a sound and prudent manner.  A sound fit and proper framework will help to ensure that persons who do not possess the requisite skills and experience for a particular position, or who have demonstrated impropriety through past actions, would not be able to assume a role as a responsible person in an APRA-regulated institution.

Application of minimum fit and proper criteria should reduce the risk of failure in APRA-regulated institutions resulting from incompetence, fraud, dishonesty or mismanagement.  The financial sector as a whole would be strengthened if persons who have inadequate skills and experience, or who have otherwise demonstrated that they are not fit and proper, are prevented from working in responsible person roles.  The prudential requirements would create strong incentives for APRA-regulated institutions to conduct their businesses in a safe and sound manner, through minimising the ability of persons to act in responsible person positions. While it is not possible to predict the effects of dishonest or reckless behaviour, and thereby identify the sorts or numbers of incidents that these measures should prevent or their dollar cost, APRA is confident that the measures will contribute significantly  to overall financial system stability.

Additionally, the proposed prudential standards clearly specify APRA’s expectations as to the minimum criteria to be met by people who serve in responsible person roles.  This would result in increased certainty for institutions as they would be able to design their policies for fitness and propriety with confidence that they will be able to satisfy APRA that their responsible persons do not pose an unacceptable risk. 

APRA-regulated institutions would also benefit from a prudential framework that APRA considers reflects good practice with respect to fit and proper requirements, and governance more generally, and that is consistent with international benchmarks in this area.

Costs

Introducing harmonised fit and proper requirements will require APRA-regulated institutions to create or review their policies and procedures in this area.  As a general rule, most institutions already spend considerable time and money on fitness reviews, via the (typically) annual performance assessment process.  This process achieves many ends, one of which is a continuing review of fitness.  Fitness is also an essential element in any hiring, transfer or promotion decision.  It is unlikely that the proposed prudential standards will change an institution’s spending on fitness assessments.

As to propriety, current industry practice is uneven.  Some larger and more sophisticated institutions already possess propriety policies and procedures which are well in excess of the proposed prudential standard.  Institutions which are currently lacking in this area will need to devote some time and attention to developing a written policy, and there are likely to be minor costs associated with creating and publicising this policy such as drafting, reviewing and training. Those institutions with adequate fit and proper polices already in place would not be materially impacted by this Option.

For institutions with inadequate practices, there may be a cost in removing and replacing a responsible person who is not fit and proper. APRA has not been able to quantify these costs.    

From an information systems perspective, institutions will be required to complete a single form that will capture basic details on their responsible persons. Typically, this information is already provided to APRA. APRA-regulated institutions also provide other data to APRA via the same mechanism; hence the costs, both in monetary terms and effort, will be low.

Because many APRA-regulated institutions already have systems for assessing the fitness and propriety of their responsible persons, APRA expects that the incremental cost of the proposed prudential standards will be minor. 

Responsible persons of APRA-regulated institutions

Benefits

The introduction of prudential standards on fitness and propriety will give responsible persons in APRA-regulated institutions a clear sense of their obligations in this area.  They will have clear guidance on APRA’s expectations of responsible persons and the circumstances in which APRA may exercise its powers of removal or disqualification. 

Responsible persons will have the additional benefit of reduced likelihood that other responsible persons are not fit and proper.  Where a responsible person in an institution is not fit and proper and this causes financial instability or collapse, other responsible persons may tend to suffer reputational damage regardless of whether they contributed to the problem or not.  Ensuring that all responsible persons in APRA-regulated institutions are fit and proper minimises this risk. 

Costs

Responsible persons in regulated institutions should not be faced with any direct costs as a result of these changes.  Selection processes for job applicants would, typically, already include procedures for assessing fitness, particularly, and propriety. 

The prudential standards do not put a direct, positive obligation on responsible persons to act in a certain way; they simply provide for a minimum standard of conduct which, for prudently run institutions, should not require responsible persons to alter their behaviour. 

The prudential standards would be expected to impose costs on responsible persons who are not fit and proper for positions they hold.  These costs are an unavoidable consequence of setting a minimum standard and are in keeping with expectations of prudent management of regulated institutions.

Depositors and policyholders

Benefits

Depositors and policyholders would benefit from the new prudential framework as the enhanced fit and proper requirements should serve to strengthen the overall quality of management in APRA-regulated institutions.  The interests of beneficiaries would be better protected by having responsible persons in these institutions who meet minimum standards of fitness and propriety, and through the expected reduced risk of failure from incompetence, fraud or mismanagement.

The interests of depositors and policyholders would be further safeguarded since responsible persons of APRA-regulated institutions would be obliged to ensure that the outcome of their actions is not to the detriment of beneficiaries. Failure by a responsible person to properly exercise their responsibilities would require the regulated institution to re-assess the fitness and propriety of that person, and would also lead APRA to reconsider their fitness and propriety.

Costs

Depositors and policyholders could be adversely affected if new fit and proper requirements were to lead to additional costs that were passed on as increased fees or premiums.  However, it is considered highly unlikely that the proposals under this Option would result in increased costs to depositors or policyholders.  This is because the types of matters that the proposal would require institutions to formalise are matters that APRA would expect institutions already to be undertaking in some form when appointing people as responsible persons.

Under this Option, institutions would be required to develop a formal process to evaluate the fitness and propriety of their responsible persons and then ensure, on an ongoing basis, that these people are fit and proper.  This process and the ongoing requirements should sit within existing risk management and compliance functions in most institutions.  While institutions would incur costs in putting in place the necessary requirements (as outlined above), these costs are not expected to be material relative to the overall operating costs of individual institutions.  It is therefore considered unlikely that increased costs to depositors and policyholders would result.

Option 2 – Retain the existing prudential standards on fit and proper without amendment

Australian Prudential Regulation Authority

Benefits

The main benefit for APRA in retaining the existing prudential framework would be the avoidance of costs that would otherwise be incurred if changes to the framework were to be made.

Costs

There would be no development costs to APRA under this Option as there would be no change to the existing framework.  Increased supervision costs, however, would result because APRA would be unable to satisfy itself that responsible persons in APRA-regulated institutions are fit and proper without increasing the intensity of its supervision.  As the fit and proper standards applied by APRA-regulated institutions vary across institutions and industries, the absence of minimum fit and proper requirements may result in instances where responsible persons do not possess the degree of probity and competence commensurate with their responsibilities.  This would undermine the effectiveness of the prudential regulation framework and jeopardise the position of depositors and policyholders, who would be exposed to an increased risk of financial loss due to mismanagement within APRA-regulated institutions.  This would not be conducive to overall financial system stability.

The lack of a harmonised framework would mean a continuation of the current inconsistencies in the framework, which adds to the administrative complexity of prudential supervision and difficulties in enforcement as time and resources are spent on different supervisory tools and enforcement actions for each industry.

By not implementing formal ‘fit and proper’ requirements, current supervisory arrangements would remain below international benchmarks.  APRA could face reputational costs under this Option if it became apparent that APRA had continued to operate a framework that it knew to fall short of international benchmarks or if the costs associated with the necessary increased supervision impacted on the industry.

APRA-regulated institutions

Benefits

Under this Option, APRA-regulated institutions would benefit as they would not be required to have a Fit and Proper policy that meets certain specified requirements and the costs that would result from this.  

Costs

APRA-regulated institutions would incur, or continue to incur, potential costs if their current fit and proper policies and procedures result in a less robust assessment of the fitness and propriety of responsible persons. The possibility of mismanagement, incompetence and fraud by responsible persons who do not meet minimum standards of fitness and propriety would continue, and may result in losses to the institutions concerned.

Without standards that require self-regulation, APRA supervision will necessarily be more intensive, creating costs to institutions. The costs in this respect are difficult to quantify.

Institutions would also face continued uncertainty as to the criteria that they should apply in assessing whether a person is fit and proper. They may not be able to confidently assess whether a person is fit and proper, given the absence of a set of minimum criteria. This would result in costs for individual institutions in those cases where APRA reached a different conclusion to the institution as to the fitness and propriety of an individual, thereby necessitating that the person not be appointed or be removed from the responsible person position.

Responsible persons of APRA-regulated institutions

Benefits

Responsible persons who are not fit and proper would benefit under this Option.  They would not face the risk that increased minimum standards would mean that they are no longer eligible to hold a responsible person position. 

Costs

Under this Option, responsible persons would not experience the benefits of clear guidance on APRA’s minimum standards and the reduced likelihood that the improper actions of other responsible persons will reflect adversely on them. They would also be faced with more frequent APRA supervisory reviews of fitness and propriety. Typically this review would involve costs in terms of time and resources for preparation of documents and presentations as well as formulating a response to any finding from APRA.

Depositors and policyholders

Benefits

The benefits to depositors and policyholders under this Option would be unchanged from the present.  Since APRA-regulated institutions would not be required to comply with additional prudential requirements, no extra costs would be incurred that could potentially be passed onto depositors and policyholders through increased fees or premiums.

Costs

Retaining the status quo would involve opportunity costs for depositors and policyholders in that the potential for improvement in the overall quality of management in APRA-regulated institutions would not be realised.  Depositors and policyholders would not have the assurance that their interests are being protected by responsible persons who meet minimum standards of fitness and propriety.

Consultation

The initial round of public consultation on the proposed prudential standards commenced in March 2004, with the release of a consultation paper and draft prudential standards.  Thirty nine submissions were received in response.  There was widespread acceptance of the need to ensure that responsible persons in APRA-regulated institutions are fit and proper.  A number of substantive issues were raised by respondents and APRA adapted its proposals in a number of key areas. 

A second round of public consultation commenced in June 2005.  The prudential standards were redrafted and were accompanied by a discussion paper which outlined APRA’s responses to concerns raised by industry.  Thirty-five submissions were received and again there was widespread acceptance of the need for APRA-regulated institutions to ensure that their responsible persons are fit and proper.  Respondents made a number of minor drafting suggestions as well as raising some more substantive concerns.  As well as written submissions APRA has held a significant number of meetings, discussions and information sessions with institutions, industry bodies and other interested parties. APRA made other amendments to the draft standards as a result of this further round of consultation.  A number of changes have been made which clarify APRA’s intentions for the application of the standard. 

The main issues raised and APRA’s response are set out below.

Prescription

Comments were made that the level of prescription was excessive and could lead to a ‘tick-the-box’ mentality with regard to compliance.  Further, there were comments that the standards imposed a ‘one-size-fits-all’ approach.  APRA has significantly streamlined the standard so that it only covers  areas that are considered core to the assessment of a person’s fitness and propriety. It will be up to individual institutions as to how they satisfy themselves that responsible persons meet the criteria in the standard. Matters that are intended to be guidance or for information have been moved to supporting material and do not form part of the requirements. 

Transition period

A significant number of respondents commented that the intended transition period of three months after the release of the standard would not allow them adequate time to make the necessary changes to comply with the standard. APRA has therefore moved the commencement date to 1 October 2006. 

Application to subsidiaries

Some submissions opposed the proposal to apply the standard to subsidiaries.  Others requested clarification on specific aspects of the proposal.  These included a request for further clarification on how the threshold tests for assets and revenue were to be applied and a request that APRA clarify how the standard was to apply when a material subsidiary was an APRA regulated institution. 

APRA has altered the requirements in the standard to remove requirements that apply independently to subsidiaries.  Instead, the standard now defines responsible persons to include a person who performs activities for a subsidiary of the regulated institution where those activities may materially affect the whole, or a substantial part, of the business of the regulated institution or its financial standing, either directly or indirectly.  The intention of the standards has always been to capture only those persons who are in a position to have a material impact on the regulated institution’s business, and the new provisions reflect this fact.   

Definition of a responsible person

A number of respondents were of the view that the definition of ‘senior management’ was too broad and would capture too many people.  Further, a number of respondents felt that the provision stating that contactors and consultants could potentially be responsible persons required clarification.

The definition of responsible person has been modified and further guidance has been provided that clarifies these issues. 

Criteria to determine if a responsible person is fit and proper

A number of respondents were of the view that the Fit and Proper criteria were too prescriptive and in some cases subjective.  Respondents were concerned that it might be difficult to gather the necessary information to assess some of the criteria.  Some respondents expressed the view that institutions should be able to make increased use of attestations to assess the criteria.

In order to assist institutions in applying the criteria, further information has been provided in guidance material that seeks to clarify these concerns.   

Criteria applying to responsible person auditors and actuaries

A number of submissions sought clarification on who was captured by this section in an ADI.  Some respondents questioned how the requirements applicable to auditors would apply in the case of a material overseas subsidiary. 

The wording of the prudential standard has been amended to clarify who the responsible auditor is.  Further information, by way of explanation, has also been provided in supporting guidance material. 

When a responsible person is found not fit and proper

Respondents had concerns about liability issues relating to removing persons.  It was stated that in the case of existing responsible persons, it may be difficult to amend employment contracts if necessary. 

The standard requires institutions to take all prudent steps in applying the policy.  If they cannot prudently remove a person, they must notify APRA, who can then give consideration to removing the person.  While it may be difficult to amend employment contracts, it is not unreasonable to expect institutions to take prudent steps to ensure that their responsible persons are fit and proper. 

Informing APRA

The draft prudential standard required that regulated institutions provide certain information about their responsible persons to APRA and ensure this information remains up-to-date.  Institutions would also be required to provide an annual list of their responsible persons and a statement as to whether they have contravened the prudential standard in the previous financial year.  A copy of the Fit and Proper policy was required to be submitted to APRA when approved and materially amended.

APRA has reviewed the required information and streamlined this requirement to include only basic identification information relating to responsible persons, notification in the case of a person being assessed as not fit and proper and other information APRA requests.  An annual form containing the necessary information submitted to APRA will be sent to regulated institutions for certification as to its continued accuracy.  The Fit and Proper Policy will no longer need to be submitted but must be made available to APRA if requested. 

The standards have been updated to further clarify the timing for the submission of the requested information.  The timing for provision of requested information is consistent with the  Corporations Act, where possible, to minimise the burden of reporting requirements.

These changes should result in a significant reduction in the cost of complying with the new requirements.

Conclusion and recommended option

Option 1 is the preferred option

Option 1 meets the stated objectives.  It provides an enhanced framework to ensure that individuals acting as responsible persons in APRA-regulated institutions have the appropriate skills, training, experience and propriety to manage such institutions.  It also provides a clear benchmark for the fitness and propriety of responsible persons, via the introduction of fit and proper prudential standards harmonised across APRA-regulated industries. 

The proposed standards will outline the minimum requirements that APRA expects APRA-regulated institutions, and responsible persons within them, to meet.  This will help to promote confidence in the prudentially-regulated financial sector and will increase protection for depositors and policyholders.  These standards will be supported by the legislative framework that enables APRA to remove and/or disqualify persons who do not meet the minimum criteria for fitness and propriety.

This Option is likely to involve some additional costs for APRA and some APRA-regulated institutions, both during the initial set-up period and on an ongoing basis.  APRA may have to devote additional resources to supervision in the short term, but these costs should fall over time as regulated institutions become more familiar with the new fit and proper requirements and establish the processes necessary to comply.  The additional costs incurred by regulated institutions are unlikely to be of such magnitude as to impact directly on depositors and policyholders. 

Overall, the benefits from certain and comprehensive fit and proper requirements that aim to reduce the incidence of mismanagement and fraud, and therefore afford additional protection to depositors and policyholders, are expected to outweigh significantly the modest costs associated with these requirements.

While Option 1 requires APRA-regulated institutions to apply their own fit and proper standards in the appointment of responsible persons, APRA retains reserve powers to disqualify a person where, in APRA’s opinion, the person is not ‘fit and proper’.  This ‘negative’ test would provide APRA with flexibility to direct its resources to particular cases, rather than having to develop a systematic process covering every relevant person of an authorised institution. 

Option 1 also meets international benchmarks for minimum supervisory standards in banking and insurance.

Option 2 falls short of meeting the stated objectives.  It does not improve the existing fit and proper requirements for general insurers, nor does it impose such a framework on ADIs or life companies.  This Option would make APRA’s supervisory task more difficult relative to Option 1, and would not afford adequate protection to depositors and policyholders.  The status quo is not a reflection of “good practice” regulation, either domestically or internationally.

Implementation and review

APRA proposes to make three new prudential standards under the relevant industry Acts:

• APS 520 Fit and Proper Requirements for ADIs;
• GPS 520 Fit and Proper Requirements for general insurers; and
• LPS 520 Fit and Proper Requirements for life companies.

It is intended that these prudential requirements will be released in the first quarter of 2006 and commence on 1 October 2006. There are no transition matters in the Fit and Proper standards.

These prudential standards will be reviewed on a regular basis to ensure that they continue to reflect good practice and remain relevant and effective, for both APRA’s prudential regulatory purposes and for regulated institutions.

[1]  In addition, Part 15 of the Superannuation Industry (Supervision) Act 1993 contains provisions relating to disqualified persons.

[2]  Paragraph 7 specifies who the responsible persons are in relation to an eligible foreign life insurance company (EFLIC).  The main difference is that the members of the Compliance Committee of the EFLIC, as defined in subsection 16ZF(1) of the Act, are the responsible persons, rather than the directors of the EFLIC (there are also other categories of responsible persons).  The Compliance Committee has particular responsibilities under the Act in relation to the Australian operations of the EFLIC.

[3]  This Regulation Impact Statement does not cover fitness and propriety requirements for superannuation funds or trustees, which are subject to separate requirements under the Superannuation Industry (Supervision) Act 1993.

[4]  Issued by the Basel Committee on Banking Supervision in October 1999.

[5]  Fit and proper test - refer Principle 3, essential criterion 7 and Principle 17, essential criterion 4.

[6]  Issued by the International Association of Insurance Supervisors in October 2003.

[7]  Refer Insurance Core Principle 7.

[8]  Refer Prudential Standard GPS 220 Risk Management for General Insurers (GPS 220).

[9]   Refer section 23(2) of the Banking Act 1959.

[10]  Other than the superannuation industry.