A review of the challenges facing the Australian market by Bill Peck and Mark Burger.

There are winds of change blowing through Australia, as they are through many of the world's insurance and (re)insurance markets: rationalisation and convergence of both underwriters and intermediaries, increasing polarisation of the market with a smaller number of large players dominating and increased globalisation with a large majority of the companies now operating in Australia with head offices outside Australia. And, of course, Australia has borne witness to the fact that the global (re)insurance business has become a more sophisticated game with greater capital requirements.

There are other changes and resulting challenges taking place in the Australian marketplace.
• After some poor underwriting results, direct insurers are focussing on core business and leaving markets they no longer consider they canprofitably service. MMI (part of Allianz), AMP General and GIO have all indicated that they are leaving certain markets to concentrate on what are their acclaimed core competencies.
• Companies selling personal line products continue to look for innovative ways to sell direct to customers. While the Australian population is, in relative terms, prepared to adopt new brands and accept new distribution channels, there remains the underlying problem of market size - there are only 19 million people in Australia.
• The large global insurance and reinsurance players are increasingly dominating the market either through mergers within the sector or greater tolerance for underwriting losses. (Re)insurers are now becoming increasingly aggressive about dis-intermediation in searching out new more direct distribution channels.
• Accountants are entering the risk management business and suggesting that they may threaten some of the traditional insurance broking roles.
• Litigation costs are increasing with the continued development of a “plaintiff's bar” using the internet to develop global links (particularly with the US) and the sharing of information and ideas.

Superimposed change from the regulators
These changes are challenge enough for any management. However, the Australian regulators are now exacerbating the situation with a raft of new legislation which will have a dramatic impact on both the Australian insurance and reinsurance sector.The government has determined to introduce a goods and services tax (GST) with effect from 1 July 2000. While GST is of course not unique to Australia, the inclusion of general insurance as a taxable supply, taxed in the same way as other services, is unique to Australia and New Zealand. While the Australian approach is broadly consistent with that in New Zealand, the extent and detail of the proposed legislation is much greater.The phasing in of the GST remains uncertain and, whatever the rhetoric of the government, it seems that the general insurance industry will sustain aheavy cost in GST implementation.

While GST is absorbing a large amount of management time within most companies in Australia, it will not in itself lead to structural or market changes. However, the other two major pieces of legislation anticipated by the government are far more likely to lead to structural change and continued rationalisation:
• The introduction of a new licensing and disclosure regime for the selling of all (wholesale and retail) financial products (including general insurance and other risk products) in 2001.
• Proposed changes to the solvency and capital adequacy requirements for underwriting companies.

A new licensing regime
The present government has continued and expanded the Corporate law economic reform programme (CLERP) commenced by its predecessor. Changes to the regulatory regime for takeovers, capital raisings and directors' duties are about to occur. Of greater impact to the financial services sector, and particular the general insurance industry, is CLERP 6. This is a new regulatory regime aimed at harmonising licensing and distribution regulation across the whole financial services sector. Draft legislation is anticipated at the end of this year. However, from the detailed discussion papers that have already been released, we can anticipate the following:
• A uniform licensing system under which any wholesale or retail provider of financial services will have to be licensed. The licensing model will require the licensee to specifically authorise and be responsible for individuals involved in the selling process.
• To obtain and retain a licence, the licensee must have sufficient financial substance, competent staff and appropriate systems and training and compliance standards.
• Licensees will be subject to a disclosure regime including its role, relationships and its commission and fees. This disclosure regime will apply to a retail market that will include small and medium business enterprises as well as to the consumer market.
• A product disclosure regime will also apply.

Prudential requirements
Adding yet another challenge, the Australian Prudential Regulation Authority (APRA) has announced a review of the Insurance Act 1973 which is the prudential legislation for the general insurance and reinsurance industry in Australia.

APRA has issued a discussion paper raising what it sees are the issues needing review in relation to solvency and capital adequacy. It is inviting comments and questions for submission by 17 December 1999 and insurers and reinsurers should take up this invitation to ensure that they participate in the process and achieve an industry acceptable result.

APRA has put forward a number of propositions in its paper including:
• There should be a more sophisticated and flexible way of measuring the amount of capital needed to carry on insurance business. The net effect of the recommendations is that additional capital will probably be required, particularly for long tail business.
• Capital requirements should be flexible to allow innovative ways of securitising risk and flexible forms of direct capital.
• There should be a consistent approach to the valuation of liabilities, including selection of prudential margins. Liabilities should be formallycertified by a qualified internal or external actuary.
• Higher initial capitalisation than $2 million is needed.
• Asset and liability matching should be encouraged by requiring additionalcapital for mis-matching.
• Captives and reinsurers could be de-regulated.

Our initial research indicates that both these changes are likely to have a substantial impact on the Australian general insurance industry. For example, it seems from preliminary discussions with underwriters that they think that CLERP 6 will make it easier to promote direct sales both to retail consumers and, probably, small business.

The competency, training and compliance requirements and their cost burden, will threaten the continued profitable existence of the smallindependent broker and multi agent. These sectors of the intermediary market will either move into larger associations or, possibly, be taken over by underwriters looking to capture control of distribution.

The somewhat ineffectual prohibition on over-rider commissions for brokers will disappear and be substituted with commission and fee disclosure. This will probably drive the larger end of the intermediary market back to playing a proper broker role rather than running large agency facilities to exploit the size and value of their distribution channels. However, commission disclosure will eventually lead to a more informed market and high commission products will probably not be sustainable. Intermediarieswith large facilities will have to focus on cost reduction to maintain profitability.

The capital changes will encourage direct companies to look at innovative ways of efficiently providing capital, including sub-debt (whether with orwithout any inherent insurance risk), catastrophe debt and equity and securitisation.

There will continue to be rationalisation as smaller and weaker companies will find the capital adequacy hurdles increasingly hard to meet.

Reinsurance and captives
Of particular interest to the readers of this magazine is that APRA has suggested that the reinsurance sector could be deregulated in Australia by requiring direct companies to allocate capital to cover the reinsurance risk. If this occurs, the amount of capital that has to be allocated to reinsurance risk will no doubt be affected by ratings and concentration risk.

At this early stage, it seems likely that global reinsurers operating in Australia will promote the cause of de-regulation, as generally they have higher ratings and are part of very large global groups with substantial capital. Reinsurers which want this outcome should make appropriate submissions.

APRA has also suggested that captives be deregulated where they do not provide third party cover. While this in itself is not likely to promote the growth of captives, it is possible that captives will be increasingly used by major corporate groups as a means for directly accessing the reinsurance markets (particularly if reinsurers are deregulated).

The predicted increase in premium rates over the next few years is likely to force corporates to look at alternative methods of funding their risk, rather than simply transferring it to the insurance market. Again, while other mechanisms such as multi-class and year deals with a blended finite element offer similar results, captives are another mechanism for achieving the same end.

Its not just the rules that are changing. There has also been rationalisation of regulators in the financial services sector. Prudential regulation and the supervision of financial institutions has devolved entirely on APRA. This organisation is responsible for banks and other deposit taking institutions, life insurers and reinsurers, general insurers and reinsurers and superannuation (pension) funds.

Some of the general insurance expertise has been lost in the creation of the new APRA and its establishment in Sydney. However, the people involved in the prudential supervision of general insurance companies are now applying a broader based approach to risk and its management and using techniques borrowed from other parts of the financial sector.

The distribution of all financial products is now regulated and supervised by the Australian Securities and Investment Commission (ASIC). ASIC is proving to be a stricter regulator with a more overtly punitive style whose aim is both retribution as well as pour décourager les autres.

Any silver linings?
In conclusion, Australia remains a challenging market for insurers, reinsurers and intermediaries. The new regulators and the new regulatory regimes proposed for distribution and capital adequacy will only increase the challenges faced by companies operating in this market.

That said, these changes will, like other changes, create as many opportunities as threats and there is no doubt money to be made for those who have a broader vision and are fleet of foot.

Bill Peck and Mark Burger are partners, corporate & regulatory group, Phillips Fox lawyers.