John Edmond examines run-off Down Under and the impact of the APRA prudential reforms
Recent history has shown a dramatic increase in the number of general insurers in Australia entering into run-off, peaking acutely in 2002.When considered together with a number of high-profile insolvencies, it might seem that the insurance industry is in turmoil. In truth, the insurance cycle continues and the statistics are more likely a result of a tightening of the regulator's approach.Australian Prudential Regulation Authority (APRA) statistics demonstrate that 111 insurers were authorised to conduct new or renewal business in Australia as at 5 February 20041. In addition, at the same date, 33 companies were authorised to conduct run-off business only. This means, at that point, at least 22% of the registered insurance companies in Australia were in run-off. The time during which those 33 companies have been in the run-off business varies greatly; however, ten went into run-off in 2002.The Insurance Act 1973 (Cth) codified safety and soundness requirements for general insurers. These became the responsibility of APRA in 1997, as a result of the Federal Government's financial sector reforms following the Financial System Inquiry. In its discussion paper of November 20032, APRA expressly recognised that:"By the time of APRA's inception in July 1998, the Insurance Act 1973 had long been overtaken by market and regulatory developments and was in need of reform. The emergence of some substantial losses in the industry during this period served to reinforce the case for reform."The 'substantial losses' referred to by APRA undoubtedly include the 2001 collapse of HIH Insurance, which had been regarded as Australia's second-largest general insurance company.APRA has adopted a two-stage approach to reform. Stage I reforms are in place, and, together with the proposed Stage II reforms, will apply to both insurers and reinsurers seeking licences in the Australian market.
Stage I reformsAPRA's proposals for the first stage were approved by the Federal Government in November 2000 and enacted under the General Insurance Reform Act 2001 in August 2001. The final standards were tabled in Parliament in 2002 and took effect on 1 July 2002. The purpose of the stage 1 reforms is threefold:- to shift to upgraded, risk-based capital adequacy requirements;- to put in checks and balances created by stronger corporate governance standards; and- to stimulate a universal 'health check' on all companies under re-authorisation.Commenting on the first stage reforms, APRA stated in November 2003 that:3"the new framework substantially strengthened and modernised the prudential requirements applying to general insurers in Australia. By strengthening requirements in relation to both financial soundness (liability, valuation and capital adequacy) and risk management (particularly in relation to governance and reinsurance), and coupling these with new legislative provisions that strengthen APRA's capacity to intervene in the affairs of an ailing insurer, the Australian general insurance industry is now subject to much more effective standards of regulation than has been the case in the past."Of particular note is the requirement that the board of a general insurer must now develop a high-level 'reinsurance management strategy' that should, at a minimum:- be submitted to APRA for approval and regularly updated;
- pay regard to counterparty diversification and creditworthiness;
- include controls on the use of financial reinsurance; and
- set out clear processes for reinsurance decision-making.
Importantly, every general insurer seeking a licence to operate after 1 July 2002 was required by the legislation to apply for reauthorisation.APRA did not grant full reauthorisation to a small number of general insurers, which it deemed inadequately capitalised or otherwise unable to satisfy its authorisation criteria. This is perhaps the principal reason why 2002 saw a considerable leap in the number of companies entering into run-off.As part of the stage I reforms, the board and CEO of a general insurer were also required to develop a risk management strategy aimed at mitigating all of its material financial and operational risks in order to meet these expectations. The guidelines state that an insurer's internal checks and balances should include, for example:- no shareholder should have disproportionate representation on the board;- a non-executive chair and non-executive majority of the board;
- an audit committee of the board with a non-executive majority;
- 'fit and proper' tests for directors, managers and advisers; and
- clearly defined roles for managers and advisers.
Furthermore, directors are required to provide annually to APRA a written declaration of the board, certifying that, collectively, they have:- complied with all relevant prudential requirements;
- identified and managed all material risks; and
- propagated a strong risk control culture across the company.
Proposed stage II reformsOn 4 April 2003, the HIH Royal Commissioner, Justice Owen, delivered his report into the collapse of HIH Insurance to the Governor General.APRA came in for some criticism in it, and there is a view among some observers that the reforms were introduced as a result. In fairness, APRA had started the regulatory reform some time before the HIH collapse and subsequent Royal Commission. APRA has, however, specifically recognised that the collapse added urgency to the process and accelerated the timelines.The Commissioner's report has undoubtedly affected the stage II reforms.On 20 November 2003, APRA produced a discussion paper on the proposed stage II reforms. The Commissioner's recommendations reflect APRA's view that further work is required to strengthen the prudential supervision framework for general insurance in Australia. In particular, APRA's stated belief is that the current prudential requirements made under the Insurance Act 1973 need to be extended to cover consolidated groups, to improve disclosure, and to strengthen the actuarial supervisory governance and audit arrangements of general insurers.APRA this year intends to release a separate consultation paper setting out its proposals for developing a regime of consolidated supervision to minimise the risk of adverse developments in other parts of a corporate group that includes an authorised general insurer from damaging the soundness of the insurer. Further, APRA also intends to release a separate consultation paper and a draft prudential standard to deal with the fit and proper requirements for directors and senior management in the general insurance, life insurance and authorised deposit-taking industries (ADIs).The most significant proposals in the APRA discussion paper are:Capital management plan (CMP) - Implementation of a CMP giving details of the insurer's strategy for setting and monitoring capital resources.The board will be required to approve the CMP, which must be submitted to APRA annually or whenever a material change is made to the CMP.Directors - It is proposed that the meaning of a non-executive director, for prudential standard purposes, should be redefined to include directors who are not employed by the insurer or any of its related entities, either directly or indirectly. It is also proposed that a director should not serve as a director of another general insurer (or parent company) outside the group to which the insurer belongs.Board audit committees - APRA proposes that the board audit committee comprise at least three members, all of whom must be non-executive directors and a majority of whom must also be independent. An 'independent director' is proposed by APRA to be independent of the management of the insurer and any of its related entities, and free from any business or other relationship with those entities that could materially affect their independent judgment.Board risk committee - APRA proposes to mandate the establishment of a 'board risk committee' to develop, set and monitor adherence to risk management strategies.Board/senior management performance - APRA proposes to require an insurer to have in place procedures for assessing the performance of the board, individual directors and senior management.Reinsurance recoveries - APRA proposes not to permit reinsurance recoveries to be deducted from gross liabilities for the purpose of calculating the insurer's minimum capital requirement, unless and until a fully documented, executed and enforceable reinsurance contract is in place.It is perhaps this last selected proposal that will be of most interest to those in the reinsurance industry. Quite simply, if the parties to the reinsurance agreement do not ensure that the wording is finalised and signed, then the insurer will not be permitted to include the effect of that reinsurance contract in its balance sheet.
Run-off reformsParagraph 3.2 of the discussion paper 4 deals with APRA's views on general insurers in run-off. APRA considers the issue to be that, because insurers in run-off remain exposed to risks due to the inherent uncertainty in potential future claims, policyholders still need to be protected. APRA, therefore, believes that prudential standards should be applied to all insurers in run-off. It also proposes some additional requirements, such as a prudential standard applicable to general insurers in run-off to classify such insurers as those where insurance business is being conducted for the sole purpose of discharging liabilities.The following elements would be incorporated into the new prudential standard and reflect existing supervisory practice and conditions on authorisation:- a general insurer must not reduce its capital without prior approval from APRA. The regulator would generally not consent to a reduction in capital, unless a general insurer submits an actuarial report to APRA (by an actuary who meets approved actuary status), which demonstrates that company assets will enable the insurer to cover insurance liabilities to a 99.5% level of sufficiency, plus any other liabilities, and are realisable in an appropriate timeframe;- unless otherwise agreed with APRA, all funds of the insurer must be invested in deposits with the locally incorporated ADIs. Investments in any other assets must be specially approved by APRA;- the risk management strategy approved by the board must include details of how the company is managing the run-off of insurance liabilities; and- the insurer must comply with all other prudential standards (where not inconsistent with the standard specific to run-off).It is to be remembered that the proposals are, at this stage, just that - proposals. They are, however, likely to form the basis of the next round of amendments to the Insurance Act and the Prudential Standards and Guidance Notes issued under the Act. They will undoubtedly have a significant impact on the regulatory, reporting, disclosure and compliance framework within which the general insurance industry in Australia will operate.There is not a great deal of available statistics concerning the run-off of companies in the Australian insurance market. While those currently available suggest that a significant contributor to the 2002 peak was the existence of APRA's stage I reforms, the regulator's intention in bringing both sets of reforms is clear; to reduce the likelihood of failures in the general insurance market.References
1 All statistics are taken from the APRA website - www.apra.gov.au.
2 Prudential Supervision of General Insurance - Stage II Reforms.
3 Prudential Supervision of General Insurance - Stage II Reforms.
4 Page 50.
John Edmond is a Senior Associate (admitted in NSW and in England & Wales) in the insurance and reinsurance practice group of Allens Arthur Robinson's Sydney office.