APRA’s observations on the implementation of the new PHI capital framework
To: All Private Health Insurers
APRA’s new prudential standards for the private health insurance (PHI) industry, which commenced on 1 July 2023, have significantly changed how capital adequacy is determined for insurers and improved alignment with APRA’s insurance capital framework, consistent with international best practice.
In late 2023, APRA reviewed and peer-compared a number of Internal Capital Adequacy Assessment Process (ICAAP) Summary Statements to identify examples of better practice and possible areas for improvement. APRA also conducted a review of the September and December 2023 APRA quarterly data submissions to monitor the impacts arising from the implementation of the new PHI capital framework. This letter, and its accompanying attachments, outlines APRA’s observations from these reviews.
ICAAP Summary Statements
An important component of the new prudential standards is the requirement for insurers to have an ICAAP. This includes a requirement for insurers to prepare an ICAAP Summary Statement (Summary Statement) as set out in Prudential Standard HPS 110 Capital Adequacy (HPS 110).
Significant financial institutions (SFIs) were required to submit their first Summary Statements by 1 July 2023. To assist with implementation APRA provided non-SFIs a two-year transition period to meet the new ICAAP-related requirements in the prudential standards. Non-SFIs have until 1 July 2025 to submit their Summary Statements (unless otherwise notified by APRA).
APRA understands the PHI industry is undergoing major change brought about by the new PHI capital framework and the new accounting standard AASB 17 Insurance Contracts (AASB 17). Most entities reviewed by APRA made an adequate attempt in meeting the requirements for Summary Statements in HPS 110. However, there is room for further improvement to uplift industry better practice and enhance capital management and oversight.
Attachment A sets out APRA’s observations from its review of selected Summary Statements which are relevant to the broader PHI industry including insurers subject to transitional arrangements. There are also examples of better practice drawing on the relevant ICAAP experience from General Insurance and Life Insurance.
Capital Framework Implementation and Reporting
APRA reviewed the September and December 2023 quarterly data submissions to assess whether the impact of adopting the new PHI capital framework was consistent with APRA’s expected outcomes. Overall, the impact of the new framework on the industry’s capital position was in line with the expectations set out in the 2022 information paper1 and the PHI Industry continues to be in a strong capital position.
Attachment B outlines APRA’s observations from its review, and the information being shared is intended to assist insurers with implementation and reporting under the new PHI capital framework. APRA understands the specific impacts on individual insurers may differ and expects that the quality of reporting will continue to improve over time.
Next steps
As communicated to the PHI industry in the 2022 APRA response paper2, non-SFIs that are on transitional arrangements must submit their ICAAP implementation plans to APRA by 1 July 2024. Non-SFIs' are encouraged to ensure their plans are succinct and focus on key timeframes, milestones, and responsibilities.
As part of APRA’s ongoing supervision of entities APRA may, from time to time, discuss the ICAAP implementation plan with senior management and the boards of insurers to understand progress.
APRA expects that industry practice will continue to improve across the areas identified in this letter as the implementation of the new prudential standards progresses.
Sean Carmody
Executive Director, Insurance Division
Australian Prudential Regulation Authority
Attachment A: Observations on selected PHI ICAAP Summary Statements
The observations are classified under five headings, “Integration and Coverage”, “Governance”, “Risk Management”, “Capital Management” and “Stress Testing & Scenario Analysis". These areas are inter-related in many aspects and should be considered as a whole.
Insurers should also refer to Prudential Practice Guide CPG 110 Internal Capital Adequacy Assessment Process and Supervisory Review (CPG 110) which sets out APRA‘s expectations regarding the development and implementation of insurers’ ICAAPs.
Integration and Coverage
Most Summary Statements were proportionate to the size and complexity of the insurer’s operations, although there were varying degrees of sophistication and maturity relative to the insurer’s business profile.
Some insurers have incorporated their Capital Management Plan (CMP) as a sub-section of their Summary Statement, while others have either maintained a standalone CMP or retired their CMP completely and replaced it with the Summary Statement. APRA does not expect insurers to continue to produce a CMP as it is superseded by the ICAAP.
Most Summary Statements mentioned key components such as the risk appetite statement (RAS), risk management framework (RMF) and risk management strategy (RMS), business plans and reporting, although the level of detail and quality of discussion on each varied markedly.
An area of observed weakness was a lack of explanation as to how these key components interact to aid the identification, and quantification of risks, capital targets, capital allocation and business decision-making.
All insurers conducted a self-assessment against Summary Statement requirements outlined in HPS 110, although some insurers appeared to be following a “box-checking” approach to meet the minimum requirements. APRA expects the capital management process documented in Summary Statements to be fully embedded into the day to day running of the business and actively used to support strategic decision making.
Better practice for consideration includes:
- Clear articulation on the linkages and interactions between the key components of an ICAAP in driving decisions on setting capital targets, capital allocation and business planning. The board should satisfy themselves that the process outline in the Summary Statements is being actively embedded in business planning process.
- While the Summary Statement may refer to other policies and procedures, the expectation outlined in CPG 110 is that it should be relatively self-contained.
Governance
Many Summary Statements lacked detail on the extent of board reporting and monitoring of the ICAAP.
Another weakness was a lack of explanation as to the roles of the board and management in the end-to-end ICAAP process, including how the board is engaged in the process of developing and finalising the ICAAP and the mechanisms for the board to provide and receive feedback on it.
Better practice for consideration includes:
- Clear articulation on how the board is actively engaged in the development of ICAAP from an early stage. Example includes the board’s involvement in developing and setting stresses or scenarios. The board should be satisfied that its chosen capital settings support its desired risk appetite and risk profile, such that the business remains adequately capitalised across a range of scenarios or stress events.
- Clear articulation of the board’s risk oversight on ICAAP implementation including the process for the board to receive and provide feedback
- Clear articulation of the board’s expectations regarding the content and frequency of relevant reporting.
Risk Management
Few insurers undertook a broad assessment of their risk environment, with most insurers limiting their focus to the risk areas included in the Prescribed Capital Amount (PCA) methodology.
APRA expects that insurers should review the material risks identified in their risk management framework (RMF) and assess the level of capital resources that may be required to address these risks and not solely rely on the regulatory capital requirements.
Better practice for consideration:
- Clear articulation of the links between the insurer’s risk profile, risk appetite and capital requirements, including an ability to demonstrate how all the identified material risks have been considered in the Summary Statement.
- Comprehensive analysis of risks, including a broader assessment of material risks other than those risks explicitly covered by the regulatory capital requirements that are specific to the insurer.
Capital Management
As the new capital requirements apply at both an insurer and a fund level, the ICAAP must consider the capital requirements for the insurer as a whole and for each of its health benefits funds (HBF) and the general fund (GF). In a majority of cases, the Summary Statements reviewed only considered capital requirements at an insurer level, with limited discussion on the capital requirements at individual fund level.
Many Summary Statements reviewed included a reference to capital targets but provided limited explanation of how this was linked to the insurer’s risk appetite and its trigger framework. While there is no prescribed approach in the prudential standards, APRA expects the Summary Statement to provide a high-level description of the insurers approach for setting its capital targets, with considerations given to the insurer’s capital needs and the board’s appetite for a potential breach of regulatory capital requirements.
Summary Statements must include specific actions to restore an insurer’s regulatory capital following a breach. In this regard some Summary Statements identified specific management actions, such as selling down assets or raising capital from external markets. However, in these cases, there was limited evidence of insurers assessing whether the then prevailing market or economic conditions might restrict the timing of these actions or the amount of capital that might be available for raising.
Better practice for consideration:
- The Summary Statement adequately discusses the capital requirements at the health benefits fund level as well as at an insurer level.
- Clear articulation of the process for setting capital targets, including an explanation of the linkages between the insurer’s capital targets, its risk appetite, and its trigger framework.
- Planned management actions clearly define who is accountable within the entity and the timeframes over which the management actions occur. The actions are assessed for timeliness and effectiveness under a range of economic and market conditions, noting that in a stressed environment, certain actions may not be available, take longer or may not generate as much capital as required.
Stress Testing and Scenario Analysis
APRA observed a range of approaches for stress testing and scenario analysis; however, the choice of stresses or scenarios were not always clearly articulated. While the Summary Statement is not expected to include all of the details relating to the process of determining the stress test and scenario testing parameters, it is expected to outline in sufficient detail as to why a particular stress or scenario was selected.
Better practice for consideration:
- Using more sophisticated forms of stress testing, such as reverse stress testing and scenario analysis using a range of scenarios.
- Scenarios used are sufficiently severe and plausible, reflecting the insurer’s risk profile. A high-level explanation on how the stress testing parameters and scenarios were selected.
- Clear articulation of the board’s engagement in the stress testing and scenario analysis process, including how the outcomes from these engagements are incorporated into business planning, risk management and capital management.
Attachment B: Observations on recent APRA returns
APRA’s review of the September and December 2023 quarterly data submissions indicated the transition to the new PHI capital framework has progressed well. The industry impact on capital, PCA and coverage ratios3 are closely aligned with the initial expectations set out in 2022 information paper4.
Overall, there was improved risk sensitivity, better comparability of the PCA across insurers and better alignment with APRA’s insurance capital framework in the reported results. However, APRA’s review also highlighted the need for insurers to continue improving data quality and accuracy as evidenced by the number of reporting errors.
Review of capital impact
The industry PCA coverage ratios remained strong at 2.5x and 2.6x respectively in September and December 2023. This was closely aligned with APRA’s expected industry coverage ratio of 2.5x outlined in the 2022 information paper. Key components:
- The September 2023 industry capital base reduced, compared to the June 2023 net accounting assets under the old capital framework, due to the exclusion of deferred tax assets, goodwill and intangibles. The deductions in the capital base were closely aligned with expectation when excluding movements due to acquisitions.
- The actual PCA impact was higher as projected in the 2022 information paper, driven by higher Future Exposure Risk Charge (FERC), partially offset by a lower increase in Asset Risk Charge (ARC).
APRA encourages insurers to consider the reasonableness of their planned management actions assumptions when determining the FERC under Prudential Standard HPS 115 Capital Adequacy: Insurance Risk Charge and evaluate them against the stresses or scenarios used in their ICAAPs. APRA recommends that insurers better document the choice of management actions following a robust consideration of their feasibility and impact in a range of situations as identified in Attachment A.
As insurers are finalising the implementation of their ICAAPs, APRA expects that capital target levels will be reviewed and refined further in the next two years as the transition period ends.
Deferred Claims Liability
Deferred claims liability (DCL) was an amount set up during COVID-19 to meet the potential liability of deferred treatments of policyholders due to lockdown restrictions. Under Prudential Standard HPS 115 Capital Adequacy: Insurance Risk Charge, insurers are required to include a DCL Risk Charge relating to the risk that the value of the DCL will be greater than the value determined in accordance withPrudential Standard HPS 340 Insurance Liability Valuation.
APRA observed a range of approaches by insurers when setting the DCL, with varying degrees of consideration given to accounting requirements under AASB17 and capital requirements. Insurers are reminded to consider the regulatory requirements under HPS 115 and HPS 340 and apply a DCL Risk Charge accordingly, for reserve set up, for the purposed described above.
Health Business Assets
The new PHI capital framework and associated reporting standards introduced a distinction between an insurer’s HBF and its GF through the inclusion of the definition of GF under Prudential Standard HPS 001 Definitions. The September 2023 reporting period was the first time APRA collected data on this basis. Part 3, Division 3 of the Private Health Insurance (Prudential Supervision) Act (the Act) describes the operation of the HBFs.
In particular, the Act requires that the assets of a not-for-profit insurer’s health benefits fund must be kept separate and distinct from all other assets of the insurer. For Insurers who have reported assets outside their HBF, APRA expects them to be able to demonstrate their approach in managing the business outside of the HBF, such as the origin of those assets and liabilities and what activities will reside outside the HBF going forward.
Reporting
APRA acknowledges the PHI industry has performed reasonably well to date in implementing the regulatory and reporting changes. Nonetheless, APRA’s review of the September and December 2023 quarterly data submissions has found various reporting issues. The most significant issue is the lack of consistency in the results reported across different reporting tables and reporting forms. The review also highlighted a lack of understanding on certain reporting items. Examples include individual reporting line items under CET1 with respect to paragraph 35 to 37 of Reporting Standard HRS 112 Capital Adequacy: Measurement of Capital and the application of the prescribed yields for each stress scenario under Prudential Standard HPS114 Capital Adequacy: Asset Risk Charge.
Insurers are required to strengthen the control and governance processes in place in producing these data submissions. APRA has issued Frequently Asked Questions (FAQs) to clarify requirements in the reporting standards. APRA will be engaging directly with individual insurers regarding their specific reporting errors but expects all insurers to ensure the accuracy of their data submissions.
Footnotes
1Information paper - The new Private Health Insurance Capital Framework (apra.gov.au), September 2022
2 Finalising the review of the Private Health Insurance Capital Framework - response paper (apra.gov.au), September 2022
3Coverage ratio is equals to the capital base divided by the PCR which includes any APRA approved regulatory adjustment.
4Information paper - The new Private Health Insurance Capital Framework (apra.gov.au), September 2022