A look through the rear view mirror and the road ahead

Ian Laughlan, Member - Financial Services Accountants Association, Leura

Are we there yet?

Before we answer that, let’s start with APRA’s role in helping an insurer on its journey.

In the first instance, APRA is intent on understanding you, your passengers, your car, the journey you are on and how you plan to get there. We want to ensure that:

• you have a clear destination and a map to get there
• your journey is consistent with what you have told your passengers
• your car has plenty of fuel and is well serviced
• your car has all the latest safety features to help you avoid having an accident; and other safety features to help protect you and your passengers if you actually have an accident
• you understand the risks in the journey and you have a plan to manage those risks
• you drive within your risk appetite and within the comfort zone of your passengers

We are also there to give you a nudge if you start falling asleep at the wheel. And though this is not our preferred approach, if necessary we will be like the Highway Patrol in holiday season – checking that you don’t exceed the speed limit or commit other offences, catching you if you do and exacting punishment. And in the extreme, we will appoint a new driver!

Today I want to give you an overview of both what we see through the rear view mirror and our perspective of the road ahead.

General Matters

Markets

First, some very brief comments on market conditions, as a backdrop to the rest of my talk.

Global share markets have improved considerably over the last year, and the general sentiment is much more positive. The growth has been partly due to the ongoing monetary easing in the US and more recently in Japan, and is despite continued uncertainty in Europe and ongoing fiscal issues in the US.

Some progress has been made in addressing the European debt crisis and stabilising sovereign interest rates, but great uncertainty remains. The Australian economy continues to be remarkably healthy by the standards of many advanced economies though government debt has generated much political heat and discussion. Record low interest rates have become embedded in many advanced economies, and this is causing quite a bit of stress for the insurance industry – particularly in life insurance - in the countries concerned. In Australia, interest rates have fallen to half-century lows. I will comment later on the implications of this for each of the general and life industries.

In summary, general conditions have improved somewhat over the last year. APRA, however, remains very vigilant and alert to potential problems emerging with the economy, at industry level or with individual insurers.

LAGIC

As you know, LAGIC was implemented on 1 January this year. So far it has gone quite well from our perspective. We appreciate though, that behind the scenes there has been a great deal of work by industry to get to this point!

The first quarterly returns have been submitted by insurers and this is another significant milestone. The March 2013 editions of the Quarterly Performance Statistics for both life and general insurance have just been released. These reports include the first set of significant data enhancements following recent consultation with the industry, with more enhancements to follow over the next twelve months.

No doubt as we review the actual LAGIC outcomes and we field more questions, some issues will emerge, but we are confident that overall the industry has coped well and done a good job of implementation to date.Our focus is now on monitoring insurers’ capital calculations and generally ensuring LAGIC is well bedded down. In particular, we want to ensure the quality of the LAGIC work is of a high standard.

ICAAP

ICAAP is a key component of LAGIC and for each insurer we are keenly interested in the quality of the ICAAP Summary Statement and how it is being used in the management of the business. We intend to review ICAAP Summary Statements in two phases. The first involves a high level analysis of gaps in the summary statements against the requirements of the relevant prudential standards - GPS110 and LPS110. This phase has been completed and I will share some of the results with you shortly.

The second phase will involve a detailed assessment of the individual ICAAP Summary Statements, with feedback to insurers and where necessary requests for amendments. Not every insurer will be included in this phase, but all will be reviewed in due course. We then will focus on the use of the ICAAP in the management of the business. The annual ICAAP Report from each insurer will play a critical role in this process. Our assessments of the reports will be done in the normal course of supervision, and feedback will be provided to each insurer as required.

Let me now talk to the results of phase one of our analysis. In this work, we identified for review seventeen areas in the prudential standards and guidance. The last three items are covered by guidance in CPG110, rather than in a prudential standard. The ICAAP summary statements were assessed in each area.

Here is a heat map showing a typical subset of insurers:

• Green indicates adequate coverage.
• Orange indicates the matter was mentioned but coverage was inadequate.
• Red indicates no mention at all.

Overall, the summary statements were completed reasonably well, in the sense that by and large they addressed the required matters. However, there were instances of items being completely omitted. In a number of other cases they were addressed inadequately.

Often, even though an adequate standard was reached, the insurer’s supervisor considered that there was significant room for improvement. These cases will be addressed in the upcoming benchmarking process in phase 2 of our review, when we will identify and encourage better practice.

The overall picture was similar for life insurers, friendly societies and general insurers. Insurer size did not seem to necessarily be an indicator of better quality. Many smaller insurers rated better than some of the larger ones. Indeed, some large insurers were not well rated. Two areas that were often poorly addressed were Independent Review and Stress Testing. In both cases, there were instances when they were noted, but not much else. The summary statements would have benefited from some discussion of who would undertake the independent review, how frequently it would be done and whether it would be done as one review or completed in parts.

The Stress Testing commentary often should have had more fulsome discussion of what the board sought from stress testing. For example, which factors would be stressed, and what scenarios would be considered, particularly in terms of the major risks to the entity.

The areas of Risk Appetite, Risk Assessment and Internal Controls also were not well addressed in many cases. Reference was often made to risk appetite statements and risk management frameworks, but the discussion was limited - particularly about how the risks impacted capital and how capital would then be managed. Developing this linkage between risk appetite and risk management on the one hand and capital on the other is a fertile area for the development of better practice.

Pillar 2 Experience

Under Pillar 2, APRA may increase the prescribed capital determined under Pillar 1 if we are of the view that this amount does not adequately account for all of the insurer’s risks. Such an adjustment may increase the total required capital amount and/or strengthen the composition of the insurer’s capital base (i.e. the insurer may have to hold an increased proportion of higher quality capital).

Together, Pillar 1 and Pillar 2 make up the Prudential Capital Requirement, or PCR.

APRA considered whether or not Pillar 2 adjustments should apply in dealing with the transition to the LAGIC capital requirements. Prior to LAGIC’s finalisation, there was some concern expressed by various insurers that APRA would impose unexpected Pillar 2 adjustments to their capital requirements. Because of the risk-sensitive nature of LAGIC and its fairly comprehensive coverage of risk types, we did not expect many insurers would need a Pillar 2 adjustment.

Indeed, as it turned out there were only a fairly small number of Pillar 2 adjustments – primarily for general insurers. Most of these adjustments reflected a continuation of higher capital requirements that pre-dated LAGIC. The adjustments actually made reflected a broad range of circumstances specific to the insurers concerned. So Pillar 2 adjustments are not common at present. Note, though, that APRA will readily impose them in future whenever warranted.

Transition of capital instruments

A small number of capital instruments that did not meet the LAGIC requirements for capital were granted transitional credit. The conditions granted varied according to the particular circumstances of the insurer.

Other transition arrangements

APRA also granted transitional relief from the full impact of the LAGIC capital changes for a small number of insurers that were particularly impacted.

Pillar 3

Pillar 3 is about market discipline resulting from publically available information – such as regulatory capital strength. Current Pillar 3 practices for insurers in Australia are somewhat behind best international practice.

Recently, partly in recognition of this, APRA proposed making all of the data we collect from insurers under Financial Sector (Collection of Data) Act to be non-confidential. APRA will decide which insurance data submitted to APRA is to be determined non-confidential in the third quarter of 2013. Our decision will take into account industry submissions, supervisors’ views and our assessment of the public benefit of making the data non-confidential. Rest assured we will take a cautious and considered approach in our deliberations.

In the meantime, we will continue to apply protection measures to ensure that confidential information relating to an individual insurer cannot be derived from APRA’s published statistics.

We also will be giving consideration to other information that should be disclosed under Pillar 3. For example, risk governance arrangements (such as board and management committees and the processes they follow), details of capital instruments, remuneration arrangements and so on.[1] We have already flagged our intention to publish more information about the financial strength of individual statutory funds for life insurers.

Capital raising experience

LAGIC introduced new requirements for the quality of capital[2], including the concepts of Common Equity Tier 1 (CET1), Alternative Tier 1 (AT1) and Tier 2 (T2). AT1 and T2 instruments must have a provision for conversion to CET1 at the point of non-viability of the company.

To date there has been limited experience with capital issues by insurers under the LAGIC provisions. However, several listed ADIs and the Suncorp NOHC (which is authorised under the general insurance standards) have been successful in issuing AT1 instruments which included non-viability provisions. More recently Suncorp issued a Tier 2 instrument with non-viability provisions. This experience suggests that the market will be receptive to issues by insurers of LAGIC-compliant AT1 and T2 instruments.

Accounting Matters

Insurance remains one of the areas still being considered by the IASB and FASB in their work on convergence of accounting standards. Progress is being made but the final version of the insurance contracts standard will not come into force until 1 January 2018 at the earliest. The IASB is looking to consult on refinements to the Insurance Contracts standards in the second half of 2013.

Overall, the refinements seem to be headed in the right direction for Australian insurers.

Audit Quality

Audit quality has been receiving considerable attention in recent times both internationally and domestically.

For example, the International Auditing and Assurance Standards Board (IAASB) issued a consultative paper that proposed a Framework for audit quality in January 2013. The IAASB Framework looks to raise awareness of the key elements of audit quality, encourages key stakeholders to explore ways to improve audit quality, and looks to facilitate greater dialogue on this topic. Audit quality is also one of the many issues on the Financial Stability Board’s agenda.

In Australia, ASIC’s Audit Inspection Findings for 2011-2012[3] showed there had been a decline in audit quality. ASIC identified three areas needing improvement:

• the sufficiency and appropriateness of audit evidence obtained by the auditor;
• the level of professional scepticism exercised by auditors; and
• the extent of reliance that can be placed on the work of other auditors and experts.

APRA has a keen interest in audit quality, not least because information from audited financial statements is used for determining the regulatory capital position of an insurer and returns to APRA are subject to audit. Discussions with auditors can also be valuable to APRA in its supervision work. Audit quality has also drawn the attention of the Financial Reporting Council, and it has formed a committee (on which APRA is represented) to consider the matter.

Governance and Risk Management

APRA is continuing its work on risk appetite. Both the understanding by boards and management of the importance of a clearly articulated risk appetite and the quality of risk appetite statements have improved markedly in recent years. We will continue to monitor progress here and increasingly focus on how risk appetite is embedded in management and board decisions In due course we will issue more guidance. In the meantime, insurers should continue to give close attention to risk appetite.

Importantly, we are also giving much more attention to risk governance and risk culture. Our thinking and intended supervisory approach to these issues is explained in some detail in two recent speeches by APRA’s chairman, John Laker[4] and by me[5]. I urge you to read these speeches carefully.

APRA recently issued for consultation proposals for a new cross-industry risk management prudential standard, CPS 220. This is generally consistent with the existing insurance standards, but introduces two significant new requirements: a board risk committee and a chief risk officer with unfettered access to the risk committee/board.[6]

To help new (and current) board members, we intend to develop an ‘information pamphlet’. This will give a concise and plain-English view of what APRA expects of board members in their oversight of prudential matters. The initial phase of this work involves a stock-take of our existing requirements for boards to assess whether they are consistent across industries and whether there are any that are unreasonable or cumbersome.

Level 3

Level 3 is about the supervision of conglomerate groups, and so applies to a relatively small number of insurers. In December, we released draft prudential standards on group governance and risk exposures. More recently, we issued proposals on capital adequacy.[7] The new requirements are expected to take effect from 1 January 2014.

APRA’s Powers

In December last year Treasury issued a discussion paper seeking stakeholder views on a range of options directed primarily at strengthening Australia's framework for financial regulation. In particular, this includes strengthening APRA's crisis management powers. This will help align Australia's regulatory regime with international best practice following the GFC. Given Government priorities, this work is unlikely to proceed before 2014.

International Developments

APRA has previously discussed various initiatives of the International Association of Insurance Supervisors (IAIS) and the Financial Stability Board (FSB). I will now give a very brief update on the more important of these.

ComFrame

ComFrame is a common framework for the supervision of internationally active insurance groups (or IAIGs for short) – that is, those that operate in more than one jurisdiction. The intention with ComFrame is that there is a consistent and co-operative approach to the regulation of insurers that operate internationally.

ComFrame was initiated in 2010 and consultation, development and field testing will take us through to 2018. IAIS Members then will implement it in their respective jurisdictions. Progress at the IAIS on ComFrame has been slower than planned. It remains a controversial project amongst both industry members and supervisors, and it continues to undergo quite intense development.

Australia probably will have very few formal IAIGs. In any event, ComFrame as currently envisaged is quite consistent with APRA’s established requirements for groups, and so it is unlikely to drive major change in Australia.

FSB

The Financial Stability Board’s importance has increased dramatically post the GFC. We are affected by the FSB, through its influence on the Basel Committee and the IAIS. As its name would suggest the FSB is focused on financial stability, which in turn leads to a focus on systemically important financial institutions – SIFIs. The FSB’s initial focus was on global systemically important banks – or G-SIBs. It has since turned its attention to

• Domestic systemically important banks - D-SIBs, and
• Global systemically important insurers – G-SIIs

A huge amount of work has been done at the IAIS on the assessment of the global systemic importance of insurers and on measures that would then be applied to those designated G-SIIs. Again, this is proving to be controversial work, but much progress has been made and the major issues are expected to be finalised in coming months. There will be no Australian G-SIIs.

In due course the FSB will turn its attention to D-SIIs, and this is when it will become interesting for Australia’s insurers. In any event, APRA intends to closely consider the merits for formal recovery and resolution plans for insurers, as proposed for SIFIs. This slide helps explain how these plans and ICAAP complement each other.

FSAP

Last year, Australia was subject to the five-yearly Financial Sector Assessment Program conducted by the IMF and World Bank.

As part of this process, Australia (not just APRA) was assessed against the IAIS Insurance Core Principles (ICPs) - which had just been revised and upgraded.

The assessment was positive, but there are improvements we could make to meet the ICPs in full – for example with disclosure requirements (see earlier comments on Pillar 3).

General insurance

Let’s now consider the general insurance industry specifically.

Capital Coverage

The general insurance industry has had a financially sound last 12 months or so.

It ended 2012 with a healthy coverage of 1.83 times APRA’s minimum capital requirement (MCR). This was supported by strong earnings.

The March quarterly report just released shows that both capital and prescribed capital amount have fallen under the LAGIC capital framework that came into effect on 1 January this year. However, under LAGIC the capital coverage ratio of the industry has remained steady at 1.82 times the new prescribed capital amount. Of course, this is after any management actions taken as a result of LAGIC.

Interest rates

General insurers continue to invest predominantly in highly-rated interest-bearing securities. However, insurers may decide to increase their appetite for investment risk in response to current low interest rates. More broadly, a low yield environment puts pressure on insurers’ pricing. It can also adversely impact reserving adequacy and operational risk profiles because of actions taken to compensate for any loss of interest. APRA will monitor this closely. Over coming months, a group of insurers will be the subject of a specific assessment of the governance and management of the risks which may emerge in this environment.

Underwriting

The underwriting performance of the short tail property classes improved significantly in 2012 due to a combination of premium increases and relatively benign weather conditions. However the performance of the long tail classes was mixed. Competitive pressure continues to result in limited premium increases in some classes. Risks to long tail claims costs are also evident.

Some insurers responded to the natural catastrophe events of 2010 and 2011 by reducing capacity in geographical areas of high natural peril risk.

Another important change has seen the inclusion of riverine flood cover in many home and contents insurance policies. This has brought with it increased underwriting and pricing risk particularly for small and medium-sized insurers. Reputational and potential political risk is still evident in this area, with affordability of some property insurance premiums becoming a prominent issue in areas such as north Queensland.

Signs of a firming in the housing market continued in early 2013. However the unemployment rate trended higher and should this continue it may result in higher claims for lenders’ mortgage insurers (LMIs). A Moody’s stress test in 2012 suggested that the LMIs’ capital levels would be challenged in the event of an unexpectedly severe economic downturn, and this resulted in rating downgrades for Genworth, QBE LMI and Westpac LMI.

Management and controls in insurers’ pricing processes continue to be a key issue identified in APRA insurance risk reviews. Underwriting and claims management controls improved somewhat among insurers reviewed closely by APRA in 2012 compared to those in 2011.

As mentioned earlier, the weak economic conditions in Europe and Euro zone sovereign debt concerns continue to be a risk. In this context, a number of the global insurance and reinsurance groups with a presence in Australia have significant operations in Europe, and so we will monitor this situation closely.

Reinsurance

The standard of governance and risk management catastrophe reinsurance arrangements remains an important focus for APRA. This includes the use of scenario testing and catastrophe models, recognition of the limitations of those models, management of data quality, the role of brokers and so on. A recent APRA review found increasing board engagement in this area but significant improvement is needed by many insurers. We would like to see the appointed actuary’s financial condition report address this issue in some detail.

Reinsurance counterparties generally continue to be highly rated. However the amount of reinsurance recoverables reaching their second balance date anniversary after the relevant event increased in 2012. This attracted a higher risk charge for the impacted insurers and reinsurers. These recoverables relate to 2011 and earlier catastrophe events.

APRA is proposing to implement a regular reinsurance counterparty data collection. The data collection will enable APRA to assess the impact of a reinsurer downgrade or failure on the prescribed capital amount, capital base and hence capital coverage, for individual insurers and the general insurance industry.

In 2012 APRA saw further developments in reinsurance capacity provided by the capital markets and possible alternatives to traditional reinsurance. APRA will monitor developments in this market and their suitability for prudential purposes.

As you know, the horizontal component of the Insurance Concentration Risk Charge (ICRC) was deferred until 1 January 2014, to give insurers and reinsurers time to determine and implement a strategy and to obtain appropriate reinsurance or raise additional capital. APRA expects insurers to now have a clear strategy in place, and we expect to see details in upcoming ICAAP reports.

We will make further comment on catastrophe reinsurance in coming months.

Internal models

An internal model for capital requirements under LAGIC has been approved for one major insurer and others are working on models with a view to also gaining APRA approval.

Life insurance

Let’s turn now to life insurance.

Capital Coverage

The March Quarterly report for life insurance among other things showed that after the introduction of LAGIC and the quarter’s experience, the overall surplus of the life industry has not changed greatly from the position at December 2012. Of course, the March position allows for the quarter’s experience and any management actions taken in response to LAGIC.

Interest rates

Low interest rates will have some impact on life insurance product pricing and reserving. This should be quite manageable given the nature of most life business in Australia, but will require close attention. As for general insurance, we will be alert to any deliberate shift in appetite for investment risk to compensate for the low rates.

Claims experience

In recent years we have challenged the industry and individual insurers about the management of disability business and group life insurance in particular. We have also noted concerns about individual term life business, where there was some evidence of deteriorating mortality experience.

A year or two ago, for group life business we were seeing a very competitive market, evident in pricing, underwriting and operational practices. Pricing was often based on poor data and there sometimes were technical and governance issues. And there was evidence of an inadequate skill base (e.g. claims management) to cope with industry growth.

We made it very clear to industry that significant improvement was needed. At that time there were some signs of poor claims experience emerging – and that has now become more evident as you will see. Since then, prudential standard SPS 250 has introduced requirements for trustees to maintain appropriate data for insurance purposes and to give due consideration to claims philosophy when selecting an insurer.

We also were seeing worsening morbidity experience, for both group and individual business.

We were unclear on the underlying reasons for this. Was it poor or liberal underwriting or perhaps poor claims management? On the other hand it could have been the impact of constant addition of product features at little or no cost.

So what are we now seeing?

This shows the declining results for group life business and the poor profitability of disability business, both individual and group. These are aggregate industry figures. The picture for some companies is much worse than shown here. For others the results are quite good. So we need to be careful – the problems are not endemic.

As a result of the poor group claims experience, there have been some very significant increases in premium rates for large superannuation funds in recent times - of the order of 25% to 40% in a number of cases.

This is a direct reflection of poor past pricing and governance practices, and recognition that the premium rates were just not sustainable. It also gives a clear sign that better practices are now being followed by some insurers - with stronger governance, more robust experience analysis, justification of assumptions etc. So the industry is starting to address its shortcomings in the management of group business. Unfortunately, superannuation members bear the brunt of the mispricing that occurred in the past.

Mortality experience for retail business, as best we can judge, has shown no further signs of deterioration. However, we urge insurers to continue to closely monitor experience and analyse any adverse trends.

Lapse experience

Recent lapse experience has been poor for a number of companies. Various comments on this have been made in market updates and in industry publications.

This recent article captures the sentiment nicely:

No doubt there are various forces at work here, including product competition, the economy and activities of advisers. The question is whether this experience is a short term blip or a more fundamental change. We urge all companies to monitor the position closely and seek to understand the reasons for their experience, and from this form a robust view on likely long term experience.

Finally, a quick comment on lapse experience for directly marketed business. As previously noted, this business has high lapse rates in the early policy years, and we have expressed concerns about the reputational implications of this. In the normal course of events, these high lapse rates are allowed for in pricing. The risk is that actual experience is worse than anticipated and profit is depressed. We have seen some evidence that this is occurring, so we will monitor this experience closely.

Old Book Experience

We have mentioned this at various industry seminars but it bears repeating. Sometimes when we discuss claims experience with an insurer (particularly disability experience), we are given an argument that the problem is due to the "old book". That is, policies written in years gone by are exhibiting much poorer profitability than business written recently. Management (often quite genuinely) hides behind this argument, and is able to rationalise the position to itself and the board.

This is a real concern for APRA, because it can indicate a poor understanding of the dynamics of a book of business over time. The point is that one would expect any book of business to exhibit worsening claims experience over time because of the selection effect of lapses. That is, healthy people are more likely to lapse and unhealthy people are inclined to retain their cover. This is particularly true when premium rates which are stepped by age and CPI increases combine to deliver a substantial year on year increase. Inevitably those forces flow through as worsening claims experience.

Now that phenomenon should be well recognised and addressed in claims reserving over a policy’s life so that (all other things being equal) excessive profit is not declared in the early years at the expense of lower profit or losses in later years.

A recent actuarial paper addresses this issue.[8]

Statutory Funds

The statutory fund concept was developed many years ago. Since then investment instruments have changed greatly, products are very different to what they once were, and administration practices have become highly mechanised. APRA is embarking on a small exercise to assess the way statutory funds are managed in practice to ensure they will work as intended, particularly under severe stress. We will be writing to CEOs about this shortly.

Director Responsibilities to Policyholders

The Life Insurance Act and the Insurance Act make it clear that directors have responsibility for protection of policyholder interests. The Life Insurance Act goes further and makes it clear under Section 48 that a director of a life company

"... in the event of conflict ... gives priority to the interests of owners and prospective owners of those policies over the interests of shareholders."

In the interests of good governance, boards should consider recognising the responsibilities directors have with respect to policyholder interests, with appropriate comment and publication of director names on their websites.

So are we there yet? Clearly not, but much progress has been made.

In reality of course, we will never get there. The world will continue to change and issues and events will arise that will cause stress to insurers or the industry as a whole. Many of these will be within the bounds of expectations while some will come out of the blue.

APRA will adapt and wherever possible stay ahead of developments. We will learn from what we see in the rear view mirror and will be very vigilant in scanning the road ahead, anticipating as best we can potential problems and issues. We will continually seek to lift industry standards.

We urge you to do the same.

Footnotes

1. For example, refer to APRA’s recent consultation on this subject in respect to banks 
2. Prudential standards LPS 112 and GPS 112
3. http://www.asic.gov.au/asic/asic.nsf/byheadline/12-301MR+ASICs+audit+inspection+findings+for+2011-12
4. Laker, J. The Importance of Good Governance, Australian British Chamber of Commerce, 27 February 2013
5. Laughlin, I. Stay ahead of the risk: Risk governance and risk culture, Institute of Actuaries of Australia, 20 May 2013
6. Supervision of conglomerate groups (Level 3) May 2013
7. Harmonising cross-industry risk management requirements May 2013
8. Gilling, M., Anti-Selective Lapse Effects in YRT Business, Actuaries Summit 20-21 May 2013