A regulator's perspective: What lies ahead

John Trowbridge, Executive Member - IFSA Annual Life Insurance Conference

Thank you for the opportunity to speak at this first annual IFSA Life Insurance Industry conference. IFSA should be congratulated for establishing this conference and for strengthening of the voice of the life insurance industry within IFSA, a voice that has been swamped for some time by the superannuation and funds management representation within IFSA.

Today I will begin by reviewing some industry history before looking at several contemporary issues. I will then take you through APRA's current regulatory agenda, make some observations on international developments and conclude with some comments on the interaction between APRA and IFSA.

The life insurance industry has transformed itself more than once in the last 30 years and may well do so again in the next decade or two. There are several reasons for this, but let us look firstly at what has happened in the last 30 years -

• In 1980, the industry was dominated by mutuals and by traditional agents selling regular premium business, but traditional endowment and whole of life policies were giving way to investment linked business. The independent funds management industry barely existed and the life insurance industry dominated the non-banking part of the financial sector.
• In 1990, the industry was still dominated by mutuals but the major banks had entered the industry, regular premium business was in decline, risk only business was emerging more strongly and, following introduction of the award superannuation in 1983, investment linked superannuation was a growth business.
• In 2000, there were no remaining traditional mutuals and virtually no endowment and whole of life insurance products being sold. Life insurance agents were transforming themselves into financial planners and the industry was increasingly dominated by investment linked superannuation and risk only products.
• In 2010, the business of the industry is not very different from 2000 but its risk only business has grown strongly in that decade, its share of superannuation business has progressively declined and the industry has undergone considerable consolidation –
  • Twenty years ago there were 54 direct writing life companies and 6 reinsurers. Today that number is 26 direct writing companies of which 2 are inactive, and 5 active reinsurers. A number of the direct life companies are within financial groups with multiple life licences which will be rationalised over time. In reality there are now only 18 direct life insurance groups.
  • The life industry‟s share of superannuation assets has reduced from 33% ten years ago to 15% today
  • Banking groups now own 58% of life insurance assets compared with under 10% twenty years ago.

While risk insurance premium growth has been strong in recent years, today more than one third of all risk insurance premiums are sourced through group risk schemes provided by superannuation funds, often as part of a default life insurance offering.

The demutualisations of the 1990s came about for a range of reasons related to the changing structure of financial services in Australia at the time. And with demutualisation came a new accountability. Life insurers actually appointed CFOs who sat at the executive table alongside the chief actuaries. Boards and CEOs experimented with various product, distribution and investment ideas. At the same time, specialist funds management businesses were emerging, fed by two kinds of tax arrangements that were and still are favourable to unit trust vehicles -

1. For non-superannuation savings and investment, life companies pay tax on the "inside build-up", i.e. on investment income. Therefore they give the holders of investment policies an after tax return, whereas in unit trusts (or managed investment schemes), returns are paid gross of tax and it is the responsibility of the investor to meet any tax obligations.
   • History shows us that the latter, i.e. tax being the responsibility of the investor instead of the investment institution, is generally more attractive to consumers.
   • It is notable also that life companies had higher expense rates than the new breed of specialist fund managers and opaque investment strategies, two features that gave the new fund managers a competitive advantage over the life companies.
2. For superannuation savings and investment, life companies had been the only vehicle generally available to employers and employees but the newcomers to the funds management industry could now offer the same products and services without needing to do so via a registered life insurance company.

In summary, the existence of superannuation portfolios and investment linked savings portfolios in life insurance companies today is a reflection of the industry's history up to the 1990s.

Superannuation assets held in and outside life companies

It is hardly surprising therefore that the market share of superannuation savings that are held in registered life companies has been steadily declining ever since.

On the other hand, the more that superannuation has grown under the SGC regime, the more has attention been given to life risk insurance.

Penetration of life risk protection into the Australian community has always been low and no single company or group of companies in the industry has found a way of unlocking the potential for substantially greater penetration. Nevertheless the offering of automatic life cover in the last few years by many superannuation funds, particularly those of the life companies and industry funds, has been a catalyst for high growth rates in the industry for both group life and individual life cover.

Premium history 2004-2009

Annual premium revenue for risk business has grown from about $4.5bn in 2004 to $7.7bn in 2009, a growth rate of 10% pa.

This is a healthy development and represents a vital service to the community, particularly in the pre-retirement phase when individuals and families need death and disability income protection. But there are two emerging pressure points –

1. The group life schemes of some industry funds are becoming so large as to threaten indigestion for those life companies interested in writing the business, and in all likelihood will continue to grow larger. Let us hope that the industry funds and the life companies between them can negotiate a workable future for this kind of business.
2. There is a growing community need for post-retirement products. This need is influenced by three main factors –
   • demography, or the ageing of the population, in the form of growing numbers of people reaching retirement age and the longevity of the retired population continuing to increase
   • the progressive maturing of defined contribution superannuation alongside the continuing decline in corporate pension schemes and other defined benefit schemes
   • the shock of the global financial crisis, especially to retirees whose wealth has been diminished and for whom some form of annuity product would probably be beneficial.

The Henry review, in its interim report last year, signalled this as a major issue and the intergenerational review continues to signal the importance of adequacy of retirement incomes.

The current superannuation focus on individualising risk with each individual carrying the risks of investment, inflation and longevity will require some re-thinking if appropriate longevity protection is to be provided. While the concept of mutuality and pooling of risk seems to have receded from view, it may need to be reintroduced in the future.

The recent introduction of variable annuity products into the Australian market is an interesting development but these products are complex to manage and also difficult for the individual to understand as to the level of risk protection being provided and the price of the protection. The life insurance industry has had a history of complexity in product design and needs to be careful not to reintroduce that level of complexity into post-retirement products.

Industry structure and evolution

Regarding the industry structure and its evolution, we can ask three questions -

• firstly, why has the industry developed the way it has?
• secondly, where will the industry go?
• thirdly, where will APRA go?

1. Why has the industry developed the way it has?

If we think of the industry's evolution in terms of the nature of its products and services and their popularity or their penetration into the Australian community, then the answer to the question is one that I have already hinted at. It is tax.

The history of the life insurance industry around the world, its successes, influence, scale etc have reflected the tax environment. Tax arrangements tend to drive the product offerings and the structure of the life industry. The nature of tax rules on premiums and investment income, or on the treatment of investment products and annuities are some examples.

In Australia, tax was very favourable for the industry until the 1970s when the Whitlam government eliminated tax deductions on premiums. Subsequent tax rules and tax changes have been either neutral or unfavourable to the life insurance industry. I have already explained how the unit trust industry benefits in effect from the way that life insurance companies are taxed on investment products.

2. Where will the industry go?

If there is no change in tax arrangements and no change in the industry's general approach to its business, we can expect an extrapolation of the last decade –

• risk business will tend to develop at a good pace, for both individual and group contracts,
• superannuation business will continue and may grow but is likely to continue to decline relative to the superannuation industry as a whole, and
• non-superannuation investment products and traditional endowment and whole of life business will continue to run off.

And what could happen if there were tax changes?

As an example, if investment products sold by life companies were to be taxed in the same way as unit trusts, so that it is the policyholder or investor rather than the life company who is responsible for tax, we might expect a rebuilding of non-superannuation savings and investment portfolios through life companies. We might then also see product innovation such as universal life constructed around various ways of bundling risk cover and investment products together.

And there might even be a community benefit to such change. If life companies were able to offer investment products competitively, policyholders would of course be dealing with institutions that are subject to APRA's prudential supervision, with no changes required to APRA or ASIC regulations. Unit trust investors, debenture holders etc do not have that kind of protection.

Another example is annuity products. If, as a result of the Henry tax review or otherwise, the government saw fit to encourage annuities, changes to tax or perhaps other rules for the post retirement phase of superannuation could lead to the industry offering products with a valuable community or social purpose at prices which are attractive to potential policyholders.

3. Where will APRA go?

Before going to this question, let me first tell you where APRA has been.

The changes of the 80s and 90s led to a revision of life insurance regulation which had become outdated. The Life Insurance Act 1995 was a major change. It included establishing the LIASB, introducing margin on services accounting and introducing the dual financial soundness regime of solvency and capital adequacy.

The LIASB was disbanded at the end of 2008 and the responsibility for LI Capital was moved directly to APRA, in line with the other industries.

APRA was established on 1 July 1998 and inherited the current solvency regime under the 1995 Life Insurance Act. Since then it has undertaken many regulatory and supervisory initiatives in life insurance, banking, superannuation and general insurance. For example, APRA has introduced -

• risk management requirements, including the preparation of a documented risk management plan, business plan and financial projections.
• governance requirements, especially around board composition and board responsibility.
• outsourcing, business continuity and now remuneration.
• new reporting standards, introduced in 2008, to reflect the changed nature of the industry.

And most importantly, especially in light of the GFC, it was building the capabilities and the modus operandi of its supervisory teams - but more of this later.

But first, let us have a look at the events of the last two years.

The Global Financial Crisis

It is worth commenting on the way the Australian life industry managed through the severe asset downturn of the last two years. Clearly, one of the largest threats to the life industry is the degree of asset/liability mismatch risk that it carries and the exposure to deterioration in capital that can occur during periods of extreme asset price volatility.

APRA's view at the beginning of the GFC was that the Australian life insurance industry was well capitalised and more able structurally to withstand falls in asset prices than it had been in the past. Companies had been de-risking their investment portfolios for non-linked business and were also holding resilience reserves to cover substantial economic shocks. While this was true on an industry wide basis, it was also true that some individual life companies would be more exposed than others to the risk of a downturn.

Over the last two years APRA has increased its intensity of supervision of the industry. Remember that the stock market peaked in October 2007 and its subsequent decline through 2008 to its nadir in March 2009 marks the toughest period in the financial sector in living memory. To relieve pressure the government stabilised our banking system and the economy by introducing in October 2008 the wholesale funding and large deposit guarantee. This kind of action was unprecedented.

During this period, APRA worked closely with the industry to ensure that all companies were responding appropriately to the crisis. This included two stress tests of increasing formality and depth, the first in May 2008 and the second at the end of 2008.

APRA was very pleased with the response from the life insurance industry, in terms of the steps taken by companies to protect their viability. As a result the industry has come through the GFC in good shape, albeit in some cases at quite some cost to shareholders.

And that brings us to where we were this time last year, when the last stress test had been completed but the stock market was still falling and governments around the world were announcing and introducing very substantial stimulus packages.

Cast your mind back, for it is easy to forget. No one knew how bad it would become before getting better, and stories of corporate meltdowns and personal financial disasters were hitting the press every day.

The good news is that almost everything today, in the economy and in financial markets, is better than a year ago and considerably better than many people expected. Confidence has returned, employment and investment markets seem to be stable and we are again able to talk of economic growth. We remain cautious of course, but so far so good.

APRA's current regulatory agenda

The overall APRA agenda is now substantial, partly due to the aftermath of the GFC. The G20 and the Financial Stability Board have extended our agenda but you will be pleased to hear that most of the extensions relate to banking. The main issues for these institutions revolve around capital and liquidity.

In life insurance, two important recent projects are now behind us, namely the problem of unit pricing errors that had besieged the industry and resulted in the Unit Pricing Good Practice Guide, initially produced by APRA and ASIC in 2005, and revised financial reporting to which I have already referred.

We currently have three projects under way that affect the industry, which are:

• Group Supervision
• Capital review
• Remuneration.

There are also two other important projects that are on our radar screen but that are not controlled by APRA. They are product rationalisation and experience studies.

1. Group supervision

The primary purpose of group supervision is to take account of the contagion risk that can exist across the different entities within group structures.

Group supervision of life insurers by APRA has only recently become possible because legislation enabling the registration of life insurance NOHCs passed through the Parliament last year.

From a broader perspective, APRA is intending to issue a consultation paper on the supervision of conglomerate groups very soon, possibly this month. This consultation paper will consider the extension of capital, governance and risk management standards to such groups and will seek to take account of both regulated and unregulated entities in the group.

I'll refer to this topic again when we come to international developments.

2. Capital review

APRA is presently conducting a review of the general insurance and life insurance capital standards. The objectives are to:

• improve the risk-sensitivity and appropriateness of the standards;
• improve the alignment of the standards between industries; and
• consider the standards in light of international developments.

APRA is intending to adjust the current standards in the light of experience to date with the existing standards. Nonetheless, this is a significant project.

The proposals will include modest changes to the capital adequacy framework for general insurers but will be more substantial for life insurers. The most important is a conceptual change from the current dual solvency and capital adequacy regime to a single assessment of liabilities and an associated identification of the capital base of a life insurer, as depicted below.

At present there is no concept of a capital base, which leads to a range of difficulties such as complexity for management, boards and observers of the industry, and also lack of comparability with banks, general insurers and also foreign life insurers. This change will be a valuable simplification and will enable, among other things, group supervision to be carried out for life insurers in like manner to banks and general insurers.

It is intended that the new capital prudential standards will be implemented in 2012.

A discussion paper will be released shortly, probably in April. APRA will then initiate a quantitative impact study toward the middle of this year that all insurers will be encouraged to undertake.

3. Remuneration

Last November, APRA finalised its position on the prudential requirements for remuneration. Extensions to the governance standard (LPS 510) and a prudential practice guide (PPG 511) were published.

The industry broadly supported APRA‟s approach, accepting that poorly structured remuneration practices may result in excessive risk-taking by individuals and undermine the risk management systems of prudentially regulated institutions.

The revised governance standard comes into effect on 1 April 2010. By this date, APRA requires that the Board Remuneration Committee, with appropriate composition and charter, be established and a suitable Remuneration Policy be in place.

Please note that any licensed insurer that has difficulty in fully meeting the requirements needs to advise APRA before 1 April 2010 if transitional arrangements need to be considered.

These are the three items on APRA's agenda that affect life insurers. Then we have –

4. Product rationalisation

Product rationalisation remains an area of concern from APRA's perspective because of the potential operational risk. It is hoped that a regulatory regime for allowing life insurance product rationalisation will emerge in the near future on the basis of the discussion paper recently released by the Minister.

5. Experience studies

The lack of current industry mortality and morbidity analysis has been a concern of APRA for some time. So APRA was delighted to see IFSA initiate a mortality study two years ago and to gain the full support of the industry to do so. The success of the current project is gratifying and we can only continue to encourage IFSA and the life companies to continue to support this work.

The international scene - financial stability, regulation and insurance

Ever since the visibility of the sub-prime crisis in the US and the failures of Bear Stearns and Lehman Bros in 2008, there has been widespread concern about financial stability. It has been accompanied by enormous interest in the causes of the instability and initiatives that might be taken to protect the financial system and prevent future instability.

The G20 leaders have driven their governments and regulators to look closely at what can be done and the Financial Stability Board has emerged as a kind of international overseer of the progress of the financial stability agenda of governments and regulators around the world.

The most significant financial stability issues are in the banking sector. They relate not only to credit quality or quality of lending but also to systemic risk and the ability of individual banks to keep operating if one or more other banks in the system cease to operate. The attention has been on capital and liquidity, supported by considerable efforts to work out how to avoid pro-cyclical behaviour where one or more institutions in trouble can effectively bring down the whole financial system and thereby cause great damage to the economy.

There are also some important financial stability issues that the insurance sector needs to consider. The IAIS, in which APRA participates actively and on whose executive committee I represent APRA, has established a Financial Stability Task Force and has been exploring the insurance related aspects of financial stability.

Initial thinking was about insurance interactions with the GFC but that would be a narrow view. If one thing is certain, it is that the next financial crisis will be different from the last. The lessons for the insurance industry and its regulators from the GFC are still being examined but there are some important examples of how insurers can be systemically relevant. Three such examples are –

• In 2002 in the UK, the stock market downturn was such that life insurers found themselves not just selling stock to protect their own positions but fuelling further price falls by their selling. You will remember this situation being the genesis of AMP‟s withdrawal from the UK.. It did end without catastrophic consequences but not without extraordinary intervention by the regulator.
• In 2008, an unregulated subsidiary of AIG in the US needed financial support from its parent, which was forthcoming only because of support given by the US government. Without this support, it is likely that the AIG group would have collapsed, leading to unknown adverse financial and economic consequences
• In 2008, some bancassurance groups, notably ING and Fortis in Europe, discovered that problems in their banking arms risked the failure of their insurance arms, leading in these cases to dismemberment of the groups.

The AIG case points to the need for high-quality regulation and supervision of solo insurers. The good news in this case is that this level of regulation and supervision seems to have existed around the world in 2008 and 2009 because no policyholders of AIG insurance subsidiaries have suffered from the problems of the parent.

The second and third examples (AIG, ING, Fortis - and there are some others) draw attention to the importance of effective group regulation and supervision. They also illustrate, however, that such regulation and supervision were not universally in place in 2008. This issue has become the number one challenge for the world's insurance regulators in the next period:-

• to ensure firstly that they have the legislative powers they need for effective group supervision,
• secondly that they have designed and implemented suitable regulations,
• and thirdly that they have the supervisory, capability and resources to oversee such groups effectively.

And if they are not able to meet all of these conditions, they or their governments need to consider restricting the scope of the commercial activities of groups that contain insurance companies in a way that limits the contagion risks within groups, in order to protect both financial stability and policyholders. In the banking environment, this idea has recently been dubbed "the Volcker rule".

In Australia APRA believes it is on top of this problem of group regulation and supervision. In many countries, however, not only are the regulators trying to come to terms with the problem but in many cases the legislative powers they need do not yet exist.

And that brings me to my final point about lessons from the GFC. It is, to quote Jaime Caruano of the BIS, speaking last month at an international meeting of the Joint Forum in Melbourne, in relation to the relevance of the supervision activities of regulators. "The strength of supervision mattered, not just the rule-setting, as demonstrated by Australia and Canada. Contrary to the notion that strict regulation restricts competiveness, the crisis shows that the financial systems of countries with strict supervision came out better." APRA's approach to supervision is more intrusive than in some other jurisdictions, but I think we can take this as an endorsement of our approach.

APRA, IFSA and the industry

This conference and also IFSA's Lifewise initiative reflect an increasing emphasis by IFSA on life insurance and the role that it plays in our society and in our economy.

From APRA's perspective, these are excellent initiatives.

APRA has also had increasing liaison with IFSA on life insurance in recent times. In particular, three years ago we established, with IFSA, regular meetings between senior executives of the industry and APRA.

When the LIASB was being disbanded and its regulatory powers transferred to APRA, which occurred from 1 January 2008, we at APRA needed to reassess the way that we interact with the industry. We decided to supplement the CEO meetings with two new fora. One is regular meetings between APRA and the appointed actuaries of life companies, in their capacity as representatives of their companies, and the other is between APRA and the life insurance committee of the Institute of Actuaries of Australia, where the actuaries involved are acting as representatives of the profession. We believe that these arrangements are working very well.

Finally let me say that we at APRA are delighted to see the interaction with IFSA and the industry being further extended through this conference. I can only encourage the continuation of this interaction because it is clearly in the mutual interest and, through that interest, to the benefit of the community at large.