Opening Statement

John Laker, Chairman - Senate Standing Committee on Economics, Canberra

My opening remarks today, Madam Chair, focus on two matters that have been receiving close attention from APRA since our last appearance. The first of these matters is the impact of the recent spate of natural disasters in Australia, including the floods in Queensland and Victoria, Tropical Cyclone Yasi and the Perth bushfires, on the general insurance and deposit‑taking industries regulated by APRA. To this catalogue of disasters we must now add the devastating earthquake in Christchurch, New Zealand.

The first of these matters is the impact of the recent spate of natural disasters in Australia, including the floods in Queensland and Victoria, Tropical Cyclone Yasi and the Perth bushfires, on the general insurance and deposit-taking industries regulated by APRA. To this catalogue of disasters we must now add the devastating earthquake in Christchurch, New Zealand.

The largest and most immediate impact of the natural disasters in Australia has, not surprisingly, been felt by the general insurance industry. Based on data received directly from a number of general insurers and from the Insurance Council of Australia, the gross insured claims from these events for the industry are likely to be in the order of $3 billion. These are, to be clear, initial estimates and it will be some time before the true quantum of insured claims will be known. Of this total, $1.5 billion relates to the Brisbane flooding and a little above $700 million to the earlier flooding in Toowoomba and elsewhere in Queensland. Initial estimates of insured claims arising from Tropical Cyclone Yasi are a little above $500 million, with an additional amount of up to $200 million from the Victorian floods and up to $50 million from the Perth bushfires. Of course, actual losses sustained by the Australian community from these events have been much larger, but not all the losses are covered by insurance.

APRA has specific prudential requirements for general insurers in regard to capital and reinsurance that are designed to ensure they are able to handle the costs of catastrophes, single or multiple.

As a consequence, only a portion of the gross incurred losses will need to be met from the direct resources of APRA-regulated general insurers, because each insurer has itself insured against the risk of these events via its own reinsurance programs. These programs, which are typically placed with large international reinsurance companies, allow for the claims to be shared beyond Australian shores.

What is unusual in this particular episode is the number of large adverse events that have occurred in such a relatively short period. This has two broad effects — it has a substantial effect on the capital of insurers providing cover against these events, and it requires reinstatement and/or additional reinsurance arrangements to be put in place expeditiously.

Given the unusual circumstances, APRA has established a small team of specialist staff devoted full-time to establishing the scale of the insured claims from these events, and to assessing the impact of these claims on individual general insurers and on the industry as a whole. We want to satisfy ourselves that each APRA-regulated general insurer has the financial capacity, now and in the future, to meet our capital requirements and, ultimately, its claims from policyholders. As such, we have examined general insurers one-by-one, assessing the extent to which each will be the subject of claims relating to these events, the strength of its financial position and the coverage provided by its reinsurance arrangements. Our objective has been to identify promptly any general insurers that might be challenged to meet our capital requirements, and to work with them on any necessary remedial action.

Some large general insurers have already indicated publicly that they expect most of the losses will be borne by their reinsurance programs. Some smaller general insurers, where the relative loss has been larger, have already sought and received additional capital from their foreign parents to cover potential losses that still may arise as the claims develop and all late notifications are received. Overall, APRA does not expect that any general insurer it regulates will have difficulty continuing to operate in the face of the potential losses from these recent disasters. We are confident in the capacity of the general insurance industry in Australia to meet all of its claims obligations.

We do expect, however, that a number of general insurers will incur additional costs to reinstate reinsurance cover that has been eroded and, if required, to buy additional reinsurance cover for the remainder of the year. In some cases, the cost of the reinsurance cover being sought could be greater than the net claims incurred from the catastrophes themselves.

To help inform our assessments, we are seeking updated capital plans and financial forecasts from each affected general insurer. In addition, we have been applying a stress-test that assumes a further major catastrophe event before the end of the financial year, at least as large as those to date, and testing the potential impact on the financial position of each general insurer. The Christchurch earthquake has, unfortunately, provided a real world stress-test.

The earthquake will involve further claims on the general insurance industry in Australia but, at this very early stage, it is difficult to put any quantum on these claims. Gross incurred claims may prove to be larger again than the claims from the recent natural disasters in Australia, but initial feedback from the general insurers affected by the earthquake is that their net claims will not be substantial; again, the bulk of the claims will be borne by their reinsurers. We are monitoring developments in Christchurch very closely and have been in contact with the Reserve Bank of New Zealand, which has supervisory responsibility for the general insurance industry in New Zealand.

The resilience of our general insurance industry is, at least in part, reflective of the benefits of APRA’s robust prudential regime and, in particular, the strengthened risk-based capital requirements introduced in 2002. These capital requirements are currently being revisited as part of a comprehensive review of capital standards for general insurance and life insurance. One of the aims of this review is to make the capital standards more sensitive to the risk profile of each insurer.

The impact of the natural disasters on authorised deposit-taking institutions (ADIs) with activities and/or credit exposures in the affected areas is likely to be considerably less than on the general insurance industry. Initially, the impact was an operational one. A number of ADIs in the flood-affected areas experienced significant disruptions and many were forced to close branches for a period of days. APRA was in ongoing contact with the relevant ADIs as to the status of their operations, as of course was the Reserve Bank of Australia (RBA). Cash distribution was temporarily disrupted and some ATMs were unavailable but, overall, the industry’s disaster coordination protocols worked well to ensure reasonable continuity of banking services. This no doubt owes something to the considerable attention APRA and the ADI industry have paid to business continuity and disaster recovery capabilities in the last few years.

The impact of the disasters on ADIs’ loan books and on profitability is too early to assess. The major banks and regional ADIs have a substantial amount of lending exposures in the affected regions, both to businesses and households. We are closely monitoring the potential impacts on credit quality and are receiving regular reports from ADIs on the status of loans to affected borrowers. However, natural disasters are unfortunately nothing new for ADIs and they have policies for dealing with borrowers and other customers who have experienced hardship as a result.

Some ADIs have already indicated they have taken the prudent step of establishing provisions for potential loan losses and APRA will be monitoring these loss estimates over coming months. Historical experience is that natural disasters do not have long-term impacts on credit quality overall, as the initial property damage and short-term income loss from a disaster itself is mitigated by economic activity from the rebuilding process, together with insurance and any government assistance. Broadly speaking, we expect the impact of the recent spate of disasters on the affected ADIs will be readily manageable.

The second matter on which I would like to bring the Committee up-to-date concerns the global reforms to bank capital adequacy and liquidity being driven by the Basel Committee on Banking Supervision. Just before we met in October, the Basel Committee had announced broad agreement on the calibration and transition arrangements for the capital reforms, and the formal rules text was issued in December, with no surprises. As I advised the Committee in October, APRA does not expect the tougher global capital regime will have significant implications for ADIs in Australia, which remained well-capitalised throughout the global financial crisis. We are now preparing a consultation paper on how the capital reforms will be implemented in Australia.

Also in December, the Basel Committee released the formal rules text for a new global liquidity framework that seeks to promote stronger liquidity buffers and more stable sources of funding for banking institutions. The centrepiece of this framework is a new global liquidity standard — the so-called Liquidity Coverage Ratio (LCR) requirement — that aims to ensure that banking institutions have sufficient high-quality liquid assets to survive an acute stress scenario. The Committee will recall that this new requirement posed problems for Australia, since the volume of high-quality liquid assets (particularly government securities) needed to meet the requirement is simply not available here.

I am pleased to advise the Committee that a sensible solution to this so-called ‘Australian problem’ has been found that does not compromise the intent of the global liquidity reforms. That solution, agreed between the RBA and APRA, allows an ADI to establish a committed secured liquidity facility with the RBA, sufficient in size to cover any shortfall between the ADI’s holdings of high-quality liquid assets and the LCR requirement. That facility will count towards the LCR requirement. The approach will be applicable only to the larger ADIs (around 40 in number).

This solution is not in any sense a ‘concession’ to ADIs in Australia. In return for the committed facility, the RBA will charge a market-based commitment fee. This fee is intended to leave participating ADIs with broadly the same set of incentives to prudently manage their liquidity as their counterparts in jurisdictions where there is an ample supply of high-quality liquid assets in their domestic currency. These ADIs will need to demonstrate to APRA that they have taken all reasonable steps towards meeting their LCR requirements through their own balance sheet management, before relying on the RBA facility.

We are now preparing a consultation paper on how the liquidity reforms will be implemented in Australia. There are substantial lead-times before the capital and liquidity reforms come into effect, allowing the opportunity, if needed, for extensive discussions with industry and other interested parties. The RBA will be consulting separately on the liquidity facility but, as always, APRA and the RBA are closely coordinating their joint work in this area.

We are now happy to take the Committee’s questions.