(i) Direct Credit Substitutes
- To the extent that an insurer has issued:
(a) guarantees (including written put options serving as guarantees);
(b) letters of credit; or
(c) any other credit substitute (other than insurance) in favour of another party;
the insurer is exposed to risk of having to make payment on these instruments should the guaranteed party default or fail to deliver.
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Insurers must set aside capital to cover the risk of such events occurring. Within the Prescribed Method, this is to be achieved by applying, to the face value of the credit substitute, the Investment Capital Factor that would be applied to the obligation or asset over which the credit substitute has been written. Where the credit substitute is supported by collateral or a guarantee, the provisions of paragraphs 11-13 may be applied.
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A different approach to that contained in paragraphs 20-21 is available for surety bond business. Insurers have the choice of either:
(a) treating any surety bonds the insurer has issued as a type of direct credit substitute. In this case, the insurer must determine 25% of the value of the surety bond, and apply to that amount the Investment Capital Factor that would be applied to the obligation or asset over which the surety bond has been written. Where the surety bond is supported by a risk mitigation arrangement, the applicable Investment Capital Factor will be that assigned to the counterparty to that arrangement, but only to the extent that the risk mitigation arrangement applies; or
(b) seeking written approval from APRA to treat any surety bonds the insurer has issued as if they were an insurance risk (for the purposes of meeting the requirements of the Prudential Standards only). This would require the insurer to include surety bond exposures within the insurer's assessment of insurance liabilities, as determined under GPS 210 Liability Valuation, and to apply the relevant capital factors within GGN 110.3.[20] For the purpose of calculating net outstanding claims liabilities and net premium liabilities (as determined under GPS 210) the insurer may treat any risk mitigation arrangement as if it were reinsurance. An insurer seeking APRA's approval for this approach would need to include with its application a confirmation from the company's Approved Actuary that that person is able to appropriately measure the risk of the surety bond business within the insurer's insurance liabilities.
Insurers must use the same approach for all surety bond business, and apply that approach consistently over time.