Guidance Note GGN 110.4
Investment Risk Capital Charge
- This Guidance Note details the calculation of the Investment Risk Capital Charge for an insurer using the Prescribed Method to determine its Minimum Capital Requirement (MCR).
- The capital charge for investment risk is in response to the risk of an adverse movement in the value of an insurer’s on-balance sheet assets and/or certain off-balance sheet obligations. Investment risk derives from a number of sources. These include:
(a) credit risk the risk of an adverse movement in the value of an asset owing to changes in the credit quality of the issuer of that asset (including the default of the issuer);
(b) market/mismatch risk the risk of an adverse movement in the value of an asset, which is not offset by a corresponding movement in the value of liabilities; and
(c) liquidity risk the risk that the reported asset value will not be readily realised in certain circumstances.
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It is not possible to devise a simple capital framework that takes all of these risk factors into an account in an accurate fashion. The capital charge for Investment Risk attempts to cover these risks by requiring insurers to hold an amount of capital against each asset that is proportional to the value of that asset. The capital factors assigned to assets reflect broad judgements by APRA for capital adequacy purposes only, and should not be taken as a substitute for individual company assessments of the risks associated with particular assets. Over and above the minimum capital requirements required by this Standard, the Board and senior management of an insurer have primary responsibility for ensuring that adequate systems are in place to individually assess the risks in an insurer’s operations, to allocate the appropriate amount of capital to cover that risk and to suitably value the transactions that give rise to that risk.
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To calculate the capital charge for Investment Risk, each of an insurer’s assets (and certain off-balance sheet exposures) is assigned to one of nine categories. The Investment Risk Capital Charge is determined by multiplying the balance sheet value of each asset by the appropriate Investment Capital Factor for its category (subject to any thresholds in the case of assets exceeding the specified thresholds detailed in paragraphs 16-18). The total capital charge for Investment Risk is the sum of the Investment Risk Capital Charges for each individual asset. The Investment Capital Factors to be applied to each asset are presented in Attachment 1 to this Guidance Note.
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For the purpose of applying the capital factors, the term ‘debt obligations’ refers to all loans, deposits, placements, interest rate securities and other payables. Where reference is required to credit/counterparty ratings, these should be applied in accordance with Attachment 2.
Extended Licensed Entity
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In certain circumstances, an insurer may choose to hold assets in a special purpose vehicle or other related entity, rather than on its own balance sheet. Subject to meeting the conditions outlined below, APRA may allow an insurer to determine its Investment Risk Capital Charge (and any Investment Concentration Capital Charge) based on the individual assets of the related entity, rather than simply on the insurer’s direct exposure to that entity.
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The extent to which the risk of an insurer’s exposure to a related entity is commensurate with the underlying holdings of that entity depends on the insurer’s extent of control over, and integration with, the entity as well as on the existence of any third party liabilities of the entity. Potential complications under a scenario where underlying asset holdings must be liquidated during financial stress must also be considered.
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Subject to the specific requirements set out in paragraph 9, an insurer may apply to APRA to have one or more related entities approved as part of its Extended Licensed Entity (ELE). Once approved, APRA will allow the insurer to “look through” the legal structures involved, and to “consolidate” the balance sheet of the related entity with its own for the purposes of determining the Investment Risk Capital Charge. In effect, this allows the insurer to treat its own balance sheet and that of the approved entity as a single entity for the purpose of calculating that charge.
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In deciding whether to approve an entity as part of an insurer’s ELE, APRA will have regard to the following criteria in respect of the relationship between the insurer and the related entity:
(a) the related entity must be a wholly-owned and controlled by the insurer, with a Board of directors/trustees that is comprised entirely of members of the insurer’s Board or senior management;
(b) the insurer must demonstrate to APRA that there are no legal or regulatory barriers (including cross-border issues for a branch or if the proposed ELE is not an Australian entity) to the transfer of the assets back to the insurer;
(c) the insurer’s risk management systems and controls must be fully extended to the operations of the related entity. The senior management of the insurer must be in a position to monitor the operations of the related entity to the same extent as the operations of the insurer itself. Systems for monitoring and control over the related entity must be included within the internal and external audit programs of the insurer;
(d) the insurer must be able to furnish stand-alone accounting records for the related entity, and provide APRA with full and unfettered access to this information at any time (including during on-site visits);
(e) the related entity must not conduct any business that the insurer would otherwise be prevented from doing under the Insurance Act 1973; and
(f) where the related entity holds or invests in assets on behalf of the insurer, the related entity must have no material third party liabilities (APRA will exempt tax liabilities and employee entitlements from this requirement).
Treatment of Collateral and Guarantees as Risk Mitigants
- The capital charge for Investment Risk may be reduced where the insurer holds certain types of collateral against an asset, or where the asset has been guaranteed, as a means of reducing risk.
(i) Collateral
- Where an insurer possesses recognised collateral against an asset, it may apply the Investment Risk Capital Factor relevant to the collateral to the value of the asset (instead of applying the capital factor that would otherwise apply to the asset). Collateral will be recognised only to the extent that it takes the form of a charge, mortgage or other security interest in, or over, an Eligible Collateral Item. Eligible Collateral Items are cash, Government securities, or debt obligations (as defined in paragraph 5) where the obligor has a counterparty rating in Grade 1, 2 or 3. The Eligible Collateral Item must also be held for the period for which the asset is held. Where the market value of the collateral does not cover the full value of the asset, only that part of an asset that is covered by collateral may be assigned the Investment Capital Factor applicable to the collateral.
(ii) Guarantees
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Assets that have been explicitly, unconditionally and irrevocably guaranteed for their remaining term to maturity by a guarantor with a counterparty rating (or for governments, the long-term foreign currency credit rating) in Grades 1, 2 or 3 may be assigned the Investment Capital Factor that would be applicable to the guarantor.
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Guarantees provided to an insurer by its own parent or a related entity[18] are not eligible for this treatment.
Charged and Encumbered Assets
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Subject to paragraph 15, assets of the insurer that are under a fixed or floating charge, mortgage or other security are subject to an Investment Capital Factor of 100%, to the extent of the indebtedness secured on those assets. This will replace the Investment Capital Factor that would otherwise apply to the secured assets.
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Where the security supports an insurer’s insurance liabilities, the Investment Capital Factor of 100% is applicable only to the amount by which the market value of the charged assets exceeds the insurer’s supported liabilities.
Investment Concentration Charge
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An insurer may be exposed to an additional risk arising from an excessive exposure to a particular asset (including reinsurance recoveries). To address the risk associated with excessive asset concentration, an insurer must hold additional capital in those cases where an insurer’s holdings of an asset or exposure to a particular obligor (or group of related obligors) exceeds the thresholds set out below. The aggregation of exposures to individual counterparties must be undertaken for an insurer and any entities approved as part of its ELE (see paragraphs 6-9).
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The thresholds referred to in paragraph 16 are based on the credit rating[19] of the counterparty, and are as follows:
| Counterparty Rating(unsecured obligations) | Threshold as a Percentage of Capital Base |
|---|
| Grades 1, 2 or 3Grade 4Grade 5 | no limit50%25% |
- For holdings of assets in excess of the thresholds, an insurer must apply the relevant Investment Capital Factor to the asset up to the value of the threshold, and apply a 100% Capital Factor to the value in excess of this level.
Off-Balance Sheet Transactions
- An insurer can be exposed to various Investment Risks through transactions or dealings other than those reflected on its balance sheet.
(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.
(ii) Derivatives
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Derivatives include forwards, futures, swaps, options and other similar contracts. Derivatives expose insurers to the full range of investment risks, even though in many cases there may be no, or only a very small, initial outlay. Insurers must set aside capital to cover the Investment Risk of these transactions, particularly in instances where the derivatives are used for reasons other than to hedge an underlying physical position. Under the Prescribed Method, insurers are required to hold capital against derivatives using the method described below.
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The requirements set out below do not apply to:
(a) foreign exchange (except gold) contracts which have an original maturity of 14 calendar days or less; and
(b) instruments traded on futures and options exchanges which are subject to daily mark-to-market and margin payments.
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The capital charge for each derivative contract is based on its ‘asset equivalent value’. The asset equivalent value is the sum of the current mark-to-market exposure of the derivative (where positive) and a potential exposure add-on.
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The potential exposure add-on is determined by multiplying the notional principal amount of the derivative contract (regardless of whether the contract has a zero, positive or negative mark-to-market value) by the relevant credit conversion factor specified in the table below according to the nature and residual maturity of the instrument.[21]
| Residual Maturity | Interest Rate Contracts | Foreign Exchange & Gold Contracts | Equity Contracts | Precious Metal Contracts (except Gold) | Other Contracts |
|---|
| Less than 1 year | Nil | 1.0% | 6.0% | 7.0% | 10.0% |
| 1 year to less than 5 years | 0.5% | 5.0% | 8.0% | 7.0% | 12.0% |
| 5 years or more | 1.5% | 7.5% | 10.0% | 8.0% | 15.0% |
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The asset equivalent value of each derivative must then be multiplied by the Investment Capital Factor applicable to a debt obligation of the counterparty to the derivative contract to determine the Investment Risk Capital Charge.
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APRA acknowledges that the method of measuring the risk of derivative positions outlined in paragraphs 23-27 is simple, and may not always reflect the underlying risk to which the insurer is exposed. However, given the limited usage of derivatives within the general insurance industry, APRA is of the view that a simple method will be adequate for the vast majority of Australian insurers. Where an insurer enters into significant derivative transactions – defined for the purposes of this Standard as contributing greater than 5% of the insurer’s total Investment Risk Capital Charge or, in relation to exchange traded derivatives, where the notional principal amount of these instruments is greater than the capital base of the insurer – or where the insurer is otherwise making extensive use of derivatives for speculative purposes, APRA reserves the right to require the insurer to hold additional capital against these positions using a method that APRA will prescribe.
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Insurers should not generally enter into derivative contracts at off-market prices. This includes historical rate rollovers on foreign exchange contracts. If any derivative contracts are undertaken at off-market prices, insurers must contact APRA to discuss the reasons for such actions and to agree the capital (and other prudential) treatment of these transactions.
Attachment 1
Investment Capital Factors
| Asset | Investment Capital Factor |
|---|
| CashDebt Obligations of:the Commonwealth Government;an Australian State or Territory government; orthe national government of a foreign country where: the security has a Grade 1 counterparty rating; or, if not rated, the long-term, foreign currency counterparty rating of that country is Grade 1.GST receivables (input tax credits) | 0.5% |
| Any debt obligation that matures or is redeemable in less than one year with a rating of Grade 1 or 2Cash management trusts with a rating of Grade 1 or 2 | 1% |
| Any other debt obligation (that matures or is redeemable in one year or more) with a rating of Grade 1 or 2Reinsurance recoveries, deferred reinsurance expenses and other reinsurance assets due from reinsurers with a counterparty rating of Grade 1 or 2 | 2% |
| Unpaid premiums due less than 6 months previouslyUnclosed businessAny other debt obligation with a rating of Grade 3Reinsurance recoveries, deferred reinsurance expenses and other reinsurance assets due from reinsurers with a counterparty rating of Grade 3 | 4% |
| Any other debt obligations with a counterparty rating of Grade 4Reinsurance recoveries, deferred reinsurance expenses and other reinsurance assets due from reinsurers with a counterparty rating of Grade 4 | 6% |
| Any other debt obligations with a counterparty rating of Grade 5Reinsurance recoveries, deferred reinsurance expenses and other reinsurance assets due from reinsurers with a counterparty rating of Grade 5Listed equity instruments (including subordinated debt)Units in listed trustsUnpaid premiums due more than 6 months previously | 8% |
| Direct holdings of real estateUnlisted equity instruments (including subordinated debt)Units in unlisted trusts (excluding Cash Management Trusts listed above)Other assets not specified elsewhere in this table | 10% |
| Loans to directors of the insurer or directors of related entities[22] (or a director’s spouse)Unsecured loans to employees exceeding $1,000Assets under a fixed or floating charge (refer paragraphs 14‑15) | 100% |
| Goodwill (including any intangible components of investments in subsidiaries)Other intangible assetsFuture income tax benefits(Assets in this category are zero weighted because they are deducted from Tier 1 capital when calculating an insurer’s capital base – refer GGN 110.1) | 0% |
Attachment 2
Counterparty Grades
| Grade | Standard & Poor’s | Moody’s | AM Best | Fitch |
|---|
| 1 | AAA | Aaa | A++ | AAA |
| 2 | AA+AAAA- | Aa1Aa2Aa3 | A+ | AA+AAAA- |
| 3 | A+AA- | A1A2A3 | AA- | A+AA- |
| 4 | BBB+BBBBBB- | Baa1Baa2Baa3 | B++ | BBB+BBBBBB- |
| 5 | BB+ or below | Ba1 or below | B+ or below | BB+ or below |
Unrated assets or exposures should be classified as Grade 4.
Insurers should, in general, use the same rating agency for determining counterparty gradings. Where the insurer has counterparties with multiple ratings from two or more of the rating agencies in the table above, the insurer should consistently choose the ratings of a single agency whenever possible. For example, an insurer may have a number of counterparties that are rated by Standard & Poor’s and AM Best. In this case, the insurer should choose a single agency that will be consistently used whenever the individual ratings conflict.
APRA’s approval must be sought if an insurer wishes to use the rating determined by a rating agency not included in the table above.