Capital Adequacy for General Insurers

Objective and Key Requirements of this StandardThis Prudential Standard aims to ensure that the security of policyholder obligations of all insurers is established at an appropriate level by requiring that each insurer maintain at least a minimum amount of capital.Capital is the cornerstone of an insurer’s strength. It provides a buffer against losses that have not been anticipated and, in the event of problems, enables the insurer to continue operating while those problems are addressed or resolved. In this way, the maintenance of adequate capital resources can engender confidence on the part of policyholders, creditors and the market more generally in the financial soundness and stability of the insurer.Beyond the minimum levels of capital specified by this Standard, it is the responsibility of an insurer’s Board and senior management to ensure that the insurer’s capital resources are appropriate to the size, business mix and complexity of its business. Accordingly, the insurer must have suitable systems in place to identify, manage and monitor the risks associated with its business activities, and to hold capital commensurate with its overall risk profile.The key requirements of this Prudential Standard are:An insurer may choose one of two methods for determining its Minimum Capital Requirement (MCR). Insurers with sufficient resources are encouraged to develop an in-house capital measurement model to calculate the MCR (this is referred to as the Internal Model Based (IMB) Method). Use of this method will, however, be conditional on APRA’s and the Treasurer’s prior approval and will require insurers to satisfy a range of qualitative and quantitative criteria. Insurers that do not use the IMB Method must use the Prescribed Method outlined in this Standard.Regardless of which method is used to calculate the Minimum Capital Requirement, an insurer’s MCR is determined having regard to a range of risk factors that may threaten the ability of the insurer to meet policyholder obligations. Under the Prescribed Method, these fall under three broad types: insurance risk (the risk that the true value of net insurance liabilities could be greater than the value determined under Prudential Standard GPS 210 Liability Valuation); investment risk (the risk of an adverse movement in the value of an insurer’s assets and/or off-balance sheet exposures); and concentration risk (the risk associated with an accumulation of exposures to a single catastrophic event). An insurer using the IMB Method will be expected to include these risks, as well as other relevant risk factors, within its calculation methodology.An insurer must, at all times, have eligible capital in excess of its MCR. Eligible capital is comprised of Tier 1 and Tier 2 capital: broadly, Tier 1 capital is permanent, and does not impose on-going servicing costs on the insurer, while Tier 2 instruments may be of limited life and/or have on-going servicing obligations. Within an insurer’s eligible capital, Tier 2 capital cannot exceed Tier 1 capital.Foreign-incorporated insurers authorised to operate in Australia as branches (foreign insurers) have slightly different requirements than those applied to locally-incorporated insurers. Specifically, foreign insurers are required to maintain assets in Australia in excess of their liabilities in Australia, of an amount at least equal to their MCR.Disclosure and transparency are important allies of the supervisory process. To improve policyholder and market understanding of its capital adequacy position, an insurer should disclose, in its published annual accounts, details of its eligible capital and MCR.Details on these requirements are contained below, and in Guidance Notes GGN 110.1, GGN 110.2, GGN 110.3, GGN 110.4 and GGN 110.5, which form part of this Standard. Additional guidance relating to the definition of assets in Australia is set out in GPS 120 Assets in Australia.

Prudential Standard

This Prudential Standard, made under section 32 of the Insurance Act 1973 (the Act), applies to all general insurers authorised under the Act.
As a consequence of the key role played by capital in the financial health of an insurer, APRA requires that each insurer maintain sufficient capital to enable its insurance obligations to be met under a wide range of circumstances. This required level of capital for regulatory purposes is referred to as the Minimum Capital Requirement (MCR).

Definition of Capital Base

In assessing the adequacy of an insurer’s capital resources, attention must be paid not only to the types of events or problems that it might encounter, but also the quality of the support provided by various types of capital instruments. The following matters are relevant to whether a capital instrument is adequate for supervisory purposes, namely the extent to which each instrument:

(a) provides a permanent and unrestricted commitment of funds;

(b) is freely available to absorb losses from business activities;

(d) ranks behind the claims of policyholders and other creditors in the event of the winding-up of the insurer.

Not all types of capital instruments meet these criteria equally. Due to the need to ensure that the capital base of an insurer provides adequate support, APRA imposes some restrictions on the composition of capital eligible to meet the MCR. The capital instruments deemed eligible for inclusion in an insurer’s capital base, and the conditions as to their inclusion, are outlined in Guidance Note GGN 110.1 Measurement of Capital Base.
An insurer’s balance sheet may contain certain assets - such as future income tax benefits, goodwill and other intangibles - that are acceptable from an accounting perspective, but for supervisory purposes are either generally not available, or of questionable value, should the insurer encounter difficulties. Insurers are therefore required to deduct from eligible capital any holdings in these types of assets. Details of these deductions are provided in Guidance Note GGN 110.1.
An insurer must, at all times, hold eligible capital (after deductions) in excess of its MCR. Where an insurer proposes any reduction in its capital, it must obtain APRA’s prior written consent - see Guidance Note GGN 110.1.

Minimum Capital Requirement (MCR)

An insurer’s capital resources must be adequate for the size, business mix and complexity of its business. To this end, APRA adopts a risk-based approach to the measurement of capital adequacy of all insurers. The MCR is intended to be broadly commensurate with the full range of risks to which an insurer is exposed (including risks relating to insurance claims, investments, counterparty default, asset-liability mismatches, catastrophes, and operational errors and problems).
The MCR may be determined using either:

(a) an internal model developed by the company to reflect the circumstances of its business  Internal Model Based (IMB) Method;[8]

(b) the standardised framework detailed in this Standard and accompanying Guidance Notes – the Prescribed Method; or

Regardless of the outcome of calculations made under paragraph 8, an insurer’s MCR cannot be less than $5 million.
It is recognised that any measure of the adequacy of an insurer’s capital involves considerable judgement and estimation, and requires the quantification of risks even where it is extremely difficult to do so. As a result, APRA may adjust an insurer’s MCR where it believes that the amount determined under this Standard does not adequately reflect the risk profile of an individual insurer.[9] That is, an individual insurer may be required by APRA to maintain a specified level of eligible capital in excess of that calculated using one of the risk measurement methodologies outlined in paragraph 8. This might be the case, for example, for a newly established insurer, an insurer that has encountered financial or operational difficulties, or for an insurer that is deemed by APRA to have a disproportionate exposure to a particular type of risk.
In the normal course of business, an insurer must have in place capital management processes to monitor and ensure its continual compliance with the MCR. These processes should be consistent with the insurer’s overall business plan and must include actions and procedures to avert any breaches of the MCR.

(i) Internal Model Based Method

Insurers with sufficient resources are encouraged to develop an in-house capital measurement model to calculate the MCR. Use of the IMB Method will be conditional on APRA’s and the Treasurer’s prior approval[10] and will require insurers to satisfy a range of criteria, as detailed in Guidance Note GGN 110.2 Internal Model Based Method. As is the case for Prudential Standards covering other supervised industries, APRA must be satisfied that the insurer’s capital calculation methodology is suitably rigorous and broadly consistent with comparable segments of the industry. Insurers unable or unwilling to develop a model that meets the criteria specified by APRA must use the Prescribed Method outlined below.

(ii) Prescribed Method

For insurers using the Prescribed Method, the MCR will be determined as the sum of the capital charges for:

(a) insurance risk;

(b) investment risk; and

- Insurance Risk

The Insurance Risk Capital Charge is in response to the risk that the true value of net insurance liabilities could be greater than the value determined under Prudential Standard GPS 210 Liability Valuation. The methodology for determining the Insurance Risk Capital Charge is set out in Guidance Note GGN 110.3 Insurance Risk Capital Charge.
The capital charge has two components: a charge in respect of outstanding claims risk; and a charge in respect of premiums liability risk. The capital charge for outstanding claims risk is in response to the risk that the true value of the outstanding claims liabilities could be greater than the value determined under GPS 210. The capital charge for premiums liability risk is in response to the risk that premiums relating to

post calculation date exposures, including premiums written after the calculation date, could be insufficient to fund the liabilities arising from that business.

The Outstanding Claims Capital Charge is determined as the sum, over all classes of business of the insurer, of the value of the net outstanding claims liabilities for each class (determined using GPS 210), multiplied by the appropriate Outstanding Claims Capital Factor for that class.
The Premiums Liability Capital Charge is determined as the sum, over all classes of business of the insurer, of the net premiums liabilities for each class (determined using GPS 210), multiplied by the appropriate Premiums Liability Capital Factor for that class.

- Investment Risk

The capital charge for investment risk is in response to the risk of an adverse movement in the value of an insurer’s assets and/or off-balance sheet exposures. Investment risk can be derived from a number of sources, including market risk and credit risk. The methodology for determining the Investment Risk Capital Charge is set out in Guidance Note GGN 110.4 Investment Risk Capital Charge.
Subject to paragraphs 20 to 22, the Investment Risk Capital Charge is determined as the sum, across all assets and certain off-balance sheet exposures, of the value of each investment multiplied by the relevant Investment Capital Factor for that investment. For the purposes of this Standard, assets and exposures should be valued according to Australian Accounting Standards.
The capital charge may be adjusted to recognise any reduction in investment risk arising from the availability of risk mitigants (eg collateral security or guarantees), subject to the criteria detailed in Guidance Note GGN 110.4.
An insurer may be required to hold additional capital, in the form of a capital charge for Investment Concentration Risk, if its exposure to a particular asset or counterparty exceeds the thresholds set out in Guidance Note GGN 110.4.
In certain circumstances, an insurer may choose to hold assets in a special purpose vehicle, rather than on its own balance sheet. APRA may allow the insurer to “look through” the legal structures involved, and determine its Investment Risk Capital Charge (and any Investment Concentration Capital Charge) based on the individual assets of the special purpose vehicle, rather than simply on its direct exposure to the entity. APRA will have regard to the criteria outlined in paragraph 9 of GGN 110.4 in exercising this discretion.

- Concentration Risk

The capital charge for concentration risk is in response to the risk associated with an accumulation of exposures to a single catastrophic event. The methodology for determining the capital charge is set out in Guidance Note GGN 110.5 Concentration Risk Capital Charge.
The Concentration Risk Capital Charge is set equal to the insurer’s Maximum Event Retention. APRA intends to monitor an insurer’s calculation of its Maximum Event Retention and may require adjustments to be made to the calculation where APRA is not satisfied with the methodologies and/or assumptions used.

Foreign Insurers

By the nature of its Australian balance sheet, a foreign-incorporated insurer authorised under the Act to operate in Australia as a branch (a foreign insurer) will not typically have capital instruments of the type specified in Guidance Note GGN 110.1. Foreign insurers are nevertheless required to meet a variant of the MCR. Specifically, foreign insurers are required to maintain assets in Australia[11] in excess of their liabilities in Australia, of an amount at least equal to the MCR determined by this Standard.
Further detail regarding the treatment of foreign insurers can be found in GPS 120 Assets in Australia.

Disclosure

Disclosure and transparency are important allies of the supervisor. To improve policyholder and market understanding of its capital adequacy position, an insurer should disclose, in its published annual accounts, the following items:

(a) the amount of eligible Tier 1 capital, with separate disclosure of each of the items specified in GGN 110.1;

(b) the aggregate amount of any deductions from Tier 1 capital;

(d) the aggregate amount of any deductions from Tier 2 capital;

(e) the total capital base of the insurer derived from the items (a) to (d);

(f) the MCR of the insurer; and

(g) the capital adequacy multiple of the insurer (item (e) divided by (f)).

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