Part Guidance Note GGN 110.1 - Insurance Act 1973 - Determination of Prudential Standards - GPS 110 - Capital Adequacy for General Insurers; GPS 120 - Assets in Australia for General Insurers; GPS 210 - Liability Valuation for General Insurers; GPS 220 - Risk Management for General Insurers; GSP 230 - Reinsurance Arrangements for General Insurers; GPS 410 - Transfer and Amalgamation of Insurance Business for General Insurers and Transitional Prudential Standard GPS 900- Early Approvals of Auditors and Actuaries (07/02/2002) - Guidance Note GGN 110.1

Guidance Note GGN 110.1

Measurement of Capital Base

An insurer must maintain a capital base sufficient to enable its insurance obligations to be met under a range of circumstances. In particular, an insurer must maintain, at a minimum, a capital base in excess of its Minimum Capital Requirement (MCR) at all times. This Guidance Note sets out the range of capital instruments that are eligible for inclusion in the capital base of an insurer.
An insurer is advised to consult APRA in advance of issuing any capital instrument (whether that instrument is to be issued by the insurer, or through an associate or special purpose vehicle) in order to avoid any dispute over eligibility.
The definitions and the qualifying criteria detailed in this Guidance Note are applicable to all locally-incorporated insurers. As outlined in paragraph 25 of GPS 110 Capital Adequacy, a different measure of capital adequacy applies to foreign-incorporated insurers operating in Australia as branches (foreign insurers). This reflects the nature of a foreign insurer’s Australian balance sheet, which does not generally include separately identifiable capital instruments.

Capital Base

Capital, for supervisory purposes, is considered in two tiers. Tier 1, or core capital, comprises the highest quality capital elements that fully meet all the essential characteristics of capital described in paragraph 3 of GPS 110. Tier 2, or supplementary capital, includes other instruments that, to varying degrees, fall short of the quality of Tier 1 capital but nonetheless contribute to the overall financial strength of an insurer.
A locally-incorporated insurer’s capital base is defined as the sum of Tier 1 and Tier 2 capital, less the deductions specified below. An insurer must ensure that its capital base exceeds its MCR, as defined under GPS 110, at all times. An example illustrating the calculation of an insurer’s capital base is included as Attachment 1.

Tier 1 Capital

Tier 1 capital comprises the highest quality capital elements, including the proceeds of instruments that are both permanent and non-cumulative in nature. Tier 1 capital (net of deductions set out in paragraph 18 below) must constitute at least 50% of an insurer’s capital base.[12]
Tier 1 capital comprises:

(a) paid-up ordinary shares;

(b) general reserves;

(d) current year’s earnings net of expected dividends and tax expenses;

(e) technical provisions in excess of those required by GPS 210 Liability Valuation;[13]

(f) non-cumulative irredeemable preference shares; and

(g) other “innovative” capital instruments (issued by the insurer or through special purpose vehicles).

Items (a) to (e) in paragraph 7 may be included as part of the insurer’s capital base without the need for APRA’s prior approval. If an insurer wishes to have instruments covered by items (f) and (g) of paragraph 7 included in its Tier 1 capital, this will require APRA’s approval. APRA may revoke its approval in relation to an instrument if it becomes aware that the instrument does not meet the relevant criteria.
A capital instrument is not eligible for inclusion in Tier 1 capital to the extent that its inclusion will result in the aggregate amount of items (f) and (g) in paragraph 7 exceeding 20% of aggregate Tier 1 capital (before deductions). Any amount ineligible for inclusion as Tier 1 capital as a result of this limit will be eligible for inclusion as Upper Tier 2 capital.
Unless otherwise approved by APRA, an insurer’s total servicing obligations on Tier 1 capital instruments must not exceed the insurer’s after-tax earnings in the year to which they relate. That is, there should be no dividend or interest payments out of retained earnings without APRA’s prior approval (see paragraphs 20-22).

Tier 2 Capital

Consistent with paragraph 6, Tier 2 capital is limited to a maximum of 100% of an insurer’s Tier 1 capital (net of deductions).
Tier 2 capital consists of instruments that, to varying degrees, fall short of the quality of Tier 1 capital but nonetheless contribute to the overall strength of an insurer. Such instruments include some forms of hybrid capital instruments that have the characteristics of both equity and debt. Tier 2 capital is divided into Upper Tier 2 and Lower Tier 2 capital.
Upper Tier 2 instruments include:

(a) cumulative irredeemable preference shares;

(b) mandatory convertible notes and similar capital instruments;

(d) any other hybrid (debt/equity) capital instruments of a permanent nature (eg capital amounts that are ineligible for inclusion as Tier 1 capital as a result of the limit referred to in paragraph 9.)

Lower Tier 2 instruments include:

(a) term subordinated debt;

(b) limited life redeemable preference shares; and

All capital instruments that an insurer wishes to include in Tier 2 capital will require APRA’s approval. APRA may revoke its approval in relation to an instrument if it becomes aware that the instrument does not meet the relevant criteria.
A capital instrument is not eligible for inclusion in Tier 2 capital to the extent that its inclusion will result in the aggregate amount of Lower Tier 2 capital exceeding 50% of eligible Tier 1 capital (net of deductions).
Capital instruments with a limited life (ie Lower Tier 2 Capital) must have an original maturity greater than 5 years. These instruments will also be subject to amortisation over the last four years of their life according to the following schedule:

Term to Maturity	Issued Amount Eligible for Inclusion in Tier 2 Capital
4 years or more	100%
3 to less than 4 years	80%
2 to less than 3 years	60%
1 to less than 2 years	40%
Less than 1 year	20%

Deductions from an Insurer’s Capital Base

(i) Deductions from Tier 1 Capital

The amount of Tier 1 capital to be included in an insurer’s capital base will be net of the following deductions:

(a) goodwill;

(b) other intangible assets; and

(ii) Own Instrument Purchases

An insurer may not, without obtaining APRA’s prior approval, enter into an arrangement where it may purchase, or provide financial assistance with a dominant purpose of facilitating the purchase by another party of, its own Tier 1 or Tier 2 capital instruments. Any such purchases will be subject to a limit agreed with APRA. APRA will require an amount of capital equal to that limit to be deducted from Tier 1 or Tier 2 capital as appropriate (depending on whether the prospective purchases relate to Tier 1 or Tier 2 capital instruments).

Reductions in Capital

A reduction in an insurer’s capital includes, but is not limited to: share buybacks; the redemption, repurchase or early repayment of any eligible capital instruments issued by the insurer or a special purpose vehicle; trading in own shares (see paragraph 19); or where aggregate interest and dividend payments on Tier 1 capital exceed the insurer’s after-tax earnings in the year to which they relate (ie dividend and interest payments on Tier 1 capital wholly or partly funded from retained earnings).
An insurer must seek APRA’s prior approval before making a reduction in its capital base. APRA’s approval may be subject to conditions.
Where APRA’s prior approval is required under paragraph 21, the insurer should provide APRA with a capital plan extending for at least two years. The insurer will need to satisfy APRA, on the basis of the capital plan provided, that the company’s capital base after the proposed reduction will remain adequate for its future needs. In deciding whether or not to approve a reduction in capital, APRA will have regard to all relevant considerations, including whether the insurer’s capital plan shows that the insurer will maintain an adequate level of capital, taking account of factors such as the immediate capital position, commitments to raise capital, and core profitability.

Attachment 1

Determining an Insurer’s Capital Base

Assume an insurer has the following balance sheet:

Assets		Liabilities
Investments	20,000	Premium liabilities	4,000
Investments in relateds	3,000	Outstanding claims provisions	5,000
Intangibles	600	Other liabilities	300
Future income tax benefits	100	Mandatory convertible notes	3,000
Other assets	3,300	Term subordinated debt	5,000
			17,300
		Shareholders’ Funds
		Shareholders’ funds	4,000
		General reserves	1,000
		Retained earnings	2,500
		Hybrid debt/capital instruments	2,000
		Current year earnings	200
			9,700

Total	27,000	Total	27,000

The insurer’s capital base would be calculated as follows:

Capital Instruments	Amount	Notes
Tier 1 Capital
Shareholders’ funds	4,000
General reserves	1,000
Retained earnings	2,500
Current year earnings	200	After allowance for likely dividends and tax payments
Other Tier 1 instruments	1,925	$2,000 issued; only $1,925 eligible due to limit in para. 9
Less Deductions
Intangibles	(600)
Future income tax benefits	(100)
Total Tier 1 Capital	8,925
Tier 2 Capital
Cum. Irredeemable prefs.	-
Mandatory conv.notes	3,000
Perpetual sub.debt	-
Ineligible Tier 1 capital	75	See ‘Other instruments’ in Tier 1 Capital
Term sub. Debt	2,000	$5,000 issued 5 years ago, original maturity of 6.5 years
Other Tier 2 instruments	-
Total Tier 2 Capital	5,075	All eligible because does not exceed limit in para. 11
Tier 1 plus Tier 2 Capital	14,000

Guidance Note GGN 110.1Guidance Note GGN 110.1

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