Part Guidance Note GGN 110.2 - 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 110.2 | Zoe
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 110.2Guidance Note GGN 110.2
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The Internal Model Based (IMB) method is intended to allow an insurer to calculate its Minimum Capital Requirement (MCR) based on the output of its in-house capital allocation model. Hence, each insurer will have the flexibility to develop a methodology that is best suited to its business, provided that the model chosen is comprehensive, rigorous and broadly consistent with comparable segments of the industry. Use of the IMB method will, however, be strictly conditional on APRA’s and the Treasurer’s approval.[15]
To ensure that the MCRs calculated by insurers using the IMB method are sufficiently prudent, comparable and consistent across the industry, model approval will require that the insurer’s risk management system and the methodology underlying the capital calculation meet certain criteria. APRA will, in consultation with industry, refine these criteria over time to ensure that they are consistent with the evolution of industry modelling capabilities. In broad terms, however, the insurer should satisfy the quantitative and qualitative requirements outlined in this Guidance Note.
Each insurer will have discretion to determine the precise nature of its modelling approach. However, an insurer must be able to demonstrate that its internal model:
(a) operates within a risk management environment that is conceptually sound and supported by adequate resources;
(b) is based on a set of quantitative parameters specified in this Guidance Note, including a required probability of default and a modelling time horizon over which that probability is to be measured. These parameters will be set at a level that ensures insurers achieve and maintain a minimum level of financial soundness;
(c) addresses all material risks to which the insurer could be reasonably expected to be exposed and is commensurate with the relative importance of those risks, based on the company’s business mix;
(d) is closely integrated into the day-to-day risk management process of the insurer; and
(e) is supported by appropriate audit and compliance procedures.
In addition to the quantitative and qualitative requirements of this Guidance Note, insurers seeking approval to use the IMB method must have in place adequate processes for validating the accuracy of the capital measurement model, and for monitoring and assessing its on‑going performance. A proven track record of reasonable accuracy in measuring risk will also be required.
Qualitative Factors
It is important that insurers using the IMB method have risk management systems and capital measurement models that are conceptually sound and implemented with integrity. Accordingly, there are a number of qualitative criteria that APRA will have regard to in deciding whether to approve an internal model for capital adequacy purposes.
The qualitative criteria are:
(a) The insurer should have an independent risk management unit that is responsible for the design and implementation of the insurer’s capital measurement model. This unit could form part of the insurer’s actuarial function, its financial control division, or other appropriate group within the insurer’s organisational structure that is separate from the insurer’s general business units. It is not APRA’s intention to mandate a particular organisational structure for insurers, provided the designated unit has adequate independence, appropriate skills and resources, and direct reporting access to the senior management of the insurer. Amongst other things, this unit should produce and analyse the periodic results of the capital measurement model and conduct regular validation of the model against the actual experience observed by the insurer.
(b) The insurer’s Board and senior management should be actively involved in the risk control process and must regard risk control as an essential aspect of the business to which significant resources need to be devoted. The periodic reports and validation results produced by the independent risk management unit must be reviewed by a level of management with sufficient seniority and authority to enforce restrictions on the insurer’s overall risk exposure.
(c) The capital measurement model must be closely integrated into the day-to-day risk management process of the insurer. Accordingly, the output of the models should be an integral part of the process of planning, monitoring and controlling the insurer’s risk profile.
(d) An independent review of the capital measurement model should be carried out periodically as part of the insurer’s own internal audit process. A review of the overall risk management process should take place at regular intervals (ideally not less than once a year) and should specifically address, at a minimum:
(i) the scope of the risks captured by the capital measurement model;
(ii) the integrity of the management information system;
(iii) the verification of the consistency, timeliness and reliability of data sources used to run internal models, including the independence of such data sources;
(iv) the accuracy and appropriateness of volatility, correlation and distributional assumptions;
(v) the verification of the model’s accuracy through periodic back testing or other validation process;
(vi) the validation of any significant change in the capital measurement model;
(vii) the adequacy of the documentation of the capital measurement model and accompanying risk management systems and processes;
(viii) the organisation of the risk management unit; and
(ix) the integration of the capital measurement model into the broader risk management framework of the insurer.
Quantitative Standards
The insurer’s capital measurement model should calculate an amount of capital sufficient to reduce the insurer’s probability of default over a one year time horizon to 0.5% or below[16].
An insurer may measure its capital requirement over a different combination of probability of default and time horizon, provided the insurer can demonstrate to APRA that the alternative parameters are appropriate for its business mix and produce a result which is consistent with the benchmark set in paragraph 6.
Specification of Risk Factors
An important part of an insurer’s internal capital measurement model is the specification of an appropriate set of risk factors, ie the risks that impact on the value of the insurer’s assets and liabilities. The risk factors contained in the capital measurement model must be sufficient to capture the risks inherent in the insurer’s portfolio. Although insurers will have some discretion in specifying the risk factors for their internal models, the criteria specified in paragraphs 10-13 should generally be taken into account.
The risks specified in paragraphs 10-13 are intended to provide guidance to insurers on the sorts of risk factors that should be incorporated into capital measurement models. However, the list is not intended to be exhaustive: there may be additional factors specific to an individual insurer’s activities that will need to be built into any internal model before it can be used to calculate the insurer’s MCR. Similarly, there may be factors included in paragraphs 10-13 which are irrelevant or immaterial to a particular insurer’s business or modelling technique. In these cases, the insurer will not be required to devote significant modelling resources where this is clearly unwarranted.
(i) Investment Risks
An insurer’s capital measurement model must consider the risk that the amount or timing of the cash flows connected with the insurer’s assets will differ from expectations or assumptions as of the valuation date. Factors that should be considered include:
(i) default/counterparty failure;
(ii) the future market value of assets;
(iii) the liquidity of assets; and
(iv) the impact of changes in interest rates on the value of asset cash flows (this includes cash flows from bonds, mortgages, real estate and dividends).
(ii) Insurance Risks
An insurer’s capital measurement model must consider the risk that the amount or timing of cash flows connected with the insurer’s obligations will differ from expectations or assumptions as at the valuation date. Factors that should be considered include:
(a) outstanding claims risk - the risk that the actual cost of claims for obligations incurred before the calculation date will differ from expectations or assumptions due to factors such as:
(i) unexpected inflation in claim costs;
(ii) changes in interest rates;
(iii) changes in the legal environment in which claims will be resolved, including the environment in which claims are pursued by policyholders or third parties;
(iv) changes to the basic premises underlying the provisions for a particular coverage (such as has occurred with environmental impairment liability);
(v) patterns of pricing adequacy which affect the payment of claims or the adequacy of case reserves;
(vi) currency fluctuations which affect the costs of losses when expressed in local currency;
(vii) the randomness of the claims process itself; and
(viii) incompleteness of databases.
(b) premiums risk - 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 due to changes in factors including:
(i) changes in interest rates;
(ii) competitive pressures that do not allow the insurer to achieve assumed levels of exposure and/or rate adequacy;
(iii) regulatory intervention that restrains premium increases or decreases or requires business to be underwritten that would not be underwritten in the absence of such intervention;
(iv) retrospective premiums or dividends that differ from assumptions; and
(v) amounts collectible from agents that differ from assumptions.
(c) loss projection risk - the uncertainty regarding assumptions about future claims costs. Loss projection risk is a function of the factors that affect reserve risk and also of the uncertainty regarding factors such as:
(i) unanticipated changes in loss costs and exposures from the historical experience period;
(ii) loss costs for the mix of new policies being underwritten, including the effect of adverse selection; and
(iii) loss adjustment practices in the future that may differ from those in the past.
(d) concentration risk - the uncertainty regarding the cost of catastrophic events. Concentration risk can be considered a component of loss projection risk, and is a function of factors such as:
(i) the coverages being written;
(ii) the concentration of insured values in specific geographic areas or legal jurisdictions; and
(iii) uncertainty regarding the frequency, severity and nature of catastrophic events.
(e) reinsurance risk - uncertainty regarding the price and availability of desired reinsurance, and of the uncertainty regarding the collectability of reinsurance recoverables arising from the financial condition of the reinsurer or ambiguity about coverages provided. Reinsurance risk recognises how reinsurance responds under stress, such as a large catastrophe or other strain on collectability, aggregates, reinstatements and other reinsurance parameters.
(f) expense risk - the risk that expenses will differ from projections due to factors such as:
(i) contingent commissions to agents;
(ii) marginal expenses of adding new business; and
(iii) overhead costs, including the risk that overhead costs will be changed by regulatory intervention, and the risk that there may be periods of changing premium during which overhead costs will not change in proportion to premium.
(iii) Operational Risk
As well as accurately measuring financial risks, an insurer’s model for measuring capital adequacy must take into account the various operational risks that it also faces, ie the risk of financial loss occurring through error, fraud or failure to perform activities in a timely manner as a result of breakdown of people or systems, internal controls, corporate governance and external events. These risks, although difficult to quantify, have the potential to impose significant costs upon, and possibly seriously jeopardise, the financial soundness and on-going business of the insurer. An insurer’s capital measurement model will therefore need to include a measure of operational risk within its capital calculation.
(iv) Correlation Between Risk Classes
An insurer’s capital measurement model must estimate the effects of the risks specified in paragraphs 10-12 individually on the financial position of the insurer, and evaluate the interrelationships between these risks and other risks.
Stress Testing
Stress testing is an important component of any modelling approach. Insurers that use the IMB method for determining their MCR must have in place a comprehensive stress testing program to supplement their capital measurement calculations.
APRA will not impose standard stress scenarios on insurers, but will expect insurers using the IMB method to have developed a comprehensive range of scenarios against which its capital calculations can be compared. It is important that these scenarios are tailored to the particular circumstances of the insurer, and reflect low‑probability but potentially high-impact events that might adversely affect the insurer’s financial position. These scenarios will include, but should not be limited to, sensitivity analysis on the assumptions made within the capital measurement model, as well as the assessment of the impact of plausible stress scenarios (eg major catastrophe events or extreme market conditions).
Stress testing results should be incorporated into model validation procedures, and included as part of regular management reporting.
Partial Models
APRA will consider applications by insurers to use the IMB method to calculate elements of its MCR, and to use the Prescribed Method for those parts of the insurer’s business for which it does not have an internal
model. However, recognising that there is a range of factors which are not explicitly addressed within the Prescribed Method (eg operational risk), APRA may impose an additional capital requirement on the results of any partial model to compensate for this.
Model Review Process
An insurer must obtain APRA’s prior approval before it will be able to use its internal capital measurement model to determine its MCR. Approval will be subject to the outcome of a comprehensive model review process including:
(a) completion of a detailed questionnaire about the model and accompanying risk control environment; and
(b) one or more on-site visits to discuss the detail of the model, risk management systems, and surrounding organisational structure and controls.
Once APRA is satisfied with the extent to which the insurer has met the criteria outlined in this Guidance Note, APRA will (subject to obtaining the Treasurer’s consent) approve the model.[17] Any conditions on which the approval is granted will also be specified.
APRA will require, as a minimum condition of its model approval, that the insurer undertake to advise APRA in advance of any material changes to its capital measurement model or surrounding controls, and that APRA be provided with any information necessary to satisfy itself that the insurer continues to meet the criteria outlined in this Guidance Note.
Once an insurer has commenced using the IMB method for the measurement of its MCR, the insurer will be required to continue using this method of capital measurement unless:
(a) APRA revokes model approval and directs the insurer to use the Prescribed Method for calculating its MCR; or
(b) the insurer seeks and receives approval from APRA to return to the Prescribed Method.