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Prudential Standard GPS 116

Capital Adequacy: Concentration Risk Capital Charge

Authority

1. This Prudential Standard is made under section 32 of the Insurance Act 1973 (the Act).

Application

2. This Prudential Standard applies to insurers authorised under the ActF[1]F

3. Subject to any specific transition rules, this Prudential Standard applies to insurers from 1 May 2010 (effective date).

4. As a consequence of the key role played by capital in the financial health of an insurer, every insurer must 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).

Interpretation

5. Unless otherwise defined in this Prudential Standard, expressions in bold are defined in Prudential Standard GPS 001 Definitions.

Concentration Risk Capital Charge

6. This Prudential Standard sets out the calculation of the Concentration Risk Capital Charge for an insurer using the Prescribed Method to determine its MCR. Specifically, it sets out the issues that an insurer must consider in setting its Maximum Event Retention (MER). The Concentration Risk Capital Charge is set equal to an insurer’s MER plus the cost of one reinstatement of the catastrophe reinsurance cover in cases where the reinstatement reinsurance cover has not been pre-paid by the insurer. It is the responsibility of the insurer’s Board and senior management to ensure that the MER is set at a level which is consistent with the insurer’s risk profile and its reinsurance program).

Definitions

7. The MER is the largest loss to which an insurer will be exposed (taking into account the probability of that loss) due to a concentration of risk exposures, after netting out any potential reinsurance assets[2].

8. Probable Maximum Loss (PML) is the largest gross loss to which an insurer will be exposed (within the realms of possibility) due to a concentration of risk exposures, without any allowance for potential reinsurance assets.

9. Return period is the expected average period within which a particular catastrophic event will re-occur. For the purposes of this Prudential Standard, insurers will be required to assume a return period of 1 in 250 years, or greater.

Background

10. An insurer is exposed to the possibility of very large losses arising from their portfolios as a result of various natural catastrophes or other accumulation of large losses, e.g. earthquakes, fires, storms, etc. Such events may occur only rarely and yet their financial impact on an insurer can be very significant, possibly resulting in the failure of an insurer.

11. In practice, an insurer uses the concept of MER to estimate its exposure to catastrophic events. The use of MER allows the insurer to:

(a) calculate the level of reinsurance cover which the insurer requires;

(b) apportion reinsurance costs fairly among different segments of business; and

(c) control exposures to geographical zones or business types, where the risks of catastrophic loss are higher than acceptable, having regard to the insurer’s risk profile and risk appetite.

Issues affecting the level of MER

12. In determining the level of MER for a given portfolio, the insurer must consider:

(a) the classes of business in which the insurer is engaged;

(b) the types of catastrophic risk which need to be addressed;

(c) the level of capital available to the insurer;

(d) the geographical zones in which the insurer transacts business;

(e) the effects of combined risks, e.g. where an insurer provides coverage for both workers’ compensation business and building insurance in the same geographical area;

(f) how the geographical zones will be grouped for calculation purposes; and

(g) the insurer’s overall risk appetite and desired probability of ruin.

13. An insurer must at a minimum adopt an MER which relates to an accumulation of exposures to a single event. However, APRA may require an insurer with a complex portfolio of insurance risks to estimate its MER using a whole of portfolio approach.[3]

14. When calculating the MER, an insurer must have regard to the documentation of reinsurance contracts it has in place. To determine the extent to which potential reinsurance assets expected from reinsurance contracts may be used to offset the PML calculated, refer to paragraph 34 of Prudential Standard GPS 110 Capital Adequacy (GPS 110).

Specialist insurers

15. Specialist insurers, such as providers of medical indemnity, may not be exposed to large losses from natural catastrophes. They may, however, still be exposed to large losses arising from groups of claims resulting from a common dependent source. For example, a medical insurer may face a large number of claims arising from a class action related to a faulty medical procedure.

Determining the level of the MER

16. The insurer must base the calculation of its MER on:

(a) the relevant area of concentration (e.g. geographic region);

(b) which peril produces the greatest MER;

(c) the return period of the relevant catastrophe and the sensitivity of the MER to changes in the return period;

(d) results produced by modelling the insurer’s own past experience; and

(e) any external, commercially available data and modelling facilities, bearing in mind the appropriateness of these data to the insurer’s portfolio of risks.

17. An insurer must calculate its MER in a manner consistent with the processes for setting, monitoring and altering the MER specified in the insurer’s Reinsurance Management Strategy (REMS), as required under Prudential Standard GPS 230 Reinsurance Management.

18. It is common practice for an insurer to use computer-based modelling techniques, developed either in-house or by external providers, to estimate likely losses under different catastrophe scenarios. If an insurer uses such a model, the model must be conceptually sound and capable of consistently producing realistic calculations of the MER. APRA will expect the insurer to be able to demonstrate an understanding of the model used in estimating the MER. This understanding will include:

(a) the type of data and assumptions used in the model;

(b) the methodology used to incorporate the data and assumptions into the model; and

(c) the sensitivity of the resulting MER figure to changes in the model’s assumptions.

19. An insurer must be able to demonstrate that they have thoroughly researched the model and tested at least several different scenarios of return period for each type of catastrophic event that may affect their portfolio of risks. Similarly, an insurer must calculate its MER using data that is consistent, accurate and complete. Where an insurer lacks access to the relevant data, it must be able to explain the rationale for, and details of, any estimates of data that it uses. This would include analysis of the sensitivity of the results to changes in the estimates and assumptions.

20. In setting an appropriate level of MER, the Board must consider the insurer’s claims history, capital availability and reinsurance arrangements.

21. A lenders mortgage insurer (LMI) must determine its MER by reference to Attachment A.

Reporting

22. An insurer must consult with APRA regarding the adequacy and appropriateness of the methodology for setting its MER. Where APRA is not satisfied with the methodologies or the assumptions used, it may allow or require the insurer to make adjustments to the calculation of its MER.

23. An insurer must inform APRA of any changes to its MER arising as a result of changes in its REMS, risk profile, classes of business underwritten or reinsurance program.

Determinations made under previous GPS 110

24. An approval, determination, direction or requirement made by APRA under a provision specified in Column 1 of the following table that is in operation immediately prior to the commencement of this Prudential Standard is taken, on and from the effective date, to have been made under the provision of this Prudential Standard specified in the same row of Column 2 of the table.

Attachment A

MER for lenders mortgage insurers

1. This Attachment applies to a lenders mortgage insurer (LMI), meaning an insurer that has written or reinsured, or proposes to write or reinsure, policies of lenders mortgage insurance. For these purposes, lenders mortgage insurance has its ordinary commercial meaning and includes insurance under a policy which protects a lender from losses in the event of borrower default on a loan secured by mortgage over residential or other property. This Attachment outlines the methodology for the calculation of the MER, and the applicable Concentration Risk Capital Charge, for an LMI that uses the Prescribed Method to determine its MCR. This Prudential Standard sets the Concentration Risk Capital Charge as equal to an LMI’s MER.
2. An LMI must also meet the requirements in the main body of this Prudential Standard. In the event of any inconsistency between this Attachment and the main body of this Prudential Standard, the requirements in this Attachment take precedence in relation to an LMI.

Definitions

3. Loans, as referred to in this Attachment, are loans secured by an insured mortgage over residential or other property.

4. Sum insured is the original exposure amount for an LMI as stated in the mortgage insurance policy.

5. Loan-to-Valuation Ratio (LVR) is the ratio of the amount of the loan to the value of the secured residential property, as at the date of origination of the loan. Where the mortgage insurance premium is capitalised in the loan amount, the LVR must be calculated including the premium; that is, the loan amount must be increased by the amount of the capitalised premium, irrespective of whether the premium is insured. The inclusion of a First Home Owners Grant (FHOG) in the deposit for a mortgaged property will not otherwise increase the LVR of a loan.

6. Probability of default (PD) is the risk of default by the borrower.

7. Loss given default (LGD) is the loss to the LMI upon default by the borrower.

8. Age is the length of time from the date of origination of the loan to the date of calculation for the purposes of determining the seasoning factors in Table A.

9. A standard loan is a loan predominantly secured by residential property and meets the following criteria:

(a) the LMI or lender has formally verified the borrower’s income and employment; and

(b) the borrower passes standard credit checks and income requirements as documented in the LMI or lender’s underwriting or credit policies and procedures.

10. A non-standard loan is a loan predominantly secured by residential property which does not meet the criteria in paragraph 9 above.

11. A commercial loan is a loan which is not predominantly secured by a registered mortgage over residential property.

12. Coverage type refers to whether the LMI policy of insurance provided is for 100 per cent of the loan or pool amount or less than 100 per cent of the loan amount or pool amount. The latter is referred to as top cover for individual LMI policies and partial cover for pooled LMI policies.

13. Individual LMI policy is lenders mortgage insurance underwritten and issued in respect of an individual loan. Bulk and/or tranche transactions associated with securitisations where each loan is individually insured falls into this category.

14. Pooled LMI policy is lenders mortgage insurance underwritten and issued in respect of a pool of loans. For clarity, each loan is not individually insured.

15. Premiums Liabilities, as referred to in this Attachment, are as calculated in accordance with Prudential Standard GPS 310 Audit and Actuarial Reporting and Valuation.

16. Outstanding Claims Liabilities (OCL), as referred to in this Attachment, are as calculated in accordance with Prudential Standard GPS 310 Audit and Actuarial Reporting and Valuation.

PML and Prescribed Stress Scenario

17. Probable Maximum Loss (PML) is, in concept, the largest loss to which an insurer is likely to be exposed due to a concentration of policies, without any allowance for potential reinsurance assets. For the purpose of this Attachment, the PML is assumed to arise from a catastrophic event that is expected to re-occur, on average, once in every 250 years. For LMIs, APRA requires the PML to be determined on the basis of a Prescribed Stress Scenario.

18. The Prescribed Stress Scenario is in the form of a three-year economic or property downturn, and is applied to the business in force as at the calculation date. The LMI must assume a constant aggregate sum insured over the three-year scenario (except for LMIs in run-off as provided in paragraph 31).

19. The modelled losses must be allocated in the proportion of 25 per cent to year one, 50 per cent to year two and 25 per cent to year three, or the downturn. These losses are in addition to future claim payments provisioned for as Premiums Liabilities.

Determining the MER for an LMI

20. An LMI’s MER is calculated by:

(a) working out the PML (which will comprise the amount worked out by applying paragraphs 21 to 31 ‘Prescribed Calculation of PML’ of this Attachment);

(b) deducting the amount of Allowable Reinsurance (which is worked out in accordance with paragraphs 32 to 37 of this Attachment) from the PML; and

(c) adding an allowance of five per cent of the PML for claims handling expenses.

Prescribed calculation of PML

21. The PML of an LMI is calculated by the addition of the amounts calculated in paragraph 22 to 31 for all LMI policies in force at the calculation date.

22. For each individual LMI policy, the PML is the sum insured multiplied by all of the relevant factors that apply to the policy loan type as set out in Table A.

23. Where a policy or loan has characteristics of more than one loan and/or coverage type, the exposure must be recognised in the category which produces the highest PML for that exposure.

24. For each pooled LMI policy, the PML is calculated by applying the principles in paragraphs 22 and 23 and then applying the terms of the pool cover to the calculated PML amount.[4]

25. For an LMI writing inwards reinsurance on a non-proportional basis, the PML for each of these contracts is calculated by:

(a) determining the impact of the Prescribed Stress Scenario on the business which is reinsured by applying the rules in paragraphs 21 to 24 above; and

(b) applying the terms of the inwards reinsurance contract to the amount calculated in (a) above to determine the amount of the claim by the cedant against the LMI. This amount becomes the LMI’s PML.

26. For an LMI writing coverage for an additional loan, or otherwise changing or extending an individual LMI policy, the LMI must determine the PML based on the total sum insured to which it is exposed and the LVR must be based on the total loan as at the most recent date of underwriting (and in accordance with paragraph 5 above). The age of the individual LMI policy should be based on the origination date of the original loan and not the date of the extension to the individual LMI policy. An LMI can apply to APRA to use a higher seasoning factor based on a shorter age of the loan for an individual LMI policy or group of individual LMI policies. The application to APRA should describe the LMI’s approach to determining the age and therefore seasoning factor which will be applied to each individual LMI policy or group individual LMI policies.

27. For an LMI writing any other lenders mortgage insurance business not captured in paragraphs 22 to 26 above, the LMI must consult with APRA. APRA will determine the basis for determining the PML.

28. APRA may direct an LMI to assume that the sum insured, LVR or age of a particular loan or group of loans is either:

(a) the sum insured, LVR or age as specified in APRA’s direction; or

(b) the sum insured, LVR or age worked out by applying instructions contained in APRA’s direction.

29. APRA may determine a formula for the calculation of the PML in relation to an exposure which does not readily fit into the definitions of loans and / or coverage types.

30. APRA may direct an LMI to reclassify a loan where it considers the relevant factor(s) in Table A of the original classification do not reflect the inherent risk of the loan.

LMIs in run-off

31. For an LMI no longer writing new business (i.e. in run-off), the sum insured is expected to decrease over the three-year scenario and it may be appropriate for an LMI in run-off to adjust its PML downwards. The methodology for adjusting an LMI’s PML in a run-off situation must be approved by APRA and documented in the LMI’s REMS.

Available Reinsurance

32. Only reinsurance arrangements which meet the ‘two month rule’ and ‘six month rule’ as well as the Australian governing law and jurisdiction requirements as set out in Prudential Standard GPS 230 Reinsurance Management can be counted towards Available Reinsurance. Only reinsurance arrangements which are contractually committed can be applied during the Prescribed Stress Scenario.

33. APRA recognises that the business which is covered by an LMI’s reinsurance arrangements and therefore relevant to the Available Reinsurance calculation will vary for each LMI. In some cases, the level of paid claims, Outstanding Claims Liabilities and/or Premiums Liabilities[5] for the period of the Prescribed Stress Scenario may need to be allowed for in determining how much reinsurance will be available to meet claims arising from the Prescribed Stress Scenario. If an LMI allows for any of these amounts in its Available Reinsurance calculation, the level must be subject to review by the Appointed Actuary, as part of prescribed actuarial advice[6] or through other written advice.

34. An LMI must allocate the PML, and any addition to this in accordance with paragraph 33, over each year of the prescribed three-year stress scenario and then apply its reinsurance program(s) to the resulting projected claims. To the extent that approximations are necessary, a best estimate approach must be used.

35. In calculating Available Reinsurance, the LMI must consider the impact of the Prescribed Stress Scenario on its overall reinsurance arrangements and take account of all the relevant financial impacts.[7]

36. APRA has the discretion to require the LMI to vary the amount of Available Reinsurance applied in the LMI's calculation of its MER.[8]

Allowable Reinsurance

37. The amount of Available Reinsurance to be deducted from the PML in determining the MER is limited to a maximum of 60 per cent of the PML, irrespective of the amount available under paragraphs 32 to 36 of this Attachment. This amount of Available Reinsurance is referred to as Allowable Reinsurance.

Reinsurance Management Strategy

38. The methodology for the determination of the Available and Allowable Reinsurance and how these are applied to the PML must be set out in the LMI’s REMS.

39. The REMS should also set out how the LMI will manage the exposure to and mitigants in place for the risk in relation to future reinsurance arrangements.

Table A - PD, LGD and seasoning factors to be applied in determining the MER of LMIs

Standard loans

The aggregate PD and LGD factors by LVR, over the three-year scenario, for standard loans are:

The seasoning factors by age for standard loans are:

Non-standard loans

The aggregate PD and LGD factors by LVR, over the three-year scenario, for non‑standard loans are:

The seasoning factors by age for non-standard loans are:

Commercial loans

The PML for the three-year scenario is the sum insured multiplied by 8%. No seasoning factor applies to commercial loans.