Insurance (prudential standard) determination No. 15 of 2008 - Prudential Standard GPS 111 - Capital Adequacy: Level 2 Insurance Groups
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Turn the raw legal text into a practical explanation grounded in Insurance (prudential standard) determination No. 15 of 2008 - Prudential Standard GPS 111 - Capital Adequacy: Level 2 Insurance Groups.
Unless otherwise defined in this Prudential Standard, expressions in bold are defined in Prudential Standard GPS 001 Definitions (GPS 001).
For the purposes of this Prudential Standard equity exposures are as defined in Attachment A.
As a consequence of the key role played by capital in the financial strength of insurance groups, every Level 2 insurance group must maintain sufficient capital to enable the obligations of the group 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 a Level 2 insurance group’s capital base, attention must be paid not only to the types of events or problems that it might encounter, but also to the quality of the support provided by various types of capital instruments. The following matters are relevant to whether an instrument is suitable for capital adequacy 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;
(c) does not impose any unavoidable servicing charges against earnings; and
(d) ranks behind the claims of policyholders and creditors in the event of the winding-up of an entity within the Level 2 insurance group.
Not all types of capital instruments meet these criteria equally. Due to the need to ensure that the capital base of a Level 2 insurance group provides adequate support for the group’s operations, 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 specified in GPS 112. GPS 112 defines the different categories and components of eligible capital and the limits applicable to each category of eligible capital. These requirements will apply to Level 2 insurance groups with some modifications as set out in paragraphs 46 to 61.
The consolidated balance sheet of a Level 2 insurance group may contain certain assets (such as deferred tax assets, goodwill and other intangibles) that are acceptable from an accounting perspective. However, for supervisory purposes, such assets are either generally not available, or of questionable value, should the group encounter difficulties. Level 2 insurance groups are therefore required to deduct from their capital base any holdings in these types of assets. Details of these deductions are as specified in GPS 112 except where modified by this Prudential Standard.
Minority interests arising from consolidation of Tier 1 capital of controlled entities are to be treated as Fundamental Tier 1 capital for the purposes of determining the Level 2 insurance group’s capital base.
A Level 2 insurance group must, at all times, maintain a capital base sufficient to enable its obligations to be met under a range of circumstances. A Level 2 insurance group must, at all times, hold eligible capital[2] in excess of its MCR. Where a Level 2 insurance group proposes any reduction in its capital base, it must obtain APRA’s prior written consent.[3]
In determining its capital base, a Level 2 insurance group must ensure that the category of capital applied to each individual component of capital for each Level 1 insurer is not upgraded to a higher category of capital when that component of capital is captured in the measurement of the Level 2 insurance group’s capital base. Any such component of capital must be reclassified to the appropriate lower category of capital when measured at Level 2.
For the purposes of paragraph 23 of GPS 112, ‘financial year’ of a Level 2 insurance group refers to the last two half-years for which the Level 2 insurance group was required to submit half-yearly returns[4] to APRA preceding the date of the proposed payment of interest or dividend.
Responsibility for capital management
It is the responsibility of the Board of directors (Board) of the parent entity of a Level 2 insurance group to ensure that the group maintains a level and quality of capital commensurate with the risks to which the group is exposed.
In determining the appropriate level of capital for the Level 2 insurance group, the Board must have regard to:
(a) the potential for risk to compound across the group;
(b) concentration of capital and risk within individual entities in the group;
(c) guarantees and other commitments between entities in the group;
(d) the capital needs of individual entities in the group;
(e) the nature of capital held by the group, including its maturity, servicing costs and any double counting or upgrading of capital within the group; and
(f) the ability to readily transfer surplus or free capital within the group and the type of capital which would be available to individual entities from other group entities if required.
In order to ensure a Level 2 insurance group has sufficient capital to cover its risks and to meet its regulatory, insurance and strategic needs, the Board of the parent entity of the group must:
(a) establish policies on group capital adequacy taking into account, but not limited to, the elements specified in paragraph 18 of this Prudential Standard;
(b) ensure that appropriate systems and procedures are in place to identify, assess, measure and monitor capital and group risks on a continuous basis; and
(c) ensure that the group has sufficient capital freely available to meet unexpected losses and adverse shocks experienced by the group.
Minimum Capital Requirement (MCR)
A Level 2 insurance group’s capital base must be adequate for the scale, nature and complexity of the business and its risk profile. To this end, this Prudential Standard establishes a risk-based approach to the measurement of capital adequacy of a Level 2 insurance group. The MCR is intended to be commensurate with the full range of risks to which the group is exposed (including risks relating to insurance claims, investments, counterparty default, asset-liability mismatches, catastrophic events, and operational errors and problems).
The MCR may be determined using either:
(a) an internal model developed by the Level 2 group to reflect the circumstances of its business the Internal Model-based (IMB) Method (refer to paragraph 25);
(b) the standardised framework detailed in this Prudential Standard – the Prescribed Method (refer to paragraphs 26 to 39); or
(c) a combination of the methods specified in paragraphs (a) and (b).
APRA recognises that any measure of the adequacy of a Level 2 insurance group’s capital base involves judgement and estimation, and requires the quantification of risks that may be difficult to quantify. As a result, APRA may adjust a Level 2 insurance group’s MCR where it believes that the amount determined using any of the methods specified in paragraph 21 does not adequately reflect the risk profile of the group. In exercise of this discretion to adjust a Level 2 insurance group’s MCR, APRA will have regard to the following:
(a) the length of time the group has been operating substantially in its current form;
(b) whether the group is in or appears likely to be in financial or operational difficulty;
(c) whether the group is deemed by APRA to have a disproportionate exposure to a particular type of risk;
(d) whether particular risks faced by the group are adequately dealt with by the prudential standards; and
(e) any other relevant matters.
In the normal course of business, a Level 2 insurance group must have in place group capital management processes. These must be set out in the group’s Business Plan in accordance with Prudential Standard GPS 221 Risk Management: Level 2 Insurance Groups (GPS 221).
APRA may, by notice in writing, require a Level 2 insurance group to hold total eligible capital that exceeds the MCR determined in accordance with paragraphs 21 and 22 above by a specified proportion of that MCR. In exercise of this discretion APRA will have regard to the particular circumstances of the Level 2 insurance group, its approach to capital management and the factors set out in paragraph 22.