Capital Adequacy: Internal Model-based Method

Authority

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

Application

2. This Prudential Standard applies to:

(a) insurers[1]; and

(b) authorised NOHCs[2].

3. An insurer or authorised NOHC may choose to apply to APRA for approval[3] to use the Internal Model-based Method (IMB Method) to determine the Minimum Capital Requirement (MCR), in accordance with either Prudential Standard GPS 110 Capital Adequacy (GPS 110)[4] or Prudential Standard GPS 111 Capital Adequacy: Level 2 Insurance Groups (GPS 111)[5] , in which case this Prudential Standard applies to the insurer or Level 2 insurance group as the case may be. Where an application relates to the capital adequacy of a Level 2 insurance group, the appropriate applicant will be the parent entity.

4. An insurer or parent entity that chooses to apply for approval to use the IMB Method must comply with this Prudential Standard and continue to comply with GPS 110 or GPS 111 at all times. This standard is effective from 31 March 2009.

Interpretation

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

6. In the remainder of this Prudential Standard, the term “insurer” is taken to include, in the case of a Level 2 insurance group, both the parent entity that makes the application and the group to which the IMB Method will be applied.[6]

7. For the purposes of this Prudential Standard:

(a) Economic capital model (ECM) means the internal capital measurement model developed for an insurer’s own purposes;

(b) Regulatory capital model (RCM) means the particular implementation and application of the ECM that is to be used for the purpose of determining the MCR using the IMB Method;

(c) A business segment is any part of the insurance business for which:

(i) if the segment is covered by the ECM, both the method of modelling underwriting and reserving risk and the outcomes from the modelling are separately identifiable for that segment; and

(ii) if the segment is not covered by the ECM, the means of determining its overall contribution to the MCR, and the amount of that contribution, are separately identifiable.

Internal Model-based Method

8. The IMB Method is intended to allow an insurer to have its MCR determined based on its own ECM. The underlying purpose of allowing an insurer to use the IMB Method is to have regulatory capital requirements that better reflect the nature and extent of risks in the insurer’s particular business structure and business mix.

9. There is no prescribed form or structure for an insurer’s ECM. Each insurer has the flexibility to develop a model that is suited to its business, and to use the ECM in the way it chooses. The manner in which the ECM is used as part of the RCM to determine the MCR is likely to vary from the use of the ECM by the insurer for its own risk and capital management purposes.

10. The ECM and RCM must meet the criteria specified in this Standard and the RCM must be approved by APRA before it can be used for the purpose of determining the insurer’s MCR. Paragraph 30 of this Standard specifies the matters to be included in the RCM.

11. APRA will not provide approval for use of the IMB Method unless an insurer has and maintains an advanced and stable approach to risk management, including operational risk management. APRA will make an assessment of the insurer’s approach to risk management at the time of application under this Standard and on subsequent review of the RCM. This assessment will be based on information provided as part of the application under this Standard, as well as the information available through APRA’s normal supervisory processes.

12. APRA will not provide approval for use of the IMB Method unless an insurer has and maintains a prudent approach to capital management. The insurer must have an internal measure of target capital that is higher than the MCR determined using the RCM. APRA will make an assessment of the adequacy of the insurer’s approach to capital management, including target capital, at the time of application under this Standard and on subsequent review of the RCM. This assessment will be based on information provided as part of the application under this Standard as well as the information available through APRA’s normal supervisory processes, including the insurer’s business plan.[7]

Quantitative standards

13. The insurer’s MCR must be an amount of capital sufficient for the insurer’s probability of default to be 0.5 per cent or less. Default means the inability to meet claim payments or other liabilities, excluding liabilities that form part of the insurer’s capital base, as and when they fall due. In determining the MCR, the RCM must allow for:

(a) business written over a one year time horizon;

(b) catastrophe risk losses and operational risk losses occurring over the one year time horizon; and

(c) the run-off of underwriting, reserving, credit and market risks to extinction.

APRA does not require any specific form or structure for the RCM, provided it is satisfied that the result is no less conservative than that specified in this paragraph. It is possible for the RCM to allow for the items listed above without being structured in precisely that form.

Model governance

14. APRA will not provide approval for use of the IMB Method unless it is satisfied with the insurer’s governance arrangements for the ECM and RCM. Key requirements for the governance arrangements include:

(a) integration of the ECM with the Risk Management Framework[8];

(b) adequate resourcing, skills and objectivity of the team that is responsible for the development and review of the ECM;

(c) approval by the Board or relevant Board committee of the development and use of the ECM;

(d) adequate control processes for the development of the ECM, for calibrating and updating the model at least annually, for changing the model and for applying the RCM;

(e) comprehensive documentation of the model (both the ECM and RCM);

(f) adequate linkages between the output of the ECM and the capital management of the insurer;

(g) regular reporting, to the relevant Board committees, Board and senior management, of results from the ECM and RCM and issues arising related to the ECM and RCM; and

(h) adequately documented independent review of the RCM (including those aspects of the ECM that are directly relevant to the RCM), which may be undertaken by an internal group (e.g. internal audit) or by an appropriately qualified external party. The party performing the review must be independent of the normal business operations of the insurer and must not have been significantly involved in the development and calibration of the ECM or the RCM. The scope and frequency of independent review must be agreed with APRA and must address both the governance and technical sufficiency of the ECM and RCM.

Model use

15. APRA will not provide approval for use of the IMB Method unless it is satisfied that the ECM plays an integral role in the insurer’s management and decision-making processes, and that this use is embedded in the insurer’s operations. APRA’s consideration of model use will include, but will not be limited to, some of the indicators set out in the Attachment to this standard.

Model sufficiency

16. APRA will not provide approval for use of the IMB Method unless it is satisfied that the insurer’s ECM and RCM are sufficient to give a reliable measure of required capital.

17. An insurer’s ECM and RCM must adequately capture all the material risks of the insurer’s portfolio and business including the following risk categories:

(a) catastrophe risk – natural or man-made events that produce insurance losses from many insureds at the same time;

(b) underwriting risk – the possibility that future insurance exposures (both from business in force and future business) will be loss making;

(c) reserving risk – the possibility that the provisions for claims outstanding will be inadequate to meet the ultimate costs when the business is run off to extinction;

(d) market risk – the risk arising from all aspects of the value of investments and currencies, including interest rate changes, market price changes, counterparty default, exchange rates and liquidity of investments;

(e) credit risk – the risk of loss arising from failure to collect funds from creditors, including reinsurers and intermediaries; and

(f) operational risk – the risk of loss resulting from inadequate or failed internal processes, people and systems, or from external events. This includes legal risk[9] but excludes strategic or reputational risk.

18. APRA may direct an insurer in relation to the manner in which each of these material risk categories are dealt with in the insurer’s ECM and RCM, including, but not limited to, altering the matters to be covered under each category and permitting categories to be dealt with in a cumulative manner. APRA may allow a transition period for compliance with a direction.

19. It is not necessary for the ECM and RCM to capture risks outside the above definitions, such as strategic or reputation risks. However, material risks that are not captured in the ECM and RCM must continue to be managed under the risk management framework of the insurer[10].

20. For each component of risk, the ECM must utilise a distribution with appropriate shape and tail characteristics. In combining components of risk, the model must make appropriate allowance for correlation between risks, particularly correlations in the tail of distributions. An insurer wishing to incorporate diversification assumptions in respect of operational risk must demonstrate an adequate process for estimating dependencies (particularly for extreme losses) and must apply conservatism in its dependence assumptions commensurate with the uncertainty of the estimates.

21. The operational risk module of the ECM must consider all of the following four elements:

(a) relevant internal event data (for which the insurer must maintain a suitably comprehensive operational risk event recording system);

(b) relevant external event data;

(c) scenario analysis; and

(d) the business environment and internal control systems.

22. The RCM must divide the insurance business into a sufficiently fine partition of business segments to reflect the major types of business that have different risk characteristics, and this partition must be reasonably aligned with the insurer’s operational structure.

Partial models

23. An insurer may apply to APRA for approval to use the IMB Method to calculate certain elements of its MCR, or the MCR for some business segments, while using the Prescribed Method[11] for the remaining elements or segments. APRA will consider applications that omit small or newly acquired business segments from the ECM, with Prescribed Method calculations for the omitted segments included in the RCM. Other partial use of the IMB Method will be approved only in exceptional circumstances.

24. An insurer must provide APRA with appropriate information, both at the time of the initial application for approval to use the IMB Method and subsequent to obtaining IMB Method approval, on any parts of the business activities of the insurer for which it is proposed to use the Prescribed Method to calculate the MCR.

Application and review process

25. An insurer wishing to apply for approval to use the IMB Method must consult with APRA at an early stage. To assist APRA in assessing the readiness of an insurer to commence the approval process, APRA has developed a series of self-assessment indicators which are set out in the Attachment.

26. APRA will consider an insurer’s self-assessment without seeking evidence or verification (which occurs later in the application and assessment process). If the self-assessment reveals major deficiencies, APRA will advise the insurer of further progress that is needed before the insurer continues with the application seeking approval to use the IMB Method.

27. APRA’s approval to use the IMB Method to determine MCR will be subject to a comprehensive model review process including:

(a) submission by the insurer of a detailed application for approval, with comprehensive information about the ECM and RCM, its governance and use, and the risk management environment of the insurer; and

(b) one or more on-site visits by APRA to the insurer to discuss the detail of the ECM and RCM, risk management systems, and surrounding governance and organisational structure and controls.

28. If it is satisfied that the criteria specified in this Standard have been met, APRA will approve the use of the RCM to determine the insurer’s MCR. Approval is given by APRA modifying relevant requirements in GPS 110 or GPS 111 pursuant to section 32(3A) of the Act. Modification may include requirements to be met on a continuing basis, including specifying that the MCR determined using the RCM will be subject to a minimum that is expressed as a percentage of the Prescribed Method calculation. During the first two years of the use of the IMB Method by an insurer, that minimum is to be 90 per cent of the amount determined using the Prescribed Method.

29. Use of the IMB Method does not relieve an insurer from complying with the following aspects of the capital standards:

(a) deductions from capital specified in GPS 111 and GPS 112;

(b) investment concentration charges and investment risk capital charges on reinsurance recoverables due from a non-APRA-authorised reinsurer specified in GPS 114; and

(c) the treatment of holdings in related companies representing retained profits that are equity accounted.

In order to avoid double-counting, any assets which are dealt with in accordance with paragraphs (a) to (c) above in the RCM, may be treated as risk-free or risk-reduced, in a manner agreed with APRA.

30. The RCM submitted to APRA for approval must include:

(a) an adequate specification of the version and assumptions of the relevant ECM;

(b) any particular parameters and other implementation rules applied in using the RCM to determine MCR;

(c) any adjustments required to achieve consistency with the Prescribed Method as specified in para 29;

(d) the addition of Prescribed Method MCR calculations for any business segments or other elements of the MCR calculation not included in the ECM;

(e) the procedure for determining the MCR based on the RCM at reporting dates other than the date as at which the annual calibration is undertaken;

(f) the application of any minima or other conditions imposed by APRA; and

(g) any other relevant matters that APRA may require.

31. Once the modification under subsection 32(3A) comes into effect, the insurer must determine the MCR in accordance with the approved RCM until APRA varies or revokes its approval.

32. APRA may, at any time by notice in writing to the insurer, vary or revoke its approval[12], including where APRA determines that:

(a) the insurer has not complied with this Prudential Standard; or

(b) it is appropriate having regard to the particular circumstances of the insurer to make the variation or revocation.

33. Where an insurer becomes aware that it is not complying with this Standard or with the modification of GPS 110 or GPS 111, the insurer must as soon as practicable notify APRA and provide a plan for a timely return to compliance. Failure to notify APRA, provide an acceptable plan, satisfactorily implement the plan or demonstrate that the non-compliance is immaterial will result in reconsideration by APRA of the insurer’s eligibility to use the IMB Method. For the period of any non-compliance APRA may require the insurer to hold additional regulatory capital or take other action.

Annual Internal Model Report

34. An insurer with approval to the IMB Method must provide an Internal Model Report to APRA annually (or more or less frequently as specified by APRA). An annual Internal Model Report must be submitted to APRA on or before the date that the Insurance Liability Valuation Report is due to be submitted to APRA in accordance with paragraph 30 of Prudential Standard GPS 310 Audit and Actuarial Reporting and Valuation or paragraph 27 of Prudential Standard GPS 311 Audit and Actuarial Reporting and Valuation: Level 2 Insurance Groups. Any more or less frequent Internal Model Report must be submitted within the timeframe specified by APRA. The scope of the Internal Model Report must be agreed between the insurer and APRA prior to its preparation.

Material changes

35. An insurer with approval for use of the IMB Method must advise APRA in advance of any material changes to the ECM or surrounding controls that are relevant to the RCM. APRA may require the insurer to make a new approval application, including independent review in the same manner as required under paragraph 14 (h), in circumstances including:

(a) material changes to the model or parameters;

(b) material changes to the business of the insurer, e.g. material acquisitions or disposals; or

(c) such other circumstances as APRA may determine.

Disclosure

36. GPS 110 and GPS 111 require insurers to disclose certain information about regulatory capital.[13] If an insurer uses the IMB method, the disclosure must include a statement to that effect, and the relevant MCR calculations using both the IMB Method and the Prescribed Method. APRA does not expect this disclosure to give rise to a need for external audit of the RCM.

Attachment to GPS 113

Paragraph 15 of this standard relating to the use test, and paragraph 25 relating to the application process refer to the indicators listed in this attachment.

Indicators

1. Inclusion of all the major risk types in the insurer’s risk management framework. Relation between the risk appetite of the insurer and its capital requirements and expected shareholder returns. Linkages with external credit ratings.

2. Inclusion of definitions and methodologies for all significant risk types that are applied consistently across business units in the insurer’s risk management framework. Usage of a coherent framework for measuring all risk types.

3. Existence of risk tolerances, risk limits and delegations across the organisation, and the extent to which they are established by reference to the information referred to in points 1 and 2 above.

4. The extent to which the insurer has developed and is using a Board-approved economic capital model as an integral part of its capital management framework and separately from any regulatory need.

5. A Board-approved process for determining a ‘cost of capital’ and required hurdle rate(s) of return for evaluating business strategies, opportunities and product pricing. The extent to which this information is applied consistently across all the business units.

6. The extent to which the evaluation of new business initiatives (including acquisition and expansion plans) is based on projected returns and the economic capital required to support these initiatives. The extent to which the economic capital is based on the economic capital model and other considerations.

7. The extent to which the setting and monitoring of the product pricing is influenced by the economic capital allocated and the required returns relative to that capital.

8. The extent to which capital allocation for business units and products is based on the underlying risks as reflected in the economic capital model. Demonstration that the assessment of business unit performance is based on return on allocated capital and/or other risk-based measures.

9. The extent to which performance and incentive remuneration of key executives is influenced by risk based measures, including economic capital allocation.