Collateral, guarantees and letters of crCollateral, guarantees and letters of credit in respect of reinsurance recoverables due from non-APRA-authorised reinsurers

Collateral, guarantees and letters of credit in respect of reinsurance recoverables due from non-APRA-authorised reinsurers

23. Where an insurer possesses recognised collateral in Australia against reinsurance recoverables due from a non-APRA-authorised reinsurer, it may apply the Investment Capital Factor relevant to the collateral to the value of the reinsurance recoverables (instead of applying the Investment Capital Factor that would otherwise apply to the reinsurance recoverables). For the purposes of this paragraph, collateral is recognised only:

(a) to the extent that it takes the form of:

(i) assets held in Australia which form part of a trust fund maintained by a trustee resident in Australia;

(ii) deposits held by the insurer in Australia made by the non-APRA-authorised reinsurer;

(iii) a combination of the two forms of collateral specified in paragraphs (a) and (b); or

(iv) any other form of collateral as may be approved by APRA in writing in a particular case;

(b) if it provides effective security against liabilities arising under the reinsurance contract; and

(c) if it is not available for distribution to creditors of the reinsurer other than the insurer in the event of insolvency of the reinsurer.

24. Where the fair value of the collateral does not cover the full value of the reinsurance recoverables, only that part of the value of the reinsurance recoverables that is covered by collateral may be assigned the Investment Capital Factor applicable to the collateral.

25. Where an insurer possesses a guarantee or letter of credit in respect of the reinsurance recoverables due from a non APRA authorised reinsurer, the Investment Capital Factor to be used is that applicable to the guarantor or the issuer of the letter of credit, as the case may be. This paragraph applies only if:

(a) the guarantor or issuer of the letter of credit is an authorised deposit-taking institution[2] or, in the case of a Category E insurer, its parent entity or other related entity provided the entity has a counterparty rating of Grade 1, 2 or 3;

(b) the guarantee or letter of credit is explicit, unconditional and irrevocable;

(c) the guarantor or issuer of the letter of credit is obliged to pay the insurer in Australia; and

(d) the obligation of the guarantor or issuer of the letter of credit to pay the insurer is specifically linked to performance of the reinsurance contract or contracts under which the reinsurance recoverables arise.

Except in the case of a Category E insurer, a guarantee or letter of credit provided to an insurer by its parent entity or other related entity is not eligible for the treatment provided for in this paragraph.

26. The collateral, guarantee or letter of credit referred to in paragraphs 23 and 25 must be effective for the expected period for payment of claims under the reinsurance contract under which the reinsurance recoverables arise. If this is impractical, the collateral, guarantee or letter of credit must be effective for at least 2 years but be renegotiable each year to allow at least a year to identify alternative arrangements if the collateral, guarantee or letter of credit cannot be renegotiated.

Charged and encumbered assets

27. Subject to paragraph 28, assets of the insurer that are under a fixed or floating charge[3], mortgage or other security are subject to an Investment Capital Factor of 100 per cent, to the extent of the indebtedness secured on those assets. This will replace the Investment Capital Factor that would otherwise apply to the secured assets.

28. Where the security referred to in paragraph 27 exclusively supports an insurer’s insurance liabilities, the Investment Capital Factor of 100 per cent is applicable only to the amount by which the fair value of the charged assets exceeds the insurer’s supported insurance liabilities. These insurance liabilities are to be valued at a 75 per cent level of sufficiency according to Prudential Standard GPS 310 Audit and Actuarial Reporting and Valuation (GPS 310).

Investment Concentration Charge

29. For the purposes of calculating the Investment Concentration Charge, two or more counterparties will form a group of related counterparties if they are linked by:

(a) cross guarantees;

(b) common ownership or management;

(c) the ability of a counterparty to exercise control (defined in accordance with Australian Accounting Standards) over the other(s), where direct or indirect;

(d) financial interdependency such that the financial soundness of any of them may affect the financial soundness of the other(s); or

(e) other connections or relationships which, according to an the insurer’s assessment, identify the counterparties as constituting a single risk.

30. An insurer may be exposed to an additional risk arising from an excessive exposure (both on-balance sheet and off-balance sheet) to a particular asset, counterparty or group of counterparties (including in relation to reinsurance assets). Subject to paragraph 31, to address the risk associated with excessive exposure, an insurer must hold additional capital in those cases where an insurer’s exposure to a particular asset, counterparty or group of related counterparties exceeds the thresholds set out in paragraph 32. The aggregation of exposures to individual counterparties must be undertaken for an insurer and any entities approved as part of its ELE (refer to paragraphs 15 to 18).

31. APRA recognises that an insurer may make loans to its parent company or related companies. If such a loan is not made on commercial terms, the entire exposure from the loan is accorded an Investment Capital Factor of 100 per cent and this Investment Capital Factor applies regardless of the counterparty rating of the parent company or related company.

32. The thresholds referred to in paragraph 30 are based on the credit rating[4] of the counterparty[5] and are as follows:

33. If a large claim or aggregation of claims arising from a catastrophic event causes the outstanding reinsurance assets of an insurer to temporarily exceed the thresholds set out in paragraph 32, the insurer may apply to APRA to suspend the application of the thresholds for a specified period of time. APRA may grant written approval for such suspension subject to conditions and may specify any period of time for such suspension.

34. An insurer must apply the relevant Investment Capital Factor to an asset or assets up to the value of the threshold, and apply a 100 per cent Investment Capital Factor to the value in excess of this level to calculate the Investment Concentration Charge. In the case of exposures (both on-balance and off-balance sheet) to a group of related counterparties, exposures are aggregated both against counterparties of the same grade and upwards through the rating grades, with the threshold for each grade applying to aggregate exposures summed for that grade and all lower quality grades, excluding any exposures which are already subject to a 100 per cent Investment Capital Factor. Paragraph 35 describes the method to be applied in greater detail.

35. Exposures to a group of related counterparties at the Grade 5 level are aggregated to determine the amount in excess of the Grade 5 threshold to which the 100 per cent Investment Capital Factor is applied. Those exposures to a group of related counterparties at the Grade 5 level (up to the Grade 5 threshold) are then aggregated with all exposures to that group of related counterparties at the Grade 4 level to determine the amount in excess of the Grade 4 threshold to which the 100 per cent Investment Capital Factor is applied.

36. The following must not be taken into account in determining the Investment Concentration Charge:

(a) premium receivables and reinsurance assets to which an Investment Capital Factor of zero per cent is applied; and

(b) assets to which an Investment Capital Factor of 100 per cent is applied.

Off-balance sheet transactions

37. An insurer can be exposed to various investment risks through transactions or dealings other than those reflected on its balance sheet.

38. As a general rule, an insurer must not be exposed to an obligor for an unlimited amount and any exposure must be for a finite period. An exception to this rule is where a potential credit exposure results from reinsurance of an insurance contract that is required by law to be unlimited. If an insurer does enter into an arrangement with an obligor that does not have appropriate limits, it must:

(a) notify APRA;

(b) explain how this arrangement complies with its Risk Management Strategy; and

(c) explain how it will be valued for the purposes of capital adequacy calculations.

Such an exposure may cause APRA to review the insurer’s MCR and adjust the insurer’s MCR in accordance with paragraph 17 of GPS 110.

Direct credit substitutes

39. To the extent that an insurer has issued:

(a) guarantees (including written put options serving as guarantees);

(b) letters of credit; or

(c) any other credit substitute (other than insurance) in favour of another party,

the insurer is exposed to risk of having to make payment on these instruments should the guaranteed party default or fail to deliver.

40. An insurer must set aside capital to cover the risk of such events occurring. Within the Prescribed Method, this is to be achieved by applying, to the face value of the credit substitute, the Investment Capital Factor that would be applied to the obligation or asset over which the credit substitute has been written. Where the credit substitute is supported by collateral or a guarantee, the provisions of paragraphs 20 to 22 may be applied.

41. A different approach to that set out in paragraphs 39 and 40 is available for surety bonds issued by the insurer. The insurer has the choice of either:

(a) treating any surety bonds the insurer has issued as a type of direct credit substitute. In this case, the insurer must determine 25 per cent of the value of the surety bond, and apply to that amount the Investment Capital Factor that would be applied to the obligation or asset over which the surety bond has been written. Where the surety bond is supported by a risk mitigation arrangement, the applicable Investment Capital Factor will be that assigned to the counterparty to that arrangement, but only to the extent that the risk mitigation arrangement applies; or

(b) seeking written approval from APRA to treat any surety bonds the insurer has issued as if they were an insurance risk (for the purposes of meeting the requirements of prudential standards only). This would require the insurer to include surety bond exposures within the insurer’s assessment of insurance liabilities, as determined under GPS 310, and to apply the relevant capital factors specified in Prudential Standard GPS 115 Capital Adequacy: Insurance Risk Capital Charge.F[6] For the purpose of calculating net outstanding claims liabilities and net premiums liabilities (as determined under GPS 310) the insurer may treat any risk mitigation arrangement as if it were reinsurance. An insurer seeking APRA’s approval for this approach would need to include with its application a confirmation from the company’s Appointed Actuary that that person is able to appropriately measure the risk of the surety bond business within the insurer’s insurance liabilities.

The insurer must use the same approach for all surety bonds issued by it, and apply that approach consistently over time.

42. For the purposes of paragraph 41, a surety bond means an undertaking given by an insurer at the request of a person (Customer) pursuant to an agreement (Surety Agreement) between the insurer and the Customer made in the following circumstances:

(a) the Customer enters into the Surety Agreement in order to enable the Customer to meet a requirement of another agreement (Principal Agreement) between the Customer, or a person associated with the Customer, and a person other than the insurer (Principal);

(b) under the surety bond, the insurer undertakes to make a payment to, or perform an obligation for the benefit of, the Principal or another person nominated by the Principal (Beneficiary) in the circumstances specified in the surety bond;

(c) the surety bond is issued to the Principal or the Beneficiary in relation to or in connection with an obligation owed by the Customer, or a person associated with the Customer, to the Principal under the Principal Agreement being an obligation which:

(i) is a performance obligation or contains an element of performance on the part of the Customer, or a person associated with the Customer; and

(ii) does not relate solely to the payment of money by the Customer, or a person associated with the Customer, to the Principal; and

(d) under the Surety Agreement, the Customer is liable to the insurer if the insurer makes a payment or incurs a liability to the Principal or the Beneficiary under the surety bond.