Insurance (prudential standard) determination No. 7 of 2006 - Prudential Standard GPS 110 - Capital Adequacy
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At a minimum, the Concentration Risk Capital Charge relates to the risk associated with an accumulation of exposures to a single catastrophic event at a single site. However, APRA will require a whole of portfolio approach to be implemented by an insurer where APRA assesses that the single event approach is inadequate in evaluating that insurer’s reinsurance needs. If this is required of an insurer and it does not comply with the requirement, the insurer’s MCR may be increased in accordance with paragraph 17. The method for determining the Concentration Risk Capital Charge is set out in Attachment E. For lenders mortgage insurers, additional requirements for calculating the Concentration Risk Capital Charge are set out in Attachment F.
The Concentration Risk Capital Charge is set equal to the insurer’s Maximum Event Retention (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. APRA will monitor an insurer’s calculation of its MER and may, where it is not satisfied with the methodologies or assumptions used, require adjustments to be made to the calculation.F[11]F
In calculating the MER, an insurer must not take into account potential recoveries from a reinsurance arrangement unless the reinsurance arrangement:
(a) complies with the two month rule and six month rule imposed under Prudential Standard GPS 230 Reinsurance Management (GPS 230); or
(b) fails to comply with those rules as at the date of the relevant deadline but:
(i) subsequent to the deadline specified under the two month rule, the reinsurance arrangement is documented in accordance with the other requirements of the two month rule (in which case the reinsurance recoveries from the reinsurance arrangement may be taken into account for the purposes of calculating the MER until the reinsurance arrangement fails to comply with the six month rule); or
(ii) subsequent to the deadline specified under the six month rule, the reinsurance arrangement is documented in accordance with the other requirements of the six month rule; or
(c) has been treated by APRA, under GPS 230, as complying with the two month rule and six month rule.
Disclosure
Disclosure and transparency are important allies of the supervisor. To improve policyholder and market understanding of its capital adequacy position, an insurer must disclose, in its published annual report, the following items:
(a) the amount of eligible Tier 1 capital, with separate disclosure of each of the items specified in Attachment A;
(b) the aggregate amount of any deductions from Tier 1 capital;
(c) the amount of eligible Tier 2 capital, with separate disclosure of each of the items specified in Attachment A;
(d) the aggregate amount of any deductions from Tier 2 capital;
(e) the total capital base of the insurer derived from the items (a) to (d);
(f) the MCR of the insurer; and
(g) the capital adequacy multiple of the insurer (item (e) divided by item (f)).
Attachment A
Measurement of Capital Base
This Attachment sets out the range of capital instruments that are eligible for inclusion in the capital base of an insurer, required deductions from an insurer’s capital base and the process for obtaining approval for reductions in capital by an insurer.
The definitions and the qualifying criteria detailed in this Attachment are applicable to all locally incorporated insurers. As outlined in this Prudential Standard, a different measure of capital adequacy applies to foreign insurers. This reflects the nature of a foreign insurer’s Australian balance sheet, which does not generally include separately identifiable capital instruments.
Interpretation
Any reference in this Attachment to:
(a) Auditing and Assurance Standards is a reference to the Auditing and Assurance Standards issued by the Auditing and Assurance Standards Board as may be amended from time to time;
(b) Australian Accounting Standards is a reference to the Australian Accounting Standards issued by the Australian Accounting Standards Board as may be amended from time to time;
(c) associates is a reference to associates as defined in the Australian Accounting Standards and is to be read as also applying to joint ventures unless otherwise indicated;
(d) cash flow hedges is a reference to cash flow hedges as defined in the Australian Accounting Standards;
(e) the earnings or retained earnings of an insurer in this Attachment is a reference to the earnings or retained earnings of the insurer determined in a manner consistent with the insurer’s prudential reporting to APRA under the Collection of Data Act rather than in accordance with Australian Accounting Standards as required for statutory financial reporting under the Corporations Act 2001 (Corporations Act); and
(f) subsidiary is a reference to a subsidiary as defined under the Corporations Act.
Capital base
Capital, for supervisory purposes, is considered in two tiers. Tier 1, or core capital, comprises the highest quality capital elements that fully meet all the essential characteristics of capital described in paragraph 7 of this Attachment. Tier 2, or supplementary capital, includes other instruments that, to varying degrees, fall short of the quality of Tier 1 capital but nonetheless contribute to the overall financial strength of an insurer.
For capital adequacy purposes, a locally incorporated insurer’s capital base is defined as the sum of Tier 1 and Tier 2 capital, net of all deductions specified in this Attachment, subject to the various limits specified in paragraph 44 of this Attachment that apply. An insurer must ensure that its capital base exceeds its MCR at all times.
In assessing whether an instrument is eligible as Tier 1 or Tier 2 capital, APRA will have regard to both the form and substance of the instrument. An insurer must:
(a) provide APRA with copies of documentation associated with the issue of the instrument; and
(b) where the terms of the instrument depart from established precedent, consult APRA and provide APRA with adequate time to review the instrument in advance of issuance to ensure the eligibility of the instrument for inclusion in the insurer’s capital base.
Tier 1 capital
Tier 1 capital comprises the highest quality capital elements which fully satisfy all of the following essential characteristics:
(a) provide a permanent and unrestricted commitment of funds;
(b) are freely available to absorb losses;
(c) do not impose any unavoidable servicing charge against earnings; and
(d) rank behind the claims of policyholders and creditors in the event of winding-up.
For the purposes of calculating an insurer’s capital base, Tier 1 capital is divided into the following:
(a) Fundamental Tier 1 capital, which is the highest form of capital, consists of:
(iv) current year’s earnings net of expected dividends and tax expenses; and
(v) technical provisions in excess of those required by GPS 310.F[13]F
(b) Residual Tier 1 capital, which consists of all other items qualifying for Tier 1 status, is divided into:
(i) Non-innovative Residual Tier 1 capital – comprising perpetualF[14]F non-cumulative preference shares that satisfy the relevant criteria set out in this Attachment; and
(ii) Innovative Tier 1 capital – comprising all other Residual Tier 1 capital instruments that satisfy the relevant criteria set out in this Attachment.
Reserves are created after tax and include, but are not limited to:
(a) reserves from equity-settled share-based payments (shares or share options) granted to employees as part of their remuneration package provided that:
(i) the shares or share options granted relate only to the ordinary shares of the insurer itself; and
(ii) there are no circumstances in which such remuneration can be converted into another form (e.g. cash).
Any other reserves associated with share-based payments must be excluded from capital; and
(b) cumulative unrealised gains or losses on cash flow hedges offsetting gains or losses included in Tier 1 capital (e.g. movements in the currency value of foreign currency denominated hedging instruments which offset movements in foreign currency denominated items recognised in the foreign currency translation reserve).
Residual Tier 1 capital
To qualify as Residual Tier 1 capital, an insurer must ensure that an instrument satisfies the following criteria:F[15]F
(a) the instrument is unsecured and paid up:
(i) any partly paid issue is eligible only to the extent that it has been paid up. Subject to paragraph 15 of this Attachment, unpaid perpetual non-cumulative preference shares issued through “stapled” structures are permitted (to the extent that they are paid up); and
(ii) only the proceeds of the issue that have been received by the issuer are permitted to count as capital;
(b) the instrument is perpetual:
(i) the instrument is not redeemable at the option of the holder and has no provisions which require future redemption by the issuer; and
(ii) redemption at the option of the issuer is permitted, provided the redemption or call option is subject to APRA’s written approval at the time of exercise and it does not operate in conjunction with any other feature that creates or signals a de facto tenor of the instrument. Should this occur, APRA will consider the instrument to be a dated instrument and ineligible for inclusion as Tier 1 capital. Issue documentation must give clear and prominent notice to prospective investors that the issuer’s right to exercise any such option to redeem or purchase the instrument is subject to APRA’s prior written approval;
(c) the instrument imposes no fixed servicing costs on the issuer:
(i) dividend or interest payments to the holders of the instrument is at the discretion of the issuer. The issuer is able to waive any dividend or interest payments on the instrument and alter the timing of payments;
(ii) any unpaid dividends or interest to the holders of the instrument is non-cumulative (i.e. not required to be made up by the issuer at a later date). The instrument, both in form and substance, does not provide for cumulative dividend or interest payments. For example, the instrument does not provide for payment of a higher dividend or interest rate if dividend or interest payments are not made on time nor a reduced dividend or interest rate if such payments are made on time. Any special or optional dividends or interest payments on the instrument outside of normal scheduled payments require APRA’s prior written approval;
(iii) the non-payment of a dividend or interest on the instrument does not trigger any restrictions on the issuer other than its ability to pay dividends on ordinary shares, or purchase shares (outside normal trading operations) or retire other shares;
(iv) the instrument does not provide for payment of any form of compensation to investors other than by way of a distribution of profits. Any such profit distribution is in the form of a cash dividend or interest payments. Payment in kind is not permitted;
(v) dividend or interest payments on the instrument are not linked to the credit standing of the issuer. However, linking dividend or interest payments on the instrument to movements in general market indices is permitted; and
(vi) the rate of dividends or interest on the instrument, or the formulae for calculating dividend or interest payments on the instrument, are predetermined and set out in the issue documentation;
(d) the instrument is able to absorb losses incurred by the issuer on a going concern basis and in the winding-up of the issuer, including satisfying the criteria specified in paragraph 13 of this Attachment;
(e) the instrument is subordinated in right of repayment of principal, interest and dividends to all policyholders and creditors of the issuer, with issue documentation that clearly:
(i) indicates the subordinated nature of the instrument to prospective holders, and
(ii) precludes the exercise of any contractual rights of set-off between the instrument and any claims by the issuer on the holders of the instrument;
(f) the instrument does not contain any terms, covenants or restrictions that could inhibit the issuer’s ability to be managed in a sound and prudent manner, particularly in times of financial difficulty, or restrict APRA’s ability to resolve any problems encountered by the issuer (e.g. clauses preventing further senior debt issues are prohibited). There are no cross-default clauses in the documentation of any debt instruments of the issuer linking the issuer’s obligations under the instrument to default by another party (related or otherwise); and
(g) the instrument is marketed in line with its prudential treatment, and does not include any “repackaging” arrangements which have the effect of compromising the permanency of capital raised. If the prospectus or other offering documentation or marketing of the instrument suggests to investors that the instrument has attributes of a lower level of capital than claimed for prudential treatment, APRA will treat the instrument as an instrument falling into that lower level of capital for prudential purposes.
Where an instrument is subject to the laws of a jurisdiction other than a state or territory of Australia, the insurer must also ensure that the instrument complies with and is enforceable under the laws of that jurisdiction. APRA may require the insurer to provide confirmation by way of an independent legal opinion addressed to APRA by a firm or practitioner of APRA’s choice, at the expense of the insurer.
An insurer must inform APRA of any subsequent modification of the terms or conditions of the instrument. In assessing whether the subsequent modification of the terms or conditions of the instrument affects its eligibility to continue qualifying as Non-innovative Residual Tier 1 capital or Innovative Tier 1 capital, APRA will have regard to both the form and substance of the instrument as modified. An insurer must:
(a) provide APRA with copies of documentation associated with the modification of the instrument; and
(b) where the terms and conditions of the instrument as modified depart from established precedent, consult APRA and provide APRA with adequate time to review the instrument in advance of the modification to ensure the eligibility of the instrument for inclusion in the insurer’s capital base.
For the purposes of subparagraph 10(d) of this Attachment, the issuer must ensure that:
(a) the instrument (both principal and any unpaid dividends or interest) is treated as a specific class of share capital or member’s interest of the issuer. The contractual rights of the holders of the instrument to receive and enforce any payments under the instrument must be consistent with the intention that the instrument functions as if it constituted a specific class of share capital or member’s interest of the issuer;
(b) the issuer does not have any liability to make a dividend or interest payment on the instrument if making the payment would result in the issuer becoming, or being likely to become, insolvent for the purposes of the Corporations Act or, where the issuer is incorporated in a foreign jurisdiction, for the purposes of equivalent corporate insolvency law of that jurisdiction; and
(c) issue documentation makes explicit that:
(i) payment of dividends or interest on the instrument is at the discretion of the issuer;
(ii) failure of the issuer to make a dividend or interest payment on the instrument does not constitute an event of default;
(iii) holders have no right to apply for the winding-up or administration of the issuer, or cause a receiver, or receiver and manager, to be appointed in respect of the issuer on the grounds that the issuer fails to make, or is or may become unable to make, a dividend or interest payment under the instrument; and
(iv) holders of the instrument will have no offsetting rights or claims on the issuer in the event that the issuer cancels or suspends dividend or interest payments on the instrument.
Non-innovative Residual Tier 1 capital
To qualify as Non-innovative Residual Tier 1 capital, an insurer must ensure that perpetual non-cumulative preference shares satisfy both the criteria set out in paragraph 10 of this Attachment and the following criteria:
(a) the preference shares have not been issued indirectly through an SPV. An indirect issue is not eligible for inclusion in Non-innovative Residual Tier 1 capital although the preference shares may be included in Innovative Tier 1 capital provided they also satisfy the criteria set out in paragraph 45 of this Attachment;
(b) the preference shares do not provide for any step-up in dividends. A conversion from fixed to floating rate (or vice-versa) or a switch in index basis, where there is no change in the effective margin included in the rate of dividend is not considered a step-up;
(c) conversion of the preference shares into ordinary shares is permitted, subject to the following criteria:
(i) conversion cannot occur at the option of the holder;
(ii) the conversion formula for determining the number of ordinary shares received upon conversion of a preference share is fixed in the issue documentation and includes a cap on the maximum number of ordinary shares that holders will receive upon conversion;
(iii) for the purposes of sub-subparagraph (ii), the maximum number of ordinary shares received upon conversion of each preference share does not exceed the ratio of the price of the preference share at issue divided by 50 per cent of the price of the ordinary share at time of issue of the preference shares. For these purposes, in calculating the ordinary share price at time of issue, adjustments may be made for subsequent ordinary share splits, bonus issues and similar transactions;
(iv) the conversion is not structured in a way that would effectively provide for a return of capital or compensation for unpaid dividends; and
(v) any exercise of the conversion option by the issuer is subject to APRA’s prior written approval. Approval is not required for any mandatory conversions whose terms were agreed to by APRA prior to issuance of the preference shares; and
(d) perpetual non-cumulative preference shares issued through “stapled” structures are permitted, subject to the conditions specified in paragraph 15 of this Attachment; and
(e) adequate internal policies and controls are in place such that the unstapling procedures are correctly followed.
For the purposes of sub-subparagraph 10(a)(i) and subparagraph 14(d) of this Attachment:
(a) the preference shares are issued directly by the insurer and are “stapled” to securities (the stapled securities) issued directly by an overseas branch of the insurer. The stapled structure must not involve any use of SPVs and must be simple and transparent;
(b) either or both of the preference shares and the stapled securities are paid up. Any partly paid preference shares or stapled securities are eligible only to the extent that they have been paid up;
(c) the preference shares and the stapled securities are not traded separately and are stapled together unless and until an “unstapling event” occurs;
(d) the terms and conditions of the stapled securities mirror substantially those of the preference shares such that the stapled securities operate effectively as if they were the preference shares. Accordingly, the terms and conditions of the stapled securities do not compromise the Tier 1 qualities of the underlying preference shares;
(e) “unstapling” of the preference shares and the stapled securities at the option of the issuer is permitted. The instrument documentation must clearly stipulate the events that will cause the preference shares to be “unstapled” with the stapled securities being extinguished and the holders of the stapled securities holding the preference shares instead. “Unstapling” must take place where:
(i) proceedings for the liquidation of the insurer commence; or
(ii) APRA revokes the authorisation of the insurer pursuant to subsection 15(1) of the Act;
(f) issue documentation requires holders of the stapled securities to hold the underlying preference shares upon the occurrence of an unstapling event. Where necessary, APRA may require the insurer to provide an independent legal opinion confirming this result addressed to APRA by a firm or practitioner of APRA’s choice, at the expense of the insurer. To reduce the inherent legal risk associated with unstapling of the structure, the insurer must ensure the clarity, consistency and certainty with which the contractual terms and conditions are specified in the issue documentation, in particular that:
(i) all entities involved in the stapled structure have the capacity and power needed to issue the relevant instruments and perform obligations under them;
(ii) the rights and obligations created by the preference shares and the stapled securities are legal, valid, binding and enforceable on all relevant parties in all relevant jurisdictions; and
(iii) the unstapling mechanism will take effect as contemplated in the issue documentation even if the insurer or other entity has become, or is likely to become insolvent, including where it is in administration, receivership, winding up, or where APRA has revoked the authorisation of the insurer pursuant to subsection 15(1) of the Act.
Innovative Tier 1 capital
To qualify as Innovative Tier 1 capital, an insurer must ensure that an instrument satisfies the criteria set out in paragraph 10 of this Attachment and the following criteria:
(a) where the instrument provides for a “step-up” in dividends or interest, the terms of the step-up is limited, fixed at the time of issue and subject to APRA’s prior written approval (refer to paragraph 35 of this Attachment for further detail);
(b) a step-up in dividends or interest or an equity conversion is permitted in conjunction with an issuer call option, provided the step-up or equity conversion meets all relevant criteria and, where the application of a step-up or equity conversion is optional, the issue cannot mandate the exercise of the call option if the step-up or equity conversion is not applied;
(c) where the instrument provides for a mandatory conversion or an option to the holders or the issuer to convert into another form of eligible Tier 1 capital instrument, the instrument must not contain any conversion feature that effectively provides for a return of capital or compensation for unpaid dividends or interest. The rate of conversion in all circumstances must be fixed (e.g. by way of a formulae) at the time of issue; and
(d) where the instrument is issued indirectly through an SPV, it satisfies the criteria set out in paragraph 45 of this Attachment.