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Insurance (prudential standard) determination No. 7 of 2006 - Prudential Standard GPS 110 - Capital Adequacy
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Turn the raw legal text into a practical explanation grounded in Insurance (prudential standard) determination No. 7 of 2006 - Prudential Standard GPS 110 - Capital Adequacy.
Derivatives include forwards, futures, swaps, options and other similar contracts. Derivatives expose insurers to the full range of investment risks, even though in many cases there may be no, or only a very small, initial outlay. An insurer must set aside capital to cover the investment risk of these transactions, particularly in instances where the derivatives are used for reasons other than to hedge an underlying physical position. Under the Prescribed Method, an insurer is required to hold capital against derivatives using the method described below.
The requirements set out below do not apply to:
(a) foreign exchange (except gold) contracts which have an original maturity of 14 calendar days or less; and
(b) instruments traded on futures and options exchanges which are subject to daily mark-to-market and margin payments.
The capital charge for each derivative contract is based on its “asset equivalent value”. The asset equivalent value is the sum of the positive mark-to-market value (or replacement costs) of the contract and a potential exposure add-on.
The potential exposure add-on is determined by multiplying the notional principal amountF[39]F of the derivative contract (regardless of whether the contract has a zero, positive or negative fair value) by the relevant credit conversion factor specified in the table below according to the nature and residual maturity of the instrument.F[40]F
| Residual Maturity | Interest Rate Contracts | Foreign Exchange & Gold Contracts | Equity Contracts | Precious Metal Contracts (except Gold) | Other Contracts |
|---|---|---|---|---|---|
| Less than 1 year | Nil | 1.0% | 6.0% | 7.0% | 10.0% |
| 1 year to less than 5 years | 0.5% | 5.0% | 8.0% | 7.0% | 12.0% |
| 5 years or more | 1.5% | 7.5% | 10.0% | 8.0% | 15.0% |
The asset equivalent value of each derivative must then be multiplied by the Investment Capital Factor applicable to a debt obligation of the counterparty to the derivative contract to determine the Investment Risk Capital Charge.
APRA acknowledges that the method of measuring the risk of derivative positions described in paragraphs 31 to 35 of this Attachment is simple, and may not always reflect the underlying risk to which the insurer is exposed. However, given the limited usage of derivatives within the general insurance industry, APRA is of the view that a simple method will be adequate for the vast majority of Australian insurers. Where an insurer enters into significant derivative transactions – defined for the purposes of this Prudential Standard as contributing greater than 5 per cent of the insurer’s total Investment Risk Capital Charge or, in relation to exchange traded derivatives, where the notional principal amount of these instruments is greater than the capital base of the insurer – or where the insurer is otherwise making extensive use of derivatives for speculative purposes, APRA may require the insurer to hold additional capitalF[41]F against these positions.
An insurer must not generally enter into derivative contracts at off-market prices. This includes historical rate rollovers on foreign exchange contracts. If an insurer undertakes any derivative contracts at off-market prices, the insurer must contact APRA to discuss the reasons for such actions and the consequences for the insurer’s MCR.
In relation to paragraphs 27 to 37 of this Attachment, any amounts recorded on an insurer’s balance sheet at fair value in relation to these transactions must not be taken into account for determining the Investment Risk Capital Charge. The Investment Risk Capital Charge for these transactions must only be calculated in accordance with paragraphs 27 to 37 of this Attachment.
Table 1
Investment capital factors
| Asset | Investment Capital Factor |
|---|---|
| Cash (notes and coins)Debt obligations of:the Commonwealth Government;an Australian State or Territory government; orthe national government of a foreign country where: the security has a Grade 1 counterparty rating; or, if not rated, the long-term, foreign currency counterparty rating of that country is Grade 1Assets in respect of anticipated recoveries from the Commonwealth Government or from an Australian State or Territory governmentGST receivables (input tax credits) | 0.5% |
| Any debt obligation that matures or is redeemable in less than one year with a counterparty rating of Grade 1 or 2Cash management trusts with a counterparty rating of Grade 1 or 2 | 1% |
| Any other debt obligation (that matures or is redeemable in one year or more) with a counterparty rating of Grade 1 or 2Reinsurance recoveries and other reinsurance assets due from reinsurers with a counterparty rating of Grade 1 or 2 (subject to any determination by APRA under paragraph 6 of this Attachment) | 2% |
| Unpaid premiums due less than 6 months previously (subject to any determination by APRA under paragraph 6 of this Attachment)Unclosed businessAny other debt obligation with a counterparty rating of Grade 3Reinsurance recoveries and other reinsurance assets due from reinsurers with a counterparty rating of Grade 3 (subject to any determination by APRA under paragraph 6 of this Attachment) | 4% |
| Any other debt obligation with a counterparty rating of Grade 4Reinsurance recoveries and other reinsurance assets due from reinsurers with a counterparty rating of Grade 4 (subject to any determination by APRA under paragraph 6 of this Attachment) | 6% |
| Any other debt obligation with a counterparty rating of Grade 5Reinsurance recoveries and other reinsurance assets due from reinsurers with a counterparty rating of Grade 5Listed equity instruments (including subordinated debt)Units in listed trustsUnpaid premiums due more than 6 months previously | 8% |
| Direct holdings of real estateUnlisted equity instruments (including subordinated debt)Units in unlisted trusts (excluding Cash Management Trusts listed above)Other assets not specified elsewhere in this table | 10% |
| Loans to directors of the insurer or directors of related bodies corporateF[42]F (or a director’s spouse)Unsecured loans to employees exceeding $1,000Assets under a fixed or floating charge (refer to paragraphs 16 to 17 of this Attachment) | 100% |
| Goodwill (including any intangible components of investments in subsidiariesF[43]F)Other intangible assetsDeferred tax assetsSurpluses in employer-sponsored defined benefit superannuation funds (except where APRA has made an exception under paragraph 41 of Attachment A in which case an Investment Capital Factor of 10% applies.The amount of any reinsurance recoveries receivable that is deducted from Tier 1 Capital in accordance with subparagraph 39(m) or (n) of Attachment APremium receivables relating to the relevant fractionF[44]F of a proportional reinsurance treaty for which the underlying risks have not yet been accepted by the relevant direct insurer up to the limit of the premium receivable deduction calculated in paragraph 40 of Attachment AAmounts recorded on the balance sheet in relation to instruments subject to paragraphs 27 to 37 of this Attachment |
| 0% |