Insurance (prudential standard) determination No. 7 of 2010 - Prudential Standard GPS 114 - Capital Adequacy: Investment Risk Capital Charge
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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. For the avoidance of doubt:
(a) the paragraphs in this Prudential Standard relating to derivatives apply to both covered and uncovered derivative positions; and
(b) a short position in any traded instrument is taken to be a derivative for the purposes of this Prudential Standard and paragraph 27 does not apply to any collateral arrangement associated with the short position.
The Investment Risk Capital Charge for a derivative is determined as the sum of three components:
(a) the equity market risk component;
(b) the equity basis risk component; and
(c) the counterparty risk component.
The components in paragraphs (a) and (b) are applicable only to derivatives over listed equities. Paragraphs 47 to 50 set out the application of the counterparty risk component.
Where an insurer holds derivatives over listed equities, the Investment Risk Capital Charge applicable to all holdings of listed equities under paragraph 10 is to be replaced with the equity market risk component. The equity market risk component is equal to 16 per cent of the absolute value of the net exposure to listed equities and derivatives over listed equities (where the derivatives exposure for options is calculated on a delta-weighted basis).
The equity basis risk component applies only to derivatives over listed equities for which the notional equity position is negative, and will be a specified percentage of the absolute value of the notional equity position. The percentage is the lesser of eight per cent and 16 x (100 per cent - overlap percentage). The overlap percentage measures the effectiveness of the hedge between the derivative and the physical portfolio it is being used to hedge and is equal to the sum of the lesser of A and B for each stock in that portfolio where:
(a) A is the stock's proportionate weight in the portfolio; and
(b) B is the stock's proportionate weight in the index on which the derivative is based.
A derivative that is not being used to hedge a portfolio will have a basis risk percentage of eight per cent. A portfolio may consist of one or more stocks.
Subdivision Derivatives - Insurance (prudential standard) determination No. 7 of 2010 - Prudential Standard GPS 114 - Capital Adequacy: Investment Risk Capital Charge - Derivatives | Zoe
The counterparty risk component does 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 counterparty risk component 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 amount[7] 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.[8]
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 counterparty risk component.
Where:
(a) an insurer enters into significant derivative transactions (defined for the purposes of this Prudential Standard as contributing greater than five 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
(b) an insurer is otherwise making extensive use of derivatives for speculative purposes,
APRA may require the insurer to hold additional capital[9] 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 39 to 52, 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 39 to 52.
An insurer must consult with APRA prior to entering into derivative contracts other than those over:
(a) equities;
(b) interest rates; and
(c) foreign exchange.
APRA will, as part of the consultation, determine an appropriate capital treatment for such contracts.
Determinations made under previous GPS 114
An approval, determination, direction or requirement made by APRA or taken to have been made by APRA under a provision specified in Column 1 of the following table that is in operation immediately prior to the commencement of this Prudential Standard is taken, on and from the effective date, to have been made under the provision of this Prudential Standard specified in the same row of Column 2 of the table.
Column 1: Provision of Prudential Standard GPS 114 Capital Adequacy: Investment Risk Capital Charge made on 23 June 2008 as amended by Insurance (prudential standard) No. 1 of 2009 made on 11 May 2009
Column 2: Provision of this Prudential Standard
Paragraph 13: determine calculation of Investment Risk Capital Charge for a specified asset or an asset of a specified class.
Paragraph 13
Paragraph 17: approve a related entity as part of an insurer’s ELE.
Paragraph 17
Paragraph 33: suspend the application of thresholds relating to Investment Concentration Charge for a period of time following a catastrophic event.
Paragraph 33
Paragraph 41(b) of previous GPS 110: approve surety bonds as insurance risk.
Paragraph 41(b)
Attachment B, Paragraph 6: approve use of rating determined by a rating agency not included in the table of Attachment B, Paragraph 1.
Attachment B, Paragraph 6
Attachment A
This Attachment sets out the manner in which Investment Capital Factors are to be determined in order to calculate the Investment Risk Capital Charge in accordance with paragraph 10 of this Prudential Standard.
For assets of an insurer or its ELE held under a trust (other than a cash management trust[10]), the insurer may apply the Investment Capital Factor applicable to the underlying assets (including derivatives) of the trust if the insurer has information on the underlying assets. For the purpose of determining the Investment Risk Capital Charge, the Investment Capital Factors specified in Table 1 must be applied to the insurer’s share of the underlying assets of the trust as though the insurer held those assets directly.
An insurer must consult APRA on the Investment Capital Factor applicable to hybrid instruments with both equity and debt features (e.g. embedded derivatives) in calculating the Investment Risk Capital Charge. In particular, APRA may require the insurer to apply different Investment Capital Factors to different components of a hybrid instrument.
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%
2.
Any debt obligation that matures or is redeemable in less than one year with a counterparty rating of Grade 1 or 2 (excluding subordinated debt[11] and debt obligations of government dealt with specifically in this Table)Cash management trusts with a counterparty rating of Grade 1 or 2
1%
3.
Any other debt obligation (that matures or is redeemable in one year or more) with a counterparty rating of Grade 1 or 2 (excluding subordinated debt and debt obligations of government dealt with specifically in this Table)Reinsurance assets in relation to APRA-authorised reinsurers with a counterparty rating of Grade 1 or 2 (subject to any determination by APRA under paragraph 13 of this Prudential Standard)
2%
4.
Reinsurance assets in relation to non-APRA-authorised reinsurers with a counterparty rating of Grade 1 or 2 except for reinsurance recoverables specified under paragraph 5 of this Attachment
3%
5.
Unpaid premiums due less than 6 months previously (subject to any determination by APRA under paragraph 13 of this Prudential Standard)Unclosed businessAny other debt obligation with a counterparty rating of Grade 3 (excluding subordinated debt)Reinsurance assets in relation to APRA-authorised reinsurers with a counterparty rating of Grade 3 (subject to any determination by APRA under paragraph 13 of this Prudential Standard)Cash management trusts with a counterparty rating of Grade 3
4%
6.
Any other debt obligation with a counterparty rating of Grade 4 (excluding subordinated debt)Reinsurance assets in relation to APRA-authorised reinsurers with a counterparty rating of Grade 4 (subject to any determination by APRA under paragraph 13 of this Prudential Standard)Reinsurance assets in relation to non-APRA-authorised reinsurers with a counterparty rating of Grade 3 except for reinsurance recoverables specified under paragraph 5 of this AttachmentCash management trusts with a counterparty rating of Grade 4
6%
7.
Any other debt obligation with a counterparty rating of Grade 5 (excluding unlisted subordinated debt)Reinsurance assets in relation to APRA-authorised reinsurers with a counterparty rating of Grade 5Unpaid premiums due more than 6 months previouslyCash management trusts with a counterparty rating of Grade 5Listed subordinated debt
8%
8.
Reinsurance assets in relation to non-APRA-authorised reinsurers with a counterparty rating of Grade 4 except for reinsurance recoverables specified under paragraph 5 of this Attachment
9%
9.
Unlisted subordinated debt
10%
10.
Reinsurance assets in relation to non-APRA-authorised reinsurers with a counterparty rating of Grade 5 except for reinsurance recoverables specified under paragraph 5 of this Attachment
12%
11.
Listed equity instrumentsListed trusts except where otherwise provided for in this Attachment
16%
12.
Direct holdings of real estateUnlisted equity instrumentsUnlisted trusts except where otherwise provided for in this AttachmentOther assets not assigned an Investment Capital Factor elsewhere in this Table (other than hybrid instruments with both equity and debt features (see paragraph 3 of this Attachment)
20%
13.
Loans to directors of the insurer or directors of related bodies corporate (or a director’s spouse)Unsecured loans to employees exceeding $1,000Assets under a fixed or floating charge (refer to paragraphs 27 to 28 of this Prudential Standard)
100%
14.
Amounts required to be deducted from an insurer’s capital base under Prudential Standard GPS 112 Capital Adequacy: Measurement of CapitalAmounts recorded on the balance sheet in relation to instruments subject to paragraphs 39 to 54 of this Prudential Standard
0%
Transition for reinsurance assets due from non APRA-authorised reinsurers
Reinsurance assets due from non-APRA-authorised reinsurers are treated as if they were reinsurance assets due from APRA-authorised reinsurers for the purposes of calculating the Investment Risk Capital Charge up to and including 31 December 2008.
Treatment of certain reinsurance recoverables from non-APRA-authorised reinsurers
This paragraph applies to reinsurance recoverables from non-APRA-authorised reinsurers arising under reinsurance contracts incepting on or after 31 December 2008. For reinsurance recoverables from non-APRA-authorised reinsurers, the Investment Capital Factors specified in Table 2 apply (in replacement of those specified in Table 1) to each reinsurance recoverable on and from the second annual balance date after the event giving rise to the reinsurance recoverable.[12] This treatment applies only to the extent that the reinsurance recoverables are not supported by collateral, a guarantee or a letter of credit as specified in paragraphs 23 to 26 of this Prudential Standard.[13]
Table 2 - Investment Capital Factors for reinsurance recoverables due from non-APRA-authorised reinsurers
Counterparty Grade
Investment Capital Factor
1
20%
2
40%
3
60%
4
100%
5
100%
Notwithstanding anything else in this Attachment, with effect from 1 January 2009, an Investment Capital Factor of 100 per cent applies to a reinsurance recoverable due from non-APRA-authorised reinsurers if:
(a) the recoverable has become a receivable (i.e. it is due and payable); and
(b) the receivable is overdue for more than six months since a request for payment has been made to the reinsurer; and
(c) there is no formal dispute between the insurer and reinsurer in relation to that receivable.[14]
For the purposes of determining the amount of a reinsurance recoverable, if there is an offsetting arrangement between the insurer and the reinsurer that results in premium being withheld by the insurer in lieu of claim payments, the withholding of that premium is taken to be payment. However, if there is a requirement for offsets to be approved by the reinsurer the date of the offset request is taken to be the date of the request for payment.