The core concept is the Operational Risk Charge (ORC) as the minimum capital requirement for operational risk. Operational risk itself is defined as the risk of loss resulting from inadequate or failed internal processes, people, and systems, or from external events. The ORC is not a buffer for expected losses; it is a capital floor to absorb unexpected losses from operational failures.

The standard divides a life company’s business into three categories for ORC calculation: risk business, investment-linked business, and other business. Risk business attracts the ORCR, which uses a higher percentage factor (3 per cent for most funds, 2 per cent for a statutory fund that is a specialist reinsurer). The ORCR formula takes the maximum of current gross premium or net policy liabilities, plus a volatility term that captures the absolute change in gross premiums exceeding 20 per cent of the prior year’s premium.

For investment-linked and other business, the ORCI and ORCO each use a much lower percentage factor (0.25 per cent for most funds, 0.15 per cent for specialist reinsurer funds). The formula multiplies this percentage by net policy liabilities plus a volatility term based on the excess of current gross premiums over 20 per cent of prior gross liabilities, plus another volatility term based on excess of gross claims payments over 20 per cent of prior gross liabilities.

The standard introduces accrued premium as a key input. Accrued premium is gross premiums received, adjusted for changes in premiums in advance and unpaid premiums, but excluding premiums sourced from benefits paid under another life policy issued by the same company (to avoid double counting). For ORCI and ORCO, accrued premium must also include deposits received. All premium figures are gross of commissions, before profit-share rebates (group insurance), and inclusive of stamp duty, policy fees, loadings, and discounts.

Another important concept is policy liabilities net of reinsurance (NL1) and gross of reinsurance (GL0). The net figure is used in the base calculation, while the gross figure appears in volatility caps (20 per cent of prior gross liabilities). The use of gross figures in volatility terms ensures that reinsurance does not dampen the capital charge for growth or runoff volatility, because the volatility cap refers to the full underlying business exposure.

The standard distinguishes between statutory funds (for non-friendly societies) and the management fund (for friendly societies). For a friendly society, the ORC is calculated only at the management fund level after summing across all benefit funds for risk business, investment-linked business, and other business. Benefit funds themselves have zero ORC. Similarly, a life company’s shareholders’ fund has zero ORC. This means the ORC is entirely a statutory fund (or management fund) liability.

The standard applies to all life companies registered under the Life Insurance Act 1995, including friendly societies. This includes domestic life insurers, friendly societies, and Eligible Foreign Life Insurance Companies (EFLIC) to the extent of their business conducted through Australian statutory funds. It does not apply to the offshore operations of EFLICs.

For a life company that is not a friendly society, the standard applies separately to each statutory fund. The ORC must be calculated for each statutory fund, and the shareholders’ fund gets zero ORC. Specialist reinsurer statutory funds (those predominantly engaged in reinsurance) receive a lower percentage factor for both ORCR and ORCI/ORCO: 2 per cent (instead of 3 per cent) and 0.15 per cent (instead of 0.25 per cent) respectively.

For a friendly society, the standard applies to its management fund only. Benefit funds have zero ORC. However, the ORC for the management fund is calculated by summing the relevant premium and liability amounts across all benefit funds. This means friendly societies must still aggregate data from multiple benefit funds to determine the ORC at the management fund level.

The Board of directors of each life company is the primary addressee of the prudential requirement. The Board cannot delegate its ultimate responsibility for capital adequacy. The company’s management and actuarial functions will be directly involved in performing the calculations, maintaining data on premiums, policy liabilities, claims payments, and reinsurance arrangements.

APRA retains the power to adjust or exclude specific requirements for a particular life company by written notice. This provision allows APRA to tailor the ORC for unusual circumstances, but also creates uncertainty for life companies that may be subject to bespoke adjustments. A life company that previously received an exemption or discretion under the old LPS 118 must contact APRA to confirm it can still rely on that discretion under the new standard , there is no automatic grandfathering.

The standard does not directly affect policyholders or beneficiaries, but the adequacy of capital held for operational risk indirectly influences their security. A life company with insufficient operational risk capital may face regulatory action that could affect its ability to write new business or pay claims.

The Board of directors has the ultimate responsibility for ensuring the life company maintains an adequate level and quality of capital against operational risk. This duty is stated in the objectives and key requirements, and it sits above any technical calculation. The Board must form its own view on whether the ORC is sufficient given the company’s specific operational risk profile, scale, nature, and complexity. The ORC formula provides a minimum, but the Board may decide a higher operational risk capital buffer is prudent.

The life company must apply the standard separately to each statutory fund (for a non-friendly society) or to the management fund (for a friendly society). The ORC must be calculated at each reporting date, presumably concurrent with other capital adequacy calculations under the Life Insurance Act. The company must use the defined formulas for ORCR, ORCI, and ORCO, using the prescribed percentage factors (2/3 per cent for risk business; 0.15/0.25 per cent for investment-linked/other). It must correctly classify its business into risk, investment-linked, and other categories. If a business is neither risk nor investment-linked, it falls into “other business” for ORCO.

The company must calculate accrued premium correctly, excluding only premiums sourced from benefits paid under another life policy issued by the same company. This prevents double counting where a policyholder uses a maturity benefit to buy a new policy. Premiums sourced from benefits under policies issued by other companies are not excluded. Deposits must be included in accrued premium for ORCI and ORCO but not for ORCR? The standard says: “for the calculation of ORCI and ORCO, ‘accrued premium’ must also include deposits received.” Implicitly, for ORCR, deposits are not included, which is consistent with risk business typically involving mortality risk rather than investment deposits.

The company must calculate GP1, NL1, GP0, GL0, and C1 for each statutory fund or aggregated across benefit funds for friendly societies. For specialist reinsurer funds, the lower percentages apply. The volatility terms (the absolute value of the excess of current premium/claims over 20 per cent of prior year’s gross premium/liabilities) are unconventional: they add capital when business volume grows or shrinks beyond a threshold. This means both growth and decline in premium or claims above 20 per cent increase the ORC.

The right to seek adjustment or exclusion from APRA is a key provision. A life company may apply to APRA for a variation of any specific requirement. APRA can grant this by notice in writing. There is no prescribed process or criteria in the standard, so the right is at APRA’s discretion. The standard does not require APRA to consult or give reasons. This creates regulatory risk: a company that relies on the formula may later face adjustment without necessarily having a pathway to challenge it.

A life company that previously received an exemption or discretion under the 2012 version must contact APRA before relying on it under the new standard. This is a duty, not a right. Failure to contact APRA could mean the previous exemption is invalid, leading to a breach.

The standard itself does not specify penalties. Enforcement arises through the Life Insurance Act 1995 and APRA’s broader powers.

The ORC is a minimum capital requirement. If a life company fails to hold capital at least equal to the ORC, it may be in breach of the prudential standard. Breach of a prudential standard may constitute a contravention of the Life Insurance Act, triggering APRA’s enforcement powers including directions, imposition of additional capital requirements, appointment of a statutory manager, or suspension/revocation of the life company’s registration. The Act provides for civil penalties for certain contraventions, but the standard does not specify which sections apply.

APRA may, under section 230A(5) of the Act, revoke or vary a determination. If APRA issues a notice adjusting or excluding a requirement under paragraph 17, failure to comply with that notice would also be a breach.

The standard does not impose reporting obligations explicitly. However, the ORC is part of the prescribed capital amount which must be reported to APRA under other prudential standards (e.g., LPS 110 Capital Adequacy). A life company that miscalculates the ORC may face a capital shortfall that is not detected until the next reporting cycle. The volatility terms increase the incentive for accurate data: a 1 per cent error in premium or liabilities can produce a disproportionate error in the ORC.

There is no penalty for over-holding capital, but shareholders bear the opportunity cost of holding excess capital that could otherwise be deployed or distributed.

APRA can adjust or exclude a requirement without the life company’s consent. While this may be a relief in some cases (e.g., reducing the charge for a specific risk), it can also be imposed to increase the charge. The standard does not specify a right of review or appeal for such a notice. This gives APRA significant unilateral power over a key capital component.

The standard also does not provide for transitional relief or phasing-in from the 2023 commencement. Life companies must be compliant from 1 July 2023. Those relying on a previous exemption must contact APRA proactively; otherwise they risk a compliance gap.

Prudential Standard LPS 118 is made under subsection 230A(1) of the Life Insurance Act 1995. It is one of many prudential standards determined by APRA under that Act. It revokes and replaces the previous LPS 118 (determination No. 7 of 2012). The standard refers to Prudential Standard LPS 001 Definitions for defined terms. Terms that appear in bold in LPS 118 are defined in LPS 001. This means the interpretation of “premiums in advance,” “unpaid premiums,” “policy liabilities,” “adjusted policy liabilities,” “statutory fund,” “benefit fund,” “management fund,” “shareholders’ fund,” “specialist reinsurer,” and other terms is governed by LPS 001.

The ORC is one component of the prescribed capital amount under the Standard Method in Prudential Standard LPS 110 Capital Adequacy. LPS 118 does not itself define the overall capital requirement; it only specifies the operational risk component. Life companies must also hold capital for insurance risk, market risk, credit risk, and other charges under LPS 110 and other related standards (e.g., LPS 115 Capital Adequacy: Insurance Risk Charge, LPS 120 Capital Adequacy: Asset and Market Risk Charge). The ORC is additive to those other charges.

The standard applies only to business conducted through Australian statutory funds for an EFLIC, as per section 16ZD of the Act. This limits the standard’s extraterritorial reach. For domestic life companies, the standard applies to all registered business.

The Life Insurance Act 1995 provides the overarching framework for registration, capital adequacy, and APRA’s enforcement powers. The Act also deals with priority of assets in winding up and the protection of policyholder benefits. The ORC indirectly supports policyholder protection by ensuring that capital is available for operational losses that might otherwise erode policyholder benefits.

The standard interacts with accounting standards and actuarial standards for the measurement of policy liabilities and premiums. The calculation of adjusted policy liabilities (net of reinsurance) will depend on the valuation methodology applied under LPS 340 Valuation of Policy Liabilities or equivalent. Discrepancies between accounting policies and prudential definitions could affect the ORC.

State stamp duty laws affect the premium base: premiums for ORC must include stamp duty, so changes in state duty rates flow into the capital charge. This creates a regulatory externality: a state tax increase immediately raises the minimum operational risk capital required, even though operational risk itself has not changed.

This instrument (Life Insurance (prudential standard) determination No. 10 of 2023) revokes the previous determination No. 7 of 2012, which included the earlier version of LPS 118. The standard commences on 1 July 2023. The determination was signed on 24 May 2023.

The standard itself does not include a summary of changes from the 2012 version. To understand what changed, one would need to compare the text of both versions. Based on the source text alone, we know that paragraph 18 (previous exercise of discretion) is new or restated: it requires a life company to contact APRA to rely on a previous exemption or discretion. The 2012 version may have had a similar provision but the standard now explicitly requires contact. The percentages (2%/3% and 0.15%/0.25%) may have changed from earlier versions; without the old text we cannot confirm. The formula structure appears similar to typical Basel-based operational risk charges but with a volatility adjustment that is not seen in many other jurisdictions.

The instrument was made by a delegate of APRA (Helen Rowell, Deputy Chair), using the power under subsection 230A(5) to revoke and subsection 230A(1) to determine a new standard. The revocation and new determination take effect on the same day, with no gap.

There is no mention of transitional provisions or phasing in. Life companies were presumably expected to be ready for the new standard from 1 July 2023. If a life company had systems built around the 2012 version, it would need to update its capital calculation models to reflect any formula changes. The absence of a transitional period increases implementation risk.

The source text does not mention any litigation. There is no reference to court cases or tribunal decisions interpreting LPS 118. Since the standard is a prudential instrument determined by APRA, it is unlikely to be directly litigated unless APRA takes enforcement action against a life company for non-compliance, or a life company challenges an APRA adjustment notice under paragraph 17. There is no known case law on LPS 118 as of the date of this instrument (2023). The standard is relatively new, and any litigation would likely emerge only after enforcement or dispute.

In the broader context, prudential standards are often challenged on procedural grounds (e.g., whether APRA followed proper process) or on the basis of unreasonableness under administrative law, but such cases are rare and not specific to this standard. The standard itself does not give life companies a right of review of APRA’s adjustments, which might invite judicial review under the Administrative Decisions (Judicial Review) Act 1977 if an adjustment is seen as arbitrary or beyond power.

Practitioners should be aware that any litigation would likely turn on interpretation of terms defined in LPS 001 and the application of the formulas to specific business lines. Given the complexity of the formulas, disputes could arise on what constitutes “accrued premium” (e.g., whether a particular receipt is a deposit or a premium) or what is “risk business” versus “investment-linked business” versus “other business”.

Zero ORC for benefit funds and shareholders’ fund is not a free pass. While the ORC is zero for these funds, the management fund (for a friendly society) must aggregate data from all benefit funds. The capital is still required at the management fund level. Similarly, the shareholders’ fund of a non-friendly society has zero ORC, but the statutory funds must hold the charge. There is no mechanism to shift operational risk capital out of statutory funds into the shareholders’ fund.

The volatility term can increase capital even when premiums decline. The ORCR formula adds the absolute value of (GP1 - GP0) exceeding 20% of GP0. A sharp drop in premium volume (e.g., losing a large group risk contract) will increase the ORC just as much as a sharp rise. This is unusual: operational risk does not necessarily increase when business shrinks, but the formula penalises both growth and contraction beyond 20 per cent.

The volatility cap uses gross-of-reinsurance figures for the base (20% of GP0 or GL0), but the net premium (GP1) is gross of reinsurance for the comparison. This means that a life company that reinsures heavily may still face a large ORC if gross premiums are volatile, even if net risk is stable. Conversely, a company using little reinsurance might have lower volatility in net liabilities but still be caught by the gross-based cap.

Specialist reinsurer status has a narrow definition. The lower percentages (2% and 0.15%) apply only to a statutory fund that is a specialist reinsurer. The term is defined in LPS 001, and a fund must meet criteria to qualify. A life company that operates both direct and reinsurance business may need to have separate statutory funds to access the lower rate. If it commingles, the higher rate applies.

Deposits are included in accrued premium for ORCI and ORCO. This means that investment-linked business that receives significant deposits (e.g., from rollovers or regular contributions) will have a higher ORC base than if deposits were excluded. Deposits are not premiums in the traditional sense, but the standard treats them equally for capital purposes.

Accrued premium excludes internal switches. If a policyholder uses a maturity benefit from one policy to buy another policy from the same life company, that amount is excluded from accrued premium. This prevents double counting. However, if the same amount is paid out and then invested in a different life company’s policy, it would be included.

No grandfathering of previous APRA discretions. A life company that received an exemption under the 2012 standard must contact APRA to have it confirmed for the new standard. There is no automatic continuation. A company that forgets to contact APRA may be technically non-compliant and could be hit with a higher ORC.

APRA can adjust or exclude a requirement at any time without notice. The standard only says “by notice in writing”. There is no requirement for APRA to consult, to provide reasons, or to consider the life company’s representations. This could be used to impose a higher charge on a particular company, perhaps due to its risk profile. A life company should monitor communications from APRA regularly.

The ORC is a minimum, not a target. The Board must still consider whether the ORC is adequate given the life company’s specific operational risk profile. A company that holds exactly the ORC may still be in breach of the broader requirement to “maintain an adequate level and quality of capital commensurate with the scale, nature and complexity of its business and risk profile.” The Board’s duty goes beyond the formula.

The standard applies to each statutory fund separately, not to the life company as a whole. This means a life company with multiple statutory funds cannot offset a surplus in one fund against a deficit in another. Each fund must meet its own ORC. For a friendly society, the management fund must hold the ORC aggregated from all benefit funds, but there are no separate ORCs for each benefit fund.

Compliance with LPS 118 requires life companies to adopt a systematic process for:

1. Classify business into risk, investment-linked, and other categories. This classification should align with the definitions used for LPS 110 and other standards. Maintain a mapping of all products to these three categories. Review new products to ensure correct classification.

2. Collect and validate data for each statutory fund (or management fund). Data required includes:

   • Premiums received (gross of reinsurance) for each of the three business categories, for the current 12-month period (GP1) and the prior 12-month period (GP0). Include stamp duty, policy fees, loadings, discounts, and (for ORCI and ORCO) deposits. Exclude premiums sourced from benefits paid under another policy of the same life company.
   • Premiums in advance and unpaid premiums at start and end of each period, to calculate accrued premium.
   • Adjusted policy liabilities net of reinsurance (NL1) at reporting date, and gross of reinsurance (GL0) at the same date 12 months prior.
   • Payments to meet liabilities to policy owners (gross of reinsurance) for the current 12-month period (C1), excluding payments used as premiums for another policy of the same company.

3. Apply the formulas precisely per paragraphs 9-16. For each statutory fund (non-friendly society) or management fund (friendly society), compute:

   • ORCR: (A) times [max(GP1, NL1) + max(0, |GP1 - GP0| - 0.2 * GP0)] where A = 2% for specialist reinsurer fund, 3% otherwise.
   • ORCI and ORCO: (B) times [NL1 + max(0, GP1 - 0.2 * GL0) + max(0, C1 - 0.2 * GL0)] where B = 0.15% for specialist reinsurer fund, 0.25% otherwise.
   • ORC = ORCR + ORCI + ORCO.

   For a friendly society, sum GP1, NL1, GP0 across all benefit funds for risk business (for ORCR) and similarly for ORCI and ORCO, then apply formulas at the management fund level.

4. Determine specialist reinsurer status. If a statutory fund is a specialist reinsurer as defined in LPS 001, apply the lower percentages. Ensure the status is properly documented and communicated to APRA.

5. Board oversight. The Board must:

   • Review and approve the ORC calculation methodology.
   • Satisfy itself that the ORC is adequate, with consideration of the company’s specific operational risk exposures (e.g., cyber risk, outsourcing, model risk) that may not be fully captured by the formula.
   • Consider whether a buffer above the minimum is warranted.
   • Maintain records of the basis for its decision.

6. Contact APRA about previous exemptions. If the life company relied on an exemption or discretion under the old LPS 118, it must write to APRA seeking confirmation that it may continue to rely on that discretion under the new standard. Do this promptly after commencement.

7. Monitor APRA notices. Watch for any written notice from APRA adjusting or excluding a requirement. If received, adjust the ORC calculation accordingly and record the basis.

8. Integrate with other capital calculations. The ORC must be included in the prescribed capital amount reported under LPS 110. Ensure systems are aligned so that the ORC feeds automatically into the overall capital adequacy calculation.

9. Documentation and audit trail. Maintain detailed documentation of data sources, calculation steps, assumptions, classification decisions, and Board approvals. This will be important for APRA reviews and for internal audit. The volatility terms require careful tracking of prior-year data; data must be kept for at least 12 months to compute the volatility.

10. Friendly societies: aggregation complexities. Friendly societies must aggregate data from multiple benefit funds. They must ensure that the sum of GP1 across all risk business is correct, including any inter-fund transfers. Benefit funds themselves have zero ORC, but the management fund must still hold capital. The society must ensure that the management fund has sufficient assets to meet the ORC, which is a liability of that fund.

11. Test for scenarios of sharp premium changes. Because the volatility term punishes both growth and decline beyond 20%, stress-test the ORC under scenarios such as loss of a major group policy, or a significant new business inflow. The Board should understand how the ORC behaves under plausible operational changes.

12. Seek APRA clarification if uncertain. If any term or formula application is ambiguous, contact APRA early rather than risk a misstatement in reporting. The standard is relatively concise; there are no worked examples, so APRA’s interpretation should be sought where the text is unclear (e.g., definition of “payments to meet liabilities to policy owners”).