Review

Who does this affect?

General insurers and Level 2 insurance groups who wish to use an IMB Method for determining MCR.

What do you need to do?

Consider applying to APRA for approval to use an IMB Method.

Authors
Ann Newbrun  
Special Counsel

Julie Shooter  
Solicitor

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Philip Ward  
Partner
T +61 2 9296 2213

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Peter Stockdale  
Partner
T +61 2 9296 2330

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Sydney
Ann Newbrun  

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APRA released a reform package on Friday 19 December 2008 which sets out the requirements that a general insurer or Level 2 insurance group must meet to obtain approval to use an Internal Model-based (“IMB”) Method for determining its Minimum Capital Requirement (“MCR”). The package consists of a revised prudential standard (GPS 113) and a new prudential practice guide (GPG 113), which will become effective from 31 March 2009.

The IMB Method enables an insurer to have its MCR determined based on its own Economic Capital Model (“ECM”). (The particular implementation of the ECM used to determine its MCR is referred to as the Regulatory Capital Model [“RCM”]). This approach allows an insurer’s regulatory capital requirements to better reflect the nature and extent of risks in the insurer’s particular business structure and business mix.

APRA’s response to public submissions

In June 2008, APRA published a discussion paper, revised draft GPS 113 and proposed GPG 113. APRA has considered public submissions on the IMB Method and the final package incorporates APRA’s response to the issues raised.

The draft GPS 113 stated that diversification benefits between operational risk and other risk categories may not be allowed. In the final prudential standard, APRA has clarified that diversification benefits between operational risk and other risks may now be allowed, subject to an insurer demonstrating an adequate process for estimating dependencies and applying conservatism in its dependence assumptions commensurate with the uncertainty of estimates.

APRA has noted that the ECM is to reflect the emergence of planned profit over a one year projection period. APRA expected this allowance to be conservative and previously proposed that, in most circumstances, a planned profit allowance would be no more than around 5% of net earned premium. APRA has revised GPG 113 to remove the reference to the 5% limit. APRA will permit an insurer to include an allowance for planned profit consistent with its business plan as long as the allowance is sufficiently conservative for regulatory capital purposes. APRA will consider the reasonableness of the planned profit allowance relative to recent performance, market conditions and other factors.

APRA originally proposed that the use of the IMB Method was not to relieve an insurer from complying with various aspects of capital standards relating to:

• deductions from capital specified in GPS 111 and GPS 112

• investment concentration charges specified in GPS 114, and

• the treatment of holdings in related companies representing retained profits that are equity accounted.

Public submissions expressed concern that capital charges may be counted twice in the RCM. APRA has clarified that it does not intend any ‘double counting’ of capital charges and the final prudential standard allows the insurer to eliminate any double counting when it makes relevant calculations (subject to APRA review and agreement of the approach taken).

Pre-conditions for IMB Method approval

APRA will not approve the use of the IMB Method unless an insurer has, and maintains, an advanced and stable approach to risk management (including operational risk management) and a prudent approach to capital management. Furthermore, the insurer must have an internal measure of target capital that is higher than the MCR determined using the RCM. APRA will only approve the use of the IMB Method for an insurer that already meets these requirements. APRA will make an assessment of the insurer’s approach to risk management and capital adequacy at the time of application to use the IMB Method.

Self assessment

To assist APRA in assessing the readiness of an insurer to commence the approval process, APRA has developed a series of self-assessment indicators which are set out in the attachment to GPS 113. Indicators include:

• inclusion of all major risk types in the insurer’s risk management framework

• the existence of a board approved process for determining a ‘cost of capital’

• the extent of development and use of a board approved ECM

• the extent to which evaluation of new business initiatives is based on projected returns

• the extent to which capital allocation is based on underlying risks reflected in the ECM, and

• the extent to which performance and incentive remuneration of key executives is influenced by risk based measures.

APRA will consider the insurer’s self assessment without seeking evidence or verification (this occurs later in the application process). If the self assessment reveals major deficiencies, APRA will advise the insurer of further progress that is needed before it can continue with the application.

Criteria for approving IMB Method

APRA’s approval to use the IMB Method will be subject to a comprehensive model review process including:

• submission by the insurer of a detailed application for approval with details of ECM, RCM, its governance and use, and risk management environment, and

• on-site visits by APRA.

Once the insurer has satisfied the pre-conditions, it must meet three groups of criteria in relation to its ECM in order to obtain APRA approval. The three criteria are:

1. Model governance

APRA must be satisfied with the insurer’s governance arrangements for the ECM and RCM. Key requirements for governance arrangements include:

• integration of the ECM with the risk management framework

• adequate resourcing, skills and objectivity of the team that is responsible for the development and review of the ECM

• approval by the Board or relevant Board committee of the development and use of the ECM

• adequate control processes for the development of the ECM, for calibrating and updating the model at least annually, for changing the model and for applying the RCM

• comprehensive documentation of the model

• adequate linkages between the output of the ECM and the capital management of the insurer

• regular reporting, to the relevant Board committees, Board and senior management, of results from the ECM and RCM and issues arising related to the ECM and RCM, and

• adequately documented independent review of the RCM.

2. Model use

APRA must be satisfied that the ECM plays an integral role in the insurer’s management and decision-making processes, and that this use is embedded in the insurer’s operations.

3. Model sufficiency

APRA must be satisfied that the insurer’s ECM and RCM are sufficient to give a reliable measure of the required capital.

An insurer’s ECM and RCM must adequately capture all the material risks of the insurer’s portfolio and business including the following risk categories:

• catastrophe risk

• underwriting risk

• reserving risk

• market risk

• credit risk, and

• operational risk.

The insurer’s MCR must also be an amount of capital sufficient for the insurer’s probability of default to be 0.5% or less.

If APRA is satisfied that the criteria specified above have been met, APRA will approve the use of the RCM to determine the insurer’s MCR, modifying the requirements for capital adequacy in GPS 110 or GPS 111. Modification may include requirements to be met on a continuing basis, including specifying that the MCR determined using the RCM will be subject to a minimum expressed as a percentage of the Prescribed Method calculation. During the first two years of using the IMB Method, that minimum is to be 90% of the amount determined using the Prescribed Method.

An insurer with approval to use the IMB Method must provide an Internal Model Report to APRA on an annual basis, notify APRA in advance of any material changes to the ECM or surrounding controls and publish annually the MCR figure using both the IMB Method and the Prescribed Method.