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General insurance industry: the Supervisor's perspective. Speech, 29 November 2002

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APRA Speech

General Insurance Industry - The Supervisor's Perspective Graeme Thompson Friday, 29 November 2002


The editorial of the Australian Financial Review of 13November ended by asking whether APRA is up to the task of being a fully effective prudential regulator of general insurance and other financial sectors.

I provided the clear response yes in a letter to the paper, which unfortunately had some of its more important points edited out in the printed copy - I would like to use this opportunity to elaborate on my answer, with particular focus on our responsibilities for general insurance.

Regulatory reform

As you know, APRA was responsible for prudential regulation of the HIH insurance group, a role that we as individuals and as an organisation took very seriously and discharged in good faith.

Our regard for that responsibility has put us at pains over the past 18 months to discover and acknowledge publicly our shortcomings in relation to HIH. To assist us we commissioned a comprehensive report from an international expert-you may have read John Palmer’s report which was described by Counsel assisting the Royal Commission as not pulling any punches.

That report speaks for itself and there is little to add other than to note that while, in some important respects, APRA was behind a large eight-ball we could also have done a better job. We conceded this publicly 18 months ago.

The more important issue now, nearly two years on, is the health of the insurance industry and the quality of insurance supervision and regulation going forward.

The good news for both industry and policyholders is that we have made major improvements in our prudential supervision in the past year-the culmination of processes that, in many cases, commenced well before HIH hit the wall.

Headline items have included:

a new tougher Insurance Act effective 1 July ● a complementary set of APRA Prudential Standards that are more comprehensive and adaptable in controlling insurance company risks-inter alia, we have increased regulatory capital requirements by about 50percent on average, required capital to be held against a wider range of risks and ensured more consistency and rigor in liability valuation;


a period of intense activity from late 2001 through to 30June this year, when all insurers had to convince us that they could meet the higher hurdles of the new regime ●

and qualify to be re-licensed by APRA; some consequential rationalisation among the smaller insurers-we now have 112 companies writing new business (down from 137), with another 34 in run-off (up from 24); and 15 licenses were returned to us by companies that transferred their business to other members of a group under common ownership;


On the whole we would assess the industry as reasonable healthy-notwithstanding the pressures of rising reinsurance costs and low investment returns. In the re-licensing process, APRA took thorough stock of each company’s soundness and risk controls. Most companies are now clearly meeting the new higher capital requirements comfortably, while some are on closely monitored transition paths to bring them into full compliance by 2004.

This is not to say there is room for complacency. The initial management material provided by many companies in their applications for re-authorisation was substandard and many had, in particular, to re-work their reinsurance and risk control strategies to bring them to an acceptable standard.

We see the required continuing involvement of Boards in ensuring compliance with these risk-management strategies as a very important element in the new upgraded governance framework.

Governance standards

This framework includes much strengthened incentives and penalties to discourage deception and neglect.

It puts extra attestation and reporting obligations onto directors, executives, auditors and actuaries. And all of these need to be suitable for their role and conscious of their increased responsibilities-including whistle-blowing obligations in the case of actuary and external auditor.

The fit and proper tests for directors, executives and advisers now go well beyond not having a conviction for dishonesty or a history of bankruptcy. Companies should have directors, executives and advisers who are technically competent, honest and free from conflicts of interest. While APRA will not routinely vet every appointment, we do require companies to investigate the background of key personnel and we will use our powers to remove unsuitable people.

In further strengthening the checks and balances in insurance, we also now require:

no disproportionate shareholder representation on a board ● a non-executive chair and a majority of non-executive directors ● an audit committee of the board, also with a non-executive chair. ●

The desirability of tighter rules about audit rotation, the joint supply of audit and consulting services and movement of former auditors into directorships or senior management positions with auditees is being debated widely at present. We are finalising our views on these matters but will await the outcome of decisions on CLERP9 before deciding whether additional restrictions are warranted on insurers and other APRA-regulated institutions.


The reforms that we made to the prudential framework are an essential strengthening of APRA’s supervisory tools-they bring Australia’s supervisory arrangements more closely into line with international standards of best practice. In many respects, they set the pace and we can now be assured that our regulatory standards are second to none.

We have, however, always made it clear that we do not see these changes as completing the task. The new arrangements are not perfect and, even if they were perfect today, they would not be tomorrow. One advantage of a system based on APRA-issued Prudential Standards is to permit the rules to be adjusted more readily to keep pace with market developments and supervisory needs.

We already have a number of fine-tuning items on the agenda and these are summarised in APRA’s public submission to the HIH Royal Commission on Future Policy Directions.

We are also pursuing improvement in three broader areas:

expanding supervisory oversight to encompass consolidated group supervision; ● more disclosure of prudential information by APRA and insurers themselves; ● addressing unregulated or quasi insurance operations. ●

Group supervision

There needs to be an increased focus on conglomerate/consolidated supervision in the prudential regime for general insurance. Although we now have legislative powers over non-operating holding companies-and are using them-the new framework of Standards still concentrates on individual licensed entities, rather than the wider corporate group of which they may be part. It also lacks explicit regard to activities conducted in related companies overseas. Effectively, it assumes that supervisors, by ensuring that each licensed insurer is adequately managed and financially sound, can ring-fence an insurer from problems elsewhere in the group.

Insurance supervisors around the world have historically operated on this basis. Increasingly, however, they are accepting the difficulty of ring fencing and the need to deal with contagion risk.

The emergence of financial conglomerates was one of the reasons for APRA’s establishment. Early on, we tackled prudential standards for conglomerate groups involving banks and other deposit-takers incorporating the following principles:

a regulated entity needs to be supervised both as a stand-alone entity, and as part of any wider corporate group; ●

a regulated entity should not be able to structure its affairs so as to ‘double leverage’ its capital (ie capital invested in subsidiary entities should not also be available to support the regulated entity as well);


a regulated entity should have some limit on its credit and other non-equity exposures to other members of its corporate group; and ●

there should be group-wide risk management and internal control systems. ●

APRA will examine how these principles can be applied to general insurance commencing early in 2003. We accept that their introduction could produce tensions with existing commercial practices or where Australian standards are substantially tougher than in other

countries. As required by Government, we will consider whether the prudential benefits from change outweigh the costs of disturbing existing arrangements.

Many general insurance companies operate in complex corporate structures and are often not the parent. Indeed, many are subsidiaries of commercial entities eg captive insurers. While we will need some regulatory authority over such operating holding companies, we have no aspiration to supervise the general activities of non-financial entities-whether parents or siblings.


Internationally, prudential supervisors are increasingly looking to information disclosure and consequential enhanced market discipline to be allies in their work.

Market disciplines can reinforce supervisory requirements by creating strong incentives for insurers to conduct their business prudently. They can provide an insurer with extra incentive to maintain a healthy capital base as a cushion against potential future losses.

A comparison of Australia’s largest financial institutions would show that, by and large, disclosure of prudential (ie risk-related) information by insurers is relatively scant. Consequently, we intend to pursue a disclosure regime that will give market participants more help in assessing the riskiness and the risk controls of general insurers. We encourage industry to take the initiative on this-if not, APRA will use its powers to make it happen.

The sort of information that we have in mind would include:

the risks to which an insurer is exposed, with details of insurance/underwriting risks, credit risks, market risks and operational risks (information could include claims development tables, risk retentions, insurance and investment portfolios broken down by geography, industry and line of business, counter-party exposure tables, market risk analyses and operational losses);


strategies and techniques used to measure and control those risks, including stress tests; ●

overview of capital management strategies; and ● the structure, management, and organisation of a company’s risk management functions. ●

Unregulated and quasi insurance

In an environment of rising insurance premiums, small businesses, professional associations and community groups may look to alternative, unregulated insurance providers without fully appreciating the risks involved. This applies especially to public liability and professional indemnity, which by nature lie at the high end of the insurance risk spectrum and are likely to be priced accordingly by regulated insurers. Unregulated insurance is not in the public interest because the average consumer is in no position to understand the complexities, uncertainties and limitations of the cover provided and, in particular, the possibility of the provider not being around when a claim is made. The two main forms of unregulated and, I suggest, unreliable insurance are provided by unauthorised foreign insurers and discretionary mutual funds.

Foreign insurers wishing to operate in Australia can apply for a local licence and submit to

the disciplines that this entails-and most do. Unfortunately, some fringe foreign players prefer to use lightly regulated jurisdictions as a base from which to distribute their products into countries with higher standards. They target ill-informed consumers who buy purely on price without understanding the greater risk involved. We are taking every opportunity to warn prospective policyholders to check whether a locally unauthorised foreign insurer is licensed and regulated in its home country, and has the financial capacity to pay future claims.

Discretionary mutual funds that pool resources to provide coverage to members on a discretionary basis are not licensed under the Insurance Act because there are no contractual terms and conditions governing the payment of a claim. They have been established over many years by groups seeking savings through forms of cover that escape various taxes, the Insurance Contracts Act and industry complaints schemes, as well as APRA’s capital and other requirements of the Insurance Act. (Examples include medical defence organisations, certain legal indemnity and, more recently, home warranty schemes.) While some such schemes have significant funding and competent management, we regard them as problematic long-term players in an environment of volatile claims trends and rising court awards. We are taking every opportunity to encourage such schemes to convert to authorised status, as will happen next year with medical indemnity.

APRA’s supervisory capacities

As prudential regulator, APRA needs not only to develop a strong set of minimum standards for insurers-where great progress has clearly been made in the past year. We also need to monitor insurers’ operations intelligently against these standards and to take early action where compliance is lacking.

We are tackling this task on two fronts: first, by increasing the number and the quality of people devoted to the task and, second, by introducing more sophisticated and structured early warning and supervisory processes within APRA.

On the first of these, let’s take a quick look at APRA today. We are an organisation of some 430 financial analysts, accountants, lawyers, actuaries, economists, statisticians, mathematicians, finance academics and risk managers drawn from APRA’s predecessor agencies, banks, insurance companies, legal and accounting firms, superannuation funds and other regulatory and enforcement bodies.

Around 95percent of APRA staff have at least one professional qualification and around half of those have additional post graduate qualifications. Collectively they received around 14,500 hours of training last year.

In fact, our staff is so well qualified in 2002 that poaching by private sector employers offering top-of-the-market remuneration in a highly competitive finance sector is one of our biggest challenges.

On the second point, we now use a risk-based approach to our supervisory process. This means drawing on an internal rating system that scores each company-across all the industries we regulate-to decide the appropriate supervisory strategy in each case and to guide the allocation of our limited resources.

During the past year, we’ve designed an upgraded rating system called the Probability and

Impact Rating System or PAIRS for short.

This system is more sophisticated and objective than the previous one. Importantly, it also takes into account the potential impact of a regulated entity’s failure as well as its probability of failure. We combine the probability and impact measures to create a single numerical Supervisory Attention Index.

The probability component of the rating system is a systematic and structured measure of each entity’s inherent risk, adjusted for the mitigating effects of its risk controls and capital support.

APRA is not in a position to publicise these ratings-they are currently protected under the secrecy provisions of our Act. Our almost 4,000 regulated entities, however, will be advised of how APRA rates them as PAIRS is progressively introduced in the next two years.

When the system is bedded down, we will be better placed than previously to gauge the scale of APRA’s overall supervisory task. That is to protect the interests of our beneficiaries-policyholders, depositors and superannuation fund members-to identify priority areas within the regulated population and allocate resources according to degree of risk, and to monitor trends in market risk profiles.

Once an insurer is assigned its PAIRS rating, a supervisory strategy will be designed that aligns intensity and focus with the assessed threat of serious problems. To describe supervisory strategies we have identified four broad stances: Normal, Oversight, Mandated Improvement and Restructure.

End piece

So to sum all this up and return to the question I referred to at the beginning.

The regulatory system, broadly defined, for general insurers has been strengthened in many significant respects over the past two years. We have new legislation, new prudential standards and we have enhanced APRA’s all round supervisory capacities. As a result of these advances I have no doubt that we would deal much more effectively with an incipient HIH if one arises in the future.

I am also encouraged by the industry’s own increased awareness of the need for high standards of risk management and governance. The collapse of HIH and its flow-on effects have been cathartic events for general insurers and their regulator alike.

As a result of all of these factors the industry is more robust, more attuned to risk and its proper pricing, and generally better managed than ever before.

Of course, there are no grounds for complacency and it should be clear from what I’ve said that there is more work to be done. For both APRA and the industry, the task of maintaining compliance with the new prudential regime and improving the industry’s health further will be ongoing.

Thank you.

Australian Prudential Regulation Authority