Australia’s prudential regulator, the Australian Prudential Regulation Authority (APRA), employs a risk-based approach to capital adequacy regulation. The core obligation for Australian APRA-authorised general insurers is to maintain a capital base in excess of the Prudential Capital Requirement (PCR). The  PCR calculation is complex and applies a number of different risk charges which are determined by  putting assets of an insurer under various stress tests.

APRA considers the counterparty risk posed by a foreign reinsurer who is not APRA-authorised to be  significantly higher than the counterparty risk posed by local APRA- authorised reinsurers.  Accordingly, the default stress  factors applied to reinsurance recoverables due from foreign  reinsurers are significantly higher and consequently will ordinarily increase the local cedant’s  capital requirements.

However, and as relevant for foreign reinsurers looking to offer cover to Australian cedants, where  compliant collateral arrangements are in place, the impact of the above mentioned default stress  factors are lessened.

As APRA’s attention has recently been increasingly focused on scrutinising the terms of these  reinsurance collateral arrangements, we discuss some of the key considerations for non-APRA  authorised reinsurers to be aware of.

Perhaps one of the most important points to make at the outset is that APRA prefers to be consulted  early on in the process of negotiating reinsurance collateral arrangements, even in circumstances  where APRA does not necessarily have to approve the arrangements. Reinsurers and cedants should  bear this in mind as it can impact the timetable for negotiations and implementation of the collateral arrangements.

Types of collateral

The core requirements are set out in APRA’s General Insurance Prudential Standard GPS 114 Capital  Adequacy: Asset Risk Charge (January 2013) (GPS 114) and in the associated ‘Frequently Asked  Questions’ document which APRA has published to supplement GPS 114.

APRA categorises the various forms of acceptable reinsurance collateral arrangements as either:

  1. recognised collateral
  2. guarantees and letters of credit (LOCs) There are different requirements which apply to each of the above categories and as such, we deal  with each in turn.

Recognised collateral

Under GPS 114, only the following types of collateral are recognised:

  1. assets held in Australia that form part of a trust fund maintained by a trustee resident in  Australia for the benefit of the cedant
  2. deposits made by the reinsurer which are held by and controlled by the cedant in Australia
  3. a combination of both of the above
  4. any other form of collateral specifically approved by APRA. In our experience, such other forms  of collateral which APRA has approved include funds (or premiums) withheld arrangements and funds  deposited arrangements

The collateral must:

  1. be effective for the expected period for payment of claims under the reinsurance contract (or,  if this is impractical, it must be effective for a period of at least 24 months)
  2. provide effective security against liabilities arising under the reinsurance contract
  3. not be available for distribution to:
    1. creditors of the cedant (other than the cedant’s policyholders) in the event of the insolvency  of the cedant 
    2. creditors of the reinsurer (other than the cedant) in the event of the insolvency of the reinsurer (ie the rights of the reinsurer to the collateral  must  be subordinate to the rights of the cedant until all liabilities under the relevant  reinsurance contracts have been discharged). It may be necessary to provide a legal opinion from  the foreign reinsurer’s home jurisdiction on this point

It is not uncommon for additional requirements to be imposed by APRA. For example, GPS 114 includes  the following list of requirements which will be imposed in respect of funds (or premiums) withheld  arrangements:

  1. where the foreign reinsurer retains a registrable interest in the collateral funds, the cedant  must be granted a registrable charge over the interest to ensure that the collateral is retained to  discharge policy liabilities in a winding up of the reinsurer
  2. where the collateral is held in the form of securities purchased from amounts held in a funds  (or premiums) withheld account, the securities must be either:
    1. held separately from all other investments of the cedant
    2. be identifiable in the books and records of the cedant as being securities held for the  benefit of meeting policy liabilities reinsured under the relevant contracts of reinsurance

Guarantees and LOCs

Guarantees and LOCs must meet certain criteria to be recognised by APRA, including:

  1. the guarantor or issuer must generally be an Australian authorised deposit-taking institution  (ADI)
  2. the guarantee or LOC must be explicit, unconditional and irrevocable
  3. the guarantor or issuer must be obliged to pay the cedant in Australia
  4. the obligation of the guarantor or issuer to pay the cedant must be specifically linked to  performance of the reinsurance contract
  5. the guarantee or LOC must be effective for the expected period for payment of claims under the  reinsurance contract (or, if this is impractical, it must be effective  for a period of at least 24  months and must require the reinsurer to give the cedant 12 months written notice of the its  intention to terminate)

Remarks We have extensive experience in drafting and negotiating these types of collateral arrangements,  acting for local Australian cedants and for foreign reinsurers.