The Australian Prudential Regulation Authority (APRA) has released its Response to Submissions made on APRA’s current review of capital adequacy standards for general and life insurers.

General insurers and Level 2 insurance groups ought be aware that the finalised prudential standards will be effective from 1 January 2013. APRA has indicated that it will shortly release the final reporting forms and instructions for the new capital framework.

General insurers with reporting periods ending on or after 1 January 2013 will be expected to commence reporting under the new capital framework in 2013. APRA expects that the new capital adequacy regime will improve the risk-sensitivity and appropriateness of the capital standards and improve the alignment of the capital standards across industries. For more information on APRA’s recent regulatory initiatives with respect to capital adequacy please see our previous articles here, here and here.

In its Response to Submissions, APRA indicated that, in light of submissions, it has altered its position in relation to some of the content of its previously released consultation material on capital adequacy standards.

In a nutshell, what has changed?

The prudential standards effective from 1 January 2013 are listed in Appendix 1. Virtually all the prudential standards have been revised when compared to those effective until 31 December 2012. The following prudential standards are new:

  • GPS 117 Capital Adequacy: Asset Concentration Risk Charge;
  • GPS 118 Capital Adequacy: Operational Risk Charge; and
  • GPS 320 Actuarial and Related Matters.

What has APRA revised as a result of the submissions received?

The following is a non-exhaustive summary of some of the revisions made by APRA:

Common Equity Tier 1 Capital:

Dividend reinvestment plans – APRA will now allow new shares purchased under dividend reinvestment plans to offset declared dividends where the estimated take up rate for plans has been agreed in advance with APRA.

Additional Tier 1 Capital and Tier 2 Capital:

Non-viability requirements – APRA will require capital instruments, other than ordinary shares, to convert to ordinary shares or be written-off in certain circumstances. The capital instrument must include a provision under which, on the occurrence of a non-viability trigger event it will convert or be written-off (the non-viability requirements).

  • Conversion into listed shares: APRA’s general position that conversion of non-common equity instruments must be into listed shares remains unchanged. However APRA will allow conversion into unlisted equity where: there is no listed upstream entity in the relevant group; or the insurer’s non-common equity instrument is issued to its listed parent entity.
  • Governing law: APRA will only require Australian law to apply to the terms and conditions of capital instruments implementing the non-viability requirements.
  • Tax effects: In determining the amount of CET 1 Capital, insurers do not need to account for the potential tax liabilities that may be involved where a ‘fail-safe’ write-off provision is triggered. (However, where the write-off is the primary rather than the fail-safe non-viability mechanism, tax liability and other haircuts must be accounted for from the date of issue.)

Reductions in Capital:

The profits test requirement has been removed.

Assets Under a Fixed or Floating Charge:

Additional wording has been inserted into GPS 112 to ensure that assets subject to a fixed or floating charge, mortgage or other security will be treated appropriately in respect of regulatory adjustments to CET 1 Capital.

Definition of ‘associate’:

APRA has included a definition of ‘associate’ in GPS 001 which is consistent with the definition in AASB 128 (Australian Accounting Standard AASB 128 Investments in Associates and Joint Ventures).

What remains largely unchanged?

APRA has indicated that the proposed strengthening of capital requirements with respect to the following remain either completely or largely unchanged:

Additional Tier 1 Capital and Tier 2 Capital:

Incentives to redeem – APRA’s view remains unchanged as to the requirement of a clearly defined period between a call date and a conversion date in order for a call option not to be, in substance, an incentive to redeem.

Calls or conversion within 5 years – A change in an accounting standard is not per se a regulatory event warranting early redemption as it would not necessarily result in a change to regulatory capital. Insurers are encouraged to consult with APRA where they believe that such a change constitutes exceptional circumstances (APRA has also confirmed that it does not propose allowing calls to be made within the first 5 years of an instrument for a change of control event).

Non-viability requirements:

  • Guidance on triggering non-viability: APRA is contemplating providing broad guidance on the factors that would lead APRA to conclude that an insurer has become ‘non-viable’.
  • Dilution floor: Conversions will remain subject to a 20% dilution floor.

Level 2 insurance groups - application of non-viability at the group level – APRA has confirmed that the relevant jurisdiction in determining a trigger event is the jurisdiction in which the capital instrument is recognised for regulatory purposes.

Other changes

Insurance Concentration Risk Charge – reinstatement costs in the horizontal requirement need only be to the level required for the requisite number of events.

Treatment of unrated assets – the counterparty grade for non-publicly rated assets that are not rated by any other method is grade 5. This treatment is applied irrespective of whether or not the asset is secured.

Next Steps

General insurers ought to review the Response to Submissions along with the final versions of all prudential standards in order to familiarise themselves with the new prudential standards regime that will be effective from 1 January 2013.

In addition to this, APRA is currently seeking feedback from general insurers on its latest industry consultation on two draft prudential practice guides involving ICAAP, supervisory review and insurance concentration risk and a draft information paper involving the calculation of the Asset Risk Charge with respect to the Life and General Insurance Capital Project (LAGIC). Submissions close on 21 December.